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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------------
(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, 2002
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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). 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. [_]
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 June 30, 2002 was approximately $172,889,401.
As of February 6, 2003, the number of outstanding shares of Common Stock
was 18,903,483.
Documents Incorporated by Reference:
Portions of the Company's Proxy Statement relating to the 2003 Annual
Meeting of Shareholders, which will be filed within 120 days after December 31,
2002, are incorporated by reference into Part III, Items 10-13 of this Form
10-K.
PROSPERITY BANCSHARES, INC.(SM)
2002 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I
Item 1. Business ............................................................................................. 2
General ............................................................................................ 2
Recent Mergers and Acquisitions .................................................................... 3
Recent Developments ................................................................................ 3
Stock split ........................................................................................ 4
Available information .............................................................................. 4
Officers and Associates ............................................................................ 4
Banking Activities ................................................................................. 4
Business Strategies ................................................................................ 5
Competition ........................................................................................ 6
Supervision and Regulation ......................................................................... 6
Item 2. Properties ........................................................................................... 13
Item 3. Legal Proceedings .................................................................................... 16
Item 4. Submission of Matters to a Vote of Security Holders .................................................. 16
PART II
Item 5. Market for Registrant's Common Equity and Related Shareholder Matters ................................ 16
Item 6. Selected Consolidated Financial Data ................................................................. 18
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ................ 20
Overview ........................................................................................... 20
Critical Accounting Policies ....................................................................... 20
Results of Operations .............................................................................. 21
Financial Condition ................................................................................ 25
Item 7A. Quantitative and Qualitative Disclosures about Market Risk ........................................... 38
Item 8. Financial Statements and Supplementary Data .......................................................... 38
Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure ................. 40
PART III
Item 10. Directors and Executive Officers of the Registrant ................................................... 40
Item 11. Executive Compensation ............................................................................... 40
Item 12. Security Ownership of Certain Beneficial Owners and Management ....................................... 40
Item 13. Certain Relationships and Related Transactions ....................................................... 40
Item 14. Controls and Procedures .............................................................................. 40
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K ...................................... 41
Signatures
PART I
Special Cautionary Notice Regarding Forward-Looking Statements
Statements and financial discussion and analysis contained in this
annual report on Form 10-K that are not historical facts are forward-looking
statements made pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Forward-looking statements are based on
assumptions and involve a number of risks and uncertainties, many of which are
beyond the Company's control. Many possible events or factors could affect the
future financial results and performance of the Company and could cause such
results or performance to differ materially from those expressed in the
forward-looking statements. These possible events or factors include, without
limitation:
.. changes in 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;
.. changes in statutes and government regulations or their interpretations
applicable to financial holding companies and the Company's present and
future banking and other subsidiaries, including changes in tax
requirements and tax rates;
.. acts of terrorism, an outbreak of hostilities or other international or
domestic calamities, weather or other acts of God and other matters beyond
the Company's control; and
.. other risks and uncertainties listed from time to time in the Company's
reports and documents filed with the Securities and Exchange Commission.
A forward-looking statement may include a statement of the assumptions
or bases underlying the forward-looking statement. The Company believes it has
chosen these assumptions or bases in good faith and that they are reasonable.
However, the Company cautions you that assumptions or bases almost always vary
from actual results, and the differences between assumptions or bases and actual
results can be material.
The Company undertakes no obligation to publicly update or otherwise
revise any forward-looking statements, whether as a result of new information,
future events or otherwise, unless the securities laws require the Company to do
so.
1
ITEM 1. BUSINESS
General
Prosperity Bancshares, Inc.(SM) (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 its bank
subsidiary, Prosperity Bank(SM) ("Prosperity Bank" or the "Bank"). The Bank
provides a broad line of financial products and services to small and
medium-sized businesses and consumers. The Bank operates forty (40) full-service
banking locations in the greater Houston metropolitan area and fifteen
contiguous counties situated south and southwest of Houston and extending into
South Texas and two (2) full service banking locations in Dallas, Texas. The
Company's headquarters are located at 4295 San Felipe in Houston, Texas and its
telephone number is (713) 693-9300.
The Company's market consists of the communities served by its locations in
the Greater Houston CMSA, additional locations in eight contiguous counties
located to the south and southwest of Houston and its two banking locations in
Dallas, Texas. The Greater Houston CMSA includes Brazoria, Chambers, Fort Bend,
Galveston, Harris, Liberty, Montgomery and Walker 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 Banking Center locations and additional
business development.
Operating under a community banking philosophy, the Company seeks to
develop broad customer relationships based on service and convenience while
maintaining its conservative approach to lending and 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.
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, in September 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. 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. In February 2001, the Company completed a
merger with Commercial Bancshares, Inc., ("Commercial"), whereby Commercial was
merged with the Company and Heritage Bank, Commercial's wholly owned subsidiary,
was merged with the Bank. Heritage Bank had 12 full-service banking locations in
the Houston metropolitan area and in three adjacent counties. 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.
2
Recent Mergers and Acquisitions
On November 1, 2002, the Company acquired First National Bank of Bay City,
Bay City, Texas (the "FNB Acquisition"), through the merger of FNB with and into
Prosperity Bank for approximately $5.1 million in cash. FNB operated one (1)
location in Bay City, Texas, which was closed and consolidated with Prosperity
Bank's Bay City Banking Center. As of November 1, 2002, FNB had total assets of
$27.1 million, total loans of $8.2 million and total deposits of $23.8 million.
On October 1, 2002, the Company acquired Southwest Bank Holding Company,
Dallas, Texas (the "Southwest Acquisition") for approximately $19.6 million in
cash. Southwest's wholly owned subsidiary, Bank of the Southwest, Dallas, Texas,
became a subsidiary of the Company but was merged into the Bank on January 2,
2003. Southwest was privately held and operated two (2) banking offices in
Dallas, Texas. As of October 1, 2002, Southwest had total assets of $121.9
million, total loans of $58.7 million and total deposits of $108.9 million.
On September 1, 2002, the Company acquired Paradigm Bancorporation, Inc.
(the "Paradigm Acquisition") in a stock transaction for approximately 2.58
million shares of Prosperity common stock for all outstanding shares of
Paradigm. Paradigm operated a total of eleven (11) banking offices - six (6) in
the greater metropolitan Houston area and five (5) in the nearby Southeast Texas
cities of Dayton, Galveston, Mont Belvieu, and Winnie. The Company subsequently
closed three banking offices and consolidated them into existing banking
centers. As of September 1, 2002, Paradigm Bancorporation had total assets of
$248.7 million, total loans of $175.7 million and total deposits of $218.3
million.
In connection with the acquisition of Paradigm, 75,192 shares of Company
Common Stock and cash in lieu of fractional share interests were placed into
escrow to cover possible losses that may be incurred by the Company in the three
year period following completion of the merger with respect to certain specified
loans made by Paradigm prior to execution of the merger agreement. At the end of
the three year period, or sooner if all of these loans are paid in full or
upgraded, the escrow agent will distribute a pro rata portion of the shares and
cash to each of the Paradigm shareholders. While the shares are held in escrow,
the Paradigm shareholders will not receive any dividends paid against the shares
until such time, if any, that the shares are issued.
In the event that during the three year escrow period a specified loan is
either (i) not paid in full or (ii) deemed by the Company in its sole discretion
to continue to be a specified loan based on the performance of the loan and the
financial stability of the borrower, the shares of Common Stock will be used to
compensate the Company for the losses associated with these loans.
On July 12, 2002, the Company acquired The First State Bank, Needville,
Texas (the "First State Acquisition") for approximately $3.7 million in cash.
Prosperity Bank's existing Needville Banking Center has relocated into the
former First State Bank location effective July 15, 2002. As of July 12, 2002,
The First State Bank had total assets of $16.3 million, loans of $5.5 million
and deposits of $14.1 million.
On May 8, 2002, the Company acquired Texas Guaranty Bank, N.A. (the "Texas
Guaranty Acquisition") for approximately $11.8 million in cash. Texas Guaranty
Bank operated three (3) offices in the western portion of Houston, Texas, all of
which became full service banking centers of Prosperity Bank. As of May 8, 2002,
Texas Guaranty Bank had total assets of $74.0 million, loans of $45.7 million
and deposits of $61.8 million.
Recent Developments
On February 3, 2003, the Company announced the signing of a definitive
agreement pursuant to which the Company will acquire Abrams Centre Bancshares,
Dallas, Texas ("Abrams") and its subsidiary, Abrams Centre National Bank, for
approximately $16.3 million in cash. Abrams operates two (2) banking offices in
Dallas, Texas. As of December 31, 2002, Abrams had total assets of $93.6
million, loans of $50.6 million, deposits of $69.0 million and shareholders'
equity of $13.9 million. The transaction is expected to close in the second
quarter 2003 and is subject to approval by regulators and certain closing
conditions.
On March 4, 2003, the Company entered into a definitive agreement with
Dallas Bancshares Corporation, Dallas, Texas ("Dallas"). Pursuant to the
agreement, Dallas Bancshares will merge into the Company and it's wholly owned
subsidiary, BankDallas will merge into the Bank. Under the terms of the
agreement, the Company will pay approximately $7.0 million in cash. Dallas
Bancshares is privately held and operates one (1) banking office in Dallas,
Texas. As of December 31, 2002, BankDallas had total assets of $40.9 million,
loans of $30.6 million, deposits of $36.5 million and shareholders' equity of
$4.3 million. The transaction is expected to close in the second quarter of
2003. The Company will not complete the acquisition unless customary closing
conditions are satisfied or waived,
3
including receipt of the necessary regulatory and shareholder approvals and
consents from applicable regulatory agencies including the Federal Reserve
Board, the Texas Banking Department and the Federal Deposit Insurance
Corporation.
Stock Split
On May 31, 2002, the Company effected a two-for-one stock split in the form
of a 100 percent stock dividend to shareholders of record on May 20, 2002. The
Company issued approximately 8.1 million shares in connection with the split.
All per share and share information has been restated to reflect this split.
Available Information
The Company's website address is www.prosperitybanktx.com. The Company
makes available free of charge on or through its website its annual report on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all
amendments to those reports filed or furnished pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably
practicable after such material is electronically filed with or furnished to the
Securities and Exchange Commission. However, the information found on the
Company's website is not part of this or any other report.
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 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, Dayton, Galveston, Mathis, Medical
Center, River Oaks, Tanglewood 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 or Managers.
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 and Dallas 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, 2002, the Company and the Bank had 501 full-time
equivalent associates, 187 of whom were officers of the Bank. The Company
provides medical and hospitalization insurance to its full-time associates. The
Company considers its relations with associates to be excellent. Neither the
Company nor the Bank is a party to any collective bargaining agreement.
Banking Activities
The Company, through the Bank, offers a variety of traditional loan and
deposit products to its customers, which consist primarily of consumers and
small and medium-sized businesses. The Bank tailors its products to the specific
needs of customers in a given market. At December 31, 2002, the Bank maintained
approximately 111,000 separate deposit accounts and 16,500 separate loan
accounts and approximately 20.7% of the Bank's total deposits were
noninterest-bearing demand deposits. For the year ended December 31, 2002, the
Company's average cost of funds was 1.97%.
The Company has been an active mortgage lender, with 1-4 family residential
and commercial mortgage loans comprising 57.5% of the Company's total loans as
of December 31, 2002. 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, free personalized checks, free travelers checks, free cashier's
checks, free money orders, free ATM or debitcard, imaged statement, free
Advantage Overdraft protection up to $200 on qualifying accounts, free Internet
Banking, discounted Internet Bill Pay and certain travel discounts.
4
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 fixed discounted fees for checking.
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
commercial loan portfolios. The Company successfully introduced home equity
lending in 1998. The balance of home equity loans was $23.2 million at December
31, 2002 and $20.5 million at December 31, 2001. During the two-year period from
December 31, 2000 to December 31, 2002, the Company grew its commercial and
industrial loans from $47.0 million to $83.8 million, or 106.0% and its
commercial mortgages from $75.9 million to $184.0 million, or 142.4%. 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. 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 Banking Centers. 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.
5
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.
The following description summarizes some of the laws to which the Company
and the Banks 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
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
6
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 Federal Deposit
Insurance Corporation Improvement Act ("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.
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, 2002, the Company's ratio of Tier 1 capital to total
risk-weighted assets was 14.10% and its ratio of total capital to total
risk-weighted assets was 15.30%. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Financial Condition - Capital
Resources."
7
In addition to the risk-based capital guidelines, the Federal Reserve Board
uses a leverage ratio as an additional tool to evaluate the capital adequacy of
bank holding companies. The leverage ratio is a company's Tier 1 capital divided
by its average total consolidated assets. Certain highly rated bank holding
companies may maintain a minimum leverage ratio of 3.0%, but other bank holding
companies are required to maintain a leverage ratio of 4.0%. As of December 31,
2002, the Company's leverage ratio was 6.56%.
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.
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
8
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.
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.
9
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, 2002, the Bank's ratio of Tier 1 capital to total risk-weighted
assets was 13.71% and its ratio of total capital to total risk-weighted assets
was 14.91%. 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, 2002,
the Bank's ratio of Tier 1 capital to average total assets (leverage ratio) was
6.26%.
Corrective Measures for Capital Deficiencies. The federal banking
regulators are required to take "prompt corrective action" with respect to
capital-deficient institutions. Agency regulations define, for each capital
category, the levels at which institutions are "well capitalized," "adequately
capitalized," "under capitalized," "significantly under capitalized" and
"critically under capitalized." A "well capitalized" bank has a total risk-based
capital ratio of 10.0% or higher; a Tier 1 risk-based capital ratio of 6.0% or
higher; a leverage ratio of 5.0% or higher; and is not subject to any written
agreement, order or directive requiring it to maintain a specific capital level
for any capital measure. An "adequately capitalized" bank has a total risk-based
capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or
higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated
a composite 1 in its most recent examination report and is not experiencing
significant growth); and does not meet the criteria for a well capitalized bank.
A bank is "under capitalized" if it fails to meet any one of the ratios required
to be adequately capitalized. 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.
10
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 2002, both the BIF and SAIF rates were .00170% 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.
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
assesent 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.
11
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.
The USA Patriot Act of 2001. The Uniting and Strengthening America by
Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of
2001 ("USA Patriot Act") was enacted in October 2001. The USA Patriot Act is
intended to strengthen U.S. law enforcement's and the intelligence communities'
ability to work cohesively to combat terrorism on a variety of fronts. The
potential impact of the USA Patriot Act on financial institutions of all kinds
is significant and wide ranging. The USA Patriot Act contains sweeping
anti-money laundering and financial transparency laws and requires various
regulations, including: (i) due diligence requirements for financial
institutions that administer, maintain, or manage private bank accounts or
correspondent accounts for non-U.S. persons; (ii) standards for verifying
customer identification at account opening; (iii) rules to promote cooperation
among financial institutions, regulators and law enforcement entities in
identifying parties that may be involved in terrorism or money laundering; (iv)
reports by nonfinancial trades and business filed with the Treasury Department's
Financial Crimes Enforcement Network for transactions exceeding $10,000; and (v)
filing of suspicious activities reports involving securities by brokers and
dealers if they believe a customer may be violating U.S. laws and regulations.
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 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.
