SOUTHWEST BANCORP OF TEXAS INC - 10-Q Quarterly Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the Quarter Ended March 31, 2004

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

Commission file number: 000-22007

Southwest Bancorporation of Texas, Inc.

(Exact Name of Registrant as Specified in its Charter)


Texas (State or Other Jurisdiction of Incorporation or Organization)		76-0519693 (I.R.S. Employer Identification No.)

4400 Post Oak Parkway

Houston, Texas 77027

(Address of Principal Executive Offices, including zip code)

(713) 235-8800

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act.) Yes þ No o

There were 34,315,852 shares of the Registrant’s Common Stock outstanding as of the close of business on April 26, 2004.

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

INDEX TO FORM 10-Q


		Page

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
	Report of Independent Accountants		2
	Condensed Consolidated Balance Sheet as of March 31, 2004 and December 31, 2003 (unaudited)		3
	Condensed Consolidated Statement of Income for the Three Months Ended March 31, 2004 and 2003 (unaudited)		4
	Condensed Consolidated Statement of Changes in Shareholders’ Equity for the Three Months Ended March 31, 2004 (unaudited)		5
	Condensed Consolidated Statement of Cash Flows for the Three Months Ended March 31, 2004 and 2003 (unaudited)		6
	Notes to Condensed Consolidated Financial Statements (unaudited)		7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			14
Item 3. Quantitative and Qualitative Disclosures About Market Risk			36
Item 4. Controls and Procedures			36
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			37
Item 2. Changes in Securities and Use of Proceeds			37
Item 3. Defaults upon Senior Securities			37
Item 4. Submission of Matters to a Vote of Security Holders			37
Item 5. Other Information			37
Item 6. Exhibits and Reports on Form 8-K			37
Signatures			38
Awareness Letter of PricewaterhouseCoopers LLP
Certification of CEO pursuant to Section 302
Certification of CFO pursuant to Section 302
Certification of CEO pursuant to Section 906
Certification of CFO pursuant to Section 906

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Shareholders

Southwest Bancorporation of Texas, Inc.:

We have reviewed the accompanying condensed consolidated balance sheet of Southwest Bancorporation of Texas, Inc. and Subsidiaries (“the Company”) as of March 31, 2004, the related condensed consolidated statement of income for the three-month periods ended March 31, 2004 and 2003, the condensed consolidated statement of changes in shareholders’ equity for the three-month period ended March 31, 2004, and the condensed consolidated statement of cash flows for the three-month periods ended March 31, 2004 and 2003. These interim financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

We previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet as of December 31, 2003, and the related consolidated statements of income, of changes in shareholders’ equity, and of cash flows for the year then ended (not presented herein), and in our report dated February 25, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2003 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ PricewaterhouseCoopers LLP

Houston, Texas

April 29, 2004

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEET

(unaudited)


				March 31,			December 31,
				2004			2003


				(Dollars in thousands, except
				per share amounts)
ASSETS
Cash and due from banks				$	290,796		$	390,890
Federal funds sold and other cash equivalents					52,678			94,908

		Total cash and cash equivalents			343,474			485,798
Securities — available for sale					1,576,977			1,549,398
Loans held for sale					101,944			96,899
Loans held for investment					3,720,950			3,491,673
Allowance for loan losses					(48,071	)		(43,008	)
Premises and equipment, net					131,347			117,951
Accrued interest receivable					21,380			21,630
Goodwill					55,094			25,647
Core deposit intangibles					11,661			6,185
Other assets					199,462			193,563

		Total assets		$	6,114,218		$	5,945,736

LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
	Demand — noninterest-bearing			$	1,625,647		$	1,513,038
	Demand — interest-bearing				72,009			43,452
	Money market accounts				1,843,409			1,709,755
	Savings				142,213			131,059
	Time, $100 and over				658,675			642,590
	Other time				360,991			363,345

			Total deposits		4,702,944			4,403,239
	Securities sold under repurchase agreements				305,750			285,571
	Other borrowings				496,708			679,812
	Junior subordinated deferrable interest debentures				51,547			51,547
	Accrued interest payable				1,505			1,822
	Other liabilities				32,533			24,424

			Total liabilities		5,590,987			5,446,415

Commitments and contingencies
Shareholders’ equity:
	Common stock — $1 par value, 150,000,000 shares authorized; 34,346,435 issued and 34,306,321 outstanding at March 31, 2004; 34,229,143 issued and 34,213,899 outstanding at December 31, 2003				34,346			34,229
	Additional paid-in capital				97,721			95,394
	Retained earnings				381,298			368,069
	Accumulated other comprehensive income				11,209			2,050
	Treasury stock, at cost — 40,114 shares and 15,244 shares, respectively				(1,343	)		(421	)

			Total shareholders’ equity		523,231			499,321

			Total liabilities and shareholders’ equity	$	6,114,218		$	5,945,736

The accompanying notes are an integral part of the condensed consolidated financial statements.

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF INCOME

(unaudited)



				Three Months Ended
				March 31,

				2004		2003


				(Dollars in thousands,
				except per share amounts)
Interest income:
	Loans			$	49,632	$	45,156
	Securities:
		Taxable			12,815		10,734
		Tax-exempt			1,734		1,217
	Federal funds sold and other				189		206

			Total interest income		64,370		57,313

Interest expense:
	Deposits				8,070		10,106
	Borrowings				2,932		2,126

			Total interest expense		11,002		12,232

			Net interest income		53,368		45,081
Provision for loan losses					2,000		3,000

			Net interest income after provision for loan losses		51,368		42,081

Noninterest income:
	Service charges on deposit accounts				11,040		9,617
	Investment services				2,970		2,295
	Other fee income				4,953		3,648
	Bank-owned life insurance income				1,491		1,190
	Other operating income				1,397		1,369
	Gain on sale of loans, net				577		1,099
	Gain on sale of securities, net				26		35

			Total noninterest income		22,454		19,253

Noninterest expenses:
	Salaries and employee benefits				29,243		23,826
	Occupancy expense				8,258		6,500
	Professional services				2,320		2,067
	Losses on deposit accounts				176		328
	Merger-related expenses				1,522		—
	Core deposit intangible amortization expense				903		—
	Other operating expenses				8,924		6,790

			Total noninterest expenses		51,346		39,511

			Income before income taxes		22,476		21,823
Provision for income taxes					7,189		6,748

	Net income			$	15,287	$	15,075

Earnings per common share:
		Basic		$	0.45	$	0.45

		Diluted		$	0.44	$	0.44

Dividends per common share				$	0.06	$	—

The accompanying notes are an integral part of the condensed consolidated financial statements.

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

(unaudited)


												Accumulated
												Other
			Common Stock				Additional					Comprehensive					Total
							Paid-in		Retained			Income		Treasury			Shareholders’
			Shares		Dollars		Capital		Earnings			(Loss)		Stock			Equity


			(Dollars in thousands, except per share amounts)
BALANCE, DECEMBER 31, 2003				34,229,143	$	34,229	$	95,394	$	368,069		$	2,050	$	(421	)	$	499,321
	Exercise of stock options			117,292		117		1,970										2,087
	Purchase of treasury stock														(922	)		(922	)
	Deferred compensation amortization							357										357
	Cash dividends, $0.06 per common share									(2,058	)							(2,058	)
	Comprehensive income:
		Net income for the three months ended March 31, 2004								15,287								15,287
		Net change in unrealized appreciation on securities available for sale, net of deferred taxes of ($4,665)											8,671					8,671
		Reclassification adjustment for losses included in net income, net of deferred taxes of ($263)											488					488

		Total comprehensive income																24,446

BALANCE, MARCH 31, 2004				34,346,435	$	34,346	$	97,721	$	381,298		$	11,209	$	(1,343	)	$	523,231

The accompanying notes are an integral part of the condensed consolidated financial statements.

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(unaudited)



					Three Months Ended
					March 31,

					2004			2003


					(Dollars in thousands)
Cash flows from operating activities:
	Net income				$	15,287		$	15,075
	Adjustments to reconcile net income to net cash provided by operating activities:
		Provision for loan losses				2,000			3,000
		Depreciation				3,449			2,604
		Realized gain on securities available for sale, net				(26	)		(35	)
		Amortization and accretion of securities’ premiums and discounts, net				1,457			2,459
		Amortization of mortgage servicing rights				587			1,129
		Amortization of computer software				1,479			1,098
		Amortization of core deposit intangibles				903			—
		Amortization of deferred compensation				357			301
		Income tax benefit from exercise of stock options				422			222
		Net change in:
			Loans held for sale			(5,045	)		13,991
			Other assets and liabilities, net			(4,091	)		(8,926	)

				Net cash provided by operating activities		16,779			30,918

Cash flows from investing activities:
	Proceeds from maturity and call of securities available for sale					25,810			43,474
	Proceeds from sale of securities available for sale					340,849			49,151
	Principal paydowns of mortgage-backed securities available for sale					62,744			137,699
	Purchase of securities available for sale					(400,160	)		(226,212	)
	Purchase of Federal Reserve Bank stock					(1,919	)		—
	Purchase of Federal Home Loan Bank stock					(11,302	)		(167	)
	Net increase in loans held for investment					(65,886	)		(64,623	)
	Proceeds from sale of premises and equipment					731			10
	Purchase of premises and equipment					(16,689	)		(5,860	)
	Purchase of mortgage servicing rights					—			(87	)
	Acquisition of Reunion Bancshares, Inc. (net of cash acquired of $30,596)					(19,404	)		—
	Investment in unconsolidated equity investees					(278	)		(209	)

				Net cash used in investing activities		(85,504	)		(66,824	)

Cash flows from financing activities:
	Net increase (decrease) in noninterest-bearing demand deposits					54,322			(19,332	)
	Net increase (decrease) in time deposits					(6,449	)		108,382
	Net increase in other interest-bearing deposits					44,767			11,162
	Net increase (decrease) in securities sold under repurchase agreements					20,179			(35,936	)
	Net decrease in other short-term borrowings					(187,196	)		(152,377	)
	Proceeds from long-term borrowings					2,195			—
	Payments on long-term borrowings					(102	)		(95	)
	Payments of cash dividends					(2,058	)		—
	Net proceeds from exercise of stock options					1,665			465
	Purchase of treasury stock					(922	)		—

				Net cash used in financing activities		(73,599	)		(87,731	)

Net decrease in cash and cash equivalents						(142,324	)		(123,637	)
Cash and cash equivalents at beginning of period						485,798			535,364

Cash and cash equivalents at end of period					$	343,474		$	411,727

The accompanying notes are an integral part of the condensed consolidated financial statements.

