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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

     
[X]
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  For the quarterly period ended: September 30, 2004
  Or
[  ]
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  For the transition period from           to

Commission file number:  000-50518

Franklin Bank Corp.

(Exact name of Registrant as specified in its charter)
     
Delaware   11-3626383
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification Number)
9800 Richmond Avenue, Suite 680    
Houston, Texas   77042
(Address of principal executive offices)   (Zip Code)

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

             
        Page
  FINANCIAL INFORMATION        
  Financial Statements (unaudited)     1  
 
  Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003     1  
 
  Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2004 and 2003     2  
 
  Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003     3  
 
  Notes to Interim Consolidated Financial Statements     4  
  Management's Discussion and Analysis of Financial Condition and Results of Operations     6  
  Quantitative and Qualitative Disclosures About Market Risk     16  
  Controls and Procedures     17  
  OTHER INFORMATION     18  
  Legal Proceedings     18  
  Unregistered Sales of Equity Securities and Use of Proceeds     18  
  Defaults Upon Senior Securities     18  
  Submission of Matters to a Vote of Security Holders     18  
  Other Information     18  
  Exhibits     18  
 
  Signatures        
 Certification of CEO Pursuant to Rule 13a-14(a)
 Certification of CFO Pursuant to Rule 13a-14(a)
 Certification of CEO Pursuant to Section 1350
 Certification of CFO Pursuant to Section 1350

 


Table of Contents

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

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

                 
    September 30,   December 31,
    2004
  2003
    (unaudited)
ASSETS
               
Cash and cash equivalents
  $ 248,919     $ 47,064  
Securities available for sale, at fair value (amortized cost of $65.4 million and $91.5 million at September 30, 2004 and December 31, 2003, respectively)
    64,851       91,168  
Federal Home Loan Bank stock and other investments, at cost
    65,218       32,866  
Mortgage-backed securities available for sale, at fair value (amortized cost of $126.6 million and $177.5 million at September 30, 2004 and December 31, 2003, respectively)
    126,983       177,572  
Loans held for sale
    208,723       114,472  
Loans held for investment (net of allowance for credit losses of $6.3 million and $4.9 million at September 30, 2004 and December 31, 2003, respectively)
    2,496,450       1,698,644  
Goodwill
    57,492       54,377  
Other intangible assets, net of amortization
    4,198       3,705  
Premises and equipment, net
    11,000       9,381  
Real estate owned
    4,339       1,789  
Other assets
    20,381       20,262  
 
   
 
     
 
 
TOTAL ASSETS
  $ 3,308,554     $ 2,251,300  
 
   
 
     
 
 
LIABILITIES
               
Deposits
  $ 1,567,710     $ 1,259,843  
Federal Home Loan Bank advances
    1,438,778       713,119  
Junior subordinated notes
    20,224       20,135  
Other liabilities
    20,186       12,765  
 
   
 
     
 
 
Total liabilities
    3,046,898       2,005,862  
STOCKHOLDERS’ EQUITY
               
Common stock $0.01 par value, 35,000,000 shares authorized and 21,225,263 issued and outstanding at September 30, 2004 and December 31, 2003
    212       212  
Additional paid-in capital
    243,037       243,089  
Retained earnings
    18,614       2,418  
Accumulated other comprehensive loss — Unrealized losses on securities available for sale, net
    (132 )     (125 )
Cash flow hedges, net
    (75 )     (156 )
 
   
 
     
 
 
Total stockholders’ equity
    261,656       245,438  
 
   
 
     
 
 
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  $ 3,308,554     $ 2,251,300  
 
   
 
     
 
 

See notes to interim consolidated financial statements.

1


Table of Contents

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

                                 
    Three Months Ended September 30,
  Nine Months Ended September 30,
    2004
  2003
  2004
  2003
INTEREST INCOME
                               
Cash equivalents and short-term investments
  $ 930     $ 559     $ 2,598     $ 1,013  
Mortgage-backed securities
    1,162       316       3,953       913  
Loans
    30,078       10,306       76,435       24,376  
 
   
 
     
 
     
 
     
 
 
Total interest income
    32,170       11,181       82,986       26,302  
INTEREST EXPENSE
                               
Deposits
    7,302       3,186       19,121       7,920  
Federal Home Loan Bank advances
    7,519       2,164       16,350       4,581  
Reverse repurchase agreements
          35             35  
Junior subordinated notes
    373       371       1,115       1,101  
 
   
 
     
 
     
 
     
 
 
Total interest expense
    15,194       5,756       36,586       13,637  
Net interest income
    16,976       5,425       46,400       12,665  
PROVISION FOR CREDIT LOSSES
    556       221       1,747       876  
 
   
 
     
 
     
 
     
 
 
Net interest income after provision for credit losses
    16,420       5,204       44,653       11,789  
NON-INTEREST INCOME
                               
Gain on sale of single family loans
    1,883       602       3,149       1,370  
Loan fee income
    1,297       716       2,934       1,047  
Deposit fees
    628       48       1,782       127  
Gain on sale of securities
    72       247       185       860  
Other
    82       167       850       261  
 
   
 
     
 
     
 
     
 
 
Total non-interest income
    3,962       1,780       8,900       3,665  
NON-INTEREST EXPENSE
                               
Salaries and benefits
    5,009       1,409       13,927       4,381  
Occupancy
    900       522       2,654       1,051  
Data processing
    1,015       434       2,616       846  
Professional fees
    869       364       2,217       1,124  
Professional fees — related parties
    125       210       375       620  
Loan expenses, net
    695       422       1,510       538  
Core deposit amortization
    119       28       355       (174 )
Other
    1,620       811       4,978       1,695  
 
   
 
     
 
     
 
     
 
 
Total non-interest expenses
    10,352       4,200       28,632       10,081  
 
   
 
     
 
     
 
     
 
 
Income before taxes
    10,030       2,784       24,921       5,373  
INCOME TAX EXPENSE
    3,494       975       8,725       1,888  
 
   
 
     
 
     
 
     
 
 
NET INCOME
  $ 6,536     $ 1,809     $ 16,196     $ 3,485  
 
   
 
     
 
     
 
     
 
 
Net income per common share
                               
Basic
  $ 0.30     $ 0.17     $ 0.76     $ 0.33  
Diluted
  $ 0.30     $ 0.17     $ 0.75     $ 0.33  
Basic weighted average number of common shares outstanding
    21,225,263       10,623,320       21,225,263       10,505,628  
Diluted weighted average number of common shares outstanding
    21,605,178       10,623,320       21,659,674       10,505,628  

See notes to consolidated interim financial statements.

