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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-K

Commission file number: 000-50518

Franklin Bank Corp.

(Exact name of Registrant as specified in its charter)

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 þ          No o

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.      o

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

     Based upon the June 30, 2004, NASDAQ National Market closing price of $15.82 per share, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was approximately $307.7 million.

     There were 21,225,263 and 21,895,785 shares of the registrant’s common stock outstanding as of June 30, 2004 and March 11, 2005, respectively.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the Proxy Statement for the 2005 Annual Meeting of Shareholders of Franklin Bank Corp. to be filed with the Commission not later than 120 days after December 31, 2004, are incorporated by reference in this Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.

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FRANKLIN BANK CORP.

ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

PART I

      In this report, Franklin Bank Corp. (including its subsidiaries) is sometimes referred to as the “company”, “we”, “our”, or “us”, and Franklin Bank, S.S.B. is sometimes referred to as “Franklin Bank” or the “bank”.

      We are a Texas-based savings and loan holding company with approximately $3.5 billion in assets, $1.5 billion in deposits and $280.7 million in stockholders’ equity as of December 31, 2004. Through our wholly-owned subsidiary, Franklin Bank, S.S.B., a Texas state savings bank, we originate single family residential mortgage loans, provide community banking products and services and commercial banking services to corporations and other business clients. As of December 31, 2004, in addition to our corporate offices in Houston, Texas, where we provide many of our banking services, we had 22 banking offices in Texas, five regional commercial lending offices in Florida, Arizona, Michigan, Pennsylvania and Texas, 56 retail mortgage offices in 20 states throughout the United States, and regional wholesale origination offices in California and Tennessee.

      On February 29, 2004, we acquired Lost Pines Bancshares, Inc., or Lost Pines, a Texas-based bank holding company with approximately $40.2 million in assets and $36.3 million in deposits at the date of acquisition. On December 4, 2004, we acquired Cedar Creek Bancshares, Inc., or Cedar Creek, a Texas-based bank holding company with approximately $107.3 million in assets and $96.7 million in deposits at the date of acquisition.

Our Strategy

      Our principal growth and operating strategy is to:

Acquisitions

      Since our formation in August 2001, we have completed the following acquisitions:

      We continue to seek opportunities to expand our community banking business by acquiring financial institutions in growing Texas markets outside of metropolitan areas. We believe that acquisitions such as these complement our asset strategy and provide an excellent source of deposits, a key component of our growth. When we acquire a financial institution we integrate its lending and deposit platforms with ours as soon as practical. We operate the acquired entity either as a new geographic division or as a branch within one of our existing geographic divisions. In addition, we attempt to maintain key managers for continuity with the customers.

History

      In August 2001, our founders organized Franklin Bank Corp. as a new Delaware holding company, formerly known as BK2 Inc., for the purpose of acquiring all of the outstanding capital stock of Franklin Bank, which was then engaged in traditional community banking activities in the greater Austin, Texas market. We completed this acquisition on April 9, 2002.

      At the time of the acquisition, Franklin Bank had approximately $61.3 million in assets, $58.5 million in deposits and $3.1 million in stockholders’ equity, and operated two banking offices in Austin, Texas, with a community banking focus. We acquired the bank with the intent of implementing a business strategy to expand the bank’s branches, grow and diversify its lending activities and increase its overall profitability.

      In April 2003, we acquired Highland Lakes Bancshares Corporation, or Highland, located in Kingsland, Texas. At the time of the acquisition, Highland had approximately $83.6 million in assets and $72.9 million in deposits. The acquisition of Highland complemented our existing banking offices and expanded our presence in our central Texas market.

      In December 2003, we acquired Jacksonville Bancorp. Inc., or Jacksonville, which had $467.6 million in assets and $399.8 million in deposits at the time of acquisition. The acquisition of Jacksonville added nine banking offices in the east Texas area.

      On February 29, 2004, we acquired Lost Pines, which had approximately $40.2 million in assets and $36.3 million in deposits at the date of acquisition. The acquisition of Lost Pines expanded our presence in our central Texas market.

      On December 4, 2004, we acquired Cedar Creek, which had approximately $107.3 million in assets and $96.7 million in deposits at the date of acquisition. The acquisition of Cedar Creek added five banking offices that complement our east Texas presence.

      On December 21, 2004, we announced that we had entered into a definitive agreement to acquire The First National Bank of Athens, or Athens. At December 31, 2004, Athens had approximately $217.7 million in assets and $189.9 million in deposits. The Athens acquisition will add four banking offices in our east Texas market.

      On January 27, 2005, we announced that we had entered into a definitive agreement to acquire Elgin Bank of Texas, or Elgin. At December 31, 2004, Elgin had approximately $84.5 million in assets and $73.9 million in deposits. The acquisition of Elgin will add three banking offices to our central Texas market.

Business Activities

      Our banking services are concentrated in mortgage banking, community banking, and commercial lending product lines.

      We originate, acquire and sell residential mortgage loans. We focus on originating single family mortgages, for sale into the secondary market, that conform in credit characteristics to secondary marketing standards and criteria set by government sponsored enterprises, and on acquiring loans for our portfolio, targeting high quality borrowers with high credit ratings. We believe that mortgage loans to high quality borrowers with high credit ratings can provide us with better returns on a portfolio basis than loans in the “conforming” mortgage loan market because of our comprehensive credit evaluation and risk-based pricing. Our product types include Federal Housing Administration and Veterans Administration, or FHA/ VA, insured mortgages, “alternate A” or expanded criteria mortgages, Federal National Mortgage Association, or FNMA, Federal Home Loan Mortgage Corporation, or FHLMC, conventional mortgages and jumbo mortgage loans to high credit quality borrowers. We currently originate mortgage loans through two channels, retail and wholesale, and acquire mortgage loans through our correspondents. The earnings that we derive from our origination channels are based on the interest spread on our mortgage loans held for sale and the gain from the subsequent sale of these loans into the secondary market. Additionally, our origination channels

originate loans for our portfolio that meet our risk parameters. We intend to expand our mortgage banking business by increasing the loans originated through our retail and wholesale channels through the addition of loan officers and locations. For the year ended December 31, 2004, approximately 72% of our interest income came from mortgage banking activities, including approximately 63% from our portfolio loans and approximately 9% from our held for sale portfolio.

      Retail Mortgage Origination. We currently originate mortgage loans directly to borrowers through our community banking locations and through our retail mortgage offices located in 20 states throughout the United States. Since the inception of this product in January 2003, we have expanded the number of our offices from three to 56 at the end of December 2004. Through these offices we originated $304.8 million in mortgage loans for the year ended December 31, 2004.