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

The unaudited condensed consolidated financial statements include the accounts of Southwest Bancorporation of Texas, Inc. (“the Company”) and its direct and indirect wholly-owned subsidiaries except for those where it has been determined that the Company is not the primary beneficiary as defined by Financial Accounting Standards Board Interpretation No. 46 (“FIN No. 46”). All material intercompany accounts and transactions have been eliminated. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal and recurring adjustments, necessary for a fair presentation of the Company’s consolidated financial position at March 31, 2004 and December 31, 2003, consolidated net income for the three months ended March 31, 2004 and 2003, consolidated cash flows for the three months ended March 31, 2004 and 2003, and consolidated changes in shareholders’ equity for the three months ended March 31, 2004. Interim period results are not necessarily indicative of results of operations or cash flows for a full-year period.

Substantially all of the Company’s revenue and income is derived from the operations of Southwest Bank of Texas National Association (“the Bank”) and Mitchell Mortgage Company, LLC (“Mitchell”). The Bank provides a full range of commercial and private banking services to small and middle market businesses and individuals primarily in the Houston metropolitan area. Mitchell originates, sells and services single family residential mortgages, residential and commercial construction loans and commercial mortgages.

On January 31, 2004, Reunion Bancshares, Inc. (“Reunion”), parent of Lone Star Bank in Dallas (“Lone Star”), was merged with and into the Company. On July 1, 2003, The Company completed its merger with Maxim Financial Holdings, Inc., parent company of MaximBank (“Maxim”), whereby Maxim was merged into the Company. The results of operations for Reunion and Maxim have been included in the consolidated financial statements since their respective acquisition dates. See “Note 2 — Merger Related Activity” for further discussion of the mergers.

The year-end condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. These financial statements and the notes thereto should be read in conjunction with the Company’s annual report on Form 10-K for the year ended December 31, 2003.

New Accounting Pronouncements

On May 15, 2003, the Financial Accounting Standards Board (“the FASB”) approved Statement of Financial Accounting Standards (“SFAS”) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments, including mandatorily redeemable preferred securities, were previously classified as equity or as mezzanine debt. On October 29, 2003, the FASB deferred the effective date for certain provisions of SFAS No. 150. The Company adopted this statement with no impact on its financial condition or results of operations.

On December 16, 2003, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 03-3 (“SOP 03-3”), Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 provides guidance on the accounting for differences between contractual and expected cash flows from the purchaser’s initial investment in loans or debt securities acquired in a transfer, if those differences are attributable, at least in part, to credit quality. Among other things, SOP 03-3: (1) prohibits the recognition of the excess of contractual cash flows over expected cash flows as an adjustment of yield, loss accrual, or valuation allowance at the time of purchase; (2) requires that subsequent increases in expected cash flows be recognized prospectively through an adjustment of yield; and (3) requires the subsequent decreases in expected cash flows be recognized as an impairment. In addition, SOP 03-3 prohibits the creation

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

or carrying over of a valuation allowance in the initial accounting of all loans within its scope that are acquired in a transfer. SOP 03-3 becomes effective for loans or debt securities acquired in fiscal years beginning after December 15, 2004. The Company does not expect the requirements of SOP 03-3 to have a material impact on its financial condition or results of operations.

On March 9, 2004, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments. SAB No. 105 summarizes the view of the staff regarding the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments including recognition of the loan commitment and financial statement disclosures. The Company does not expect the requirements of SAB No. 105 to have a material impact on its financial condition or results of operations.

Reclassifications

Certain previously reported amounts have been reclassified to conform to the 2004 financial statement presentation. These reclassifications had no effect on net income, total assets, or stockholders’ equity.


	Stock-Based Compensation

The Company applies the intrinsic value method in accounting for its stock-based compensation plans in accordance with Accounting Principles Board Opinion No. 25. In 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123., Accounting for Stock-Based Compensation, (“SFAS No. 123”) which, if fully adopted by the Company, would change the method the Company applies in recognizing the expense of its stock-based compensation plans for awards subsequent to 1994. Adoption of the expense recognition provisions of SFAS No. 123 is optional and the Company decided not to elect these provisions of SFAS No. 123. However, pro forma disclosures as if the Company adopted the expense recognition provisions of SFAS No. 123 are required by SFAS No. 123 and are presented below.

If the fair value based method of accounting under SFAS No. 123 had been applied, the Company’s net income available for common shareholders and earnings per common share would have been reduced to the pro forma amounts indicated below (assuming that the fair value of options granted during the year are amortized over the vesting period):



		Three Months Ended
		March 31,

		2004		2003


		(Dollars in thousands,
		except per share
		amounts)
Net income
	As reported	$	15,287	$	15,075
	Pro forma	$	14,677	$	14,295
Stock-based compensation cost, net of income taxes
	As reported	$	247	$	208
	Pro forma	$	857	$	988
Basic earnings per common share
	As reported	$	0.45	$	0.45
	Pro forma	$	0.43	$	0.42
Diluted earnings per common share
	As reported	$	0.44	$	0.44
	Pro forma	$	0.42	$	0.41

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

The effect of applying SFAS No. 123 in the above pro forma disclosure is not indicative of future amounts. The Company anticipates making awards in the future under its stock-based compensation plans.


2.	Merger Related Activity

On January 31, 2004, the Company completed its merger with Lone Star, whereby Lone Star was merged with and into the Bank. The addition of the five Lone Star branches expands the Company’s branch network to include the Dallas market and represents an attractive growth opportunity for the Company.

The merger was a cash transaction with $43.5 million paid at closing and an additional $6.5 million deposited into an escrow account. The release of this account is contingent upon the performance of the loan portfolio and other potential liabilities over a three-year period. The purchase price was funded through the proceeds of the trust preferred securities offering.

The purchase price has been allocated to the assets acquired and the liabilities assumed based on their estimated fair value at the date of the merger. The excess of the purchase price over the estimated fair values of the net assets acquired was $29.1 million, which was recorded as goodwill, none of which is expected to be deductible for tax purposes. Goodwill is evaluated annually for possible impairment under the provisions of SFAS No. 142, Goodwill and Other Intangible Assets.

The following table summarized the estimated fair value of the assets acquired and liabilities assumed at the date of the merger.


	January 31, 2004

	(Dollars in thousands)
Cash	$	30,596
Securities		30,946
Loans		163,822
Loan discount		(1,038	)
Allowance for loan losses		(2,116	)
Goodwill		29,111
Core deposit intangibles		6,379
Other assets		3,784
Deposits		(207,026	)
Deposit premium		(39	)
Borrowings		(2,000	)
Other liabilities		(2,419	)

Cash paid	$	50,000

Core deposit intangibles (“CDI”) are amortized using an economic life method based on deposit attrition projections derived from nationally-observed patterns within the banking industry. As a result, CDI amortization will decline over time with most of the amortization during the initial years. CDI is being amortized over a weighted average period of thirteen and one-third years with no residual value.

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

The unaudited pro forma combined historical results, as if Lone Star and Maxim had been included in operations at January 1, 2003, are estimated to be as follows.



	Pro forma
	Three Months Ended
	March 31,

	2004		2003


	(Dollars in thousands,
	except per share amounts)
Net interest income after provision for loan losses and noninterest income	$	74,516	$	67,306
Income before income taxes		22,543		22,184
Net income		15,334		15,420
Earnings per common share, basic	$	0.45	$	0.46
Earnings per common share, diluted	$	0.44	$	0.45

These pro forma results are not necessarily indicative of what actually would have occurred if the mergers had been completed as of the beginning of each fiscal period presented, nor are they necessarily indicative of future consolidated results.


3.	Comprehensive Income

Comprehensive income consists of the following:



	Three Months Ended
	March 31,

	2004		2003


	(Dollars in thousands)
Net income	$	15,287	$	15,075
Net change in unrealized appreciation on securities available for sale, net of deferred tax		8,671		(554	)
Reclassification adjustment for (gains) losses included in net income, net of deferred tax		488		(41	)

Total comprehensive income	$	24,446	$	14,480


4.	Mortgage Servicing Rights

The Company originates residential and commercial mortgage loans both for its own portfolio and to sell to investors with servicing rights retained through its ownership of Mitchell. Mitchell also purchases mortgage servicing rights.

Mortgage servicing assets are periodically evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and original loan terms (primarily 15 and 30 years). Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. In periods of falling market interest rates, accelerated loan prepayment speeds can adversely impact the fair value of these mortgage servicing rights relative to their book value. In the event that the fair value of these assets were to increase in the future, the Company can recognize the increased fair value to the extent of the impairment allowance but cannot recognize an asset in excess of its amortized book value. Any provision and subsequent recovery would be recorded as a component of other fee income in the accompanying statement of income.

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

The following table summarizes the changes in capitalized mortgage servicing rights for the periods indicated:



		Three Months Ended
		March 31,

		2004			2003


		(Dollars in
		thousands)
Mortgage servicing rights:
Balance, beginning of period		$	8,299		$	10,628
	Originations		214			510
	Purchases		—			86
	Amortization		(587	)		(1,129	)

Balance, end of period			7,926			10,095

Valuation allowance:
Balance, beginning of period			—			2,371
	Provision		—			—
	Recovery		—			—

Balance, end of period			—			2,371

Mortgage servicing rights, net		$	7,926		$	7,724

Loans serviced for others totaled $905.7 million at March 31, 2004 and $1.05 billion at March 31, 2003. Capitalized mortgage servicing rights represent 88 basis points and 74 basis points of the portfolio serviced at March 31, 2004 and March 31, 2003, respectively.

5. Earnings Per Common Share

Earnings per common share is computed as follows:



		Three Months Ended
		March 31,

		2004		2003


		(In thousands, except
		per share amounts)
Net income		$	15,287	$	15,075

Divided by average common shares and common share equivalents:
	Average common shares		34,272		33,877
	Average common shares issuable under the stock option plan		869		763

Total average common shares and common share equivalents			35,141		34,640

Basic earnings per common share		$	0.45	$	0.45

Diluted earnings per common share		$	0.44	$	0.44

Stock options outstanding of 105,000 and 527,000 for the three months ended March 31, 2004 and 2003, respectively, have not been included in diluted earnings per share because to do so would have been antidilutive for the periods presented. Stock options are antidilutive when the exercise price is higher than the current market price of the Company’s common stock.

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

6. Segment Information

The Company has two operating segments: the bank and the mortgage company. Each segment is managed separately because each business requires different marketing strategies and each offers different products and services.

The Company evaluates each segment’s performance based on the revenue and expenses from its operations. Intersegment financing arrangements are accounted for at current market rates as if they were with third parties.