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Table of Contents

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

                 
    Nine Months Ended September 30,
    2004
  2003
    (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
               
Net income
  $ 16,196     $ 3,485  
Adjustments to reconcile net income to net cash flows used by operating activities:
               
Provision for credit losses
    1,747       876  
Net gain on sale of mortgage-backed securities and loans
    (3,334 )     (2,307 )
Depreciation and amortization
    1,508       737  
Federal Home Loan Bank stock dividends
    (602 )     (285 )
Funding of loans held for sale
    (466,430 )     (200,127 )
Proceeds from sale of loans held for sale
    232,143       104,421  
Proceeds from principal repayments of loans held for sale
    144,449       23,518  
Net change in loans held for sale
    (4,413 )     (1,557 )
Change in interest receivable
    (5,391 )     (4,298 )
Change in other assets
    5,979       (2,190 )
Change in other liabilities
    5,380       4,845  
 
   
 
     
 
 
Net cash used by operating activities
    (72,768 )     (72,882 )
CASH FLOWS FROM INVESTING ACTIVITIES
               
Purchase of Lost Pines
    (7,148 )      
Purchase of Highland Lakes Bank
          (15,995 )
Cash and cash equivalents acquired from Lost Pines
    7,850        
Cash and cash equivalents acquired from Highland Lakes Bank
          14,105  
Funding of loans held for investment
    (697,140 )     (145,841 )
Proceeds from principal repayments of loans held for investment
    1,030,019       362,282  
Proceeds from principal repayments of mortgage-backed securities
    48,809       16,527  
Proceeds from sales of loans held for investment
    210,255        
Proceeds from sales and repayments of securities
    38,988       70,379  
Proceeds from sale of real estate owned
    1,239       1,070  
Purchases of loans held for investment
    (1,315,229 )     (1,103,295 )
Purchases of mortgage-backed securities
          (114,230 )
Purchases of Federal Home Loan Bank stock and other securities
    (33,036 )     (76,803 )
Purchases of premises and equipment
    (1,400 )     (630 )
Net change in loans held for investment
    (6,370 )     5,464  
 
   
 
     
 
 
Net cash used by investing activities
    (723,163 )     (986,967 )
CASH FLOWS FROM FINANCING ACTIVITIES
               
Net change in deposits
    271,875       596,029  
Proceeds from Federal Home Loan Bank advances
    992,500       542,550  
Repayment of Federal Home Loan Bank advances
    (266,589 )     (56,500 )
Repayment of notes payable
          (19 )
Payment of common stock issuance costs
          (51 )
 
   
 
     
 
 
Net cash provided by financing activities
    997,786       1,082,009  
 
   
 
     
 
 
NET INCREASE IN CASH AND CASH EQUIVALENTS
    201,855       22,160  
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
    47,064       18,675  
 
   
 
     
 
 
CASH AND CASH EQUIVALENTS AT PERIOD END
  $ 248,919     $ 40,835  
 
   
 
     
 
 
Supplemental disclosures of cash flow information
               
Cash paid for interest
  $ 32,554     $ 10,515  
Cash paid for taxes
    4,215       69  
Noncash investing activities
               
Real estate owned acquired through foreclosure
  $ 3,294     $ 648  
Noncash financing activities
               
Issuance of common stock for Highland acquisition
  $     $ 2,700  

 

See notes to consolidated interim financial statements.

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Table of Contents

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):

                                 
    Three months ended   Nine months ended
    September 30,
  September 30,
    2004
  2003
  2004
  2003
Net income, as reported
  $ 6,536     $ 1,809     $ 16,196     $ 3,485  
Deduct: total stock-based employee expense determined under the fair value method for all awards granted, net of tax
    (286 )     (119 )     (634 )     (287 )
 
   
 
     
 
     
 
     
 
 
Pro forma net income
  $ 6,250     $ 1,690     $ 15,562     $ 3,198  
 
   
 
     
 
     
 
     
 
 
Common share data
                               
Basic earnings per share
                               
As reported
  $ 0.30     $ 0.17     $ 0.76     $ 0.33  
Pro forma
  $ 0.29     $ 0.16     $ 0.73     $ 0.30  
Diluted earnings per share
                               
As reported
  $ 0.30     $ 0.17     $ 0.75     $ 0.33  
Pro forma
  $ 0.29     $ 0.16     $ 0.72     $ 0.30  

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2. Earnings per Common Share

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

                                 
    Three months ended   Nine months ended
    September 30,
  September 30,
    2004
  2003
  2004
  2003
Net income
  $ 6,536     $ 1,809     $ 16,196     $ 3,485  
Shares
                               
Average common shares outstanding
    21,225,263       10,623,320       21,225,263       10,505,628  
Potentially dilutive common shares from options
    379,915             434,411        
 
   
 
     
 
     
 
     
 
 
Average common shares and potentially dilutive common shares outstanding
    21,605,178       10,623,320       21,659,674       10,505,628  
Basic EPS
  $ 0.30     $ 0.17     $ 0.76     $ 0.33  
 
