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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 June 30, 2004

OR

[ ]         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 69,159,150 shares of the Registrant’s Common Stock outstanding as of the close of business on July 30, 2004.




SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

INDEX TO FORM 10-Q

           
Page

       
 Item 1.  Financial Statements        
      2  
      3  
      4  
      5  
      6  
      7  
 Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations     16  
 Item 3.  Quantitative and Qualitative Disclosures About Market Risk     40  
 Item 4.  Controls and Procedures     40  
       
 Item 1.  Legal Proceedings     42  
 Item 2.  Changes in Securities and Use of Proceeds     42  
 Item 3.  Defaults upon Senior Securities     42  
 Item 4.  Submission of Matters to a Vote of Security Holders     42  
 Item 5.  Other Information     43  
 Item 6.  Exhibits and Reports on Form 8-K     43  
    44  
 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

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PART I.  FINANCIAL INFORMATION

ITEM 1.  Financial Statements

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

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 June 30, 2004, and the related condensed consolidated statement of income for the three-month and six-month periods ended June 30, 2004 and 2003, the condensed consolidated statement of changes in shareholders’ equity for the six-month period ended June 30, 2004, and the condensed consolidated statement of cash flows for the six-month periods ended June 30, 2004 and 2003. These interim financial statements are the responsibility of the Company’s management.

      We conducted our review in accordance with standards of the Public Company Accounting Oversight Board (United States). 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 the standards of the Public Company Accounting Oversight Board, 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 the Standards of the Public Company Accounting Oversight Board (United States), 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

July 29, 2004

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SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEET
(unaudited)
                     
June 30, December 31,
2004 2003


(Dollars in thousands, except
per share amounts)
ASSETS
Cash and due from banks
  $ 270,551     $ 390,890  
Federal funds sold and other cash equivalents
    45,612       94,908  
     
     
 
 
Total cash and cash equivalents
    316,163       485,798  
Securities available for sale
    1,624,540       1,549,398  
Loans held for sale
    97,929       96,899  
Loans held for investment, net of allowance for loan losses of $47,492 and $43,008
    3,864,720       3,448,665  
Premises and equipment, net
    138,156       117,951  
Accrued interest receivable
    23,456       21,630  
Goodwill
    54,998       25,647  
Core deposit intangibles
    10,653       6,185  
Other assets
    210,827       193,563  
     
     
 
   
Total assets
  $ 6,341,442     $ 5,945,736  
     
     
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
               
 
Demand — noninterest-bearing
  $ 1,622,348     $ 1,513,038  
 
Demand — interest-bearing
    62,316       43,452  
 
Money market accounts
    1,854,181       1,709,755  
 
Savings
    144,194       131,059  
 
Time, $100 and over
    746,200       642,590  
 
Other time
    350,930       363,345  
     
     
 
   
Total deposits
    4,780,169       4,403,239  
Securities sold under repurchase agreements
    518,719       285,571  
Other borrowings
    461,600       679,812  
Junior subordinated deferrable interest debentures
    51,547       51,547  
Accrued interest payable
    1,548       1,822  
Other liabilities
    17,679       24,424  
     
     
 
   
Total liabilities
    5,831,262       5,446,415  
     
     
 
Commitments and contingencies
               
Shareholders’ equity:
               
 
Preferred stock — $0.01 par value, 1,000,000 shares authorized; 0 issued and outstanding at June 30, 2004 and December 31, 2003
           
 
Common stock — $1 par value, 150,000,000 shares authorized; 69,148,940 issued and 69,068,502 outstanding at June 30, 2004; 68,458,286 issued and 68,427,798 outstanding at December 31, 2003
    69,149       68,458  
 
Additional paid-in capital
    73,618       65,380  
 
Retained earnings
    395,453       368,069  
 
Deferred compensation
    (6,116 )     (4,215 )
 
Accumulated other comprehensive income (loss)
    (20,576 )     2,050  
 
Treasury stock, at cost — 80,438 shares and 30,488 shares, respectively
    (1,348 )     (421 )
     
     
 
   
Total shareholders’ equity
    510,180       499,321  
     
     
 
   
Total liabilities and shareholders’ equity
  $ 6,341,442     $ 5,945,736  
     
     
 

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

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SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF INCOME
(unaudited)
                                       
Three Months Ended Six Months Ended
June 30, June 30,


2004 2003 2004 2003




(Dollars in thousands, except per share amounts)
Interest income:
                               
 
Loans
  $ 51,289     $ 46,988     $ 100,921     $ 92,143  
 
Securities:
                               
   
Taxable
    12,351       10,250       25,166       20,985  
   
Tax-exempt
    2,327       1,239       4,061       2,455  
 
Federal funds sold and other
    119       284       308       491  
     
     
     
     
 
     
Total interest income
    66,086       58,761       130,456       116,074  
     
     
     
     
 
Interest expense:
                               
 
Deposits
    8,408       9,535       16,478       19,641  
 
Borrowings
    2,660       2,050       5,592       4,176  
     
     
     
     
 
     
Total interest expense
    11,068       11,585       22,070       23,817  
     
     
     
     
 
     
Net interest income
    55,018       47,176       108,386       92,257  
Provision for loan losses
    3,000       3,000       5,000       6,000  
     
     
     
     
 
     
Net interest income after provision for loan losses
    52,018       44,176       103,386       86,257  
     
     
     
     
 
Noninterest income:
                               
 
Service charges on deposit accounts
    11,190       9,316       22,230       18,932  
 
Investment services
    2,885       2,430       5,855       4,725  
 
Other fee income
    5,399       3,959       10,352       7,607  
 
Bank-owned life insurance income
    1,906       1,195       3,397       2,385  
 
Other operating income
    1,382       918       2,779       2,286  
 
Gain on sale of loans, net
    712       1,146       1,289       2,246  
 
Gain (loss) on sale of securities, net
    (25 )     1,115       1       1,150  
     
     
     
     
 
     
Total noninterest income
    23,449       20,079       45,903       39,331  
     
     
     
     
 
Noninterest expenses:
                               
 
Salaries and employee benefits
    30,084       24,076       59,327       47,902  
 
Occupancy expense
    8,887       6,885       17,145       13,384  
 
Professional services
    2,780       2,147       5,100       4,214  
 
Core deposit intangible amortization expense
    1,008             1,911        
 
Other operating expenses
    9,129       8,055       19,751       15,174  
     
     
     
     
 
     
Total noninterest expenses
    51,888       41,163       103,234       80,674  
     
     
     
     
 
     
Income before income taxes
    23,579       23,092       46,055       44,914  
Provision for income taxes
    7,358       7,129       14,547       13,877  
     
     
     
     
 
 
Net income
  $ 16,221     $ 15,963     $ 31,508     $ 31,037  
     
     
     
     
 
Earnings per common share:
                               
 
Basic
  $ 0.24     $ 0.23     $ 0.46     $ 0.46  
     
     
     
     
 
 
Diluted
  $ 0.23     $ 0.23     $ 0.45     $ 0.45  
     
     
     
     
 
Dividends per common share
  $ 0.03     $     $ 0.06     $  
     
     
     
     
 
The accompanying notes are an integral part of the condensed consolidated financial statements.

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SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
(unaudited)
                                                                                   
Accumulated
Other
Preferred Stock Common Stock Additional Comprehensive Total


Paid-in Retained Deferred Income Treasury Shareholders’
Shares Dollars Shares Dollars Capital Earnings Compensation (Loss) Stock Equity










(Dollars in thousands, except per share amounts)
BALANCE, DECEMBER 31, 2003
        $       68,458,286     $ 68,458     $ 65,380     $ 368,069     $ (4,215 )   $ 2,050     $ (421 )   $ 499,321  
 
Exercise of stock options
                    556,526       557       5,611                                       6,168  
 
Issuance of restricted common stock, net of shares forfeited into Treasury
                    126,500       126       2,503               (2,629 )                      
 
Issuance of non-employee director stock
                    7,628       8       124                                       132  
 
Purchase of treasury stock
                                                                    (927 )     (927 )
 
Deferred compensation amortization
                                                    728                       728  
 
Cash dividends, $0.06 per common share
                                            (4,124 )                             (4,124 )
 
Comprehensive income:
                                                                               
 
Net income for the six months ended June 30, 2004
                                            31,508                               31,508  
 
Net change in unrealized appreciation (depreciation) on securities available for sale, net of deferred taxes of $12,274
                                                            (22,793 )             (22,793 )
 
Reclassification adjustment for losses included in net income, net of deferred taxes of ($89)
                                                            167               167  
                                                                             
 
 
Total comprehensive income
                                                                            8,882  
     
     
     
     
     
     
     
     
     
     
 
BALANCE, JUNE 30, 2004
        $       69,148,940     $ 69,149     $ 73,618     $ 395,453     $ (6,116 )   $ (20,576 )   $ (1,348 )   $ 510,180  
     
     
     
     
     
     
     
     
     
     
 

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

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SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)
                         