Summarized financial information by operating segment for the three months ended March 31, 2004 and 2003 follows:



	Three Months Ended March 31,


	2004									2003

	Bank		Mortgage		Eliminations			Consolidated		Bank		Mortgage		Eliminations			Consolidated


	(Dollars in thousands)
Interest income	$	62,091	$	3,545	$	(1,266	)	$	64,370	$	54,839	$	3,898	$	(1,424	)	$	57,313
Interest expense		11,002		1,266		(1,266	)		11,002		12,232		1,424		(1,424	)		12,232

Net interest income		51,089		2,279		—			53,368		42,607		2,474		—			45,081
Provision for loan losses		1,934		66		—			2,000		2,918		82		—			3,000
Noninterest income		20,997		1,457		—			22,454		17,504		1,749		—			19,253
Noninterest expense		49,011		2,335		—			51,346		36,922		2,589		—			39,511

Income before income taxes	$	21,141	$	1,335	$	—		$	22,476	$	20,271	$	1,552	$	—		$	21,823

Total assets	$	6,082,980	$	292,342	$	(261,104	)	$	6,114,218	$	5,083,405	$	279,918	$	(253,454	)	$	5,109,869

Intersegment interest was paid to the bank by the mortgage company in the amount of $1.3 million and $1.4 million for the three months ended March 31, 2004 and 2003, respectively. Advances from the bank to the mortgage company of $261.1 million and $253.5 million were eliminated in consolidation at March 31, 2004 and 2003, respectively.


7.	Off-Balance Sheet Credit Commitments

In the normal course of business, the Company enters into various transactions, which, in accordance with generally accepted accounting principles, are not included in its consolidated balance sheet. These transactions are referred to as “off-balance sheet commitments.” The Company enters into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit and standby letters of credit, which involve elements of credit risk in excess of the amounts reflected in the consolidated balance sheet. The Company minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures.

The Company enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Customers use credit commitments to ensure that funds will be available for working capital purposes, for capital expenditures and to ensure access to funds at specified terms and conditions. Substantially all of the Company’s commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. Management assesses the credit risk associated with certain commitments to extend credit. Commitments to extend credit were $2.45 billion at March 31, 2004 and $2.14 billion at December 31, 2003.

SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

credit arrangements contain collateral and debt covenants similar to those contained in loan agreements. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Company would be required to fund the commitment. The maximum potential amount of future payments the Company could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, the Company would be entitled to seek recovery from the customer. Standby letters of credit were $256.9 million at March 31, 2004 and $227.0 million at December 31, 2003. As of March 31, 2004 and December 31, 2003, $212,000 and $248,000, respectively, has been recorded as a liability for the fair value of the Company’s potential obligations under these guarantees.


8.	Goodwill and Core Deposit Intangibles

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles for the three months ended March 31, 2004 were as follows:


				Core Deposit
		Goodwill		Intangibles


		(Dollars in thousands)
Balance, December 31, 2003		$	25,647	$	6,185
	Acquisition of Lone Star		29,111		6,379
	Adjustment to acquisition of Maxim		336		—
	Amortization		—		(903	)

Balance, March 31, 2004		$	55,094	$	11,661


9.	Common Stock Cash Dividend

On February 4, 2004, the Company’s Board of Directors declared a cash dividend of $0.06 cents per common share paid on March 15, 2004 to shareholders of record as of March 1, 2004.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS

Certain of the matters discussed in this document and in documents incorporated by reference herein, including matters discussed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” may constitute forward-looking statements for purposes of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. The words “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate,” and similar expressions are intended to identify such forward-looking statements.

The Company’s actual results may differ materially from the results anticipated in these forward-looking statements due to a variety of factors, including, without limitation (a) the effects of future economic conditions on the Company and its customers; (b) the costs and effects of litigation and of unexpected or adverse outcomes in such litigation; (c) governmental monetary and fiscal policies, as well as legislative and regulatory changes; (d) the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Financial Accounting Standards Board and other accounting standard setters; (e) the risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities and interest rate protection agreements, as well as interest rate risks; (f) the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in the Company’s market area and elsewhere, including institutions operating locally, regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the Internet; (g) technological changes; (h) acquisitions and integration of acquired businesses; (i) the failure of assumptions underlying the establishment of reserves for loan losses and estimations of values of collateral and various financial assets and liabilities; and (j) acts of war or terrorism. All written or oral forward-looking statements attributable to the Company are expressly qualified in their entirety by these cautionary statements.

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company’s condensed consolidated financial statements and should be read in conjunction with the Consolidated Financial Statements of the Company and Notes thereto and other detailed information appearing in the Company’s Annual Report.

Overview

This overview of management’s discussion and analysis highlights selected information in this document and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources, and critical accounting estimates, you should read this entire document carefully. These have an impact on the Company’s financial condition and results of operations.

Net income was $15.3 million and $15.1 million and diluted earnings per common share was $0.44 for each of the quarters ended March 31, 2004 and 2003, respectively. This increase in net income was primarily the result of strong loan growth, maintaining strong asset quality, and expense control. Returns on average assets were 1.02% and 1.22% and returns on average common shareholders’ equity were 12.04% and 13.48% for the three months ended March 31, 2004 and 2003, respectively. Return on average assets and return on average common shareholders’ equity in 2004 were negatively impacted by the decline in the net interest margin discussed below. Return on average assets is calculated by dividing annualized net income by the daily average of total assets. Return on average common shareholders’ equity is calculated by dividing annualized net income by the daily average of common shareholders’ equity.

Total assets at March 31, 2004 and December 31, 2003 were $6.11 billion and $5.95 billion, respectively. This growth was a result of a favorable local economy, the addition of new loan officers, the merger with Lone Star, aggressive marketing, and the Company’s overall growth strategy. Loans were $3.82 billion at March 31, 2004, an increase of $234.3 million, or 7%, from $3.59 billion at December 31, 2003. Deposits increased to $4.70 billion at March 31, 2004 from $4.40 billion at December 31, 2003. As of March 31, 2004, approximately $160.6 million of loans and $215.9 million of deposits relate to the former Lone Star branches.

Two principal components of the Company’s growth strategy are expansion through de novo branching and strategic merger transactions. During 2003, three new branches were opened in the Houston metropolitan area and the merger with Maxim was completed in July 2003, adding eight branches in Galveston County. The merger with Lone Star, announced in October 2003, closed on January 31, 2004. This transaction adds five branch locations in Dallas and initiated the Company’s entry into the important Dallas/Metroplex market. The Company anticipates opening an operations center in Dallas during the second quarter of 2004 to enable it to offer its treasury management products to commercial businesses in that market.

Net interest margin, defined as annualized net interest income divided by average interest-earning assets, for the three months ended March 31, 2004 was 4.03% down from 4.11% for the three months ended March 31, 2003. The decline in the net interest margin is attributable to declines in the level of interest rates as managed by the Federal Reserve Board. Declines in yields on interest-earning assets were partially offset by reductions in the cost of interest-bearing liabilities. Demand deposits are a significant funding source and averaged 33% of total deposits for the period ended March 31, 2004 as compared to 30% at March 31, 2003.

Noninterest income increased $3.2 million, or 17%, to $22.5 million for the three months ended March 31, 2004 compared to $19.3 million for the same period in 2003. Noninterest income has become an important component of the Company’s net income and comprises 30% of total revenue, defined as net interest income plus noninterest income, at March 31, 2004. The primary drivers of the increase were continued growth in service charge income arising from the sale of treasury management products to commercial customers, the increase in net non-sufficient funds charges on retail deposit accounts, and improved results from mortgage servicing, letter of credit activity, and sale of investment products and services.

Noninterest expenses increased $11.8 million, or 30%, to $51.3 million for the three months ended March 31, 2004 compared to $39.5 million for the same period in 2003. The Company continues to invest in its technology infrastructure to accommodate the growth in its various business activities, including the sale of treasury management products and services, as well as to continually upgrade its capabilities to meet customer and data security requirements. In addition, growth in personnel and branch facilities and the amortization of core deposit intangibles resulting from recent mergers affected the overall level of expenses for the quarter.

Credit quality is an area of importance to the Company and asset quality indicators remain positive in the first quarter of 2004. Net recoveries were 0.11% of average loans compared to 0.15% of net charge-offs for the same period in the prior year. Nonperforming assets to total loans and other real estate was 0.68% at March 31, 2004, an increase from 0.25% at March 31, 2003. The allowance for loan losses to nonperforming loans was 232.06% at March 31, 2004 compared to 171.94% at March 31, 2003. Although loans grew by 17% at March 31, 2004 compared to the same period last year, there was no material change in the composition of the loan portfolio.

The Company’s capital position remains strong. Its Tier 1 capital ratio of 9.81% and Total Capital ratio of 10.76% were augmented by the issuance of $50.0 million in trust preferred securities issued by SWBT Statutory Trust I (which is not consolidated for reporting purposes) in October 2003. The proceeds of this issuance were used in January 2004 to fund the merger with Reunion. See the Company’s Annual Report on Form 10-K, “— Financial Condition — Liquidity.”

Results of Operations

Interest Income

Interest income for the three months ended March 31, 2004 was $64.4 million, an increase of $7.1 million, or 12%, from the three months ended March 31, 2003. This increase in interest income is due to a

$876.1 million increase in average interest-earning assets to $5.33 billion for the three months ended March 31, 2004, a 20% increase from the same period last year. This increase is partially offset by a decrease in the average yield on interest-earning assets to 4.86% for the three months ended March 31, 2004, a decrease of 36 basis points when compared to the same period in 2003.

Interest income on securities increased $2.6 million to $14.5 million for the three months ended March 31, 2004. This increase was due to a $398.0 million increase in average securities outstanding to $1.56 billion for the three months ended March 31, 2004, a 34% increase from the same period a year ago. This increase is partially offset by a 43 basis point decrease in the average yield on securities to 3.76% for the three months ended March 31, 2004, compared to 4.19% for the same period last year.

Interest income on loans increased $4.5 million to $49.6 million for the three months ended March 31, 2004. This increase was due to a $474.9 million increase in average loans outstanding to $3.70 billion for the three months ended March 31, 2004, a 15% increase from the same period a year ago. This increase is partially offset by a 28 basis point decrease in the average yield on loans to 5.40% for the three months ended March 31, 2004, compared to 5.68% for the same period last year.

The yield on the loan portfolio has been impacted by the Federal Reserve’s continued reduction in interest rates. The Company’s prime rate declined by 25 basis points to 4.00% in July 2003. The impact of the reduction in the prime rate has been partially mitigated by interest rate floors and base rate provisions in the Company’s loan documents.

