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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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(Mark One)
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For The Fiscal Year Ended December 31, 2001
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 0-25051
PROSPERITY BANCSHARES, INC. /SM/
(Exact name of registrant as specified in its charter)
TEXAS 74-2331986
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4295 SAN FELIPE 77027
HOUSTON, TEXAS (Zip Code)
(Address of principal executive offices)
Registrant's Telephone Number, Including Area Code: (713) 693-9300
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value
$1.00 per share
---------------
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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of the Form 10-K or any amendment of this
Form 10-K. [ ]
As of February 13, 2002, the number of outstanding shares of Common Stock
was 8,110,035. As of such date, the aggregate market value of the shares of
Common Stock held by non-affiliates, based on the closing price of the Common
Stock on the Nasdaq National Market System on such date, was approximately
$154,769,165.
Documents Incorporated by Reference:
Portions of the Company's Proxy Statement relating to the 2002 Annual
Meeting of Shareholders, which will be filed within 120 days
after December 31, 2001, are incorporated by reference into Part
III, Items 10-13 of this Form 10-K.
PROSPERITY BANCSHARES, INC./sm/
2001 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I
Item 1. Business................................................................................... 1
General................................................................................... 1
Recent Mergers and Acquisitions........................................................... 2
Officers and Associates................................................................... 2
Bank Activities........................................................................... 3
Business Strategies....................................................................... 3
Competition............................................................................... 4
Supervision and Regulation................................................................ 4
Item 2. Properties.................................................................................. 11
Item 3. Legal Proceedings........................................................................... 13
Item 4. Submission of Matters to a Vote of Security Holders......................................... 13
PART II
Item 5. Market for Registrant's Common Equity and Related Shareholder Matters....................... 13
Item 6. Selected Consolidated Financial Data........................................................ 14
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations....... 16
Overview.................................................................................. 16
Results of Operations..................................................................... 16
Financial Condition....................................................................... 21
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.................................. 34
Item 8. Financial Statements and Supplementary Data................................................. 36
Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure........ 36
PART III
Item 10. Directors and Executive Officers of the Registrant.......................................... 36
Item 11. Executive Compensation...................................................................... 36
Item 12. Security Ownership of Certain Beneficial Owners and Management.............................. 36
Item 13. Certain Relationships and Related Transactions.............................................. 36
Part IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K............................. 36
PART I
Special Cautionary Notice Regarding Forward-Looking Statements
Statements and financial discussion and analysis contained in the Annual
Report on Form 10-K 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. The Company's actual results may differ materially from what
is expressed in any forward-looking statement. The important factors that could
cause actual results to differ materially from the forward-looking statements
include, without limitation:
. 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 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;
. 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 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;
. 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; and
. changes in statutes and government regulations or their
interpretations applicable to bank holding companies and the Company's
present and future banking and other subsidiaries, including changes
in tax requirements and tax rates.
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, unless the securities laws require the Company to do
so.
ITEM 1. BUSINESS
General
The Company was formed in 1983 as a vehicle to acquire the former
Allied Bank in Edna, Texas which was chartered in 1949. The Company is a
registered financial holding company that derives substantially all of its
revenues and income from the operation of Prosperity Bank/SM/ (the "Bank"). The
Bank, which changed its name from First Prosperity Bank/SM/ on May 1, 2001, is a
full-service bank that provides a broad line of financial products and services
to small and medium-sized businesses and consumers through 29 full-service
banking locations. The Company's headquarters are located at 4295 San Felipe in
Houston, Texas and its telephone number is (713) 693-9300.
1
The Company's market consists of the communities served by its
eighteen locations in the Greater Houston CMSA and an additional eleven
locations in eight contiguous counties located to the south and southwest of
Houston. The Greater Houston CMSA includes Brazoria, Fort Bend, Galveston,
Harris, Liberty, and Montgomery counties. Texas Highway 59 (scheduled to become
Interstate Highway 69), which serves as the primary "NAFTA Highway" linking the
interior United States and Mexico, runs directly through the center of the
Company's market area. The increased traffic along this NAFTA Highway has
enhanced economic activity in the Company's market area and created
opportunities for growth. The diverse nature of the economies in each local
market served by the Company provides the Company with a varied customer base
and allows the Company to spread its lending risk throughout a number of
different industries including farming, ranching, petrochemicals, manufacturing,
tourism, recreation and professional service firms and their principals. The
Company's market areas outside of Houston are dominated by either small
community banks or branches of large regional banks. Management believes that
the Company, as one of the few mid-sized financial institutions that combines
responsive community banking with the sophistication of a regional bank holding
company, has a competitive advantage in its market area and excellent growth
opportunities through acquisitions, new branch locations and additional business
development.
Operating under a community banking philosophy, the Company seeks to
develop broad customer relationships based on service and convenience while
maintaining its conservative approach to lending and strong asset quality. The
Company has grown through a combination of internal growth, the acquisition of
community banks, branches of banks and the opening of new banking centers.
Utilizing a low cost of funds and employing stringent cost controls, the Company
has been profitable in every full year of its existence, including the period of
adverse economic conditions in Texas in the late 1980s. From 1988 to 1992, as a
sound and profitable institution, the Company took advantage of this economic
downturn and acquired the deposits and certain assets of failed banks in West
Columbia, El Campo and Cuero, Texas and two failed banks in Houston, which
diversified the Company's franchise and increased its core deposits. The Company
opened a full-service Banking Center in Victoria, Texas in 1993 and the
following year established a Banking Center in Bay City, Texas. The Company
expanded its Bay City presence in 1996 with the acquisition of an additional
branch location from Norwest Bank Texas, and in 1997, the Company acquired the
Angleton, Texas branch of Wells Fargo Bank. In 1998, the Company enhanced its
West Columbia Banking Center with the purchase of a commercial bank branch
located in West Columbia and acquired Union State Bank in East Bernard, Texas.
Recent Mergers and Acquisitions
In 1999, the Company acquired South Texas Bancshares, Inc. and its
wholly owned subsidiary, The Commercial National Bank of Beeville, with
locations in Beeville, Mathis and Goliad, Texas (the "South Texas Acquisition").
The Company acquired trust powers in connection with the South Texas
Acquisition. Additionally, effective September 15, 2000, the Company purchased
certain assets and assumed certain liabilities of five branches of Compass Bank
located in El Campo, Hitchcock, Needville, Palacios and Sweeny, Texas (the
"Compass Acquisition"). With the exception of the El Campo location, the former
Compass branches are being operated as full-service Banking Centers. The El
Campo location has been combined with the Company's El Campo Banking Center.
On February 23, 2001, the Company completed a merger with Commercial
Bancshares, Inc., a Texas corporation ("Commercial"), whereby Commercial was
merged with and into the Company (the "Commercial Merger"). In connection with
the Commercial Merger, Heritage Bank, Commercial's wholly owned subsidiary, was
merged with and into the Bank. Similar to its previous acquisitions, this merger
has enabled the Company to achieve certain economies of scale and savings from
the operation of the newly acquired banking offices as additional Banking
Centers. Heritage Bank had 12 full-service banking locations in the Houston
metropolitan area and in three adjacent counties, including Houston-Bellaire,
Cleveland, Cypress, Fairfield, Houston-Downtown, Houston-Medical Center,
Houston-River Oaks, Houston-Tanglewood, Houston-Waugh Drive, Liberty, Magnolia
and Wharton. The transaction was accounted for as a pooling of interests and
therefore the historical financial data of the Company has been restated to
include the accounts and operations of Commercial for all periods prior to the
effective time of the Commercial Merger.
On February 22, 2002, the Company entered into a definitive agreement
with American Bancorp of Oklahoma, Inc. to acquire one of its subsidiary banks,
Texas Guaranty Bank, N.A., headquartered in Houston, Texas for $11.8 million in
cash. Following the acquisition, Texas Guaranty Bank will be merged into
Prosperity Bank. The Company will not complete the acquisition unless customary
closing conditions are satisfied or waived, including receipt of the necessary
regulatory approvals and consents from applicable regulatory agencies including
the Federal Reserve Board, the Texas Banking Department and the Federal Deposit
Insurance Corporation. Texas Guaranty Bank operates three banking offices in the
western portion of the greater Houston metropolitan area. As of December 31,
2001, Texas Guaranty Bank had total assets of $82.2 million, total loans of
$59.7 million, total deposits of $62.9 million and shareholders' equity of $9.4
million.
Officers and Associates
The Company's directors and officers are important to the Company's
success and play a key role in the Company's business development efforts by
actively participating in a number of civic and public service activities in the
communities served by the
2
Company, such as the Rotary Club, Lion's Club, Pilot Club, United Way and
Chamber of Commerce. In addition, the Company's Banking Centers in Bay City,
Clear Lake, Cleveland, East Bernard, Medical Center, Post Oak, River Oaks and
Wharton maintain Community Development Boards, whose function is to solicit new
business, develop customer relations and provide valuable community knowledge to
their respective Banking Center Presidents.
The Company has invested heavily in its officers and associates by
recruiting talented officers in its market areas and providing them with
economic incentive in the form of stock options and bonuses based on
cross-selling performance. The senior management team has substantial experience
in both the Houston markets and the surrounding communities in which the Company
has a presence. Each Banking Center location is administered by a local
President or Manager with knowledge of the community and lending expertise in
the specific industries found in the community. The Company entrusts its Banking
Center Presidents and Managers with authority and flexibility within general
parameters with respect to product pricing and decision making in order to avoid
the bureaucratic structure of larger banks. The Company operates each Banking
Center as a separate profit center, maintaining separate data with respect to
each Banking Center's net interest income, efficiency ratio, deposit growth,
loan growth and overall profitability. Banking Center Presidents and Managers
are accountable for performance in these areas and compensated accordingly. Each
Banking Center has its own local telephone number, which enables a customer to
be served by a local banker.
As of December 31, 2001, the Company and the Bank had 312 full-time
equivalent associates, 123 of whom were officers of the Bank. The Company
provides medical and hospitalization insurance to its full-time associates. The
Company considers its relations with associates to be excellent. Neither the
Company nor the Bank is a party to any collective bargaining agreement.
Bank Activities
The Company offers a variety of traditional loan and deposit products
to its customers, which consist primarily of consumers and small and
medium-sized businesses. The Company tailors its products to the specific needs
of customers in a given market. At December 31, 2001, the Company maintained
approximately 74,000 separate deposit accounts and 9,500 separate loan accounts
and approximately 16.8% of the Company's total deposits were noninterest-bearing
demand deposits. For the period ended December 31, 2001, the Company's average
cost of funds was 3.32%.
The Company has been an active mortgage lender, with 1-4 family
residential and commercial mortgage loans comprising 59.8% of the Company's
total loans as of December 31, 2001. The Company also offers loans for
automobiles and other consumer durables, home equity loans, debit cards,
personal computer banking and other cash management services and telebanking. By
offering certificates of deposit, NOW accounts, savings accounts and overdraft
protection at competitive rates, the Company gives its depositors a full range
of traditional deposit products. The Company has successfully introduced the
Royal account, which for a monthly fee provides consumers with a package of
benefits including unlimited free checking, personalized checks, credit card
protection, free travelers checks, cashier's checks, money orders and certain
travel discounts.
The businesses targeted by the Company in its lending efforts are
primarily those that require loans in the $100,000 to $4.0 million range. The
Company offers these businesses a broad array of loan products including term
loans, lines of credit and loans for working capital, business expansion and the
purchase of equipment and machinery, interim construction loans for builders and
owner-occupied commercial real estate loans. For its business customers, the
Company has developed a specialized checking product called Small Business
Checking which provides discounted fees for checking and normal account
analysis.
Business Strategies
The Company's main objective is to increase deposits and loans through
additional expansion opportunities while maintaining efficiency, individualized
customer service and maximizing profitability. To achieve this objective, the
Company has employed the following strategic goals:
Continue Community Banking Emphasis. The Company intends to continue
operating as a community banking organization focused on meeting the specific
needs of consumers and small and medium-sized businesses in its market areas.
The Company will continue to provide a high degree of responsiveness combined
with a wide variety of banking products and services. The Company staffs its
Banking Centers with experienced bankers with lending expertise in the specific
industries found in the community, giving them authority to make certain pricing
and credit decisions, thereby attempting to avoid the bureaucratic structure of
larger banks.
Increase Loan Volume and Diversify Loan Portfolio. Historically, the
Company has elected to sacrifice some earnings for the historically lower credit
losses associated with home mortgage loans. While maintaining its conservative
approach to lending, the Company plans to emphasize both new and existing loan
products, focusing on growing its home equity, commercial mortgage and
3
commercial loan portfolios. The Company successfully introduced home equity
lending in 1998. The balance of home equity loans was $20.5 million at December
31, 2001 and $16.8 million at December 31, 2000. During the three-year period
from December 31, 1999 to December 31, 2001, the Company grew its commercial and
industrial loans from $42.0 million to $47.0 million, or 11.9% and its
commercial mortgages from $64.7 million to $78.4 million, or 21.2%. In addition,
the Company targets professional service firms such as legal and medical
practices for both loans secured by owner-occupied premises and personal loans
to their principals.
Continue Strict Focus on Efficiency. The Company plans to maintain its
stringent cost control practices and policies. The Company has invested
significantly in the infrastructure required to centralize many of its critical
operations, such as data processing and loan application processing. For its
Banking Centers, which the Company operates as independent profit centers, the
Company supplies complete support in the areas of loan review, internal audit,
compliance and training. The Company maintains a Products Committee which
provides support in the areas of product development, marketing and pricing.
Management believes that this centralized infrastructure can accommodate
substantial additional growth while enabling the Company to minimize operational
costs through certain economies of scale.
Enhance Cross-Selling. The Company recognizes that its customer base
provides significant opportunities to cross-sell various products and it seeks
to develop broader customer relationships by identifying cross-selling
opportunities. The Company uses incentives and friendly competition to encourage
cross-selling efforts and increase cross-selling results. Officers and
associates have access to each customer's existing and related account
relationships and are better able to inform customers of additional products
when customers visit or call the various Banking Centers or use their drive-in
facilities. In addition, the Company includes product information in monthly
statements and other mailings.
Expand Market Share Through Internal Growth and a Disciplined
Acquisition Strategy. The Company intends to continue seeking opportunities,
both inside and outside its existing markets, to expand either by acquiring
existing banks or branches of banks or by establishing new branches. All of the
Company's acquisitions have been accretive to earnings immediately and have
supplied the Company with relatively low-cost deposits which have been used to
fund the Company's lending activities. Factors used by the Company to evaluate
expansion opportunities include the similarity in management and operating
philosophies, whether the acquisition will be accretive to earnings and enhance
shareholder value, the ability to achieve economies of scale to improve the
efficiency ratio and the opportunity to enhance the Company's image and market
presence.
Maintain Strong Asset Quality. The Company intends to maintain the
strong asset quality that has been representative of its historical loan
portfolio. As the Company diversifies and increases its lending activities, it
may face higher risks of nonpayment and increased risks in the event of economic
downturns. The Company intends, however, to continue to employ the strict
underwriting guidelines and comprehensive loan review process that have
contributed to its low incidence of nonperforming assets and its minimal
charge-offs.
Competition
The banking business is highly competitive, and the profitability of
the Company depends principally on its ability to compete in its market areas.
The Company competes with other commercial banks, savings banks, savings and
loan associations, credit unions, finance companies, mutual funds, insurance
companies, brokerage and investment banking firms, asset-based nonbank lenders
and certain other nonfinancial entities, including retail stores which may
maintain their own credit programs and certain governmental organizations which
may offer more favorable financing than the Company. The Company has been able
to compete effectively with other financial institutions by emphasizing customer
service, technology and responsive decision-making with respect to loans; by
establishing long-term customer relationships and building customer loyalty; and
by providing products and services designed to address the specific needs of its
customers. Under the Gramm-Leach-Bliley Act, securities firms and insurance
companies that elect to become financial holding companies may acquire banks and
other financial institutions. The Gramm-Leach-Bliley Act may significantly
change the competitive environment in which the Company and its subsidiaries
conduct business.
Supervision and Regulation
The supervision and regulation of bank holding companies and their
subsidiaries is intended primarily for the protection of depositors, the deposit
insurance funds of the Federal Deposit Insurance Corporation ("FDIC") and the
banking system as a whole, and not for the protection of the bank holding
company shareholders or creditors. The banking agencies have broad enforcement
power over bank holding companies and banks including the power to impose
substantial fines and other penalties for violations of laws and regulations.
4
The following description summarizes some of the laws to which the
Company and the Bank are subject. References herein to applicable statutes and
regulations are brief summaries thereof, do not purport to be complete, and are
qualified in their entirety by reference to such statutes and regulations. The
Company believes that it is in compliance in all material respects with these
laws and regulations.
The Company
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The Company is a financial holding company registered under the
Gramm-Leach-Bliley Act and a bank holding company registered under the Bank
Holding Company Act of 1956, as amended ("BHCA"). Accordingly, the Company is
subject to supervision, regulation and examination by the Board of Governors of
the Federal Reserve System ("Federal Reserve Board"). The Gramm-Leach-Bliley
Act, the BHCA and other federal laws subject financial and bank holding
companies to particular restrictions on the types of activities in which they
may engage, and to a range of supervisory requirements and activities, including
regulatory enforcement actions for violations of laws and regulations.
Regulatory Restrictions on Dividends; Source of Strength. It is the
policy of the Federal Reserve Board that bank holding companies should pay cash
dividends on common stock only out of income available over the past year and
only if prospective earnings retention is consistent with the organization's
expected future needs and financial condition. The policy provides that bank
holding companies should not maintain a level of cash dividends that undermines
the bank holding company's ability to serve as a source of strength to its
banking subsidiaries.
Under Federal Reserve Board policy, a bank holding company is expected
to act as a source of financial strength to each of its banking subsidiaries and
commit resources to their support. Such support may be required at times when,
absent this Federal Reserve Board policy, a holding company may not be inclined
to provide it. As discussed below, a bank holding company in certain
circumstances could be required to guarantee the capital plan of an
undercapitalized banking subsidiary.
In the event of a bank holding company's bankruptcy under Chapter 11
of the U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is
required to cure immediately any deficit under any commitment by the debtor
holding company to any of the federal banking agencies to maintain the capital
of an insured depository institution. Any claim for breach of such obligation
will generally have priority over most other unsecured claims.
Scope of Permissable Activities. Under the BHCA, bank holding
companies generally may not acquire a direct or indirect interest in or control
of more than 5% of the voting shares of any company that is not a bank or bank
holding company or from engaging in activities other than those of banking,
managing or controlling banks or furnishing services to or performing services
for its subsidiaries, except that it may engage in, directly or indirectly,
certain activities that the Federal Reserve Board determined to be closely
related to banking or managing and controlling banks as to be a proper incident
thereto. In approving acquisitions or the addition of activities, the Federal
Reserve considers whether the acquisition or the additional activities can
reasonably be expected to produce benefits to the public, such as greater
convenience, increased competition, or gains in efficiency, that outweigh such
possible adverse effects as undue concentration of resources decreased or unfair
competition, conflicts of interest or unsound banking practices.
However, the Gramm-Leach-Bliley Act, effective March 11, 2000,
eliminated the barriers to affiliations among banks, securities firms, insurance
companies and other financial service providers and permits bank holding
companies to become financial holding companies and thereby affiliate with
securities firms and insurance companies and engage in other activities that are
financial in nature. The Gramm-Leach-Bliley Act defines "financial in nature" to
include securities underwriting, dealing and market making; sponsoring mutual
funds and investment companies; insurance underwriting and agency; merchant
banking activities; and activities that the Federal Reserve Board has determined
to be closely related to banking. No regulatory approval will be required for a
financial holding company to acquire a company, other than a bank or savings
association, engaged in activities that are financial in nature or incidental to
activities that are financial in nature, as determined by the Federal Reserve
Board.
Under the Gramm-Leach-Bliley Act, a bank holding company may become a
financial holding company by filing a declaration with the Federal Reserve Board
if each of its subsidiary banks is well capitalized under the FDICIA prompt
corrective action provisions, is well managed, and has at least a satisfactory
rating under the Community Reinvestment Act of 1977 ("CRA"). The Company
received approval to become a financial holding company on April 18, 2000.
While the Federal Reserve Board will serve as the "umbrella" regulator
for financial holding companies and has the power to examine banking
organizations engaged in new activities, regulation and supervision of
activities which are financial in nature or determined to be incidental to such
financial activities will be handled along functional lines. Accordingly,
activities of subsidiaries of a financial holding company will be regulated by
the agency or authorities with the most experience regulating that activity as
it is conducted in a financial holding company.
5
Safe and Sound Banking Practices. Bank holding companies are not
permitted to engage in unsafe and unsound banking practices. The Federal Reserve
Board's Regulation Y, for example, generally requires a holding company to give
the Federal Reserve Board prior notice of any redemption or repurchase of its
own equity securities, if the consideration to be paid, together with the
consideration paid for any repurchases or redemptions in the preceding year, is
equal to 10% or more of the company's consolidated net worth. The Federal
Reserve Board may oppose the transaction if it believes that the transaction
would constitute an unsafe or unsound practice or would violate any law or
regulation. Depending upon the circumstances, the Federal Reserve Board could
take the position that paying a dividend would constitute an unsafe or unsound
banking practice.
The Federal Reserve Board has broad authority to prohibit activities
of bank holding companies and their nonbanking subsidiaries which represent
unsafe and unsound banking practices or which constitute violations of laws or
regulations, and can assess civil money penalties for certain activities
conducted on a knowing and reckless basis, if those activities caused a
substantial loss to a depository institution. The penalties can be as high as
$1.0 million for each day the activity continues.
Anti-Tying Restrictions. Bank holding companies and their affiliates
are prohibited from tying the provision of certain services, such as extensions
of credit, to other services offered by a holding company or its affiliates.
Capital Adequacy Requirements. The Federal Reserve Board has adopted a
system using risk-based capital guidelines to evaluate the capital adequacy of
bank holding companies. Under the guidelines, specific categories of assets are
assigned different risk weights, based generally on the perceived credit risk of
the asset. These risk weights are multiplied by corresponding asset balances to
determine a "risk-weighted" asset base. The guidelines require a minimum total
risk-based capital ratio of 8.0% (of which at least 4.0% is required to consist
of Tier 1 capital elements). Total capital is the sum of Tier 1 and Tier 2
capital. As of December 31, 2001, the Company's ratio of Tier 1 capital to total
risk-weighted assets was 18.34% and its ratio of total capital to total
risk-weighted assets was 19.52%. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Financial Condition - Capital
Resources."
In addition to the risk-based capital guidelines, the Federal Reserve
Board uses a leverage ratio as an additional tool to evaluate the capital
adequacy of bank holding companies. The leverage ratio is a company's Tier 1
capital divided by its average total consolidated assets. Certain highly rated
bank holding companies may maintain a minimum leverage ratio of 3.0%, but other
bank holding companies are be required to maintain a leverage ratio of 4.0%. As
of December 31, 2001, the Company's leverage ratio was 7.57%.
The federal banking agencies' risk-based and leverage ratios are
minimum supervisory ratios generally applicable to banking organizations that
meet certain specified criteria, assuming that they have the highest regulatory
rating. Banking organizations not meeting these criteria are expected to operate
with capital positions well above the minimum ratios. The federal bank
regulatory agencies may set capital requirements for a particular banking
organization that are higher than the minimum ratios when circumstances warrant.
Federal Reserve Board guidelines also provide that banking organizations
experiencing internal growth or making acquisitions will be expected to maintain
strong capital positions substantially above the minimum supervisory levels,
without significant reliance on intangible assets.
Imposition of Liability for Undercapitalized Subsidiaries. Bank
regulators are required to take "prompt corrective action" to resolve problems
associated with insured depository institutions whose capital declines below
certain levels. In the event an institution becomes "undercapitalized," it must
submit a capital restoration plan. The capital restoration plan will not be
accepted by the regulators unless each company having control of the
undercapitalized institution guarantees the subsidiary's compliance with the
capital restoration plan up to a certain specified amount. Any such guarantee
from a depository institution's holding company is entitled to a priority of
payment in bankruptcy.
The aggregate liability of the holding company of an undercapitalized
bank is limited to the lesser of 5% of the institution's assets at the time it
became undercapitalized or the amount necessary to cause the institution to be
"adequately capitalized." The bank regulators have greater power in situations
where an institution becomes "significantly" or "critically" undercapitalized or
fails to submit a capital restoration plan. For example, a bank holding company
controlling such an institution can be required to obtain prior Federal Reserve
Board approval of proposed dividends, or might be required to consent to a
consolidation or to divest the troubled institution or other affiliates.