Six Months Ended
June 30,

2004 2003


(Dollars in thousands)
Cash flows from operating activities:
               
 
Net income
  $ 31,508     $ 31,037  
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
   
Provision for loan losses
    5,000       6,000  
   
Depreciation
    7,027       5,460  
   
Provision for mortgage servicing rights in excess of fair value
          234  
   
Realized gain on securities available for sale, net
    (1 )     (1,150 )
   
Gain on sale of premises and equipment, net
    (2 )     (12 )
   
Amortization and accretion of securities’ premiums and discounts, net
    3,189       5,118  
   
Amortization of mortgage servicing rights
    1,206       2,594  
   
Amortization of computer software
    3,125       2,203  
   
Amortization of core deposit intangibles
    1,911        
   
Other amortization
    728       644  
   
Income tax benefit from exercise of stock options
    1,880       864  
   
Net change in:
               
     
Loans held for sale
    (1,030 )     8,605  
     
Other assets and liabilities, net
    (4,720 )     5,967  
     
     
 
 
Net cash provided by operating activities
    49,821       67,564  
     
     
 
Cash flows from investing activities:
               
 
Proceeds from maturity and call of securities available for sale
    25,810       44,174  
 
Proceeds from sale of securities available for sale
    559,839       212,700  
 
Principal paydowns of mortgage-backed securities available for sale
    166,551       277,537  
 
Purchase of securities available for sale
    (834,392 )     (640,297 )
 
Purchase of Federal Reserve Bank stock
    (3,400 )      
 
Purchase of Federal Home Loan Bank stock
    (11,705 )     (339 )
 
Proceeds from redemption of FHLB stock
    15,102        
 
Net increase in loans held for investment
    (269,608 )     (167,081 )
 
Proceeds from sale of premises and equipment
    733       48  
 
Purchase of premises and equipment
    (28,722 )     (12,863 )
 
Purchase of mortgage servicing rights
          (249 )
 
Acquisition of Reunion Bancshares, Inc. (net of cash acquired of $30,596)
    (19,404 )      
 
Investment in unconsolidated equity investees
    (2,298 )      
     
     
 
       
Net cash used in investing activities
    (401,494 )     (286,370 )
     
     
 
Cash flows from financing activities:
               
 
Net increase in noninterest-bearing demand deposits
    51,023       53,426  
 
Net increase in time deposits
    71,015       127,439  
 
Net increase in other interest-bearing deposits
    47,827       46,539  
 
Net increase (decrease) in securities sold under repurchase agreements
    233,148       (39,886 )
 
Net decrease in other short-term borrowings
    (122,193 )     (60,802 )
 
Proceeds from long-term borrowings
    2,200       100,000  
 
Payments on long-term borrowings
    (100,219 )     (192 )
 
Payments of cash dividends
    (4,124 )      
 
Net proceeds from exercise of stock options
    4,288       1,746  
 
Purchase of treasury stock
    (927 )      
     
     
 
       
Net cash provided by financing activities
    182,038       228,270  
     
     
 
Net increase (decrease) in cash and cash equivalents
    (169,635 )     9,464  
Cash and cash equivalents at beginning of period
    485,798       535,364  
     
     
 
Cash and cash equivalents at end of period
  $ 316,163     $ 544,828  
     
     
 

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

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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 June 30, 2004 and December 31, 2003, consolidated net income for the three and six months ended June 30, 2004 and 2003, consolidated cash flows for the six months ended June 30, 2004 and 2003, and consolidated changes in shareholders’ equity for the six months ended June 30, 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

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SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

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 requirements of SAB No. 105 did not have a material impact on the financial condition or results of operations of the Company.

  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 Six Months Ended
June 30, June 30,


2004 2003 2004 2003




(Dollars in thousands, except per share amounts)
Net income
                               
 
As reported
  $ 16,221     $ 15,963     $ 31,508     $ 31,037  
 
Pro forma
  $ 15,668     $ 15,430     $ 30,349     $ 29,762  
Stock-based compensation cost, net of income taxes
                               
 
As reported
  $ 252     $ 237     $ 495     $ 445  
 
Pro forma
  $ 805     $ 770     $ 1,654     $ 1,720  
Basic earnings per common share
                               
 
As reported
  $ 0.24     $ 0.23     $ 0.46     $ 0.46  
 
Pro forma
  $ 0.23     $ 0.23     $ 0.44     $ 0.44  
Diluted earnings per common share
                               
 
As reported
  $ 0.23     $ 0.23     $ 0.45     $ 0.45  
 
Pro forma
  $ 0.22     $ 0.22     $ 0.43     $ 0.43  

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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 junior subordinated deferrable interest debentures.

      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 $29.2 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
    29,155  
Core deposit intangibles
    6,379  
Other assets
    3,779  
Deposits
    (207,026 )
Deposit premium
    (39 )
Borrowings
    (2,000 )
Other liabilities
    (2,458 )
     
 
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.

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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 Pro forma
Three Months Ended Six Months Ended
June 30, June 30,


2004 2003 2004 2003




(Dollars in thousands, except per share amounts)
Net interest income after provision for loan losses and noninterest income
  $ 75,467     $ 70,438     $ 149,983     $ 137,743  
Income before income taxes
    23,579       28,489       46,122       50,995  
Net income
    16,221       19,646       31,555       35,275  
Earnings per common share, basic
  $ 0.24     $ 0.29     $ 0.46     $ 0.52  
Earnings per common share, diluted
  $ 0.23     $ 0.28     $ 0.45     $ 0.51  

      Maxim recorded a gain on sale of securities of $5.3 million in the second quarter of 2003, which has been recorded in the pro forma results above. 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.

      On May 20, 2004, the Company and Southwest Bank of Texas National Association entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Klein Bancshares, Inc. (“Klein”), whereby Klein will merge into the Company. Klein is the parent company of Klein Bank located in northwest Harris County and Montgomery County, Texas. The Merger Agreement, which is subject to approval of the shareholders of Klein and various regulatory authorities, provides for a cash and common stock transaction valued at $165.0 million. At June 30, 2004, Klein had total assets of $597.3 million, total loans of $165.4 million and total deposits of $540.3 million. The transaction is expected to close in the fourth quarter of 2004.

 
3. Comprehensive Income

      Comprehensive income consists of the following:

                                 
Three Months Ended Six Months Ended
June 30, June 30,


2004 2003 2004 2003




(Dollars in thousands)
Net income
  $ 16,221     $ 15,963     $ 31,508     $ 31,037  
Net change in unrealized appreciation (depreciation) on securities available for sale, net of deferred tax
    (31,464 )     2,400       (22,793 )     1,846  
Reclassification adjustment for (gains) losses included in net income, net of deferred tax
    (321 )     (1,704 )     167       (1,744 )
     
     
     
     
 
Total comprehensive income (loss)
  $ (15,564 )   $ 16,659     $ 8,882     $ 31,139  
     
     
     
     
 
 
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.

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SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

      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 loan type, 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.

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

                                   
Three Months Ended Six Months Ended
June 30, June 30,


2004 2003 2004 2003




(Dollars in thousands)
Mortgage servicing rights:
                               
Balance, beginning of period
  $ 7,926     $ 10,095     $ 8,299     $ 10,628  
 
Originations
    286       517       500       1,027  
 
Purchases
          163             249  
 
Amortization
    (619 )     (1,465 )     (1,206 )     (2,594 )
     
     
     
     
 
Balance, end of period
    7,593       9,310       7,593       9,310  
     
     
     
     
 
Valuation allowance:
                               
Balance, beginning of period
          2,371             2,371  
 
Provision
          234             234  
 
Recovery
                       
     
     
     
     
 
Balance, end of period
          2,605             2,605  
     
     
     
     
 
Mortgage servicing rights, net
  $ 7,593     $ 6,705     $ 7,593     $ 6,705  
     
     
     
     
 

      Loans serviced for others totaled $885.3 million at June 30, 2004 and $978.7 million at June 30, 2003. Capitalized mortgage servicing rights represent 86 basis points and 69 basis points of the portfolio serviced at June 30, 2004 and June 30, 2003, respectively.

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SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

5.     Earnings Per Common Share

      Earnings per common share is computed as follows:

                                   
Three Months Ended Six Months Ended
June 30, June 30,


2004 2003 2004 2003




(In thousands, except per share amounts)
Net income
  $ 16,221     $ 15,963     $ 31,508     $ 31,037  
     
     
     
     
 
Divided by average common shares and common share equivalents:
                               
 
Average common shares outstanding
    68,746       67,928       68,646       67,754  
 
Average common shares issuable under the stock option plan
    1,782       1,528       1,760       1,526  
     
     
     
     
 
 
Total average common shares and common share equivalents
    70,528       69,456       70,406       69,280  
     
     
     
     
 
Basic earnings per common share
  $ 0.24     $ 0.23     $ 0.46     $ 0.46  
     
     
     
     
 
Diluted earnings per common share
  $ 0.23     $ 0.23     $ 0.45     $ 0.45  
     
     
     
     
 

      Stock options outstanding of 47,000 and 414,000 for the three months ended June 30, 2004 and 2003, respectively, and 181,000 and 1,016,000 for the six months ended June 30, 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.

