UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

Commission file number:  000-50518

Franklin Bank Corp.

Registrant’s telephone number, including area code:
(713) 339-8900

Securities registered pursuant to Section 12(b) of the Act:
None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.01 Par Value,
(Title of each class)

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

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [  ] No [X]

     As of November 11, 2004, there were 21,225,263 shares of the registrant’s common stock, $.01 par value, outstanding.

FRANKLIN BANK CORP.
INDEX TO FORM 10-Q

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

FRANKLIN BANK CORP.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)

See notes to interim consolidated financial statements.

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FRANKLIN BANK CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share data)
(unaudited)

See notes to consolidated interim financial statements.

2

FRANKLIN BANK CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)

See notes to consolidated interim financial statements.

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FRANKLIN BANK CORP.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004
(unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying Consolidated Financial Statements are unaudited and include the accounts of Franklin Bank Corp. (the “company”), a subsidiary of the company, and Franklin Bank (the “bank”) and have been prepared in accordance with accounting principles generally accepted in the United States of America. The information included in these interim financial statements reflects all adjustments that are, in the opinion of management, necessary for a fair presentation of all periods presented. Such adjustments are of a normal recurring nature unless otherwise disclosed in the Form 10-Q. Operating results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the entire year or any interim period. The interim financial information should be read in conjunction with Franklin Bank Corp’s 2003 Annual Report on Form 10-K. Certain prior period amounts have been reclassified to conform to the current period presentation and had no effect on net income or stockholders’ equity.

Recent accounting standards

In December 2003, the Accounting Standards Executive Committee of the AICPA issued Statement of Position No. 03-3 (“SOP 03-3”), Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 addresses the accounting for differences between the contractual cash flows and the cash flows expected to be collected from purchased loans or debt securities if those differences are attributable, in part, to credit quality. SOP 03-3 requires purchased loans and debt securities to be recorded initially at fair value based on the present value of the cash flows expected to be collected with no carryover of any valuation allowance previously recognized by the seller. Interest income should be recognized based on the effective yield from the cash flows expected to be collected. To the extent that the purchased loans experience subsequent deterioration in credit quality, a valuation allowance would be established for any additional cash flows that are not expected to be received. However, if more cash flows subsequently are expected to be received than originally estimated, the effective yield would be adjusted on a prospective basis. SOP 03-3 will be effective for loans and debt securities acquired after December 31, 2004. The company does not expect the requirements of SOP 03-3 to have a material impact on its financial condition, results of operations or cash flows.

In March 2004, SEC Staff Accounting Bulletin (SAB) No. 105, Application of Accounting Principles to Loan Commitments (“SAB 105”) was issued, which addresses the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments. SAB 105 provides that the fair value of recorded loan commitments to be held for sale that are accounted for as derivatives should not incorporate the expected future cash flows related to the associated servicing of the future loan. In addition, SAB 105 requires registrants to disclose their accounting policy for loan commitments. The provisions of SAB 105 must be applied to loan commitments accounted for as derivatives that are entered into after March 31, 2004. The company measures the fair value of interest rate lock commitments based on the estimated fair value of the underlying mortgage loans, including the value of the servicing, when selling the loans with the servicing in the same transaction to the same party. When the loans are sold and the servicing is retained by the company, the fair value of the interest rate lock commitments is based on the estimated fair value of the underlying mortgages, excluding the value of the servicing. SAB 105 did not have a material impact on the company’s Consolidated Financial Statements.

In March 2004, the Emerging Issues Task Force reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. This Issue provides guidance for determining when an investment is other-than-temporarily impaired. This Issue specifically addresses whether an investor has the ability and intent to hold an investment until recovery. In addition, Issue 03-1 contains disclosure requirements that provide useful information about impairments that have not been recognized as other-than-temporary for investments within the scope of this Issue. On September 30, 2004, the Financial Accounting Standards Board deferred the effective date of this Issue’s guidance on how to evaluate and recognize an impairment loss that is other-than-temporary. This Issue’s guidance is pending the issuance of a final FASB Staff Position (“FSP”) relating to the draft FSP EITF Issue 03-1-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” This deferral did not change the disclosure guidance which remains effective for fiscal years ending after December 15, 2003.