12
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 42 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 following:
Banking Center Expiration Date of Lease
---------------- --------------------------
Bellaire ...................... October 2007
City West ..................... November 2003
Copperfield ................... April 2005
Downtown ...................... October 2012
Fairfield ..................... May 2005
Galveston ..................... November 2005
Gladebrook .................... October 2010
Medical Center ................ February 2005
Post Oak ...................... June 2007
River Oaks .................... December 2004
Waugh ......................... February 2011
The expiration dates of the leases listed above do not include the renewal
option periods which may be available. The following table sets forth specific
information on each of the Company's locations:
Location Address Deposits at December 31, 2002
-------- ------- -----------------------------
(Dollars in thousands)
Aldine 1906 Aldine Bender $ 17,923
Houston, TX 77032
Angleton 116 South Velasco 43,830
Angleton, TX 77516
Bay City (1) 1600 Seventh St. 72,068
Bay City, TX 77404
Beeville (2) 100 South Washington 68,983
Beeville, TX 78102
Bellaire 6800 West Loop South Suite 100 29,168
Bellaire, TX 77401
Camp Wisdom 3515 W. Camp Wisdom Road 35,173
Dallas, TX 75237
CityWest 2500 CityWest Blvd. 15,694
Houston, TX 77042
Clear Lake 100 West Medical Center Blvd. 44,128
Webster, TX 77598
Cleveland 104 West Crockett 62,099
Cleveland, TX 77237
13
Location Address Deposits at December 31, 2002
-------- ------- -----------------------------
(Dollars in thousands)
Copperfield 8686 Highway 6 North $ 2,171
Houston, TX 77095
Cuero 106 North Esplanade 26,616
Cuero, TX 77954
Cypress 25820 U.S. 290 35,158
Cypress, TX 77429
Dayton 106 North Main 63,769
Dayton, TX 77535
Downtown 777 Walker, Suite L140 9,904
Houston, TX 77002
East Bernard 700 Church St. 56,455
East Bernard, TX 77435
Edna 102 North Wells 62,133
Edna, TX 77962
El Campo 1301 North Mechanic 99,468
El Campo, TX 77437
Fairfield 15050 Fairfield Village Square Dr. 6,666
Cypress, TX 77433
Galveston 2424 Market St. 4,225
Galveston, TX 77550
Gladebrook 3934 FM 1960 West, Suite 100 35,853
Houston, TX 77068
Goliad 145 North Jefferson 12,455
Goliad, TX 77963
Highway 6-West 1070 Highway 6 South 7,858
Houston, TX 77077
Hitchcock 8300 Highway 6 11,121
Hitchcock, TX 77563
Liberty 520 Main St. 55,081
Liberty, TX 77575
Magnolia 18935 FM 1488 28,710
Magnolia, TX 77355
Mathis 103 North Highway 359 27,526
Mathis, TX 78368
Medical Center 7505 South Main St., Suite 100 25,515
Houston, TX 77030
14
Location Address Deposits at December 31, 2002
-------- ------- -----------------------------
(Dollars in thousands)
Memorial 12602 Memorial Drive $ 22,912
Houston, TX 77024
Mont Belvieu 10305 Eagle Drive 6,753
Mont Belvieu, TX 77580
Needville(3) 9022 Main St. 26,635
Needville, TX 77461
Palacios 600 Henderson 24,774
Palacios, TX 77465
Post Oak 3040 Post Oak Blvd. Suite 150 76,047
Houston, TX 77056
River Oaks 4295 San Felipe 114,752
Houston, TX 77027
Sweeny 206 North McKinney 12,395
Sweeny, TX 77480
Tanglewood 5707 Woodway 10,387
Houston, TX 77057
Victoria 2702 North Navarro 44,039
Victoria, TX 77901
Waugh 55 Waugh Drive 29,025
Houston, TX 77007
West Columbia 510 East Brazos 48,612
West Columbia, TX 77486
Westmoreland 2415 S. Westmoreland Rd. 71,678
Dallas, TX 75211
Wharton 143 West Burleson 71,769
Wharton, TX 77488
Winnie 146 Spur 5 10,748
Winnie, TX 77665
Woodcreek 2828 FM 1960 East 56,335
Houston, TX 77073
- ------------------
(1) The Bay City Banking Center consists of the main office located at 1600
Seventh Street and a drive-thru facility located approximately one- quarter
mile from the main office.
(2) 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.
(3) The Company is currently constructing a new facility for the Needville
Banking Center located at 13325 Highway 36, Needville, Texas 77461. The
building is expected to be completed by the end of 2003.
15
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 2002.
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 under the symbol "PRSP". Prior to that
date, the Common Stock was privately held and not listed on any public exchange
or actively traded. As of February 6, 2003, there were 18,903,483 shares
outstanding and 536 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 National Market during the two years ended December
31, 2002:
2002 High Low
---- ---- ---
Fourth Quarter ................ $19.950 $15.280
Third Quarter ................. 19.950 15.000
Second Quarter ................ 18.590 15.550
First Quarter ................. 16.275 13.475
2001 High Low
---- ---- ---
Fourth Quarter ................ $13.870 $11.930
Third Quarter ................. 13.935 10.750
Second Quarter ................ 12.610 8.750
First Quarter ................. 11.313 9.375
Dividends
On May 31, 2002, the Company effected a two-for-one stock split in the form
of a 100 percent stock dividend to shareholders of record on May 20, 2002. The
Company issued approximately 8.1 million shares in connection with the split.
All per share and share information has been restated to reflect this split.
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 $0.22 per share in 2002 and
$0.195 per share in 2001, 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 they consider the payment to be an unsafe or unsound practice.
16
The cash dividends paid per share by quarter for the Company's last two
fiscal years were as follows:
2002 2001
---- ----
Fourth quarter ............... $0.055 $0.050
Third quarter ................ 0.055 0.050
Second quarter ............... 0.055 0.050
First quarter ................ 0.055 0.045
Securities Authorized for Issuance under Equity Compensation Plans
The Company currently has two stock option plans, both of which were
approved by the Company's shareholders. The following table provides information
as of December 31, 2002 regarding the Company's equity compensation plans under
which the Company's equity securities are authorized for issuance:
Number of securities
remaining available for
future issuance under
Number of securities to equity compensation
be issued upon exercise Weighted-average plans (excluding
of outstanding options, exercise price of securities reflected
Plan category warrants and rights outstanding options in column (a))
- ----------------------------- ------------------------- ------------------- -----------------------
Equity compensation plans
approved by security holders .......... 684,153(1) $ 7.88 541,000
Equity compensation plans not
approved by security holders .......... -- -- --
--------------- --------- -----------
Total ............................. 684,153 $ 7.88 541,000
(1) Includes (a) 29,673 shares which may be issued upon exercise of options
outstanding assumed by the Company in connection with the acquisition of
Paradigm Bancorporation, Inc. at a weighted average exercise price of $10.66 and
(b) 2,480 shares which may be issued upon exercise of options outstanding
assumed by the Company in connection with the merger with Commercial Bancshares,
Inc. at a weighted-average exercise price of $5.16.
17
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, 2002 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, 2002
and 2001 and for each of the years in the three-year period ended December 31,
2002 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. All per share data has been restated to
include the two-for-one stock split effective May 31, 2002.
As of and for the Years Ended December 31,
------------------------------------------------------------------
2002 2001 2000 1999 1998
---------- --------- ---------- --------- ---------
(Dollars in thousands, except per share data)
Income Statement Date:
Interest income .................................... $ 80,742 $ 76,520 $ 70,079 $ 56,458 $ 46,026
Interest expense ................................... 25,931 35,785 35,564 26,189 21,923
---------- ---------- ---------- ---------- ---------
Net interest income ............................. 54,811 40,735 34,515 30,269 24,103
Provision for credit losses ........................ 1,010 700 275 420 264
---------- ---------- ---------- ---------- ---------
Net interest income after provision
for credit losses ............................. 53,801 40,035 34,240 29,849 23,839
Noninterest income ................................. 11,528 8,590 7,760 6,151 4,808
Noninterest expense ................................ 34,453 30,295(1) 26,767 21,822 17,989
---------- ---------- ---------- ---------- ---------
Income before taxes ............................. 30,876 18,330(1) 15,233 14,178 10,658
Provision for income taxes ......................... 9,555 5,372(1) 4,532 4,747 3,577
---------- ---------- ---------- ---------- ---------
Net income ......................................... $ 21,321 $ 12,958(1) $ 10,701 $ 9,431 $ 7,081
========== ============= ========== ========== =========
Per Share Data(2):
Basic earnings per share ........................... $ 1.25 $ 0.80(3) $ 0.67 $ 0.59 $ 0.51
Diluted earnings per share ......................... 1.22 0.79(3) 0.65 0.58 0.50
Book value per share ............................... 8.19 5.47 4.98 4.32 3.88
Cash dividends declared ............................ 0.22 0.195 0.18 0.10 0.10
Dividend payout ratio .............................. 18.13% 24.39% 25.75% 19.10% 33.82%
Weighted average shares outstanding (basic)
(in thousands) .................................. 17,122 16,172 16,064 15,972 13,832
Weighted average shares outstanding (diluted)
(in thousands) .................................. 17,442 16,498 16,454 16,408 14,230
Shares outstanding at end of period
(in thousands) .................................. 18,896 16,210 16,144 15,990 15,946
Balance Sheet Data (at period end):
Total assets ....................................... $1,822,256 $1,262,325 $1,146,140 $1,027,631 $ 800,158
Securities ......................................... 950,317 752,322 586,952 514,983 455,202
Loans .............................................. 679,559 424,400 411,203 366,803 276,106
Allowance for credit losses ........................ 9,580 5,985 5,523 5,031 3,682
Total deposits ..................................... 1,586,611 1,123,397 1,033,546 878,589 714,365
Borrowings and notes payable ....................... 37,939 18,080 13,931 53,119 17,508
Total shareholders' equity ......................... 154,739 88,725 80,333 69,025 61,781
Company-obligated mandatorily redeemable
preferred securities of subsidiary
trusts (4) ...................................... 33,000 27,000 12,000 12,000 --
Average Balance Sheet Data:
Total assets ....................................... $1,469,860 $1,191,190 $1,045,882 $ 875,781 $ 700,410
Securities ......................................... 818,362 666,241 550,431 465,788 392,026
Loans .............................................. 524,885 419,553 383,054 319,178 238,855
Allowance for credit losses ........................ 7,350 5,586 5,245 4,272 2,994
Total deposits .................................... 1,300,884 1,061,195 920,526 767,879 628,557
Total shareholders' equity ......................... 114,234 85,319 72,952 64,911 47,574
Company-obligated mandatorily redeemable
preferred securities of subsidiary
trusts (4) ...................................... 28,750 18,875 12,000 1,500 --
(Table continued on next page)
18
As of and for the Years Ended December 31,
----------------------------------------------------------------
2002 2001 2000 1999 1998
--------- -------- -------- -------- -------
(Dollars in thousands, except per share data)
Performance Ratios:
Return on average assets ............................... 1.45% 1.09%(5) 1.02% 1.08% 1.01%
Return on average equity ............................... 18.66 15.19(5) 14.67 14.53 14.88
Net interest margin (tax-equivalent) (6) ............... 4.16 3.86 3.69 3.77 3.75
Efficiency ratio(7) .................................... 50.36 60.14(5) 62.29 59.29 61.72
Asset Quality Ratios(8):
Nonperforming assets to total loans and
other real estate ................................... 0.38% 0.00% 0.32% 0.34% 0.14%
Net loan charge-offs (recoveries)
to average loans .................................... 0.08 0.06 (0.04) (0.11) (0.08)
Allowance for credit losses to total
loans ............................................... 1.41 1.41 1.34 1.37 1.33
Allowance for credit losses to
nonperforming loans(9) .............................. 408.53 n/m(10) 700.89 657.65 941.69
Capital Ratios(8):
Leverage ratio ......................................... 6.56% 7.57% 6.17% 6.17% 6.59%
Average shareholders' equity to average
total assets ........................................ 8.52 7.16 6.98 7.41 6.79
Tier 1 risk-based capital ratio ........................ 14.10 18.34 13.80 13.89 15.06
Total risk-based capital ratio ......................... 15.30 19.52 14.93 15.74 16.14
- ------------------
(1) Certain income statement data for the year ended December 31, 2001
includes the merger-related expenses of $2.4 million, net of tax.
(2) Adjusted for a two-for one stock split effective May 31, 2002 and 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.
(4) Consists of $12.0 million of trust preferred securities of Prosperity
Capital Trust I due November 12, 2029, $15.0 million of trust preferred
securities of Prosperity Statutory Trust II due July 31, 2031 and $6.0
million of trust preferred securities of Paradigm Capital Trust II due
February 20, 2031.
(5) Selected performance ratios for the year ended December 31, 2001 include
the merger-related expenses of $2.4 million.
(6) Calculated on a tax-equivalent basis using a 35% federal income tax rate
for the years ended December 31, 2002 and 2001 and a 34% federal income tax
rate for the years ended December 31, 1998, 1999 and 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, restructured loans and any other loan management deems
nonperforming.
(10) Amount not meaningful. Nonperforming assets totaled $1,000 at December 31,
2001.
19
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 February 23,
2001.
For the Years Ended December 31, 2002, 2001 and 2000
Overview
Net income was $21.3 million, $13.0 million and $10.7 million for the
years ended December 31, 2002, 2001 and 2000, respectively, and diluted earnings
per share were $1.22, $0.79 and $0.65, respectively, for these same periods.
Earnings growth during both 2002 and 2001 resulted principally from an increase
in loan volume and acquisitions, including the Paradigm Acquisition and the
Commercial Merger. The Company posted returns on average assets of 1.45%, 1.09%
and 1.02% and returns on average equity of 18.66%, 15.19% and 14.67% for the
years ended December 31, 2002, 2001 and 2000, respectively. The Company posted
returns on average assets excluding amortization of goodwill and core deposit
intangibles and related tax expense of 1.46%, 1.18% and 1.12% and returns on
average equity excluding amortization of goodwill and core deposit intangibles
and related tax expense of 18.82%, 16.55% and 16.08% for the years ended
December 31, 2002, 2001 and 2000, respectively. The Company's efficiency ratio
was 50.36% in 2002, 60.14% in 2001 and 62.29% in 2000. The Company's efficiency
ratio excluding amortization of goodwill and core deposit intangibles was 50.06%
in 2002, 57.29% in 2001 and 59.47% in 2000.
Total assets at December 31, 2002, 2001 and 2000 were $1.822 billion,
$1.262 billion and $1.146 billion, respectively. Total deposits at December 31,
2002, 2001 and 2000 were $1.587 billion, $1.123 billion, and $1.034 billion,
respectively, with deposit growth in each period resulting from acquisitions and
internal growth. Total loans were $679.6 million at December 31, 2002, an
increase of $255.2 million or 60.1% from $424.4 million at the end of 2001.
Total loans were $411.2 million at year-end 2000. At December 31, 2002, the
Company had $2.3 million in nonperforming loans and its allowance for credit
losses was $9.6 million. Shareholders' equity was $154.7 million, $88.7 million
and $80.3 million at December 31, 2002, 2001 and 2000, 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 5,537,220 (after two for one stock split) shares of its Common
Stock to the holders of Commercial 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.
On May 31, 2002, the Company effected a two-for-one stock split in the
form of a 100 percent stock dividend to shareholders of record on May 20, 2002.
The Company issued approximately 8.1 million shares in connection with the
split. All per share and share information has been restated to reflect this
split.
Critical Accounting Policies
The Company's accounting policies are integral to understanding the
results reported. Accounting policies are described in detail in Note 1 to the
consolidated financial statements. The Company believes that of its significant
accounting policies, the following may involve a higher degree of judgment and
complexity:
Allowance for Credit Losses - The allowance for credit losses is 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.
20
Results of Operations
Net Interest Income
The Company's operating results depend primarily on its net interest
income, which is the difference between interest income on interest-earning
assets, including securities and loans, and interest expense incurred on
interest-bearing liabilities, including deposits and other borrowed funds.
Interest rate fluctuations, as well as changes in the amount and type of earning
assets and liabilities, combine to affect net interest income. The Company's net
interest income is affected by changes in the amount and mix of interest-earning
assets and interest-bearing liabilities, referred to as a "volume change." It is
also affected by changes in yields earned on interest-earning assets and rates
paid on interest-bearing deposits and other borrowed funds, referred to as a
"rate change."
2002 versus 2001. Net interest income for the year ended December 31,
2002 was $54.8 million compared with $40.7 million for the year ended December
31, 2001, an increase of $14.1 million or 34.6%. The improvement in net interest
income for 2002 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 94 basis points. Average interest-earning assets increased $247.9 million
from $1.116 billion at December 31 2001 to $1.364 billion at December 31, 2002.
Total cost of interest-bearing liabilities decreased 160 basis points from 3.99%
at December 31, 2001 to 2.39% at December 31, 2002. Total yield on
interest-earning assets decreased 66 basis points from 6.58% at December 31,
2001 to 5.92% at December 31, 2002. The net interest margin on a tax-equivalent
basis increased 30 basis points to 4.16% at December 31, 2002 from 3.86% at
December 31, 2001.
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.