   
 
     
 
     
 
     
 
 
Diluted EPS
  $ 0.30     $ 0.17     $ 0.75     $ 0.33  
 
   
 
     
 
     
 
     
 
 

     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):

                                         
    Lost Pines
  Jacksonville
  Highland
  Franklin
  Total
Balance, December 31, 2002
  $     $     $     $ 7,790     $ 7,790  
Highland acquisition
                10,066             10,066  
Jacksonville acquisition
          35,289                   35,289  
Purchase price adjustment
                      1,232       1,232  
 
   
 
     
 
     
 
     
 
     
 
 
Balance at December 31, 2003
          35,289       10,066       9,022       54,377  
Lost Pines acquisition
    3,887                         3,887  
Purchase price adjustment
    86       (702 )     (156 )           (772 )
 
   
 
     
 
     
 
     
 
     
 
 
Balance at September 30, 2004
  $ 3,973     $ 34,587     $ 9,910     $ 9,022     $ 57,492  
 
   
 
     
 
     
 
     
 
     
 
 

     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):

                         
    Core   Mortgage    
    Deposit   Servicing    
    Intangible
  Rights
  Total
Balance, December 31, 2002
  $ 1,310     $ 6     $ 1,316  
Highland acquisition
    556             556  
Jacksonville acquisition
    2,000       669       2,669  
Franklin core deposit intangible adjustment
    (1,369 )           (1,369 )
Servicing rights originated
          423       423  
Amortization
    (92 )     (35 )     (127 )
Amortization adjustment
    237             237  
 
   
 
     
 
     
 
 
Balance at December 31, 2003
    2,642       1,063       3,705  
Lost Pines acquisition
    165             165  
Jacksonville core deposit intangible adjustment
    5             5  
Servicing rights originated
          850       850  
Amortization
    (355 )     (172 )     (527 )
 
   
 
     
 
     
 
 
Balance at September 30, 2004
  $ 2,457     $ 1,741     $ 4,198  
 
   
     
     
 

     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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financial condition and results of operations. These policies are described in further detail in the Company’s 2003 Annual Report of Form 10-K under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies”.

Significant Transactions

     On September 7, 2004, the company announced the signing of a definitive agreement with Cedar Creek Bancshares, Inc., or Cedar Creek, whereby Cedar Creek will merge into a subsidiary of Franklin Bank Corp. This transaction is scheduled to close during the fourth quarter of 2004. Cedar Creek operates five community banking offices in East Texas. At June 30, 2004, Cedar Creek had approximately $104.9 million in assets and $93.8 million in deposits. The company has received all regulatory approvals required for the completion of the merger.

     On February 29, 2004, we acquired Lost Pines for approximately $7.1 million in cash, including $274,000 in direct acquisition costs. Lost Pines was a Texas-based bank holding company with approximately $39.9 million in assets and $36.2 million in deposits at the date of the acquisition.

     On December 30, 2003, we acquired Jacksonville for approximately $69.4 million in cash, including $1.7 million in direct acquisition costs. Jacksonville was a Texas-based savings and loan holding company with approximately $467.6 million in assets and $399.8 million in deposits at the time of the acquisition.

     In December 2003, the company sold 10,508,016 shares of common stock at an initial offering price of $14.50 per share. Underwriting discounts and other issuance costs totaling $12.1 million are included as a reduction to paid-in capital on our consolidated statement of stockholders’ equity. Of the proceeds, approximately $67.7 million was used to acquire Jacksonville, approximately $52.3 million was contributed to the capital of the bank for general corporate purposes and approximately $6.9 million was used to fund the acquisition of Lost Pines.

     On April 30, 2003, we completed our acquisition of Highland. Total consideration for Highland was $18.8 million, including $15.0 million in cash, $2.7 million in shares of our common stock, valued at $10.00 per share, and $1.1 million in direct acquisition costs. At the time of the acquisition, Highland’s total assets were approximately $83.6 million and deposits were approximately $72.9 million. The acquisition of Highland complemented our existing community banking branches and expanded our presence in our target Texas market.

Results of Operations

     The company derives a majority of its income from interest earned on its loan portfolio. Funding for these assets was sourced from the cash raised in the private stock offering completed in November 2002 and from community banking deposits, brokered deposits and borrowings from the Federal Home Loan Bank. The funds raised in the company’s initial public offering in December 2003 were utilized to acquire Jacksonville and Lost Pines and for general corporate purposes. The company’s mortgage banking activities, which generate gains on sales of single family loans and securities and loan fees, also contribute to our net income.

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

     Net income was $16.2 million, or $0.75 per diluted share, for the nine months ended September 30, 2004, compared to $3.5 million, or $0.33 per diluted share, for the nine months ended September 30, 2003. The results of operations for the nine months ended September 30, 2004 include activity for Lost Pines beginning March 1, 2004. The results of operations for the nine months ended September 30, 2003 include activity for Highland beginning May 1, 2003.

     Net interest income. Net interest income increased $33.7 million to $46.4 million for the nine months ended September 30, 2004, compared to $12.7 million for the same period in 2003. The increase was due to a $1.7 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 rose 54 basis points, from 1.78% for the nine months ended September 30, 2003, to 2.32% for the nine months ended September 30, 2004. This increase was 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 nine months ended September 30, 2004 and 2003. Balances for both periods presented are based on daily averages, except for Jacksonville, for the period January 1, 2004, until it was converted to our general ledger on March 12, 2004, Lost Pines, for the period March 1, 2004 until it was converted to our general ledger on July 23, 2004 and Highland for the period May 1, 2003 until it was converted to our general ledger on May 23, 2003, whose average balances are calculated using average monthly balances (dollars in thousands).