Acquisitions by Bank Holding Companies. The BHCA requires every bank
holding company to obtain the prior approval of the Federal Reserve Board before
it may acquire all or substantially all of the assets of any bank, or ownership
or control of any voting shares of any bank, if after such acquisition it would
own or control, directly or indirectly, more than 5% of the voting shares of
such bank. In approving bank acquisitions by bank holding companies, the Federal
Reserve Board is required to consider the financial and managerial resources and
future prospects of the bank holding company and the banks concerned, the
convenience and needs of the communities to be served, and various competitive
factors.
6
Control Acquisitions. The Change in Bank Control Act prohibits a
person or group of persons from acquiring "control" of a bank holding company
unless the Federal Reserve Board has been notified and has not objected to the
transaction. Under a rebuttable presumption established by the Federal Reserve
Board, the acquisition of 10% or more of a class of voting stock of a bank
holding company with a class of securities registered under Section 12 of the
Exchange Act, such as the Company, would, under the circumstances set forth in
the presumption, constitute acquisition of control of the Company.
In addition, any entity is required to obtain the approval of the
Federal Reserve Board under the BHCA before acquiring 25% (5% in the case of an
acquirer that is a bank holding company) or more of the outstanding Common Stock
of the Company, or otherwise obtaining control or a "controlling influence" over
the Company.
The Bank
- --------
The Bank is a Texas-chartered banking association, the deposits of
which are insured by the Bank Insurance Fund ("BIF"). The Bank is not a member
of the Federal Reserve System; therefore, the Bank is subject to supervision and
regulation by the FDIC and the Texas Banking Department. Such supervision and
regulation subject the Bank to special restrictions, requirements, potential
enforcement actions and periodic examination by the FDIC and the Texas Banking
Department. Because the Federal Reserve Board regulates the bank holding company
parent of the Bank, the Federal Reserve Board also has supervisory authority
which directly affects the Bank.
Equivalence to National Bank Powers. The Texas Constitution, as
amended in 1986, provides that a Texas-chartered bank has the same rights and
privileges that are or may be granted to national banks domiciled in Texas. To
the extent that the Texas laws and regulations may have allowed state-chartered
banks to engage in a broader range of activities than national banks, the
Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") has
operated to limit this authority. FDICIA provides that no state bank or
subsidiary thereof may engage as principal in any activity not permitted for
national banks, unless the institution complies with applicable capital
requirements and the FDIC determines that the activity poses no significant risk
to the insurance fund. In general, statutory restrictions on the activities of
banks are aimed at protecting the safety and soundness of depository
institutions.
Financial Modernization. Under the Gramm-Leach-Bliley Act, a national
bank may establish a financial subsidiary and engage, subject to limitations on
investment, in activities that are financial in nature, other than insurance
underwriting as principal, insurance company portfolio investment, real estate
development, real estate investment and annuity issuance. To do so, a bank must
be well capitalized, well managed and have a CRA rating of satisfactory or
better. Subsidiary banks of a financial holding company or national banks with
financial subsidiaries must remain well capitalized and well managed in order to
continue to engage in activities that are financial in nature without regulatory
actions or restrictions, which could include divestiture of the financial in
nature subsidiary or subsidiaries. In addition, a financial holding company or a
bank may not acquire a company that is engaged in activities that are financial
in nature unless each of the subsidiary banks of the financial holding company
or the bank has a CRA rating of satisfactory of better.
Although the powers of state chartered banks are not specifically
addressed in the Gramm-Leach-Bliley Act, Texas-chartered banks such as the Bank,
will have the same if not greater powers as national banks through the parity
provision contained in the Texas Constitution.
Branching. Texas law provides that a Texas-chartered bank can
establish a branch anywhere in Texas provided that the branch is approved in
advance by the Texas Banking Department. The branch must also be approved by the
FDIC, which considers a number of factors, including financial history, capital
adequacy, earnings prospects, character of management, needs of the community
and consistency with corporate powers.
Restrictions on Transactions with Affiliates and Insiders.
Transactions between the Bank and its nonbanking subsidiaries, including the
Company, are subject to Section 23A of the Federal Reserve Act. In general,
Section 23A imposes limits on the amount of such transactions, and also requires
certain levels of collateral for loans to affiliated parties. It also limits the
amount of advances to third parties which are collateralized by the securities
or obligations of the Company or its subsidiaries.
Affiliate transactions are also subject to Section 23B of the Federal
Reserve Act which generally requires that certain transactions between the Bank
and its affiliates be on terms substantially the same, or at least as favorable
to the Bank, as those prevailing at the time for comparable transactions with or
involving other nonaffiliated persons.
7
The restrictions on loans to directors, executive officers, principal
shareholders and their related interests (collectively referred to herein as
"insiders") contained in the Federal Reserve Act and Regulation O apply to all
insured institutions and their subsidiaries and holding companies. These
restrictions include limits on loans to one borrower and conditions that must be
met before such a loan can be made. There is also an aggregate limitation on all
loans to insiders and their related interests. These loans cannot exceed the
institution's total unimpaired capital and surplus, and the FDIC may determine
that a lesser amount is appropriate. Insiders are subject to enforcement actions
for knowingly accepting loans in violation of applicable restrictions.
Restrictions on Distribution of Subsidiary Bank Dividends and Assets.
Dividends paid by the Bank have provided a substantial part of the Company's
operating funds and for the foreseeable future it is anticipated that dividends
paid by the Bank to the Company will continue to be the Company's principal
source of operating funds. Capital adequacy requirements serve to limit the
amount of dividends that may be paid by the Bank. Under federal law, the Bank
cannot pay a dividend if, after paying the dividend, the Bank will be
"undercapitalized." The FDIC may declare a dividend payment to be unsafe and
unsound even though the Bank would continue to meet its capital requirements
after the dividend. Because the Company is a legal entity separate and distinct
from its subsidiaries, its right to participate in the distribution of assets of
any subsidiary upon the subsidiary's liquidation or reorganization will be
subject to the prior claims of the subsidiary's creditors. In the event of a
liquidation or other resolution of an insured depository institution, the claims
of depositors and other general or subordinated creditors are entitled to a
priority of payment over the claims of holders of any obligation of the
institution to its shareholders, including any depository institution holding
company (such as the Company) or any shareholder or creditor thereof.
Examinations. The FDIC periodically examines and evaluates insured
banks. Based on such an evaluation, the FDIC may revalue the assets of the
institution and require that it establish specific reserves to compensate for
the difference between the FDIC-determined value and the book value of such
assets. The Texas Banking Department also conducts examinations of state banks
but may accept the results of a federal examination in lieu of conducting an
independent examination.
Audit Reports. Insured institutions with total assets of $500 million
or more must submit annual audit reports prepared by independent auditors to
federal and state regulators. In some instances, the audit report of the
institution's holding company can be used to satisfy this requirement. Auditors
must receive examination reports, supervisory agreements and reports of
enforcement actions. In addition, financial statements prepared in accordance
with generally accepted accounting principles, management's certifications
concerning responsibility for the financial statements, internal controls and
compliance with legal requirements designated by the FDIC, and an attestation by
the auditor regarding the statements of management relating to the internal
controls must be submitted. For institutions with total assets of more than $3
billion, independent auditors may be required to review quarterly financial
statements. FDICIA requires that independent audit committees be formed,
consisting of outside directors only. The committees of such institutions must
include members with experience in banking or financial management, must have
access to outside counsel, and must not include representatives of large
customers.
Capital Adequacy Requirements. The FDIC has adopted regulations
establishing minimum requirements for the capital adequacy of insured
institutions. The FDIC may establish higher minimum requirements if, for
example, a bank has previously received special attention or has a high
susceptibility to interest rate risk.
The FDIC's risk-based capital guidelines generally require state banks
to have a minimum ratio of Tier 1 capital to total risk-weighted assets of 4.0%
and a ratio of total capital to total risk-weighted assets of 8.0%. The capital
categories have the same definitions for the Bank as for the Company. As of
December 31, 2001, the Bank's ratio of Tier 1 capital to total risk-weighted
assets was 15.72% and its ratio of total capital to total risk-weighted assets
was 16.90%. See "Management's Discussion and Analysis of Financial Condition and
Result of Operation of the Company - Financial Condition - Capital Resources."
The FDIC's leverage guidelines require state banks to maintain Tier 1
capital of no less than 4.0% of average total assets, except in the case of
certain highly rated banks for which the requirement is 3.0% of average total
assets. The Texas Banking Department has issued a policy which generally
requires state chartered banks to maintain a leverage ratio (defined in
accordance with federal capital guidelines) of 6.0% . As of December 31, 2001,
the Bank's ratio of Tier 1 capital to average total assets (leverage ratio) was
6.50%. See "Management's Discussion and Analysis of Financial Condition and
Result of Operation of the Company - Financial Condition - Capital Resources."
Corrective Measures for Capital Deficiencies. The federal banking
regulators are required to take "prompt corrective action" with respect to
capital-deficient institutions. Agency regulations define, for each capital
category, the levels at which institutions are "well capitalized," "adequately
capitalized," "under capitalized," "significantly under capitalized" and
"critically under capitalized." A "well capitalized" bank has a total risk-based
capital ratio of 10.0% or higher; a Tier 1 risk-based capital ratio of 6.0% or
higher; a leverage ratio of 5.0% or higher; and is not subject to any written
agreement, order or directive requiring it to maintain a specific
8
capital level for any capital measure. An "adequately capitalized" bank has a
total risk-based capital ratio of 8.0% or higher; a Tier 1 risk-based capital
ratio of 4.0% or higher; a leverage ratio of 4.0% or higher (3.0% or higher if
the bank was rated a composite 1 in its most recent examination report and is
not experiencing significant growth); and does not meet the criteria for a well
capitalized bank. A bank is "under capitalized" if it fails to meet any one of
the ratios required to be adequately capitalized. The Bank is classified as
"well capitalized" for purposes of the FDIC's prompt corrective action
regulations.
In addition to requiring undercapitalized institutions to submit a
capital restoration plan, agency regulations contain broad restrictions on
certain activities of undercapitalized institutions including asset growth,
acquisitions, branch establishment and expansion into new lines of business.
With certain exceptions, an insured depository institution is prohibited from
making capital distributions, including dividends, and is prohibited from paying
management fees to control persons if the institution would be undercapitalized
after any such distribution or payment.
As an institution's capital decreases, the FDIC's enforcement powers
become more severe. A significantly undercapitalized institution is subject to
mandated capital raising activities, restrictions on interest rates paid and
transactions with affiliates, removal of management and other restrictions. The
FDIC has only very limited discretion in dealing with a critically
undercapitalized institution and is virtually required to appoint a receiver or
conservator.
Banks with risk-based capital and leverage ratios below the required
minimums may also be subject to certain administrative actions, including the
termination of deposit insurance upon notice and hearing, or a temporary
suspension of insurance without a hearing in the event the institution has no
tangible capital.
Deposit Insurance Assessments. The Bank must pay assessments to the
FDIC for federal deposit insurance protection. The FDIC has adopted a risk-based
assessment system as required by FDICIA. Under this system, FDIC-insured
depository institutions pay insurance premiums at rates based on their risk
classification. Institutions assigned to higher risk classifications (that is,
institutions that pose a greater risk of loss to their respective deposit
insurance funds) pay assessments at higher rates than institutions that pose a
lower risk. An institution's risk classification is assigned based on its
capital levels and the level of supervisory concern the institution poses to the
regulators. In addition, the FDIC can impose special assessments in certain
instances. The current range of BIF assessments is between 0% and 0.27% of
deposits.
The FDIC established a process for raising or lowering all rates for
insured institutions semi-annually if conditions warrant a change. Under this
system, the FDIC has the flexibility to adjust the assessment rate schedule
twice a year without seeking prior public comment, but only within a range of
five cents per $100 above or below the premium schedule adopted. Changes in the
rate schedule outside the five cent range above or below the current schedule
can be made by the FDIC only after a full rulemaking with opportunity for public
comment.
On September 30, 1996, President Clinton signed into law an act that
contained a comprehensive approach to re-capitalizing the Savings Association
Insurance Fund ("SAIF") and to assure the payment of the Financing Corporation's
("FICO") bond obligations. Under this new act, banks insured under the BIF are
required to pay a portion of the interest due on bonds that were issued by FICO
to help shore up the ailing Federal Savings and Loan Insurance Corporation in
1987. The BIF-rate was required to equal one-fifth of the SAIF rate through
year-end 1999, or until the insurance funds merged, whichever occurred first.
Thereafter, BIF and SAIF payers will be assessed pro rata for the FICO bond
obligations. With regard to the assessment for the FICO obligation, for the
fourth quarter 2001, both the BIF and SAIF rates were .0184% of deposits.
Enforcement Powers. The FDIC and the other federal banking agencies
have broad enforcement powers, including the power to terminate deposit
insurance, impose substantial fines and other civil and criminal penalties and
appoint a conservator or receiver. Failure to comply with applicable laws,
regulations and supervisory agreements could subject the Company or its banking
subsidiaries, as well as officers, directors and other institution-affiliated
parties of these organizations, to administrative sanctions and potentially
substantial civil money penalties. The appropriate federal banking agency may
appoint the FDIC as conservator or receiver for a banking institution (or the
FDIC may appoint itself, under certain circumstances) if any one or more of a
number of circumstances exist, including, without limitation, the fact that the
banking institution is undercapitalized and has no reasonable prospect of
becoming adequately capitalized; fails to become adequately capitalized when
required to do so; fails to submit a timely and acceptable capital restoration
plan; or materially fails to implement an accepted capital restoration plan. The
Texas Banking Department also has broad enforcement powers over the Bank,
including the power to impose orders, remove officers and directors, impose
fines and appoint supervisors and conservators.
9
Brokered Deposit Restrictions. Adequately capitalized institutions
cannot accept, renew or roll over brokered deposits except with a waiver from
the FDIC, and are subject to restrictions on the interest rates that can be paid
on such deposits. Undercapitalized institutions may not accept, renew, or roll
over brokered deposits.
Cross-Guarantee Provisions. The Financial Institutions Reform,
Recovery and Enforcement Act of 1989 ("FIRREA") contains a "cross-guarantee"
provision which generally makes commonly controlled insured depository
institutions liable to the FDIC for any losses incurred in connection with the
failure of a commonly controlled depository institution.
Community Reinvestment Act. The CRA and the regulations issued
thereunder are intended to encourage banks to help meet the credit needs of
their service area, including low and moderate income neighborhoods, consistent
with the safe and sound operations of the banks. These regulations also provide
for regulatory assessment of a bank's record in meeting the needs of its service
area when considering applications to establish branches, merger applications
and applications to acquire the assets and assume the liabilities of another
bank. FIRREA requires federal banking agencies to make public a rating of a
bank's performance under the CRA. In the case of a bank holding company, the CRA
performance record of the banks involved in the transaction are reviewed in
connection with the filing of an application to acquire ownership or control of
shares or assets of a bank or to merge with any other bank holding company. An
unsatisfactory record can substantially delay or block the transaction.
Consumer Laws and Regulations. In addition to the laws and regulations
discussed herein, the Bank is also subject to certain consumer laws and
regulations that are designed to protect consumers in transactions with banks.
While the list set forth herein is not exhaustive, these laws and regulations
include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds
Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity
Act, and the Fair Housing Act, among others. These laws and regulations mandate
certain disclosure requirements and regulate the manner in which financial
institutions must deal with customers when taking deposits or making loans to
such customers. The Bank must comply with the applicable provisions of these
consumer protection laws and regulations as part of their ongoing customer
relations.
Privacy. In addition to expanding the activities in which banks and
bank holding companies may engage, the Gramm-Leach-Bliley Act also imposed new
requirements on financial institutions with respect to customer privacy. The
Gramm-Leach-Bliley Act generally prohibits disclosure of customer information to
non-affiliated third parties unless the customer has been given the opportunity
to object and has not objected to such disclosure. Financial institutions are
further required to disclose their privacy policies to customers annually.
Financial institutions, however, will be required to comply with state law if it
is more protective of customer privacy than the Gramm-Leach-Bliley Act.
Instability and Regulatory Structure
- ------------------------------------
Various legislation, such as the Gramm-Leach-Bliley Act which expanded
the powers of banking institutions and bank holding companies, and proposals to
overhaul the bank regulatory system and limit the investments that a depository
institution may make with insured funds, is from time to time introduced in
Congress. Such legislation may change banking statutes and the operating
environment of the Company and its banking subsidiaries in substantial and
unpredictable ways. The Company cannot determine the ultimate effect that the
Gramm-Leach-Bliley Act will have, or the effect that any potential legislation,
if enacted, or implemented regulations with respect thereto, would have, upon
the financial condition or results of operations of the Company or its
subsidiaries.
Expanding Enforcement Authority
- -------------------------------
One of the major additional burdens imposed on the banking industry by
FDICIA is the increased ability of banking regulators to monitor the activities
of banks and their holding companies. In addition, the Federal Reserve Board and
FDIC are possessed of extensive authority to police unsafe or unsound practices
and violations of applicable laws and regulations by depository institutions and
their holding companies. For example, the FDIC may terminate the deposit
insurance of any institution which it determines has engaged in an unsafe or
unsound practice. The agencies can also assess civil money penalties, issue
cease and desist or removal orders, seek injunctions, and publicly disclose such
actions. FDICIA, FIRREA and other laws have expanded the agencies' authority in
recent years, and the agencies have not yet fully tested the limits of their
powers.
Effect on Economic Environment
- ------------------------------
The policies of regulatory authorities, including the monetary policy
of the Federal Reserve Board, have a significant effect on the operating results
of bank holding companies and their subsidiaries. Among the means available to
the Federal Reserve Board to affect the money supply are open market operations
in U.S. government securities, changes in the discount rate on member bank
borrowings, and changes in reserve requirements against member bank deposits.
These means are used in varying combinations to
10
influence overall growth and distribution of bank loans, investments and
deposits, and their use may affect interest rates charged on loans or paid for
deposits.
Federal Reserve Board monetary policies have materially affected the
operating results of commercial banks in the past and are expected to continue
to do so in the future. The nature of future monetary policies and the effect of
such policies on the business and earnings of the Company and its subsidiaries
cannot be predicted.
ITEM 2. PROPERTIES
The Company conducts business at 29 full-service banking locations.
The Company's headquarters are located at 4295 San Felipe, Houston, Texas. The
Company owns all of the buildings in which its Banking Centers are located other
than the Bellaire, Cypress, Downtown, Fairfield, Medical Center, Needville, Post
Oak, River Oaks, and Waugh Banking Centers. The lease terms of these Banking
Centers expire in October 2007, March 2002, October 2002, December 2002,
December 2004, December 2002, July 2002, December 2004, and February 2011,
respectively. The expiration dates do not include the renewal option periods
which may be available. The following table sets forth specific information on
each such location:
Location Address Deposits at December 31, 2001
-------- ------- -----------------------------
(Dollars in thousands)
Angleton 116 South Velasco $ 31,385
Angleton, TX 77516
Bay City 1600 Seventh St. $ 48,568
Bay City, TX 77404
Beeville (1) 100 South Washington $ 74,764
Beeville, TX 78102
Bellaire 6800 West Loop South Suite 100 $ 26,680
Bellaire, TX 77401
Clear Lake 100 West Medical Center Blvd. $ 57,706
Webster, TX 77598
Cleveland 104 West Crockett $ 76,272
Cleveland, TX 77237
Cuero 106 North Esplanade $ 25,500
Cuero, TX 77954
Cypress (2) 26130 Hempstead Highway $ 33,222
Cypress, TX 77429
Downtown 777 Walker, Suite L140 $ 7,847
Houston, TX 77002
East Bernard 700 Church St. $ 61,921
East Bernard, TX 77435
Edna 102 North Wells $ 46,438
Edna, TX 77962
El Campo 1301 North Mechanic $ 80,750
El Campo, TX 77437
Fairfield 15050 Fairfield Village Square Dr. $ 6,180
Cypress, TX 77429
11
Goliad 145 North Jefferson $ 11,911
Goliad, TX 77963
Hitchcock 8300 Highway 6 $ 13,513
Hitchcock, TX 77563
Liberty 520 Main St. $ 55,523
Liberty, TX 77575
Magnolia 18935 FM 1488 $ 30,763
Magnolia, TX 77355
Mathis 103 North Highway 359 $ 27,983
Mathis, TX 78368
Medical Center 7505 South Main St., Suite 100 $ 18,548
Houston, TX 77030
Needville 8914 North Main St. $ 14,815
Needville, TX 77461
Palacios 600 Henderson $ 25,522
Palacios, TX 77465
Post Oak 3040 Post Oak Blvd. Suite 150 $ 56,423
Houston, TX 77056
River Oaks 4295 San Felipe $104,395
Houston, TX 77027
Sweeny 206 North McKinney $ 12,678
Sweeny, TX 77480
Tanglewood 5707 Woodway $ 5,113
Houston, TX 77057
Victoria 2702 North Navarro $ 31,011
Victoria, TX 77903
West Columbia 510 East Brazos $ 47,398
West Columbia, TX 77486
Waugh 55 Waugh Drive $ 18,635
Houston, TX 77019
Wharton 143 West Burleson $ 71,933
Wharton, TX 77488
- ----------
(1) The Beeville Banking Center consists of the main office located at 100
South Washington and a drive-thru facility located approximately one-half
mile from the main office.
(2) The Company currently leases the building in which its Cypress Banking
Center is located, however, it is constructing a new facility located at
25820 Northwest Freeway, Cypress, TX 77429. The Company anticipates that
the Cypress Banking Center will relocate to the new building during March
or April 2002.
12
ITEM 3. LEGAL PROCEEDINGS
Neither the Company nor the Bank is currently a party to any material
legal proceeding.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the
fourth quarter of 2001.
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The Company's Common Stock began trading on November 12, 1998 and is
listed on the Nasdaq National Market System ("Nasdaq NMS") under the symbol
"PRSP". Prior to that date, the Common Stock was privately held and not listed
on any public exchange or actively traded. The Company had a total of 8,105,435
shares outstanding at December 31, 2001. As of December 31, 2001, there were 449
shareholders of record. The number of beneficial owners is unknown to the
Company at this time.
The following table presents the high and low sales prices for the
Common Stock reported on the Nasdaq NMS during the two years ended December 31,
2001:
2001 High Low
- ---- ---- ---
Fourth Quarter ......................... $27.740 $23.860
Third Quarter........................... 27.870 21.500
Second Quarter.......................... 25.220 17.500
First Quarter........................... 22.625 18.750
2000 High Low
- ---- ---- ---
Fourth Quarter.......................... $20.000 $17.125
Third Quarter........................... 18.875 16.125
Second Quarter.......................... 16.875 13.938
First Quarter........................... 16.689 12.875
Holders of Common Stock are entitled to receive dividends when, as and
if declared by the Company's Board of Directors out of funds legally available
therefor. While the Company has declared dividends on its Common Stock since
1994, and paid quarterly dividends aggregating $0.39 per share in 2001 and $0.36
per share in 2000, there is no assurance that the Company will continue to pay
dividends in the future.
The principal source of cash revenues to the Company is dividends paid
by the Bank with respect to the Bank's capital stock. There are certain
restrictions on the payment of such dividends imposed by federal and state
banking laws, regulations and authorities. Under federal law, the Bank cannot
pay a dividend if it will cause the Bank to be "undercapitalized." The Bank is
also subject to risk-based capital rules that restrict its ability to pay
dividends. The risk-based capital rules set a specific schedule for achieving
minimum capital levels in relation to risk-weighted assets. Regulatory
authorities can impose stricter limitations on the ability of the Bank to pay
dividends if the they consider the payment to be an unsafe or unsound practice.
The cash dividends paid per share by quarter for the Company's last
two fiscal years were as follows:
2001 2000
---- ----
Fourth quarter............................... $0.10 $0.09
Third quarter................................ 0.10 0.09
Second quarter............................... 0.10 0.09
First quarter................................ 0.09 0.09
13
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data for, and as of the
end of, each of the years in the five-year period ended December 31, 2001 are
derived from and should be read in conjunction with the Company's consolidated
financial statements and the notes thereto and the information contained in
"Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations." The consolidated financial statements as of December 31, 2001
and 2000 and for each of the years in the three-year period ended December 31,
2001 and the report thereon of Deloitte & Touche LLP are included elsewhere in
this document. The historical financial data of the Company has been restated to
include the accounts and operations of Commercial Bancshares, Inc. for all
periods prior to February 23, 2001.