21
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,
---------------------------------------------------------------------------------------------------
2002 2001 2000
------------------------------- ------------------------------- ----------------------------------
Average Interest Average Average Interest Average Average Interest Average
Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
Balance Paid Rate Balance Paid Rate Balance Paid Rate
---------- -------- --------- ---------- ------ -------- ---------- ------ ------
(Dollars in thousands)
Assets
Interest-earning assets:
Loans ........................ $ 524,885 $ 38,330 7.30% $ 419,553 $ 34,731 8.28% $ 383,054 $ 33,599 8.77%
Securities(1) ................ 818,362 42,104 5.14 666,241 40,353 6.06 550,431 33,978 6.17
Federal funds sold and
other temporary
investments ................. 20,956 308 1.47 30,478 1,436 4.71 37,929 2,502 6.60
---------- ---------- ---------- ---------- ---------- ----------
Total interest-earning
assets .................... 1,364,203 80,742 5.92% 1,116,272 76,520 6.58% 971,414 70,079 7.21%
---------- ---------- ----------
Less allowance for
credit losses ............... (7,350) (5,586) (5,245)
---------- ---------- ----------
Total interest-earning
assets, net of
allowance ................. 1,356,853 1,110,686 966,169
Noninterest-earning assets ... 113,007 80,504 79,713
---------- ---------- ----------
Total assets ............... $1,469,860 $1,191,190 $1,045,882
========== ========== ==========
Liabilities and
shareholders' equity
Interest-bearing liabilities:
Interest-bearing demand
deposits .................... $ 249,045 $ 3,162 1.27% 199,077 $ 4,529 2.27% $ 185,486 $ 6,346 3.42%
Savings and money
market accounts ............. 315,717 5,219 1.65 252,576 7,978 3.16 220,266 8,628 3.92
Certificates of deposit ...... 505,796 16,595 3.28 428,314 22,273 5.20 339,580 18,577 5.47
Federal funds purchased
and other borrowings ........ 16,435 955 5.81 17,219 1,005 5.84 32,333 2,013 6.23
---------- ---------- ---------- ---------- ---------- ----------
Total interest-bearing
liabilities ............... 1,086,993 25,931 2.39% 897,186 35,785 3.99% 777,665 35,564 4.57%
---------- ---------- ---------- ---------- ---------- ----------
Noninterest-bearing
liabilities:
Noninterest-bearing
demand deposits ............. 230,326 181,228 175,194
Company obligated
mandatorily redeemable
trust preferred
securities of subsidiary
trusts ...................... 28,750 18,875 12,000
Other liabilities ............ 9,557 8,582 8,071
---------- ---------- ----------
Total liabilities .......... 1,355,626 1,105,871 972,930
---------- ---------- ----------
Shareholders' equity ........... 114,234 85,319 72,952
---------- ---------- ----------
Total liabilities and
shareholders' equity ...... $1,469,860 $1,191,190 $1,045,882
========== ========== ==========
Net interest rate spread ....... 3.53% 2.86% 2.64%
Net interest income and
margin(2) ..................... $ 54,811 4.02% $ 40,735 3.65% $ 34,515 3.55%
========== ========== ==========
Net interest income and
margin (tax-equivalent
basis)(3) ..................... $ 56,734 4.16% $ 43,057 3.86% $ 35,890 3.69%
========== ========== ==========
- ------------------------------------------
(1) Yield is based on amortized cost and does not include any component of
unrealized gains or losses.
(2) The net interest margin is equal to net interest income divided by average
interest-earning assets.
(3) In order to make pretax income and resultant yields on tax-exempt
investments and loans comparable to those on taxable investments and loans,
a tax-equivalent adjustment has been computed using a federal income tax
rate of 35% for the years ended December 31, 2002 and December 31, 2001 and
34% for the period ended December 31, 2000 and other applicable effective
tax rates.
22
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,
--------------------------------------------------------------------
2002 vs. 2001 2001 vs. 2000
-------------------------------- --------------------------------
Increase Increase
(Decrease) (Decrease)
Due to Due to
-------------------- --------------------
Volume Rate Total Volume Rate Total
-------- -------- -------- -------- -------- --------
(Dollars in thousands)
Interest-earning assets:
Loans .................................................... $ 8,719 $ (5,120) $ 3,599 $ 3,201 $ (2,069) $ 1,132
Securities ............................................... 9,214 (7,463) 1,751 7,149 (774) 6,375
Federal funds sold and other temporary
investments ........................................... (449) (679) (1,128) (492) (574) (1,066)
-------- -------- -------- -------- -------- --------
Total increase (decrease) in interest income .......... 17,484 (13,262) 4,222 9,858 (3,417) 6,441
-------- -------- -------- -------- -------- --------
Interest-bearing liabilities:
Interest-bearing demand deposits ......................... 1,137 (2,504) (1,367) 465 (2,282) (1,817)
Savings and money market accounts ........................ 1,994 (4,753) (2,759) 1,266 (1,916) (650)
Certificates of deposit .................................. 4,029 (9,707) (5,678) 4,854 (1,158) 3,696
Federal funds purchased and other borrowings ............. (46) (4) (50) (941) (67) (1,008)
-------- -------- -------- -------- -------- --------
Total increase (decrease) in interest expense ........ 7,114 (16,968) (9,854) 5,644 (5,423) 221
-------- -------- -------- -------- -------- --------
Increase in net interest income ............................. $ 10,370 $ 3,706 $ 14,076 $ 4,214 $ 2,006 $ 6,220
======== ======== ======== ======== ======== ========
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, 2002 was $9.6 million, representing
1.41% of outstanding loans. The provision for credit losses for the year ended
December 31, 2002 was $1.0 million compared with $700,000 for the year ended
December 31, 2001. The increase of $310,000 was primarily due to an increase in
net loan charge-offs for the year ended December 31, 2002. At December 31, 2002,
the Company had $396,000 in net loan charge-offs compared with $239,000 in net
loan charge-offs during 2001. The provision for credit losses for the year ended
December 31, 2001 was $700,000 compared with $275,000 in 2000. Net loan
recoveries were $171,000 in 2000.
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 2002, noninterest income totaled $11.5 million, an
increase of $2.9 million or 34.2% compared with $8.6 million in 2001. The
increase was primarily due to an increase in insufficient funds charges and
customer service charges which resulted from an increase in the number of
accounts due to the Texas Guaranty, First State, Paradigm, FNB and Southwest
Acquisitions. Noninterest income for 2001 was $8.6 million, an $830,000 or 10.7%
increase from $7.8 million in 2000, resulting largely from an increase in income
due to the Commercial Merger. The following table presents for the periods
indicated the major categories of noninterest income:
Years Ended December 31,
---------------------------------------
2002 2001 2000
-------- ------- -------
(Dollars in thousands)
Service charges on deposit accounts ................... $ 9,764 $ 7,530 $ 6,576
Other noninterest income .............................. 1,764 1,060 1,184
-------- ------- -------
Total noninterest income ........................... $ 11,528 $ 8,590 $ 7,760
======== ======= =======
23
Noninterest Expense
For the years ended December 31, 2002, 2001 and 2000, noninterest expense
totaled $34.5 million, $30.3 million and $26.8 million, respectively. The
Company's efficiency ratio improved in 2002 as it was reduced from 60.14% at
December 31, 2001 to 50.36% at December 31, 2002. This reduction reflects the
Company's continued success in controlling operating expenses and the cost
savings achieved following the integration of the Texas Guaranty Acquisition in
the second quarter of 2002, the Paradigm and First State Acquisitions in the
third quarter of 2002 and the FNB and Southwest Acquisitions in the fourth
quarter of 2002. The Company's efficiency ratio was 62.29% at December 31, 2000.
The following table presents for the periods indicated the major categories
of noninterest expense:
Years Ended December 31,
--------------------------------------
2002 2001 2000
------- ------- -------
(Dollars in thousands)
Salaries and employee benefits ..................................... $16,379 $12,955 $12,931
Non-staff expenses:
Net occupancy expense ...................................... 2,345 1,971 1,761
Depreciation expense ....................................... 1,830 1,570 1,553
Data processing ............................................ 2,131 2,126 1,956
Regulatory assessments and FDIC insurance .................. 367 249 284
Ad valorem and franchise taxes ............................. 676 434 473
Goodwill and core deposit intangibles amortization ......... 192 1,363 1,160
Communications expense (1) ................................. 1,926 1,424 750
Minority expense-trust preferred securities ................ 2,104 1,580 1,151
Merger-related expenses .................................... -- 2,425 --
Other ...................................................... 6,503 4,198 4,748
------- ------- -------
Total noninterest expense .......................... $34,453 $30,295 $26,767
======= ======= =======
- ----------------------------------
(1) Communications expense includes telephone, data circuits, postage and
courier expenses.
For the year ended December 31, 2002, noninterest expense totaled $34.5
million, an increase of $4.2 million or 13.7% over $30.3 million for the same
period in 2001. The amount of noninterest expense for 2001 included $2.4 million
in merger related expenses. This increase is principally due to increases in
salaries and employee benefits, building and equipment costs and general
operating expenses associated with the Texas Guaranty, First State, Paradigm,
FNB and Southwest Acquisitions. Salaries and employee benefits increased $3.4
million from $13.0 million at December 31, 2001 to $16.4 million at December 31,
2002 primarily due to increased staff associated with the acquisitions completed
in 2002. Non-interest expense was also impacted by an increase in minority
interest expense related to the trust preferred securities due to the issuance
of $15.0 million in trust preferred securities in July 2001 and the acquisition
of Paradigm Capital Trust II in September 2002 which has issued $6.0 million of
trust preferred securities. This increase was partially offset by a decrease in
goodwill amortization expense due to a recent accounting change. Minority
expense-trust preferred securities increased $524,000 from $1.6 million at
December 31, 2001 to $2.1 million at December 31, 2002. Other operating expenses
of $6.5 million at December 31, 2002 represented an increase of $2.3 million or
54.9% compared with $4.2 million in 2001. These increases were principally due
to the Texas Guaranty, First State, Paradigm, FNB and Southwest Acquisitions.
Total noninterest expenses in 2001 were $30.3 million, an increase of 13.2% from
$26.8 million in 2000 primarily due to the Compass Acquisition in the fourth
quarter of 2000.
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, 2002, income tax expense was $9.6 million compared with $5.4
million for the year ended December 31, 2001 and $4.5 million for the year ended
December 31, 2000. The increases were primarily attributable to higher pretax
net earnings which resulted from an increase in net interest income for the year
ended December 31, 2002 when compared to the same period in 2001 and 2000. In
addition, the Company incurred $2.4 million in merger-related expenses during
the year ended December 31, 2001 which had a tax benefit of approximately
$849,000. The effective tax rate in the years ended December 31, 2002, 2001 and
2000 was 30.9%, 29.3% and 29.8%, respectively.
24
Goodwill Amortization
In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards SFAS No. 142, Goodwill and Other
Intangible Assets (SFAS No. 142). 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 for impairment in
accordance with SFAS No. 121 and subsequently, SFAS No. 144 after its adoption.
The Company adopted the provisions of SFAS No. 142 as of 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 are no
longer amortized.
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, 2002, total loans were $679.6 million, an increase of
$255.2 million or 60.1% from $424.4 million at December 31, 2001. The growth in
loans in partially attributable to internal growth and the Texas Guaranty, First
State, Paradigm, FNB and Southwest Acquisitions. At December 31, 2002, total
loans were 42.8% of deposits and 37.3% of total assets. At December 31, 2001,
total loans were 37.8% of deposits and 33.6% of total assets. Loans increased
3.2% during 2001 from $411.2 million at December 31, 2000 to $424.4 million at
December 31, 2001.
The following table summarizes the Company's loan portfolio by type of loan
as of the dates indicated:
December 31,
---------------------------------------------------------------------------------------------
2002 2001 2000 1999 1998
----------------- ----------------- ----------------- ----------------- -----------------
Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ ------- ------ ------- ------ -------
(Dollars in thousands)
Commercial and industrial ............ $ 93,797 13.8% $ 46,986 11.1% $ 45,529 11.3% $ 42,003 11.5% $ 33,242 12.0%
Real estate:
Construction and land
development ....................... 52,377 7.7 20,963 4.9 20,128 4.9 21,333 5.8 12,477 4.5
1-4 family residential .............. 206,586 30.4 175,253 41.3 175,525 42.7 165,238 45.1 123,581 44.8
Home equity ......................... 23,249 3.4 20,541 4.8 16,762 4.1 11,343 3.1 8,077 2.9
Commercial mortgages ................ 183,970 27.1 78,446 18.5 75,896 18.5 64,738 17.7 41,436 15.0
Farmland ............................ 11,887 1.7 10,686 2.5 12,218 3.0 8,552 2.3 6,455 2.3
Multifamily residential ............. 15,502 2.3 9,694 2.3 2,961 0.7 3,071 0.8 2,074 0.8
Agriculture .......................... 24,683 3.6 15,757 3.7 13,251 3.2 13,592 3.7 15,138 5.5
Other ................................ 3,020 0.4 953 0.2 2,563 0.6 2,671 0.7 2,511 0.9
Consumer ............................. 64,488 9.6 45,121 10.7 45,370 11.0 34,262 9.3 31,115 11.3
-------- ----- -------- ----- -------- ----- -------- ----- -------- -----
Total loans ................... $679,559 100.0% $424,400 100.0% $411,203 100.0% $366,803 100.0% $276,106 100.0%
======== ===== ======== ===== ======== ===== ======== ===== ======== =====
The lending focus of the Company is on growing its commercial mortgage and
commercial loan portfolios. 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.
Loans from $750,000 to $2.0 million are evaluated and acted upon by an
officers' loan committee, which meets weekly. Loans from $2.0 million to $7.5
million are evaluated and acted upon by the Directors Loan Committee, which
consists of three directors and meets as necessary. Loans over $7.5 million must
be evaluated and acted upon by the full board of directors which meets monthly.
25
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.
In addition to commercial loans, the Company makes commercial mortgage
loans to finance the purchase of real estate. 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.
26
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, 2002 are summarized in the following table:
December 31, 2002
---------------------------------------------------
After One
One Year Through After Five
or Less Five Years Years Total
-------- ---------- ---------- ---------
(Dollars in thousands)
Commercial and industrial ............................... $ 44,597 $ 35,896 $ 13,304 $ 93,797
Construction and land development ....................... 38,469 10,084 3,824 52,377
-------- -------- -------- ---------
Total ..................................... $ 83,066 $ 45,980 $ 17,128 $ 146,174
======== ======== ======== =========
Loans with a predetermined interest rate ................ $ 17,895 $ 23,370 $ 6,020 $ 47,285
Loans with a floating interest rate ..................... 65,171 22,610 11,108 98,889
-------- -------- -------- ---------
Total ..................................... $ 83,066 $ 45,980 $ 17,128 $ 146,174
======== ======== ======== =========
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 $2.6 million in nonperforming assets as of December 31,
2002 compared with $1,000 at December 31, 2001 and $1.3 million at December 31,
2000.
Interest foregone on nonaccrual loans for the year ended December 31, 2002
was approximately $25,000.
The following table presents information regarding nonperforming assets at
the dates indicated:
December 31,
-----------------------------------------------------------------
2002 2001 2000 1999 1998
------- -------- --------- --------- --------
(Dollars in thousands)
Nonaccrual loans ...................................... $ 1,125 $ 1 $ 10 $ 756 $ 108
Restructured loans .................................... -- -- -- 5 150
Other nonperforming loans ............................. 1,100 -- -- -- --
Accruing loans 90 or more days past due ............... 120 -- 778 4 133
Other real estate ..................................... 219 -- 545 500 --
------- -------- --------- --------- --------
Total nonperforming assets ..................... $ 2,564 $ 1 $ 1,333 $ 1,265 $ 391
======= ======== ========= ========= ========
Nonperforming assets to total loans
and other real estate .............................. 0.38% 0.00% 0.32% 0.34% 0.14%
27
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,
-----------------------------------------------------------------
2002 2001 2000 1999 1998
--------- --------- --------- --------- ---------
(Dollars in thousands)
Average loans outstanding ............................ $ 524,885 $ 419,553 $ 383,054 $ 319,178 $ 238,855
========= ========= ========= ========= =========
Gross loans outstanding at end of period ............. $ 679,559 $ 424,400 $ 411,203 $ 366,803 $ 276,106
========= ========= ========= ========= =========
Allowance for credit losses at
beginning of period ............................... $ 5,985 $ 5,523 $ 5,031 $ 3,682 $ 2,567
Balance acquired with the Texas Guaranty, First State,
Paradigm, FNB, Southwest, Compass, South
Texas and Union Acquisitions, respectively ........ 2,981 -- 46 566 661
Provision for credit losses .......................... 1,010 700 275 420 264
Charge-offs:
Commercial and industrial ......................... (356) (180) (116) (30) (67)
Real estate and agriculture ....................... (231) (175 (38) (43) (14)
Consumer .......................................... (180) (74) (63) (64) (83)
Recoveries:
Commercial and industrial ......................... 111 15 43 236 276
Real estate and agriculture ....................... 175 121 263 218 52
Consumer .......................................... 85 55 82 46 26
--------- --------- --------- --------- ---------
Net (charge-offs) recoveries ......................... (396) (238) 171 363 190
--------- --------- --------- --------- ---------
Allowance for credit losses at end of period ......... $ 9,580 $ 5,985 $ 5,523 $ 5,031 $ 3,682
========= ========= ========= ========= =========
Ratio of allowance to end of period
loans ............................................. 1.41% 1.41% 1.34% 1.37% 1.33%
Ratio of net charge-offs (recoveries) to
average loans ..................................... 0.08 0.06 (0.04) (0.11) (0.08)
Ratio of allowance to end of period
nonperforming loans ............................... 408.5 n/m(1) 700.89 657.65 941.69
(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
28
the operations of the borrower and loan to value ratio;
. 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, 2002, net charge-offs totaled $396,000 or
0.08% of average loans outstanding for the period, compared with net charge-offs
of $238,000 or 0.06% of average loans during 2001. The Company's net recoveries
totaled $171,000 or (0.04)% of average loans outstanding in 2000. During 2002,
the Company recorded a provision for credit losses of $1.0 million compared with
$700,000 for 2001. At December 31, 2002, the allowance for credit losses totaled
$9.6 million, or 1.41% of total loans. The Company made a provision for credit
losses of $700,000 during 2001 compared with a provision of $275,000 for 2000.