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.

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SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

      Summarized financial information by operating segment for the three and six months ended June 30, 2004 and 2003 follows:

                                                                 
Three Months Ended June 30,

2004 2003


Bank Mortgage Eliminations Consolidated Bank Mortgage Eliminations Consolidated








(Dollars in thousands)
Interest income
  $ 63,965     $ 3,504     $ (1,383 )   $ 66,086     $ 56,261     $ 3,904     $ (1,404 )   $ 58,761  
Interest expense
    11,068       1,383       (1,383 )     11,068       11,585       1,404       (1,404 )     11,585  
     
     
     
     
     
     
     
     
 
Net interest income
    52,897       2,121             55,018       44,676       2,500             47,176  
Provision for loan losses
    1,967       1,033             3,000       2,686       314             3,000  
Noninterest income
    21,527       1,922             23,449       18,505       1,574             20,079  
Noninterest expense
    49,325       2,563             51,888       38,494       2,669             41,163  
     
     
     
     
     
     
     
     
 
Income before income taxes
  $ 23,132     $ 447     $     $ 23,579     $ 22,001     $ 1,091     $     $ 23,092  
     
     
     
     
     
     
     
     
 
                                                                 
Six Months Ended June 30,

2004 2003


Bank Mortgage Eliminations Consolidated Bank Mortgage Eliminations Consolidated








(Dollars in thousands)
Interest income
  $ 126,055     $ 7,050     $ (2,649 )   $ 130,456     $ 111,099     $ 7,803     $ (2,828 )   $ 116,074  
Interest expense
    22,070       2,649       (2,649 )     22,070       23,817       2,828       (2,828 )     23,817  
     
     
     
     
     
     
     
     
 
Net interest income
    103,985       4,401             108,386       87,282       4,975             92,257  
Provision for loan losses
    3,901       1,099             5,000       5,604       396             6,000  
Noninterest income
    42,524       3,379             45,903       36,008       3,323             39,331  
Noninterest expense
    98,335       4,899             103,234       75,416       5,258             80,674  
     
     
     
     
     
     
     
     
 
Income before income taxes
  $ 44,273     $ 1,782     $     $ 46,055     $ 42,270     $ 2,644     $     $ 44,914  
     
     
     
     
     
     
     
     
 
Total assets
  $ 6,311,259     $ 318,087     $ (287,904 )   $ 6,341,442     $ 5,413,743     $ 297,093     $ (268,704 )   $ 5,442,132  
     
     
     
     
     
     
     
     
 

      Intersegment interest was paid to the bank by the mortgage company in the amount of $1.4 million for each of the three months ended June 30, 2004 and 2003, respectively. For the six months ended June 30, 2004 and 2003, intersegment interest was $2.6 million and $2.8 million, respectively. Advances from the bank to the mortgage company of $287.9 million and $268.7 million were eliminated in consolidation at June 30, 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.

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SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

      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 $2.60 billion at June 30, 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 certain 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 $291.7 million at June 30, 2004 and $227.0 million at December 31, 2003. As of June 30, 2004 and December 31, 2003, $503,000 and $248,000, respectively, has been recorded as a liability for the fair value of the Company’s potential obligations under these agreements.

8.     Goodwill and Core Deposit Intangibles

      Changes in the carrying amount of the Company’s goodwill and core deposit intangibles for the six months ended June 30, 2004 were as follows:

                   
Core Deposit
Goodwill Intangibles


(Dollars in thousands)
Balance, December 31, 2003
  $ 25,647     $ 6,185  
 
Acquisition of Lone Star
    29,155       6,379  
 
Adjustment to acquisition of Maxim
    196        
 
Amortization
          (1,911 )
     
     
 
Balance, June 30, 2004
  $ 54,998     $ 10,653  
     
     
 

      The following table shows the estimated future amortization expense for core deposit intangibles:

         
Core Deposit
Intangibles

(Dollars in thousands)
Remaining 2004
  $ 1,584  
2005
    2,499  
2006
    1,774  
2007
    1,356  
2008
    1,043  
Thereafter
    2,397  

9.     Common Stock Cash Dividend

      On May 5, 2004, the Company’s Board of Directors declared a cash dividend of $0.03 cents per common share paid on June 15, 2004 to shareholders of record as of June 1, 2004.

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SOUTHWEST BANCORPORATION OF TEXAS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

10.     Common Stock Dividend

      On June 17, 2004, the Company declared a stock dividend payable at the rate of one share of the Company’s common stock for each share of the Company’s common stock issued and outstanding as of July 1, 2004, payable on July 15, 2004, to the holders of record as of the close of business on July 1, 2004. This stock dividend has been given retroactive effect in the accompanying financial statements and related notes. In addition, earnings per share data has been restated for all periods presented.

11.     Supplemental Cash Flow Information

      Supplemental cash flow information for the six months ended June 30, 2004 and 2003 is as follows:

                   
Six Months
Ended June 30,

2004 2003


(Dollars in
thousands)
Non-cash investing and financing activities:
               
 
Loans transferred to foreclosed real estate
  $ 9,221     $ 3,375  

      The Company acquired Lone Star for $50.0 million. In conjunction with the acquisition, liabilities were assumed as follows:

           
January 31, 2004

(Dollars in thousands)
Fair value of assets acquired
  $ 261,523  
Cash paid for the capital stock
    (50,000 )
     
 
 
Liabilities assumed
  $ 211,523  
     
 

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

SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS

      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.

      Total assets at June 30, 2004 and December 31, 2003 were $6.34 billion and $5.95 billion, respectively. This growth was the result of a favorable economy, the addition of new loan officers, the merger with Lone Star, and the Company’s overall growth strategy. In addition, the Company successfully completed during the period ending June 30, 2004 an aggressive marketing campaign designed to attract new loan and deposit customers. Gross loans were $4.01 billion at June 30, 2004, an increase of $421.6 million, or 12%, from $3.59 billion at December 31, 2003. Deposits increased to $4.78 billion at June 30, 2004 from $4.40 billion at December 31, 2003. As of June 30, 2004, approximately $145.8 million of loans and $212.4 million of deposits relate to the former Lone Star branches. Shareholders’ equity was $510.2 million and $499.3 million at June 30, 2004 and December 31, 2003, respectively.

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Table of Contents

      For the three months ended June 30, 2004, net income was $16.2 million ($0.23 per diluted common share) compared to $16.0 million ($0.23 per diluted common share) for the same period in 2003, an increase of 2%. For the six months ended June 30, 2004, net income was $31.5 million ($0.45 per diluted common share) compared to $31.0 million ($0.45 per diluted common share) for the same period in 2003, an increase of 2%. Return on average assets and return on average common shareholders’ equity for the three months ended June 30, 2004 was 1.06% and 12.66%, respectively, as compared to 1.25% and 13.60% for the three months ended June 30, 2003. For the six months ended June 30, 2004, return on average assets and return on average common shareholders’ equity was 1.04% and 12.35%, respectively, as compared to 1.24% and 13.54% for the six months ended June 30, 2003. 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.

      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 branches in Dallas and initiated the Company’s entry into the important Dallas/ Metroplex market. Additionally, in May 2004, the Company announced plans for a merger with Klein Bank. Completion of this transaction, which will result in the addition of 27 branches in Northwest Harris County and Montgomery County, is targeted for October 2004. The Company opened 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 June 30, 2004 was 3.99%, down from 4.09% for the three months ended June 30, 2003. For the six months ended June 30, 2004, net interest margin was 4.01%, a decrease from 4.10% at June 30, 2003. The decline in the net interest margin was due to lower yields on the loan portfolio and to lower yields realized on the securities portfolio reflecting the effects of declines in the level of interest rates as managed by the Federal Reserve Board. Declines in the 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 34% of total deposits for the three months ended June 30, 2004, as compared to 30% for the same period last year. For the six months ended June 30, 2004, demand deposits averaged 33% of total deposits, as compared to 30% for the same period last year.

      Noninterest income is an important component of the Company’s net income and comprises 30% of total revenue, defined as net interest income plus noninterest income, for the three and six months ended June 30, 2004. Noninterest income increased $3.4 million, or 17%, to $23.4 million for the three months ended June 30, 2004, compared to $20.1 for the same period in 2003. For the six months ended June 30, 2004, noninterest income increased $6.6 million, or 17%, to $45.9 million, as compared to $39.3 million for the same period last year. The primary drivers of the increase were continued growth in service charge income arising from the sale of treasury management products to commercial customers and the mergers with Maxim and Lone Star, 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.