      We believe that our retail mortgage office structure provides us with a low fixed cost method of originating mortgage loans. This structure is set up so that each mortgage loan manager is compensated based solely on the mortgage office’s profitability. For each loan originated, the mortgage office receives a credit, which is similar to a fee paid to a mortgage loan broker, and is charged an administration fee to cover our processing costs for that loan. All direct expenses of the mortgage office are charged to that office and the mortgage office manager’s compensation is the net income generated by that mortgage office. This allows us to compete at the point of sale to the consumer while minimizing the fixed costs found in a traditional retail mortgage origination network. We monitor the profitability of each mortgage office and minimize our exposure by closing those mortgage offices that do not meet their profitability goals. Most of our retail mortgage office leases are short term, and we utilize third party providers for our closing and post closing functions, which gives us the flexibility to scale our mortgage origination business to the volumes that we are originating at any given time.

      Through these offices, we interact with our borrowers with the assistance of loan officers who facilitate the efficient processing and closing of the loans. In addition, we intend to reach new and existing retail loan customers through direct-to-the-customer tools, such as the Internet, direct mail and advertising in selected print media. Furthermore, our mortgage loan officers obtain business by developing a referral network of realtors, real estate attorneys, builders and accountants.

      Wholesale Mortgage Origination. Wholesale mortgage origination refers to the origination of mortgage loans with the assistance of mortgage companies or mortgage brokers. The loans are originated and closed in either our name or, under certain circumstances, the assisting entity’s name with immediate assignment to us. We currently originate wholesale residential mortgage loans in Texas, California and Tennessee and may expand on a nationwide basis. We believe the wholesale origination of loans represents an efficient way for us to originate loans. During the year ended December 31, 2004, we originated $305.8 million in mortgage loans through our wholesale offices.

      In the wholesale origination process, the mortgage company or mortgage broker identifies applicants, gathers required information and documents, and acts as our liaison with the borrower during the lending process. We provide updated pricing for our mortgage loan products to these entities on a daily basis. Once a completed mortgage application is presented to us, our staff underwrites it according to our standard credit criteria.

      Prior to starting a relationship with a wholesale originator, we conduct due diligence on the entity. Our due diligence includes reviewing their financial condition, running credit and fraud checks on their principals, checking business references and verifying with the applicable regulators that a broker is in good standing. Once approved, we require that the entity sign an agreement that governs the mechanics of doing business with us and that sets forth the representations and warranties the broker makes regarding each loan submitted to us.

      Correspondent Acquisitions. We acquire mortgage loans through correspondent relationships we have with financial institutions, mortgage companies and mortgage brokers. These entities originate, fund and bundle mortgages with the intent to sell them to us. When acquiring loans on a correspondent basis, we commit to purchase the loan prior to the closing of the mortgage based upon predetermined and agreed upon

criteria. For the year ended December 31, 2004, we purchased approximately $1.8 billion of single family mortgage loans and intend in the future to continue to purchase recently originated loans from larger financial institutions, mortgage companies and investment banks on an opportunistic basis. These purchases allow us to obtain residential mortgage loans for our portfolio without the cost of originating them ourselves.

      Loan Disposition. We currently sell a majority of the mortgage loans we originate into the secondary market under normal customary terms, and may in the future sell some loans through securitizations. We typically sell fixed-rate loans into the secondary market, but may also from time to time sell adjustable-rate loans. The majority of our sales are made under mandatory delivery agreements with major financial institutions, including FNMA, for whom we are an approved seller/servicer, and Countrywide Home Loans Inc. We generally sell the servicing rights to our loans when we sell the loans, except where there are cross-selling opportunities to community banking customers. During the year ended December 31, 2004, we sold into the secondary market $825.5 million in single family mortgage loans.

      Our community banking operations offer a wide variety of small business and consumer banking products, including checking, money market and savings accounts, certificates of deposit, auto loans, home improvement loans, home equity loans, small business loans, small commercial real estate loans and mortgage loans. Currently, our banking network consists of 23 banking offices, eight located in central Texas area, 14 located in east Texas and one located in Houston, Texas. Most of our banking offices are full service offices and offer a full range of deposits and loans.

      We intend to aggressively grow our community banking activities through the establishment of new banking offices, acquisitions, direct mail and online banking. Our community banking strategy is focused on expanding our presence by acquiring and establishing new banking offices in growing Texas markets outside the state’s principal metropolitan areas. A key part of our strategy is to hire experienced local bankers in those markets with extensive ties in the community. We employ competitive pricing policies, advertising and customer service to attract and retain deposits and to provide superior service in the markets we serve. As a result, we have experienced a steady growth in deposits. As of December 31, 2004, total deposits from our community banking products totaled $720.7 million. Interest expense relating to those deposits represented approximately 20% of our total interest expense for the year ended December 31, 2004. Interest income on our community banking products was approximately 4% of our total interest income for the same period.

      On April 30, 2003, we closed our acquisition of Highland, located in Kingsland, Texas. At the time of the acquisition, Highland had approximately $83.6 million in assets and $72.9 million in deposits. Highland’s wholly-owned subsidiary, Highland Lakes Bank, or Highland Bank, was a Texas state bank that operated one banking office in Kingsland, Texas. This acquisition complemented our existing banking offices and expanded our presence in our central Texas market.

      On December 30, 2003 we acquired Jacksonville, a Texas-based savings and loan holding company with approximately $467.6 million in assets and $399.8 million in deposits as of the date of the acquisition. Jacksonville’s wholly-owned subsidiary, Jacksonville Savings Bank, S.S.B., or Jacksonville Bank, was a Texas state savings bank that operated nine community banking offices in east Texas. Jacksonville provides community banking products including single family residential mortgage loans, home equity loans and, to a lesser extent, multi-family and commercial real estate, construction, land, business and consumer loans.

      On February 29, 2004, we acquired Lost Pines, a Texas-based bank holding company with approximately $40.2 million in assets and $36.3 million in deposits at the date of acquisition. Lost Pines’ wholly-owned subsidiary, Lost Pines National Bank, was a national bank that operated two community banking offices outside of Austin, Texas. Lost Pines provides community banking products and originates commercial real estate and commercial loans. The Lost Pines acquisition expands our presence in our central Texas market.

      On December 4, 2004, we acquired Cedar Creek, with approximately $107.3 million in assets and $96.7 million in deposits at the date of acquisition. Cedar Creek provides community banking products and

originates commercial loans. The acquisition of Cedar Creek added five community banking offices that complement our east Texas presence.

      On December 21, 2004, we announced that we had entered into a definitive agreement to acquire The First National Bank of Athens, or Athens. At December 31, 2004, Athens had approximately $217.7 million in assets and $189.9 million in deposits. The Athens acquisition will add four community banking offices in our east Texas market.