At December 31, 2001, the allowance aggregated $6.0 million, or 1.41% of total
loans. At December 31, 2000, the allowance was $5.5 million, or 1.34% of total
loans.
29
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,
------------------------------------------------------------
2002 2001
--------------------------- ---------------------------
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 ................................ $ 559 11.1% $ 357 11.1%
Real estate .............................................. 397 74.4 553 74.4
Agriculture .............................................. 42 3.7 11 3.7
Consumer and other ....................................... 71 10.8 10 10.8
Unallocated .............................................. 8,781 -- 5,054 --
------ ----- ------ -----
Total allowance for credit losses ...................... $9,850 100.0% $5,985 100.0%
====== ===== ====== =====
December 31,
--------------------------------------------------------------------------
2000 1999 1998
----------------------- ----------------------- --------------------
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 .................... $ 625 11.3% $ 620 11.5% $ 520 12.0%
Real estate .................................. 116 73.9 74 74.8 79 70.3
Agriculture .................................. 17 3.2 22 3.7 40 5.5
Consumer and other ........................... 28 11.6 25 10.0 14 12.2
Unallocated .................................. 4,737 -- 4,290 -- 3,029 --
------ ----------- ------ ----------- ------ -----------
Total allowance for credit
losses ............................... $5,523 100.0% $5,031 100.0% $3,682 100.0%
====== =========== ====== =========== ====== ===========
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,
2002 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, 2002.
Securities
The Company uses its securities portfolio both as a source of income and
as a source of liquidity. At December 31, 2002, investment securities totaled
$950.3 million, an increase of $198.0 million or 26.3% from $752.3 million at
December 31, 2001, primarily due to the Company investing excess deposits. At
December 31, 2002, securities represented 52.2% of total assets compared with
59.6% of total assets at December 31, 2001.
30
Securities increased $165.4 million or 28.2% from $587.0 million at
December 31, 2000 to $752.3 million at December 31, 2001, primarily due to the
investment of excess deposits.
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,
--------------------------------------------------------------------
2002 2001 2000 1999 1998
----------- ----------- ----------- ----------- -----------
(Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies. .............. $ 97,098 $ 143,397 $ 334,562 $ 316,859 $ 305,592
70% non-taxable preferred stock ............... 44,029 24,058 19,085 4,049 --
States and political subdivisions. ............ 58,994 51,503 46,819 40,369 30,250
Corporate debt securities ..................... 25,338 22,712 24,879 28,038 27,610
Equity securities ............................. -- -- 2 2 --
Collateralized mortgage obligations. .......... 168,282 17,378 18,307 12,267 12,914
Mortgage-backed securities .................... 552,515 492,940 142,354 117,436 78,283
Other ......................................... -- -- 25 25 25
----------- ----------- --------- ----------- -----------
Total ..................................... $ 946,256 $ 751,988 $ 586,033 $ 519,045 $ 454,674
=========== =========== =========== =========== ===========
The following table summarizes the contractual maturity of securities and
their weighted average yields:
December 31, 2002
-----------------------------------------------------------------------------------
After One Year After Five Years
but but
Within One Within Five Within Ten After Ten
Year Years Years Years Total
--------------- --------------- ---------------- -------------- ----------------
Amount Yield Amount Yield Amount Yield Amount Yield Total Yield
-------- ----- --------- ----- -------- ----- -------- ----- ---------- -----
(Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies .......... $ 24,296 5.43% $ 51,658 5.48% $ 20,710 5.67% $ 499 6.49% $ 97,163 5.51%
70% non-taxable preferred stock .......... -- -- -- -- 19,145 3.78 24,000 5.43 43,145 4.70
States and political subdivisions ........ 5,361 6.44 19,079 6.37 10,553 6.50 17,809 7.44 52,802 6.76
Corporate debt securities ................ 9,541 5.89 15,797 5.86 -- -- -- -- 25,338 5.87
Collateralized mortgage obligations ...... -- -- 199 4.11 7,429 2.96 161,236 4.75 168,864 4.67
Mortgage-backed securities ............... 1,403 5.67 12,344 5.42 117,494 5.06 423,764 4.83 555,005 4.89
Qualified Zone Academy Bond (QZAB) ....... -- -- -- -- 8,000 2.00 -- -- 8,000 2.00
-------- ----- -------- ----- -------- ---- -------- ----- --------- -----
Total .................................... $ 40,601 5.68% $ 99,077 5.70% $183,331 4.86% $627,308 4.91% $ 950,317 5.01%
======== ===== ======== ===== ======== ==== ======== ===== ========= =====
Contractual maturity of mortgage-backed securities and collateralized
mortgage obligations is not a reliable indicator of their expected life because
borrowers have the right to prepay their obligations at any time. 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. The 70% non-taxable
preferred stock includes investments in Government National Mortgage Association
(Ginnie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac)
preferred stock.
31
The following table summarizes the carrying value by classification of
securities as of the dates shown:
December 31,
-------------------------------------------------------------------
2002 2001 2000 1999 1998
--------- --------- --------- ------- -------
(Dollars in thousands)
Available-for-sale ...................... $ 309,219 $ 482,233 $ 334,773 $ 224,790 $ 113,828
Held-to-maturity ........................ 641,098 270,089 252,179 290,193 341,374
--------- --------- --------- --------- ---------
Total .............................. $ 950,317 $ 752,322 $ 586,952 $ 514,983 $ 455,202
========= ========= ========= ========= =========
The following tables present the amortized cost and fair value of
securities classified as available-for-sale at December 31, 2002, 2001 and 2000:
December 31, 2002 December 31, 2001
----------------------------------------- -------------------------------------------
Gross Gross Gross Gross
Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair
Cost Gains Losses Value Cost Gains Losses Value
--------- ---------- ---------- ------- --------- --------- ------- -------
(Dollars in thousands) (Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies ............ $ 18,511 $ 65 $ -- $ 18,576 $ 2,248 $ 201 $ -- $ 2,449
70% non-taxable preferred stock .......... 44,029 -- 884 43,145 24,058 107 -- 24,165
States and political subdivisions ........ 27,115 1,808 -- 28,923 28,165 483 73 28,575
Collateralized mortgage obligations ...... 18,616 596 14 19,198 17,356 314 22 17,648
Mortgage-backed securities ............... 196,887 2,600 110 199,377 410,072 1,646 2,322 409,396
-------- ------- ------- -------- -------- ------- ------ --------
Total ................................ $305,158 $ 5,069 $ 1,008 $309,219 $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
======== ======== ======= ========
The following tables present the amortized cost and fair value of
securities classified as held-to-maturity at December 31, 2002, 2001 and 2000:
December 31, 2002 December 31, 2001
----------------------------------------- --------------------------------------------
Gross Gross Gross Gross
Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair
Cost Gains Losses Value Cost Gains Losses Value
--------- ---------- ---------- ------ --------- ---------- ----------- --------
(Dollars in thousands) (Dollars in thousands)
U.S. Treasury securities and obligations
of U.S. government agencies ............ $ 78,587 $3,131 $ -- $ 81,718 $141,149 $ 3,180 $ 204 $144,125
Corporate debt securities ................ 25,338 942 87 26,193 22,712 609 167 23,154
States and political subdivisions ........ 31,879 1,241 6 33,114 23,338 605 12 23,931
Collateralized mortgage obligations ...... 149,666 1,662 12 151,316 22 -- -- 22
Mortgage-backed securities ............... 355,628 12,297 5 367,920 82,868 535 408 82,995
-------- ------- ------- -------- -------- ------- ------- --------
Total ................................ $641,098 $19,273 $ 110 $660,261 $270,089 $ 4,929 $ 791 $274,227
======== ======= ======= ======== ======== ======= ======= ========
32
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. ...................... $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
======== ======== ======= ========
Mortgage-backed securities are securities that have been developed by
pooling a number of real estate mortgages and which are principally issued by
federal agencies such as Ginnie Mae, Federal National Mortgage Association
(Fannie Mae) and Freddie Mac. These securities are deemed to have high credit
ratings, and minimum regular monthly cash flows of principal and interest are
guaranteed by the issuing agencies.
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, 2002, 76.4% of the mortgage-backed securities held by the Company
had contractual final maturities of more than ten years with a weighted average
life of 2.06 years.
Collateralized mortgage obligations (CMOs) are bonds that are backed by
pools of mortgages. The pools can be Ginnie Mae, Fannie Mae or Freddie Mac pools
or they can be private-label pools. 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, 2002 were $1.587 billion, an increase of
$463.2 million or 41.2% from $1.123 billion at December 31, 2001. The increase
is primarily attributable to internal growth and the Texas Guaranty, First
State, Paradigm, FNB and Southwest acquisitions in 2002. Noninterest-bearing
deposits of $327.7 million at December 31, 2002 increased $138.9 million or
33
73.5% from $189.0 million at December 31, 2001. Noninterest-bearing deposits at
December 31, 2001 were $189.0 million compared with $188.0 million at December
31, 2000. Interest-bearing deposits at December 31, 2002 were $1.259 billion, up
$324.3 million or 34.7% from $934.6 million at December 31, 2001.
Interest-bearing deposits at December 31, 2001 of $934.6 million represented a
$89.0 million or 10.5% increase from $845.6 million at December 31, 2000. Total
deposits at December 31, 2000 were $1.033 billion.
The daily average balances and weighted average rates paid on deposits
for each of the years ended December 31, 2002, 2001 and 2000 are presented
below:
Years Ended December 31,
-----------------------------------------------------------------------------
2002 2001 2000
------------------------ --------------------- -----------------------
Amount Rate Amount Rate Amount Rate
----------- --------- -------- ------- ----------- ----------
(Dollars in thousands)
Interest-bearing checking ..................... $ 249,045 1.27% $ 199,077 2.27% $ 185,486 3.42%
Regular savings ............................... 58,218 1.41 41,472 2.36 39,085 2.76
Money market savings .......................... 257,499 1.71 211,104 3.31 181,181 4.17
Time deposits ................................. 505,796 3.28 428,314 5.20 339,580 5.47
---------- ---------- ---------
Total interest-bearing deposits ........ 1,070,558 2.33 879,967 3.95 745,332 4.50
Noninterest-bearing deposits .................. 230,326 -- 181,228 -- 175,194 --
---------- ---------- ---------
Total deposits ......................... $1,300,884 1.92% $1,061,195 3.28% $ 920,526 3.64%
========== ==== ========== ==== ========= ====
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, 2002
-----------------
(Dollars in thousands)
Three months or less ...................... $104,001
Over three through six months ............. 52,754
Over six through 12 months ................ 50,527
Over 12 months ............................ 40,708
--------
Total .................................... $247,990
========
Other Borrowings
Deposits are the primary source of funds for the Company's lending and
investment activities. As needed, the Company obtains additional funds from the
Federal Home Loan Bank ("FHLB") and correspondent banks. At December 31, 2002,
the Company had $37.9 million in FHLB borrowings of which $12.6 million
consisted of long-term FHLB notes payable and $25.3 million consisted of FHLB
advances compared with $18.1 million in FHLB borrowings at December 31, 2001 of
which $13.3 million consisted of long-term FHLB notes payable and $4.8 million
consisted of FHLB advances. The highest outstanding balance of FHLB advances
during 2002 was $31.4 million compared with $30.2 million during 2001. The
maturity dates on the FHLB notes payable range from 2004 to 2018 and the
interest rates range from 5.95% to 6.48%. FHLB advances are considered
short-term, overnight borrowings. At December 31, 2001, the Company had $13.3
million in FHLB notes payable compared with $13.9 million at December 31, 2000.
The Company had no federal funds purchased at December 31, 2002, December 31,
2001 or December 31, 2000.
At December 31, 2002, 2001, and 2000, 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
34
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.
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
quarterly interest rate on the debentures issued to Trust II for the period from
October 31, 2002 through December 31, 2002 was equal to 5.34%. 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.
In connection with the Paradigm acquisition, on September 1, 2002 the
Company acquired Paradigm Capital Trust II ("Paradigm Trust"), which has $6.0
million of floating rate preferred securities issued. The Company also assumed
the obligations under the floating rate debentures held by Paradigm Trust. The
floating rate debentures will mature on February 20, 2031, which date may be
shortened to a date not earlier than February 20, 2006 if certain conditions are
met. These debentures, which are the only assets of Paradigm Trust, are
subordinate and junior in right of payment to all present and future senior
indebtedness (as defined in the Indenture) of Paradigm, and now the Company as
Paradigm's successor. The Company has fully and unconditionally guaranteed
Paradigm Trust's obligations under the preferred securities.
The debentures issued to Paradigm Trust accrue interest at a floating rate
that adjusts quarterly based on the 3-month LIBOR plus 4.50%. The quarterly
distributions on the preferred securities are paid at the same rate that
interest is paid on the debentures. For the quarter ended December 31, 2002, the
rate on the debentures was 6.33%.
For financial reporting purposes, Trust I, Trust II and Paradigm Trust 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
35
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-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, 2002:
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 $4.1 million) ... $ 83,151 $ 141,128 $ 221,670 $ 499,307 $ 946,256
Loans ................................................. 235,043 58,487 56,608 329,421 679,559
Federal funds sold and other earning assets ........... 14,092 100 199 100 14,491
----------- ----------- --------- ---------- -----------
Total interest-earning assets ................... $ 332,286 $ 200,715 $ 278,477 $ 828,828 $ 1,640,306
----------- ----------- --------- ---------- -----------
Interest-bearing liabilities:
Demand, money market and savings
deposits ........................................... $ 676,397 $ -- $ -- $ -- $ 676,397
Certificates of deposit and other
time deposits ...................................... 77,106 245,343 150,479 109,587 582,515
FHLB Advances and FHLB notes payable ................. 25,352 262 323 12,002 37,939
----------- ----------- --------- ---------- -----------
Total interest-bearing liabilities ................. $ 778,855 $ 245,605 $ 150,802 $ 121,589 $ 1,296,851
----------- ----------- --------- ---------- -----------
Period GAP ......................................... $ (446,569) $ (44,890) $ 127,675 $ 707,239 $ 343,455
Cumulative GAP ..................................... $ (446,569) $ (491,459) $(363,784) $ 343,455
Period GAP to total assets ......................... (24.51)% (2.46)% 7.01% 38.81%
Cumulative GAP to total assets ..................... (24.51)% (26.97)% (19.96)% 18.85%
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, 2002 simulation analysis, the Company
estimates that its current net interest income structure would decrease by
approximately 3.52% over the next twelve months assuming an immediate 100 basis
point decline in rates and increase by approximately 3.62% over the next twelve
months assuming an immediate 100 basis point increase in rates. The Company
estimates that its current net interest income structure would decrease by
approximately 5.65% over the next twelve months assuming an immediate 200 basis
point decline in rates and increase by approximately 3.73% over the next twelve
months assuming an immediate 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.
36
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, 2002, 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, 2002, the
Company had cash and cash equivalents of $80.8 million, up from $41.7 million,
at December 31, 2001. The increase was mainly due to an increase in federal
funds sold of $13.3 million and increases in total deposits and the number of
deposit accounts.
The Company's future cash payments associated with its contractual
obligations pursuant to its long-term debt, operating leases, letters of credit
and commitments to extend credit as of December 31, 2002 are summarized below:
Payments due in:
--------------------------------------------------------------------------
Fiscal Fiscal
Fiscal 2003 2004-2005 2006-2007 Thereafter Total
----------- ---------- --------- ---------- -----
(Dollars in thousands)
Company-obligated manditorily redeemable
trust preferred securities of subsidiary
trusts ....................................... $ -- $ -- $ -- $ 33,000 $ 33,000
Long-term debt .................................. 704 2,122 3,306 6,507 12,639
Operating leases ................................ 1,322 1,702 1,017 933 4,974
----------- ---------- ---------- ---------- ---------
Total ..................................... $ 2,026 $ 3,824 $ 4,323 $ 40,440 $ 50,613
=========== ========== ========== ========== ==========
The Company's commitments associated with outstanding letters of credit
and commitments to extend credit as of December 31, 2002 are summarized below.