                                                 
    Nine Months Ended September 30,
    2004
  2003
            Interest   Average           Interest   Average
    Average   Income/   Yield/   Average   Income/   Yield/
    Balance
  Expense
  Rate
  Balance
  Expense
  Rate
Interest-Earning Assets
                                               
Short-term interest earning assets
  $ 64,692     $ 450       0.91 %   $ 45,719     $ 344       0.99 %
Trading assets
                      6,109       109       2.38 %
Available for sale securities
    73,926       1,535       2.77 %     17,971       275       2.05 %
FHLB stock and other investments
    49,330       613       1.66 %     16,956       285       2.25 %
Mortgage-backed securities
    156,366       3,953       3.37 %     46,721       913       2.61 %
Loans
                                               
Single family
    1,961,881       60,391       4.10 %     737,341       21,326       3.86 %
Residential construction
    219,981       9,118       5.54 %     46,501       1,678       4.83 %
Commercial real estate
    48,687       2,435       6.68 %     13,029       651       6.68 %
Mortgage banker finance
    28,455       872       4.09 %     154       4       3.45 %
Commercial business
    10,133       402       5.30 %     9,252       422       6.10 %
Consumer
    61,200       3,217       7.02 %     4,924       295       8.00 %
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total loans
    2,330,337       76,435       4.38 %     811,201       24,376       4.01 %
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total interest-earning assets
    2,674,651       82,986       4.14 %     944,677       26,302       3.71 %
Non-interest-earning assets
    98,458                       28,648              
 
   
 
                   
 
             
Total assets
  $ 2,773,109                     $ 973,325          
 
   
 
                     
 
             
Interest-Bearing Liabilities
                                               
Deposits
                                               
Community banking
                                               
Checking accounts
  $ 68,031       492       0.97 %   $ 11,991       87       0.98 %
Money market and savings
    174,671       2,110       1.61 %     41,972       544       1.73 %
Certificates of deposit
    339,417       5,002       1.97 %     57,775       1,150       2.66 %
Non-interest bearing deposits
    38,387                   10,331              
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total community banking
    620,506       7,604       1.64 %     122,069       1,781       1.95 %
Wholesale and money desk
    809,237       11,517       1.90 %     388,381       6,139       2.11 %
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total deposits
    1,429,743       19,121       1.79 %     510,450       7,920       2.07 %
FHLB advances
    1,056,370       16,350       2.06 %     332,205       4,581       1.83 %
Reverse repurchase agreements
                      4,059       35       1.14 %
Junior subordinated notes
    20,175       1,115       7.26 %     20,045       1,101       7.25 %
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total interest-bearing liabilities
    2,506,288       36,586       1.94 %     866,759       13,637       2.10 %
 
           
 
     
 
             
 
     
 
 
Non-interest-bearing liabilities and stockholders’ equity
    266,821                       106,566                
 
   
 
                     
 
               
Total liabilities and stockholders’ equity
  $ 2,773,109                     $ 973,325              
 
   
 
                     
 
               
Net interest income/interest rate spread
          $ 46,400       2.20 %       $ 12,665       1.61 %
 
           
 
     
 
           
 
     
 
 
Net yield on interest-earning assets
                    2.32 %                 1.78 %
 
                   
 
                   
 
 
Ratio of average interest-earning assets to average interest-bearing liabilities
                    106.72 %                 108.99 %
 
                   
 
                   
 
 

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

                 
    Nine Months Ended
    September 30,
    2004
  2003
Gain on sale of single family loans
  $ 3,149     $ 1,370  
Loan fee income
    2,934       1,047  
Deposit fees
    1,782       127  
Gains on sale of securities
    185       860  
Other
    850       261  
 
   
 
     
 
 
 
  $ 8,900     $ 3,665  
 
   
 
     
 
 

     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):

                 
    Nine Months Ended
    September 30,
    2004
  2003
Salaries and benefits
  $ 13,927     $ 4,381  
Occupancy
    2,654       1,051  
Data processing
    2,616       846  
Professional fees
    2,592       1,744  
Loan expenses, net
    1,510       538  
Core deposit amortization
    355       (174 )
Other
    4,978       1,695  
 
   
 
     
 
 
 
  $ 28,632     $ 10,081  
 
   
 
     
 
 

     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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presented are based on daily averages, except for Lost Pines subsequent to its conversion to Franklin’s general ledger on July 23, 2004, whose average balances are calculated using average monthly balances (dollars in thousands).
                                                 
    Three Months Ended September 30,
    2004
  2003
            Interest   Average           Interest   Average
    Average   Income/   Yield/   Average   Income/   Yield/
    Balance
  Expense
  Rate
  Balance
  Expense
  Rate
Interest-Earning Assets
                                               
Short-term interest earning assets
  $ 63,869     $ 213       1.31 %   $ 73,153     $ 173       0.93 %
Available for sale securities
    66,603       420       2.51 %     52,272       275       2.06 %
FHLB stock and other investments
    61,795       297       1.91 %     24,347       111       1.78 %
Mortgage-backed securities
    139,764       1,162       3.33 %     57,245       316       2.21 %
Loans
                                               
Single family
    2,343,467       23,741       4.05 %     913,141       8,843       3.87 %
Residential construction
    247,668       3,685       5.92 %     80,740       959       4.71 %
Commercial real estate
    50,114       859       6.82 %     14,972       257       6.81 %
Mortgage banker finance
    51,387       571       4.42 %     458       4       3.45 %
Commercial business
    8,268       122       5.86 %     10,059       155       6.10 %
Consumer
    61,926       1,100       7.07 %     4,336       88       8.04 %
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total loans
    2,762,830       30,078       4.35 %     1,023,706       10,306       4.02 %
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total interest-earning assets
    3,094,861       32,170       4.15 %     1,230,723       11,181       3.62 %
Non-interest-earning assets
    112,697                       40,045                  
 
   
 
                     
 