Stock—Based Compensation

     The company measures its employee stock-based compensation using the intrinsic value based method of accounting under the provisions of AICPA Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, no compensation cost has been recognized for the company’s stock options. Pro-forma information regarding net income is required under SFAS No. 123, “Accounting for Stock-Based Compensation” and has been determined as if the company accounted for its employee stock-option plans under the fair value method of SFAS No. 123. The fair value of options at the date of grant was estimated using a Black-Scholes option-pricing model, which requires use of highly subjective assumptions. Also, employee stock options have characteristics that are significantly different from those of traded options, including vesting provisions and trading limitations that impact their liquidity. Because employee stock options have differing characteristics, and changes in the subjective input assumptions can materially affect the fair- value estimate, the Black-Scholes valuation model does not necessarily provide a reliable measure of the fair value of the employee stock options. The following table shows the pro forma amounts attributable to stock-based employee compensation cost for the periods presented (dollars in thousands except per share data):

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     Basic and diluted earnings per common share (“EPS”) were computed as follows (dollars in thousands, except per share data):

     Options to purchase 293,505 and 240,700 shares of common stock at exercise prices of $10.00 and $12.00, respectively, were excluded from the computation of diluted EPS for the three and nine months ended September 30, 2003, because the options’ exercise prices were greater than the fair market value of the common stock.

3. Goodwill and Intangible Assets

     The changes in the carrying amount of goodwill for the year ended December 31, 2003 and the nine months ended September 30, 2004 are as follows (in thousands):

     Intangible assets other than goodwill include core deposit premiums paid and mortgage servicing rights. The changes in other intangible assets are as follows (in thousands):

     During the first quarter of 2003 certain estimates regarding goodwill related to the acquisition of Franklin Bank were finalized and the core deposit intangible study based on the actual deposit accounts acquired was finalized. The study valued the core deposit intangible at $204,000 as compared to the estimated valuation of $1.6 million at acquisition, which was based on the asset and liability tables for the first quarter of 2002 as published by the Office of Thrift Supervision. As a result, $237,000 of amortization recorded in 2002 was reversed in 2003.

     At September 30, 2004 and December 31, 2003, the fair value of servicing rights retained from single family loan sales totaled $2.0 million and $1.1 million related to $151.9 million and $117.8 million, respectively, of principal serviced for others. The bank did not securitize any financial assets during the nine months ended September 30, 2004 or the year ended December 31, 2003.

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

Cautionary Note Regarding Forward Looking Information

     A number of the presentations and disclosures in this report, including any statements preceded by, followed by or which include the words “may,” “could,” “should,” “will,” “would,” “hope,” “might,” “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “assume” or similar expressions constitute forward-looking statements. These forward-looking statements, implicitly and explicitly, include information concerning possible or assumed future results of operations, trends, financial results and business plans, including those relating to:

•

earnings growth;

•

revenue growth;

•

future acquisitions;

•

origination volume in our mortgage business;

•

non-interest income levels, including fees from product sales;

•

credit performance on loans made or acquired by us;

•

tangible capital generation;

•

margins on sales or securitizations of loans;

•

cost and mix of deposits;

•

market share;

•

expense levels;

•

results from new business initiatives in our community banking business; and

•

other business operations and strategies.

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     Forward-looking statements involve inherent risks and uncertainties that are subject to change based on various important factors, some of which are beyond our control. We caution you that a number of important factors could cause actual results to differ materially from those contained in any forward-looking statement. Such factors include, but are not limited to:

	•		risks and uncertainties related to acquisitions and divestitures, including related integration and restructuring activities, and changes in our mix of product offerings;
	•		prevailing economic conditions;

•

changes in interest rates, loan demand, real estate values, and competition, which can materially affect origination levels and gains on sale results in our mortgage business, as well as other aspects of our financial performance;

•

the level of defaults, losses and prepayments on loans made by us, whether held in portfolio, sold in the whole loan secondary markets or securitized, which can materially affect charge-off levels, credit loss reserve levels and our periodic valuation of our retained interests from securitizations we may engage in;

•

changes in accounting principles, policies and guidelines;

•

adverse changes or conditions in capital or financial markets, which can adversely affect our ability to sell or securitize loan originations on a timely basis or at prices which are acceptable to us, as well as other aspects of our financial performance;

•

actions by rating agencies and the effects of these actions on our businesses, operations and funding requirements;

•

changes in applicable laws, rules, regulations or practices with respect to accounting, tax and legal issues, whether of general applicability or specific to us and our subsidiaries; and

•

other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services.