Since commitments associated with letters of credit and commitments to extend
credit may expire unused, the amounts shown do not necessarily reflect the
actual future cash funding requirements:
Fiscal Fiscal
Fiscal 2003 2004-2005 2006-2007 Thereafter Total
----------- ---------- --------- ---------- -----
Total (Dollars in thousands)
Standby letters of credit ...................... $ 1,322 $ 353 $ -- $ 6 $ 1,681
Commitments to extend credit .................... 43,795 4,308 16,874 13,382 78,359
----------- ---------- ---------- ---------- ----------
Total ..................................... $ 45,117 $ 4,661 $ 16,874 $ 13,388 $ 80,040
=========== ========== ========== ========== ==========
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."
37
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 $154.7 million at December 31,
2002 from $88.7 million at December 31, 2001, an increase of $66.0 million or
74.4%. This increase was primarily the result of net income of $21.3 million
partially offset by dividends paid on the Common Stock of $3.9 million and an
increase in Common Stock issued of $45.9 million in connection with the Paradigm
Acquisition. During 2001, shareholders' equity increased by $8.4 million or
10.1% from $80.3 million at December 31, 2000 due primarily to net income of
$13.0 million partially offset by dividends paid on the Common Stock of $3.2
million and trust preferred issuance costs of $476,000.
The following table provides a comparison of the Company's and the
Bank's leverage and risk-weighted capital ratios as of December 31, 2002 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, 2002
----------------- ---------------------- -----------------
The Company
Leverage ratio............................. 3.00%(1) N/A 6.56%
Tier 1 risk-based capital ratio............ 4.00 N/A 14.10
Total risk-based capital ratio............. 8.00 N/A 15.30
The Bank
Leverage ratio............................. 3.00%(2) 5.00% 6.26%
Tier 1 risk-based capital ratio............ 4.00 6.00 13.71
Total risk-based capital ratio............. 8.00 10.00 14.91
- --------------------
(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.
38
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, 2002. 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 2002
----------------------------------------------------
(unaudited)
December 31 September 30 June 30 March 31
----------- ------------ ------- --------
(Dollars in thousands, except per share data)
Interest income ....................................... $ 22,837 $ 20,419 $ 19,106 $ 18,380
Interest expense ...................................... 6,828 6,464 6,283 6,356
----------- ------------ -------- ---------
Net interest income .............................. 16,009 13,955 12,823 12,024
Provision for credit losses ........................... 650 120 120 120
----------- ------------ -------- ---------
Net interest income after provision .............. 15,359 13,835 12,703 11,904
Noninterest income .................................... 4,148 2,893 2,326 2,161
Noninterest expense ................................... 10,160 8,506 8,125 7,662
----------- ------------ -------- ---------
Income before income taxes ....................... 9,347 8,222 6,904 6,403
Provision for income taxes ............................ 2,965 2,569 2,109 1,912
----------- ------------ -------- ---------
Net income ............................................ $ 6,382 $ 5,653 $ 4,795 $ 4,491
=========== ============ ======== =========
Earnings per share:
Basic ............................................. $ 0.34 $ 0.33 $ 0.30 $ 0.28
=========== ============ ======== =========
Diluted ........................................... $ 0.33 $ 0.32 $ 0.29 $ 0.27
=========== ============ ======== =========
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 ................................... 7,361 7,068 6,737 9,129(1)
----------- ------------ -------- ---------
Income before income taxes ....................... 5,737 5,329 5,057 2,207(1)
Provision for income taxes ............................ 1,747 1,598 1,487 540(1)
----------- ------------ -------- ---------
Net income ....................................... 3,990 $ 3,731 3,570 $ 1,667(1)
=========== ============ ======== =========
Earnings per share:
Basic ............................................ $ 0.25 $ 0.23 $ 0.22 $ 0.11(1)
=========== ============ ======== =========
Diluted .......................................... $ 0.24 $ 0.23 $ 0.22 $ 0.10(1)
=========== ============ ======== =========
- -----------------------
(1) The financial data for the quarter ended March 31, 2001 includes the merger-
related expenses of $2.4 million.
39
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, 2002.
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 2003
Annual Meeting of Shareholders (the "2003 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 2003 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 2003 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 2003 Proxy Statement is incorporated herein by
reference in response to this item.
ITEM 14. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. Within 90 days prior to the
date of this report, the Company carried out an evaluation, under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures. Based on this
evaluation, the Company's Chief Executive Officer and Chief Financial Officer
concluded that the Company's disclosure controls and procedures (as defined in
Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934 (the
"Exchange Act")) are effective to ensure that information required to be
disclosed by the Company in reports that it files or submits under the Exchange
Act is recorded, processed, summarized and reported to the Company's management
within the time periods specified in the Securities and Exchange Commission's
rules and forms.
Changes in internal controls. Subsequent to the date of their evaluation, there
were no significant changes in the Company's internal controls or in other
factors that could significantly affect the Company's disclosure controls and
procedures, and there were no corrective actions with regard to significant
deficiencies and material weaknesses based on such evaluation.
40
PART IV.
ITEM 15. 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, 2002 and 2001
Consolidated Statements of Income for the Years Ended December 31,
2002, 2001 and 2000
Consolidated Statements of Changes in Shareholders' Equity for the
Years Ended December 31, 2002, 2001 and 2000
Consolidated Statements of Cash Flows for the Years Ended December 31,
2002, 2001 and 2000
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.
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 dated
as of May 1, 2002 by and between Prosperity
Bancshares, Inc. and Paradigm
Bancorporation, Inc. (incorporated herein by
reference to Exhibit 2.1 to the Company's
Registration Statement on Form S-4
(Registration No. 333-91248))
2.2 - Stock Purchase Agreement dated as of
February 22, 2002 by and between Prosperity
Bancshares, Inc. and American Bancorp of
Oklahoma, Inc. (incorporated herein by
reference to Exhibit 2.1 to the Company's
Quarterly Report on Form 10-Q for the
quarter ended March 31, 2002)
2.3 - Agreement and Plan of Reorganization dated
as of April 26, 2002 by and among Prosperity
Bancshares, Inc., Prosperity Bank and The
First State Bank (incorporated herein by
reference to Exhibit 2.2 to the Company's
Quarterly Report on Form 10-Q for the
quarter ended March 31, 2002)
2.4 - 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))
2.5 - 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)
2.6 - 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))
3.1 - Amended and Restated Articles of
Incorporation of Prosperity (incorporated
herein by reference to Exhibit 3.1 to the
Company's Form 10-Q for the quarter ended
March 31, 2001)
3.2 - Amended and Restated Bylaws of Prosperity
(incorporated herein by reference to Exhibit
3.1 to the Company's Registration Statement
on Form S-1 (Registration No. 333-63267))
41
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 to 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 to 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 to 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 to 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 to 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 to the Company's
Quarterly Report on Form 10-Q for the quarter ended
September 30, 2001)
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))
42
10.8+ - Paradigm Bancorporation, Inc. 1999 Stock Incentive Plan
(incorporated herein by reference to Exhibit 4.2 to the
Company's Registration Statement on Form S-8 (Registration
No. 333-100815))
21.1* - Subsidiaries of Prosperity
23.1* - Consent of Deloitte & Touche LLP
99.1* - Certification of Chief Executive Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to section 906 of
the Sarbanes-Oxley Act of 2002
99.2* - Certification of Chief Financial Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to section 906 of
the Sarbanes-Oxley Act of 2002
-----------------------------------------
+ Management contract or compensatory plan or arrangement.
Reports on Form 8-K
The following reports on Form 8-K were filed during the fourth quarter
2002:
(i) The Company filed a Current Report on Form 8-K under Item 5 on
November 5, 2002 to announce the completion of the acquisition of
The First National Bank of Bay City, in Bay City, Texas.
(ii) The Company filed a Current Report on Form 8-K under Item 5 on
October 22, 2002 to announce the release of the Company's
earnings for the third quarter 2002.
(iii) The Company filed a Current Report on Form 8-K under Item 5 on
October 2, 2002 to announce the completion of the merger of
Southwest Bank Holding Company, Dallas, Texas, into the Company.
43
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 7, 2003.
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 7, 2003.
Signature Positions
--------- ---------
/s/ DAVID ZALMAN President and Chief Executive Officer (principal
--------------------------------------- executive officer)
David Zalman
/s/ NED S. HOLMES Chairman of the Board; Director
---------------------------------------
Ned S. Holmes
/s/ DAVID HOLLAWAY Chief Financial Officer (principal
--------------------------------------- financial officer and principal
David Hollaway 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/ WILLIAM H. FAGAN, M.D. Director
---------------------------------------
William Fagan, M.D.
/s/ CHARLES J. HOWARD, M.D. Director
---------------------------------------
Charles Howard, M.D.
/s/ PERRY MUELLER, JR., D.D.S. Director
---------------------------------------
Perry Mueller, Jr., D.D.S.
/s/ A. VIRGIL PACE, JR. Director
---------------------------------------
A. Virgil Pace, Jr.
/s/ TRACY T. RUDOLPH Director
---------------------------------------
Tracy T. Rudolph
/s/ HARRISON STAFFORD II Director
---------------------------------------
Harrison Stafford II
/s/ ROBERT STEELHAMMER Director
---------------------------------------
Robert Steelhammer
/s/ H.E. TIMANUS, JR. Director
---------------------------------------
H. E. Timanus, Jr.
44
Certifications
I, David Zalman, President and Chief Executive Officer of the
registrant, certify that:
1. I have reviewed this annual report on Form 10-K of Prosperity
Bancshares, Inc.;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
in order to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other
financial information included in this annual report, fairly present in all
material respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
(a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including
its consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
this annual report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this annual report (the "Evaluation Date"); and
(c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated
in this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect the internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: March 7, 2003
/s/ David Zalman
----------------------------------------
David Zalman
President and Chief Executive Officer
45
I, David Hollaway, Chief Financial Officer of the registrant,
certify that:
1. I have reviewed this annual report on Form 10-K of Prosperity
Bancshares, Inc.;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
in order to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other
financial information included in this annual report, fairly present in all
material respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
(a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including
its consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
this annual report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this annual report (the "Evaluation Date"); and
(c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated
in this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect the internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: March 7, 2003
/s/ David Hollaway
--------------------------------------
David Hollaway
Chief Financial Officer
46
TABLE OF CONTENTS TO FINANCIAL STATEMENTS
Page
----
Prosperity Bancshares, Inc.(SM)
Independent Auditors' Report .................................................. F-2
Consolidated Balance Sheets as of December 31, 2002 and 2001 ................. F-3
Consolidated Statements of Income for the Years Ended December 31,
2002, 2001 and 2000 ...................................................... F-4
Consolidated Statements of Changes in Shareholders' Equity for the
Years Ended December 31, 2002, 2001 and 2000 ............................. F-5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2002, 2001 and 2000 ......................................... 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, 2002 and 2001 and the related consolidated statements of income,
shareholders' equity and cash flows for each of the three years in the period
ended December 31, 2002. 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, 2002 and 2001, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2002 in conformity with accounting principles generally accepted in
the United States of America.
As discussed in Note 1 to the consolidated financial statements, in 2002 the
Company adopted the provisions of Statement of Accounting Standards No. 141
"Business Combinations" and Statement of Accounting Standards No. 142 "Goodwill
and Other Intangible Assets."
/s/ Deloitte & Touche LLP
Houston, Texas
February 14, 2003
F-2
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31,
----------------------------------
2002 2001
---------- ----------
(Dollars in thousands)
ASSETS
Cash and due from banks (Note 4) ...................................... $ 66,806 $ 41,005
Federal funds sold .................................................... 13,993 715
---------- ----------
Total cash and cash equivalents ................................... 80,799 41,720
Interest bearing deposits in financial institutions ................... 498 198
Available for sale securities, at fair value (Note 5) ................. 309,219 482,233
Held to maturity securities, at cost (Note 5) ......................... 641,098 270,089
Loans (Notes 6 and 10) ................................................ 679,559 424,400
Less allowance for credit losses (Note 7) ............................. (9,580) (5,985)
---------- ----------
Loans, net .............................................. 669,979 418,415
Accrued interest receivable ........................................... 10,348 8,466
Goodwill .............................................................. 68,290 22,641
Core deposit intangibles, net of accumulated amortization
of $192,000 ........................................................ 4,120 --
Bank premises and equipment, net (Note 8) ............................. 27,010 15,077
Other real estate owned ............................................... 219 --
Other assets .......................................................... 10,676 3,486
---------- ----------
TOTAL ASSETS .......................................................... $1,822,256 $1,262,325
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES:
Deposits (Note 9):
Noninterest-bearing ............................................ $ 327,699 $ 188,832
Interest-bearing ............................................... 1,258,912 934,565
---------- ----------
Total deposits .......................................... 1,586,611 1,123,397
Other borrowings (Note 10) ......................................... 37,939 18,080
Accrued interest payable ........................................... 2,550 2,869
Other liabilities .................................................. 7,417 2,254
---------- ----------
Total liabilities ....................................... 1,634,517 1,146,600
COMMITMENTS AND CONTINGENCIES
(Notes 12 and 16)
COMPANY-OBLIGATED MANDITORILY REDEEMABLE
TRUST PREFERRED SECURITIES OF SUBSIDIARY
TRUSTS (Note 19) ................................................... 33,000 27,000
SHAREHOLDERS' EQUITY (Notes 14 and 17):
Common stock, $1 par value; 50,000,000 shares
authorized; 18,903,028 and 16,218,022
shares issued at December 31, 2002 and
2001, respectively; 18,895,876 and
16,210,870 shares outstanding at
December 31, 2002 and 2001, respectively ........................... 18,903 16,218
Capital surplus .................................................... 60,312 16,865
Retained earnings .................................................. 72,917 55,462
Accumulated other comprehensive income -- net
unrealized gains on available for sale
securities, net of tax of $1,424 and of $117,
respectively ................................................ 2,644 217
Less treasury stock, at cost, 7,152 shares ......................... (37) (37)
---------- ----------
Total shareholders' equity .............................. 154,739 88,725
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS'
EQUITY ......................................................... $1,822,256 $1,262,325
========== ==========
See notes to consolidated financial statements.
F-3
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
For the Years Ended
December 31,
--------------------------------------------
2002 2001 2000
--------- -------- ---------
(Dollars in thousands, except per share data)
INTEREST INCOME:
Loans, including fees ................................ $ 38,330 $ 34,731 $ 33,599
Securities:
Taxable ........................................... 39,289 37,413 31,845
Nontaxable ........................................ 1,599 1,597 1,477
70% nontaxable preferred dividends ................ 1,216 1,343 656
Federal funds sold ................................... 285 1,401 2,414
Deposits in financial institutions .................. 23 35 88
--------- -------- ---------
Total interest income ........................... 80,742 76,520 70,079
--------- -------- ---------
INTEREST EXPENSE:
Deposits ............................................. 24,976 34,780 33,551
Note payable and other borrowings .................... 955 1,005 2,013
--------- -------- ---------
Total interest expense .......................... 25,931 35,785 35,564
--------- -------- ---------
NET INTEREST INCOME ..................................... 54,811 40,735 34,515
PROVISION FOR CREDIT LOSSES (Note 7) .................... 1,010 700 275
--------- -------- ---------
NET INTEREST INCOME AFTER PROVISION
FOR CREDIT LOSSES .................................... 53,801 40,035 34,240
--------- -------- ---------
NONINTEREST INCOME:
Customer service fees ................................ 9,764 7,530 6,576
Other ................................................ 1,764 1,060 1,184
--------- -------- ---------
Total noninterest income ........................ 11,528 8,590 7,760
--------- -------- ---------
NONINTEREST EXPENSE:
Salaries and employee benefits
(Note 15) ......................................... 16,379 12,955 12,931
Net occupancy expense ................................ 2,345 1,971 1,761
Data processing ...................................... 2,131 2,126 1,956
Goodwill amortization ................................ -- 1,363 1,160
Core deposit intangible amortization ................. 192 -- --
Depreciation expense ................................. 1,830 1,570 1,553
Minority interest trust preferred securities ......... 2,104 1,580 1,151
Merger related expenses .............................. -- 2,425 --
Other ................................................ 9,472 6,305 6,255
--------- -------- ---------
Total noninterest expense ....................... 34,453 30,295 26,767
--------- -------- ---------
INCOME BEFORE INCOME TAXES .............................. 30,876 18,330 15,233
PROVISION FOR INCOME TAXES (Note 13) .................... 9,555 5,372 4,532
--------- -------- ---------
NET INCOME .............................................. $ 21,321 $ 12,958 $ 10,701
========= ======== =========
EARNINGS PER SHARE (Note 1):
Basic ................................................ $ 1.25 $ 0.80 $ 0.67
========= ======== =========
Diluted .............................................. $ 1.22 $ 0.79 $ 0.65
========= ======== =========
See notes to consolidated financial statements.