Interest Expense

Interest expense on deposits and borrowings for the three months ended March 31, 2004 was $11.0 million, a decrease of $1.2 million, or 10%, from the three months ended March 31, 2003. This decrease in interest expense was attributable to a decrease in the average rate on interest-bearing liabilities to 1.11% for the three months ended March 31, 2004, a decrease of 38 basis points when compared to the same period in 2003. This decrease is partially offset by a $648.4 million increase in average interest-bearing liabilities to $3.99 billion for the three months ended March 31, 2004, an increase of 19% from the same period last year.

Net Interest Income

Net interest income for the three months ended March 31, 2004 was $53.4 million compared to $45.1 million for the three months ended March 31, 2003, an increase of $8.3 million, or 18%. The increase is primarily attributable to growth in average interest-earning assets and to a decrease in rates paid on interest-bearing liabilities. Average interest-earning assets, primarily loans and securities, increased $876.1 million, or 20%, for the quarter ended March 31, 2004 when compared to the same period last year. This increase in interest-earning assets contributed $10.9 million to net interest income. The average rate on interest-bearing liabilities was 1.11% for the quarter ended March 31, 2004, a decrease of 38 basis points from 1.49% for the same period last year.

For the three months ended March 31, 2004, the net interest margin, defined as annualized net interest income divided by average interest-earning assets, declined to 4.03%, compared to 4.11% for the three months ended March 31, 2003. This decrease resulted from a decrease in the yield on interest-earning assets of 36 basis points, from 5.22% for the three months ended March 31, 2003 to 4.86% for the three months ended March 31, 2004. This decrease in yield was partially offset by a decrease in the cost of funds of 38 basis points from 1.49% for the three months ended March 31, 2003 to 1.11% for the three months ended March 31, 2004.

The following table presents for the periods indicated the total dollar amount of 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. No tax equivalent adjustments were made and all average balances are daily average balances. Nonaccruing loans have been included in the table as loans carrying a zero yield. Interest on nonaccruing loans is included to the extent it is received. The yield on the securities portfolio is based on average historical cost balances and does not give effect to changes in fair value that are reflected as a component of consolidated shareholders’ equity.



			Three Months Ended March 31,


			2004								2003

			Average			Interest		Average			Average			Interest		Average
			Outstanding			Earned/		Yield/			Outstanding			Earned/		Yield/
			Balance			Paid		Rate			Balance			Paid		Rate


			(Dollars in thousands)
Interest-earning assets:
	Loans		$	3,697,254		$	49,632		5.40	%	$	3,222,366		$	45,156		5.68	%
	Securities			1,555,791			14,549		3.76			1,157,825			11,951		4.19
	Federal funds sold and other			74,589			189		1.02			71,316			206		1.17

		Total interest-earning assets		5,327,634			64,370		4.86	%		4,451,507			57,313		5.22	%

Less allowance for loan losses				(45,770	)							(38,216	)

				5,281,864								4,413,291
Noninterest-earning assets				731,933								591,037

		Total assets	$	6,013,797							$	5,004,328

Interest-bearing liabilities:
	Money market and savings deposits		$	1,973,198			3,208		0.65	%	$	1,733,563			4,292		1.00	%
	Time deposits			1,005,189			4,862		1.95			965,267			5,814		2.44
	Repurchase agreements and other borrowed funds			1,008,229			2,932		1.17			639,359			2,126		1.35

		Total interest-bearing liabilities		3,986,616			11,002		1.11	%		3,338,189			12,232		1.49	%

Noninterest-bearing liabilities:
	Noninterest-bearing demand deposits			1,491,064								1,172,389
	Other liabilities			25,425								40,323

		Total liabilities		5,503,105								4,550,901
Shareholders’ equity				510,692								453,427

		Total liabilities and shareholders’ equity	$	6,013,797							$	5,004,328

Net interest income						$	53,368							$	45,081

Net interest spread									3.75	%							3.73	%

Net interest margin									4.03	%							4.11	%

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 outstanding balances, the volatility of interest rates, and the change in number of days due to leap year. For purposes of this table, changes attributable to both rate and volume which cannot be segregated have been allocated proportionately to the change due to volume and the change due to rate.



		Three Months Ended March 31,


		2004 vs. 2003


		Increase (Decrease) Due to

		Volume		Rate			Days		Total


		(Dollars in thousands)
Interest-earning assets:
Loans		$	6,710	$	(2,611	)	$	377	$	4,476
Securities			4,142		(1,644	)		100		2,598
Federal funds sold and other			10		(28	)		1		(17	)

	Total increase (decrease) in interest income		10,862		(4,283	)		478		7,057

Interest-bearing liabilities:
Money market and savings deposits			598		(1,718	)		36		(1,084	)
Time deposits			242		(1,243	)		49		(952	)
Repurchase agreements and borrowed funds			1,237		(449	)		18		806

	Total increase (decrease) in interest expense		2,077		(3,410	)		103		(1,230	)

Increase (decrease) in net interest income		$	8,785	$	(873	)	$	375	$	8,287

Provision for Loan Losses

The provision for loan losses was $2.0 million for the three months ended March 31, 2004 as compared to $3.0 million for the three months ended March 31, 2003. Factors that impact the provision for loan losses are net charge-offs or recoveries, changes in the size of the loan portfolio, and the recognition of changes in current risk factors. Although no assurance can be given, management believes that the present allowance for loan losses is adequate considering loss experience, delinquency trends, and current economic conditions. Management regularly reviews the Company’s loan loss allowance in accordance with its standard procedures. (See “— Financial Condition — Credit Management.”)

Noninterest Income

Noninterest income for the three months ended March 31, 2004 was $22.5 million, an increase of $3.2 million, or 17%, from $19.3 million during the comparable period in 2003. The following table shows the breakout of noninterest income between the bank and the mortgage company for the periods indicated.



		Three Months Ended March 31,


		2004						2003

		Bank		Mortgage		Combined		Bank		Mortgage			Combined


		(Dollars in thousands)
Service charges on deposit accounts		$	11,040	$	—	$	11,040	$	9,617	$	—		$	9,617
Investment services			2,970		—		2,970		2,295		—			2,295
Factoring fee income			954		—		954		1,007		—			1,007
Loan fee income			653		622		1,275		412		731			1,143
Bank-owned life insurance income			1,491		—		1,491		1,190		—			1,190
Letters of credit fee income			862		—		862		522		—			522
Mortgage servicing fees, net of amortization			—		190		190		—		(318	)		(318	)
Gain on sale of loans, net			65		512		577		—		1,099			1,099
Gain on sale of securities, net			26		—		26		35		—			35
Other income			2,936		133		3,069		2,426		237			2,663

	Total noninterest income	$	20,997	$	1,457	$	22,454	$	17,504	$	1,749		$	19,253

Banking Segment. The largest component of noninterest income is service charges on deposit accounts, which were $11.0 million for the three months ended March 31, 2004, an increase of $1.4 million, or 15%, from $9.6 million for the same period last year. Several factors contributed to this growth. First, the Bank’s treasury management group continues to grow, with service charges from commercial analysis and fee income up $283,000, or 6%, for the three months ended March 31, 2004 when compared to the same period last year. This success at winning new business results from the Company’s ability to design custom cost-effective cash management solutions for middle market and large corporate customers. Second, net non-sufficient funds charges on deposit accounts were $5.1 million for the three months ended March 31, 2004, an increase of $961,000, or 23%, from $4.1 million for the same period last year. Additionally, the total number of deposit accounts grew from 162,953 at March 31, 2003 to 195,839 at March 31, 2004.

Investment services income was $3.0 million for the three months ended March 31, 2004, an increase of $675,000, or 29%, from $2.3 million for the same period last year. This increase is mainly due to increases in trust services fees and commissions on insurance products.

Other income was $2.9 million for the three months ended March 31, 2004, an increase of $510,000, or 21%, from the same period last year. This increase is primarily attributable to an increase in retail services fee income, primarily from debit card and ATM fees.

Mortgage Segment. Gain on sale of loans, net, was $512,000 for the three months ended March 31, 2004, a decrease of $587,000, or 53%, from the same period last year. This decrease is attributable to a decrease in principal balances sold in the current year. The principal balances of mortgage loans sold were $31.9 million and $51.6 million during the three months ended March 31, 2004 and 2003, respectively. The market value of loans held for sale is impacted by changes in current interest rates. An increase in interest rates results in a decrease in the market value of these loans while a decrease in interest rates results in an increase in the market value of these loans.

Mortgage servicing fees, net of amortization and impairment, were $190,000 for the three months ended March 31, 2004, an increase of $508,000 when compared to ($318,000) for the same period last year. This increase is attributable to a decrease in amortization recorded in the current year. The mortgage industry

experienced high levels of prepayment activity in 2003 as a result of lower interest rates. Capitalized mortgage servicing costs are expensed against the related fee income as the underlying loans are paid off.

Amortization of capitalized mortgage servicing costs for the three months ended March 31, 2004 was $587,000, a decrease of $542,000, or 48%, from $1.1 million for the three months ended March 31, 2003. See “Note 4 — Mortgage Servicing Rights” for further discussion on the accounting for these assets.

Noninterest Expenses

For the three months ended March 31, 2004, noninterest expenses were $51.3 million, an increase of $11.8 million, or 30%, from $39.5 million for the three months ended March 31, 2003. The increase in noninterest expenses was primarily due to salaries and employee benefits, occupancy expenses and merger-related costs.

Salaries and employee benefits for the three months ended March 31, 2004 were $29.2 million, an increase of $5.4 million, or 23%, from the three months ended March 31, 2003. This increase was due primarily to hiring of additional personnel required to accommodate the Company’s growth and the mergers with Maxim and Lone Star. Total full-time employees were 1,839 and 1,528 at March 31, 2004 and 2003, respectively.

Occupancy expense for the three months ended March 31, 2004 was $8.3 million, an increase of $1.8 million, or 27%, from $6.5 million for the three months ended March 31, 2003. Major categories within occupancy expense are depreciation expense and maintenance contract expense. Depreciation expense increased $827,000, or 32%, to $3.4 million for the three months ended March 31, 2004. This increase was due primarily to additional depreciation resulting from the addition of new branches, including the eight Maxim branches and five Lone Star branches, and capitalized leasehold improvements associated with renovations at the Company’s headquarters. In addition, depreciation on computer equipment has increased in the current year for expenditures made to support the Company’s growth. Maintenance contract expense for the three months ended March 31, 2004 was $1.4 million, an increase of $322,000, or 29%, compared to $1.1 million for the same period last year. The Company has purchased maintenance contracts for major operating systems throughout the organization.