As of and for the Years Ended December 31,
------------------------------------------------------------------
2001 2000 1999 1998 1997
---------- ---------- ----------- ---------- ----------
(Dollars in thousands, except per share data)
Income Statement Data:
Interest income............................. $ 76,520 $ 70,079 $ 56,458 $ 46,026 $ 39,197
Interest expense............................ 35,785 35,564 26,189 21,923 18,434
---------- ---------- ----------- ---------- ----------
Net interest income...................... 40,735 34,515 30,269 24,103 20,763
Provision for credit losses................. 700 275 420 264 720
---------- ---------- ----------- ---------- ----------
Net interest income after provision
for credit losses...................... 40,035 34,240 29,849 23,839 20,043
Noninterest income.......................... 8,590 7,760 6,151 4,808 4,758
Noninterest expense......................... 30,295/1/ 26,767 21,822 17,989 16,037
---------- ---------- ----------- ---------- ----------
Income before taxes...................... 18,330/1/ 15,233 14,178 10,658 8,764
Provision for income taxes.................. 5,372/1/ 4,532 4,747 3,577 2,811
---------- ---------- ----------- ---------- ----------
Net income.................................. $ 12,958/1/ $ 10,701 $ 9,431 $ 7,081 $ 5,953
========== ========== =========== ========== ==========
Per Share Data(2):
Basic earnings per share.................... $ 1.60/3/ $ 1.33 $ 1.18 $ 1.02 $ 0.90
Diluted earnings per share.................. 1.57/3/ 1.30 1.15 1.00 0.89
Book value per share........................ 10.95 9.95 8.63 7.75 6.46
Cash dividends declared..................... 0.39 0.36 0.20 0.20 0.15
Dividend payout ratio....................... 24.39% 25.75% 19.10% 33.82% 35.24%
Weighted average shares outstanding (basic)
(in thousands)........................... 8,086 8,032 7,986 6,916 6,578
Weighted average shares outstanding (diluted)
(in thousands)........................... 8,249 8,227 8,204 7,115 6,670
Shares outstanding at end of period
(in thousands)........................... 8,105 8,072 7,995 7,973 6,790
Balance Sheet Data (at period end):
Total assets................................ $1,262,325 $1,146,140 $ 1,027,631 $ 800,158 $ 653,462
Securities.................................. 752,322 586,952 514,983 455,202 360,496
Loans....................................... 424,400 411,203 366,803 276,106 209,013
Allowance for credit losses................. 5,985 5,523 5,031 3,682 2,567
Total deposits.............................. 1,123,397 1,033,546 878,589 714,365 593,086
Borrowings and notes payable................ 18,080 13,931 53,119 17,508 10,823
Total shareholders' equity.................. 88,725 80,333 69,025 61,781 43,868
Company-obligated mandatorily redeemable
preferred securities of subsidiary
trusts (4)............................... 27,000 12,000 12,000 -- --
Average Balance Sheet Data:
Total assets................................ $1,191,190 $1,045,882 $ 875,781 $ 700,410 $ 596,625
Securities.................................. 666,241 550,431 465,788 392,026 329,484
Loans....................................... 419,553 383,054 319,178 238,855 197,423
Allowance for credit losses................. 5,586 5,245 4,272 2,994 1,984
Total deposits.............................. 1,061,195 920,526 767,879 628,557 540,488
Total shareholders' equity.................. 85,319 72,952 64,911 47,574 45,098
Company-obligated mandatorily redeemable
preferred securities of subsidiary
trusts (4)............................... 18,875 12,000 1,500 -- --
(Table continued on next page)
14
As of and for the Years Ended December 31,
------------------------------------------------------------------
2001 2000 1999 1998 1997
---------- ---------- ----------- ---------- ----------
(Dollars in thousands, except per share data)
Performance Ratios:
Return on average assets.................. 1.09%/5/ 1.02% 1.08% 1.01% 1.00%
Return on average equity.................. 15.19/5/ 14.67 14.53 14.88 13.20
Net interest margin (tax-equivalent) (6).. 3.86 3.69 3.77 3.75 3.87
Efficiency ratio(7)....................... 60.14/5/ 62.29 59.29 61.72 62.31
Asset Quality Ratios(8):
Nonperforming assets to total loans and
other real estate...................... 0.00% 0.32% 0.34% 0.14% 0.93%
Net loan charge-offs (recoveries)
to average loans....................... 0.06 (0.04) (0.11) (0.08) 0.06
Allowance for credit losses to total
loans.................................. 1.41 1.34 1.37 1.33 1.23
Allowance for credit losses to
nonperforming loans(9)................. n/m/10/ 700.89 657.65 941.69 132.39
Capital Ratios(8):
Leverage ratio............................ 7.57% 6.17% 6.17% 6.59% 6.00%
Average shareholders' equity to average
total assets........................... 7.16 6.98 7.41 6.79 7.56
Tier 1 risk-based capital ratio........... 18.34 13.80 13.89 15.06 14.15
Total risk-based capital ratio............ 19.52 14.93 15.74 16.14 15.12
- ----------
(1) Certain income statement data for the year ended December 31, 2001 includes
the merger-related expenses of $2.4 million. If these merger-related
expenses were excluded, the income statement data would have been as
follows:
Noninterest expense................................... $ 27,870
-----------
Income before income taxes............................ 20,755
Provision for income taxes............................ 6,221
-----------
Net income............................................ $ 14,534
(2) Adjusted for a four-for-one stock split effective September 10, 1998.
(3) Earnings per share amounts for the year ended December 31, 2001 include the
merger-related expenses of $2.4 million. If these merger-related expenses
were excluded, basic earnings per share would have been $1.80 and diluted
earnings per share would have been $1.76.
(4) Consists of $12.0 million of trust preferred securities of Prosperity
Capital Trust I due November 12, 2029 and $15.0 million of trust preferred
securities of Prosperity Statutory Trust II due July 31, 2031.
(5) Selected performance ratios for the year ended December 31, 2001 include
the merger-related expenses of $2.4 million. If these merger-related
expenses were excluded, the performance ratios would have been as follows:
Return on average assets............................... 1.22%
Return on average equity............................... 17.04
Efficiency ratio....................................... 55.06
(6) Calculated on a tax-equivalent basis using a 35% federal income tax rate
for the year ended December 31, 2001 and a 34% federal income tax rate for
the years ended December 31, 1997 through December 31, 2000.
(7) Calculated by dividing total noninterest expense, excluding securities
losses and credit loss provisions, by net interest income plus noninterest
income. The interest expense related to debentures issued by the Company in
connection with the issuance by subsidiary trusts of trust preferred
securities is treated as interest expense for this calculation.
Additionally, taxes are not part of this calculation.
(8) At period end, except for net loan charge-offs to average loans and average
shareholders' equity to average total assets, which is for periods ended at
such dates.
(9) Nonperforming loans consist of nonaccrual loans, loans contractually past
due 90 days or more and restructured loans.
(10) Amount not meaningful. Nonperforming assets totaled $1,000 at December 31,
2001.
15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Management's Discussion and Analysis of Financial Condition and
Results of Operations analyzes the major elements of the Company's balance
sheets and statements of income. This section should be read in conjunction with
the Company's consolidated financial statements and accompanying notes and other
detailed information appearing elsewhere in this Annual Report on Form 10-K. The
Commercial Merger was accounted for as a pooling of interests and therefore the
historical financial data of the Company has been restated to include the
accounts and operations of Commercial for all periods prior to the effective
time of the merger.
For the Years Ended December 31, 2001, 2000 and 1999
Overview
Net income was $13.0 million, $10.7 million and $9.4 million for the
years ended December 31, 2001, 2000 and 1999, respectively, and diluted earnings
per share were $1.57, $1.30 and $1.15, respectively for these same periods.
Earnings growth during both 2000 and 2001 resulted principally from an increase
in loan volume and acquisitions, including the Compass and the South Texas
Acquisitions. The Company posted returns on average assets of 1.09%, 1.02% and
1.08% and returns on average equity of 15.19%, 14.67% and 14.53% for the years
ended December 31, 2001, 2000 and 1999, respectively. The Company posted returns
on average assets excluding amortization of goodwill and related tax expense of
1.18%, 1.12% and 1.15% and returns on average equity excluding amortization of
goodwill and related tax expense of 16.55%, 16.08% and 15.52% for the years
ended December 31, 2001, 2000 and 1999, respectively. The Company's efficiency
ratio was 60.14% in 2001, 62.29% in 2000 and 59.29% in 1999. The Company's
efficiency ratio excluding amortization of goodwill was 57.29% in 2001, 59.47%
in 2000 and 57.20% in 1999.
Total assets at December 31, 2001, 2000 and 1999 were $1.262 billion,
$1.146 billion and $1.028 billion, respectively. Total deposits at December 31,
2001, 2000 and 1999 were $1.123 billion, $1.034 billion, and $878.6 million,
respectively, with deposit growth in each period resulting from acquisitions and
internal growth. Total loans were $424.4 million at December 31, 2001, an
increase of $13.2 million or 3.2% from $411.2 million at the end of 2000. Total
loans were $366.8 million at year-end 1999. At December 31, 2001, the Company
had $1,000 in nonperforming loans and its allowance for credit losses was $6.0
million. Shareholders' equity was $88.7 million, $80.3 million and $69.0 million
at December 31, 2001, 2000 and 1999, respectively.
On February 23, 2001, the Company completed its merger with Commercial
Bancshares, Inc. As a result of the Commercial Merger, the Company issued an
aggregate of 2,768,610 shares of its Common Stock to the holders of Commercial
common stock. In addition, in lieu of issuing shares of Company Common Stock,
cash in the amount of $569,625 was paid to a dissenting shareholder in March
2001 and cash in the amount of $97,650 was paid to a dissenting shareholder in
May 2001. The options to purchase shares of Commercial common stock which were
outstanding at the effective time of the Commercial Merger were converted into
options to purchase 13,330 shares of Company Common Stock. In connection with
the Commercial Merger, the Company incurred approximately $2.4 million in pretax
merger-related expenses and other charges (the "Special Charge"). The
transaction was accounted for as a pooling of interests and therefore the
historical financial data of the Company has been restated to include the
accounts and operations of Commercial for all periods prior to the effective
time of the Commercial Merger.
Results of Operations Excluding Merger-Related Expenses
If the Company had not incurred the Special Charge of $2.4 million in
connection with the Commercial Merger, net income for the year ended December
31, 2001 would have been $14.5 million ($1.76 per common share on a diluted
basis) compared with $10.7 million ($1.30 per common share on a diluted basis)
for the year ended December 31, 2000, an increase in net income of $3.8 million,
or 35.8%. The Company would have posted a return on average common equity of
17.04%, a return on average assets of 1.22% and an efficiency ratio of 55.06%
for the year ended December 31, 2001. The Company would have posted a return on
average assets excluding amortization of goodwill and related tax expense of
1.32% and a return on average equity excluding amortization of goodwill and
related tax expense of 18.39% for the year ended December 31, 2001. The
Company's efficiency ratio excluding amortization of goodwill would have been
52.21% for the year ended December 31, 2001.
Results of Operations
Net Interest Income
The Company's operating results depend primarily on its net interest
income, which is the difference between interest income on interest-earning
assets, including securities and loans, and interest expense incurred on
interest-bearing liabilities, including deposits and other borrowed funds.
Interest rate fluctuations, as well as changes in the amount and type of earning
assets and liabilities, combine to affect net interest income. The Company's net
interest income is affected by changes in the amount and mix of
16
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."
2001 versus 2000. Net interest income for the year ended December 31,
2001 was $40.7 million compared with $34.5 million for the year ended December
31, 2000, an increase of $6.2 million or 18.0%. The improvement in net interest
income for 2001 was principally due to an increase in total average
interest-earning assets and a decrease in the rate paid on interest-bearing
liabilities that exceeded the decrease in the yield on interest-earning assets
by 22 basis points. Average interest-earning assets increased $144.9 million
from $971.4 million at December 31 2000 to $1.116 billion at December 31, 2001.
Total cost of interest-bearing liabilities decreased 58 basis points from 4.57%
at December 31, 2000 to 3.99% at December 31, 2001. Total yield on
interest-earning assets decreased 36 basis points from 7.21% at December 31,
2000 to 6.85% at December 31, 2001. The net interest margin on a tax-equivalent
basis increased 17 basis points to 3.86% at December 31, 2001 from 3.69% at
December 31, 2000.
2000 versus 1999. Net interest income for the year ended December 31,
2000 was $34.5 million compared with $30.3 million for the year ended December
31, 1999, an increase of $4.2 million or 14.0%. The improvement in net interest
income for 2000 was mainly due to an increase in total average interest-earning
assets and an increase in the yield on earning-assets, partially offset by an
increase in the cost of interest-bearing liabilities. Average interest-earning
assets increased $156.2 million from $815.2 million at December 31, 1999 to
$971.4 million at December 31, 2000. Total cost of interest-bearing liabilities
increased 59 basis points from 3.98% at December 31, 1999 to 4.57% at December
31, 2000. Total yield on interest-earning assets increased 28 basis points from
6.93% at December 31, 1999 to 7.21% at December 31, 2000. At December 31, 2000,
the net interest margin on a tax-equivalent basis decreased eight basis points
to 3.69% from 3.77% at December 31, 1999.
17
The following table presents for the periods indicated the total dollar
amount of average balances, interest income from average interest-earning assets
and the resultant yields, as well as the interest expense on average
interest-bearing liabilities, expressed both in dollars and rates. Except as
indicated in the footnotes, no tax-equivalent adjustments were made and all
average balances are daily average balances. Any nonaccruing loans have been
included in the table as loans carrying a zero yield.
Years Ended December 31,
-------------------------------------------------------------------------
2001 2000
------------------------------------- ---------------------------------
Average Interest Average Average Interest Average
Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
Balance Paid Rate Balance Paid Rate
----------- ----------- --------- ----------- -------- -------
(Dollars in thousands)
Assets
Interest-earning assets:
Loans .................................... $ 419,553 $ 34,731 8.28% $ 383,054 $ 33,599 8.77%
Securities(1) ............................ 666,241 40,353 6.06 550,431 33,978 6.17
Federal funds sold and other temporary
investments ............................. 30,478 1,436 4.71 37,929 2,502 6.60
----------- ----------- ---------- --------
Total interest-earning assets .......... 1,116,272 76,520 6.85% 971,414 70,079 7.21%
----------- --------
Less allowance for credit losses ......... (5,586) (5,245)
----------- ----------
Total interest-earning assets, net
of allowance .......................... 1,110,686 966,169
Noninterest-earning assets .............. 80,504 79,713
----------- ----------
Total assets ........................... $ 1,191,190 $1,045,882
=========== ==========
Liabilities and shareholders' equity
Interest-bearing liabilities:
Interest-bearing demand deposits ......... $ 199,077 $ 4,529 2.27% $ 185,486 $ 6,346 3.42%
Savings and money market accounts ........ 252,576 7,978 3.16 220,266 8,628 3.92
Certificates of deposit .................. 428,314 22,273 5.20 339,580 18,577 5.47
Federal funds purchased and other
borrowings .............................. 17,219 1,005 5.84 32,333 2,013 6.23
----------- ----------- ---------- --------
Total interest-bearing
liabilities ........................... 897,186 35,785 3.99% 777,665 35,564 4.57%
----------- ----------- ---------- --------
Noninterest-bearing liabilities:
Noninterest-bearing demand deposits ...... 181,228 175,194
Company obligated mandatorily redeemable
trust preferred securities of subsidiary
trusts ................................. 18,875 12,000
Other liabilities ........................ 8,582 8,071
----------- ----------
Total liabilities ...................... 1,105,871 972,930
----------- ----------
Shareholders' equity ....................... 85,319 72,952
----------- ----------
Total liabilities and shareholders'
equity ................................ $ 1,191,190 $1,045,882
=========== ==========
Net interest rate spread .................. 2.86% 2.64%
Net interest income and margin(2) .......... $ 40,735 3.65% $ 34,515 3.55%
=========== ========
Net interest income and margin
(tax-equivalent basis)(3) ................. $ 43,057 3.86% $ 35,890 3.69%
=========== ========
Years Ended December 31,
--------------------------------
1999
--------------------------------
Average Interest Average
Outstanding Earned/ Yield/
Balance Paid Rate
----------- -------- -------
(Dollars in thousands)
Assets
Interest-earning assets:
Loans .................................... $319,178 $26,710 8.37%
Securities(1) ............................ 465,788 28,170 6.05
Federal funds sold and other temporary
investments ............................. 30,214 1,578 5.22
-------- -------
Total interest-earning assets .......... 815,180 56,458 6.93%
-------
Less allowance for credit losses ......... (4,272)
--------
Total interest-earning assets, net
of allowance .......................... 810,908
Noninterest-earning assets .............. 64,873
--------
Total assets ........................... $875,781
========
Liabilities and shareholders' equity
Interest-bearing liabilities:
Interest-bearing demand deposits ......... $170,338 $ 5,255 3.09%
Savings and money market accounts ........ 190,515 6,486 3.40
Certificates of deposit .................. 260,682 12,346 4.74
Federal funds purchased and other
borrowings .............................. 36,107 2,102 5.82
-------- -------
Total interest-bearing
liabilities ........................... 657,642 26,189 3.98%
-------- -------
Noninterest-bearing liabilities:
Noninterest-bearing demand deposits ...... 146,344
Company obligated mandatorily redeemable
trust preferred securities of subsidiary
trusts ................................. 3,813
Other liabilities ........................ 3,071
--------
Total liabilities ...................... 810,870
--------
Shareholders' equity ....................... 64,911
--------
Total liabilities and shareholders'
equity ................................ $875,781
========
Net interest rate spread................... 2.95%
Net interest income and margin(2) .......... $30,269 3.71%
=======
Net interest income and margin
(tax-equivalent basis)(3) ................. $30,763 3.77%
=======
- ----------
(1) Yield is based on amortized cost and does not include any component of
unrealized gains or losses.
(2) The net interest margin is equal to net interest income divided by average
interest-earning assets.
(3) In order to make pretax income and resultant yields on tax-exempt
investments and loans comparable to those on taxable investments and loans,
a tax-equivalent adjustment has been computed using a federal income tax
rate of 35% for the year ended December 31, 2001 and 34% for the periods
ended December 31, 2000 and December 31, 1999 and other applicable
effective tax rates.
18
The following table presents the dollar amount of changes in interest
income and interest expense for the major components of interest-earning assets
and interest-bearing liabilities and distinguishes between the increase
(decrease) related to higher outstanding balances and the volatility of interest
rates. For purposes of this table, changes attributable to both rate and volume
which cannot be segregated have been allocated to rate.
Years Ended December 31,
--------------------------------------------------------
2001 vs. 2000 2000 vs. 1999
-------------------------- ---------------------------
Increase Increase
(Decrease) (Decrease)
Due to Due to
---------------- -----------------
Volume Rate Total Volume Rate Total
------ ------- ------- ------- ------- -------
(Dollars in thousands)
Interest-earning assets:
Loans .............................................. $3,201 $(2,069) $ 1,132 $ 5,345 $ 1,544 $ 6,889
Securities ......................................... 7,149 (774) 6,375 5,119 689 5,808
Federal funds sold and other temporary
investments .................................... (492) (574) (1,066) 403 521 924
------ ------- ------- ------- ------- -------
Total increase (decrease) in interest income.... 9,858 (3,417) 6,441 10,867 2,754 13,621
------ ------- ------- ------- ------- -------
Interest-bearing liabilities:
Interest-bearing demand deposits ................... 465 (2,282) (1,817) 467 624 1,091
Savings and money market accounts .................. 1,266 (1,916) (650) 1,013 1,129 2,142
Certificates of deposit ............................ 4,854 (1,158) 3,696 3,737 2,494 6,231
Federal funds purchased and other borrowings ....... (941) (67) (1,008) (220) 131 (89)
------ ------- ------- ------- ------- -------
Total increase (decrease) in interest expense... 5,644 (5,423) 221 4,997 4,378 9,375
------ ------- ------- ------- ------- -------
Increase (decrease) in net interest income ............ $4,214 $ 2,006 $ 6,220 $ 5,870 $(1,624) $ 4,246
====== ======= ======= ======= ======= =======
Provision for Credit Losses
The Company's provision for credit losses is established through
charges to income in the form of the provision in order to bring the Company's
allowance for credit losses to a level deemed appropriate by management based on
the factors discussed under "Financial Condition - Allowance for Credit Losses".
The allowance for credit losses at December 31, 2001 was $6.0 million,
representing 1.41% of outstanding loans. The provision for credit losses for the
year ended December 31, 2001 was $700,000 compared with $275,000 for the year
ended December 31, 2000. The increase of $425,000 was primarily due to $238,000
in net loan charge-offs during 2001 compared with $171,000 in net loan
recoveries during 2000. The provision for credit losses for the year ended
December 31, 2000 was $275,000 compared with $420,000 in 1999. Net loan
recoveries were $363,000 in 1999.
Noninterest Income
The Company's primary sources of noninterest income are service
charges on deposit accounts and other banking service related fees. Loan
origination fees are recognized over the life of the related loan as an
adjustment to yield using the interest method. In 2001, noninterest income
totaled $8.6 million, an increase of $830,000 or 10.7% compared with $7.8
million in 2000. The increase was primarily due to an increase in insufficient
funds charges. Noninterest income for 2000 was $7.8 million, a $1.6 million or
26.2% increase from $6.2 million in 1999, resulting largely from an increase in
income due to the South Texas Acquisition and an increase in customer service
fees. The following table presents for the periods indicated the major
categories of noninterest income:
Years Ended December 31,
------------------------------
2001 2000 1999
------ ------ ------
(Dollars in thousands)
Service charges on deposit accounts ........ $7,530 $6,576 $4,925
Other noninterest income ................... 1,060 1,184 1,226
------ ------ ------
Total noninterest income ................ $8,590 $7,760 $6,151
====== ====== ======
19
Noninterest Expense
For the years ended December 31, 2001, 2000 and 1999, noninterest
expense totaled $30.3 million, $26.8 million and $21.8 million, respectively.
The Company's efficiency ratio improved in 2001 as it was reduced from 62.29% at
December 31, 2000 to 60.14% at December 31, 2001. Excluding merger-related
expenses of $2.4 million, the Company's efficiency ratio would have been 55.06%
at December 31, 2001. This reduction reflects the Company's continued success in
controlling operating expenses and the cost savings achieved following the
integration of the Commercial Merger in the first quarter of 2001, the Compass
Acquisition in the fourth quarter of 2000 and the South Texas Acquisition in the
fourth quarter of 1999. The Company's efficiency ratio was 59.29% at December
31, 1999.
The following table presents for the periods indicated the major
categories of noninterest expense:
Years Ended December 31,
---------------------------
2001 2000 1999
------- ------- -------
(Dollars in thousands)
Salaries and employee benefits ...................... $12,955 $12,931 $11,149
Non-staff expenses:
Net occupancy expense ....................... 1,971 1,761 1,350
Depreciation expense ........................ 1,570 1,553 1,241
Data processing ............................. 2,126 1,956 1,651
Regulatory assessments and FDIC insurance ... 249 284 189
Ad valorem and franchise taxes .............. 434 473 368
Goodwill amortization ....................... 1,363 1,160 751
Minority expense-trust preferred securities.. 1,580 1,151 561
Merger-related expenses ..................... 2,425 -- --
Other ....................................... 5,622 5,498 4,562
------- ------- -------
Total noninterest expense ........... $30,295 $26,767 $21,822
======= ======= =======
For the year ended December 31, 2001, noninterest expense totaled
$30.3 million, an increase of $3.5 million or 13.2% over $26.8 million for the
same period in 2000. The increase in noninterest expense included $2.4 million
in merger related expenses. Excluding merger related expenses, noninterest
expense increased $1.1 million or 4.1%. Minority expense-trust preferred
securities increased $429,000 from $1.2 million at December 31, 2000 to $1.6
million at December 31, 2001. Other operating expenses of $5.6 million
represented an increase of $124,000 or 2.3% compared with $5.5 million in 2000.
These increases were principally due to the Compass Acquisition. Total
noninterest expenses in 2000 were $26.8 million, a 22.7% increase over the 1999
level of $21.8 million primarily due to the South Texas and Compass
Acquisitions. Salaries and employee benefits in 2000 increased by 16.0% from
$11.1 million to $12.9 million. The increase was principally due to additional
staff associated with the Compass and South Texas Acquisitions.
Income Taxes
The amount of federal income tax expense is influenced by the amount
of taxable income, the amount of tax-exempt income, the amount of nondeductible
interest expense and the amount of other nondeductible expenses. For the year
ended December 31, 2001, income tax expense was $5.4 million compared with $4.5
million for the year ended December 31, 2000 and $4.7 million for the year ended
December 31, 1999. The effective tax rate in the years ended December 31, 2001,
2000 and 1999 was 29.3%, 29.8% and 33.5%, respectively.