                 
Total assets
  $ 3,207,558                     $ 1,270,768                  
 
   
 
                     
 
                 
Interest-Bearing Liabilities
                                               
Deposits
                                               
Community banking
                                               
Checking accounts
  $ 64,564       154       0.95 %   $ 14,306       32       0.89 %
Money market and savings
    180,659       769       1.69 %     64,860       256       1.57 %
Certificates of deposit
    335,192       1,760       2.09 %     75,669       505       2.65 %
Non-interest bearing deposits
    52,961                   14,853              
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total community banking
    633,376       2,683       1.69 %     169,688       793       1.86 %
Wholesale and money desk
    937,041       4,619       1.96 %     482,819       2,393       1.95 %
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total deposits
    1,570,417       7,302       1.85 %     652,507       3,186       1.94 %
FHLB advances
    1,341,130       7,519       2.29 %     474,502       2,164       1.81 %
Reverse repurchase agreements
                      12,046       35       1.14 %
Junior subordinated notes
    20,205       373       7.22 %     20,074       371       7.23 %
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total interest-bearing liabilities
    2,931,752       15,194       2.09 %     1,159,129       5,756       1.96 %
Non-interest-bearing liabilities and stockholders’ equity
    275,806                       111,639                  
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total liabilities and stockholders’ equity
  $ 3,207,558                     $ 1,270,768                  
 
   
 
                     
 
                 
Net interest income/interest rate spread
          $ 16,976       2.07 %           $ 5,425       1.67 %
 
           
 
     
 
             
 
     
 
 
Net yield on interest-earning assets
                    2.18 %                     1.78 %
 
                   
 
                     
 
 
Ratio of average interest-earning assets to average interest-bearing liabilities
                    105.56 %                     106.18 %
 
                   
 
                     
 
 
Non-interest income. Non-interest income is comprised of the following (in thousands):
                 
    Three Months Ended
    September 30,
    2004
  2003
Gain on sale of single family loans
  $ 1,883     $ 602  
Loan fee income
    1,297       716  
Deposit fees
    628       48  
Gains on sale of securities
    72       247  
Other
    82       167  
 
   
 
     
 
 
 
  $ 3,962     $ 1,780  
 
   
 
     
 
 
     Non-interest income increased $2.2 million to $4.0 million for the three months ended September 30, 2004, compared to $1.8 million for the same period a year ago. This increase was primarily due to the expansion of our mortgage banking activities, the acquisitions of Jacksonville and Lost Pines and the overall growth of the company.

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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):

                 
    Three Months Ended
    September 30,
    2004
  2003
Salaries and benefits
  $ 5,009     $ 1,409  
Occupancy
    900       522  
Data processing
    1,015       434  
Professional fees
    994       574  
Loan expenses, net
    695       422  
Core deposit amortization
    119       28  
Other
    1,620       811  
 
   
 
     
 
 
 
  $ 10,352     $ 4,200  
 
   
 
     
 
 

     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.

                                         
    September 30, 2004
       
    Amortized   Unrealized   Unrealized   Fair        
    Cost
  Gains
  Losses
  Value
       
Available-for-sale securities
                                       
Mortgage-backed securities:
                                       
Agency fixed rate
  $ 18,386     $ 135     $ (128 )   $ 18,393          
Agency adjustable rate
    108,237       671       (318 )     108,590          
 
   
 
     
 
     
 
     
 
         
Total mortgage-backed securities
    126,623       806       (446 )     126,983          
 
   
 
     
 
     
 
     
 
         
Federal Home Loan Bank stock
    64,783                   64,783          
Mutual fund investment
    51,296             (618 )     50,678          
Agency securities
    9,192       50       (9 )     9,233          
U.S. Treasury securities
    1,298             (1 )     1,297          
Municipal bonds
    1,873       22             1,895          
Corporate securities
    1,749       2       (3 )     1,748          
Other equity investments
    435                   435          
 
   
 
     
 
     
 
     
 
         
Total Federal Home Loan Bank stock and other investments
    130,626       74       (631 )     130,069          
 
   
 
     
 
     
 
     
 
         
Total investment portfolio
  $ 257,249     $ 880     $ (1,077 )   $ 257,052          
 
   
 
     
 
     
 
     
 
         

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    December 31, 2003
    Amortized   Unrealized   Unrealized   Fair
    Cost
  Gains
  Losses
  Value
Available-for-sale securities
                               
Mortgage-backed securities:
                               
Agency adjustable rate
  $ 147,271     $ 201     $ (97 )   $ 147,375  
Agency fixed rate
    30,181       16             30,197  
 
   
 
     
 
     
 
     
 
 
Total mortgage-backed securities
    177,452       217       (97 )     177,572  
 
   
 
     
 
     
 
     
 
 
Other investments
                               
Federal Home Loan Bank stock
    32,429                   32,429  
Mutual fund investment
    51,295             (308 )     50,987  
U.S. Agency securities
    38,888                   38,888  
U.S. Treasury securities
    1,294             (1 )     1,293  
Other equity securities
    437                   437  
 
   
 
     
 
     
 
     
 
 
Total Federal Home Loan Bank stock and other investments
    124,343             (309 )     124,034  
 
   
 
     
 
     
 
     
 
 
 
  $ 301,795     $ 217     $ (406 )   $ 301,606  
 
   
 
     
 
     
 
     
 
 

     Our investment portfolio declined $44.5 million during the nine months ended September 30, 2004, to $257.1 million, from $301.6 million at December 31, 2003. The decline in the investment portfolio was due to sales totaling $22.3 million and principal repayments. The Lost Pines acquisition added $10.2 million to our investment portfolio.

Loan Portfolio. The following table sets forth the composition of our loan portfolio as of the dates indicated (dollars in thousands).