      The growth in noninterest expenses was affected by the mergers with Maxim and Lone Star as well as the hiring of additional personnel and additional expenditures to support the Company’s growth. Noninterest expenses increased $10.7 million, or 26%, to $51.9 million for the three months ended June 30, 2004, compared to $41.2 million for the same period in 2003. For the six months ended June 30, 2004, noninterest expenses increased $22.5 million, or 28%, to $103.2 million, compared to $80.7 million for the same period last year. 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.

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      Credit quality is an area of importance to the Company and asset quality indicators remained positive in the second quarter of 2004. Net charge-offs were 0.38% of average loans compared to 0.35% for the same period in the prior year. For the six months ended June 30, 2004, net charge-offs were 0.14% of average loans compared to 0.25% for the same period in 2003. Nonperforming assets to total loans and other real estate was 0.61% at June 30, 2004, a decrease from 0.68% at June 30, 2003. The allowance for loan losses to nonperforming loans was 380.76% at June 30, 2004, compared to 204.70% at June 30, 2003. Although loans grew by 19% at June 30, 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 I Capital Ratio of 9.51% and Total Capital ratio of 10.39% were augmented by the issuance of $50.0 in trust preferred securities 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 Lone Star. 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 June 30, 2004 was $66.1 million, an increase of $7.3 million, or 12%, from the three months ended June 30, 2003. This increase in interest income is due to a $921,000 increase in average interest-earning assets to $5.54 billion for the three months ended June 30, 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 4.79% for the three months ended June 30, 2004, a decrease of 31 basis points when compared to the same period in 2003. For the six months ended June 30, 2004, interest income was $130.5 million, an increase of $14.4 million, or 12%, from the same period in 2003. This increase in interest income is due to a $898,000 increase in average interest-earning assets to $5.44 billion for the six months ended June 30, 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 4.83% for the six months ended June 30, 2004, a decrease of 33 basis points when compared to the same period in 2003.

      Interest income on loans increased $4.3 million to $51.3 million for the three months ended June 30, 2004. This increase resulted from a $568.4 million increase in average loans outstanding to $3.87 billion for the three months ended June 30, 2004, a 17% increase from the same period a year ago. This increase is partially offset by a 37 basis point decrease in the average yield on loans to 5.33% for the three months ended June 30, 2004, compared to 5.70% for the same period last year.

      For the six months ended June 30, 2004, interest income on loans was $100.9 million, an increase of $8.8 million, or 10%, from the same period a year ago. This increase was due to a $521.4 million increase in average loans outstanding to $3.79 billion for the six months ended June 30, 2004, a 16% increase from the same period a year ago. This increase is partially offset by a 33 basis point decrease in the average yield on loans to 5.36% for the six months ended June 30, 2004, compared to 5.69% for the same period last year.

      Interest income on securities increased $3.2 million to $14.7 million for the three months ended June 30, 2004. This increase was due to a $406.0 million increase in average securities outstanding to $1.63 billion for the three months ended June 30, 2004, a 33% increase from the same period a year ago. This increase is partially offset by a 15 basis point decrease in the average yield on securities to 3.62% for the three months ended June 30, 2004, compared to 3.77% for the same period last year.

      For the six months ended June 30, 2004, interest income on securities was $29.2 million, an increase of $5.8 million, or 25%, from the same period a year ago. This increase was due to a $401.8 million increase in average securities outstanding to $1.59 billion for the six months ended June 30, 2004, a 34% increase from the same period a year ago. This increase is partially offset by a 28 basis point decrease in the average yield on securities to 3.69% for the six months ended June 30, 2004, compared to 3.97% for the same period last year.

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Interest Expense

      Interest expense on deposits and borrowings for the three months ended June 30, 2004 was $11.1 million, a decrease of $517,000, or 4%, from the three months ended June 30, 2003. This decrease in interest expense was attributable to a decrease in the average rate on interest-bearing liabilities to 1.10% for the three months ended June 30, 2004, a decrease of 27 basis points when compared to the same period in 2003. This decrease is partially offset by a $654.7 million increase in average interest-bearing liabilities to $4.06 billion for the three months ended June 30, 2004, an increase of 19% from the same period last year.

      Interest expense on deposits and borrowings for the six months ended June 30, 2004 was $22.1 million, a decrease of $1.7 million, or 7%, from the six months ended June 30, 2003. This decrease in interest expense was attributable to a decrease in the average rate on interest-bearing liabilities to 1.10% for the six months ended June 30, 2004, a decrease of 32 basis points when compared to the same period in 2003. This decrease is partially offset by a $651.4 million increase in average interest-bearing liabilities to $4.02 billion for the six months ended June 30, 2004, an increase of 19% from the same period last year.

 
Net Interest Income

      Net interest income for the three months ended June 30, 2004 was $55.0 million compared to $47.2 million for the three months ended June 30, 2003, an increase of $7.8 million, or 17%. 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-earnings assets, primarily loans and securities, increased $920.5 million, or 20%, for the quarter ended June 30, 2004 when compared to the same period last year. This increase in interest-earning assets contributed $11.6 million to net interest income. The average rate on interest-bearing liabilities was 1.10% for the quarter ended June 30, 2004, a decrease of 27 basis points from 1.37% for the same period last year.

      For the three months ended June 30, 2004, the net interest margin, defined as annualized net interest income divided by average interest-earning assets, declined to 3.99%, compared to 4.09% for the three months ended June 30, 2003. This decrease resulted from a decrease in the yield on interest-earning assets of 31 basis points, from 5.10% for the three months ended June 30, 2003 to 4.79% for the three months ended June 30, 2004. This decrease in yield was partially offset by a decrease in the cost of funds of 27 basis points from 1.37% for the three months ended June 30, 2003 to 1.10% for the three months ended June 30, 2004.

      For the six months ended June 30, 2004, net interest income was $108.4 million, compared to $92.3 million for the same period last year, an increase of $16.1 million, or 17%. 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-earnings assets, primarily loans and securities, increased $897.8 million, or 20%, for the six months ended June 30, 2004 when compared to the same period last year. This increase in interest-earning assets contributed $22.4 million to net interest income. The average rate on interest-bearing liabilities was 1.10% for the six months ended June 30, 2004, a decrease of 32 basis points from 1.42% for the same period last year.

      For the six months ended June 30, 2004, the net interest margin declined to 4.01%, compared to 4.10% for the six months ended June 30, 2003. This decrease resulted from a decrease in the yield on interest-earning assets of 33 basis points, from 5.16% for the six months ended June 30, 2003 to 4.83% for the six months ended June 30, 2004. This decrease in yield was partially offset by a decrease in the cost of funds of 32 basis points from 1.42% for the six months ended June 30, 2003 to 1.10% for the six months ended June 30, 2004.

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      The following table presents for the period 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-earning 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 an 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 June 30,

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
  $ 3,873,174     $ 51,289       5.33 %   $ 3,304,819     $ 46,988       5.70 %
 
Securities
    1,628,789       14,678       3.62       1,222,798       11,489       3.77  
 
Federal funds sold and other
    42,375       119       1.13       96,204       284       1.18  
     
     
     
     
     
     
 
   
Total interest-earning assets
    5,544,338       66,086       4.79 %     4,623,821       58,761       5.10 %
             
     
             
     
 
Less allowance for loan losses
    (49,658 )                     (39,930 )                
     
                     
                 
      5,494,680                       4,583,891                  
Noninterest-earning assets
    686,900                       526,301                  
     
                     
                 
   
Total assets
  $ 6,181,580                     $ 5,110,192                  
     
                     
                 
 
Interest-bearing liabilities:
                                               
 
Money market and savings deposits
  $ 2,052,257       3,353       0.66 %   $ 1,810,986       4,035       0.89 %
 
Time deposits
    1,065,937       5,055       1.91       964,980       5,500       2.29  
 
Repurchase agreements and other borrowed funds
    940,165       2,660       1.14       627,729       2,050       1.31  
     
     
     
     
     
     
 
   
Total interest-bearing liabilities
    4,058,359       11,068       1.10 %     3,403,695       11,585       1.37 %
             
     
             
     
 
Noninterest-bearing liabilities:
                                               
 
Noninterest-bearing demand deposits
    1,574,075                       1,208,477                  
 
Other liabilities
    33,824                       27,349                  
     
                     
                 
   
Total liabilities
    5,666,258                       4,639,521                  
Shareholders’ equity
    515,322                       470,671                  
     
                     
                 
   
Total liabilities and shareholders’ equity
  $ 6,181,580                     $ 5,110,192                  
     
                     
                 
Net interest income
          $ 55,018                     $ 47,176          
             
                     
         
Net interest spread
                    3.69 %                     3.73 %
                     
                     
 
Net interest margin
                    3.99 %                     4.09 %
                     
                     
 

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Six Months Ended June 30,

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
  $ 3,785,214     $ 100,921       5.36 %   $ 3,263,820     $ 92,143       5.69 %
 
Securities
    1,592,290       29,227       3.69       1,190,491       23,440       3.97  
 
Federal funds sold and other
    58,481       308       1.06       83,829       491       1.18  
     
     
     