      On January 27, 2005, we announced that we had entered into a definitive agreement to acquire Elgin Bank of Texas, or Elgin. At December 31, 2004, Elgin had approximately $84.5 million in assets and $73.9 million in deposits. The acquisition of Elgin will add three community banking offices to our central Texas market.

      We will continue to seek opportunities to acquire financial institutions that are consistent with our strategy of growing our community banking.

      We provide commercial banking services to corporations and other business clients. We offer financing for single family residential construction, mortgage banking warehouse lines and for commercial real estate, including retail, industrial, office buildings and multi-family properties. These products are offered through our corporate office in Houston, Texas and regional lending offices located in Dallas, Texas, Detroit, Michigan, Orlando, Florida, Philadelphia, Pennsylvania and Phoenix, Arizona. We intend to extend our commercial lending operations in other desirable markets in order to further diversify our portfolio geographically.

      Residential Construction Lending The focus of our residential construction lending business is financing the construction of multiple single-family detached dwellings in established subdivisions. We have expanded our geographical scope from Texas to include Arizona, Florida, Georgia, Nevada, Illinois, Michigan, New York, California, New Jersey, North Carolina, Washington and Pennsylvania. We currently provide residential construction loans from our corporate offices in Houston, Texas, and our regional lending offices.

      The builders we target for financing are medium size builders that construct at least 50 homes each year. In order to be approved for a construction loan, we require that builders satisfy specific qualification requirements, including reputation in the community, speculative inventory levels, geographic area concentration and other factors. As of December 31, 2004, we had $617.1 million in residential construction loans committed, of which $336.3 million were outstanding. For the year ended December 31, 2004, we derived approximately 11% of our total interest income from residential construction lending products.

      Residential construction lending generally entails a higher degree of risk than traditional mortgage lending, including the risk of a general downturn in the builder’s local economy, interest rate increases and misrepresentation by the builders of the completion status of the home against which loan funds have been drawn.

      We utilize certain lending practices to reduce these risks, including pricing all residential construction loans based on a risk adjusted return on capital and underwriting them based on debt/net worth, cash flow coverage, loan to value and loan to cost ratios, interest reserve coverage, experience of management, inventory turnover by subdivision and guarantees. We monitor the ongoing financial condition of the builder and the status of construction by regular review of periodic builder reports and financials and site inspection of the actual construction. We approve draws only after third party on-site inspections and review of subdivision performance and borrowers’ inventory. We believe these requirements reduce the potential for misdirected advances to other areas of the builder’s business.

      Mortgage Banker Finance We provide small- and medium-sized mortgage companies with credit facilities, including secured warehouse lines of credit, repurchase agreements, and working capital credit lines. We also offer these companies a complete line of cash management products tailored to their business, including balance reporting, online banking, cash management and custody services. In addition to providing

interest income, we expect the mortgage banker finance business to give us an excellent source of deposits generated by our cash management products.

      These loans are subject to the risk that the collateral may be fraudulently or improperly documented. Additionally, mortgage banking companies are generally more thinly capitalized than other commercial borrowers.

      To reduce these risks we have assembled a team of experienced mortgage banker finance professionals to manage this business. We have established the necessary procedures, controls, and systems to operate this business, including taking control of the mortgage collateral and employing field auditors to examine our mortgage banking clients. As of December 31, 2004, we had $253.0 million in warehouse lines committed of which $138.1 million was outstanding.

      Our target customers are existing mortgage banking companies that have an excellent track record in the mortgage business. We approve potential mortgage banker finance customers and determine advance rates for loans based on a number of factors, including credit performance, experience, perceived interest rate risk, liquidity risk, and risks associated with the particular mortgage loans originated by the mortgage banking firm.

      Commercial Real Estate. We provide commercial real estate loans, including interim construction loans, for retail, industrial, office buildings, multi-family and other types of income producing properties.

      We have established certain lending practices to reduce our risks relating to these types of loans. These include, but are not limited to, maximum loan-to-value, minimum debt service coverage, physical inspections and the operating experience of the borrower.

      As of December 31, 2004, we had $99.5 million in commercial real estate loans outstanding.

Underwriting and Risk Management

      We originate and purchase loans in accordance with the underwriting criteria described below. Generally, our underwriting guidelines are designed to help us evaluate a borrower’s credit history and capacity to repay the loan, the value of the property, if any, that will secure the loan, and the adequacy of such property as collateral for the loan.

      Currently, we underwrite every loan we originate or purchase, other than certain purchased single family loans that contain homogeneous characteristics. This means we thoroughly review the borrower’s credit history, financial documents and appraisal for accuracy and completeness. Our underwriting standards are applied in accordance with applicable federal and state laws and regulations.

      For originated residential mortgage loans, we use standardized secondary market underwriting and credit criteria in order to ensure the quality of the asset. In addition, we review credit scores derived from the application of one or more nationally recognized credit scoring models. We also require a qualified appraisal of the mortgaged property, conforming to FNMA and FHLMC standards. Each appraisal includes a market data analysis based on recent sales of comparable homes in the area and a replacement cost analysis based on the current cost of building a similar home. The appraisal may not be more than 180 days old on the day the loan is originated.

      For purchased single family residential mortgage loan packages, the management credit committee classifies the seller/servicer into “A” rating or “B” rating. If the seller/servicer is assigned an “A” rating then a loan package may be eligible for a limited underwriting based on a stratified sample. If the seller/servicer is assigned a “B” rating then prior to any purchase, 100% of the loans must have both a full underwriting and legal documentation review. As of December 31, 2004, the majority of our purchases have been from “A” rated seller/servicers.

      Loan packages from an “A” rated seller/servicer are reviewed through an internally developed report that identifies loans which have multiple levels of risk with no mitigating factor provided from the report. Included in the data elements that are viewed as risk factors; loans with loan-to-value, or LTV, greater than 80% with no mortgage insurance, 3 or 4 unit properties, 2nd liens, LTV greater than 90%, loan amount greater than

$650,000 with LTV greater than 65%, condominium with LTV greater than 75%, cash out refinances with LTV greater than 75% and borrowers with Fair Isaac & Co., or FICO, scores less than 660. Individual loans in a loan package where multiple risk factors are identified with no mitigating factors will be underwritten to determine if any mitigating factors exist or will be removed from the loan package. Any loan with a principal balance equal to or greater than $1.0 million will be underwritten. Additionally, loans where property values have increased by 20% over the past one to two years will be reviewed for mitigating factors, such as LTV and FICO scores. Our management credit committee is presented with and approves the level of underwriting on each loan package.