                                 
    September 30, 2004
  December 31, 2003
    Amount
  Percent
  Amount
  Percent
Held for investment:
                               
Single family mortgages
  $ 2,033,239       81.79 %   $ 1,404,730       83.19 %
Mortgage banker finance
    70,563       2.84       3,715       0.22  
Residential construction
    269,176       10.83       161,759       9.58  
Commercial real estate
    47,475       1.91       37,115       2.20  
Commercial business
    8,706       0.35       8,556       0.50  
Multi-family
    2,625       0.10       5,948       0.35  
Consumer
    54,260       2.18       66,821       3.96  
 
   
 
     
 
     
 
     
 
 
Sub-total
    2,486,044       100.00 %     1,688,644       100.00 %
Allowance for credit losses
    (6,292 )             (4,850 )        
Deferred loan fees
    16,698               14,850          
 
   
 
             
 
         
Total loans held for investment
    2,496,450               1,698,644          
 
   
 
             
 
         
Held for sale:
                               
Single family mortgages
    204,839               112,706        
Deferred loan fees
    3,884               1,766        
 
   
 
             
 
       
Total loans held for sale
    208,723               114,472        
 
   
 
             
 
         
Total loans
  $ 2,705,173             $ 1,813,116          
 
   
 
             
 
       

     The loan portfolio increased $889.5 million, to $2.7 billion at September 30, 2004, compared to $1.8 billion at December 31, 2003. This increase was primarily in the single family, residential construction and mortgage banker finance portfolios. Additionally, the Lost Pines acquisition added approximately $19.3 million to the loan portfolio. Single family loans held for investment increased $628.5 million to $2.0 billion at September 30, 2004, from $1.4 billion at December 31, 2003. During the nine months ended September 30, 2004, purchases of single family loans held for investment totaled $1.3 billion, partially offset by principal repayments of $489.0 million and sales of $208.7 million. Single family loans held for sale increased $92.1 million to $204.8 million at September 30, 2004, from $112.7 million at December 31, 2003. This growth came from originations totaling $466.4 million in our three wholesale origination offices and our 56 retail mortgage origination offices. Sales of single family loans held for sale totaled $230.5 million and principal repayments were $144.4 million. The residential construction loan portfolio increased $107.5 million to $269.2 million at September 30, 2004, from $161.7 million at December 31, 2003 due to fundings which totaled $337.2 million. Principal repayments on residential construction loans were $230.7 million during the nine months ended September 30, 2004. The mortgage banker finance portfolio increased $66.8 million to $70.6 million at September 30, 2004, compared to $3.7 million at December 31, 2003.

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Deposits. The following table sets forth the composition of our deposits as of the dates indicated (in thousands).

                 
    September 30,   December 31,
    2004
  2003
Non-interest bearing
  $ 35,215     $ 24,156  
Custodial accounts
    10,795       3,887  
Interest bearing deposits
               
Transaction accounts
    59,310       70,206  
Money market accounts
    154,825       113,830  
 
   
 
     
 
 
Sub-total
    214,135       184,036  
Savings accounts
    28,238       35,888  
Certificates of deposit
               
Consumer & commercial
    333,067       326,257  
Wholesale & brokered
    946,260       685,619  
 
   
 
     
 
 
Sub-total
    1,279,327       1,011,876  
Total interest bearing deposits
    1,521,700       1,231,800  
 
   
 
     
 
 
Total deposits
  $ 1,567,710     $ 1,259,843  
 
   
 
     
 
 

     Deposits increased $307.9 million during the nine months ended September 2004, to $1.6 billion, from $1.3 billion at December 31, 2003. This increase is due to a $47.3 million increase in community banking deposits and a $260.6 million increase in brokered and wholesale deposits. The increase in community banking deposits includes $36.2 million acquired from Lost Pines. Excluding the effect of the Lost Pines acquisition, community banking deposits increased $11.1 million. We expect that brokered and wholesale deposits will remain a significant source of our deposit funding.

Borrowings. Borrowings are comprised of Federal Home Loan Bank “FHLB” advances. FHLB advances increased $725.7 million during the nine months ended September 30, 2004 to $1.4 billion, from $713.1 million at December 31, 2003. The increase in borrowings contributed to the funding of asset growth during the period. At September 30, 2004, FHLB advances were 47.5% of our total funding liabilities.

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Credit Quality

Non-Performing Assets

     Non-performing assets are comprised of non-performing loans and real estate owned. The table below details our non-performing assets as of the dates indicated (in thousands).

                 
    September 30,   December 31,
    2004
  2003
Non-performing loans
               
Single family mortgages
  $ 2,969     $ 4,018  
Commercial
    2,136       1,246  
Consumer
    639       298  
 
   
 
     
 
 
Total nonperforming loans
    5,744       5,562  
 
   
 
     
 
 
Real estate owned
               
Single family mortgages
    1,119       439  
Commercial
    2,133       434  
Other
           
 
   
 
     
 
 
Total real estate owned
    3,252       873  
 
   
 
     
 
 
Total non-performing assets
  $ 8,996     $ 6,435  
 
   
 
     
 
 

     At September 30, 2004, we had $9.0 million in non-performing assets comprised of $5.7 million in loans that were four payments or more delinquent in nonaccrual status, and $3.3 million of real estate owned. This compares to $6.4 million in non-performing assets at December 31, 2003, comprised of $5.6 million in loans that were 90 days or more in nonaccrual status, and $873,000 of real estate owned. Additionally, at September 30, 2004, the company had $2.4 million of loans that were four payments or more delinquent and still accruing interest, which are comprised of single family loans serviced by others and are under an agreement whereby we receive scheduled payments until foreclosure. Beginning in 2004, we changed our methodology for determining non-accrual loans from those loan 90 days or more delinquent to four payments or more delinquent. Had this change been in effect as of December 31, 2003 our non-performing loans would have been $2.8 million.