     In addition, we regularly explore opportunities for acquisitions of, and hold discussions with, financial institutions and related businesses, and also regularly explore opportunities for acquisitions of liabilities and assets of financial institutions and other financial services providers. Discussions regarding potential acquisitions may be commenced at any time, may proceed rapidly and agreements may be concluded and announced at any time. Any potential acquisition, and any combination of potential acquisitions, may be material in size relative to our existing assets and operations. We routinely analyze our lines of business and from time to time may increase, decrease or terminate one or more activities.

     If one or more of the factors affecting our forward-looking information and statements proves incorrect, then our actual results, performance or achievements could differ materially from those expressed in, or implied by, the forward-looking information and statements contained in this report. Therefore, we caution you not to place undue reliance on our forward-looking information and statements. The forward-looking statements are made as of the date of this report, and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those projected in the forward-looking statements. All forward-looking statements contained in this report are expressly qualified by these cautionary statements.

Critical Accounting Policies

     Certain of the company’s accounting policies, by their nature, involve a significant amount of subjective and complex judgment by our management. These policies relate to our allowance for credit losses, rate lock commitments and goodwill and other intangible assets. We believe that our estimates, judgments and assumptions are reasonable given the circumstances existing at the time such estimates, judgements and assumptions are made. However, actual results could differ significantly from these estimates and assumptions, which could have a material impact on our

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     Non-interest income increased $5.2 million to $8.9 million for the nine months ended September 30, 2004, compared to $3.7 million for the same period a year ago. This increase was primarily due to the expansion of our mortgage banking activities, the acquisitions of Highland, Jacksonville and Lost Pines and the overall growth of the company.

     Gains on sales of single family loans increased $1.8 million during the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003. We originate loans through our retail and wholesale mortgage offices with the intention of selling the majority of loans originated, including the related servicing. During the nine months ended September 30, 2004, we sold $439.2 million of single family loans, resulting in a gain of $3.2 million. Loans sold totaling $208.7 million were from our held for investment portfolio to reduce the extension risk of the duration in this portfolio, to reduce our exposure in California and to reduce the overall size of the portfolio. Sales during the nine months ended September 30, 2003, totaled $103.8 million for a gain of $1.4 million. The increase in sales was due to an increase in average originations per branch as well as an increase in the number of branches. At September 30, 2004, we had 59 retail and wholesale mortgage origination offices, up from 33 at September 30, 2003.

     Loan fee income increased $1.9 million during the nine months ended September 30, 2004, to $2.9 million, from $1.0 million for the nine months ended September 30, 2003. This increase is related to mortgage broker fee income earned on loans originated by us in the name of other institutions. Mortgage broker fees totaled $2.5 million for the nine months ended September 30, 2004, compared to $649,000 for the same period a year ago.

     Deposit fees increased $1.7 million during the nine months ended September 30, 2004, to $1.8 million, up from $127,000 during the nine months ended September 30, 2003. This increase was related to service charges on checking accounts, overdraft fees and fees charged for other banking related services and was directly related to an increase in the number of checking accounts from approximately 2,500 at September 30, 2003 to approximately 15,000 at September 30, 2004. The increase in the number of checking accounts was due to the acquisitions of Jacksonville on December 30, 2003 and Lost Pines on February 29, 2004.

     Gains on sales of securities were $185,000 related to the sale of $22.3 million of securities during the nine months ended September 30, 2004. This compares to a gain of $860,000 related of sales of $45.2 million of securities in the corresponding prior year period. All of the securities sold during the nine months ended September 30, 2004 came from the Jacksonville acquisition.

     The increase in other non-interest income totaling $589,000 includes the reversal of the credit mark on a loan acquired in the Franklin acquisition which was paid in full during the nine months ended September 30, 2004. The acquisition of Highland added $176,000 related to ancillary income on other customer services provided and income earned on owned properties and other sources during the current period.