     
     
     
 
   
Total interest-earning assets
    5,435,985       130,456       4.83 %     4,538,140       116,074       5.16 %
             
     
             
     
 
Less allowance for loan losses
    (47,714 )                     (39,078 )                
     
                     
                 
      5,388,271                       4,499,062                  
Noninterest-earning assets
    716,284                       558,490                  
     
                     
                 
   
Total assets
  $ 6,104,555                     $ 5,057,552                  
     
                     
                 
 
Interest-bearing liabilities:
                                               
 
Money market and savings deposits
  $ 2,012,728       6,561       0.66 %   $ 1,772,488       8,327       0.95 %
 
Time deposits
    1,035,563       9,917       1.93       965,123       11,314       2.36  
 
Repurchase agreements and other borrowed funds
    974,197       5,592       1.15       633,512       4,176       1.33  
     
     
     
     
     
     
 
   
Total interest-bearing liabilities
    4,022,488       22,070       1.10 %     3,371,123       23,817       1.42 %
             
     
             
     
 
Noninterest-bearing liabilities:
                                               
 
Noninterest-bearing demand deposits
    1,532,569                       1,190,533                  
 
Other liabilities
    36,491                       33,799                  
     
                     
                 
   
Total liabilities
    5,591,548                       4,595,455                  
Shareholders’ equity
    513,007                       462,097                  
     
                     
                 
   
Total liabilities and shareholders’ equity
  $ 6,104,555                     $ 5,057,552                  
     
                     
                 
Net interest income
          $ 108,386                     $ 92,257          
             
                     
         
Net interest spread
                    3.73 %                     3.74 %
                     
                     
 
Net interest margin
                    4.01 %                     4.10 %
                     
                     
 

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      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 June 30, Six Months Ended June 30,
2004 vs. 2003 2004 vs. 2003
Increase (Decrease) Due to Increase (Decrease) Due to


Volume Rate Total Volume Rate Days Total







(Dollars in thousands)
Interest-earning assets:
                                                       
Loans
  $ 7,971     $ (3,669 )   $ 4,302     $ 14,671     $ (6,277 )   $ 384     $ 8,778  
Securities
    3,777       (588 )     3,189       7,908       (2,218 )     97       5,787  
Federal funds sold and other
    (159 )     (6 )     (165 )     (150 )     (35 )     2       (183 )
     
     
     
     
     
     
     
 
 
Total increase (decrease) in interest income
    11,589       (4,263 )     7,326       22,429       (8,530 )     483       14,382  
     
     
     
     
     
     
     
 
Interest-bearing liabilities:
                                                       
Money market and savings deposits
    533       (1,215 )     (682 )     1,129       (2,929 )     34       (1,766 )
Time deposits
    569       (1,014 )     (445 )     824       (2,268 )     47       (1,397 )
Repurchase agreements and borrowed funds
    1,014       (404 )     610       2,248       (849 )     17       1,416  
     
     
     
     
     
     
     
 
 
Total increase (decrease) in interest expense
    2,116       (2,633 )     (517 )     4,201       (6,046 )     98       (1,747 )
     
     
     
     
     
     
     
 
Increase (decrease) in net interest income
  $ 9,473     $ (1,630 )   $ 7,843     $ 18,228     $ (2,484 )   $ 385     $ 16,129  
     
     
     
     
     
     
     
 
 
Provision for Loan Losses

      The provision for loan losses was $3.0 million for each of the three months ended June 30, 2004 and June 30, 2003. The provision for loan losses was $5.0 million for the six months ended June 30, 2004 as compared to $6.0 million for the six months ended June 30, 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.”)

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Noninterest Income

      Noninterest income for the three months ended June 30, 2004 was $23.4 million, an increase of $3.4 million, or 17%, from $20.1 million during the comparable period in 2003. Noninterest income for the six months ended June 30, 2004 was $45.9 million, an increase of $6.6 million, or 17%, from $39.3 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 June 30, Six Months Ended June 30,


2004 2003 2004 2003




Bank Mortgage Combined Bank Mortgage Combined Bank Mortgage Combined Bank Mortgage Combined












(Dollars in thousands)
Service charges on deposit accounts
  $ 11,190     $     $ 11,190     $ 9,316     $     $ 9,316     $ 22,230     $     $ 22,230     $ 18,932     $     $ 18,932  
Investment services
    2,885             2,885       2,430             2,430       5,855             5,855       4,725             4,725  
Factoring fee income
    891             891       1,072             1,072       1,845             1,845       2,078             2,078  
Loan fee income
    768       709       1,477       667       1,049       1,716       1,421       1,331       2,752       1,079       1,780       2,859  
Bank-owned life insurance income
    1,906             1,906       1,195             1,195       3,397             3,397       2,385             2,385  
Letters of credit fee income
    1,006             1,006       656             656       1,868             1,868       1,178             1,178  
Mortgage servicing fees, net of amortization and impairment
          168       168             (922 )     (922 )           358       358             (1,241 )     (1,241 )
Gain on sale of loans, net
          712       712             1,146       1,146       65       1,224       1,289             2,246       2,246  
Gain on sale of securities, net
    (25 )           (25 )     1,115             1,115       1             1       1,150             1,150  
Other income
    2,906       333       3,239       2,054       301       2,355       5,842       466       6,308       4,481       538       5,019  
     
     
     
     
     
     
     
     
     
     
     
     
 
 
Total noninterest income
  $ 21,527     $ 1,922     $ 23,449     $ 18,505     $ 1,574     $ 20,079     $ 42,524     $ 3,379     $ 45,903     $ 36,008     $ 3,323     $ 39,331  
     
     
     
     
     
     
     
     
     
     
     
     
 

      Banking Segment. The largest component of noninterest income is service charges on deposit accounts, which were $11.2 million for the three months ended June 30, 2004, an increase of $1.9 million, or 20%, from $9.3 million for the same period last year. Service charges on deposit accounts were $22.2 million for the six months ended June 20, 2004, an increase of $3.3 million, or 17%, from $18.9 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 $739,000, or 17%, for the three months ended June 30, 2004, when compared to the same period last year. For the six months ended June 30, 2004, such charges were $10.4 million, an increase of $1.0 million, or 11%, from $9.4 million for the six months ended June 30, 2003. 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 fund charges on deposit accounts were $5.4 million for the three months ended June 30, 2004, an increase of $1.0 million, or 23%, from $4.4 million for the same period last year. For the six months ended June 30, 2004, net non-sufficient fund charges on deposit accounts were $10.4 million, an increase of $2.1 million, or 25%, from $8.4 million for the six months ended June 30, 2003. Additionally, the total number of deposit accounts grew from 166,259 at June 30, 2003 to 203,222 at June 30, 2004.

      Investment services income was $2.9 million for the three months ended June 30, 2004, an increase of $455,000, or 19%, from $2.4 million for the same period last year. For the six months ended June 30, 2004, investment services income was $5.9 million, an increase of $1.1 million, or 24%, from $4.7 million for the six

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months ended June 30, 2003. 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 June 30, 2004, an increase of $852,000, or 41%, from the same period last year. For the six months ended June 30, 2004, other income was $5.8 million, an increase of $1.4 million, or 30%, from $4.5 million for the six months ended June 30, 2003. This increase is primarily attributable to in increase in retail services fee income, primarily from debit card and ATM fees.

      Mortgage Segment. Gain on sale of loans, net, was $712,000 for the three months ended June 30, 2004, a decrease of $434,000, or 38%, from the same period last year. For the six months ended June 30, 2004, gain on sale of loans, net, was $1.2 million, a decrease of $1.0 million, or 46%, from $2.2 million for the six months ended June 30, 2003. This decrease is attributable to an increase in interest rates in the current year. 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 $168,000 for the three months ended June 30, 2004, an increase of $1.1 million when compared to ($922,000) for the same period last year. For the six months ended June 30, 2004, mortgage servicing fees, net of amortization and impairment, were $358,000, an increase of $1.6 million when compared to the same period last year. This increase in mortgage servicing fee income is attributable to a reduction in amortization of capitalized mortgage servicing costs. The mortgage industry experienced high levels of prepayment activity as a result of lower interest rates which resulted in increased amortization of capitalized mortgage servicing costs in 2003. 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 June 30, 2004 was $619,000, a decrease of $846,000, or 58%, from $1.5 million for the three months ended June 30, 2003. In addition, during the quarter ended June 30, 2003, the Company recognized a non-cash, pretax, write-down of the carrying value of the mortgage servicing asset of $234,000 in accordance with the quarterly revaluation of the capitalized mortgage servicing costs. For the six months ended June 30, 2004, amortization of capitalized mortgage servicing costs was $1.2 million, an decrease of $1.4 million, or 54%, when compared to $2.6 million for the same period last year. See “Note 4 — Mortgage Servicing Rights” for further discussion on the accounting for these assets.