Goodwill Amortization
In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 141, Business
Combinations, (SFAS No. 141) and SFAS No. 142, Goodwill and Other Intangible
Assets (SFAS No. 142). SFAS No. 141 requires that the purchase method of
accounting be used for all business combinations. SFAS No. 141 specifies
criteria that intangible assets acquired in a business combination must meet to
be recognized and reported separately from goodwill. SFAS No. 142 requires that
goodwill and intangible assets with indefinite useful lives no longer be
amortized, but instead be tested for impairment at least annually in accordance
with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible
assets with estimable useful lives be amortized over their respective estimated
useful lives to their estimated residual values, and reviewed
20
for impairment in accordance with SFAS No. 121 and subsequently, SFAS No. 144
after its adoption.
The Company adopted the provisions of SFAS No. 141 as of July 1, 2001,
and SFAS No. 142 was effective January 1, 2002. Goodwill and intangible assets
determined to have an indefinite useful life acquired in a purchase business
combination completed after June 30, 2001, but before SFAS No. 142 is adopted in
full, are not amortized.
As of the date of adoption of SFAS No. 142, the Company expects to
have unamortized goodwill in the amount of $22.6 million and no unamortized
identifiable intangible assets, all of which will be subject to the transition
provisions of SFAS No. 142. Amortization expense related to goodwill was $1.4
million and $1.2 million for years ended December 31, 2001 and 2000,
respectively. Because of the extensive effort needed to comply with adopting
SFAS No. 142, it is not practicable to reasonably estimate the impact of
adopting the Statement on the Company's financial statements at the date of this
report, including whether the Company will be required to recognize any
transitional impairment losses as the cumulative effect of a change in
accounting principle.
Impact of Inflation
The effects of inflation on the local economy and on the Company's
operating results have been relatively modest for the past several years. Since
substantially all of the Company's assets and liabilities are monetary in
nature, such as cash, securities, loans and deposits, their values are less
sensitive to the effects of inflation than to changing interest rates, which do
not necessarily change in accordance with inflation rates. The Company tries to
control the impact of interest rate fluctuations by managing the relationship
between its interest rate sensitive assets and liabilities. See "Financial
Condition - Interest Rate Sensitivity and Market Risk."
Financial Condition
Loan Portfolio
At December 31, 2001, total loans were $424.4 million, an increase of
$13.2 million or 3.2% from $411.2 million at December 31, 2000. At December 31,
2001, total loans were 37.8% of deposits and 33.6% of total assets. At December
31, 2000, total loans were 39.8% of deposits and 35.9% of total assets.
Loans increased 12.1% during 2000 from $366.8 million at December 31,
1999 to $411.2 million at December 31, 2000. The loan growth during 2000 was due
to strong loan demand and the South Texas Acquisition.
The following table summarizes the Company's loan portfolio by type of
loan as of the dates indicated:
December 31,
------------------------------------------------------------
2001 2000 1999
------------------ ------------------ ------------------
Amount Percent Amount Percent Amount Percent
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
Commercial and industrial .... $ 46,986 11.1% $ 46,529 11.3% $ 42,003 11.5%
Real estate:
Construction and land
development ............... 20,963 4.9 20,128 4.9 21,333 5.8
1-4 family residential ...... 175,253 41.3 175,525 42.7 165,238 45.1
Home equity ................. 20,541 4.8 16,762 4.1 11,343 3.1
Commercial mortgages ........ 78,446 18.5 75,896 18.5 64,738 17.7
Farmland .................... 10,686 2.5 12,218 3.0 8,552 2.3
Multifamily residential ..... 9,694 2.3 2,961 0.7 3,071 0.8
Agriculture .................. 15,757 3.7 13,251 3.2 13,592 3.7
Other ........................ 953 0.2 2,563 0.6 2,671 0.7
Consumer ..................... 45,121 10.7 45,370 11.0 34,262 9.3
-------- ----- -------- ----- -------- -----
Total loans ........... $424,400 100.0% $411,203 100.0% $366,803 100.0%
======== ===== ======== ===== ======== =====
December 31,
---------------------------------------
1998 1997
------------------ ------------------
Amount Percent Amount Percent
-------- ------- -------- -------
(Dollars in thousands)
Commercial and industrial .... $ 33,242 12.0% $ 28,221 13.4%
Real estate:
Construction and land
development ............... 12,477 4.5 15,113 7.2
1-4 family residential ...... 123,581 44.8 80,717 38.6
Home equity ................. 8,077 2.9 NA NA
Commercial mortgages ........ 41,436 15.0 36,515 17.5
Farmland .................... 6,455 2.3 6,206 3.0
Multifamily residential ..... 2,074 0.8 1,834 0.9
Agriculture .................. 15,138 5.5 7,262 3.5
Other ........................ 2,511 0.9 350 0.2
Consumer ..................... 31,115 11.3 32,795 15.7
-------- ----- -------- -----
Total loans ........... $276,106 100.0% $209,013 100.0%
======== ===== ======== =====
The lending focus of the Company is on 1-4 family residential loans
and small and medium-sized business loans. The Company offers a variety of
commercial lending products including term loans and lines of credit. The
Company also offers a broad range of short to medium-term commercial loans,
primarily collateralized, to businesses for working capital (including inventory
and receivables), business expansion (including acquisitions of real estate and
improvements) and the purchase of equipment and machinery. Historically, the
Company has originated loans for its own account and has not securitized its
loans. The purpose of a particular loan generally determines its structure. All
loans in the 1-4 family residential category were originated by the Company.
21
Loans from $750,000 to $2.0 million are evaluated and acted upon by an
officers' loan committee, which meets weekly. Loans above that amount must be
approved by the Directors Loan Committee, which meets monthly.
In nearly all cases, the Company's commercial loans are made in the
Company's primary market area and are underwritten on the basis of the
borrower's ability to service such 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. Working capital loans are primarily collateralized by short-term
assets whereas term loans are primarily collateralized by long-term assets. As a
result, commercial loans involve additional complexities, variables and risks
and require more thorough underwriting and servicing than other types of loans.
The Company's commercial mortgage loans are secured by first liens on
real estate, typically have variable interest rates and amortize over a ten to
15 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, appraisals and a review of the financial condition of the
borrower.
Additionally, a significant portion of the Company's lending activity
has consisted of the origination of 1-4 family residential mortgage loans
collateralized by owner-occupied 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 90% 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.
The Company makes loans to finance the construction of residential
and, to a limited extent, nonresidential properties. Construction loans
generally are secured 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.
Consumer loans made by the Company include direct "A"-credit
automobile loans, recreational vehicle loans, boat loans, home improvement
loans, home equity loans, personal loans (collateralized and uncollateralized)
and deposit account collateralized loans. The terms of these loans typically
range from 12 to 120 months and vary based upon the nature of collateral and
size of loan. Consumer loans entail greater risk than do residential mortgage
loans, particularly in the case of consumer loans that are unsecured or secured
by rapidly depreciating assets such as automobiles. In such cases, any
repossessed collateral for a defaulted consumer loan may not provide an adequate
source of repayment for the outstanding loan balance. The remaining deficiency
often does not warrant further substantial collection efforts against the
borrower beyond obtaining a deficiency judgment. In addition, consumer loan
collections are dependent on the borrower's continuing financial stability, and
thus are more likely to be adversely affected by job loss, divorce, illness or
personal bankruptcy. Furthermore, the application of various federal and state
laws may limit the amount which can be recovered on such loans.
The Company provides agricultural loans for short-term crop
production, including rice, cotton, milo and corn, farm equipment financing and
agricultural real estate financing. The Company evaluates agricultural borrowers
primarily based on their historical profitability, level of experience in their
particular agricultural industry, overall financial capacity and the
availability of secondary collateral to withstand economic and natural
variations common to the industry. Because agricultural 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 monitor and identify such
risks.
22
The contractual maturity ranges of the commercial and industrial and
construction and land development portfolios and the amount of such loans with
predetermined interest rates and floating rates in each maturity range as of
December 31, 2001 are summarized in the following table:
December 31, 2001
--------------------------------------------
After One
One Year Through After Five
or Less Five Years Years Total
-------- ---------- ---------- -------
(Dollars in thousands)
Commercial and industrial ................... $18,601 $23,059 $5,326 $46,986
Construction and land development ........... 19,658 397 908 20,963
------- ------- ------ -------
Total ......................... $38,259 $23,456 $6,234 $67,949
======= ======= ====== =======
Loans with a predetermined interest rate .... $ 8,089 $12,749 $2,408 $23,246
Loans with a floating interest rate ......... 30,170 10,707 3,826 44,703
------- ------- ------ -------
Total ......................... $38,259 $23,456 $6,234 $67,949
======= ======= ====== =======
Nonperforming Assets
The Company has several procedures in place to assist it in
maintaining the overall quality of its loan portfolio. The Company has
established underwriting guidelines to be followed by its officers. 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 requires appraisals on loans secured 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
write-downs or appropriate additions to the allowance for credit losses.
The Company generally places a loan on nonaccrual status and ceases
accruing interest when the payment of principal or interest is delinquent for 90
days, or earlier in some cases, unless the loan is in the process of collection
and the underlying collateral fully supports the carrying value of the loan. The
Company generally charges off such loans before attaining nonaccrual status.
The Company's conservative lending approach has resulted in strong
asset quality. The Company had $1,000 in nonperforming assets as of December 31,
2001 compared with $1.3 million at December 31, 2000 and 1999.
The following table presents information regarding nonperforming
assets at the dates indicated:
December 31,
--------------------------------------------
2001 2000 1999 1998 1997
------ ------- ------ ------ -------
(Dollars in thousands)
Nonaccrual loans................................. $ 1 $ 10 $ 756 $ 108 $ 1,681
Restructured loans............................... -- -- 5 150 --
Accruing loans 90 or more days past due.......... -- 778 4 133 258
Other real estate................................ -- 545 500 -- --
------ ------- ------ ------ -------
Total nonperforming assets................ $ 1 $ 1,333 $1,265 $ 391 $ 1,939
====== ======= ====== ====== =======
Nonperforming assets to total loans
and other real estate......................... 0.00% 0.32% 0.34% 0.14% 0.93%
23
Allowance for Credit Losses
The following table presents for the periods indicated an analysis of
the allowance for credit losses and other related data:
Years Ended December 31,
-----------------------------------------------------------
2001 2000 1999 1998 1997
--------- --------- --------- --------- ---------
(Dollars in thousands)
Average loans outstanding ..................... $ 419,553 $ 383,054 $ 319,178 $ 238,855 $ 197,423
========= ========= ========= ========= =========
Gross loans outstanding at end of period ...... $ 424,400 $ 411,203 $ 366,803 $ 276,106 $ 209,013
========= ========= ========= ========= =========
Allowance for credit losses at
beginning of period .......................... $ 5,523 $ 5,031 $ 3,682 $ 2,567 $ 1,968
Balance acquired with the Compass, South Texas
and Union Acquisitions, respectively ......... -- 46 566 661 --
Provision for credit losses ................... 700 275 420 264 720
Charge-offs:
Commercial and industrial .................. (180) (116) (30) (67) (106)
Real estate and agriculture ................ (175) (38) (43) (14) (47)
Consumer ................................... (74) (63) (64) (83) (111)
Recoveries:
Commercial and industrial .................. 15 43 236 276 73
Real estate and agriculture ................ 121 263 218 52 44
Consumer ................................... 55 82 46 26 26
--------- --------- --------- --------- ---------
Net (charge-offs) recoveries .................. (238) 171 363 190 (121)
--------- --------- --------- --------- ---------
Allowance for credit losses at end of period .. $ 5,985 $ 5,523 $ 5,031 $ 3,682 $ 2,567
========= ========= ========= ========= =========
Ratio of allowance to end of period
loans......................................... 1.41% 1.34% 1.37% 1.33% 1.23%
Ratio of net (recoveries) charge-offs to
average loans................................. 0.06 (0.04) (0.11) (0.08) 0.06
Ratio of allowance to end of period
nonperforming loans........................... n/m/1/ 700.89 657.65 941.69 132.39
(1) Amount not meaningful. Nonperforming loans totaled $1,000 at December 31,
2001.
The allowance for credit losses is a reserve 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 changes 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. Charge-offs occur when
loans are deemed to be uncollectable.
The Company considers risk elements attributable to particular loan
types or categories in assessing the quality of individual loans. Some of the
risk elements include:
. for 1-4 family residential mortgage loans, the borrower's ability to
repay the loan, including a consideration of the debt to income ratio and
employment and income stability, the loan to value ratio, and the age,
condition and marketability of collateral;
. for commercial mortgage loans and multifamily residential loans, the debt
service coverage ratio (income from the property in excess of operating
expenses compared to loan payment requirements), operating results of the
owner in the case of owner-occupied properties, the loan to value ratio,
the age and condition of the collateral and the volatility of income,
property value and future operating results typical of properties of that
type;
. for 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;
24
. 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 ability to lease property constructed for lease,
the quality and nature of contracts for presale or preleasing, 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; 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.
The Company follows a loan review program to evaluate the credit risk
in the loan portfolio. Through the loan review process, the Company maintains an
internally classified loan list 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. Loans classified as "substandard"
are those loans with clear and defined weaknesses such as a highly-leveraged
position, unfavorable financial ratios, uncertain repayment sources or poor
financial condition, which may jeopardize recoverability of the debt. Loans
classified as "doubtful" are those loans which have characteristics similar to
substandard accounts but with an increased risk that a loss may occur, or at
least a portion of the loan may require a charge-off if liquidated at present.
Loans classified as "loss" are those loans which are in the process of being
charged off. For each classified loan, the Company generally allocates a
specific loan loss reserve equal to a predetermined percentage of the loan
amount, depending on the classification.
In addition to the internally classified loan list and delinquency
list of loans, the Company maintains a separate "watch list" which further aids
the Company in monitoring loan portfolios. Watch list loans have one or more
deficiencies that require attention in the short term or pertinent ratios of the
loan account that have weakened to a point where more frequent monitoring is
warranted. These loans do not have all of the characteristics of a classified
loan (substandard or doubtful) but do show weakened elements compared with those
of a satisfactory credit. The Company reviews these loans to assist in assessing
the adequacy of the allowance for credit losses.
In order to determine the adequacy of the allowance for credit losses,
management considers the risk classification or delinquency status of loans and
other factors, such as collateral value, portfolio composition, trends in
economic conditions and the financial strength of borrowers. Management
establishes specific allowances for loans which management believes require
reserves greater than those allocated according to their classification or
delinquent status. An unallocated allowance is also established based on the
Company's historical charge-off experience and existing general economic and
business conditions affecting the key lending areas of the Company, credit
quality trends, collateral values, loan volume and concentrations and seasoning
of the loan portfolio. The Company then charges to operations a provision for
credit losses to maintain the allowance for credit losses at an adequate level
determined by the foregoing methodology.
For the year ended December 31, 2001, net charge-offs totaled $238,000
or 0.06% of average loans outstanding for the period, compared with net
recoveries of $171,000 or (0.04)% of average loans during 2000. The Company's
net recoveries totaled $363,000 or (0.11)% of average loans outstanding in 1999.
During 2001, the Company recorded a provision for credit losses of $700,000
compared with $275,000 for 2000. At December 31, 2001, the allowance for credit
losses totaled $6.0 million, or 1.41% of total loans. The Company made a
provision for credit losses of $275,000 during 2000 compared with a provision of
$420,000 for 1999. At December 31, 2000, the allowance aggregated $5.5 million,
or 1.34% of total loans. At December 31, 1999, the allowance was $5.0 million,
or 1.37% of total loans.
25
The following tables describe the allocation of the allowance for
credit losses among various categories of loans and certain other information
for the dates indicated. The allocation is made for analytical purposes and is
not necessarily indicative of the categories in which future losses may occur.
The total allowance is available to absorb losses from any segment of loans.
December 31,
-------------------------------------------
2001 2000
-------------------- --------------------
Percent of Percent of
Loans to Loans to
Amount Total Loans Amount Total Loans
------ ----------- ------ -----------
(Dollars in thousands)
Balance of allowance for credit losses applicable to:
Commercial and industrial .................... $ 357 11.1% $ 625 11.3%
Real estate .................................. 553 74.4 116 73.9
Agriculture .................................. 11 3.7 17 3.2
Consumer and other ........................... 10 10.8 28 11.6
Unallocated .................................. 5,054 -- 4,737 --
------ ----- ------ -----
Total allowance for credit losses .... $5,985 100.0% $5,523 100.0%
====== ===== ====== =====
December 31,
------------------------------------------------------------------
1999 1998 1997
-------------------- -------------------- --------------------
Percent of Percent of Percent of
Loans to Loans to Loans to
Amount Total Loans Amount Total Loans Amount Total Loans
------ ----------- ------ ----------- ------ -----------
(Dollars in thousands)
Balance of allowance for credit losses applicable to:
Commercial and industrial ..................... $ 620 11.5% $ 520 12.0% $ 558 13.5%
Real estate ................................... 74 74.8 79 70.3 82 67.1
Agriculture ................................... 22 3.7 40 5.5 -- 3.5
Consumer and other ............................ 25 10.0 14 12.2 65 15.9
Unallocated ................................... 4,290 -- 3,029 -- 1,862 --
------ ----- ------ ----- ------ -----
Total allowance for credit
losses ................................ $5,031 100.0% $3,682 100.0% $2,567 100.0%
====== ===== ====== ===== ====== =====
Where management is able to identify specific loans or categories of
loans where specific amounts of reserve are required, allocations are assigned
to those categories. Federal and state bank regulators also require that a bank
maintain a reserve that is sufficient to absorb an estimated amount of
unidentified potential losses based on management's perception of economic
conditions, loan portfolio growth, historical charge-off experience and exposure
concentrations. Management, along with a number of economists, has perceived
during the past year an increasing instability in the national and Southeast
Texas economies and a worldwide economic slowdown that could contribute to job
losses and otherwise adversely affect a broad variety of business sectors. In
addition, as the Company has grown, its aggregate loan portfolio has increased
and since the Company has made a decision to diversify its loan portfolio into
areas other than 1-4 family residential mortgage loans, the risk profile of the
Company's loans has increased. By virtue of its increased capital levels, the
Company is able to make larger loans, thereby increasing the possibility of one
bad loan having a larger adverse impact than before.
The Company believes that the allowance for credit losses at December
31, 2001 is adequate to cover losses inherent in the portfolio as of such date.
There can be no assurance, however, that the Company will not sustain losses in
future periods, which could be substantial in relation to the size of the
allowance at December 31, 2001.
Securities
The Company uses its securities portfolio both as a source of income
and as a source of liquidity. At December 31, 2001, investment securities
totaled $752.3 million, an increase of $165.4 million or 28.2% from $587.0
million at December 31, 2000, primarily due to the Company investing excess
deposits. At December 31, 2001, securities represented 59.6% of total assets
compared with 51.2% of total assets at December 31, 2000.
26
Securities increased $72.0 million or 14.0% from $515.0 million at
December 31, 1999 to $587.0 million at December 31, 2000, primarily due to the
investment of excess deposits from the Compass Acquisition.
The following table summarizes the amortized cost of securities as of
the dates shown (available-for-sale securities are not adjusted for unrealized
gains or losses):
December 31,
----------------------------------------------------
2001 2000 1999 1998 1997
-------- -------- -------- -------- --------
(Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies ........ $143,397 $334,562 $316,859 $305,592 $255,736
70% non-taxable preferred stock ........ 24,058 19,085 4,049 -- --
States and political subdivisions ...... 51,503 46,819 40,369 30,250 13,133
Corporate debt securities .............. 22,712 24,879 28,038 27,610 14,414
Equity securities ...................... -- 2 2 -- --
Collateralized mortgage obligations .... 17,378 18,307 12,267 12,914 8,749
Mortgage-backed securities ............. 492,940 142,354 117,436 78,283 68,477
Other .................................. -- 25 25 25 25
-------- -------- -------- -------- --------
Total .............................. $751,988 $586,033 $519,045 $454,674 $360,534
======== ======== ======== ======== ========
The following table summarizes the contractual maturity of securities
and their weighted average yields:
December 31, 2001
----------------------------------------------------------
After One Year After Five Years
but but
Within One Within Five Within Ten
Year Years Years
------------------- ---------------- -----------------
Amount Yield Amount Yield Amount Yield
-------- -------- -------- ----- -------- -----
(Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies ........ $ 21,502 6.16% $ 76,002 5.94% $ 44,077 6.19%
70% non-taxable preferred stock ........ -- -- -- -- -- --
States and political subdivisions ...... 2,945 6.65 16,774 6.51 6,064 7.06
Corporate debt securities .............. 1,001 6.27 18,561 5.96 3,150 6.19
Collateralized mortgage obligations .... -- -- -- -- 3,557 2.99
Mortgage-backed securities ............. 1,423 5.72 13,250 5.81 36,605 5.29
Qualified Zone Academy Bond (QZAB) ..... -- -- -- -- 8,000 2.00
-------- -------- --------
Total .................................. $ 26,871 6.19% $124,587 5.99% $101,453 5.32%
======== ==== ======== ==== ======== ====
December 31, 2001
-----------------------------------
After Ten
Years Total
---------------- ----------------
Amount Yield Total Yield
-------- ----- -------- -----
(Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies ........... $ -- --% $141,581 6.05%
70% non-taxable preferred stock ........ 24,165 6.96 24,165 6.96
States and political subdivisions ...... 18,171 7.34 43.954 6.94
Corporate debt securities .............. -- -- 22,712 6.01
Collateralized mortgage obligations .... 14,142 3.27 17,699 3.21
Mortgage-backed securities ............. 442,933 5.52 494,211 5.51
Qualified Zone Academy Bond (QZAB) ..... -- -- 8,000 2.00
-------- --------
Total .................................. $499,411 5.59% $752,322 5.67%
======== ==== ======== ====
Contractual maturity of mortgage-backed securities and collaterazed
mortgage obligations is not a reliable indicator of their expected life because
borrowers have the right to prepay their obligations at any time. The tax-exempt
states and political subdivisions are calculated on a tax equivalent basis. The
QZAB bond is not calculated on a tax-equivalent basis and it generates a tax
credit of 7.18%, which is included in gross income.
27
The following table summarizes the carrying value by classification of
securities as of the dates shown:
December 31,
----------------------------------------------------
2001 2000 1999 1998 1997
-------- -------- -------- -------- --------
(Dollars in thousands)
Available-for-sale ...... $482,233 $334,773 $224,790 $113,828 $ 38,612
Held-to-maturity ........ 270,089 252,179 290,193 341,374 321,884
-------- -------- -------- -------- --------
Total .............. $752,322 $586,952 $514,983 $455,202 $360,496
======== ======== ======== ======== ========
The following tables present the amortized cost and fair value of
securities classified as available-for-sale at December 31, 2001, 2000 and 1999:
December 31, 2001
-----------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- --------
(Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies .......... $ 2,248 $ 201 $ -- $ 2,449
70% non-taxable preferred stock ........ 24,058 107 -- 24,165
States and political subdivisions ...... 28,165 483 73 28,575
Corporate debt securities .............. -- -- -- --
Equity securities ...................... -- -- -- --
Collateralized mortgage obligations .... 17,356 314 22 17,648
Mortgage-backed securities ............. 410,072 1,646 2,322 409,396
-------- ------ ------ --------
Total .............................. $481,899 $2,751 $2,417 $482,233
======== ====== ====== ========
December 31, 2000
----------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- --------
(Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies .......... $186,832 $ 905 $ 742 $186,995
70% non-taxable preferred stock ........ 19,085 145 -- 19,230
States and political subdivisions ...... 20,240 216 2 20,454
Corporate debt securities .............. 1,021 -- 5 1,016
Equity securities ...................... 2 5 -- 7
Collateralized mortgage obligations .... 17,979 292 54 18,217
Mortgage-backed securities ............. 88,695 652 493 88,854
-------- ------ ------ --------
Total .............................. $333,854 $2,215 $1,296 $334,773
======== ====== ====== ========
December 31, 1999
-----------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- ---------
(Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies......... $151,399 $ 61 $ 3,165 $148,295
70% non-taxable preferred stock....... 4,049 -- 49 4,000
States and political subdivisions..... 12,235 64 2 12,297
Corporate debt securities............. -- -- -- --
Equity securities..................... 2 6 -- 8
Collateralized mortgage obligations... 11,729 261 63 11,927
Mortgage-backed securities............ 49,438 47 1,222 48,263
-------- ----- ------- --------
Total............................ $228,852 $ 439 $ 4,501 $224,790
======== ===== ======= ========
The following tables present the amortized cost and fair value of
securities classified as held-to-maturity at December 31, 2001, 2000 and 1999:
December 31, 2001
-----------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- ---------
(Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies ............ $141,149 $3,180 $204 $144,125
Corporate debt securities ................ 22,712 609 167 23,154
States and political subdivisions ........ 23,338 605 12 23,931
Collateralized mortgage obligations ...... 22 -- -- 22
Mortgage-backed securities ............... 82,868 535 408 82,995
Other .................................... -- -- -- --
-------- ------ ---- --------
Total ................................ $270,089 $4,929 $791 $274,227
======== ====== ==== ========
December 31, 2000
-----------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- --------
(Dollars in thousands)
U.S. Treasury securities and obligation
of U.S. government agencies ............ $147,730 $460 $1,309 $146,881
Corporate debt securities ................ 23,858 67 760 23,165
States and political subdivisions ........ 26,579 137 205 26,511
Collateralized mortgage obligations ...... 328 -- 2 326
Mortgage-backed securities ............... 53,659 148 542 53,265
Other .................................... 25 -- -- 25
-------- ---- ------ --------
Total ................................ $252,179 $812 $2,818 $250,173
======== ==== ====== ========
28
December 31, 1999
------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- ---------
(Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies ............... $165,460 $ 29 $ 6,689 $158,800
Corporate debt securities ................... 28,038 1 1,162 26,877
States and political subdivisions ........... 28,134 52 872 27,314
Collateralized mortgage obligations ......... 538 -- 2 536
Mortgage-backed securities .................. 67,998 64 2,035 66,027
Other ....................................... 25 -- -- 25
-------- ---- ------- --------
Total ....................................... $290,193 $146 $10,760 $279,579
======== ==== ======= ========
Mortgage-backed securities are securities that have been developed by
pooling a number of real estate mortgages and which are principall y issued by
federal agencies such as the Government National Mortgage Association (GNMA),
Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage
Corporation (FHLMC). These securities are deemed to have high credit ratings,
and minimum regular monthly cash flows of principal and interest are guaranteed
by the issuing agencies.