On January 31, 2004, the Company completed its merger with Lone Star. In connection with this merger, the Company recorded $1.5 million of merger-related expenses including contract termination fees and professional fees. No such charges were recorded in the same period of the prior year.

Income Taxes

Income tax expense includes the regular federal income tax at the statutory rate, plus the income tax component of the Texas franchise tax, if applicable. 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. Taxable income for the income tax component of the Texas franchise tax is the federal pre-tax income, plus certain officers’ salaries, less interest income from federal securities. For the three months ended March 31, 2004, the provision for income taxes was $7.2 million, an increase of $441,000, or 7%, from the $6.7 million provided for in the same period in 2003. The Company’s effective tax rate was 31% for each of the three months ended March 31, 2004 and 2003.

Financial Condition

Loans Held for Investment

Loans held for investment were $3.72 billion at March 31, 2004, an increase of $229.3 million, or 7%, from $3.49 billion at December 31, 2003.

The following table summarizes the loan portfolio of the Company by type of loan as of March 31, 2004 and December 31, 2003:



			March 31, 2004					December 31, 2003

			Amount		Percent			Amount		Percent


			(Dollars in thousands)
Commercial and industrial			$	1,569,244		42.17	%	$	1,500,304		42.96	%
Real estate :
		Construction and land development		785,589		21.11			706,546		20.24
		1-4 family residential		579,372		15.57			567,009		16.24
		Commercial		594,440		15.98			521,254		14.93
		Farmland		10,773		0.29			11,140		0.32
		Other		57,329		1.54			41,854		1.20
Consumer				124,203		3.34			143,566		4.11

	Total loans held for investment		$	3,720,950		100.00	%	$	3,491,673		100.00	%

The primary lending focus of the Company is on small- and medium-sized commercial, construction and land development, residential mortgage, and consumer loans. The Company offers a variety of commercial lending products including term loans, lines of credit, and equipment financing. A broad range of short- to medium-term commercial loans, both collateralized and uncollateralized, are made available 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. The purpose of a particular loan generally determines its structure.

The Company’s commercial loans are generally underwritten on the basis of the borrower’s ability to service such debt from cash flow. As a general practice, the Company takes as collateral a lien on available real estate, equipment, accounts receivable, inventory, or other assets and personal guarantees of company owners or project sponsors. Working capital loans are primarily collateralized by short-term assets whereas term loans are primarily collateralized by long-term assets.

A substantial portion of the Company’s real estate loans consists of loans collateralized by real estate, other assets, and personal guarantees of company owners or project sponsors. Additionally, a portion of the Company’s lending activity consists of the origination of single-family residential mortgage loans collateralized by owner-occupied properties located in the Company’s primary market area. The Company offers a variety of mortgage loan products which generally are amortized over 10 to 30 years.

Loans collateralized by single-family residential real estate are typically originated in amounts of no more than 90% of appraised value. The Company requires mortgage title insurance and hazard insurance in the amount of the loan. Although the contractual loan payment periods for single-family residential real estate loans are generally for a 10 to 30 year period, such loans often remain outstanding for significantly shorter periods than their contractual terms. The Company also offers home improvement loans and home equity loans collateralized by single-family residential real estate. The terms of these loans typically range from three to 15 years.

The Company originates residential and commercial mortgage loans to sell to investors with servicing rights retained. The Company also provides residential and commercial construction financing to builders and developers and acts as a broker in the origination of multi-family and commercial real estate loans.

Residential construction financing to builders generally has been originated in amounts of no more than 80% of appraised value. The Company requires a mortgage title binder and builder’s risk insurance in the amount of the loan. The contractual loan payment periods for residential construction loans are generally for a six to twelve month period.

Consumer loans made by the Company include automobile loans, recreational vehicle loans, boat loans, personal loans (collateralized and uncollateralized), and deposit account collateralized loans. The terms of these loans typically range from 12 to 84 months and vary based upon the nature of collateral and size of loan.

The contractual maturity ranges of the commercial and industrial and funded real estate construction and land development loan portfolio and the amount of such loans with fixed interest rates and floating interest rates in each maturity range as of March 31, 2004 are summarized in the following table:



		March 31, 2004

				After One
		One Year Or		Through		After Five
		Less		Five Years		Years		Total


		(Dollars in thousands)
Commercial and industrial		$	650,775	$	790,932	$	127,537	$	1,569,244
Real estate construction and land development			418,454		346,575		20,560		785,589

	Total	$	1,069,229	$	1,137,507	$	148,097	$	2,354,833

Loans with a fixed interest rate		$	145,923	$	232,111	$	65,715	$	443,749
Loans with a floating interest rate			923,306		905,396		82,382		1,911,084

	Total	$	1,069,229	$	1,137,507	$	148,097	$	2,354,833

Loans Held for Sale

Loans held for sale of $101.9 million at March 31, 2004 increased from $96.9 million at December 31, 2003. These loans are primarily single family residential loans and are carried at the lower of cost or market and are typically sold to investors within one year of origination. The market value of these loans is impacted by changes in current interest rates. An increase in interest rates would result in a decrease in the market value of these loans while a decrease in interest rates would result in an increase in the market value of these loans. The business of originating and selling loans is conducted by the Company’s mortgage segment.

Off-Balance Sheet Credit Commitments

The Company enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Customers use credit commitments to ensure that funds will be available for working capital purposes, for capital expenditures and to ensure access to funds at specified terms and conditions. Substantially all of the Company’s commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. Management assesses the credit risk associated with commitments to extend credit. Commitments to extend credit totaled $2.45 billion at March 31, 2004 and $2.14 billion at December 31, 2003.

Standby letters of credit are written conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The Company’s policies generally require that standby letters of credit arrangements contain collateral and debt covenants similar to those contained in loan agreements. In

the event the customer does not perform in accordance with the terms of the agreement with the third party, the Company would be required to fund the commitment. The maximum potential amount of future payments the Company could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, the Company would be entitled to seek recovery from the customer. Standby letters of credit were $256.9 million at March 31, 2004 and $227.0 million at December 31, 2003. As of March 31, 2004 and December 31, 2003, $212,000 and $248,000, respectively, has been recorded as a liability for the fair value of the Company’s potential obligations under these guarantees.

Credit Management

The Company’s loan review procedures include a credit quality assurance process that includes approval by the Board of Directors of lending policies and underwriting guidelines, a loan review department staffed, in part, with Office of the Comptroller of the Currency experienced personnel, low individual lending limits for officers, loan committee approval for credit relationships in excess of $3.0 million, and a quality control process for loan documentation. The Company also maintains a monitoring process for credit extensions in excess of $100,000. The Company performs quarterly concentration analyses based on various factors such as industries, collateral types, business lines, large credit sizes, international credit exposure, and officer portfolio loads. 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. The Company continues to invest in its loan portfolio monitoring system to enhance its risk management capabilities.

The Company’s loan portfolio is well diversified by industry type, but is generally concentrated in the eight county region defined as its primary market area. Historically, the Houston metropolitan area has been affected both positively and negatively by conditions in the energy industry. It is estimated that approximately 31% of economic activity currently is related to the upstream energy industry, down from 69% in 1981. Since the mid-1980’s, the economic impact of changes in the energy industry has been lessened due to the diversification of the Houston economy driven by growth in such economic entities as the Texas Medical Center, the Port of Houston, the Johnson Space Center, and government infrastructure spending to support the population and job growth in the Houston area. As a result, the economy of the Company’s primary market area has become increasingly affected by changes in the national and international economies.

The Company monitors changes in the level of energy prices, real estate values, borrower collateral, and the level of local, regional, national, and international economic activity. For the three month period ended March 31, 2004, annualized net recoveries to average loans was 0.11%. The net charge-offs average for all FDIC insured commercial banks was 0.89% for the year ended December 31, 2003. 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 changes in general economic conditions.

Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of probable losses inherent in the loan portfolio. The allowance is established through a provision for loan losses based on management’s evaluation of the risk inherent in the loan portfolio. The allowance is increased by provisions charged against current earnings and reduced by net charge-offs. Loans are charged off when they are deemed to be uncollectible; recoveries are recorded only when cash payments are received.

At least quarterly, the Bank’s Allowance for Loan Losses Committee and the Board Loan Committee review the allowance for loan losses relative to the risk profile of the Bank’s loan portfolio and current economic conditions. The allowance is adjusted based on that review if changes are warranted.

The allowance has several components, which include specific reserves, migration analysis reserves, qualitative adjustments, which includes a general reserve component, and a separate reserve for international, cross-border risk (allocated transfer risk reserve “ATRR”).

Specific reserves cover those loans that are nonperforming or impaired. All impaired loans greater than or equal to $1.0 million are evaluated under the provisions of SFAS No. 114, Accounting by Creditors for

Impairment of a Loan. Accordingly, an allowance is established when the present value of the discounted expected cash flows (or collateral value or observable market price) is lower than the carrying value of that loan. For impaired loans less than $1.0 million, a determination is made as to the ultimate collectibility of the loan and a reserve is established for any expected shortfall.

Migration analysis reserves cover performing loans that are both classified and non-classified, excluding those loans specifically evaluated for impairment reserve applicability. The migration reserve is established for commercial real estate and commercial non-real estate loans by analyzing historical loss experience by internal risk rating. The migration analysis reserve for consumer loans is established by analyzing historical loss experience by collateral type.

Qualitative adjustments serve to modify the migration analysis reserves after considering various internal and external factors that management believes may have a material impact on the loss probabilities within the loan portfolio. The qualitative factors include, but are not limited to, economic factors affecting the Bank’s primary market area, changes in the nature and volume of the loan and lease portfolio, concentrations of credit within industries and lines of business, the experience level of the lending management and staff, and the quality of the Bank’s credit risk management systems.

The general reserve covers general economic uncertainties as well as the imprecision inherent in any loan loss forecasting methodology. It will vary over time depending on existing economic, industry, organization and portfolio conditions.

The qualitative adjustments, ATRR and general reserve are allocated to the loan portfolio categories on a risk adjusted, pro-rata basis utilizing the relative reserve contributions of each portfolio segment based on the migration analysis.

Management believes that the allowance for loan losses at March 31, 2004 is adequate to cover probable losses inherent in the loan portfolio as of such date. There can be no assurance, however, that the Bank will not sustain losses in future periods which could be greater than the size of the allowance as of March 31, 2004.