F-4
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Accumulated
Common Stock Other Total
-------------------
Capital Retained Comprehensive Treasury Shareholders'
Shares Amount Surplus Earnings Income Stock Equity
------ ------ ------- -------- ------ ----- ------
(Amounts in thousands, except share data)
BALANCE AT JANUARY 1, 2000 .............. 15,998,596 $ 15,999 $ 18,024 $ 37,719 $ (2,681) $ (37) $ 69,024
Net income ........................... 10,701 10,701
Net change in unrealized gain (loss)
on available for sale securities ... 3,286 3,286
-----------
Total comprehensive income ........... 13,987
-----------
Sale of common stock ................. 152,400 152 183 335
Trust preferred issuance costs ....... (90) (90)
Cash paid in lieu of fractional
shares in connection with issuance
of common stock in exchange for
stock of Heritage Bank ............. (24) (15) (24)
Cash paid to dissenting shareholder
in connection with the issuance of
common stock in exchange for
common stock of Heritage Bank ...... (153) (153)
Cash dividends declared, $0.18
per share .......................... (2,755) (2,755)
----------- ----------- ----------- ----------- ----------- ----------- -----------
BALANCE AT DECEMBER 31, 2000 ............ 16,150,972 16,151 17,949 45,665 605 (37) 80,333
Net income 12,958 12,958
Net change in unrealized gain (loss)
on available for sale securities ... (388) (388)
-----------
Total comprehensive income ........... 12,570
-----------
Sale of common stock ................. 130,600 131 175 306
Trust preferred issuance costs ....... (476) (476)
Cash paid to dissenting shareholders
in connection with the issuance of
common stock in exchange for
common stock of Commercial ......... (63,550) (64) (783) (847)
Cash dividends declared, $0.195
per share .......................... (3,161) (3,161)
----------- ----------- ----------- ----------- ----------- ----------- -----------
BALANCE AT DECEMBER 31, 2001 ............ 16,218,022 $ 16,218 $ 16,865 $ 55,462 $ 217 $ (37) $ 88,725
Net income ........................... 21,321 21,321
Net change in unrealized gain (loss)
on available for sale securities ... 2,427 2,427
-----------
Total comprehensive income ........... 23,748
-----------
Sale of common stock ................. 104,504 105 155 260
Common stock issued in connection
with Paradigm Acquisition .......... 2,580,502 2,580 43,295 45,875
Cash paid in lieu of fractional
shares in connection with the
Paradigm Acquisition ............... (3) (3)
Cash dividends declared, $0.22
per share .......................... (3,866) (3,866)
----------- ----------- ----------- ----------- ----------- ----------- -----------
BALANCE AT DECEMBER 31, 2002 ............ $18,903,028 $ 18,903 $ 60,312 $ 72,917 $ 2,644 $ (37) $ 154,739
=========== =========== =========== =========== =========== =========== ===========
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,
----------------------------------------------
2002 2001 2000
---------- ---------- ----------
(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ........................................ $ 21,321 $ 12,958 $ 10,701
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization ................... 2,022 2,933 2,661
Provision for credit losses ..................... 1,010 700 275
Net amortization (accretion) of premium/
discount on investments ....................... 4,317 982 (16)
Loss (gain) on sale of premises,
equipment and other real estate ............... (39) 87 --
Decrease (increase) in accrued interest
receivable and other assets ................... 7 3,358 (1,340)
(Decrease) increase in accrued interest
payable and other liabilities ................. (2,520) (1,177) 383
---------- ---------- ----------
Total adjustments ............................. 4,797 6,883 1,963
---------- ---------- ----------
Net cash provided by operating activities ..... 26,118 19,841 12,664
---------- ---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities and
principal paydowns of held to
maturity securities ............................. 211,467 212,615 79,347
Purchase of held to maturity securities ........... (300,816) (75,671) (65,703)
Proceeds from maturities and
principal paydowns of available
for sale securities ............................. 128,906 92,386 25,765
Purchase of available for sale securities ......... (119,527) (396,280) (101,572)
Net decrease (increase) in loans .................. 37,291 (13,197) (39,294)
Purchase of bank premises and equipment ........... (2,171) (3,073) (1,308)
Proceeds from sale of bank premises, equipment
and other real estate ........................... 1,229 1,312 75
Premium paid for Texas Guaranty Bank .............. (3,649) -- --
Net liabilities acquired in purchase of Texas
Guaranty Bank (net of acquired cash
of $12,723) ..................................... 3,815 -- --
Premium paid for The First State Bank ............. (1,721) -- --
Net liabilities acquired in purchase of The
First State Bank (net of acquired cash
of $4,938) ...................................... 2,859 -- --
Premium paid for Paradigm Bancorporation .......... (36,489) -- --
Net liabilities acquired in purchase of Paradigm
Bancorporation (net of acquired cash
of $14,447) ..................................... 49,223 -- --
Premium paid for First National Bank of Bay City... (2,217) -- --
Net liabilities acquired in purchase of
First National Bank of Bay City (net of acquired
cash of $5,816) ................................. 2,425 -- --
Premium paid for SouthWest Bank Holding Company ... (5,693) -- --
Net liabilities acquired in purchase of SouthWest
Bank Holding Comapny (net of acquired cash
of $14,282) ..................................... 836 -- --
Net decrease in interest-bearing deposits
in financial institutions ....................... 397 887 --
Net liabilities acquired in purchase of
Compass branches ................................ -- -- 77,473
---------- ---------- ----------
Net cash (used in) investing activities ............. (33,835) (181,021) (25,217)
---------- ---------- ----------
(Table continued on following page)
F-6
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended
December 31,
----------------------------------------------
2002 2001 2000
----------- ------------- -------------
(Dollars in thousands)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in noninterest-bearing
deposits ................................................. $ 10,118 $ 873 $ 54,429
Net increase in interest-bearing deposits .................. 26,228 88,978 13,037
Proceeds (repayments ) of other
borrowings (net) ......................................... 14,059 4,149 (49,188)
Proceeds from issuance of junior
subordinated debentures .................................. -- 15,000 --
Trust preferred issuance costs ............................ -- (476) (90)
Cash paid in lieu of fractional shares ..................... (3) -- (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 ............................................. 260 306 335
Payments of cash dividends ................................. (3,866) (3,161) (2,755)
----------- ---------- -----------
Net cash provided by
financing activities ................................ 46,796 104,822 15,600
----------- ---------- -----------
NET INCREASE (DECREASE) IN CASH AND
CASH EQUIVALENTS ........................................... $ 39,079 $ (56,358) $ 3,047
CASH AND CASH EQUIVALENTS, BEGINNING,
OF PERIOD .................................................. 41,720 98,078 95,031
----------- ---------- -----------
CASH AND CASH EQUIVALENTS, END OF
PERIOD ..................................................... $ 80,799 $ 41,720 $ 98,078
=========== ========== ===========
INCOME TAXES PAID ............................................. $ 9,182 $ 6,410 $ 4,259
=========== ========== ===========
INTEREST PAID ................................................. $ 26,250 $ 36,396 $ 32,484
=========== ========== ===========
TRANSFER OF AVAILABLE FOR SALE
SECURITIES TO HELD TO MATURITY
SECURITIES ................................................. $ 241,756 $ 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"), Prosperity Bank(SM)
and Bank of the Southwest (the "Banks"), (collectively referred to as the
"Company") provide retail and commercial banking services. As of December 31,
2002, the Company had two bank subsidiaries, Prosperity Bank(SM) and Bank of the
Southwest. Effective January 2, 2003, Bank of the Southwest was merged into
Prosperity Bank (the "Bank"). The historical financial data of the Company has
been restated to include the accounts and operations of Commercial Bancshares,
Inc. which was merged into the Company effective February 23, 2001 and was
accounted for as a pooling of interests.
The Banks operate forty (40) banking centers in fifteen contiguous
counties located in Southeast Texas and two (2) banking centers in Dallas,
Texas, with locations in Angleton, Bay City, Beeville, Houston-Bellaire,
Dallas-Camp Wisdom, Houston-City West, Houston-Clear Lake, Cleveland,
Houston-Copperfield, Cuero, Cypress, Dayton, Houston-Downtown, East Bernard,
Edna, El Campo, Fairfield, Galveston, Houston-Gladebrook, Goliad,
Houston-Highway 6, Hitchcock, Liberty, Magnolia, Mathis, Houston-Medical Center,
Houston-Memorial, Mont Belvieu, Needville, Palacios, Houston-Post Oak,
Houston-River Oaks, Sweeny, Houston-Tanglewood, Victoria, Houston-Waugh Drive,
West Columbia, Dallas-Westmoreland, Wharton, Winnie and Houston-Woodcreek.
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
F-8
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
loan's observable market price or the fair value of the collateral if the loan
is collateral dependent. At December 31, 2002, the Company had $1.1 million in
nonaccrual loans, $120,000 in 90 days or more past due loans, $1.1 million in
other nonperforming loans and no restructured loans. At December 31, 2001, the
Company had $1,000 in nonaccrual loans, no 90 days or more past due loans and no
restructured loans.
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.
F-9
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
Amortization of Goodwill -- Goodwill was amortized using the straight-line
method through December 31, 2001 (See Note 1-New Accounting Standards). Goodwill
is periodically assessed for impairment when events or changes in circumstances
indicate that the carrying amount of the asset may not be recoverable. The
Company bases its evaluation on such impairment factors as the nature of the
assets, the future economic benefit of the assets, any historical or future
profitability measurements, as well as other external market conditions or
factors that may be present.
Amortization of Core Deposit Intangibles (CDI) - CDI is amortized using an
accelerated amortization method over an eight year period.
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.
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).
Cash and Cash Equivalents -- 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 2001 and
2000 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,
-------------------------------------------------------------
2002 2001 2000
------------------- ------------------- -------------------
Per Per Per
Share Share Share
Amount Amount Amount Amount Amount Amount
-------- -------- -------- -------- -------- --------
(Dollars in thousands, except per share data)
Net income .............................. $21,321 $12,958 $10,701
Basic:
Weighted average shares
outstanding ....................... 17,122 $ 1.25 16,172 $ 0.80 16,064 $ 0.67
====== ====== ======
Diluted:
Weighted average shares
outstanding ....................... 17,122 16,172 16,064
Effect of dilutive securities --
options ........................... 320 326 390
------- ------- -------
Total ............................... 17,442 $ 1.22 16,498 $ 0.79 16,454 $ 0.65
======= ====== ======= ====== ======= ======
There were no stock options exercisable at December 31, 2002, 2001 and 2000
that would have had an anti-dilutive effect on the above computation.
F-10
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
New Accounting Standards -In June 2001, the Financial Accounting Standards
Board ("FASB"), issued Statement of Financial Accounting Standards ("SFAS") No.
141, Business Combinations. SFAS No. 141 establishes accounting and reporting
standards for business combinations. This Statement eliminates the use of the
pooling-of-interest method of accounting for business combinations, requiring
future business combinations to be accounted for using the purchase method of
accounting. Additionally, SFAS No. 141 enhances the disclosures related to
business combinations, and requires that all intangible assets acquired in a
business combination be reported separately from goodwill. These intangible
assets must then be assigned to a specifically identified reporting unit and
assigned a useful life. The provisions of this statement apply to all business
combinations initiated after June 30, 2001. The adoption of this statement did
not have a material impact on the Company's financial position or results of
operations.
In July 2001, the FASB 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 were effective for fiscal years beginning
after December 15, 2001. The adoption of this statement did not have a material
impact on the Company's financial position or results of operations.
In July 2001, FASB issued SFAS 143, Accounting for Asset Retirement
Obligations. The statement requires entities to record the fair value of a
liability for an asset retirement obligation in the period in which it is
incurred. When the liability is initially recorded, the entity capitalizes a
cost by increasing the carrying amount of the related long-lived asset. Over
time, the liability is accreted to its present value each period, and the
capitalized cost is depreciated over the useful life of the related asset. Upon
settlement of the liability, an entity either settles the obligation for its
recorded amount or incurs a gain or loss upon settlement. The standard is
effective for fiscal years beginning after September 15, 2002, with earlier
application encouraged. The adoption of this statement did not have a material
impact on the Company's financial position or results of operations.
In August 2001, the FASB issued SFAS 144, Accounting for Impairment or
Disposal of Long-lived Assets. SFAS 144 addresses financial accounting and
reporting for the impairment of long-lived assets and for long-lived assets to
be disposed of. It supersedes, with exceptions, SFAS 121, Accounting for the
Impairment of Long-lived Assets and Long-lived Assets to be Disposed Of, and was
effective for fiscal years beginning after December 15, 2001. The adoption of
this statement did not have a material impact on the Company's financial
position or results of operations.
In May of 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements
No.4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections
as of April 2002. This Statement rescinds SFAS No. 4 and 64, Reporting Gains and
Losses from Extinguishment of Debt and Extinguishment of Debt Made to Satisfy
Sinking-Fund Requirements, respectively, and restricts the classification of
early extinguishment of debt as an extraordinary item to the provisions of APB
Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions. The Statement also rescinds SFAS No. 44,
Accounting for Intangible Assets of Motor Carriers, which is no longer necessary
because the transition to the provisions of the Motor Carrier Act of 1980 is
complete. The statement also amends SFAS No. 13, Accounting for Leases, to
eliminate an inconsistency between the required accounting for sale-leaseback
transactions and the required accounting for certain lease modifications that
have economic effects that are similar to sale-leaseback transactions. Finally,
the Statement makes various technical corrections to existing pronouncements
which are not considered substantive. The provisions of this Statement are
effective for fiscal years beginning after May 15, 2002. The adoption of this
statement did not have a material impact on the Company's financial position or
results of operations.
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities. SFAS No. 146 provides guidance on the
recognition and measurement of liabilities for cost associated with exit or
disposal activities. SFAS no. 146 is effective for exit or disposal activities
that are initiated after December 31, 2002. The Company does not believe that
the implementation of this statement will have a material impact on the
Company's financial position or results of operations.
In October 2002, the FASB issued SFAS 147, Acquisitions of Certain
Financial Institutions ("SFAS 147"). SFAS 147 provides guidance on the
accounting for the acquisition of a financial institution, except transactions
between two or more mutual enterprises. The implementation of this standard did
not have a material impact on the Company's financial position or results of
operations.
F-11
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
In December 2002, the FASB issued SFAS 148, Accounting for Stock-Based
Compensation ("SFAS 148"). SFAS 148 provides guidance on the accounting for
stock based compensation. In addition, this Statement amends the disclosure
requirements of Statement 123 to require prominent disclosures in both annual
and interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results. The
Company adopted SFAS 148 as of December 31, 2002 and has elected to continue to
account for its employee stock options using the intrinsic value-based method.
Stock Split -- On May 31, 2002, the Company effected a two-for-one stock
split in the form of a 100 percent stock dividend to shareholders of record on
May 20, 2002. The Company issued approximately 8.1 million shares in connection
with the split. All per share and share information has been restated to reflect
this stock split.
2. ACQUISITIONS
On November 1, 2002, the Company completed the acquisition of First
National Bank of Bay City, Bay City, Texas (the "FNB Acquisition"), through the
merger of FNB with and into Prosperity Bank. Under the terms of the Agreement
and Plan of Reorganization dated as of August 15, 2002, as amended, the Company
paid approximately $5.1 million in cash for all of the issued and outstanding
common stock of FNB. FNB was privately held and operated one (1) location in Bay
City, Texas, which was closed and consolidated with Prosperity Bank's Bay City
Banking Center. As of November 1, 2002, FNB had total assets of $27.1 million,
total loans of $8.2 million and total deposits of $23.8 million.
In connection with the purchase, the Company paid a cash premium of $2.2
million of which $168,000 was identified as core deposit intangibles. This
premium was recorded as goodwill and the core deposit intangibles are being
amortized using an accelerated amortization method over an 8 year life.
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.
On October 1, 2002, the Company completed the acquisition of Southwest Bank
Holding Company, Dallas, Texas (the "Southwest Acquisition"). Southwest's wholly
owned subsidiary, Bank of the Southwest, Dallas, Texas, became a subsidiary of
the Company. Under the terms of the Agreement and Plan of Merger dated as of
July 14, 2002, the Company paid approximately $19.6 million in cash. Southwest
was privately held and operated two (2) banking offices in Dallas, Texas. As of
October 1, 2002, Southwest had total assets of $121.9 million, total loans of
$58.7 million and total deposits of $108.9 million.