However, unlike U.S. Treasury and U.S. government agency securities,
which have a lump sum payment at maturity, mortgage-backed securities provide
cash flows from regular principal and interest payments and principal
prepayments throughout the lives of the securities. Mortgage-backed securities
which are purchased at a premium will generally suffer decreasing net yields as
interest rates drop because home owners tend to refinance their mortgages. Thus,
the premium paid must be amortized over a shorter period. Therefore, these
securities purchased at a discount will obtain higher net yields in a decreasing
interest rate environment. As interest rates rise, the opposite will generally
be true. During a period of increasing interest rates, fixed rate
mortgage-backed securities do not tend to experience heavy prepayments of
principal and consequently, the average life of this security will not be unduly
shortened. If interest rates begin to fall, prepayments will increase. At
December 31, 2001, 90.0% of the mortgage-backed securities held by the Company
had contractual final maturities of more than ten years with a weighted average
life of 4.64 years.
Collateralized mortgage obligations (CMOs) are bonds that are backed
by pools of mortgages. The pools can be GNMA, FNMA or FHLMC pools or they can be
private-label pools. The CMOs are designed so that the mortgage collateral will
generate a cash flow sufficient to provide for the timely repayment of the
bonds. The mortgage collateral pool can be structured to accommodate various
desired bond repayment schedules, provided that the collateral cash flow is
adequate to meet scheduled bond payments. This is accomplished by dividing the
bonds into classes to which payments on the underlying mortgage pools are
allocated in different order. The bond's cash flow, for example can be dedicated
to one class of bondholders at a time, thereby increasing call protection to
bondholders. In private-label CMOs, losses on underlying mortgages are directed
to the most junior of all classes and then to the classes above in order of
increasing seniority, which means that the senior classes have enough credit
protection to be given the highest credit rating by the rating agencies.
At the date of purchase, the Company is required to classify debt and
equity securities into one of three categories: held-to-maturity, trading or
available-for-sale. At each reporting date, the appropriateness of the
classification is reassessed. Investments in debt securities are classified as
held-to-maturity and measured at amortized cost in the financial statements only
if management has the positive intent and ability to hold those securities to
maturity. Securities that are bought and held principally for the purpose of
selling them in the near term are classified as trading and measured at fair
value in the financial statements with unrealized gains and losses included in
earnings. Investments not classified as either held-to-maturity or trading are
classified as available-for-sale and measured at fair value in the financial
statements with unrealized gains and losses reported, net of tax, in a separate
component of shareholders' equity until realized.
Deposits
The Company offers a variety of deposit accounts having a wide range
of interest rates and terms. The Company's deposits consist of demand, savings,
money market and time accounts. The Company relies primarily on competitive
pricing policies and customer service to attract and retain these deposits. The
Company does not have or accept any brokered deposits.
Total deposits at December 31, 2001 were $1.123 billion, an increase
of $89.9 million or 8.7% from $1.034 billion at December 31, 2000. The increase
is primarily attributable to internal growth. Noninterest-bearing deposits of
$188.8 million at December 31, 2001 increased $873,000 or 0.5% from $188.0
million at December 31, 2000. Noninterest-bearing deposits at
29
December 31, 2000 were $188.0 million compared with $173.8 million at December
31, 1999. Interest-bearing deposits at December 31, 2001 were $934.6 million, up
$89.0 million or 10.5% from $845.6 million at December 31, 2000.
Interest-bearing deposits at December 31, 2000 of $845.6 million represented a
$140.8 million or 20.0% increase from $704.8 million at December 31, 1999. Total
deposits at December 31, 1999 were $878.6 million.
The daily average balances and weighted average rates paid on deposits
for each of the years ended December 31, 2001, 2000 and 1999 are presented
below:
Years Ended December 31,
------------------------------------------------------------------
2001 2000 1999
-------------------- ------------------ --------------------
Amount Rate Amount Rate Amount Rate
---------- ------ -------- ------- ---------- -------
(Dollars in thousands)
Interest-bearing checking ............ $ 199,077 2.27% $185,486 3.42% $170,338 3.09%
Regular savings ...................... 41,472 2.36 39,085 2.76 34,408 2.73
Money market savings ................. 211,104 3.31 181,181 4.17 156,107 3.55
Time deposits ........................ 428,314 5.20 339,580 5.47 260,682 4.74
---------- -------- --------
Total interest-bearing deposits 879,967 3.95 745,332 4.50 621,535 3.88
Noninterest-bearing deposits ......... 181,228 -- 175,194 -- 146,344 --
---------- -------- --------
Total deposits ................ $1,061,195 3.28% $920,526 3.64% $767,879 3.14%
========== ==== ======== ==== ======== ====
The following table sets forth the amount of the Company's
certificates of deposit that are $100,000 or greater by time remaining until
maturity:
December 31, 2001
-----------------
(Dollars in thousands)
Three months or less.................... $101,319
Over three through six months........... 38,006
Over six through 12 months.............. 37,140
Over 12 months.......................... 17,229
--------
Total.................................. $193,694
========
Other Borrowings
Deposits are the primary source of funds for the Company's lending and
investment activities. Occasionally, the Company obtains additional funds from
the Federal Home Loan Bank ("FHLB") and correspondent banks. At December 31,
2001, the Company had $18.1 million in FHLB borrowings of which $13.3 million
consisted of FHLB notes payable. The highest outstanding balance of FHLB
advances during 2001 was $30.2 million. At December 31, 2000, the Company had
$13.9 million in FHLB notes payable compared with $53.3 million at December 31,
1999. At December 31, 2001, the Company had no federal funds purchased. The
Company had no federal funds purchased at December 31, 2000 compared with $10.0
million in federal funds purchased at December 31, 1999.
At December 31, 2001, 2000, and 1999, the Company had no outstanding
borrowings under a revolving line of credit extended by a commercial bank.
In November 1999, the Company formed a wholly-owned statutory business
trust, Prosperity Capital Trust I ("Trust I"), which issued $12.0 million in
trust preferred securities, and in July 2001, the Company formed a second
wholly-owned statutory business trust, Prosperity Statutory Trust II ("Trust
II"), which issued $15.0 million in trust preferred securities on July 31, 2001.
Trust I and Trust II invested the proceeds in an equivalent amount of the
Company's junior subordinated debentures bearing an interest rate equal to the
distribution rate on the respective issue of trust preferred securities. The
debentures issued to Trust I will mature on November 17, 2029, which date may be
shortened to a date not earlier than November 17, 2004 if certain conditions are
met, including prior approval of the Federal Reserve Board. The debentures
issued to Trust II will mature on July 31, 2031, which date may be shortened to
a date not earlier than July 31, 2006, if certain conditions are met, including
prior approval of the Federal Reserve Board. These debentures, which are the
only assets of each trust, are subordinate and junior in right of payment to all
present and future senior indebtedness (as defined in the respective Indentures)
of the Company. The Company has fully and unconditionally guaranteed each
trust's obligations under the trust preferred securities.
30
The debentures issued to Trust I accrue interest at an annual rate of
9.60% of the aggregate liquidation amount, payable quarterly. The debentures
issued to Trust II accrue interest at a floating rate equal to 3-month LIBOR
plus 3.58% of the aggregate liquidation amount, not to exceed 12.50%, payable
quarterly. The annual interest rate on the debentures issued to Trust II for the
period from October 31, 2001 through December 31, 2001 was equal to 5.85%. The
quarterly distributions on each issuance of trust preferred securities are paid
at the same rate that interest is paid on the corresponding debentures. Under
the provisions of each issue of the debentures, the Company has the right to
defer payment of interest on the debentures at any time, or from time to time,
for periods not exceeding five years. If interest payments on either issue of
the debentures are deferred, the distributions on the respective trust preferred
securities will also be deferred.
For financial reporting purposes, Trust I and Trust II are treated as
subsidiaries of the Company and consolidated in the corporate financial
statements. The trust preferred securities are presented as a separate category
of long-term debt on the balance sheet. Although the trust preferred securities
are not included as a component of shareholders' equity on the balance sheet,
for regulatory purposes, the trust preferred securities are treated as Tier 1
capital by the Federal Reserve. The treatment of the trust preferred securities
as Tier 1 capital, in addition to the ability to deduct the expense of the
debentures for federal income tax purposes, provided the Company with a
cost-effective method of raising capital.
Interest Rate Sensitivity and Market Risk
The Company's asset liability and funds management policy provides
management with the necessary guidelines for effective funds management, and the
Company has established a measurement system for monitoring its net interest
rate sensitivity position. The Company manages its sensitivity position within
established guidelines.
As a financial institution, the Company's primary component of market
risk is interest rate volatility. Fluctuations in interest rates will ultimately
impact both the level of income and expense recorded on most of the Company's
assets and liabilities, and the market value of all interest-earning assets and
interest-bearing liabilities, other than those which have a short term to
maturity. Based upon the nature of the Company's operations, the Company is not
subject to foreign exchange or commodity price risk. The Company does not own
any trading assets.
Interest rate risk is the potential of economic losses due to future
interest rate changes. These economic losses can be reflected as a loss of
future net interest income and/or a loss of current fair market values. The
objective is to measure the effect on net interest income and to adjust the
balance sheet to minimize the inherent risk while at the same time maximizing
income. Management realizes certain risks are inherent, and that the goal is to
identify and accept the risks.
The Company's exposure to interest rate risk is managed by the Asset
Liability Committee ("ALCO"), which is composed of senior officers of the
Company, in accordance with policies approved by the Company's Board of
Directors. The ALCO formulates strategies based on appropriate levels of
interest rate risk. In determining the appropriate level of interest rate risk,
the ALCO considers the impact on earnings and capital of the current outlook on
interest rates, potential changes in interest rates, regional economies,
liquidity, business strategies and other factors. The ALCO meets regularly to
review, among other things, the sensitivity of assets and liabilities to
interest rate changes, the book and market values of assets and liabilities,
unrealized gains and losses, purchase and sale activities, commitments to
originate loans and the maturities of investments and borrowings. Additionally,
the ALCO reviews liquidity, cash flow flexibility, maturities of deposits and
consumer and commercial deposit activity. Management uses two methodologies to
manage interest rate risk: (i) an analysis of relationships between
interest-earning assets and interest-bearing liabilities; and (ii) an interest
rate shock simulation model. The Company has traditionally managed its business
to reduce its overall exposure to changes in interest rates.
The Company manages its exposure to interest rates by structuring its
balance sheet in the ordinary course of business. The Company does not enter
into instruments such as leveraged derivatives, interest rate swaps, financial
options, financial future contracts or forward delivery contracts for the
purpose of reducing interest rate risk.
An interest rate sensitive asset or liability is one that, within a
defined time period, either matures or experiences an interest rate change in
line with general market interest rates. The management of interest rate risk is
performed by analyzing the maturity and repricing relationships between
interest-earning assets and interest-bearing liabilities at specific points in
time ("GAP") and by analyzing the effects of interest rate changes on net
interest income over specific periods of time by projecting the performance of
the mix of assets and liabilities in varied interest rate environments. Interest
rate sensitivity reflects the potential effect on net interest income of a
movement in interest rates. A company is considered to be asset sensitive, or
having a positive GAP, when the amount of its interest-earning assets maturing
or repricing within a given period exceeds the amount of its interest-bearing
liabilities also maturing or repricing within that time period. Conversely, a
company is considered to be liability sensitive, or having a negative GAP, when
the amount of its interest-bearing liabilities maturing or repricing within a
given period exceeds the amount of its interest-
31
earning assets also maturing or repricing within that time period. During a
period of rising interest rates, a negative GAP would tend to affect net
interest income adversely, while a positive GAP would tend to result in an
increase in net interest income. During a period of falling interest rates, a
negative GAP would tend to result in an increase in net interest income, while a
positive GAP would tend to affect net interest income adversely.
The following table sets forth an interest rate sensitivity analysis
for the Company at December 31, 2001:
Volumes Subject to Repricing Within
-----------------------------------------------------------------
0-30 31-180 181-365 Greater than
days days days one year Total
--------- --------- --------- ------------ ----------
(Dollars in thousands)
Interest-earning assets:
Securities (net of unrealized gain of $334,000) $ 61,262 $ 88,117 $ 80,217 $522,392 $ 751,988
Loans ......................................... 118,174 33,770 34,787 237,669 424,400
Federal funds sold and other earning assets ... 715 -- -- 198 913
--------- --------- --------- -------- ----------
Total interest-earning assets ........... $ 180,151 $ 121,887 $ 115,004 $760,259 $1,177,301
--------- --------- --------- -------- ----------
Interest-bearing liabilities:
Demand, money market and savings
deposits ..................................... $ 490,024 $ -- $ -- $ -- $ 490,024
Certificates of deposit and other
time deposits ................................ 75,981 193,454 120,632 54,474 444,541
FHLB Advances ................................ 4,827 262 323 12,668 18,080
--------- --------- --------- -------- ----------
Total interest-bearing liabilities ......... $ 570,832 $ 193,716 $ 120,955 $ 67,142 $ 952,645
--------- --------- --------- -------- ----------
Period GAP ................................. $(390,681) $ (71,829) $ (5,951) $693,117 $ 224,656
Cumulative GAP ............................. $(390,681) $(462,510) $(468,461) $224,656
Period GAP to total assets ................. (30.95)% (5.69)% (0.47)% 54.91%
Cumulative GAP to total assets ............. (30.95)% (36.64)% (37.11)% 17.80%
Shortcomings are inherent in any GAP analysis since certain assets and
liabilities may not move proportionally as interest rates change. In addition to
GAP analysis, the Company uses an interest rate risk simulation model and shock
analysis to test the interest rate sensitivity of net interest income and the
balance sheet, respectively. Contractual maturities and repricing opportunities
of loans are incorporated in the model as are prepayment assumptions, maturity
data and call options within the investment portfolio. Assumptions based on past
experience are incorporated into the model for nonmaturity deposit accounts.
Based on the Company's December 31, 2001 simulation analysis, the Company
estimates that its current net interest income structure would change by
approximately 1.31% over a twelve month period in response to a 100 basis point
decline in rates and change by approximately 3.29% over a twelve month period in
response to a 100 basis point increase in rates. The Company estimates that its
current net interest income structure would change by approximately (0.99%) over
a twelve month period in response to a 200 basis point decline in rates and
change by approximately (1.37%) over a twelve month period in response to a 200
basis point increase in rates. The results are primarily from the behavior of
demand, money market and savings deposits. The Company has found that
historically, interest rates on these deposits change more slowly than changes
in the discount and federal funds rates. This assumption is incorporated into
the simulation model and is generally not fully reflected in a GAP analysis.
Liquidity
Liquidity involves the Company's ability to raise funds to support
asset growth or reduce assets to meet deposit withdrawals and other payment
obligations, to maintain reserve requirements and otherwise to operate the
Company on an ongoing basis. During the three years ended December 31, 2001, the
Company's liquidity needs have primarily been met by growth in core deposits, as
previously discussed. Although access to purchased funds from correspondent
banks is available and has been utilized on occasion to take advantage of
investment opportunities, the Company does not generally rely on these external
funding sources. The cash and federal funds sold position, supplemented by
amortizing investment and loan portfolios, have generally created an adequate
liquidity position.
Asset liquidity is provided by cash and assets which are readily
marketable or which will mature in the near future. As of December 31, 2001, the
Company had cash and cash equivalents of $41.7 million, down from $98.1 million,
at December 31, 2000. The decrease was mainly due to a decrease in federal funds
sold of $61.7 million.
32
Capital Resources
Capital management consists of providing equity to support both
current and future operations. The Company is subject to capital adequacy
requirements imposed by the Federal Reserve Board and the Bank is subject to
capital adequacy requirements imposed by the FDIC and the Texas Banking
Department. Both the Federal Reserve Board and the FDIC have adopted risk-based
capital requirements for assessing bank holding company and bank capital
adequacy. These standards define capital and establish minimum capital
requirements in relation to assets and off-balance sheet exposure, adjusted for
credit risk. The risk-based capital standards currently in effect are designed
to make regulatory capital requirements more sensitive to differences in risk
profiles among bank holding companies and banks, to account for off-balance
sheet exposure and to minimize disincentives for holding liquid assets. Assets
and off-balance sheet items are assigned to broad risk categories, each with
appropriate relative risk weights. The resulting capital ratios represent
capital as a percentage of total risk-weighted assets and off-balance sheet
items.
The risk-based capital standards issued by the Federal Reserve Board
require all bank holding companies to have "Tier 1 capital" of at least 4.0% and
"total risk-based" capital (Tier 1 and Tier 2) of at least 8.0% of total
risk-adjusted assets. "Tier 1 capital" generally includes common shareholders'
equity and qualifying perpetual preferred stock together with related surpluses
and retained earnings, less deductions for goodwill and various other
intangibles. "Tier 2 capital" may consist of a limited amount of
intermediate-term preferred stock, a limited amount of term subordinated debt,
certain hybrid capital instruments and other debt securities, perpetual
preferred stock not qualifying as Tier 1 capital, and a limited amount of the
general valuation allowance for loan losses. The sum of Tier 1 capital and Tier
2 capital is "total risk-based capital."
The Federal Reserve Board has also adopted guidelines which supplement
the risk-based capital guidelines with a minimum ratio of Tier 1 capital to
average total consolidated assets, or "leverage ratio," of 3.0% for institutions
with well diversified risk, including no undue interest rate exposure; excellent
asset quality; high liquidity; good earnings; and that are generally considered
to be strong banking organizations, rated composite 1 under applicable federal
guidelines, and that are not experiencing or anticipating significant growth.
Other banking organizations are required to maintain a leverage ratio of at
least 4.0%. These rules further provide that banking organizations experiencing
internal growth or making acquisitions will be expected to maintain capital
positions substantially above the minimum supervisory levels and comparable to
peer group averages, without significant reliance on intangible assets.
Pursuant to FDICIA, each federal banking agency revised its risk-based
capital standards to ensure that those standards take adequate account of
interest rate risk, concentration of credit risk and the risks of nontraditional
activities, as well as reflect the actual performance and expected risk of loss
on multifamily mortgages. The Bank is subject to capital adequacy guidelines of
the FDIC that are substantially similar to the Federal Reserve Board's
guidelines. Also pursuant to FDICIA, the FDIC has promulgated regulations
setting the levels at which an insured institution such as the Bank would be
considered "well capitalized," "adequately capitalized," "undercapitalized,"
"significantly undercapitalized" and "critically undercapitalized." Under the
FDIC's regulations, the Bank is classified "well capitalized" for purposes of
prompt corrective action. See "Business - Supervision and Regulation - The
Company" and " - The Bank."
Total shareholders' equity increased to $88.7 million at December 31,
2001 from $80.3 million at December 31, 2000, an increase of $8.4 million or
10.4%. This increase was primarily the result of net income of $13.0 million
offset by dividends paid on the Common Stock of $3.2 million, trust preferred
issuance costs of $476,000 and cash paid to dissenting shareholders in
connection with the issuance of common stock in exchange for common stock of
Commercial of $847,000. During 2000, shareholders' equity increased by $11.3
million or 16.4% from $69.0 million at December 31, 1999 due primarily to net
income of $10.7 million and a change in unrealized gain on available for sale
securities of $3.3 million offset by dividends paid on the Common Stock of $2.8
million.
33
The following table provides a comparison of the Company's and the
Bank's leverage and risk-weighted capital ratios as of December 31, 2001 to the
minimum and well capitalized regulatory standards:
To Be Well Capitalized
Minimum Required Under Prompt
for Capital Corrective Action Actual Ratio at
Adequacy Purposes Provisions December 31, 2001
----------------- ---------------------- -----------------
The Company
Leverage ratio ......................... 3.00%(1) N/A 7.57%
Tier 1 risk-based capital ratio ........ 4.00% N/A 18.34%
Total risk-based capital ratio ......... 8.00% N/A 19.52%
The Bank
Leverage ratio ......................... 3.00%(2) 5.00% 6.50%
Tier 1 risk-based capital ratio ........ 4.00% 6.00% 15.72%
Total risk-based capital ratio ......... 8.00% 10.00% 16.90%
- ----------
(1) The Federal Reserve Board may require the Company to maintain a leverage
ratio above the required minimum.
(2) The FDIC may require the Bank to maintain a leverage ratio above the
required minimum.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For information regarding the market risk of the Company's financial
instruments, see "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operation - Financial Condition - Interest Rate
Sensitivity and Market Risk". The Company's principal market risk exposure is to
changes in interest rates.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements, the reports thereon, the notes thereto and
supplementary data commence at page F-1 of this Annual Report on Form 10-K.
34
The following table presents certain unaudited quarterly financial
information concerning the Company's results of operations for each of the two
years ended December 31, 2001. The information should be read in conjunction
with the historical consolidated financial statements of the Company and the
notes thereto appearing elsewhere in this Annual Report on Form 10-K. The
historical financial data of the Company has been restated to include the
accounts and operations of Commercial Bancshares, Inc. for all periods prior to
February 23, 2001.
CONSOLIDATED QUARTERLY FINANCIAL DATA OF THE COMPANY
Quarter Ended 2001
----------------------------------------------------
(unaudited)
December 31 September 30 June 30 March 31
----------- ------------ ------- --------
(Dollars in thousands, except per share data)
Interest income ........................ $18,956 $19,101 $19,143 $19,320
Interest expense ....................... 7,518 8,841 9,407 10,019
------- ------- ------- -------
Net interest income ............... 11,438 10,260 9,736 9,301
Provision for credit losses ............ 650 50 -- --
------- ------- ------- -------
Net interest income after provision 10,788 10,210 9,736 9,301
Noninterest income ..................... 2,310 2,187 2,058 2,035
Noninterest expense (1) ................ 7,361 7,068 6,737 9,129
------- ------- ------- -------
Income before income taxes (1) .... 5,737 5,329 5,057 2,207
Provision for income taxes (1) ......... 1,747 1,598 1,487 540
------- ------- ------- -------
Net income (1) .................... 3,990 $ 3,731 $ 3,570 $ 1,667
======= ======= ======= =======
Earnings per share:
Basic (1) ......................... $ 0.49 $ 0.46 $ 0.44 $ 0.21
======= ======= ======= =======
Diluted (1) ....................... $ 0.48 $ 0.45 $ 0.43 $ 0.20
======= ======= ======= =======
(1) The financial data for the quarter ended March 31, 2001 includes the
merger-related expenses of $2.4 million. If these merger-related expenses
were excluded, the Company's noninterest expense would have been $6.7
million, income before income taxes would have been $4.6 million, provision
for income taxes would have been $1.4 million, net income would have been
$3.2 million, basic earnings per share would have been $0.40 and diluted
earnings per share would have been $0.39.