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



			Three Months Ended
			March 31,

			2004			2003


			(Dollars in thousands)
Allowance for loan losses, beginning balance			$	43,008		$	36,696
Provision charged against operations				2,000			3,000
Charge-offs:
	Commercial and industrial			(711	)		(480	)
	Real estate:
		Construction and land development		—			—
		1-4 family residential		(93	)		—
		Commercial		—			—
		Farmland		—			—
		Other		—			(594	)
	Consumer			(578	)		(245	)

Total charge-offs				(1,382	)		(1,319	)

Recoveries:
	Commercial and industrial			443			58
	Real estate :
		Construction and land development		—			—
		1-4 family residential		—			27
		Commercial		—			—
		Farmland		—			—
		Other		1,700			—
	Consumer			186			46

Total recoveries				2,329			131

Net (charge-offs) recoveries				947			(1,188	)
Allowance acquired through Lone Star merger				2,116			—

Allowance for loan losses, ending balance			$	48,071		$	38,508

Allowance to period-end loans				1.29	%		1.21	%
Net charge-offs (recoveries) to average loans				(0.11	)%		0.15	%
Allowance to period-end nonperforming loans				232.06	%		171.94	%

The following table reflects the distribution of the allowance for loan losses among various categories of loans based on collateral types for the dates indicated. The Company has allocated portions of its allowance for loan losses to cover the estimated losses inherent in particular risk categories of loans. This allocation is made for analytical purposes only and is not necessarily indicative of the categories in which loan losses may occur. The total allowance is available to absorb losses from any category of loans.



			March 31, 2004					December 31, 2003

					Percent of					Percent of
					Loans to					Loans to
			Amount		Total Loans			Amount		Total Loans


			(Dollars in thousands)
Balance of allowance for loan losses applicable to:
	Commercial and industrial		$	28,062		42.17	%	$	25,388		42.96	%
	Real estate:
		Construction and land development		6,532		21.11			5,503		20.24
		1-4 family residential		3,971		15.57			2,478		16.24
		Commercial		4,712		15.98			5,179		14.93
		Farmland		40		0.29			39		0.32
		Other		2,335		1.54			2,465		1.20
	Consumer			2,419		3.34			1,956		4.11

		Total allowance for loan losses	$	48,071		100.00	%	$	43,008		100.00	%

Nonperforming Assets and Impaired Loans

Nonperforming assets, which include nonaccrual loans, accruing loans 90 or more days past due, restructured loans, and other real estate and foreclosed property, were $25.4 million at March 31, 2004, compared to $17.0 million at December 31, 2003. This resulted in a ratio of nonperforming assets to loans and other real estate of 0.68% at March 31, 2004 and 0.49% at December 31, 2003. The increase in nonperforming assets is primarily due to the addition of one commercial real estate credit to nonaccrual status. Nonaccrual loans, the largest component of nonperforming assets, were $17.7 million at March 31, 2004, an increase of $6.2 million from $11.4 million at December 31, 2003.

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


		March 31,			December 31,
		2004			2003


		(Dollars in thousands)
Nonaccrual loans		$	17,671		$	11,443
Accruing loans 90 or more days past due			3,044			1,299
Restructured loans			—			—
Other real estate and foreclosed property			4,722			4,248

	Total nonperforming assets	$	25,437		$	16,990

Nonperforming assets to total loans and other real estate			0.68	%		0.49	%

Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Loans are designated as nonaccrual when reasonable doubt exists as to the full collection of interest and principal. When a loan is placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on such loans is then recognized only to the extent that cash is received and where the future collection of interest and principal is probable. Interest accruals are resumed on such loans only when they are brought fully current with respect to interest and principal and when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest. Gross interest income on nonaccrual loans that would have been recorded had these loans been performing as agreed was $170,000 and $295,000 for the three months ended March 31, 2004 and 2003, respectively.

The Company regularly updates appraisals on loans collateralized by real estate, particularly those categorized as nonperforming loans and potential problem loans. In instances where updated appraisals reflect reduced collateral values, an evaluation of the borrower’s overall financial condition is made to determine the need, if any, for possible writedowns or appropriate additions to the allowance for loan losses.

A loan is considered impaired, based on current information and events, if management believes that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. All amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement. An insignificant delay or insignificant shortfall in the amount of payment does not require a loan to be considered impaired. If the measure of the impaired loan is less than the recorded investment in the loan, a specific reserve is established for the shortfall as a component of the Bank’s allowance for loan loss methodology. All nonaccrual loans are considered impaired at March 31, 2004 and December 31, 2003.

The following is a summary of loans considered to be impaired:


		March 31,		December 31,
		2004		2003


		(Dollars in thousands)
Impaired loans with no SFAS No. 114 valuation reserve		$	12,107	$	12,568
Impaired loans with a SFAS No. 114 valuation reserve			14,004		4,240

	Total recorded investment in impaired loans	$	26,111	$	16,808

Valuation allowance related to impaired loans		$	4,550	$	2,768

The average recorded investment in impaired loans during the three months ended March 31, 2004 and the year ended December 31, 2003 was $21.5 million and $19.9 million, respectively. Interest income on impaired loans of $314,000 and $79,000 was recognized for cash payments received during the three months ended March 31, 2004 and 2003, respectively.

Securities

At the date of purchase, the Company classifies 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 classified as held to maturity are stated at cost, increased by accretion of discounts and reduced by amortization of premiums, both computed by the interest method, 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. Securities 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, as a component of accumulated other comprehensive income (loss) until realized. Gains and losses on sales of securities are determined using the specific-identification method. The Company has classified all securities as available for sale at March 31, 2004 and December 31, 2003.

The amortized cost and approximate fair value of securities classified as available for sale is as follows:



			March 31, 2004									December 31, 2003


					Gross Unrealized									Gross Unrealized
			Amortized									Amortized
			Cost		Gain		Loss			Fair Value		Cost		Gain		Loss			Fair Value


			(Dollars in thousands)
Available for sale:
	U.S. Government and agency securities		$	291,245	$	2,127	$	(1	)	$	293,371	$	250,359	$	841	$	(102	)	$	251,098
	Mortgage-backed securities			1,040,458		9,186		(1,938	)		1,047,706		1,101,988		7,078		(8,320	)		1,100,746
	Municipal securities			180,356		9,608		(177	)		189,787		152,927		5,905		(754	)		158,078
	Federal Reserve Bank stock			6,378		—		—			6,378		4,459		—		—			4,459
	Federal Home Loan Bank stock			36,770		—		—			36,770		25,469		—		—			25,469
	Other securities			2,943		22		—			2,965		9,455		93					9,548

		Total securities available for sale	$	1,558,150	$	20,943	$	(2,116	)	$	1,576,977	$	1,544,657	$	13,917	$	(9,176	)	$	1,549,398

Declines in the fair value of individual securities below their cost that are other than temporary would result in write-downs, as a realized loss, of the individual securities to their fair value. Management believes that based upon the credit quality of the debt securities, none of the unrealized loss on securities should be considered other-than-temporary.

Securities were $1.58 billion at March 31, 2004, an increase of $27.6 million from $1.55 billion at December 31, 2003. The yield on the securities portfolio for the three months ended March 31, 2004 was 3.76% compared to 4.19% for the three months ended March 31, 2003.

Included in the Company’s mortgage-backed securities at March 31, 2004 were agency issued collateral mortgage obligations with a book value of $183.3 million and a fair value of $184.9 million and non-agency issued collateral mortgage obligations with a book value of $53.6 million and a fair value of $53.9 million.

At March 31, 2004, $739.1 million of the mortgage-backed securities held by the Company had final maturities of more than 10 years. At March 31, 2004, approximately $20.8 million of the Company’s mortgage-backed securities earned interest at floating rates and will reprice within one year, and accordingly, were less susceptible to declines in value should interest rates increase.

The following table summarizes the contractual maturity of investments and their weighted average yields at March 31, 2004. The yield on the securities portfolio is based on average historical cost balances and does not give effect to changes in fair value that are reflected as a separate component of other comprehensive income. The yield on municipal securities has not been computed on a fully tax equivalent basis.



		March 31, 2004


							After One Year					After Five Years
							But Within					But Within
		Within One Year					Five Years					Ten Years					After Ten Years

		Amortized					Amortized					Amortized					Amortized
		Cost		Yield			Cost		Yield			Cost		Yield			Cost		Yield			Total		Yield


		(Dollars in thousands)
U.S. Government securities		$	25,104		2.28	%	$	261,136		3.09	%	$	5,005		3.87	%	$	—		—	%	$	291,245		3.04	%
Mortgage-backed securities			199		5.84			16,612		4.92			284,512		3.98			739,135		4.00			1,040,458		4.01
Municipal securities			1,018		4.70			4,323		4.53			25,983		4.07			149,032		4.40			180,356		4.00
Federal Reserve Bank stock			6,378		6.00			—		—			—		—			—		—			6,378		6.00
Federal Home Loan Bank stock			36,770		1.50			—		—			—		—			—		—			36,770		1.50
Other securities			1,044		0.95			152		3.28			1,697		2.80			50		3.19			2,943		2.17
Federal funds sold			45,380		1.02			—		—			—		—			—		—			45,380		1.02
Interest-bearing deposits			7,298		1.14			—		—			—		—			—		—			7,298		1.14

	Total investments	$	123,191		1.72	%	$	282,223		3.22	%	$	317,197		3.98	%	$	888,217		4.07	%	$	1,610,828		3.72	%

Other Assets

Other assets were $199.5 million at March 31, 2004, an increase of $5.9 million from $193.6 million at December 31, 2003. This increase is primarily attributable to increases in factored receivables. Factored receivables were $37.5 million at March 31, 2004, an increase of $5.5 million, or 17%, from $32.0 million at December 31, 2003. Factored receivables result from providing operating funds to businesses by converting their accounts receivable to cash.

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, interest-bearing demand, money market, and time accounts. The Company relies primarily on its product and service offerings, high quality customer service, advertising, and competitive pricing policies to attract and retain these deposits. Deposits provide the primary source of funding for the Company’s lending and investment activities, and the interest paid for deposits must be managed carefully to control the level of interest expense.

The Company had $181.2 million and $156.4 million of its deposits classified as brokered funds at March 31, 2004 and December 31, 2003, respectively. The Bank’s brokered deposits are attributable to a major treasury management relationship whereby the Bank provides banking and treasury management services to mortgage companies throughout the United States. Under this relationship, a referring source, whose business is to lend money to mortgage companies, introduces its customers to the Bank. Deposits garnered as a result of those introductions are classified as brokered deposits for financial and regulatory reporting purposes. In spite of this classification, management believes that the deposits in question are stable and relationship-based and that they do not have the characteristics or risks normally associated with brokered deposits.

The Company’s ratio of average noninterest-bearing demand deposits to average total deposits for the periods ended March 31, 2004 and December 31, 2003 was 33% and 31%, respectively.