     The increase in non-performing loans from December 31, 2003 primarily relates to one small business relationship. The increase in commercial real estate owned is due to the foreclosure on one builder loan. This loan was secured by 21 homes that were substantially complete at the time of foreclosure. The increase in single family real estate owned is due to foreclosures totaling $1.5 million during the nine months ended September 30, 2004. Sales of real estate owned totaled $1.1 million during the nine months ended September 30, 2004, of which $449,000 was commercial and $671,000 was single family.

     Loans are generally placed on nonaccrual status upon becoming three payments past due as to interest or principal. Generally, consumer loans that are not secured by real estate are placed on nonaccrual status when deemed uncollectible. Such loans are charged off when they reach 120 days past due.

     At the time a loan is placed on nonaccrual status, the accrued but uncollected interest receivable is reversed and accounted for on a cash or recovery method thereafter, until qualifying for return to accrual status. Management’s classification of a loan as nonaccrual does not necessarily indicate that the principal of the loan is uncollectible in whole or in part.

     At September 30, 2004 and December 31, 2003, we had $7.0 million and $6.2 million, respectively, in loans that were viewed by management as potential problem loans that are not included in non-performing assets. These are loans that management believes may in the future become non-performing loans.

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Allowance for Credit Losses

     We establish an allowance for credit losses based on management’s periodic evaluation of the loan portfolio and consider such factors as historical loss experience, delinquency status, identification of adverse situations that may affect the ability of obligors to repay, known and inherent risks in the portfolio, assessment of economic conditions, regulatory policies and the estimated value of the underlying collateral, if any. Single family mortgages and consumer loans are evaluated as a group. Residential construction, commercial real estate, commercial business, mortgage banker finance and multi-family loans are evaluated individually. The allowance for credit losses is based principally on the frequency and severity of losses for an asset class, the historical loss experience for the type of loan and the delinquency status. The following table shows the activity in the allowance for credit losses for the periods indicated (dollars in thousands).

                 
    For the Nine Months Ended
    September 30,
    2004
  2003
Beginning balance
  $ 4,850     $ 1,143  
 
               
Acquisitions
    362       870  
Provisions for credit losses
               
Single family
    477       1,399  
Commercial
    1,239       (519 )
Consumer
    31       (4 )
Charge-offs
               
Single family
    (101 )      
Commercial
    (457 )     (216 )
Consumer
    (122 )     (39 )
Recoveries
               
Single family
           
Commercial
    7       2  
Consumer
    6       1  
 
   
 
     
 
 
Ending balance
  $ 6,292     $ 2,637  
 
   
 
     
 
 
Allowance for credit losses to non-performing loans
    109.54 %     133.63 %
Allowance for credit losses to total loans
    0.23       0.21  
Allowance for credit losses to average loans
    0.23       0.33  
Net charge-offs to average loans
    0.00       0.03  

The allowance for credit losses at September 30, 2004 was $6.3 million, or 0.23% of total loans outstanding, an increase of $1.4 million from December 31, 2003. The increase in the allowance for credit losses was primarily due to the increase in the size of the commercial portfolio. Management believes that the allowance for credit losses is adequate to cover known and inherent risks in the loan portfolio.

     Charge-offs for the nine months ended September 30, 2004 were $680,000 and primarily relate to a residential construction loan and a small business loan. The residential construction loan charge-off totaled $193,000 and was foreclosed on in June 2004. The small business loan charge-off totaled $175,000 and was completely charged off in May 2004.

     See Note 1 to the consolidated financial statements in the company’s 2003 Annual Report on form 10-K for further discussion of our allowance for credit losses.

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Capital Resources

     Federally insured, state-chartered banks are required to maintain minimum levels of regulatory capital. These standards generally are as stringent as the comparable capital requirements imposed on national banks. The FDIC also is authorized to impose capital requirements in excess of these standards on individual banks on a case-by-case basis. For an insured institution to be considered “well capitalized,” it must maintain a minimum leverage ratio of 5% and a minimum risk-based capital ratio of 10%, of which at least 6% must be Tier 1 capital.

     The following table presents the bank’s regulatory capital and the regulatory capital requirements at September 30, 2004:

                 
    Well    
    Capitalized
  Actual
Tier 1 leverage capital ratio
    5.00 %     6.45 %
Tier 1 risk-based capital ratio
    6.00 %     11.38 %
Total risk-based capital
    10.00 %     11.73 %

     The bank’s regulatory capital at September 30, 2004 was in excess of the “well capitalized” levels.

Liquidity

     Liquidity is the measurement of our ability to meet our cash needs. Our objective in managing our liquidity is to maintain the ability to meet loan commitments, purchase investments, meet deposit withdrawals and pay other liabilities in accordance with their terms, without an adverse impact on our current or future earnings. For the nine months ended September 30, 2004 and 2003, a significant source of funding has been from our deposits, both community banking and brokered.

     Additionally, we have borrowing sources available to supplement deposits. These borrowing sources include the FHLB of Dallas and securities sold under repurchase agreements. Credit availability at the FHLB is based on our financial condition, asset size and the amount of collateral we hold at the FHLB. At September 30, 2004, our borrowings from the FHLB were $1.4 billion and our additional borrowing capacity was approximately $200 million. At September 30, 2004, we had no securities sold under agreement to repurchase.

     We are a holding company without any significant assets other than our indirect equity interest in the bank. Our ability to pay dividends on our common stock or to meet our other cash obligations, including the servicing of our junior subordinated notes, is subject to the amount of liquid assets that we maintain on a separate basis from the bank and the receipt of dividends from the bank. At September 30, 2004, we had approximately $15.6 million in available cash and the bank had the ability to pay approximately $22.8 million in dividends to us without prior regulatory approval.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     Market risk is defined as the sensitivity of income, fair market values and capital to changes in interest rates, foreign currency exchange rates, commodity prices and other relevant market prices and rates. The primary market risk that we are exposed to is interest rate risk inherent in our lending, deposit taking and borrowing activities. Substantially all of our interest rate risk arises from these activities entered into for purposes other than trading.