 
Noninterest Expenses

      For the three months ended June 30, 2004, noninterest expenses were $51.9 million, an increase of $10.7 million, or 26%, from $41.2 million for the three months ended June 30, 2003. For the six months ended June 30, 2004, noninterest expenses totaled $103.2 million, an increase of $22.6 million, or 28%, from the same period in 2003. The increase in noninterest expenses was primarily due to salaries and employee benefits, occupancy expenses, merger-related costs, and core deposit intangible amortization expense. This increase was primarily due to the mergers with Maxim and Lone Star and the hiring of additional personnel and additional investments required to accommodate the Company’s growth.

      Salaries and employee benefits for the three months ended June 30, 2004 were $30.1 million, an increase of $6.0 million, or 25%, from the three months ended June 30, 2003. For the six months ended June 30, 2004, salaries and employee benefits were $59.3 million, an increase of $11.4 million, or 24%, from $47.9 million for the same period last year. Total full-time equivalent employees were 1,830 and 1,556 at June 30, 2004 and 2003, respectively.

      Occupancy expense for the three months ended June 30, 2004 was $8.9 million, an increase of $2.0 million, or 29%, from $6.9 million for the three months ended June 30, 2003. For the six months ended June 30, 2004, occupancy expense was $17.1 million, an increase of $3.8 million, or 28%, from $13.4 million for the six months ended June 30, 2003. Major categories within occupancy expense are depreciation expense and maintenance contract expense. Depreciation expense increased $723,000, or 25%, to $3.6 million for the three months ended June 30, 2004. For the six months ended June 30, 2004, depreciation expense was

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$7.0 million, an increase of $1.6 million, or 29%, from $5.5 million for the same period last year. Maintenance contract expense for the three months ended June 30, 2004 was $1.7 million, an increase of $412,000, or 33%, compared to $1.2 million for the same period last year. For the six months ended June 30, 2004, maintenance contract expense was $3.1 million, an increase of $734,000, or 31%, from $2.4 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 $1.2 million of merger-related expenses including contract termination fees and professional fees. In addition, the Company has recorded $1.9 million in core deposit intangible amortization expense in 2004 related to the Maxim and Lone Star mergers. No such charges were recorded in 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 June 30, 2004, the provision for income taxes was $7.4 million, an increase of $229,000, or 3%, from the $7.1 million provided for in the same period in 2003. For the six months ended June 30, 2004, the provision for income taxes was $14.5 million, an increase of $670,000, or 5%, from the $13.9 million provided for in the same period in 2003. The Company’s effective tax rate was 31% for the three months ended June 30, 2004 and 2003. For the six months ended June 30, 2004, the Company’s effective tax rate was 32% compared to 31% for the same period last year.

Financial Condition

 
Loans Held for Investment

      Loans held for investment were $3.91 billion at June 30, 2004, an increase of $420.5 million, or 12%, from $3.49 billion at December 31, 2003.

      The following table summarizes the loan portfolio of the Company by type of loan as of June 30, 2004 and December 31, 2003.

                                     
June 30, 2004 December 31, 2003


Amount Percent Amount Percent




(Dollars in thousands)
Commercial and industrial
  $ 1,703,414       43.54 %   $ 1,500,304       42.96 %
Real estate:
                               
 
Construction and land development
    725,983       18.56       706,546       20.24  
 
1-4 family residential
    589,800       15.08       567,009       16.24  
 
Commercial
    692,526       17.70       521,254       14.93  
 
Farmland
    12,935       0.33       11,140       0.32  
 
Other
    63,896       1.63       41,854       1.20  
Consumer
    123,658       3.16       143,566       4.11  
     
     
     
     
 
   
Total loans held for investment
  $ 3,912,212       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

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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 in the amount of the loan and hazard insurance equal to the replacement value of the dwelling. Although the contractual loan payment period 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 June 30, 2004 are summarized in the following table:

                                   
June 30, 2004

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




(Dollars in thousands)
Commercial and industrial
  $ 734,929     $ 827,633     $ 140,852     $ 1,703,414  
Real estate construction and land development
    380,816       329,651       15,516       725,983  
     
     
     
     
 
 
Total
  $ 1,115,745     $ 1,157,284     $ 156,368     $ 2,429,397  
     
     
     
     
 
Loans with a fixed interest rate
  $ 127,158     $ 254,462     $ 66,279     $ 447,899  
Loans with a floating interest rate
    988,587       902,822       90,089       1,981,498  
     
     
     
     
 
 
Total
  $ 1,115,745     $ 1,157,284     $ 156,368     $ 2,429,397  
     
     
     
     
 

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Loans Held for Sale

      Loans held for sale of $97.9 million at June 30, 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

      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 need 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 commitments to extend credit. Commitments to extend credit totaled $2.60 billion at June 30, 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 $291.7 million at June 30, 2004 and $227.0 million at December 31, 2003. As of June 30, 2004, and December 31, 2003, $503,000 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

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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 six month period ended June 30, 2004, annualized net charge-offs to average loans was 0.14%. The net charge-offs average for all FDIC insured commercial banks was 0.72% for the quarter ended March 31, 2004. 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, a general reserve, 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.

      The allowance for loan losses increased by $4.5 million from December 31, 2003 as a result of the increase in loans held for investment, net charge-offs of $2.6 million, the allowance for loan losses acquired

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through the merger with Lone Star and provision for loan losses of $5.0 million. At June 30, 2004, the allowance for loan losses was 380.76% of nonperforming loans, an increase from 337.53% at December 31, 2003.

      Management believes that the allowance for loan losses at June 30, 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 the future periods which could be greater than the size of the allowance as of June 30, 2004.

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

                                     
Three Months Ended Six Months Ended
June 30, June 30,


2004 2003 2004 2003




(Dollars in thousands)
Allowance for loan losses, beginning balance
  $ 48,071     $ 38,508     $ 43,008     $ 36,696  
Provision charged against operations
    3,000       3,000       5,000       6,000  
Charge-offs:
                               
 
Commercial and industrial
    (735 )     (176 )     (1,446 )     (656 )
 
Real estate:
                               
   
Construction and land development
                       
   
1-4 family residential
    (593 )     (23 )     (686 )     (23 )
   
Commercial
    (2,018 )     (568 )     (2,018 )     (568 )
   
Farmland
                       
   
Other
            (2,147 )           (2,741 )
 
Consumer
    (402 )     (140 )     (980 )     (385 )
     
     
     
     
 
Total charge-offs
    (3,748 )     (3,054 )     (5,130 )     (4,373 )
     
     
     
     
 
Recoveries:
                               
 
Commercial and industrial
    18       27       461       85  
 
Real estate:
                               
   
Construction and land development
                       
   
1-4 family residential
          21             48  
   
Commercial
                       
   
Farmland
                       
   
Other
                1,700        
 
Consumer
    151       221       337       267  
     
     
     
     
 
Total recoveries
    169       269       2,498       400  
     
     
     
     
 
Net charge-offs
    (3,579 )     (2,785 )     (2,632 )     (3,973 )
Allowance acquired through Lone Star merger
                2,116        
     
     
     
     
 
Allowance for loan losses, ending balance
  $ 47,492     $ 38,723     $ 47,492     $ 38,723  
     
     
     
     
 
Allowance to period-end loans
    1.21 %     1.18 %     1.21 %     1.18 %
Net charge-offs to average loans
    0.38 %     0.35 %     0.14 %     0.25 %
Allowance to period-end nonperforming loans
    380.76 %     204.70 %     380.76 %     204.70 %

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      The following table reflects the distribution of the allowance for loan losses among the 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.

                                     
June 30, 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
  $ 25,686       43.54 %   $ 25,388       42.96 %
 
Real estate:
                               
   
Construction and land development
    4,112       18.56       5,503       20.24  
   
1-4 family residential
    2,435       15.08       2,478       16.24  
   
Commercial
    9,912       17.70       5,179       14.93  
   
Farmland
    159       0.33       39       0.32  
   
Other
    2,810       1.63       2,465       1.20  
 
Consumer
    2,378       3.16       1,956       4.11  
     
     
     
     
 
   
Total allowance for loan losses
  $ 47,492       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 $23.9 million at June 30, 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 0.61% at June 30, 2004 and 0.49% at December 31, 2003. The increase in nonperforming asset is primarily due to the addition of one foreclosed commercial real estate property. Nonaccrual loans, the largest component of nonperforming assets, were $10.7 million at June 30, 2004, a decrease of $775,000 from $11.4 million at December 31, 2003.

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

                   
June 30, December 31,
2004 2003


(Dollars in thousands)
Nonaccrual loans
  $ 10,668     $ 11,443  
Accruing loans 90 or more days past due
    1,805       1,299  
Restructured loans
           
Other real estate and foreclosed property
    11,461       4,248  
     
     
 
 
Total nonperforming assets
  $ 23,934     $ 16,990  
     
     
 
Nonperforming assets to total loans and other real estate
    0.61 %     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 $333,000 and $605,000 for the six months ended June 30, 2004 and 2003, respectively.