Quarter Ended 2000
-----------------------------------------------
(unaudited)
December 31 September 30 June 30 March 31
----------- ------------ ------- --------
(Dollars in thousands, except per share data)
Interest income ........................ $18,994 $17,487 $16,836 $16,762
Interest expense ....................... 10,178 8,855 8,284 8,247
------- ------- ------- -------
Net interest income ............... 8,816 8,632 8,552 8,515
Provision for credit losses ............ 50 75 75 75
------- ------- ------- -------
Net interest income after provision 8,766 8,557 8,477 8,440
Noninterest income ..................... 2,035 2,015 1,876 1,834
Noninterest expense .................... 7,006 6,663 6,572 6,526
------- ------- ------- -------
Income before income taxes ........ 3,795 3,909 3,781 3,748
Provision for income taxes ............. 1,076 1,185 1,135 1,136
------- ------- ------- -------
Net income ............................. $ 2,719 $ 2,724 $ 2,646 $ 2,612
======= ======= ======= =======
Earnings per share:
Basic ............................. $ 0.34 $ 0.34 $ 0.33 $ 0.33
======= ======= ======= =======
Diluted ........................... $ 0.33 $ 0.33 $ 0.32 $ 0.32
======= ======= ======= =======
35
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
There have been no disagreements with accountants on any matter of
accounting principles or practices or financial statement disclosures during the
two year period ended December 31, 2001.
PART III.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information under the captions "Election of Directors,"
"Continuing Directors and Executive Officers" and "Section 16(a) Beneficial
Ownership Reporting Compliance" in the Company's definitive Proxy Statement for
its 2002 Annual Meeting of Shareholders (the "2002 Proxy Statement") to be filed
with the Commission pursuant to Regulation 14A under the Securities Exchange Act
of 1934, as amended, is incorporated herein by reference in response to this
item.
ITEM 11. EXECUTIVE COMPENSATION
The information under the caption "Executive Compensation and Other
Matters" in the 2002 Proxy Statement is incorporated herein by reference in
response to this item.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information under the caption "Beneficial Ownership of Common
Stock by Management of the Company and Principal Shareholders" in the 2002 Proxy
Statement is incorporated herein by reference in response to this item.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information under the caption "Interests of Management and Others
in Certain Transactions" in the 2002 Proxy Statement is incorporated herein by
reference in response to this item.
PART IV.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
Consolidated Financial Statements and Schedules
Reference is made to the Consolidated Financial Statements, the
reports thereon, the notes thereto and supplementary data commencing at page F-1
of this Annual Report on Form 10-K. Set forth below is a list of such
Consolidated Financial Statements:
Independent Auditors' Report
Consolidated Balance Sheets as of December 31, 2001 and 2000
Consolidated Statements of Income for the Years Ended December 31,
2001, 2000 and 1999
Consolidated Statements of Changes in Shareholders' Equity for the
Years Ended December 31, 2001, 2000 and 1999
Consolidated Statements of Cash Flows for the Years Ended December 31,
2001, 2000 and 1999
Notes to Consolidated Financial Statements
Financial Statement Schedules
All supplemental schedules are omitted as inapplicable or because the
required information is included in the Consolidated Financial Statements or
notes thereto.
36
Exhibits
Each exhibit marked with an asterisk is filed with this Annual Report
on Form 10-K.
Exhibit
Number Description
------ -----------
2.1 - Agreement and Plan of Reorganization by and between the Prosperity Bancshares, Inc and
Commercial Bancshares, Inc. dated November 8, 2000 (incorporated herein by reference to Exhibit
2.1 to the Company's Registration Statement on Form S-4 (Registration No. 333-52342 ))
2.2 - Agreement and Plan of Reorganization by and between Prosperity Bancshares, Inc. and South Texas
Bancshares, Inc. dated June 17, 1999 (incorporated herein by reference to Exhibit 2.1 to the
Company's Form 10-Q for the quarter ended June 30, 1999)
2.3 - Agreement and Plan of Reorganization dated June 5, 1998 by and among Prosperity, First
Prosperity Bank and Union State Bank (incorporated herein by reference to Exhibit 10.4 to the
Company's Registration Statement on Form S-1 (Registration No. 333-63267) (the "Registration
Statement"))
3.1 - Amended and Restated Articles of Incorporation of Prosperity (incorporated herein by reference to
Exhibit 3.1 to the Company's Registration Statement on Form S-1 (Registration No. 333-63267))
3.2 - Amended and Restated Bylaws of Prosperity (incorporated herein by reference to Exhibit 3.2 to
the Company's Registration Statement on Form S-1 (Registration No. 333-63267))
4.1 - Form of certificate representing shares of Prosperity common stock (incorporated herein by
reference to Exhibit 4 to the Company's Registration Statement on Form S-1
(Registration No. 333-63267))
4.2 - Form of Indenture by and between Prosperity Bancshares, Inc. and First Union Trust Company,
N.A. with respect to the Junior Subordinated Debentures of Prosperity Bancshares, Inc.
(incorporated herein by reference to Exhibit 4.1 of the Company's Registration Statement on
Form S-1 (Registration No. 333-89481))
4.3 - Form of Amended and Restated Trust Agreement of Prosperity Capital Trust I (incorporated herein
by reference from Exhibit 4.5 to the Company's Registration Statement on Form S-1 (Registration
No. 333-89481))
4.4 - Form of Trust Preferred Securities Guarantee Agreement by and between Prosperity and First
Union Trust Company, N.A. (incorporated herein by reference to Exhibit 4.7 of the Company's
Registration Statement on Form S-1 (Registration No. 333-89481))
4.5 - Indenture dated as of July 31, 2001 by and between Prosperity Bancshares, Inc., as Issuer, and
State Street Bank and Trust Company of Connecticut, National Association, with respect to the
Floating Rate Junior Subordinated Deferrable Interest Debentures of Prosperity Bancshares, Inc.
(incorporated herein by reference to Exhibit 4.1 of the Company's Quarterly Report on Form 10-Q
for the quarter ended September 30, 2001)
4.6 - Amended and Restated Declaration of Trust of Prosperity Statutory Trust II dated as of July 31,
2001 (incorporated herein by reference to Exhibit 4.2 of the Company's Quarterly Report on Form
10-Q for the quarter ended September 30, 2001)
4.7 - Guarantee Agreement dated as of July 31, 2001 by and between Prosperity Bancshares, Inc. and
State Street Bank and Trust Company of Connecticut, National Association (incorporated herein
by reference to Exhibit 4.3 of the Company's Quarterly Report on Form 10-Q for the quarter
ended September 30, 2001)
37
10.1 - Prosperity Bancshares, Inc. 1995 Stock Option Plan (incorporated herein by reference to Exhibit
10.1 to the Company's Registration Statement on Form S-1 (Registration No. 333-63267))
10.2 - Prosperity Bancshares, Inc. 1998 Stock Incentive Plan (incorporated herein by reference to
Exhibit 10.2 to the Company's Registration Statement on Form S-1 (Registration No. 333-63267))
10.3 - Form of Employment Agreements (incorporated herein by reference to Exhibit 10.3 to the
Company's Registration Statement on Form S-1 (Registration No. 333-63267))
10.4 - Loan Agreement dated December 27, 1997 between Prosperity and Norwest Bank Minnesota, National
Association (incorporated herein by reference to Exhibit 10.5 to the Company's Registration
Statement on Form S-1 (Registration No. 333-63267))
10.5 - Form of Employment Agreement by and between First Prosperity Bank and H.E. Timanus, Jr.
(incorporated herein by reference to Exhibit 10.5 to the Company's Registration Statement on
Form S-4 (Registration No. 333-52342))
10.6 - Commercial Bancshares, Inc. Incentive Stock Option Plan for Key Employees (incorporated herein
by reference to Exhibit 4.5 to the Company's Registration Statement on Form S-8 (Registration
No. 333-57238))
10.7 - Form of Stock Option Agreement under the Commercial Bancshares, Inc. Incentive Stock Option
Plan for Key Employees (incorporated herein by reference to Exhibit 4.6 to the Company's
Registration Statement on Form S-8 (Registration No. 333-57238))
21* - Subsidiaries of Prosperity
23.1* - Consent of Deloitte & Touche LLP
Reports on Form 8-K
No reports on Form 8-K were filed by the Company during the three
months ended December 31, 2001.
38
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, Prosperity Bancshares, Inc., has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized, in the City
of Houston and State of Texas on March 8, 2002.
PROSPERITY BANCSHARES, INC./sm/
By: /s/DAVID ZALMAN
----------------------------------------
David Zalman
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
this report has been signed by the following persons on behalf of the registrant
in the indicated capacities on March 8, 2002.
Signature Positions
--------- ---------
/s/DAVID ZALMAN President and Chief Executive Officer (principal
- -------------------------------------
David Zalman executive officer)
/s/NED S. HOLMES Chairman of the Board; Director
- -------------------------------------
Ned S. Holmes
/s/DAVID HOLLAWAY Chief Financial Officer (principal
- -------------------------------------
David Hollaway financial officer and principal
accounting officer)
/s/HARRY BAYNE Director
- -------------------------------------
Harry Bayne
/s/JAMES A. BOULIGNY Director
- -------------------------------------
James A. Bouligny
/s/CHARLES A. DAVIS, JR. Director
- -------------------------------------
Charles A. Davis, Jr.
/s/PERRY MUELLER, JR. Director
- -------------------------------------
Perry Mueller, Jr.
/s/A. VIRGIL PACE, JR. Director
- -------------------------------------
A. Virgil Pace, Jr.
/s/TRACY T. RUDOLPH Director
- -------------------------------------
Tracy T. Rudolph
/s/CHARLES M. SLAVIK Director
- -------------------------------------
Charles M. Slavik
/s/HARRISON STAFFORD II Director
- -------------------------------------
Harrison Stafford II
/s/ROBERT STEELHAMMER Director
- -------------------------------------
Robert Steelhammer
/s/H.E. TIMANUS, JR. Director
- -------------------------------------
H. E. Timanus, Jr.
39
TABLE OF CONTENTS TO FINANCIAL STATEMENTS
Page
------
Prosperity Bancshares, Inc./sm/
Independent Auditors' Report........................................... F-2
Consolidated Balance Sheets as of December 31, 2001 and 2000.......... F-3
Consolidated Statements of Income for the Years Ended December 31,
2001, 2000 and 1999............................................... F-4
Consolidated Statements of Changes in Shareholders' Equity for the
Years Ended December 31, 2001, 2000 and 1999...................... F-5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2001, 2000 and 1999.................................. F-6
Notes to Consolidated Financial Statements............................. F-8
F-1
INDEPENDENT AUDITORS' REPORT
To the Shareholders and Board of Directors of
Prosperity Bancshares, Inc. and Subsidiaries:
We have audited the accompanying consolidated balance sheets of Prosperity
Bancshares, Inc. and subsidiaries (collectively, the "Company") as of December
31, 2001 and 2000 and the related consolidated statements of income,
shareholders' equity and cash flows for each of the three years in the period
ended December 31, 2001. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Prosperity Bancshares, Inc. and
subsidiaries as of December 31, 2001 and 2000, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2001 in conformity with accounting principles generally accepted in
the United States of America.
/s/ Deloitte & Touche LLP
February 15, 2002
Houston, Texas
F-2
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31,
------------------------
2001 2000
---------- ----------
(Dollars in thousands)
ASSETS
Cash and due from banks (Note 3) .......................................... $ 41,005 $ 35,709
Federal funds sold ........................................................ 715 62,369
---------- ----------
Total cash and cash equivalents ....................................... 41,720 98,078
Interest bearing deposits in financial institutions ....................... 198 1,085
Available for sale securities, at fair value (amortized cost
of $481,899 and $333,854, respectively) (Note 4) ....................... 482,233 334,773
Held to maturity securities, at cost (fair value of $274,227
and $250,173, respectively) (Note 4) ................................... 270,089 252,179
Loans (Note 5) ............................................................ 424,400 411,203
Less allowance for credit losses (Note 6) ................................. (5,985) (5,523)
---------- ----------
Loans, net .................................................. 418,415 405,680
Accrued interest receivable ............................................... 8,466 10,430
Goodwill, net of accumulated amortization of $6,354
and $4,954, respectively ............................................... 22,641 24,003
Bank premises and equipment, net (Note 7) ................................ 15,077 14,487
Other real estate owned ................................................... -- 545
Other assets .............................................................. 3,486 4,880
---------- ----------
TOTAL ASSETS .............................................................. $1,262,325 $1,146,140
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES:
Deposits (Note 8):
Noninterest-bearing ................................................ $ 188,832 $ 187,959
Interest-bearing ................................................... 934,565 845,587
---------- ----------
Total deposits .............................................. 1,123,397 1,033,546
Other borrowings (Note 9) ............................................. 18,080 13,931
Accrued interest payable ............................................... 2,869 3,480
Other liabilities ...................................................... 2,254 2,850
---------- ----------
Total liabilities ........................................... 1,146,600 1,053,807
COMMITMENTS AND CONTINGENCIES
(Notes 11 and 15)
COMPANY-OBLIGATED MANDITORILY REDEEMABLE
TRUST PREFERRED SECURITIES OF SUBSIDIARY
TRUSTS (Note 18) ....................................................... 27,000 12,000
SHAREHOLDERS' EQUITY (Notes 13 and 16):
Common stock, $1 par value; 50,000,000 shares authorized; 8,109,011 and
8,075,486 shares issued at December 31, 2001 and 2000, respectively;
8,105,435 and 8,071,910 shares outstanding at December 31, 2001 and
2000, respectively ................................................. 8,109 8,075
Capital surplus ........................................................ 24,955 26,006
Retained earnings ...................................................... 55,462 45,665
Accumulated other comprehensive income (loss) -- net
unrealized gains (losses) on available for sale
securities, net of tax of $117 and of $314,
respectively ....................................................... 217 605
Less treasury stock, at cost, 3,576 shares ............................. (18) (18)
---------- ----------
Total shareholders' equity .................................. 88,725 80,333
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS'
EQUITY ............................................................. $1,262,325 $1,146,140
========== ==========
See notes to consolidated financial statements.
F-3
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
For the Years Ended
December 31,
---------------------------------------------
2001 2000 1999
------- ------- -------
(Dollars in thousands, except per share data)
INTEREST INCOME:
Loans, including fees ......................... $34,731 $33,599 $26,710
Securities:
Taxable .................................... 37,413 31,845 27,115
Nontaxable ................................. 1,597 1,477 933
70% nontaxable preferred dividends ......... 1,343 656 36
Federal funds sold ............................ 1,401 2,414 1,578
Deposits in financial institutions ........... 35 88 86
------- ------- -------
Total interest income .................... 76,520 70,079 56,458
------- ------- -------
INTEREST EXPENSE:
Deposits ...................................... 34,780 33,551 24,087
Note payable and other borrowings ............. 1,005 2,013 2,102
------- ------- -------
Total interest expense ................... 35,785 35,564 26,189
------- ------- -------
NET INTEREST INCOME .............................. 40,735 34,515 30,269
PROVISION FOR CREDIT LOSSES (Note 6) ............. 700 275 420
------- ------- -------
NET INTEREST INCOME AFTER PROVISION
FOR CREDIT LOSSES ............................. 40,035 34,240 29,849
------- ------- -------
NONINTEREST INCOME:
Customer service fees ......................... 7,530 6,576 4,925
Other ......................................... 1,060 1,184 1,226
------- ------- -------
Total noninterest income ................. 8,590 7,760 6,151
------- ------- -------
NONINTEREST EXPENSE:
Salaries and employee benefits
(Note 14) .................................. 12,955 12,931 11,149
Net occupancy expense ......................... 1,971 1,761 1,350
Data processing ............................... 2,126 1,956 1,651
Goodwill amortization ......................... 1,363 1,160 751
Depreciation expense .......................... 1,570 1,553 1,241
Minority interest trust preferred securities .. 1,580 1,151 561
Merger related expenses ....................... 2,425 -- --
Other ......................................... 6,305 6,255 5,119
------- ------- -------
Total noninterest expense ................ 30,295 26,767 21,822
------- ------- -------
INCOME BEFORE INCOME TAXES ....................... 18,330 15,233 14,178
PROVISION FOR INCOME TAXES (Note 12) ............. 5,372 4,532 4,747
------- ------- -------
NET INCOME ....................................... $12,958 $10,701 $ 9,431
======= ======= =======
EARNINGS PER SHARE (Note 1):
Basic ......................................... $ 1.60 $ 1.33 $ 1.19
======= ======= =======
Diluted ....................................... $ 1.57 $ 1.30 $ 1.15
======= ======= =======
See notes to consolidated financial statements.
F-4
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Accumulated
Other
Comprehensive
Income -- Net
Unrealized
Common Stock Gain (Loss) on
-------------------- Available
Capital Retained for Sale
Shares Amount Surplus Earnings Securities
--------- -------- ------- -------- --------------
(Amounts in thousands, except share data)
BALANCE AT JANUARY 1, 1999 ................... 7,974,644 $ 7,975 $26,602 $26,873 $ 347
Net income .............................. 9,431
Net change in unrealized gain (loss)
on available for sale securities ...... (3,028)
Total comprehensive income ..............
Sale of common stock .................... 22,500 24 76
Trust preferred issuance costs .......... (560)
Initial public offering costs ........... (113)
Issuance of common stock in exchange ....
for common stock of Heritage Bank .... 2,154 3,216
Cash dividends declared, $0.20
per share ............................. (1,801)
--------- -------- ------- ------- -------
BALANCE AT DECEMBER 31, 1999 ................. 7,999,298 7,999 26,005 37,719 (2,681)
Net income .............................. 10,701
Net change in unrealized gain (loss)
on available for sale securities ...... 3,286
Total comprehensive income ..............
Sale of common stock .................... 76,200 76 259
Trust preferred issuance costs .......... (90)
Cash paid in lieu of fractional shares in
connection with issuance of common
stock in exchange for stock of Heritage
Bank .................................. (12) (15)
Cash paid to dissenting shareholder in
connection with the issuance of common
stock in exchange for common stock of
Heritage Bank ......................... (153)
Cash dividends declared, $0.36
per share ............................. (2,755)
---------- -------- ------- ------- ------
BALANCE AT DECEMBER 31, 2000 ................. 8,075,486 8,075 26,006 45,665 605
Net income .............................. 12,958
Net change in unrealized gain (loss)
on available for sale securities ...... (388)
Total comprehensive income ..............
Sale of common stock .................... 65,300 66 240
Trust preferred issuance costs .......... (476)
Cash paid to dissenting shareholders in
connection with the issuance of common
stock in exchange for common stock of
Commercial ............................ (31,775) (32) (815)
Cash dividends declared, $0.39
per share ............................. (3,161)
---------- -------- ------- ------- -------
BALANCE AT DECEMBER 31, 2001 ................. 8,109,011 $ 8,109 $24,955 $55,462 $ 217
========== ======== ======= ======= =======
Total
Treasury Shareholders'
Stock Equity
-------- -------------
BALANCE AT JANUARY 1, 1999 ................... $(18) $61,779
Net income .............................. 9,431
Net change in unrealized gain (loss)
on available for sale securities ...... (3,028)
-------
Total comprehensive income .............. 6,403
-------
Sale of common stock .................... 100
Trust preferred issuance costs .......... (560)
Initial public offering costs ........... (113)
Issuance of common stock in exchange ....
for common stock of Heritage Bank .... 3,216
Cash dividends declared, $0.20
per share ............................. (1,801)
---- -------
BALANCE AT DECEMBER 31, 1999 ................. (18) 69,024
Net income .............................. 10,701
Net change in unrealized gain (loss)
on available for sale securities ...... 3,286
-------
Total comprehensive income .............. 13,987
-------
Sale of common stock .................... 335
Trust preferred issuance costs .......... (90)
Cash paid in lieu of fractional shares in
connection with issuance of common
stock in exchange for stock of Heritage
Bank .................................. (15)
Cash paid to dissenting shareholder in
connection with the issuance of common
stock in exchange for common stock of
Heritage Bank ......................... (153)
Cash dividends declared, $0.36
per share ............................. (2,755)
---- -------
BALANCE AT DECEMBER 31, 2000 ................. (18) 80,333
Net income .............................. 12,958
Net change in unrealized gain (loss)
on available for sale securities ...... (388)
-------
Total comprehensive income .............. 12,570
-------
Sale of common stock .................... 306
Trust preferred issuance costs .......... (476)
Cash paid to dissenting shareholders in
connection with the issuance of common
stock in exchange for common stock of
Commercial ............................ (847)
Cash dividends declared, $0.39
per share ............................. (3,161)
---- -------
BALANCE AT DECEMBER 31, 2001 ................. $(18) $88,725
==== =======
See notes to consolidated financial statements.
F-5
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended
December 31,
--------------------------------
2001 2000 1999
--------- --------- --------
(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income .................................... $ 12,958 $ 10,701 $ 9,431
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization ............... 2,933 2,661 2,048
Provision for credit losses ................. 700 275 420
Minority interest in equity of subsidiary ... -- -- 310
Net amortization of premium/
discount on investments .................. 982 (16) 592
Loss (gain) on sale of premises,
equipment and other real estate ........... 87 -- --
Decrease (increase)in accrued interest
receivable and other assets ............... 3,358 (1,340) (375)
(Decrease) increase in accrued interest
payable and other liabilities ............ (1,177) 383 208
--------- --------- --------
Total adjustments ......................... 6,883 1,963 3,203
--------- --------- --------
Net cash provided by operating activities . 19,841 12,664 12,634
--------- --------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities and
principal paydowns of held to
maturity securities ......................... 212,615 79,347 106,952
Purchase of held to maturity securities ....... (75,671) (65,703) (33,655)
Proceeds from maturities and
principal paydowns of available
for sale securities ......................... 92,386 25,765 15,418
Purchase of available for sale securities ..... (396,280) (101,572) (87,070)
Net increase in loans ......................... (13,197) (39,294) (57,093)
Purchase of bank premises and equipment ....... (3,073) (1,308) (2,279)
Proceeds from sale of bank premises, equipment
and other real estate ...................... 1,312 75 --
Purchase of Federal Home Loan Bank
stock ....................................... -- -- (3,931)
Net decrease in interest-bearing deposits
in financial institutions ................... 887 -- 990
Net liabilities acquired in purchase of
Compass branches ............................ -- 77,473 --
Premium paid for South Texas Bancshares ....... -- -- (10,255)
Net liabilities acquired in purchase of South
Texas Bancshares (net of acquired cash
of $12,271) ................................. -- -- 22,516
--------- --------- --------
Net cash (used in) investing activities ..... (181,021) (25,217) (48,407)
--------- --------- --------
(Table continued on following page)
F-6
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended
December 31,
-----------------------------
2001 2000 1999
-------- -------- -------
(Dollars in thousands)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in noninterest-bearing
deposits ................................... $ 873 $ 54,429 $ 9,499
Net increase in interest-bearing deposits .... 88,978 13,037 28,413
Proceeds (repayments ) of other
borrowings (net) .......................... 4,149 (49,188) 45,610
Proceeds from issuance of junior
subordinated debentures .................... 15,000 -- 12,000
Initial public offering costs ................ -- -- (113)
Trust preferred issuance costs .............. (476) (90) (560)
Cash paid in lieu of fractional shares ....... -- (15) --
Cash paid to dissenting shareholder in
connection with the issuance of common stock
in exchange for common stock of Heritage
Bank ....................................... (847) (153) --
Proceeds from the issuance of
common stock ............................... 306 335 99
Payments of cash dividends ................... (3,161) (2,755) (1,801)
-------- -------- -------
Net cash provided by
financing activities .................. 104,822 15,600 93,147
-------- -------- -------
NET (DECREASE) INCREASE IN CASH AND
CASH EQUIVALENTS ............................. $(56,358) $ 3,047 $57,374
CASH AND CASH EQUIVALENTS, BEGINNING
OF PERIOD .................................... 98,078 95,031 37,657
-------- -------- -------
CASH AND CASH EQUIVALENTS, END OF
PERIOD ....................................... $ 41,720 $ 98,078 $95,031
======== ======== =======
INCOME TAXES PAID ............................... $ 6,410 $ 4,259 $ 4,034
======== ======== =======
INTEREST PAID ................................... $ 36,396 $ 32,484 $25,591
======== ======== =======
TRANSFER OF AVAILABLE FOR SALE
SECURITIES TO HELD TO MATURITY
SECURITIES ................................... $170,601 $ -- $ --
======== ======== =======
See notes to consolidated financial statements.
F-7
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING
POLICIES
Nature of Operations -- Prosperity Bancshares, Inc. ("Bancshares") and
its subsidiaries, Prosperity Holdings, Inc. ("Holdings") and Prosperity Bank
(the "Bank") (collectively referred to as the "Company") provide retail and
commercial banking services. The historical financial data of the Company has
been restated to include the accounts and operations of Commercial for all
periods prior to the effective time of the Commercial Merger.