In connection with the purchase, the Company paid a cash premium of $5.7
million of which $640,000 was identified as core deposit intangibles. This
premium was recorded as goodwill and the core deposit intangibles are being
amortized using an accelerated amortization method over an 8 year life.
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.
On September 1, 2002, the Company completed the acquisition of Paradigm
Bancorporation, Inc. (the "Paradigm Acquisition") in a stock transaction. Under
the terms of the Agreement and Plan of Reorganization dated as of May 2, 2002,
Prosperity issued approximately 2.58 million shares of its common stock for all
outstanding shares of Paradigm (giving effect to the two for one stock split).
Paradigm operated a total of eleven (11) banking offices - six (6) in the
greater metropolitan Houston area and five (5) in the nearby Southeast Texas
cities of Dayton, Galveston, Mont Belvieu, and Winnie, three (3) of which were
closed following completion of the transaction. As of September 1, 2002,
Paradigm Bancorporation had total assets of $248.7 million, total loans of
$175.7 million and total deposits of $218.3 million.
In connection with the purchase, the Company paid a cash premium of $36.6
million of which $2.8 million was identified as core deposit intangibles. This
premium was recorded as goodwill and the core deposit intangibles are being
amortized using an accelerated amortization method over an 8 year life.
F-12
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
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.
On July 12, 2002, the Company completed the acquisition of The First
State Bank, Needville, Texas (the "First State Acquisition") for approximately
$3.7 million in cash. Prosperity Bank's existing Needville Banking Center has
relocated into the former First State Bank location effective July 15, 2002. As
of July 12, 2002, The First State Bank had total assets of $16.3 million, loans
of $5.5 million and deposits of $14.1 million.
In connection with the purchase, the Company paid a cash premium of
$1.7 million of which $293,000 was identified as core deposit intangibles. This
premium was recorded as goodwill and the core deposit intangibles are being
amortized using an accelerated amortization method over an 8 year life.
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.
On May 8, 2002, the Company completed the acquisition of Texas Guaranty
Bank, N.A. (the "Texas Guaranty Acquisition") for approximately $11.8 million in
cash. Texas Guaranty Bank operated three (3) offices in Houston, Texas, all of
which became full service banking centers of Prosperity Bank. As of May 8, 2002,
Texas Guaranty Bank had total assets of $74.0 million, loans of $45.7 million
and deposits of $61.8 million.
In connection with the purchase, the Company paid a cash premium of
$3.7 million of which $431,000 was identified as core deposit intangibles. This
premium was recorded as goodwill and the core deposit intangibles are being
amortized using an accelerated amortization method over an 8 year life.
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.
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"). The Company issued
2,768,610 shares of its Common Stock for all of the outstanding shares of
Commercial. 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.
In connection with this Commercial Merger, the Company incurred
approximately $2.4 million in pretax merger-related expenses and other charges.
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.
F-13
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
3. GOODWILL
In June 2001, the FASB issued SFAS no. 142, which no longer permits the
amortization of goodwill and indefinite-lived intangible assets. Instead, these
assets must be reviewed annually (or more frequently under certain conditions)
for impairment. Intangible assets that do not have indefinite lives will
continue to be amortized over their useful lives and reviewed for impairment.
The Company adopted the provisions of SFAS No. 142 and therefore discontinued
the amortization of goodwill effective January 1, 2002. During fiscal 2002, the
Company completed the initial transitional goodwill impairment test, which did
not indicate any goodwill impairment and therefore did not have an effect on the
Company's consolidated financial condition of results of operations.
The following table presents a reconciliation of reported net income and
earnings per share to the amounts adjusted for the exclusion of goodwill
amortization, net of the related income tax effect:
Fiscal 2002 Fiscal 2001 Fiscal 2000
----------- ----------- -----------
(Dollars in thousands, except per share data)
Net income ..................................................... $21,321 $ 12,958 $ 10,701
Add: Goodwill amortization, net of tax ........................ -- 1,158 1,033
------- -------- --------
Adjusted .................................................. $21,321 $ 14,116 $ 11,734
======= ======== ========
Basic earnings per common share ................................ $ 1.25 $ 0.80 $ 0.67
Add: Goodwill amortization, net of tax ........................ -- 0.07 0.06
------- -------- --------
Adjusted .................................................. $ 1.25 $ 0.87 $ 0.73
======= ======== ========
Diluted earnings per common share .............................. $ 1.22 $ 0.79 $ 0.65
Add: Goodwill amortization, net of tax ........................ -- 0.07 0.06
------- -------- --------
Adjusted ............................................... $ 1.22 $ 0.86 $ 0.71
======= ======== ========
Changes in the carrying amount of the Company's goodwill for fiscal 2002
were as follows:
Goodwill Core Deposit Intangibles
----------------- ------------------------
Balance as of December 31, 2001. ........................ $ 22,641 $ --
Less:
Amortization .......................................... -- (192)
Add:
Acquisition of Texas Guaranty Bank .................... 3,254 431
Acquisition of First State Bank of Needville .......... 1,448 293
Acquisition of Paradigm Bancorporation ................ 33,846 2,781
Acquisition of First National Bank of Bay City ........ 2,048 168
Acquisition of Southwest Bank Holding Company.......... 5,053 640
----------------- --------------
Balance as of December 31, 2002 ...... $ 68,290 $ 4,121
================= ==============
4. 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 $15.0 million and $12.1 million at December
31, 2002 and 2001, respectively.
F-14
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
5. SECURITIES
The amortized cost and fair value of debt securities are as follows:
December 31, 2002
-------------------------------------------------------------------------
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. ................................... $ 18,511 $ 65 $ -- $ 18,576 $ 18,576
70% non-taxable preferred stock ................ 44,029 -- 884 43,145 43,145
States and political subdivisions .............. 27,115 1,808 -- 28,923 28,923
Collateralized mortgage obligations ............ 18,616 596 14 19,198 19,198
Mortgage-backed securities. .................... 196,887 2,600 110 199,377 199,377
--------- --------- --------- --------- ---------
Total ....................................... $ 305,158 $ 5,069 $ 1,008 $ 309,219 $ 309,219
========= ========= ========= ========= =========
Held to Maturity
U.S. Treasury securities and
obligations of U.S. government
agencies. ................................... $ 78,587 $ 3,131 $ -- $ 81,718 $ 78,587
Corporate debt securities ...................... 25,338 942 87 26,193 25,338
States and political subdivisions .............. 31,879 1,241 6 33,114 31,879
Collateralized mortgage obligations ............ 149,666 1,662 12 151,316 149,666
Mortgage-backed securities ..................... 355,628 12,297 5 367,920 355,628
--------- --------- --------- --------- ---------
Total ................................. $ 641,098 $ 19,273 $ 110 $ 660,261 $ 641,098
======== ========= ========= ========= =========
December 31, 2001
-------------------------------------------------------------------------
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. ................................... $ 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-15
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
The amortized cost and fair value of debt securities at December 31, 2002,
by contractual maturity, are shown below. Actual 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, 2002
-------------------------------------------------------------------
Held to Maturity Available for Sale
------------------------------ ---------------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
---------- --------- --------- ---------
(Dollars in thousands)
Due in one year or less ........................ $ 36,045 $ 36,822 $ 3,034 $ 3,050
Due after one year through five
years ....................................... 71,528 75,136 15,060 15,141
Due after five years through ten
years ....................................... 27,731 28,556 31,437 30,644
Due after ten years ............................ 500 512 40,124 41,809
--------- --------- -------- ---------
Subtotal ....................................... 135,804 141,026 89,655 90,644
Mortgage-backed securities and
collateralized mortgage
obligations ................................. 505,294 519,235 215,503 218,575
--------- --------- -------- ---------
Total ..................................... $ 641,098 $ 660,261 $305,158 $ 309,219
========= ========= ======== =========
Gross proceeds from the sale of held to maturity securities was
approximately $17,400 and gross proceeds from the sale of available for sale
securities was approximately $48,800 for the year ended December 31, 2002. There
was one sale of a held to maturity security with gross proceeds of $1.0 million
and no sales of available for sale securities during 2001. The sale of the held
to maturity security during 2001 occurred due to a de-valuation of the security
to a junk bond status. No material gains were recognized related to any sale.
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, 2002 and December 31,
2001.
Securities with amortized costs of $403.5 million and $350.9 million and a
fair value of $416.8 million and $353.9 million at December 31, 2002 and 2001,
respectively, were pledged to secure public deposits and for other purposes
required or permitted by law.
F-16
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
6. LOANS
The loan portfolio consists of various types of loans made principally to
borrowers located in Southeast Texas and Dallas and is classified by major type
as follows:
December 31,
------------------------------
2002 2001
----------- -----------
(Dollars in thousands)
Commercial and industrial ................... $ 93,797 $ 46,986
Real estate:
Construction and land
development ......................... 52,377 20,963
1-4 family residential ................... 206,586 175,253
Home equity .............................. 23,249 20,541
Commercial mortgages ..................... 183,970 78,446
Farmland ................................. 11,887 10,686
Multi-family residential ................. 15,502 9,694
Agriculture ................................. 24,683 15,757
Other ....................................... 3,020 953
Consumer .................................... 64,919 45,230
----------- -----------
Total ....................................... 679,990 424,509
Less unearned discount ...................... 431 109
----------- -----------
Total ................................... $ 679,559 $ 424,400
=========== ===========
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, 2002
-----------------------------------------------------------
After One
One Year Through After Five
or Less Five Years Years Total
--------- ---------- ---------- -------
(Dollars in thousands)
Commercial and industrial .................... $ 44,597 $ 35,896 $ 13,304 $ 93,797
Construction and land development ............ 38,469 10,084 3,824 52,377
--------- ---------- ---------- ---------
Total ................................... $ 83,066 $ 45,980 $ 17,128 $ 146,174
========= ========== ========== =========
Loans with a predetermined interest rate ..... $ 17,895 $ 23,370 $ 6,020 $ 47,285
Loans with a floating interest rate .......... 65,171 22,610 11,108 98,889
--------- ---------- ---------- ---------
Total ................................... $ 83,066 $ 45,980 $ 17,128 $ 146,174
========= ========== ========== =========
F-17
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
As of December 31, 2002 and 2001, loans outstanding to directors, officers
and their affiliates totaled $9.8 million and $7.1 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.
An analysis of activity with respect to these related-party loans is as
follows:
Year Ended December 31,
-----------------------------
2002 2001
--------- ---------
(Dollars in thousands)
Beginning balance .......................... $ 7,144 $ 6,850
New loans and reclassified related loans ... 8,336 4,448
Repayments ................................. (5,676) (4,154)
--------- ---------
Ending balance ............................. $ 9,804 $ 7,144
========= =========
7. ALLOWANCE FOR CREDIT LOSSES
An analysis of activity in the allowance for credit losses is as follows:
Year Ended December 31,
-------------------------------
2002 2001 2000
------- ------- --------
(Dollars in thousands)
Balance at beginning of year ...................................... $ 5,985 $ 5,523 $ 5,031
Balance acquired with the Texas Guaranty, First State,
Paradigm, FNB, Southwest and Compass,
Acquisitions, respectively ............................... 2,981 -- 46
Addition -- provision charged to
operations ............................................... 1,010 700 275
Net (charge-offs) and recoveries:
Loans charged off .................................... (767) (429) (217)
Loan recoveries ...................................... 371 191 388
------- ------- --------
Total net (charge-offs) recoveries ................................ (396) (238) 171
------- ------- --------
Balance at end of year ............................................ $ 9,580 $ 5,985 $ 5,523
======= ======= ========
8. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
Year Ended
December 31,
---------------------------------
2002 2001
--------- ---------
(Dollars in thousands)
Land. ............................................................. $ 6,953 $ 3,161
Buildings ......................................................... 19,966 12,645
Furniture, fixtures and equipment ................................. 9,595 6,754
Construction in progress .......................................... 763 912
--------- ---------
Total ........................................................ 37,277 23,472
Less accumulated depreciation ..................................... (10,267) (8,395)
--------- ---------
Premises and equipment, net .................................. $ 27,010 $ 15,077
========= =========
F-18
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
9. 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, 2002 were as follows:
December 31, 2002
----------------------
(Dollars in thousands)
Three months or less ....................... $ 104,001
Greater than three through six months ...... 52,754
Greater than six through twelve months ..... 50,527
Thereafter ................................. 40,708
---------
Total ................................. $ 247,990
=========
Interest expense for certificates of deposit in excess of $100,000 was $6.9
million, $8.7 million and $6.0 million, for the years ended December 31, 2002,
2001 and 2000, respectively.
The Company has no brokered deposits and there are no major concentrations
of deposits.
10. 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,
2002 and 2001, Bancshares had no outstanding borrowings under the Line.
Other Borrowings - At December 31, 2002, the Company had $37.9 million in
FHLB borrowings of which $12.6 million consisted of long-term FHLB notes payable
and $25.3 million consisted of FHLB advances compared with $18.1 million in FHLB
borrowings at December 31, 2001 of which $13.3 million consisted of long-term
FHLB notes payable and $4.8 million consisted of FHLB advances. The highest
outstanding balance of FHLB advances during 2002 was $31.4 million compared with
$30.2 million during 2001. The maturity dates on the FHLB notes payable range
from 2004 to 2018 and the interest rates range from 5.95% to 6.48%. FHLB
advances consist of short-term, over-night borrowings. The advances under the
FHLB line of credit are secured by a blanket pledge of the Bank's 1-4 family
residential mortgages.
The Company had no federal funds purchased at December 31, 2002 or 2001.
11. 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-19
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
12. 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,
--------------------------
2002 2001
--------- --------
(Dollars in thousands)
Commitments to extend credit ............ $ 78,359 $ 46,789
Standby letters of credit ............... 1,681 1,481
At December 31, 2002, $21.0 million of commitments to extend credit have
fixed rates ranging from 3.60% to 12.00%. 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.
13. INCOME TAXES
The components of the provision for federal income taxes are as follows:
Year Ended December 31,
-----------------------------------------------
2002 2001 2000
-------- -------- --------
(Dollars in thousands)
Current .................................................. $ 8,963 $ 5,894 $ 4,501
Deferred ................................................. 592 (522) 31
-------- -------- --------
Total .................................................... $ 9,555 $ 5,372 $ 4,532
======== ======== ========
F-20
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,
-------------------------------------------------
2002 2001 2000
--------- --------- ----------
(Dollars in thousands)
Taxes calculated at statutory rate ......................... $ 10,807 $ 6,415 $ 5,179
Increase (decrease) resulting from:
Tax-exempt interest ................................ (690) (702) (550)
Qualified Zone Academy Bond credit ................. (373) (373) (379)
Dividends received deduction ....................... (298) (329) (156)
Amortization of goodwill ........................... 61 262 200
Other, net ......................................... 48 99 238
--------- --------- ---------
Total ...................................................... $ 9,555 $ 5,372 $ 4,532
========= ========= =========
Deferred tax assets and liabilities are as follows:
December 31,
-----------------------------
2002 2001
--------- ---------
(Dollars in thousands)
Deferred tax assets:
Allowance for credit losses ........................ $ 1,088 $ 994
Nonaccrual loan interest ........................... 104 104
Accrued liability .................................. 318 105
Transfers from acquired banks....................... 579 --
Other .............................................. 56 31
--------- ---------
Total deferred tax assets .................................. 2,145 1,234
--------- ---------
Deferred tax liabilities:
Accretion on investments ........................... $ (437) $ (545)
Bank premises and equipment ........................ (926) (1,046)
Unrealized gain on available for sale
securities ...................................... (1,417) (117)
FHLB dividends ..................................... (125) (125)
Transfer from Heritage Bank ........................ (--) (32)
--------- ---------
Total deferred tax liabilities ............................. (2,905) (1,865)
--------- ---------
Net deferred tax liabilities ............................... $ (760) $ (631)
========= =========
F-21
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
14. 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. A total of 660,000 options have been granted under the 1995
plan as of December 31, 2002. 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 680,000 (after two-for-one and four-for-one stock
splits).
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 920,000 (after two-for-one stock split) 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 399,000 (after two-for-one stock split) 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 a
total of 26,660 (after two-for-one stock split) shares of Bancshares common
stock at exercise prices ranging from $0.725 to $5.16 per share. The converted
options are governed by the original plans under which they were issued. During
2000, Commercial granted 8,680 options at an exercise price of $5.16 per share.