Non-interest expense. Non-interest expense is comprised of the following (in thousands):

     Non-interest expense increased $18.5 million during the nine months ended September 30, 2004, to $28.6 million, compared to $10.1 million for the nine months ended September 30, 2003. The increase in non-interest expense is due to the acquisitions of Jacksonville, Highland and Lost Pines and the overall growth of the company.

     Salaries and benefits increased $9.5 million during the nine months ended September 30, 2004, to $13.9 million, from $4.4 million during the same period a year ago. This increase was due to the acquisitions of Jacksonville, Highland and Lost Pines, as well as the overall growth of the company. The number of full time equivalent employees at September 30, 2004 totaled 493, as compared to 261 at September 30, 2003. The increase in headcount includes 72 from our mortgage production offices and 119 from the Jacksonville and Lost Pines acquisitions.

     Occupancy expense increased $1.6 million during the nine months ended September 30, 2004, to $2.7 million, from 1.1 million during the same period a year ago. The increase in occupancy expense is due to the acquisitions of Jacksonville, Highland and Lost Pines, which added nine, one and two community banking branches, respectively. Additionally, we expanded our corporate office in Houston, Texas, added a community banking branch in Austin, Texas and added two residential construction lending offices in 2003, and expanded our mortgage banking business, increasing the number of retail and wholesale offices from 33 at September 30, 2003 to 59 at September 30, 2004.

     Data processing expense increased $1.8 million during the nine months ended September 30, 2004, to $2.6 million, from $846,000 during the nine months ended September 30, 2003. The increase in data processing expense represents the increase in outsourced data processing services and depreciation on computer hardware and software incurred to support our expansion and growth and due to the acquisition and conversion of Jacksonville.

     Professional fees increased $848,000 during the nine months ended September 30, 2004, to $2.6 million, from $1.7 million during the nine months ended September 30, 2003. The increase in professional fees primarily relates to higher audit fees resulting from increased services, including compliance with the Sarbanes-Oxley Act of 2002, required since the company became public at the end of 2003. Additionally, legal fees have increased due to a lawsuit relating to construction lending activities that occurred prior to our acquisition of Franklin.

     Loan expense increased $972,000 to $1.5 million for the nine months ended September 30, 2004, compared to $538,000 for the nine months ended September 30, 2003. The increase in loan expense is due to an increase in mortgage banking activity from purchases and sales of single family loans during the current period as compared to the prior year period. An increase in residential construction loan originations also contributed to the increase in loan expense.

     Other non-interest expense increased $3.3 million during the nine months ended September 30, 2004, to $5.0 million, from $1.7 million during the nine months ended September 30, 2003. This increase represents costs incurred to support our growth and expansion, including higher marketing, insurance, office supplies and postage and courier expenses, as well as increased costs related to our acquisitions of Jacksonville, Highland and Lost Pines.

THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2003

     Net income was $6.5 million, or $0.30 per diluted share, for the three months ended September 30, 2004, compared to $1.8 million, or $0.17 per share, for the three months ended September 30, 2003.

     Net interest income. Net interest income increased $11.6 million to $17.0 million for the three months ended September 30, 2004, compared to $5.4 million for the same period in 2003. The increase was due to a $1.9 billion increase in average interest-earning assets, resulting primarily from purchases and originations of single family loans, an increase in residential construction loans and the acquisition of Jacksonville. The net yield increased 40 basis points, from 1.78% for the three months ended September 30, 2003 to 2.18% for the three months ended September 30, 2004. This increase was primarily due to the acquisition of Jacksonville, an increase in commercial and consumer loans, and higher yields on our single family mortgage portfolio.

     The table below illustrates the company’s average balances and related income, expense, and weighted average yields and rates for the three months ended September 30, 2004 and 2003. Balances for both periods

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     Gains on sales of single family loans increased $1.3 million during the three months ended September 30, 2004 as compared to the three months ended September 30, 2003. This increase was due to an increase in mortgage banking activity. During the three months ended September 30, 2004, we sold $290.7 million of single family loans, resulting in a gain of $1.9 million. Loans sold totaling $208.7 million were from our held for investment portfolio to reduce the extension risk of the duration in this portfolio, to reduce our exposure in California and to reduce the overall size of the portfolio. During the three months ended September 30, 2003, we sold $62.0 million of single family loans for a gain of $602,000.