The Bank operates 29 Banking Centers in fourteen contiguous counties
located in Southeast Texas, with locations in Angleton, Bay City, Beeville,
Houston-Bellaire, Houston-Clear Lake, Cleveland, Cuero, Cypress,
Houston-Downtown, East Bernard, Edna, El Campo, Fairfield, Goliad, Hitchcock,
Liberty, Magnolia, Mathis, Houston-Medical Center, Needville, Palacios,
Houston-Post Oak, Houston-River Oaks, Sweeny, Houston-Tanglewood, West Columbia,
Victoria, Houston-Waugh Drive, and Wharton.
Principles of Consolidation -- The consolidated financial statements
include the accounts of Bancshares and its wholly owned subsidiaries. All
significant intercompany transactions have been eliminated in consolidation. The
accounting and reporting policies of the Company conform to generally accepted
accounting principles ("GAAP") and the prevailing practices within the banking
industry. A summary of significant accounting and reporting policies is as
follows:
Use of Estimates -- The preparation of financial statements in
conformity with GAAP requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from these estimates.
Securities -- Securities held to maturity are carried at cost,
adjusted for the amortization of premiums and the accretion of discounts.
Management has the positive intent and the Company has the ability to hold these
assets as long-term securities until their estimated maturities.
Securities available for sale are carried at fair value. Unrealized
gains and losses are excluded from earnings and reported, net of tax, as a
separate component of shareholders' equity until realized. Securities within the
available for sale portfolio may be used as part of the Company's
asset/liability strategy and may be sold in response to changes in interest
risk, prepayment risk or other similar economic factors.
Declines in the fair value of individual held to maturity and
available for sale securities below their cost that are other than temporary
would result in write-downs of the individual securities to their fair value.
The related write-downs would be included in earnings as realized losses.
Premiums and discounts are amortized and accreted to operations using
the level-yield method of accounting, adjusted for prepayments as applicable.
The specific identification method of accounting is used to compute gains or
losses on the sales of these assets. Interest earned on these assets is included
in interest income.
Loans -- Loans are stated at the principal amount outstanding, net of
unearned discount and fees. Unearned discount relates principally to consumer
installment loans. The related interest income for multipayment loans is
recognized principally by the "sum of the digits" method which records interest
in proportion to the declining outstanding balances of the loans; for single
payment loans, such income is recognized using the straight-line method.
Statement of Financial Accounting Standards ("SFAS") No. 114,
"Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118,
"Accounting by Creditors for Impairment of a Loan - Income Recognition and
Disclosure" applies to all impaired loans, with the exception of groups of
smaller-balance homogeneous loans that are collectively evaluated for
impairment. A loan is defined as impaired by SFAS No. 114 if, based on current
information and events, it is probable that a creditor will be unable to collect
all amounts due, both interest and principal, according to the contractual terms
of the loan agreement. Specifically, SFAS No. 114 requires that the allowance
for credit losses related to impaired loans be determined based on the
difference of carrying value of loans and the present value of expected cash
flows discounted at the loan's effective interest rate or, as a practical
expedient, the loan's observable market price or the fair value of the
collateral if the loan is collateral dependent. The Company had $1,000 in
nonaccrual loans, no 90 days or more past due loans, and no restructured loans
at December 31, 2001 and had $10,000 in nonaccrual loans, $778,000 in 90 days or
more past due loans and no restructured loans at December 31, 2000.
F-8
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
Interest revenue received on impaired loans is either applied against
principal or realized as interest revenue, according to management's judgment as
to the collectibility of principal.
Nonrefundable Fees and Costs Associated with Lending Activities - Loan
origination fees in excess of the associated costs are recognized over the life
of the related loan as an adjustment to yield using the interest method.
Generally, loan commitment fees are deferred, except for certain
retrospectively determined fees, and recognized as an adjustment of yield by the
interest method over the related loan life or, if the commitment expires
unexercised, recognized in income upon expiration of the commitment.
Nonperforming Loans and Past Due Loans -- Included in the
nonperforming loan category are loans which have been categorized by management
as nonaccrual because collection of interest is doubtful and loans which have
been restructured to provide a reduction in the interest rate or a deferral of
interest or principal payments. When the payment of principal or interest on a
loan is delinquent for 90 days, or earlier in some cases, the loan is placed on
nonaccrual status unless the loan is in the process of collection and the
underlying collateral fully supports the carrying value of the loan. If the
decision is made to continue accruing interest on the loan, periodic reviews are
made to confirm the accruing status of the loan. When a loan is placed on
nonaccrual status, interest accrued during the current year prior to the
judgment of uncollectibility is charged to operations. Interest accrued during
prior periods is charged to allowance for credit losses. Generally, any payments
received on nonaccrual loans are applied first to outstanding loan amounts and
next to the recovery of charged-off loan amounts. Any excess is treated as
recovery of lost interest.
Restructured loans are those loans on which concessions in terms have
been granted because of a borrower's financial difficulty. Interest is generally
accrued on such loans in accordance with the new terms.
Allowance for Credit Losses -- The allowance for credit losses is a
valuation allowance available for losses incurred on loans. All losses are
charged to the allowance when the loss actually occurs or when a determination
is made that such a loss is probable. Recoveries are credited to the allowance
at the time of recovery.
Throughout the year, management estimates the probable level of losses
to determine whether the allowance for credit losses is adequate to absorb
losses in the existing portfolio. Based on these estimates, an amount is charged
to the provision for credit losses and credited to the allowance for credit
losses in order to adjust the allowance to a level determined to be adequate to
absorb losses.
Management's judgment as to the level of losses on existing loans
involves the consideration of current and anticipated economic conditions and
their potential effects on specific borrowers; an evaluation of the existing
relationships among loans, probable credit losses and the present level of the
allowance; results of examinations of the loan portfolio by regulatory agencies;
and management's internal review of the loan portfolio. In determining the
collectibility of certain loans, management also considers the fair value of any
underlying collateral. The amounts ultimately realized may differ from the
carrying value of these assets because of economic, operating or other
conditions beyond the Company's control.
Estimates of credit losses involve an exercise of judgment. While it
is possible that in the short term the Company may sustain losses which are
substantial in relation to the allowance for credit losses, it is the judgment
of management that the allowance for credit losses reflected in the consolidated
balance sheets is adequate to absorb probable losses that exist in the current
loan portfolio.
Premises and Equipment -- Premises and equipment are carried at cost
less accumulated depreciation. Depreciation expense is computed principally
using the straight-line method over the estimated useful lives of the assets
which range from three to 30 years.
Amortization of Goodwill -- Goodwill was amortized using the
straight-line method through December 31, 2001 (See Note 1-New Accounting
Standards).
Income Taxes -- Bancshares files a consolidated federal income tax
return. The Bank computes federal income taxes as if it filed a separate return
and remits to, or is reimbursed by, Bancshares based on the portion of taxes
currently due or refundable.
F-9
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS -- (Continued)
Deferred tax assets and liabilities are recognized for the estimated
tax consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases.
Stock-Based Compensation -- The Company accounts for its employee
stock options using the intrinsic value-based method and makes pro forma
disclosures of net income and earnings per share using the fair value-based
method (see Note 13).
Statements of Cash Flows -- For purposes of reporting cash flows, cash
and cash equivalents include cash and due from banks as well as federal funds
sold that mature in three days or less.
Reclassifications -- Certain reclassifications have been made to 2000
and 1999 balances to conform to the current year presentation. All
reclassifications have been applied consistently for the periods presented.
Earnings Per Share -- SFAS No. 128, "Earnings Per Share," requires
presentation of basic and diluted earnings per share. Basic earnings per share
has been computed by dividing net income available to common shareholders by the
weighted average number of common shares outstanding for the reporting period.
Diluted earnings per share reflects the potential dilution that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock. Net income per common share for all periods presented has
been calculated in accordance with SFAS No. 128. 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:
December 31,
-----------------------------------------------------------
2001 2000 1999
---------------- ----------------- ------------------
Per Per Per
Share Share Share
Amount Amount Amount Amount Amount Amount
------- ------ -------- ------- ------- ------
(Dollars in thousands, except per share data)
Net income.................... $12,958 $10,701 $ 9,431
Basic --
Weighted average shares
outstanding.............. 8,086 $ 1.60 8,032 $ 1.33 7,986 $1.18
====== ====== =====
Diluted:
Weighted average shares
outstanding . 8,086 8,032 7,986
Effect of dilutive securities --
options................... 163 195 218
------- ------- -------
Total....................... 8,249 $ 1.57 8,227 $ 1.30 8,204 $1.15
======= ====== ======= ====== ======= =====
New Accounting Standards -- In July 2001, the Financial Accounting
Standards Board has issued Statement of Financial Accounting Standards No. 142
(SFAS 142), "Goodwill and Other Intangible Assets," which addresses the
accounting for goodwill and other intangible assets. SFAS 142 specifies that,
among other things, intangible assets with an indefinite useful life and
goodwill will no longer be amortized. The standard requires goodwill to be
periodically tested for impairment and written down to fair value if considered
impaired. The provisions of SFAS 142 are effective for fiscal years beginning
after December 15, 2001, and are effective for interim periods in the initial
year of adoption. The Company is currently assessing the financial statement
impact of the adoption of SFAS 142.
In June 2001, the Financial Accounting Standards Board approved for
issuance Statement of Financial Accounting Standards No. 141 (SFAS 141),
"Business Combinations". This statement eliminates the pooling method of
accounting for business combinations initiated after June 30, 2001. The Company
believes that the adoption SFAS 141 did not have a material effect on its
financial statements.
SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities" establishes accounting and reporting standards for derivative
instruments and requires that an entity recognize all derivatives as either
assets or liabilities in the balance sheet and measure those instruments at fair
value. This statement is effective for periods beginning after June 15, 2000.
The implementation of this pronouncement on January 1, 2001 did not have a
material effect on the Company's financial statements.
F-10
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
2. ACQUISITIONS
On February 23, 2001, the Company completed a merger with Commercial
Bancshares, Inc., a Texas corporation ("Commercial"), whereby Commercial was
merged with and into the Company (the "Commercial Merger"). In connection with
the Commercial Merger, Heritage Bank, Commercial's wholly owned subsidiary, was
merged with and into the Bank. Heritage Bank had 12 full-service banking
locations in the Houston metropolitan area and in three adjacent counties,
including Houston-Bellaire, Cleveland, Cypress, Fairfield, Houston-Downtown,
Houston-Medical Center, Houston-River Oaks, Houston-Tanglewood, Houston-Waugh
Drive, Liberty, Magnolia and Wharton.
As a result of the Commercial Merger, the holders of Commercial common
stock received 155 shares of the Company's common stock, $1.00 par value
("Common Stock") for each share of Commercial common stock they owned at the
effective time ("Effective Time") of the Commercial Merger. Based on this
exchange ratio, the Company issued an aggregate of 2,768,610 shares of its
Common Stock in connection with the Commercial Merger. In addition, in lieu of
issuing shares of Company Common Stock, cash in the amount of $569,625 was paid
to a dissenting shareholder in March 2001 and cash in the amount of $97,650 was
paid to a dissenting shareholder in May 2001. The options to purchase shares of
Commercial common stock which were outstanding at the Effective Time were
converted into options to purchase 13,330 shares of Company Common Stock. In
connection with this Commercial Merger, the Company incurred approximately $2.4
million in pretax merger-related expenses and other charges (the "Special
Charge"). The transaction was accounted for as a pooling of interests and
therefore the historical financial data of the Company has been restated to
include the accounts and operations of Commercial for all periods prior to the
Effective Time of the Commercial Merger.
Effective September 15, 2000, the Company consummated a transaction
with Compass Bank ("Compass") whereby the Company purchased certain assets and
assumed certain liabilities of five Compass branches (the "Compass
Acquisition"). The branches are located in El Campo, Hitchcock, Needville,
Palacios and Sweeny, Texas. With the exception of the El Campo location, the
former Compass branches are being operated as full-service Banking Centers. The
El Campo location has been combined with the Company's El Campo Banking Center.
The Company purchased $5.0 million in loans and assumed $87.3 million in
deposits in connection with the transaction.
In connection with the purchase, the Company paid a cash premium of
$5.4 million. This premium was recorded as goodwill and was amortized until
December 31, 2001 on a straight-line basis (See Note 1-New Accounting
Standards).
The acquisition was accounted for using the purchase method of
accounting. Accordingly, the assets and liabilities of the acquired branches
were recorded at their fair values at the acquisition date.
Effective October 1, 1999, the Company acquired all of the outstanding
shares of South Texas Bancshares, Inc. In connection with the acquisition, The
Commercial National Bank of Beeville, a wholly-owned subsidiary of South Texas
Bancshares, was merged into the Bank. The Company purchased $33.7 million in
loans, $126.5 million in deposits, and $2.7 in real property and fixed assets in
connection with this acquisition.
In connection with the purchase, the Company paid a cash premium of
$10.3 million. This premium was recorded as goodwill and was amortized until
December 31, 2001 on a straight-line basis (See Note 1-New Accounting
Standards).
The acquisition was accounted for using the purchase method of
accounting. Accordingly, the assets and liabilities of the acquired bank were
recorded at their fair values at the acquisition date.
F-11
. PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS -- (Continued)
3. CASH AND DUE FROM BANKS
The Bank is required by the Federal Reserve Bank to maintain average
reserve balances. "Cash and due from banks" in the consolidated balance sheets
includes amounts so restricted of $12.1 million and $9.1 million at December 31,
2001 and 2000, respectively.
4. SECURITIES
The amortized cost and fair value of debt securities are as follows:
December 31, 2001
-----------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair Carrying
Cost Gains Losses Value Value
--------- --------- ---------- --------- ---------
(Dollars in thousands)
Available
U.S. Treasury securities and
obligations of U.S. government
agencies............................. $ 2,248 $ 201 $ -- $ 2,449 $ 2,449
70% non-taxable preferred stock......... 24,058 107 -- 24,165 24,165
States and political subdivisions....... 28,165 483 73 28,575 28,575
Collateralized mortgage obligations..... 17,356 314 22 17,648 17,648
Mortgage-backed securities.............. 410,072 1,646 2,322 409,396 409,396
--------- --------- --------- --------- ---------
Total................................... $ 481,899 $ 2,751 $ 2,417 $ 482,233 $ 482,233
========= ========= ========= ========= =========
Held to Maturity
U.S. Treasury securities and
obligations of U.S. government
agencies............................. $ 141,149 $ 3,180 $ 204 $ 144,125 $ 141,149
Corporate debt securities............... 22,712 609 167 23,154 22,712
States and political subdivisions....... 23,338 605 12 23,931 23,338
Collateralized mortgage
obligations.......................... 22 -- -- 22 22
Mortgage-backed securities.............. 82,868 535 408 82,995 82,868
--------- --------- --------- --------- ---------
Total................................... $ 270,089 $ 4,929 $ 791 $ 274,227 $ 270,089
========= ========= ========= ========= =========
F-12
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
December 31, 2000
-----------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair Carrying
Cost Gains Losses Value Value
--------- ---------- ---------- --------- ---------
(Dollars in thousands)
Available for Sale
U.S. Treasury securities and
obligations of U.S. government
agencies............................. $ 186,832 $ 905 $ 742 $ 186,995 $ 186,995
70% non-taxable preferred stock......... 19,085 145 -- 19,230 19,230
States and political subdivisions....... 20,240 216 2 20,454 20,454
Corporate debt securities............... 1,021 -- 5 1,016 1,016
Equity securities....................... 2 5 -- 7 7
Collateralized mortgage obligations..... 17,979 292 54 18,217 18,217
Mortgage-backed securities.............. 88,695 652 493 88,854 88,854
--------- --------- --------- --------- ---------
Total................................... $ 333,854 $ 2,215 $ 1,296 $ 334,773 $ 334,773
========= ========= ========= ========= =========
Held to Maturity
U.S. Treasury securities and
obligations of U.S. government
agencies............................. $ 147,730 $ 460 $ 1,309 $ 146,881 $ 147,730
Corporate debt securities............... 23,858 67 760 23,165 23,858
States and political subdivisions....... 26,579 137 205 26,511 26,579
Collateralized mortgage obligations..... 328 -- 2 326 328
Mortgage-backed securities.............. 53,659 148 542 53,265 53,659
Other................................... 25 -- -- 25 25
--------- --------- --------- --------- ---------
Total................................... $ 252,179 $ 812 $ 2,818 $ 250,173 $ 252,179
========= ========= ========= ========= =========
The amortized cost and fair value of debt securities at December 31,
2001, by contractual maturity, are shown below. Expected maturities will differ
from contractual maturities because borrowers may have the right to call or
prepay obligations with or without call or prepayment penalties.
December 31, 2001
---------------------------------------------
Held to Maturity Available for Sale
--------------------- ---------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
--------- --------- --------- ---------
(Dollars in thousands)
Due in one year or less........................ $ 24,943 $ 25,541 $ 504 $ 505
Due after one year through five
years....................................... 109,069 111,862 2,229 2,269
Due after five years through ten
years....................................... 52,228 52,797 9,102 9,132
Due after ten years............................ 959 1,009 40,889 41,335
--------- --------- -------- ---------
Subtotal....................................... 187,199 191,209 52,724 53,241
Mortgage-backed securities and
collateralized mortgage
obligations................................. 82,890 83,018 429,175 428,992
--------- --------- -------- ---------
Total.......................................... $ 270,089 $ 274,227 $481,899 $ 482,233
========= ========= ======== =========
There was one sale of a held to maturity security and no sales of
available for sale securities during 2001. The sale of the held to maturity
security occurred due to a de-valuation of the security to a junk bond status.
There was one sale of an available for sale security during 2000. No material
gains were recognized related to either sale.
F-13
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
The Company does not own securities of any one issuer (other than the
U.S. government and its agencies) for which aggregate adjusted cost exceeds 10%
of the consolidated shareholders' equity at December 31, 2001 and December 31,
2000.
Securities with amortized costs of $350.9 million and $219.9 million
and a fair value of $353.9 million and $218.9 million at December 31, 2001 and
2000, respectively, were pledged to secure public deposits and for other
purposes required or permitted by law.
5. LOANS
The loan portfolio consists of various types of loans made principally
to borrowers located in Southeast Texas and is classified by major type as
follows (rounded):
December 31,
-------------------------
2001 2000
----------- -----------
(Dollars in thousands)
Commercial and industrial......................... $ 46,986 $ 46,529
Real estate:
Construction and land
development............................... 20,963 20,128
1-4 family residential......................... 175,253 175,525
Home equity.................................... 20,541 16,762
Commercial mortgages........................... 78,446 75,896
Farmland....................................... 10,686 12,218
Multi-family residential....................... 9,694 2,961
Agriculture....................................... 15,757 13,251
Other............................................. 953 2,563
Consumer.......................................... 45,230 45,833
----------- -----------
Total............................................. 424,509 411,666
Less unearned discount............................ 109 463
----------- -----------
Total......................................... $ 424,400 $ 411,203
=========== ===========
The contractual maturity ranges of the commercial and industrial and
construction and land development portfolios and the amount of such loans with
predetermined interest rates and floating rates in each maturity range are
summarized in the following table:
December 31, 2001
--------------------------------------------
After One
One Year Through After Five
or Less Five Years Years Total
-------- ---------- ---------- --------
(Dollars in thousands)
Commercial and industrial......................... $18,601 $23,059 $5,326 $46,986
Construction and land development................. 19,658 397 908 20,963
------ ------ ------ -------
Total............................... $38,259 $23,456 $6,234 $67,949
======= ======= ====== =======
Loans with a predetermined interest rate.......... $ 8,089 $12,749 $2,408 $23,246
Loans with a floating interest rate............... 30,170 10,707 3,826 44,703
------ ------- ------ -------
Total............................... $38,259 $23,456 $6,234 $67,949
======= ======= ====== =======
As of December 31, 2001 and 2000, loans outstanding to directo
officers and their affiliates were $7.1 million and $6.9 million, respectively.
In the opinion of management, all transactions entered into between the Company
and such related parties have been, and are, in the ordinary course of business,
made on the same terms and conditions as similar transactions with unaffiliated
persons.
F-14
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS -- (Continued)
An analysis of activity with respect to these related-party loans is as
follows:
Year Ended
December 31,
---------------------
2001 2000
--------- ---------
(Dollars in thousands)
Beginning balance.................................. $ 6,850 $ 7,512
New loans and reclassified related loans........... 4,448 4,686
Repayments......................................... (4,154) (5,348)
--------- ---------
Ending balance..................................... $ 7,144 $ 6,850
========= =========
6. ALLOWANCE FOR CREDIT LOSSES
An analysis of activity in the allowance for credit losses is as follows:
Year Ended December 31,
-------------------------
2001 2000 1999
------- ------ ------
(Dollars in thousands)
Balance at beginning of year........................... $ 5,523 $5,031 $3,682
Balance acquired with Compass and South Texas
Bancshares Acquisitions, respectively......... -- 46 566
Addition -- provision charged to
operations.................................... 700 275 420
Net (charge-offs) and recoveries:
Loans charged off......................... (429) (217) (137)
Loan recoveries........................... 191 388 500
------- ------ ------
Total net (charge-offs) recoveries..................... (238) 171 363
------- ------ ------
Balance at end of period............................... $ 5,985 $5,523 $5,031
======= ====== ======
7. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
Year Ended
December 31,
--------------------
2001 2000
-------- --------
(Dollars in thousands)
Land..................................................... $ 3,161 $ 3,125
Buildings................................................ 12,645 13,153
Furniture, fixtures and equipment........................ 6,754 7,695
Construction in progress................................. 912 236
------- -------
Total.................................................... 23,472 24,209
Less accumulated depreciation............................ 8,395 9,722
------- -------
Premises and equipment, net.............................. $15,077 $14,487
======= =======
F-15
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
8. DEPOSITS
Included in interest-bearing deposits are certificates of deposit in
amounts of $100,000 or more. These certificates and their remaining maturities
at December 31, 2001 were as follows:
December 31,2001
----------------------
(Dollars in thousands)
Three months or less.................................. $101,319
Greater than three through six months................. 38,006
Greater than six through twelve months................ 37,140
Thereafter............................................ 17,229
--------
Total................................................. $193,694
========
Interest expense for certificates of deposit in excess of $100,000 was
$8.7 million, $6.0 million and $3.7 million, for the years ended December 31,
2001, 2000 and 1999, respectively.
The Company has no brokered deposits and there are no major
concentrations of deposits.
9. OTHER BORROWINGS
Note Payable -- During December 1997, Bancshares entered into an
agreement with a bank to borrow up to $8.0 million under a reducing, revolving
line of credit (the "Line"). The purpose of the Line is to provide funding for
potential acquisitions in the future. The maximum amount available under the
Line is reduced by $1.1 million each year beginning December 1998 with all
amounts due and payable on December 31, 2004. The Line bears interest, payable
quarterly, at the Federal Funds Rate plus 2.75%. The Line is collateralized by
100% of the issued and outstanding common shares of Holdings and the Bank. At
December 31, 2001 and 2000, Bancshares had no outstanding borrowings under the
Line.
Other Borrowings - At December 31, 2001, the Company had $18.1 million
in FHLB borrowings of which $13.3 million consisted of FHLB notes payable and
$4.8 million consisted of FHLB advances. The highest outstanding balance of FHLB
advances during 2001 was $30.2 million. At December 31, 2000, the Company had
$13.9 million in FHLB notes payable and had no FHLB advances. The advances under
the FHLB line of credit are secured by a blanket pledge of the Bank's 1-4 family
residential mortgages.
10. INTEREST RATE RISK
The Company is principally engaged in providing real estate, consumer
and commercial loans, with interest rates that are both fixed and variable.
These loans are primarily funded through short-term demand deposits and
longer-term certificates of deposit with variable and fixed rates. The fixed
real estate loans are more sensitive to interest rate risk because of their
fixed rates and longer maturities.
F-16
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
11. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
In the normal course of business, the Company is a party to various
financial instruments with off-balance-sheet risk to meet the financing needs of
its customers and to reduce its own exposure to fluctuations in interest rates.
These financial instruments include commitments to extend credit and standby
letters of credit. These instruments involve, to varying degrees, elements of
credit and interest rate risk in excess of the amounts recognized in the
consolidated balance sheets. The contract or notional amounts of these
instruments reflect the extent of the Company's involvement in particular
classes of financial instruments.