On September 1, 2002, the Company acquired Paradigm Bancorporation. The
options to purchase shares of Paradigm common stock outstanding at the effective
time of the transaction were converted (at a rate of 1 to 1.08658) into options
to purchase a total of 33,804 shares of Bancshares Common Stock at exercise
prices ranging from $8.28 to $11.50 per share. The converted options are
governed by the original plans under which they were issued.
Year Ended December 31,
-----------------------------------------------------------------------
2002 2001 2000
--------------------- -------------------- --------------------
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 ............................. 530,180 $ 4.47 486,780 $ 2.53 650,000 $ 2.40
Options granted ......................... 287,804(1) 16.92 184,000(2) 10.01 8,680 5.16
Options forfeited ....................... (29,327) 15.55 (10,000) 10.01 (19,500) 1.89
Options exercised ....................... (104,504) 2.48 (130,600) 2.34 (152,400) 2.20
-------- -------- --------
Options outstanding, end of period ...... 684,153 $ 8.65 530,180 $ 4.47 486,780 $ 2.53
======== ======= ======= ======= ======= ======
- ---------------------------------------------
(1) Includes options to acquire 33,804 shares of Bancshares Common Stock
assumed in connection with the Paradigm Acquisition.
(2) Includes options to acquire 26,660 shares of Bancshares Common Stock
assumed in connection with the Commercial Merger.
At December 31, 2002, there were 54,153 options exercisable under all
plans. During 2002, 104,504 options were exercised. At December 31, 2001, there
were 94,380 options exercisable under all plans and 130,600 options were
exercised. At December 31, 2000, there were 144,200 options exercisable under
all plans and 152,400 options were exercised.
During 2002, the Company granted 254,000 options under the 1998 Plan. The
options were granted at exercise prices ranging from $16.55 per share to $19.01
per share. 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 April 18, 2001, the Company granted 184,000 options under the 1998 Plan.
The options were granted at an exercise price of $10.01 per share. 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.
F-22
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
The weighted-average fair value of the stock options on the grant dates
ranged from $3.86 to $4.10 in 2002 and was $2.415 in 2001 respectively. The
weighted-average remaining contractual life of options outstanding as of
December 31, 2002 ranged from 9.91 years to 9.33 years for the options granted
in 2002 and 8.33 years for the options granted in 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 2002, risk-free interest
rates ranging from 5.735% to 5.490%; dividend yields ranging from 1.18% to
1.33%; and expected lives of 4.5 years (2) 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 (3) for the options granted in 2000, risk free interest rates
ranging from 4.575% to 5.313%; dividend yields ranging from 3.78% to 26.90%, and
expected lives ranging from 1.3 years to 3.0 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
and earnings per share would have been as follows:
Year Ended December 31,
-------------------------------------------------
2002 2001 2000
--------- --------- ----------
(Dollars in thousands, except per share data)
Net Income as reported ...................................... $ 21,321 $ 12,958 $ 10,701
Deduct: Total stock based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects ............. (180) (51) (10)
--------- --------- ---------
Proforma net income ......................................... $ 21,141 $ 12,907 $ 10,691
========= ========= =========
Earnings per share:
Basic-as reported ................................... $ 1.25 $ 0.80 $ 0.67
========= ========= =========
Basic-proforma ...................................... $ 1.24 $ 0.79 $ 0.67
========= ========= =========
Diluted-as reported ................................. $ 1.22 $ 0.79 $ 0.65
========= ========= =========
Diluted-proforma .................................... $ 1.21 $ 0.78 $ 0.65
========= ========= =========
15. PROFIT SHARING PLAN
The Company has adopted a profit sharing plan pursuant to Section
401(k) of the Internal Revenue Code whereby the participants may contribute a
percentage of their compensation as permitted under the Code. Matching
contributions are made at the discretion of the Company. Presently, The Company
matches 50% of an employee's contributions up to 15% of compensation, not to
exceed the maximum allowable pursuant to the Internal Revenue Code and excluding
catch-up contributions. Such matching contributions were approximately $439,000,
$351,000 and $327,000, for the years ended December 31, 2002, 2001 and 2000,
respectively.
F-23
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
16. COMMITMENTS AND CONTINGENCIES
Leases -- A summary of noncancelable future operating lease commitments as of
December 31, 2002 follows (dollars in thousands):
2003 ...................................... $ 1,322
2004 ...................................... 1,063
2005 ...................................... 639
2006 ...................................... 561
2007 ...................................... 456
---------
Total ..................................... $ 4,041
=========
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 $1.3 million for the year ended December 31, 2002, $957,000 for
the year ended December 31, 2001 and $834,000 for the year ended December 31,
2000.
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.
17. REGULATORY MATTERS
The Company and the Banks 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
Banks' financial statements. Under the capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Banks must meet specific
capital guidelines based on the Banks' assets, liabilities and certain off-
balance-sheet items as calculated under regulatory accounting practices. The
Company's and the Banks' capital amounts and the Banks' 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 Banks must
maintain minimum capital amounts and ratios as defined in the regulations.
Management believes, as of December 31, 2002 that the Company and the Banks met
all capital adequacy requirements to which they are subject. Management
believes, as of December 31, 2001 that the Company and Prosperity Bank met all
capital adequacy requirements to which they are subject.
At December 31, 2002, the most recent notification from the FDIC
categorized the Banks as "well capitalized" under the regulatory framework for
prompt corrective action. To be categorized as well capitalized the Banks 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 Banks' category.
F-24
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
The following is a summary of the Company's and the Banks' capital
ratios at December 31, 2002 and 2001. Bank of the Southwest data is reflected
for 2002 only (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, 2002:
Total Capital
(to Risk Weighted Assets) .......... $122,265 15.30% $63,914 8.0% N/A N/A
Tier I Capital
(to Risk Weighted Assets) .......... $112,685 14.10% $31,957 4.0% N/A N/A
Tier I Capital
(to Average Assets) ................ $112,685 6.56% $51,553 3.0% N/A N/A
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
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
-------------------- ------------------------ -----------------------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
PROSPERITY BANK ONLY:
As of December 31, 2002:
Total Capital
(to Risk Weighted Assets) .......... $110,587 14.91% $59,337 8.0% $74,171 10.0%
Tier I Capital
(to Risk Weighted Assets) .......... $101,677 13.71% $29,668 4.0% $44,503 6.0%
Tier I Capital
(to Average Assets) ................ $101,677 6.26% $48,730 3.0% $81,217 5.0%
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%
F-25
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
-------------------- -------------------------- --------------------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
BANK OF THE SOUTHWEST ONLY:
As of December 31, 2002:
Total Capital
(to Risk Weighted Assets) ........... $ 9,533 15.15% $ 5,035 8.0% $ 6,294 10.0%
Tier I Capital
(to Risk Weighted Assets) ........... $ 8,863 14.08% $ 2,518 4.0% $ 3,777 6.0%
Tier I Capital
(to Average Assets) ................. $ 8,863 7.62% $ 3,488 3.0% $ 5,814 5.0%
Dividends paid by Bancshares and the Banks are subject to restrictions by
certain regulatory agencies. There was an aggregate of $35.2 million and $27.6
million available for payment of dividends by Bancshares and by the Banks to
Bancshares, respectively, at December 31, 2002 under these restrictions.
Dividends paid by Bancshares during the years ended December 31, 2002 and 2001
were $3.9 million and $3.2 million, respectively. There were $18.4 million of
dividends paid by the Banks to Bancshares during the year ended 2002 and $2.3
paid by the Banks to Bancshares during the year ended 2001.
18. 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.
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.
F-26
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
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,
-----------------------------------------------------------
2002 2001
-------------------------- --------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
----------- ----------- ----------- -----------
Financial assets:
Cash and due from banks ......................... $ 66,806 $ 66,806 $ 41,005 $ 41,005
Federal funds sold .............................. 13,993 13,993 715 715
Held to maturity securities ..................... 641,098 660,261 270,089 274,227
Available for sale securities ................... 309,219 309,219 482,233 482,233
Loans ........................................... 679,559 698,496 424,400 434,441
Less allowance for credit losses ................ (9,580) (9,580) (5,985) (5,985)
----------- ----------- ----------- -----------
Total ................................................... $ 1,701,095 $ 1,739,195 $ 1,212,457 $ 1,226,636
=========== =========== =========== ===========
Financial liabilities:
Deposits ........................................ $ 1,586,611 $ 1,594,728 $ 1,123,397 $ 1,128,732
Company-obligated mandatorily redeemable
trust preferred securities of subsidiary
trusts ........................................ 33,000 33,900 27,000 28,741
Federal Home Loan Bank Advances ................. 25,300 25,300 4,775 4,775
Federal Home Loan Bank notes payable ............ 12,639 13,914 13,305 17,743
----------- ----------- ----------- -----------
Total ................................................... $ 1,657,550 $ 1,667,842 $ 1,168,477 $ 1,179,991
=========== =========== =========== ===========
The differences in fair value and carrying value of commitments to
extend credit and standby letters of credit were not material at December 31,
2002 and 2001.
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.
19. 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 accrue interest at a floating rate equal to 3-month LIBOR plus 3.58%,
not to exceed 12.50%, payable quarterly. The quarterly interest rate on
F-27
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
the Debentures for the period from October 31, 2002 through December 31, 2002
was equal to 5.34%. 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. 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.
In connection with the Paradigm acquisition, on September 1, 2002 the
Company acquired Paradigm Capital Trust II ("Paradigm Trust"), which issued $6.0
million of floating rate preferred securities on February 20, 2001. The Company
also assumed the obligations under the floating rate debentures held by Paradigm
Trust. The floating rate debentures will mature on February 20, 2031, which date
may be shortened to a date not earlier than February 20, 2006 if certain
conditions are met. These debentures, which are the only assets of the trust,
are subordinate and junior in right of payment to all present and future senior
indebtedness (as defined in the Indenture) of Paradigm. The Company has fully
and unconditionally guaranteed Paradigm Trust's obligations under the preferred
securities.
The Floating Rate Debentures held by Paradigm Trust accrue interest at
a floating rate equal to 3-month LIBOR plus 4.5%, payable quarterly. The
quarterly distributions on the preferred securities are paid at the same rate
that interest is paid on the debentures. For the quarter ended December 31,
2002, the rate on the debentures was 6.33%.
For financial reporting purposes, Trust I, Trust II and Paradigm Trust
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.
F-28
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
20. PARENT COMPANY ONLY FINANCIAL STATEMENTS
PROSPERITY BANCSHARES, INC.
(Parent Company Only)
BALANCE SHEETS
December 31,
---------------------------------
2002 2001
--------- ---------
(Dollars in thousands)
ASSETS
Cash .................................................. $ 2,027 $ 13,331
Investment in subsidiaries ............................ 181,615 98,485
Investment in Prosperity Capital Trust I .............. 380 380
Investment in Prosperity Statutory Trust II ........... 464 464
Investment in Paradigm Capital Trust II ............... 186 --
Goodwill, net ......................................... 3,983 3,983
Other assets .......................................... 587 83
--------- ---------
TOTAL ...................................................... $ 189,242 $ 116,726
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES:
Accrued interest payable and other liabilities ........ $ 473 $ 157
Junior subordinated debentures ........................ 34,030 27,844
--------- ---------
Total liabilities ............................... 34,503 28,001
--------- ---------
SHAREHOLDERS' EQUITY:
Common stock .......................................... 18,903 16,218
Capital surplus ....................................... 60,312 16,865
Retained earnings ..................................... 72,917 55,462
Unrealized losses on available
for sale securities, net of tax ..................... 2,644 217
Less treasury stock, at cost (7,152 shares at
December 31, 2002 and 2001, respectively) ........... (37) (37)
--------- ---------
Total shareholders' equity ...................... 154,739 88,725
--------- ---------
TOTAL ...................................................... $ 189,242 $ 116,726
========= =========
F-29
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,
-----------------------------------------------------
2002 2001 2000
----------- ----------- -----------
(Dollars in thousands)
OPERATING INCOME:
Dividends from subsidiaries ................. $ 13,100 $ 2,272 $ --
Other income ................................ -- -- 2
----------- ----------- -----------
Total income ........................... 13,100 2,272 2
----------- ----------- -----------
OPERATING EXPENSE:
Amortization of goodwill .................... -- 466 466
Minority expense trust preferred
securities ................................ 2,104 1,580 1,151
Other expenses .............................. 174 158 81
----------- ----------- -----------
Total operating expense ................ 2,278 2,204 1,698
----------- ----------- -----------
INCOME BEFORE INCOME TAX BENEFIT AND
EQUITY IN UNDISTRIBUTED EARNINGS OF
SUBSIDIARIES ................................... 10,822 68 (1,696)
FEDERAL INCOME TAX BENEFIT ........................ 797 716 535
----------- ----------- -----------
INCOME BEFORE EQUITY IN UNDISTRIBUTED
EARNINGS OF SUBSIDIARIES ....................... 11,619 784 (1,161)
EQUITY IN UNDISTRIBUTED EARNINGS OF
SUBSIDIARIES ................................... 9,702 12,174 11,862
----------- ----------- -----------
NET INCOME ........................................ $ 21,321 $ 12,958 $ 10,701
=========== =========== ===========
F-30
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,
--------------------------------------------
2002 2001 2000
--------- -------- ---------
(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ...................................................... $ 21,321 $ 12,958 $ 10,701
Adjustments to reconcile net income
to net cash provided by operating activities:
Equity in undistributed earnings
of subsidiaries ............................................. (9,702) (12,175) (10,962)
Amortization of goodwill ...................................... -- 466 466
Decrease (increase) in other assets ........................... 268 708 (190)
(Decrease) increase in accrued interest
payable and other liabilities .............................. (43) (61) (142)
Cash paid in lieu of fractional shares ........................ -- -- (15)
Increase in other liabilities ................................. -- -- 15
--------- -------- ---------
Total adjustments ......................................... (9,477) (11,062) (10,828)
--------- -------- ---------
Net cash flows provided by (used in)
operating activities ................................. 11,844 1,896 (127)
--------- -------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital contribution to subsidiary .............................. -- -- --
--------- -------- ---------
Net cash flows used in
investing activities ................................. -- -- --
--------- -------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of common stock ........................................ 260 306 335
Trust preferred securities issuance cost ........................ -- (476) (90)
Payments of cash dividends ...................................... (3,866) (3,161) (2,755)
Cash paid to dissenting shareholders ............................ (3) (667) --
Cash paid for acquisitions ...................................... (24,789) -- --
Dividends received from subsidiaries ............................ 5,250 -- --
Proceeds from issuance of junior
subordinated debentures .................................... -- 15,000 --
--------- -------- ---------
Net cash flows (used in) provided by
financing activities ................................. (23,148) 11,002 (2,510)
--------- -------- ---------
NET (DECREASE) INCREASE IN CASH
AND CASH EQUIVALENTS ............................................ (11,304) 12,898 (2,637)
CASH AND CASH EQUIVALENTS, BEGINNING
OF PERIOD ....................................................... 13,331 433 3,070
--------- -------- ---------
CASH AND CASH EQUIVALENTS, END OF
PERIOD .......................................................... $ 2,027 $ 13,331 $ 433
========= ======== =========
F-31
PROSPERITY BANCSHARES, INC.(SM) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
21. SUBSEQUENT EVENT (Unaudited)
On February 3, 2003, the Company announced the signing of a definitive
agreement pursuant to which Abram's Centre Bancshares, Dallas, Texas ("Abrams")
will merge into the Company. Under the terms of the agreement, the Company will
pay approximately $16.3 million in cash. Abrams operates two (2) banking offices
in Dallas, Texas. As of December 31, 2002, Abrams Centre National Bank had total
assets of $93.6 million, loans of $50.6 million, deposits of $69.0 million and
shareholders' equity of $13.9 million. The transaction is expected to close in
the second quarter of 2003. 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.
On March 4, 2003, the Company entered into a definitive agreement with
Dallas Bancshares Corporation, Dallas, Texas ("Dallas"). Pursuant to the
agreement, Dallas Bancshares will merge into the Company and it's wholly owned
subsidiary, BankDallas will merge into the bank. Under the terms of the
agreement, the Company will pay approximately $7.0 million in cash. Dallas
Bancshares is privately held and operates one (1) banking office in Dallas,
Texas. As of December 31, 2002, BankDallas had total assets of $40.9 million,
loans of $30.6 million, deposits of $36.5 million and shareholders' equity of
$4.3 million. The transaction is expected to close in the second quarter of
2003. The Company will not complete the acquisition unless customary closing
conditions are satisfied or waived, including receipt of the necessary
regulatory and shareholder approvals and consents from applicable regulatory
agencies including the Federal Reserve Board, the Texas Banking Department and
the Federal Deposit Insurance Corporation.
F-32