      For residential construction, commercial real estate loans and commercial loans, we focus on a borrower’s ability to make principal and interest payments and the value of the collateral securing the underlying loans. We use debt/net worth, cash flow coverage, experience of management and guarantees. Independent appraisers generally perform on-site inspections and valuations of the collateral for commercial real estate loans.

      We underwrite our consumer loans for vehicles and other consumer durables using credit scoring, collateral value and relationships. We utilize the same underwriting standards for home equity, home improvement and lot loans as we do for our residential mortgages.

      A management credit committee appointed by the bank’s board of directors sets our underwriting guidelines and credit policies. The bank’s management credit committee consists of the bank’s Chief Executive Officer, the Chief Credit Officer, the Chief Financial Officer, the Managing Director — Mortgage Banking, the Managing Director — Commercial Lending, the Managing Director — Administration, the Managing Director — Austin, the Managing Director — Jacksonville, the Senior Vice President — Underwriting and one rotating loan officer. The committee approves or ratifies all loans except for single family originated loans, approves all other loan funding or loan packages exceeding certain dollar amounts and reports to the board of directors at regularly scheduled meetings.

      All loans, except for single family loans, must be recommended by the loan officer and the relevant managing director and be approved by the Chief Credit Officer and the Chief Executive Officer or approved by the management credit committee. The Chief Credit Officer or any two members of the management credit committee may nevertheless disapprove a loan that satisfied the bank’s general underwriting standards.

      Residential construction and commercial real estate loans less than $2 million and mortgage banker finance loans and business loans less than $500,000 can be approved by the individual loan officer or senior underwriter, the product’s managing director plus either the bank’s Chief Executive Officer or the Chief Credit Officer. All loans that are approved outside of the management credit committee must be ratified at the next regularly scheduled meeting. Loans greater than $5 million, except for residential construction loans, commercial real estate, mortgage banker finance loans and consumer loans where the limit is $10.0 million, $7.5 million, $10.0 million and $500,000, respectively, must be approved by the bank’s board of directors’ credit committee.

      The bank’s board credit committee is comprised of Lewis S. Ranieri, Alan E. Master, John B. Selman, David M. Golush and Anthony J. Nocella.

      In addition to applying standard criteria and a centralized approval process to ensure loans are thoroughly underwritten, we also tie our loan production managers’ compensation to profitability by compensating them for overall profitability and not just the volume of the loans they originate. We believe this will result in our originated loans being of a higher quality than if the managers’ compensation were tied solely to loan volume.

      Finally, in order to monitor our overall credit exposure, we have established a bank risk management committee that is appointed by the bank’s board of directors to provide an oversight function for the credit review and risk management process. The bank’s risk management committee is comprised of the bank’s Chief Executive Officer, the Chief Credit Officer, the Chief Financial Officer, the Managing Director — Mortgage Banking, the Managing Director — Administration, the Managing Director — Commercial Lending, the Managing Director — Austin, the Managing Director — Jacksonville, the Vice-President — Administration and a Senior Vice President — Finance. This committee is charged with the review of asset

classifications, review of individual portfolio risks (including loan type concentrations, loan size, geographic concentrations, and demographic and economic conditions), and approval of the methodology and level of the allowance for loan losses. This committee monitors delinquencies, specific loan performance and negative or adverse economic trends. The committee monitors our geographic limitation policy that limits the amount of assets that can be in any one state to 25% of total assets, except for California, which is limited to the lesser of 35% of assets or 600% of regulatory capital, and Texas, which is unlimited. This policy is designed to limit the exposure that we have to any one region. The committee also monitors our concentration limitation for single family mortgage loans that limits the amount of loans that can have periodic interest rate caps greater than 2% to 200% of the bank’s regulatory capital.

Competition

      We face substantial competition for loans and deposits as well as other sources of funding in our markets. We compete in all of our lending lines of business with thrifts, commercial banks, credit unions, mortgage companies and specialty finance companies, many of which operate nationwide lending networks. In each case we must compete on the basis of service quality, product offerings and rates.

      We also compete for funding. We compete at our 23 banking offices for deposits from local customers. We also must compete nationwide for deposits to fund our lending activities. We compete for deposits with thrifts, commercial banks and credit unions and our deposit products must compete with the investment products offered by a broad variety of financial institutions including thrifts, commercial banks, credit unions, brokerage firms, investment banks, insurance companies and other financial services companies, many of which are substantially larger and have more resources than us.

      Economic factors, along with legislative and technological changes, will have an ongoing impact on the competitive environment within the financial services industry. As an active participant in the financial markets, we strive to anticipate and adapt to dynamic and competitive conditions, but there can be no assurances as to their impact on our future business. In order to compete with other competitors in our markets, we attempt to use to the fullest extent possible the flexibility which our independent status permits, including an emphasis on personalized service, local promotional activity and community involvement.

Regulation and Supervision

      The company and BK2 Holdings, Inc., its intermediate subsidiary, are registered savings and loan holding companies and are subject to Office of Thrift Supervision, or OTS, and the Texas Savings and Loan Department, or TSLD, regulation, examination, supervision and reporting requirements.

      The bank is a Texas-chartered, federally-insured state savings bank and is subject to the regulation, examination and reporting requirements of the TSLD. The Federal Deposit Insurance Corporation, or FDIC, also has regulatory and examination authority respecting the bank. The bank’s deposits are insured by the FDIC through the Bank Insurance Fund, or BIF. As a subsidiary of a savings and loan holding company, the bank is also subject to certain federal and state restrictions in its dealings with the company and affiliates thereof.

      The bank is a member of the Federal Home Loan Bank, or FHLB, of Dallas, which is one of 12 regional FHLBs that administer programs in support of the home financing credit function of savings institutions and commercial banks. Each FHLB serves as a source of liquidity for its members within its assigned region. It makes loans (i.e., advances) to members in accordance with policies and procedures established by its Board of Directors. The bank is required to maintain between 0.15% and 0.30% of its assets at each December 31 in FHLB of Dallas capital stock, which is a member’s minimum required investment, plus between 3.50% and 5.00% of its advances outstanding. At December 31, 2004, the FHLB of Dallas had set the minimum required investment at 0.15% of assets and the advance requirement at 4.25%. At December 31, 2004, the bank held $74.2 million in FHLB of Dallas capital stock, compared to its requirement of $73.8 million.

      The supervision and regulation of savings and loan holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds of the FDIC and the banking system as

a whole, and not for the protection of the shareholders or creditors of savings and loan holding companies. The banking agencies have broad enforcement power over savings and loan holding companies and banks, including the power to restrict operations and impose substantial fines and other penalties for violations of laws and regulations.

      Below is a brief description of certain laws and regulations which relate to the regulation of the company and the bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.