The Company's exposure to credit loss in the event of nonperformance
by the other party to the financial instrument for commitments to extend credit
and standby letters of credit is represented by the contractual amount of these
instruments. The Company uses the same credit policies in making these
commitments and conditional obligations as it does for on-balance-sheet
instruments.
The following is a summary of the various financial instruments
entered into by the Company:
December 31,
--------------------
2001 2000
--------- --------
(Dollars in thousands)
Financial instruments whose contract
amounts represent credit risk:
Commitments to extend credit.............. $ 46,789 $ 50,714
Standby letters of credit................. 1,481 751
At December 31, 2001, $10.8 million of commitments to extend credit
have fixed rates ranging from 3.75% to 14.00%. Commitments to extend credit are
agreements to lend to a customer as long as there is no violation of any
condition established in the contract. Commitments generally have fixed
expiration dates or other termination clauses and may require payment of a fee.
Since many of the commitments are expected to expire without being fully drawn
upon, the total commitment amounts disclosed above do not necessarily represent
future cash requirements.
Standby letters of credit are conditional commitments issued by the
Company to guarantee the performance of a customer to a third party. The credit
risk involved in issuing letters of credit is essentially the same as that
involved in extending loan facilities to customers.
The Company evaluates customer creditworthiness on a case-by-case
basis. The amount of collateral obtained, if considered necessary by the Company
upon extension of credit, is based on management's credit evaluation of the
customer.
12. INCOME TAXES
The components of the provision for federal income taxes are as
follows:
Year Ended December 31,
---------------------------------
2001 2000 1999
--------- --------- ---------
(Dollars in thousands)
Current.................................. $ 5,894 $ 4,501 $ 4,857
Deferred................................. (522) 31 (110)
-------- --------- ---------
Total.................................... $ 5,372 $ 4,532 $ 4,747
========= ========= =========
F-17
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
The provision for federal income taxes differs from the amount computed by
applying the federal income tax statutory rate on income as follows:
Year Ended December 31,
---------------------------
2001 2000 1999
------- ------- -------
(Dollars in thousands)
Taxes calculated at statutory rate ........... $ 6,415 $ 5,179 $ 4,821
Increase (decrease) resulting from:
Tax-exempt interest .................. (702) (550) (359)
Qualified Zone Academy Bond credit ... (373) (379) --
Dividends received deduction ......... (329) (156) --
Amortization of goodwill ............. 262 200 138
Other, net ........................... 99 238 147
------- ------- -------
Total ........................................ $ 5,372 $ 4,532 $ 4,747
======= ======= =======
Deferred tax assets and liabilities are as follows:
December 31,
-----------------
2001 2000
------- -------
(Dollars in thousands)
Deferred tax assets:
Allowance for credit losses .............. $ 994 $ 461
Nonaccrual loan interest ................. 104 --
Accrued liability ........................ 105 --
Other .................................... 31 116
------- -------
Total deferred tax assets ........................ 1,234 577
------- -------
Deferred tax liabilities:
Allowance for credit losses .............. $ -- $ (1)
Accretion on investments ................. (545) (360)
Bank premises and equipment .............. (1,046) (1,198)
Unrealized gain on available for sale
securities ............................ (117) (312)
FHLB dividends ........................ (125) --
Transfer from Heritage Bank ........... (32) --
Other ................................. (--) (276)
------- -------
Total deferred tax liabilities ................... (1,865) (2,147)
------- -------
Net deferred tax liabilities ..................... $ (631) $(1,570)
======= =======
F-18
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
13. STOCK INCENTIVE PROGRAM
During 1995, the Company's Board of Directors approved a stock option
plan (the "1995 Plan") for executive officers and key associates to purchase
common stock of Bancshares. On May 31, 1995, the Company granted 260,000 options
(after stock split) which vest over a ten-year period beginning on the date of
grant. The options were granted at an average exercise price of $4.40 (after
stock split). Compensation expense was not recognized for the stock options
granted under the 1995 Plan because the options had an exercise price
approximating the fair value of Bancshares' common stock at the date of grant.
The maximum number of shares reserved for issuance pursuant to options granted
under the 1995 Plan is 340,000 (after stock split).
During 1998, the Company's Board of Directors and shareholders
approved a second stock option plan (the "1998 Plan") which authorizes the
issuance of up to 460,000 shares of the common stock of Bancshares under both
"non-qualified" and "incentive" stock options to employees and "non-qualified"
stock options to directors who are not employees. The 1998 Plan also provides
for the granting of restricted stock awards, stock appreciation rights, phantom
stock awards and performance awards on substantially similar terms. Compensation
expense was not recognized for the stock options granted under the 1998 Plan
because the options had an exercise price approximating the fair value of
Bancshares' common stock at the date of grant. Options to purchase 92,000 shares
of Bancshares' common stock have been granted under the 1998 Plan.
On February 23, 2001, the Company consummated its merger with
Commercial. The options to purchase shares of Commercial common stock which were
outstanding at the effective time of the merger were converted into options to
purchase 13,330 shares of Bancshares' common stock at exercise prices ranging
from $1.45 to $10.32 per share. The converted options are governed by the
original plans under which they were issued.
Year Ended December 31,
---------------------------------------------------------------
2001 2000 1999
------------------- ------------------- -------------------
Weighted- Weighted- Weighted-
Number Average Number Average Number Average
of Exercise of Exercise of Exercise
Options Price Options Price Options Price
------- --------- ------- --------- ------- ---------
Options outstanding, beginning of period .... 243,390 $ 5.06 325,000 $ 4.80 335,500 $ 4.56
Options granted ............................. 92,000 20.01 4,340 10.32 12,000 12.75
Options forfeited ........................... (5,000) 20.01 (9,750) 3.77 -- --
Options exercised ........................... (65,300) 4.68 (76,200) 4.40 (22,500) 4.40
------- ------- -------
Options outstanding, end of period .......... 265,090 $ 8.94 243,390 $ 5.06 325,000 $ 4.80
======= ====== ======= ====== ======= ======
At December 31, 2001, there were 261,100 options exercisable under all
plans. During 2001, 65,300 options were exercised.
On April 18, 2001, the Company granted 92,000 options under the 1998
Plan. The options were granted at an exercise price of $20.01. Compensation
expense was not recorded for the stock options because the exercise price
approximated the fair value of common stock at the date of grant.
On May 4, 1999, the Company granted 12,000 options under the 1995
Plan. The options were granted at an exercise price of $12.75. Compensation
expense was not recorded for the stock options because the exercise price
approximated the fair value of common stock at the date of grant.
On February 10, 1998, the Company granted 60,000 options under the
1995 Plan. The options were granted at an exercise price of $6.25 (after stock
split). Compensation expense was not recorded for the stock options because the
exercise price approximated the fair value of common stock at the date of grant.
The weighted-average fair value of the stock options on the grant
dates was $0.39, $0.81, $2.85 and $4.83 in 1995, 1998, 1999 and 2001
respectively. The weighted-average remaining contractual life of options
outstanding as of December 31, 2001 was 3.42, 6.17, 7.42 and 9.33 years for the
options granted in 1995, 1998, 1999 and 2001, respectively. The fair value of
each stock options was estimated using an option-pricing model with the
following assumptions: (1) for the options granted in 1995, risk-free interest
rate of 6.49%; dividend yield of 4.54%; and an expected life of 6.5 years; (2)
for the options granted in 1998, risk-free interest rate of 5.87%; dividend
yield of 3.20%; and an expected life of 6.5 years; (3) for the options granted
in 1999, risk-free interest rate
F-19
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
of 5.765%; dividend yield of 1.57%; and an expected life of 4.5 years; and (4)
for the options granted in 2001, risk-free interest rate of 5.383%; dividend
yield of 1.95%; and an expected life of 4.5 years.
If compensation expense had been recorded based on the fair value at
the grant date for awards consistent with SFAS No. 123, the Company's net income
would have been $12.9 million, $10.7 million, and $9.4 million for the years
ended December 31, 2001, 2000 and 1999, respectively. Diluted earnings per share
would have been $1.57, $1.30 and $1.15 for the years ended December 31, 2001,
2000 and 1999, respectively.
14. PROFIT SHARING PLAN
The Company has adopted a profit sharing plan pursuant to Section
401(k) of the Internal Revenue Code whereby participants may contribute up to
15% of their compensation. Matching contributions are made at the discretion of
the Company. Such matching contributions were approximately $351,000, $327,000
and $292,000, for the years ended December 31, 2001, 2000 and 1999,
respectively.
15. COMMITMENTS AND CONTINGENCIES
Leases -- A summary of noncancelable future operating lease commitments as of
December 31, 2001 follows (dollars in thousands):
2002...................................... $ 765
2003...................................... 556
2004...................................... 556
2005...................................... 194
2006...................................... 194
---------
Total..................................... $ 2,265
=========
It is expected that in the normal course of business, expiring leases
will be renewed or replaced by leases on other property or equipment.
Rent expense under all noncancelable operating lease obligations
aggregated approximately $957,000 for the year ended December 31, 2001, $834,000
for the year ended December 31, 2000 and $620,000 for the year ended December
31, 1999.
Litigation - The Company has been named as a defendant in various
legal actions arising in the normal course of business. In the opinion of
management, after reviewing such claims with outside counsel, resolution of such
matters will not have a materially adverse impact on the consolidated financial
statements.
16. REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital
requirements administered by the federal banking agencies. Any institution that
fails to meet its minimum capital requirements is subject to actions by
regulators that could have a direct material effect on the Company's and the
Bank's financial statements. Under the capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines based on the Bank's assets, liabilities and certain off-
balance-sheet items as calculated under regulatory accounting practices. The
Company's and the Bank's capital amounts and the Bank's classification under the
regulatory framework for prompt corrective action are also subject to
qualitative judgements by the regulators about the components, risk weightings
and other factors.
To meet the capital adequacy requirements, the Company and the Bank
must maintain minimum capital amounts and ratios as defined in the regulations.
Management believes, as of December 31, 2001 and 2000, that the Company and the
Bank met all capital adequacy requirements to which they are subject.
At December 31, 2001, the most recent notification from the FDIC
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action. To be categorized as well capitalized the Bank must
maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios
as set forth in the table. There have been no conditions or events since that
notification which management believes have changed the Bank's category.
F-20
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
The following is a summary of the Company's and the Bank's capital ratios
at December 31, 2001 and 2000 (dollars in thousands):
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
--------------- ----------------- ------------------
Amount Ratio Amount Ratio Amount Ratio
------- ----- ------- ----- ------ -----
CONSOLIDATED:
As of December 31, 2001:
Total Capital
(to Risk Weighted Assets).......... $98,852 19.52% $40,509 8.0% N/A N/A
Tier I Capital
(to Risk Weighted Assets).......... $92,867 18.34% $20,254 4.0% N/A N/A
Tier I Capital
(to Average Assets)................ $92,867 7.57% $36,781 3.0% N/A N/A
As of December 31, 2000:
Total Capital
(to Risk Weighted Assets).......... $73,249 14.93% $39,252 8.0% N/A N/A
Tier I Capital
(to Risk Weighted Assets).......... $67,725 13.80% $19,626 4.0% N/A N/A
Tier I Capital
(to Average Assets)................ $67,725 6.17% $32,945 3.0% N/A N/A
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
--------------- ----------------- -------------------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------- -----
BANK ONLY:
As of December 31, 2001:
Total Capital
(to Risk Weighted Assets).......... $85,584 16.90% $40,502 8.0% $50,628 10.0%
Tier I Capital
(to Risk Weighted Assets).......... $79,599 15.72% $20,251 4.0% $30,377 6.0%
Tier I Capital
(to Average Assets)................ $79,599 6.50% $36,751 3.0% $61,251 5.0%
As of December 31, 2000:
Total Capital
(to Risk Weighted Assets).......... $72,206 14.73% $39,207 8.0% $49,009 10.0%
Tier I Capital
(to Risk Weighted Assets).......... $66,682 13.61% $19,604 4.0% $29,405 6.0%
Tier I Capital
(to Average Assets) $66,682 6.10% 32,809 3.0% $54,682 5.0%
Dividends paid by Bancshares and the Bank are subject to restrictions
by certain regulatory agencies. There was an aggregate of $25.4 million and
$32.7 million available for payment of dividends by Bancshares and by the Bank
to Bancshares, respectively, at December 31, 2001 under these restrictions.
Dividends paid by Bancshares during the years ended December 31, 2001 and 2000
were $3.2 million and $2.8 million, respectively. There were $2.3 million of
dividends paid by the Bank to Bancshares during the year ended 2001 and $900,000
paid by the Bank to Bancshares during the year ended 2000.
17. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
Disclosures of the estimated fair value amounts of financial
instruments have been determined by the Company using available market
information and appropriate valuation methodologies. However, considerable
judgment is necessarily required in interpreting market data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies could have a material effect on the estimated fair value amounts.
F-21
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
The following methods and assumptions were used to estimate the fair
value of each class of financial instruments for which it is practicable to
estimate that value:
Cash and Cash Equivalents -- For these short-term instruments, the
carrying amount is a reasonable estimate of fair value.
Securities -- For securities held as investments, fair value equals
quoted market price, if available. If a quoted market price is not available,
fair value is estimated using quoted market prices for similar securities.
Loan Receivables -- For certain homogeneous categories of loans (such
as some residential mortgages and other consumer loans), fair value is estimated
by discounting the future cash flows using the risk-free Treasury rate for the
applicable maturity, adjusted for servicing and credit risk. The carrying value
of variable rate loans approximates fair value because the loans reprice
frequently to current market rates.
Company-Obligated Mandatorily Redeemable Trust Preferred Securities of
Subsidiary Trusts - The fair value of the Company-Obligated Mandatorily
Redeemable Trust Preferred Securities of Subsidiary Trusts was calculated using
the quoted market price at December 31, 2001 and 2000.
Deposit Liabilities -- 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.
Long-Term Debt and Other Borrowings -- Rates currently available to
the Company for debt with similar terms and remaining maturities are used to
estimate the fair value of existing debt using a discounted cash flows
methodology.
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 estimated fair values of the Company's interest-earning financial
instruments are as follows (dollars in thousands):
December 31,
--------------------------------------------------------
2001 2000
-------------------------- --------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
----------- ----------- ----------- -----------
Financial assets:
Cash and due from banks .................. $ 41,005 $ 41,005 $ 35,709 $ 35,709
Federal funds sold and other temporary
investments ............................ 715 715 62,369 62,369
Held to maturity securities .............. 270,089 274,227 252,179 250,172
Available for sale securities ............ 482,233 482,233 334,773 334,773
Loans .................................... 424,400 434,441 411,203 422,536
Less allowance for credit losses ......... (5,985) (5,985) (5,523) (5,523)
----------- ----------- ----------- -----------
Total ............................................ $ 1,212,457 $ 1,226,636 $ 1,090,710 $ 1,100,036
=========== =========== =========== ===========
Financial liabilities:
Deposits ................................. $ 1,123,397 $ 1,128,732 $ 1,033,546 $ 1,035,241
Company-obligated mandatorily redeemable
trust preferred securities of subsidiary
trusts ................................. 27,000 28,741 12,000 11,119
Federal Home Loan Bank Advances .......... 4,775 4,775 -- --
Federal funds purchased and other
borrowings .............................. 13,305 17,743 13,931 13,931
----------- ----------- ----------- -----------
Total ............................................ $ 1,168,477 $ 1,179,991 $ 1,059,477 $ 1,060,291
=========== =========== =========== ===========
The differences in fair value and carrying value of commitments to
extend credit and standby letters of credit were not material at December 31,
2001 and 2000.
F-22
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
The fair value estimates presented herein are based on pertinent
information available to management as of the dates indicated. 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.
18 TRUST PREFERRED SECURITIES
In July 2001, the Company formed Prosperity Statutory Trust II ("Trust
II") and on July 31, 2001, Trust II issued 15,000 Floating Rate Capital
Securities (the "Capital Securities") with an aggregate liquidation value of
$15,000,000 to a third party. Concurrent with the issuance of the Capital
Securities, Trust II issued trust common securities to the Company in the
aggregate liquidation value of $464,000. The proceeds of the issuance of the
Capital Securities and trust common securities were invested in the Company's
Floating Rate Junior Subordinated Deferrable Interest Debentures (the "Floating
Rate Debentures"). The Floating Rate Debentures will mature on July 31, 2031,
which date may be shortened to a date not earlier than July 31, 2006, if certain
conditions are met (including the Company having received prior approval of the
Federal Reserve and any other required regulatory approvals). These Floating
Rate Debentures, which are the only assets of Trust II, are subordinate and
junior in right of payment to all present and future senior indebtedness (as
defined in the Indenture dated July 31, 2001) of the Company. The Floating Rate
Debentures will accrue interest at a floating rate equal to 3-month LIBOR plus
3.58%, not to exceed 12.50%, payable quarterly. The annual interest rate on the
Debentures for the period from October 31, 2001 through December 31, 2001 was
equal to 5.85%. The quarterly distributions on the Capital Securities will be
paid at the same rate that interest is paid on the Floating Rate Debentures.
The Company has fully and unconditionally guaranteed the Trust II's
obligations under the Capital Securities. Trust II must redeem the Capital
Securities when the Floating Rate Debentures are paid at maturity or upon any
earlier prepayment of the Floating Rate Debentures. The Floating Rate Debentures
may be prepaid if certain events occur, including a change in the tax status or
regulatory capital treatment of the Capital Securities or a change in existing
laws that requires Trust II to register as an investment company.
For financial reporting purposes, Trust II is treated as a subsidiary
of the Company and consolidated in the corporate financial statements. The
Capital Securities are treated as Tier 1 capital by the Federal Reserve. The
treatment of the Capital Securities as Tier 1 capital, in addition to the
ability to deduct the expense of the Floating Rate Debentures for federal income
tax purposes, provided the Company with a cost-effective method of raising
capital. The Company received net proceeds of $14.5 million, which will be used
for the general corporate purposes of the Company and the Bank, including
supporting continued expansion activities in the Houston metropolitan area and
surrounding counties through the establishment and/or acquisition of additional
Banking Centers and possible acquisitions.
In November 1999, the Company formed Prosperity Capital Trust I, a
business trust formed under the laws of the State of Delaware ("Trust I"). Trust
I issued $12.0 million of 9.60% Trust Preferred Securities and invested the
proceeds thereof in the 9.60% Junior Subordinated Deferrable Interest Debentures
(the "Fixed Rate Debentures") issued by the Company. The Fixed Rate Debentures
will mature on November 17, 2029, which date may be shortened to a date not
earlier than November 17, 2004, if certain conditions are met (including the
Company having received prior approval of the Federal Reserve and any other
required regulatory approvals). The Trust Preferred Securities will be subject
to mandatory redemption if the Fixed Rate Debentures are repaid by the Company.
The Fixed Rate Debentures may be prepaid if certain events occur, including a
change in the tax status or regulatory capital treatment of the Trust Preferred
Securities. In each case, redemption will be made at par, plus the accrued and
unpaid distributions thereon through the redemption date.
F-23
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
19. PARENT COMPANY ONLY FINANCIAL STATEMENTS
PROSPERITY BANCSHARES, INC.
(Parent Company Only)
BALANCE SHEETS
December 31,
----------------------
2001 2000
--------- ---------
(Dollars in thousands)
ASSETS
Cash ............................................. $ 13,331 $ 433
Investment in subsidiaries ....................... 98,485 86,879
Investment in Prosperity Capital Trust I ......... 380 380
Investment in Prosperity Statutory Trust II ...... 464 --
Goodwill, net .................................... 3,983 4,448
Other assets ..................................... 83 791
--------- --------
TOTAL ...................................... $ 116,726 $ 92,931
========= ========
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES:
Accrued interest payable and other liabilities ... $ 157 $ 218
Junior subordinated debentures ................... 27,844 12,380
--------- --------
Total liabilities .......................... 28,001 12,598
--------- --------
SHAREHOLDERS' EQUITY:
Common stock ..................................... 8,109 8,075
Capital surplus .................................. 24,955 26,006
Retained earnings ................................ 55,462 45,665
Unrealized losses on available
for sale securities, net of tax ................ 217 605
Less treasury stock, at cost (3,576 shares at
December 31, 2001 and 2000, respectively) ...... (18) (18)
--------- --------
Total shareholders' equity ................ 88,725 80,333
--------- --------
TOTAL ................................................. $ 116,726 $ 92,931
========= ========
F-24
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
PROSPERITY BANCSHARES, INC.
(Parent Company Only)
STATEMENTS OF INCOME
For the Years Ended December 31,
--------------------------------
2001 2000 1999
-------- -------- --------
(Dollars in thousands)
OPERATING INCOME:
Dividends from subsidiaries .......... $ 2,272 $ -- $ --
Other income ......................... -- 2 --
-------- -------- -------
Total income .................... 2,272 2 --
-------- -------- -------
OPERATING EXPENSE:
Amortization of goodwill ............. 466 466 466
Minority expense trust preferred
securities ......................... 1,580 1,151 142
Other expenses ....................... 158 81 103
-------- -------- -------
Total operating expense ........ 2,204 1,698 711
-------- -------- -------
INCOME BEFORE INCOME TAX BENEFIT AND
EQUITY IN UNDISTRIBUTED EARNINGS OF
SUBSIDIARIES ............................ 68 (1,696) (711)
FEDERAL INCOME TAX BENEFIT ................. 716 535 189
-------- -------- -------
INCOME BEFORE EQUITY IN UNDISTRIBUTED
EARNINGS OF SUBSIDIARIES ................ 784 (1,161) (522)
EQUITY IN UNDISTRIBUTED EARNINGS OF
SUBSIDIARIES ............................ 12,174 11,862 9,953
-------- -------- -------
NET INCOME ................................. $ 12,958 $ 10,701 $ 9,431
======== ======== =======
F-25
PROSPERITY BANCSHARES, INC./sm/ AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
PROSPERITY BANCSHARES, INC.
(Parent Company Only)
STATEMENTS OF CASH FLOWS
For the Years Ended December 31,
--------------------------------
2001 2000 1999
-------- -------- --------
(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income .................................... $ 12,958 $ 10,701 $ 9,431
Adjustments to reconcile net income
to net cash provided by operating activities:
Equity in undistributed earnings
of subsidiaries ........................... (12,175) (10,962) (9,173)
Amortization of goodwill .................... 466 466 466
Decrease (increase) in other assets ...... 708 (190) (193)
(Decrease) increase in accrued interest
payable .................................. (61) (142) 150
Cash paid in lieu of fractional shares ...... -- (15) --
Increase (decrease) in other liabilities .... -- 15 (6)
-------- -------- --------
Total adjustments ....................... (11,062) (10,828) (8,756)
-------- -------- --------
Net cash flows provided by (used in)
operating activities ............... 1,896 (127) 675
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital contribution to subsidiary ............ -- -- (381)
-------- -------- --------
Net cash flows used in
investing activities ............... -- -- (381)
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of common stock ...................... 306 335 99
Initial public offering costs ................. -- -- (113)
Trust preferred securities issuance cost ...... (476) (90) (560)
Payments of cash dividends .................... (3,161) (2,755) (1,801)
Transfer to Bank .............................. -- -- (18,000)
Cash paid to dissenting shareholders .......... (667) -- --
Proceeds from issuance of junior
subordinated debentures ................... 15,000 -- 12,380
-------- -------- --------
Net cash flows provided by (used in)
financing activities ............... 11,002 (2,510) (7,995)
-------- -------- --------
NET INCREASE (DECREASE) IN CASH
AND CASH EQUIVALENTS .......................... 12,898 (2,637) (7,701)
CASH AND CASH EQUIVALENTS, BEGINNING
OF PERIOD ..................................... 433 3,070 10,771
-------- -------- --------
CASH AND CASH EQUIVALENTS, END OF
PERIOD ........................................ $ 13,331 $ 433 $ 3,070
======== ======== ========
F-26
PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
20. SUBSEQUENT EVENT (Unaudited)
On February 22, 2002, the Company entered into a definitive agreement
with American Bancorp of Oklahoma, Inc. to acquire one of its subsidiary banks,
Texas Guaranty Bank, N.A., headquartered in Houston, Texas for $11.8 million in
cash. Following the acquisition, Texas Guaranty Bank will be merged into
Prosperity Bank. The Company will not complete the acquisition unless customary
closing conditions are satisfied or waived, including receipt of the necessary
regulatory approvals and consents from applicable regulatory agencies including
the Federal Reserve Board, the Texas Banking Department and the Federal Deposit
Insurance Corporation. Texas Guaranty Bank operates three banking offices in the
western portion of the greater Houston metropolitan area. As of December 31,
2001, Texas Guaranty Bank had total assets of $82.2 million, total loans of
$59.7 million, total deposits of $62.9 million and shareholders' equity of $9.4
million.
F-27