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      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. The Company considers all nonaccrual loans to be impaired.

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

                   
June 30, December 31,
2004 2003


(Dollars in thousands)
Impaired loans with no SFAS No. 114 valuation reserve
  $ 12,539     $ 12,568  
Impaired loans with a SFAS No. 114 valuation reserve
    4,080       4,240  
     
     
 
 
Total recorded investment in impaired loans
  $ 16,619     $ 16,808  
     
     
 
Valuation allowance related to impaired loans
  $ 2,494     $ 2,768  
     
     
 

      The average recorded investment in impaired loans during the six months ended June 30, 2004 and the year ended December 31, 2003 was $16.7 million and $19.9 million, respectively. Interest income on impaired loans of $578,000 and $524,000 was recognized for cash payments received during the six months ended June 30, 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 June 30, 2004 and December 31, 2003.

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

                                                                     
June 30, 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
  $ 314,655     $ 113     $ (4,887 )   $ 309,881     $ 250,359     $ 841     $ (102 )   $ 251,098  
 
Mortgage-backed securities
    1,075,144       2,385       (23,813 )     1,053,716       1,101,988       7,078       (8,320 )     1,100,746  
 
Municipal securities
    229,598       3,253       (7,139 )     225,712       152,927       5,905       (754 )     158,078  
 
Federal Reserve Bank stock
    7,859                   7,859       4,459                   4,459  
 
Federal Home Loan Bank stock
    22,072                   22,072       25,469                   25,469  
 
Other securities
    5,282       18             5,300       9,455       93               9,548  
     
     
     
     
     
     
     
     
 
   
Total securities available for sale
  $ 1,654,610     $ 5,769     $ (35,839 )   $ 1,624,540     $ 1,544,657     $ 13,917     $ (9,176 )   $ 1,549,398  
     
     
     
     
     
     
     
     
 

      The following table displays the gross unrealized losses and fair value of investments as of June 30, 2004 that were in a continuous unrealized loss position for the periods indicated:

                                                     
Greater Than
Less Than 12 Months 12 Months Total



Fair Unrealized Fair Unrealized Fair Unrealized
Value Loss Value Loss Value Loss






(Dollars in thousands)
Available for sale:
                                               
 
U.S. Government and agency securities
  $ 274,924     $ (4,887 )   $     $     $ 274,924     $ (4,887 )
 
Mortgage-backed securities
    822,492       (21,594 )     66,874       (2,219 )     889,366       (23,813 )
 
Municipal securities
    123,131       (6,498 )     8,257       (641 )     131,388       (7,139 )
 
Federal Reserve Bank stock
                                   
 
Federal Home Loan Bank stock
                                   
 
Other securities
                                   
     
     
     
     
     
     
 
   
Total securities available for sale
  $ 1,220,547     $ (32,979 )   $ 75,131     $ (2,860 )   $ 1,295,678     $ (35,839 )
     
     
     
     
     
     
 

      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 and the Company’s intent and ability to hold the securities until their recovery, none of the unrealized loss on securities should be considered other than temporary.

      Securities were $1.62 billion at June 30, 2004, an increase of $75.1 million from $1.55 billion at December 31, 2003. The yield on the securities portfolio for the six months ended June 30, 2004 was 3.69% compared to 3.97% for the six months ended June 30, 2003.

      Included in the Company’s mortgage-backed securities at June 30, 2004 were agency issued collateral mortgage obligations with a book value of $66.5 million and a fair value of $65.5 million and non-agency issued collateral mortgage obligations with a book value of $34.2 million and a fair value of $33.8 million.

      At June 30, 2004, $689.1 million of the mortgage-backed securities held by the Company had final maturities of more than 10 years. At June 30, 2004, approximately $19.6 million of the Company’s mortgage-

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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 June 30, 2004. The yield on the securities portfolio is based on average historical cost balances and does not give effect to changes in the 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.

                                                                                   
June 30, 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
  $ 10,031       3.39 %   $ 299,620       3.25 %   $ 5,004       3.87 %   $       %   $ 314,655       3.26 %
Mortgage-backed securities
    166       5.67       43,048       4.16       342,846       3.96       689,084       3.76       1,075,144       3.84  
Municipal securities
    1,019       4.70       4,012       4.53       28,726       4.09       195,841       4.38       229,598       4.35  
Federal Reserve Bank stock
    7,859       6.00                                           7,859       6.00  
Federal Home Loan Bank stock
    22,072       1.50                                           22,072       1.50  
Other securities
    3,508       0.95       779       2.95       946       3.27       49       3.18       5,282       1.68  
Federal funds sold
    37,496       1.32                                           37,496       1.32  
Interest-bearing deposits
    8,116       1.26                                           8,116       1.26  
     
     
     
     
     
     
     
     
     
     
 
 
Total investments
  $ 90,267       2.03 %   $ 347,459       3.37 %   $ 377,522       3.97 %   $ 884,974       3.90 %   $ 1,700,222       3.71 %
     
     
     
     
     
     
     
     
     
     
 
 
Other Assets

      Other assets were $210.8 million at June 30, 2004, an increase of $17.3 million from $193.6 million at December 31, 2003. This increase is primarily attributable to an increase in the deferred income tax asset related to the unrealized loss on the investment portfolio recorded in the second quarter of 2004.

 
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 $139.1 million and $156.4 million of its deposits classified as brokered funds at June 30, 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 June 30, 2004 and December 31, 2003 were 33% and 31%, respectively.

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      The average daily balances and weighted average rates paid on deposits for the six months ended June 30, 2004 and the year ended December 31, 2003 are presented below:

                                   
June 30, 2004 December 31, 2003


Amount Rate Amount Rate




(Dollars in thousands)
Interest-bearing demand
  $ 65,724       0.41 %   $ 45,493       0.22 %
Regular savings
    139,815       0.26       115,211       0.33  
Premium yield
    967,278       0.77       847,045       0.96  
Money market savings
    839,911       0.61       827,816       0.80  
Time deposits less than $100,000
    280,692       2.39       283,670       2.67  
Time deposits $100,000 and over
    658,814       1.65       629,749       1.85  
IRA’s, QRP’s and other
    96,057       2.46       91,509       2.74  
     
     
     
     
 
Total interest-bearing deposits
    3,048,291       1.09 %     2,840,493       1.30 %
     
     
     
     
 
Noninterest-bearing deposits
    1,532,569               1,281,546          
     
             
         
 
Total deposits
  $ 4,580,860             $ 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:

                   
June 30, December 31,
2004 2003


(Dollars in thousands)
3 months or less
  $ 461,669     $ 417,384  
Between 3 months and 6 months
    95,998       60,101  
Between 6 months and 1 year
    99,921       78,948  
Over 1 year
    88,612       86,157  
     
     
 
 
Total time deposits $100,000 and over
  $ 746,200     $ 642,590  
     
     
 

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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 June 30, 2004 and December 31, 2003 is summarized as follows:

                   
June 30, December 31,
2004 2003


(Dollars in thousands)
Securities sold under repurchase agreements:
               
 
Average
  $ 381,409     $ 261,320  
 
Period-end
    518,719       285,571  
 
Maximum month-end balance during period
    518,719       303,764  
Interest rate:
               
 
Weighted average for the period
    0.73 %     0.88 %
 
Weighted average at period-end
    0.73 %     0.72 %
Short-term borrowings
               
 
Average
  $ 337,465     $ 276,193  
 
Period-end
    350,962       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
    1.22 %     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 my 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.

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      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 June 30, 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 June 30, 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 to 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:
                                       
   
June 30, 2004
    (0.66 )%     0.63 %     0.00 %     1.17 %     2.93 %
   
December 31, 2003
    (1.20 )%     0.25 %     0.00 %     1.23 %     3.33 %
 
Months 13 to 24:
                                       
   
June 30, 2004
    (2.96 )%     (0.42 )%     0.00 %     3.00 %     6.05 %
   
December 31, 2003
    (4.37 )%     (1.43 )%     0.00 %     3.37 %     6.65 %
Impact on market value of portfolio equity:
                                       
   
June 30, 2004
    (0.08 )%     0.61 %     0.00 %     (1.02 )%     (1.76 )%
   
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 condition, 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 June 30, 2004 was a positive $457.9 million, or 7.22%, of total 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.