      Overview. The company has elected to treat the bank as a “savings association” for purposes of Section 10 of the Home Owners’ Loan Act, or HOLA. As a result, the company is a registered savings and loan holding company and subject to the regulation, examination, supervision and reporting requirements of the OTS and TSLD. The company must file a quarterly report with the OTS that describes its financial condition.

      For the company to continue to be regulated as a savings and loan holding company, the bank must continue to be a “qualified thrift lender.” Otherwise, the company could be required to register as a bank holding company and become subject to regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended. Regulation as a bank holding company could be adverse to the company’s business plans and impose additional and possibly more burdensome regulatory requirements on the company. See “— The Bank — Qualified Thrift Lender Test.”

      Scope of Permissible Activities. As a savings and loan holding company, the company is permitted to engage in activities considered to be “financial in nature,” incidental to such financial activity or complementary to a financial activity. Activities that are considered to be financial in nature include lending activities, insurance underwriting, insurance agency activity, investment advisory services, securities underwriting, merchant banking activities and activities authorized by the Board of Governors of the Federal Reserve System as permissible for bank holding companies under the Bank Holding Company Act (subject, in the case of bank holding company activities, to OTS approval). The company is also permitted to engage in additional activities listed in HOLA or OTS regulations, the most significant of which relate to real estate ownership, development and management activities.

      If the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of an activity constitutes a serious risk to the financial safety, soundness or stability of its subsidiary savings institution (i.e., a savings association or savings bank), the OTS may impose such restrictions as it deems necessary to address such risk, including limiting:

      Restrictions on Acquisitions. Except under limited circumstances, savings and loan holding companies are prohibited from acquiring, without prior approval of the OTS:

      In evaluating an application by a holding company to acquire a saving association, the OTS must consider the financial and managerial resources and future prospects of the holding company and savings association involved, the effect of the acquisition on the risk to the insurance funds, the convenience and needs of the community and competitive factors. Acquisitions which result in a savings and loan holding company

controlling savings associations in more than one state are generally prohibited, except in supervisory transactions involving failing savings associations or based on specific state authorization of such acquisitions. Except with the prior approval of the OTS, no director or officer of a savings and loan holding company or person owning or controlling by proxy or otherwise more than 25% of such company’s voting stock may acquire control of any savings institution, other than a subsidiary savings institution, or of any other savings and loan holding company.

      Change of Control. Federal law requires, with few exceptions, OTS approval (or, in some cases, notice and effective clearance) prior to any acquisition of control of the company. Among other criteria, under OTS regulations, “control” is conclusively presumed to exist if a person or company acquires, directly or indirectly, more than 25% of any class of voting stock of the savings association or holding company. Control is also presumed to exist, subject to rebuttal, if an acquiror acquires more than 10% of any class of voting stock (or more than 25% of any class of stock) and is subject to any of several “control factors,” including, among other matters, the relative ownership position of a person, the existence of control agreements and board composition.

      Change in Management. If a savings and loan holding company is in a “troubled condition,” as defined in the OTS regulations, it is required to give 30 days’ prior written notice to the OTS before adding or replacing a director, employing any person as a senior executive officer or changing the responsibility of any senior executive officer so that such person would assume a different senior executive position. The OTS then has the opportunity to disapprove any such appointment.

      Limitations on Dividends. The company is a legal entity separate and distinct from the bank. The company’s principal source of revenue consists of dividends from the bank. The payment of dividends by the bank is subject to various regulatory requirements, including a minimum of 30 days’ advance notice to the OTS of any proposed dividend to the company.

      Other limitations may apply depending on the size of the proposed dividend and the condition of the bank. See “— The Bank — Restrictions on Capital Distributions.”

      Texas Regulations. Under the Texas Savings Bank Act, or TSBA, each registered holding company, such as the company, is required to file reports with the TSLD as required by the Texas Savings and Loan Commissioner, or the Commissioner, and is subject to such examination as the Commissioner may prescribe.

      The bank is required to file reports with the TSLD and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions, such as any merger or acquisition with another institution. The regulatory system to which the bank is subject is intended primarily for the protection of the deposit insurance fund and depositors, not stockholders. The regulatory structure also provides the TSLD and the FDIC with substantial discretion in connection with their supervisory and enforcement functions. The TSLD and the FDIC conduct periodic examinations of the bank in order to assess its compliance with federal and state regulatory requirements. As a result of such examinations, the TSLD and the FDIC may require various corrective actions.

      Virtually every aspect of the bank’s business is subject to numerous federal and/or state regulatory requirements and restrictions with respect to such matters as the nature and amounts of loans and investments that may be made, the issuance of securities, the amount of cash reserves that must be established against deposits, the establishment of branches, mergers, non-banking activities and other operations. Numerous laws and regulations also set forth special restrictions and procedural requirements with respect to the extension of credit, credit practices, the disclosure of credit terms and discrimination in credit transactions.

      Regulatory Capital Requirements. 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.

      Under current FDIC regulations, the bank is required to comply with three separate minimum capital adequacy requirements: a “Tier 1 capital ratio” and two “risk-based” capital requirements. “Tier 1 capital” generally includes common stockholders’ equity (including retained earnings), qualifying noncumulative perpetual preferred stock and any related surplus, and minority interests in the equity accounts of fully consolidated subsidiaries, minus intangible assets, other than properly valued mortgage servicing assets, nonmortgage servicing assets and purchased credit card relationships up to certain specified limits and minus net deferred tax assets in excess of certain specified limits.

      Leverage Capital Ratio. FDIC regulations establish a minimum 3.0% ratio of Tier 1 capital to total assets, as defined, for the most highly-rated, state-chartered, FDIC-supervised banks and a minimum 4.0% ratio of Tier 1 capital to total assets, as defined, for all other state-chartered, FDIC-supervised banks. Under FDIC regulations, highly-rated banks are those that the FDIC determines are not anticipating or experiencing significant growth and have well diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity and good earnings. As of December 31, 2004, the minimum leverage capital ratio for capital adequacy purposes for the bank was 4.0% and its actual leverage capital ratio was 6.85%.

      Risk-Based Capital Requirements. The risk-based capital requirements contained in FDIC regulations generally require the bank to maintain a minimum ratio of Tier 1 capital to risk-weighted assets of at least 4.0% and a ratio of total capital to risk-weighted assets of at least 8.0%.