     The principal objective of our asset/liability management is to manage the sensitivity of net income to changing interest rates. The overall interest rate risk position and strategies are reviewed by executive management and the bank’s board of directors on an ongoing basis.

Interest Rate Risk Management

     The asset/liability committee manages our interest rate risk through structuring the balance sheet to seek to maximize net interest income while maintaining an acceptable level of risk to changes in market interest rates. The achievement of this goal requires a balance between profitability, liquidity and interest rate risk.

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     One way to measure the impact that future changes in interest rates will have is through an interest rate sensitivity gap measure. The “interest rate sensitivity gap” is defined as the difference between interest-earning assets and interest-bearing liabilities maturing or re-pricing 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. Our one year cumulative interest rate gap position at September 30, 2004 was a negative gap of $350.9 million, or 10.6%, of total assets, compared to a negative $277.7 million, or 12.3% of total assets at December 31, 2003.

     We also manage the risks associated with our single family mortgage warehouse and pipeline. Our mortgage warehouse consists of adjustable-rate loans, primarily for our portfolio and fixed-rate single family mortgage loans that are to be sold in the secondary market. Our pipeline consists of commitments to originate single family mortgage loans, both fixed and adjustable rate. The fixed rate loans in the pipeline will be sold in the secondary market. The risk associated with the pipeline is the potential for changes in interest rates on these types of loans from the time the customer locks in the rate on the loan and the time we sell the loan in the secondary market. To manage this risk, we enter into forward sales agreements to protect us from rising interest rates. On a forward sales agreement the sales price and delivery date are established at the time the agreement is entered into. As of September 30, 2004, our pipeline included $58.5 million of loans with committed interest rates of which $23.8 million were fixed rate loans. We have entered into $94.0 million in forward sales agreements, of which $3.2 million are allocated to the loans in our pipeline with committed interest rates based on expected close rate of 62% for these loans.

     To effectively measure and manage interest rate risk, we use simulation analysis to determine the impact on net interest income under various interest rate scenarios, balance sheet trends and strategies. Based on these simulations, we quantify interest rate risk and develop and implement strategies we consider to be appropriate. At September 30, 2004, we used a simulation model to analyze net interest income sensitivity to an immediate parallel and sustained shift in interest rates derived from the current treasury and LIBOR yield curves. For rising rate scenarios, the base market interest rate forecast was increased by 100 and 200 basis points. For the falling interest rate scenario, base market rates were only decreased 100 basis points, due to the current interest rate environment.

     The following table indicates the sensitivity of net interest income to the interest rate movements described above:

                 
    Adjusted Net   Percentage Change
Interest Rate Scenario
  Interest Income
  from Base
    (in thousands)
Up 200 basis points
  $ 75,618       3.49 %
Up 100 basis points
    75,205       2.93  
Base
    73,067        
Down 100 basis points.
  $ 71,248       (2.49 )

The computation of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of interest rate, asset prepayments, deposit decay and changes in re-pricing levels of deposits to general market rates, and should not be relied upon as indicative of actual results. Further, the computations do not take into account any actions that we may undertake in response to changes in interest rates.

Item 4. Controls and Procedures

     An evaluation was performed under the supervision and with the participation of the company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the company’s disclosure controls and procedures as of the end of the period covered by this report. Based on

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that evaluation, the company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that the company’s disclosure controls and procedures were effective.

     No changes were made to the company’s internal control over financial reporting during the latest fiscal quarter that materially affected, or are reasonably likely to materially affect, the company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The company and its subsidiaries are subject to various claims and legal actions that have arisen in the normal course of conducting business. Management does not expect the ultimate disposition of these matters to have a material adverse impact on the company’s financial statements.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

Not applicable.

Item 6. Exhibits

     
Exhibit Number   Description
2.1
  Agreement and Plan of merger by and among Franklin Bank Corp., FBC Acquisition LLC and Cedar Creek Bancshares, Inc., dated September 3, 2004. (Incorporated by reference from Exhibit 2.1 to the Registrant’s Current Report on Form 8-K dated September 3, 2004.)
 
   
31.1
  Rule 13a-14(a) Certification of the Company’s Chief Executive Officer
 
   
31.2
  Rule 13a-14(a) Certification of the Company’s Chief Financial Officer
 
   
32.1+
  Section 1350 Certification of the Company’s Chief Executive Officer
 
   
32.2+
  Section 1350 Certification of the Company’s Chief Financial Officer

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+ This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that section, and shall not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.

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Signatures

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
     
           Franklin Bank Corp.    
    (Registrant)   
       
 
         
     
Date: November 12, 2004  By:   /s/ Russell McCann    
    Russell McCann   
    Chief Financial Officer (Duly Authorized Officer, Principal Financial Officer and Principal Accounting Officer)   
 

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Index to Exhibits

     
Exhibit Number   Description
2.1
  Agreement and Plan of merger by and among Franklin Bank Corp., FBC Acquisition LLC and Cedar Creek Bancshares, Inc., dated September 3, 2004. (Incorporated by reference from Exhibit 2.1 to the Registrant’s Current Report on Form 8-K dated September 3, 2004.)
 
   
31.1
  Rule 13a-14(a) Certification of the Company’s Chief Executive Officer
 
   
31.2
  Rule 13a-14(a) Certification of the Company’s Chief Financial Officer
 
   
32.1+
  Section 1350 Certification of the Company’s Chief Executive Officer
 
   
32.2+
  Section 1350 Certification of the Company’s Chief Financial Officer

+ This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that section, and shall not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.

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