     Loan fee income increased $581,000 during the three months ended September 30, 2004, to $1.3 million, from $716,000 for the three months ended September 30, 2003. This increase relates to mortgage broker fee income earned on loans originated by us in the name of other institutions. Mortgage broker fees totaled $1.2 million during the three months ended September 30, 2004, compared to $387,000 during the same period a year ago.

     Deposit fees increased $580,000 during the three months ended September 30, 2004, to $628,000, up from $48,000 during the three months ended September 30, 2003. This increase was related to service charges on checking accounts, overdraft fees and fees charged for other banking related services and was directly related to an increase in the number of checking accounts from approximately 2,500 at September 30, 2003 to approximately 15,000 at September 30, 2004. The increase in the number of checking accounts was due to the Jacksonville and Lost Pines acquisitions.

     Gains on sales of securities were $72,000 related to the sale of $3.9 million of securities during the three months ended September 30, 2004. During the three months ended September 30, 2003, gains on sales of securities were $247,000 related to the sale of $26.3 million of securities.

Non-interest expense. Non-interest expense is comprised of the following (in thousands):

     Non-interest expense increased $6.2 million during the three months ended September 30, 2004, to $10.4 million, compared to $4.2 million for the three months ended September 30, 2003. The increase in non-interest expense is due to the acquisitions of Jacksonville and Lost Pines and due to the overall growth of the company.

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     Salaries and benefits increased $3.6 million during the three months ended September 30, 2004, to $5.0 million, from $1.4 million during the year ago period. This increase was due to the acquisitions of Jacksonville and Lost Pines, and due to the hiring of employees to manage and support our growth. The number of full time equivalent employees at September 30, 2004 totaled 493, as compared to 261 at September 30, 2003. The increase in headcount includes 72 from our mortgage production offices and 119 from the Jacksonville and Lost Pines acquisitions.

     Occupancy expense increased $378,000 during the three months ended September 30, 2004, to $900,000, from $522,000 for the three months ended September 30, 2003. The increase in occupancy expense was due to the acquisitions of Jacksonville and Lost Pines, which added nine and two community banking branches, respectively. Additionally, we expanded our mortgage banking business, increasing the number of retail and wholesale mortgage origination offices from 33 at September 30, 2003, to 59 at September 30, 2004.

     Professional fees increased $420,000 during the three months ended September 30, 2004, to $994,000, from $574,000 during the three months ended September 30, 2003. The increase in professional fees primarily relates to higher audit fees resulting from increased services required, including compliance with the Sarbanes-Oxley Act of 2002, since the company became public at the end of 2003. Additionally, legal fees have increased due to a lawsuit relating to construction lending activity that occurred prior to our acquisition of Franklin.

     Data processing expense increased $581,000 during the three months ended September 30, 2004, to $1.0 million, from $434,000 during the three months ended September 30, 2003. The increase in data processing expense represents the increase in outsourced data processing services and depreciation on computer hardware and software incurred to support our expansion and growth and due to the conversion of Jacksonville to our platform during the previous quarter.

     Loan expense increased $273,000 to $695,000 for the three months ended September 30, 2004, compared to $422,000 for the three months ended September 30, 2003. The increase in loan expense is due to an increase in mortgage banking activity from purchases and sales of single family loans during the current period as compared to the prior year period. An increase in residential construction loan originations also contributed to the increase in loan expense.

     Other non-interest expense increased $809,000 million during the three months ended September 30, 2004, to $1.6 million, from $811,000 during the three months ended September 30, 2003. This increase represents costs incurred to support our growth and expansion, including higher marketing, insurance, office supplies and postage and courier expenses, as well as increased costs related to our acquisitions of Jacksonville and Lost Pines.

Financial Condition

General. Total assets increased $1.0 billion to $3.3 billion at September 30, 2004, from $2.3 billion at December 31, 2003. The increase in assets was primarily attributable to purchases and originations of single family loans, new residential construction loans, growth in the mortgage banker finance portfolio, and the acquisition of Lost Pines, which added approximately $39.9 million in assets.

Investment Portfolio. The following table sets forth the composition and fair value of our investment portfolio as of the dates indicated (in thousands). At these dates, there were no securities held-to-maturity.