      For purposes of the risk-based capital requirements, “total capital” means Tier 1 capital plus supplementary (or Tier 2) capital, so long as the amount of supplementary (or Tier 2) capital that is used to satisfy the requirement does not exceed the amount of Tier 1 capital. Supplementary (or Tier 2) capital includes, among other things, cumulative perpetual preferred stock, non-cumulative perpetual preferred stock where the dividend is reset periodically, long-term preferred stock (original maturity of at least 20 years), mandatory convertible subordinated debt, perpetual subordinated debt and mandatory redeemable preferred stock. Intermediate-term preferred stock and other subordinated debt is includable in Tier 2 capital up to 50% of Tier 1 capital. The allowance for loan and lease losses up to a maximum of 1.25% of risk-weighted assets is included in Tier 2 capital, as are certain unrealized gains in equity securities and unrealized gains or losses in other assets. To determine the amount of capital required, assets and certain off-balance sheet items are assigned to various categories, with each category having a different “risk weighting.” As of December 31, 2004, the bank’s Tier 1 capital to risk-weighted assets ratio was 10.72% and its total risk-based capital to risk weighted assets ratio was 11.09%.

      Corrective Measures for Capital Deficiencies. The Prompt Corrective Action regulations, which were promulgated to implement certain provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA, also effectively impose capital requirements on state-chartered banks, by subjecting banks with less capital to increasingly stringent supervisory actions. For purposes of the Prompt Corrective Action regulations, a bank is “undercapitalized” if it has a total risk-based capital ratio of less than 8%, a Tier 1 risk-based capital ratio of less than 4%, or a leverage capital ratio of less than 4% (or less than 3% if the bank has received a composite rating of 1 in its most recent examination report and is not experiencing significant growth). A bank is “adequately capitalized” if it has a total risk-based capital ratio of 8% or higher, a Tier 1 risk-based capital ratio of 4% or higher, a leverage ratio of 4% or higher (3% or higher if the bank received a composite rating of 1 in its most recent examination report and is not experiencing significant growth), and does not meet the definition of a “well capitalized” bank. A bank is “well capitalized” if it has a total risk-based capital ratio of 10% or higher, a Tier 1 risk-based capital ratio of 6% or higher, a leverage capital ratio of 5% or higher, and is not subject to any written requirement to meet and maintain any higher capital level(s).

      Under the regulation, “well capitalized” institutions are not subject to any brokered deposit limitations, while “adequately capitalized” institutions are able to accept, renew or roll over brokered deposits only (i) with a waiver from the FDIC, and (ii) subject to the limitation that they do not pay an effective yield on any such deposit which exceeds by more that 75 basis points (a) the effective yield paid on deposits accepted in its normal market area, or (b) the national rate paid on deposits of comparable maturity for deposits accepted outside the institution’s normal market area. “Undercapitalized” institutions will not be permitted to

accept brokered deposits and are subject to certain limitations on interest rates that may be paid in connection with any deposit solicitation.

      Under the provisions of the Federal Deposit Insurance Corporation Improvement Act, or FDICIA, and the Prompt Corrective Action regulations, an “undercapitalized” bank is subject to a limit on the interest it may pay on deposits. Also, an undercapitalized bank cannot make any capital distribution, including paying a dividend (with some exceptions), or pay any management fee (other than compensation to an individual in his or her capacity as an officer or employee of the bank). Such a bank also must submit a capital restoration plan to the FDIC for approval, restrict total asset growth and obtain regulatory approval prior to making any acquisition, opening any new branch office or engaging in any new line of business. An undercapitalized bank may also be subject to other, discretionary, regulatory actions. Additional mandatory and discretionary regulatory actions apply to “significantly undercapitalized” and “critically undercapitalized” banks. Failure of a bank to maintain the required capital could result in such bank being transferred to new owners in a supervisory transaction or being declared insolvent and closed.

      FDIC Insurance Premiums. The deposits of the bank are insured to the maximum extent permitted by the BIF. As the insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC. The FDIC also has the authority to initiate enforcement actions against savings institutions.

      The FDIC has implemented a risk-based assessment system under which FDIC-insured depository institutions pay annual premiums at rates based on their risk classification. A bank’s risk classification is based on its capital levels and the level of supervisory concern the bank poses to the regulators. Institutions assigned to higher risk classifications (that is, institutions that pose a greater risk of loss to their respective deposit insurance funds) pay assessments at higher rates than institutions that pose a lower risk. A decrease in the bank’s capital ratios or the occurrence of events that have an adverse effect on the bank’s asset quality, management, earnings or liquidity could result in a substantial increase in deposit insurance premiums paid by the bank, which would adversely affect the bank’s earnings. In addition, the FDIC can impose special assessments in certain instances. The range of assessments in the risk-based system is a function of the reserve ratio in the BIF. The current range of BIF assessments is between 0% and 0.27% of deposits because the BIF reserve ratio was greater than 1.25% when the ratios were set. The BIF reserve ratio was 1.31% as of June 30, 2004, the latest date for which complete data is available. If the ratio were to fall below 1.25%, the FDIC would consider whether to levy higher assessments. Congress has also recently considered proposals that would increase assessments on certain types of rapidly growing institutions.

      Federal law aimed at recapitalizing the Savings Association Insurance Fund requires, among other things, that banks insured under the BIF pay a portion of the interest due on bonds that were issued to replace funds paid out for the failure of insured thrifts by the Federal Savings and Loan Insurance Corporation in 1987. With respect to the assessment of the bond obligations, the BIF rate was 0.0146% of deposits for the fourth quarter of 2004 and is adjusted quarterly to reflect changes in the assessment bases of the respective funds based on quarterly Call Report submissions.

      Safety and Soundness Standards. The FDIC and the other federal bank regulatory agencies have established guidelines for safety and soundness, addressing operational and managerial standards, as well as compensation matters for insured financial institutions. Institutions failing to meet these standards are required to submit compliance plans to their appropriate federal regulators. The FDIC and the other agencies have also established guidelines regarding asset quality and earnings standards for insured institutions. The bank believes that it is in compliance with these guidelines and standards.

      Activities and Investments of Insured State-Chartered Banks. The activities and equity investments of FDIC-insured, state-chartered banks are presumptively limited by federal law to those that are permissible for national banks. An insured state bank generally may not acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. The FDIC has authority, however, to allow a state-

chartered non-member bank to engage in activities or make investments not permissible for national banks. An insured state bank is permitted to, among other things:

      Qualified Thrift Lender Test. The bank is required to meet a qualified thrift lender test under both federal and state law. This test requires a savings bank to have at least 65% of its portfolio assets, as defined by regulation, in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. As an alternative, the savings bank may maintain 60% of its assets in those assets specified in Section 7701(a)(19) of the Internal Revenue Code of 1986, as amended. Under either test, such assets primarily consist of residential housing related loans and investments. As of December 31, 2004, the bank met the test.