The average daily balances and weighted average rates paid on deposits for the three months ended March 31, 2004 and the year ended December 31, 2003 are presented below:



		March 31, 2004					December 31, 2003

		Amount		Rate			Amount		Rate


		(Dollars in thousands)
Interest-bearing demand		$	60,359		0.36	%	$	45,493		0.22	%
Regular savings			136,373		0.26			115,211		0.33
Premium yield			945,497		0.77			847,045		0.96
Money market savings			830,969		0.61			827,816		0.80
Time deposits less than $100,000			283,020		2.36			283,670		2.67
Time deposits $100,000 and over			624,178		1.67			629,749		1.85
IRA’s, QRP’s and other			97,991		2.47			91,509		2.74

Total interest-bearing deposits			2,978,387		1.09	%		2,840,493		1.30	%

Noninterest-bearing deposits			1,491,064					1,281,546

	Total deposits	$	4,469,451				$	4,122,039

The following table sets forth the maturity of the Company’s time deposits that are $100,000 or greater as of the dates indicated:


		March 31,		December 31,
		2004		2003


		(Dollars in thousands)
3 months or less		$	402,572	$	417,384
Between 3 months and 6 months			86,920		60,101
Between 6 months and 1 year			76,377		78,948
Over 1 year			92,806		86,157

	Total time deposits $100,000 and over	$	658,675	$	642,590

Short-term Borrowings

Securities sold under repurchase agreements and short-term borrowings generally represent borrowings with maturities ranging from one to thirty days. Short-term borrowings consist of federal funds purchased and overnight borrowings with the Federal Home Loan Bank (“the FHLB”). Information relating to these borrowings at March 31, 2004 and December 31, 2003 is summarized as follows:


		March 31,			December 31,
		2004			2003


		(Dollars in thousands)
Securities sold under repurchase agreements:
	Average	$	288,316		$	261,320
	Period-end		305,750			285,571
	Maximum month-end balance during period		305,750			303,764
Interest rate:
	Weighted average for the period		0.72	%		0.88	%
	Weighted average at period-end		0.73	%		0.72	%
Short-term borrowings:
	Average	$	458,258		$	276,193
	Period-end		285,958			473,154
	Maximum month-end balance during period		578,698			473,154
Interest rate:
	Weighted average for the period		1.01	%		1.11	%
	Weighted average at period-end		1.02	%		0.98	%

Interest Rate Sensitivity

Asset and liability management is concerned with the timing and magnitude of the repricing of assets as compared to liabilities. It is the objective of the Company to generate stable growth in net interest income and to attempt to control risks associated with interest rate movements. In general, management’s strategy is to reduce the impact of changes in interest rates on its net interest income by maintaining a favorable match between the maturities or repricing dates of its interest-earning assets and interest-bearing liabilities. The Company adjusts its interest sensitivity during the year through changes in the mix of assets and liabilities and may use interest rate products such as interest rate swap and cap agreements. The Company’s asset and liability management strategy is formulated and monitored by the Asset Liability Management Committee (“the ALCO”), which is composed of senior officers of the Bank and two independent directors, in accordance with the Committee’s charter and policies approved by the Bank’s Board of Directors. The ALCO meets monthly to review, among other things, the sensitivity of the Bank’s assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activity, and maturities of investments and borrowings. The ALCO also establishes pricing and funding decisions with respect to the Bank’s overall asset and liability composition. The ALCO reviews the Bank’s liquidity, cash flow flexibility, maturities of investments, deposits and borrowings, retail and institutional deposit activity, current market conditions, and interest rates on both a local and national level.

To effectively measure and manage interest rate risk, the Company uses simulation analysis to determine the impact on net interest income of changes in interest rates under various interest rate scenarios, balance sheet trends, and strategies. From these simulations, interest rate risk is quantified and appropriate strategies are developed and implemented.

The following table presents an analysis of the sensitivity inherent in the Company’s net interest income and market value of portfolio equity. The data used to prepare the table is as of March 31, 2004, which may not be representative of average balances at any other time period. This analysis is reviewed by management on a monthly basis. The results are impacted by changes in the composition of the balance sheet. Management

believes that, based on available information, the Bank has been and will continue to be slightly asset sensitive. The interest rate scenarios presented in the table include interest rates at March 31, 2004 and December 31, 2003 as adjusted by instantaneous rate changes upward of up to 200 basis points and downward of up to -100 basis points. Each rate scenario reflects unique prepayment and repricing assumptions. Since there are limitations inherent in any methodology used to estimate the exposure to changes in market interest rates, this analysis is not intended to be a forecast of the actual effect of a change in market interest rates on the Company. The market value sensitivity analysis presented includes assumptions that (i) the composition of the Company’s interest sensitive assets and liabilities existing at period end will remain constant over the twelve month measurement periods, and (ii) that changes in market rates are parallel and instantaneous across the yield curve regardless of duration or repricing characteristics of specific assets or liabilities. Further, the analysis does not contemplate any actions that the Company might undertake in response to changes in market interest rates. Accordingly, this analysis is not intended and does not provide a precise forecast of the effect actual changes in market rates will have on the Company.



			Change in Interest Rates

			-100			-50			0			+100			+200

Impact on net interest income:
	Next 12 months:
		March 31, 2004		(2.27	)%		(0.53	)%		0.00	%		2.68	%		5.43	%
		December 31, 2003		(1.20	)%		0.25	%		0.00	%		1.23	%		3.33	%
	Months 13 to 24:
		March 31, 2004		(5.49	)%		(2.20	)%		0.00	%		5.53	%		9.95	%
		December 31, 2003		(4.37	)%		(1.43	)%		0.00	%		3.37	%		6.65	%
Impact on market value of portfolio equity:
		March 31, 2004		(3.23	)%		(0.92	)%		0.00	%		0.28	%		0.29	%
		December 31, 2003		(2.49	)%		(0.49	)%		0.00	%		(0.32	)%		(0.39	)%

Interest rate sensitivity (“GAP”) is defined as the difference between interest-earning assets and interest-bearing liabilities maturing or repricing within a given time period. A GAP is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A GAP is considered negative when the amount of interest rate sensitive liabilities exceeds interest rate sensitive assets. During a period of rising interest rates, a negative GAP would tend to adversely affect net interest income, 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. While GAP is a useful measurement and contributes toward effective asset and liability management, it is difficult to predict the effect of changing interest rates solely on that measure. For this reason, the Company relies on simulation analysis to manage interest rate risk. Because different types of assets and liabilities with the same or similar maturities may react differently to changes in overall market rates or conditions, changes in interest rates may affect net interest income positively or negatively, even if an institution were perfectly matched in each maturity category.

The Company’s one-year cumulative GAP position at March 31, 2004 was a positive $795.0 million or 13% of assets. This is a one-day position that is continually changing and is not indicative of the Company’s position at any other time. While the GAP position is a useful tool in measuring interest rate risk and contributes toward effective asset and liability management, management believes that a GAP analysis alone does not accurately measure the magnitude of changes in net interest income because changes in interest rates do not impact all categories of assets, liabilities, and off-balance sheet instruments equally or simultaneously.

The following table sets forth an interest rate sensitivity analysis for the Company as of March 31, 2004 and December 31, 2003.


								One Year to			More than			Total rate			Total non-
		0-90 Days			91-365 Days			Three Years			Three Years			sensitive			rate sensitive			Total


		(Dollars in thousands)
*As of March 31, 2004*
Cash and due from banks		$	—		$	—		$	—		$	—		$	—		$	290,796		$	290,796
Federal funds sold and other cash equivalents			52,678			—			—			—			52,678			—			52,678
Securities			134,922			292,449			369,121			780,485			1,576,977			—			1,576,977
Loans			2,138,679			607,329			663,051			396,164			3,805,223			17,671			3,822,894
Allowance for loan losses			—			—			—			—			—			(48,071	)		(48,071	)
Other assets			—			—			—			—			—			418,944			418,944

	Total assets	$	2,326,279		$	899,778		$	1,032,172		$	1,176,649		$	5,434,878		$	679,340		$	6,114,218

Deposits		$	878,385		$	708,991		$	615,189		$	874,732		$	3,077,297		$	1,625,647		$	4,702,944
Securities sold under repurchase agreements and other borrowings			691,820			100,348			3,033			7,257			802,458			—			802,458
Junior subordinated deferrable interest debentures			51,547			—			—			—			51,547			—			51,547
Other liabilities			—			—			—			—			—			34,038			34,038
Shareholders’ equity			—			—			—			—			—			523,231			523,231

	Total liabilities and shareholders’ equity	$	1,621,752		$	809,339		$	618,222		$	881,989		$	3,931,302		$	2,182,916		$	6,114,218

Period GAP		$	704,527		$	90,439		$	413,950		$	294,660		$	1,503,576
Cumulative GAP		$	704,527		$	794,966		$	1,208,916		$	1,503,576		$	1,503,576
Period GAP to total assets			11.52	%		1.48	%		6.77	%		4.82	%		24.59	%
Cumulative GAP to total assets			11.52	%		13.00	%		19.77	%		24.59	%		24.59	%
*As of December 31, 2003*
Period GAP		$	470,958		$	(108,540	)	$	489,436		$	462,450		$	1,314,304
Cumulative GAP		$	470,958		$	362,418		$	851,854		$	1,314,304		$	1,314,304
Period GAP to total assets			7.92	%		(1.83	)%		8.23	%		7.78	%		22.10	%
Cumulative GAP to total assets			7.92	%		6.09	%		14.32	%		22.10	%		22.10	%

Liquidity and Capital Resources

Liquidity management involves maintaining sufficient cash levels to fund operations and to meet the requirements of borrowers, depositors, and creditors. Higher levels of liquidity bear higher corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets, and higher interest expense involved in extending liability maturities. Liquid assets include cash and cash equivalents, loans and securities maturing within one year, and money market instruments. In addition, the Company holds securities maturing after one year, which can be sold to meet liquidity needs.

The Company relies primarily on customer deposits, securities sold under repurchase agreements, and operating cash flow to fund interest-earning assets. Another source of liquidity is overnight federal funds purchased from the Company’s correspondent banks. The FHLB is also a potential source of liquidity for the Bank. The FHLB allows member banks to borrow against their eligible collateral to satisfy liquidity requirements.

Maintaining a relatively stable funding base, which is achieved by diversifying funding sources, competitively pricing deposit products, and extending the contractual maturity of liabilities, reduces the Company’s exposure to roll over risk on deposits and limits reliance on volatile short-term purchased funds. Short-term funding needs arise from declines in deposits or other funding sources, funding of loan commitments and requests for new loans. The Company’s strategy is to fund assets to the maximum extent possible with core deposits that provide a sizable source of relatively stable and low-cost funds. Core deposits include all deposits, except certificates of deposit and other time deposits of $100,000 and over. Average core deposits funded approximately 72% of total interest-earning assets for the three months ended March 31, 2004 and 73% for the same period in 2003.