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      The following table sets forth an interest rate sensitivity analysis for the Company as of June 30, 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)
Cash and due from banks
  $     $     $     $     $     $ 270,551     $ 270,551  
Federal funds sold and other cash equivalents
    45,612                         45,612             45,612  
Securities
    40,265       91,707       346,484       1,146,084       1,624,540             1,624,540  
Loans
    2,345,555       515,059       683,185       455,674       3,999,473       10,668       4,010,141  
Allowance for loan losses
                                  (47,492 )     (47,492 )
Other assets
                                  438,090       438,090  
     
     
     
     
     
     
     
 
 
Total assets
  $ 2,431,432     $ 606,766     $ 1,029,669     $ 1,601,758     $ 5,669,625     $ 671,817     $ 6,341,442  
     
     
     
     
     
     
     
 
Deposits
  $ 952,222     $ 719,294     $ 605,853     $ 880,452     $ 3,157,821     $ 1,622,348     $ 4,780,169  
Securities sold under repurchase agreements and other borrowings
    969,792       2,350       1,040       7,137       980,319             980,319  
Junior subordinated deferrable interest debentures
    51,547                         51,547             51,547  
Other liabilities
                                  19,227       19,227  
Shareholders’ equity
                                  510,180       510,180  
     
     
     
     
     
     
     
 
 
Total liabilities and shareholders’ equity
  $ 1,973,561     $ 721,644     $ 606,893     $ 887,589     $ 4,189,687     $ 2,151,755     $ 6,341,442  
     
     
     
     
     
     
     
 
Period GAP
  $ 457,871     $ (114,878 )   $ 422,776     $ 714,169     $ 1,479,938                  
Cumulative GAP
  $ 457,871     $ 342,993     $ 765,769     $ 1,479,938     $ 1,479,938                  
Period GAP to total assets
    7.22 %     (1.81 )%     6.67 %     11.26 %     23.34 %                
Cumulative GAP to total assets
    7.22 %     5.41 %     12.08 %     23.34 %     23.34 %                
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. The Bank has a credit facility established with the Federal Reserve Bank for contingency funding purposes.

      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

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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 70% of total interest-earning assets for the six months ended June 30, 2004 and 73% for the same period in 2003.

      A component of the Company’s growth strategy has been to diversify its sources of funding through mergers with banks that possess a preponderance of stable core deposits, primarily from retail customers. The pending merger with Klein Bancshares, Inc. will add approximately $540.0 million in low cost deposits. 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 June 30, 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 June 30, 2004
                                               
 
Total Capital (to Risk Weighted Assets):
                                               
   
The Company
  $ 564,643       10.39 %   $ 434,852       8.00 %   $ 543,565       10.00 %
   
The Bank
    556,292       10.25       434,218       8.00       542,773       10.00  
 
Tier 1 Capital (to Risk Weighted Assets):
                                               
   
The Company
    517,151       9.51       217,426       4.00       326,139       6.00  
   
The Bank
    508,191       9.36       217,109       4.00       325,664       6.00  
 
Tier 1 Capital (to Average Assets):
                                               
   
The Company
    517,151       8.45       244,739       4.00 (1)     305,924       5.00  
   
The Bank
    508,191       8.31       244,625       4.00 (1)     305,781       5.00  
As of December 31, 2003
                                               
 
Total Capital (to Risk Weighted Assets):
                                               
   
The Company
    558,858       11.90       375,630       8.00       469,537       10.00  
   
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       375,630       6.00  
   
The Bank
    461,438       9.84       187,566       4.00       375,132       6.00  
 
Tier 1 Capital (to Average Assets):
                                               
   
The Company
    515,850       9.15       169,086       4.00 (1)     281,810       5.00  
   
The Bank
    461,438       8.20       168,917       4.00 (1)     281,529       5.00  


(1)  The Tier 1 leverage ratio consists of Tier 1 capital divided by quarterly average total assets, excluding goodwill and certain other items. The minimum leverage ratio guideline is 3% for banking organizations that do not anticipate significant growth and that have well-diversified risk, excellent asset quality, high liquidity, good earnings, effective management and monitoring of market risk and, in general, are considered top-rated, strong banking organizations.

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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 asset 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 that 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 increase 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.

      Goodwill is recorded for the excess of the purchase price over the fair value of identifiable net assets, including core deposit intangibles, acquired through a merger transaction. Goodwill is not amortized, but instead is tested for impairment at least annually using both a discounted cash flow analysis and a review of the valuation of recent bank acquisitions. The discounted cash flow analysis utilizes a risk-free interest rate, estimates of future cash flows and probabilities as to the occurrence of the future cash flows. The Company utilizes its budgets and projections of future operations based upon historical and expected industry trends to estimate future cash flows and the probability of their occurring as projected. 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 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 loans repayment rates, credit loss experience, and costs to service, as well as discount rates that consider the risk involved. Because the values of these assets are sensitive to change 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.

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      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 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 requirements of SAB No. 105 did not have a material impact on the financial condition or results of operations of the Company.

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 Executive and 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.

      In connection with our normal internal auditing process, the Company has identified certain significant deficiencies in the design of the control framework in the Company’s bank dealer division responsible for the purchase and sale of securities for customers. These design deficiencies generally related to the number of persons having access to certain of our information systems, segregation of duties, and reconciliations of processing accounts. The Company has concluded that, in the aggregate, these deficiencies constituted a material control weakness, and has performed substantial analytical and post closing procedures as a result of these design deficiencies. Based on the Company’s compensating controls and testing, management has concluded that these design deficiencies did not result in any material errors in the Company’s financial statements. The Company has substantially completed the process of correcting these design deficiencies and has implemented changes to its control environment. Other than correcting the material control weakness identified above, there were no other changes in the Company’s internal controls over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 that have materially affected, or are reasonably likely to materially affect, the internal controls over financial reporting.

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      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 June 30, 2004 and concluded that those disclosure controls and procedures are effective.


      With respect to the unaudited financial information of Southwest Bancorporation of Texas, Inc. for the three and six month periods ended June 30, 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 July 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.

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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





April, 2004
                       
May, 2004
                       
June, 2004
    210     $ 21.95              


(1) Shares were received in lieu of cash as a payment for a federal income tax obligation which arose from a restricted stock award.

ITEM 3.  Defaults upon Senior Securities

      None.

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

(a)  The Company’s Annual Meeting of Shareholders (the “Annual Meeting”) was held on May 5, 2004.
 
(b)  The following Class II directors were elected for a three-year term at the Annual Meeting: Ernest H. Cockrell, Fred R. Lummis, Paul B. Murphy, Jr. and Thomas F. Soriero, Sr.. The following Class I and III directors also continued in office after the Annual Meeting: Carin M. Barth, John B. Brock III, J. David Heaney, Paul W. Hobby, John W. Johnson, Walter E. Johnson, Barry M. Lewis, Andres Palandjoglou, Wilhelmina E. Robertson, and Stanley D. Stearns, Jr.. No votes were cast against any of the directors. The votes cast for and withheld for each director were as follows:

                 
Director For Withheld



Ernest H. Cockrell
    58,573,726       667,786  
Fred R. Lummis
    58,555,380       686,132  
Paul B. Murphy, Jr. 
    58,575,708       665,804  
Thomas F. Soriero, Sr. 
    58,576,300       665,212  

(c)  At the Annual Meeting, the Company also approved amendments to the Company’s Non-Employee Directors Deferred Fee Plan. A total of 49,698,232 votes were cast in favor of such proposal with 599,034 votes cast against the proposal, 150,782 votes abstaining from voting on the proposal and 8,793,464 votes not voting on the proposal.
 
(d)  At the Annual Meeting, the Company also approved the adoption of the 2004 Omnibus Incentive Plan. A total of 43,984,098 votes were cast in favor of such proposal with 6,401,772 votes cast against the proposal, 62,176 votes abstaining from voting on the proposal and 8,793,466 votes not voting on the proposal.
 
(e)  At the Annual Meeting, the Company also ratified the selection of PricewaterhouseCoopers LLP, as the Company’s independent auditors for the year ending December 31, 2004. A total of 57,992,190 votes were cast in favor of such proposal with 1,230,982 votes cast against the proposal and 18,340 votes abstaining from voting on the proposal.

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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:

      Four reports on Form 8-K were filed or furnished by the Company during the three months ended June 30, 2004:

   i.) A Current Report on Form 8-K dated April 19, 2004 was furnished on April 20, 2004; Item 7(c) and Item 12, reporting earnings results for the first fiscal quarter of 2004.
 
   ii.) A Current Report on Form 8-K dated May 12, 2004 was furnished on May 12, 2004; Item 7(c), Item 9 and Item 12, regarding presentation of certain data to investors.
 
  iii.) A Current Report on Form 8-K dated May 20, 2004 was furnished on May 20, 2004; Item 5, Item 7(c) and Item 9, announcing the signing of a definitive merger agreement with Klein Bancshares, Inc.
 
   iv.) A Current Report on Form 8-K dated June 17, 2004 was filed on June 18, 2004; Item 5 and Item 7(c), announcing a one-for-one stock split to be effected in the form of a 100% stock dividend.


* Filed herewith

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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)
  August 9, 2004
 
/s/ RANDALL E. MEYER

Randall E. Meyer
  Executive Vice President
and Chief Financial Officer
(Principal Financial Officer)
  August 9, 2004
 
/s/ SCOTT J. MCLEAN

Scott J. McLean
  President   August 9, 2004
 
/s/ LAURENCE L. LEHMAN III

Laurence L. Lehman III
  Senior Vice President and Controller
(Principal Accounting Officer)
  August 9, 2004

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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