      Under federal law, any savings association (including a state savings bank that is treated as a savings association under Section 10 of HOLA) that fails to meet the qualified thrift lender test must convert to a bank charter, other than a savings bank charter, unless it requalifies as a qualified thrift lender and thereafter remains a qualified thrift lender. However, any savings bank which the OTS has deemed to be a savings association upon application by such bank, such as the bank, is precluded from requalifying for five years. Because of the five-year ban on requalification, a state savings bank that fails the OTS test must divest all investments and cease all activities not permissible for a national bank within three years. Within one year after the failure, the holding company of a state savings bank must register with the Federal Reserve Board as a bank holding company and become subject to all restrictions on bank holding companies administered by the Federal Reserve Board. New investments and activities are immediately limited to those permissible for both a savings association and a national bank. The savings bank is also limited to national bank branching rights in its home state. In addition, the savings bank is immediately ineligible to receive any new FHLB borrowings and is subject to national bank limits on payment of dividends.

      Restrictions on Acquisitions. There are restrictions under federal and Texas law regarding the acquisition of control of the bank. Federal and Texas laws generally provide that no company, directly or indirectly or acting in concert with one or more persons, or through one or more subsidiaries, or through one or more transactions, may acquire control of a savings bank at any time without prior approval of the appropriate regulatory agencies. The concept of acting in concert is very broad under these laws. In addition, federal and state laws require that, prior to obtaining control of a savings bank, a person, other than a company, must give prior notice and have received no objection to such acquisition of control and/or make an application to the appropriate regulatory agencies and receive approval to effect the acquisition.

      Potential Enforcement Actions. Insured depository institutions and their institution-affiliated parties may be subject to potential enforcement actions by the FDIC and the TSLD for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. The OTS may also bring enforcement actions based on its supervision of the company as a savings and loan holding company or on its regulation of capital distributions by the bank. Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of the bank), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the imposition of restrictions and sanctions under the prompt corrective action provisions of the FDICIA. Management of the bank knows of no pending or threatened enforcement actions against the bank.

      Liquidity. The bank is required to maintain a balance of “liquid assets” (cash, balances in a Federal Reserve Bank, and other readily marketable investments, including unencumbered federal government sponsored enterprises) equal to 10% of average daily deposits for the most recently completed calendar quarter. As of December 31, 2004, the bank was in compliance with this requirement.

      Restrictions on Capital Distributions. The bank is required to provide to the OTS not less than 30 days’ advance notice of the proposed declaration by its board of directors of any dividend on its capital stock. The OTS may object to the payment of the dividend on safety and soundness grounds. In addition, the bank would be subject to a more stringent OTS review if a proposed distribution would cause the bank to become under-capitalized or would exceed current net income plus retained net income for the previous two years or if the OTS did not regard the bank as well capitalized or well managed. The bank is currently not subject to this more stringent review.

      Texas law permits the bank to pay dividends out of current or retained income in cash or additional stock so long as the savings bank meets its capital requirements.

      The FDIC prohibits an insured depository institution from paying dividends on its capital stock or interest on its capital notes or debentures (if such interest is required to be paid only out of net profits) or distributing any of its capital assets while it remains in default in the payment of any assessment due the FDIC. The bank is not in default in any assessment payment to the FDIC.

      Federal Reserve System. The Federal Reserve Board requires all depository institutions to maintain reserves against their transaction accounts (primarily checking accounts) and non-personal time deposits. As of December 31, 2004, the bank was in compliance with such requirements.

      The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy applicable liquidity requirements. Because required reserves must be maintained in the form of vault cash or a non-interest-bearing account at a Federal Reserve Bank, the effect of this reserve requirement is to reduce a bank’s earning assets. The amount of funds necessary to satisfy this requirement has not had a material effect on the bank’s operations.

      Restrictions on Transactions with Affiliates and Insiders. Transactions between the bank and its nonbanking affiliates, including the company, are subject to Sections 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation W. In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties. It also limits the amount of advances to third parties which are collateralized by any securities or obligations or the securities or obligations of any of the company’s nonbanking subsidiaries.

      Affiliate transactions are also subject to Section 23B of the Federal Reserve Act which generally requires that certain transactions between the bank and its affiliates be on terms substantially the same, or at least as favorable to the bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons.

      The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to herein as “insiders”) contained in the Federal Reserve Act and Federal Reserve Regulation O apply to all insured institutions and their subsidiaries and holding companies. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions.

      The USA PATRIOT Act of 2001. The USA PATRIOT Act requires financial institutions to prohibit correspondent accounts with foreign shell banks, establish an anti-money laundering program that includes employee training and an independent audit, follow minimum standards for identifying customers and maintaining records of the identification information and make regular comparisons of customers against agency lists of suspected terrorists, their organizations and money launderers.

      Privacy Regulation. The company and its subsidiaries are subject to numerous privacy-related laws and their implementing regulations, including but not limited to Title V of the Gramm-Leach-Bliley Act, the Fair

Credit Reporting Act, the Electronic Fund Transfer Act, the Right to Financial Privacy Act, the Children’s Online Privacy Protection Act, and other federal and state privacy and consumer protection laws. Those laws and the regulations promulgated under their authority can limit, under certain circumstances, the extent to which financial institutions may disclose nonpublic personal information that is specific to a particular individual to affiliated companies and nonaffiliated third parties. Moreover, the bank is required to establish and maintain a comprehensive Information Security Program in accordance with the Interagency Guidelines Establishing Standards for Safeguarding Customer Information. The program must be designed to:

      In addition, the Federal Trade Commission has implemented a nationwide “do not call” registry that allows consumers to prevent unsolicited telemarketing calls. Millions of households have placed their telephone numbers on this registry.

      Texas Savings Bank Law. As a Texas-chartered savings bank, the bank is subject to regulation and supervision by the TSLD under the TSBA. The TSBA contains provisions governing the incorporation and organization, location of offices, rights and responsibilities of directors and officers as well as the corporate powers, savings, lending, capital and investment requirements and other aspects of the bank and its affairs. In addition, the TSLD is given extensive rulemaking power and administrative discretion under the TSBA, including authority to enact and enforce rules and regulations.

      The bank is required under the TSBA to comply with certain capital requirements established by the TSLD. The TSBA also restricts the amount the bank can lend to one borrower to that permitted to national banks, which is generally not more than 15% of the bank’s unimpaired capital and unimpaired surplus and, if such loans are fully secured by readily marketable collateral, an additional 10% of unimpaired capital and unimpaired surplus. The TSLD generally examines the bank once every year and the current practice is for the TSLD to conduct a joint examination with the FDIC. The TSLD monitors the extraordinary activities of the bank by requiring that the bank seek the TSLD’s approval for certain transactions, such as the establishment of additional offices, a reorganization, merger or purchase and assumption transaction, changes of control, or the issuance of capital obligations. The TSLD may intervene in the affairs of a savings bank if the savings bank, or its director, officer or agent has engaged in an unsafe and unsound practice, violated the savings bank’s articles of incorporation, violated a statute or regulation, filed materially false or misleading information, committed a criminal act or a breach of fiduciary duty, or if the savings bank is, or is in imminent danger of becoming, insolvent.