Management believes the Company has sufficient liquidity to meet all reasonable borrower, depositor, and creditor needs in the present economic environment. In addition, the Bank has access to the FHLB for borrowing purposes. The Company has not received any recommendations from regulatory authorities that would materially affect liquidity, capital resources, or operations.

The following table compares the Company’s and the Bank’s reported leverage and risk-weighted capital ratios as of March 31, 2004 and December 31, 2003 to the minimum regulatory standards:



													Minimum To Be
													Well Capitalized
													Under Prompt
								Minimum Capital					Corrective Action
			Actual					Requirement					Provisions

			Amount		Ratio			Amount		Ratio			Amount		Ratio


			(Dollars in thousands)
As of March 31, 2004
	Total Capital (to Risk Weighted Assets):
		The Company	$	545,704		10.76	%	$	405,675		8.00	%	$	N/A		N/A	%
		The Bank		542,042		10.71			404,998		8.00			506,247		10.00
	Tier 1 Capital (to Risk Weighted Assets):
		The Company		497,633		9.81			202,837		4.00			N/A		N/A
		The Bank		493,428		9.75			202,499		4.00			404,998		8.00
	Tier 1 Capital (to Average Assets):
		The Company		497,633		8.35			179,276		3.00			N/A		N/A
		The Bank		493,428		8.29			178,554		3.00			297,590		5.00
As of December 31, 2003
	Total Capital (to Risk Weighted Assets):
		The Company		558,858		11.90			375,630		8.00			N/A		N/A
		The Bank		504,960		10.77			375,132		8.00			468,915		10.00
	Tier 1 Capital (to Risk Weighted Assets):
		The Company		515,850		10.99			187,815		4.00			N/A		N/A
		The Bank		461,438		9.84			187,566		4.00			375,132		8.00
	Tier 1 Capital (to Average Assets):
		The Company		515,850		9.15			169,086		3.00			N/A		N/A
		The Bank		461,438		8.20			168,917		3.00			281,529		5.00

Critical Accounting Policies

The Company has established various accounting policies which govern the application of accounting principles generally accepted in the United States in the preparation of the Company’s financial statements. The significant accounting policies of the Company are described in the footnotes to the condensed consolidated financial statements. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of assets and liabilities; management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and assumptions that could have a material impact on the carrying values of assets and liabilities and the results of operations of the Company.

The Company believes the allowance for loan losses is the critical accounting policy that requires the most significant judgments and assumptions used in the preparation of its condensed consolidated financial statements. In estimating the allowance for loan losses, management utilizes historical experience as well as other factors, including the effect of changes in the local real estate market on collateral values, the effect on the loan portfolio of current economic indicators and their probable impact on borrowers and increases or decreases in nonperforming and impaired loans. Changes in these factors may cause management’s estimate of the allowance to increase or decrease and result in adjustments to the Company’s provision for loan losses. See the Company’s Annual Report on Form 10-K, “— Financial Condition — Credit Management” for a detailed description of the Company’s estimation process and methodology related to the allowance for loan losses.

Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets. Under this standard, goodwill is not amortized, but instead is tested for impairment at least annually. Other acquired intangible assets determined to have finite lives, such as core deposit intangibles, are amortized over their estimated useful lives in a manner that best reflects the economic benefits of the intangible asset. In addition, impairment testing is performed periodically on these amortizing intangible assets.

Mortgage servicing rights assets are established and accounted for based on discounted cash flow modeling techniques which require management to make estimates regarding the amount and timing of expected future cash flows, including assumptions about loan repayment rates, credit loss experience, and costs to service, as well discount rates that consider the risk involved. Because the values of these assets are sensitive to changes in assumptions, the valuation of mortgage servicing rights is considered a critical accounting estimate. See the Company’s Annual Report on Form 10-K, “Note 1 — Nature of Operations and Summary of Significant Accounting Policies” and “Note 8 — Mortgage Servicing Rights” for further discussion on the accounting for these assets.

Other Matters

On May 15, 2003, the Financial Accounting Standards Board (“the FASB”) approved SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments, including mandatorily redeemable preferred securities, were previously classified as equity or as mezzanine debt. On October 29, 2003, the FASB deferred the effective date for certain provisions of SFAS No. 150. The Company adopted this statement with no impact on its financial condition or results of operations.

recognition of the excess of contractual cash flows over expected cash flows as an adjustment of yield, loss accrual, or valuation allowance at the time of purchase; (2) requires that subsequent increases in expected cash flows be recognized prospectively through an adjustment of yield; and (3) requires the subsequent decreases in expected cash flows be recognized as an impairment. In addition, SOP 03-3 prohibits the creation or carrying over of a valuation allowance in the initial accounting of all loans within its scope that are acquired in a transfer. SOP 03-3 becomes effective for loans or debt securities acquired in fiscal years beginning after December 15, 2004. The Company does not expect the requirements of SOP 03-3 to have a material impact on its financial condition or results of operations.

On March 9, 2004, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments. SAB No. 105 summarizes the view of the staff regarding the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments including recognition of the loan commitment and financial statement disclosures. The Company does not expect the requirements of SAB No. 105 to have a material impact on its financial condition or results of operations.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes since December 31, 2003. See the Company’s Annual Report on Form 10-K, “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition — Interest Rate Sensitivity and Liquidity.”

ITEM 4. Controls and Procedures

Management has dedicated extensive time, resources, and capital to the development and implementation of a comprehensive enterprise-wide risk management system (“ERM”). The process placed all activities of the Company into 14 processes with 11 process owners. In the initial assessment, a catalogue of the key risks in the Company were identified for ongoing monitoring. Detailed risk assessments were then conducted to determine the risk profile. Infrastructure supporting the ERM includes a Board Risk Committee, an internal Risk Management Committee, and centralized Risk Management supervision. An automated application, Enterprise Risk Management System (“ERMS”), has also been developed to facilitate execution of this methodology. The basic ERMS has been implemented and is updated on a regular basis. Management is in the process of developing measurement criteria and risk performance indicators for the various risk processes.

The Company’s chief executive officer and chief financial officer have evaluated the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Exchange Act) as of March 31, 2004 and concluded that those disclosure controls and procedures are effective.

There have been no changes in the Company’s internal controls or in other factors known to the Company that could significantly affect these disclosure controls subsequent to their evaluation, nor any corrective actions with regard to significant deficiencies and material weaknesses.

While the Company believes that its existing disclosure controls and procedures have been effective to accomplish these objectives, the Company intends to continue to examine, refine, and formalize its disclosure controls and procedures and to monitor ongoing developments in this area.

With respect to the unaudited financial information of Southwest Bancorporation of Texas, Inc. for the three month periods ended March 31, 2004 and 2003 included in this Form 10-Q, PricewaterhouseCoopers LLP reported that they have applied limited procedures in accordance with professional standards for a review of such information. However, their separate report dated April 29, 2004 appearing herein states that they did not audit and they do not express an opinion on that unaudited financial information. Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied. PricewaterhouseCoopers LLP is not subject to the liability provisions of Section 11 of the Securities Act of 1933 for their report on the unaudited financial information because that report is not a “report” or a “part” of the registration statement prepared or certified by PricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the Act.

PART II — OTHER INFORMATION

ITEM 1. Legal Proceedings

None.

ITEM 2. Changes in Securities and Use of Proceeds and Issuer Purchases of Equity Securities


					(c)
					Total Number		(d)
	(a)				of Shares		Maximum Number
	Total		(b)		Purchased as		of Shares that May
	Number of		Average		Part of Publicly		Yet Be Purchased
	Shares		Price Paid		Announced Plans		Under the Plans
Period	Purchased⁽¹⁾		per Share		or Programs		or Programs

January, 2004		24,870	$	37.09		—		—
February, 2004		—		—		—		—
March, 2004		—		—		—		—

Total		24,870	$	37.09		—		—

⁽¹⁾ Shares were received in payment of the exercise price of stock options.

ITEM 3. Defaults upon Senior Securities

None.

ITEM 4. Submission of Matters to a Vote of Securities Holders

None.

ITEM 5. Other Information

None.

ITEM 6. Exhibits and Reports on Form 8-K

a.) Exhibits:


*15	.1	Awareness Letter of PricewaterhouseCoopers LLP.
*31	.1	Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
*31	.2	Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
*32	.1	Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
*32	.2	Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

b.) Reports on Form 8-K:

Three reports on Form 8-K were filed or furnished by the Company during the three months ended March 31, 2004:

i.) A Current Report on Form 8-K dated January 19, 2004 was furnished on January 20, 2004; Item 7(c) and Item 12, reporting earnings results for the fiscal year 2003.

ii.) A Current Report on Form 8-K dated January 27, 2004 was furnished on January 29, 2004; Item 7(c), Item 9, regarding presentation of certain data to investors.

iii.) A Current Report on Form 8-K dated February 2, 2004 was filed on February 2, 2004; Item 5 and Item 7(c), announcing the completion of its merger with Reunion Bancshares, Inc.

* Filed herewith

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.


Signature	Title	Date


/s/ PAUL B. MURPHY, JR. Paul B. Murphy, Jr.	Director and Chief Executive Officer (Principal Executive Officer)	May 3, 2004

/s/ RANDALL E. MEYER Randall E. Meyer	Executive Vice President and Chief Financial Officer (Principal Financial Officer)	May 3, 2004

/s/ SCOTT J. MCLEAN Scott J. McLean	President	May 3, 2004

/s/ LAURENCE L. LEHMAN III Laurence L. Lehman III	Senior Vice President and Controller (Principal Accounting Officer)	May 3, 2004

EXHIBIT INDEX


Exhibit
Number			Description


	*15	.1	Awareness Letter of PricewaterhouseCoopers LLP.
	*31	.1	Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	*31	.2	Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	*32	.1	Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	*32	.2	Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

* Filed herewith

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	i.)	A Current Report on Form 8-K dated January 19, 2004 was furnished on January 20, 2004; Item 7(c) and Item 12, reporting earnings results for the fiscal year 2003.

	ii.)	A Current Report on Form 8-K dated January 27, 2004 was furnished on January 29, 2004; Item 7(c), Item 9, regarding presentation of certain data to investors.

	iii.)	A Current Report on Form 8-K dated February 2, 2004 was filed on February 2, 2004; Item 5 and Item 7(c), announcing the completion of its merger with Reunion Bancshares, Inc.