Consumer Protection Regulations

      The bank is subject to many federal consumer protection statutes and regulations including, but not limited to, the following:

      The Truth-in-Lending Act. The Truth-in-Lending Act, or TILA, is designed to ensure that credit terms are disclosed in a way that permits consumers to compare credit terms more readily and knowledgeably. As a result of the TILA, all creditors must use the same credit terminology and expressions of rates, the annual percentage rate, the finance charge, the amount financed, the total of payments, and the payment schedule.

      The Fair Housing Act. The Fair Housing Act regulates many practices, including making it unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap, or familial status.

      The Fair Credit Reporting Act. The Fair Credit Reporting Act, or FCRA, includes extensive rules governing credit reporting agencies and entities that collect information from consumers in connection with extensions of credit.

      The Fair and Accurate Credit Transactions Act of 2003. The Fair and Accurate Credit Transactions Act of 2003, or FACT, makes permanent the preemption of state laws contained in FCRA. In addition to preemption, FACT also imposes new requirements, including new restrictions on information sharing with affiliates for the purpose of making marketing solicitations, new consumer protection measures in the area of identity theft, a new requirement to provide a notice of action taken when a consumer is offered credit that is materially less favorable than the most favorable terms available to a substantial proportion of a lender’s customers. FACT also gives consumers the right to see their credit score and to receive a free annual copy of their credit report.

      The Equal Credit Opportunity Act. The Equal Credit Opportunity Act prohibits discrimination in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs, or good faith exercise of any rights under the Consumer Credit Protection Act.

      The Real Estate Settlement Procedures Act. The Real Estate Settlement Procedures Act, or RESPA, requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. The RESPA is applicable to all federally related mortgage loans. A “federally related mortgage loan” includes any loan secured by a first or subordinate lien on residential real property designed for occupancy by one-to-four families, including a refinancing of an existing loan secured by the same property, if:

      The Department of Housing and Urban Development, or HUD, undertook to substantially revise the rules implementing the RESPA, which specifies disclosures and procedures for mortgage lenders to provide their customers, in 2002. It is uncertain whether new rules will be proposed and whether any revised RESPA rules adopted will be favorable or adverse to us.

      The Home Mortgage Disclosure Act. The Home Mortgage Disclosure Act is intended to provide public information that can be used to help determine whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located and to assist in identifying possible discriminatory lending patterns.

      The Community Reinvestment Act. The Community Reinvestment Act, or CRA, is intended to encourage insured depository institutions, while operating safely and soundly, to help meet the credit needs of their communities. The CRA specifically directs the federal regulatory agencies, in examining insured depository institutions, to assess the institution’s record of helping to meet the credit needs of their entire community, including low- and moderate-income neighborhoods, consistent with safe and sound banking practices. The CRA further requires the agencies to take a financial institution’s record of meeting its community credit needs into account when evaluating applications for, among other things, domestic branches, consummating mergers or acquisitions, or holding company formations. To evaluate large retail institutions, the agencies apply three tests — the lending, investment, and service tests — to determine an overall CRA rating for the financial institution. The ratings range from a high of “outstanding” to a low of “substantial noncompliance.” A bank receiving a “satisfactory” or better rating is deemed in compliance with the CRA.

      The bank’s last public evaluation dated January 4, 2005, issued by its primary federal regulator, the FDIC, rated the bank “satisfactory.”

      The Bank Secrecy Act and Money Laundering Laws. The Bank Secrecy Act, or BSA, requires every financial institution within the United States to file a Currency Transaction Report with the Internal Revenue Service, or IRS, for each transaction in currency of more than $10,000 not exempted by the Treasury Department.

      The Money Laundering Prosecution Improvements Act requires financial institutions, typically banks, to verify and record the identity of the purchaser upon the issuance or sale of bank checks or drafts, cashier’s checks, traveler’s checks, or money orders involving $3,000 or more in cash. Institutions must also verify and record the identity of the originator and beneficiary of certain funds transfers.

      Electronic Fund Transfer Act. The Electronic Fund Transfer Act, or EFTA, provides a basic framework establishing the rights, liabilities, and responsibilities of participants in “electronic fund transfer systems,” defined to include automated teller machine transfers, telephone bill-payment services, point-of-sale terminal transfers, and preauthorized transfers from or to a consumer’s account (for example, direct deposit of social security payments). Its primary objective is to protect the rights of individuals using these systems. The EFTA limits a consumer’s liability for certain unauthorized electronic fund transfers and requires certain error resolution procedures.

      The Expedited Funds Availability Act. The Expedited Funds Availability Act seeks to insure prompt availability of funds deposited into a customer’s account and to expedite the return of checks.

      The Truth-in-Savings Act. The Truth-in-Savings Act, or TISA, is principally a disclosure law, the purpose of which is to encourage comparative shopping for deposit products. The common denominator used by the TISA to facilitate comparison shopping of interest payable on deposit accounts is the annual percentage yield.

      The bank attempts in good faith to assure compliance with the requirements of the consumer protection statutes to which it is subject, as well as the regulations that implement the statutory provisions. The requirements are complex, however, and even inadvertent non-compliance could result in civil and, in some cases, criminal liability.

      Legislative and Regulatory Proposals. Proposals to change the laws and regulations governing the capital, operations and taxation of, and federal insurance premiums paid by, savings banks and other financial institutions and companies that control such institutions are frequently raised in Congress, state legislatures and before the FDIC and other bank regulatory authorities. The likelihood of any major changes in the future and the impact such changes might have on us or the bank are impossible to determine. Similarly, proposals to change the accounting treatment applicable to savings banks and other depository institutions are frequently raised by the Securities and Exchange Commission, or SEC, the FDIC, the Internal Revenue Service, or IRS, and other appropriate authorities, including, among others, proposals relating to fair market value accounting for certain classes of assets and liabilities. The likelihood and impact of any additional future accounting rule changes and the impact such changes might have on us or the bank are impossible to determine at this time.

Employees

      As of December 31, 2004, all of our 548 employees were employed by the bank. We have entered into an arrangement with Administaff Companies II, L.P., to provide personnel management services to us. This service is provided through a co-employment relationship between us and Administaff, under which all of our employees are employed by both us and Administaff, and we have outsourced our human resources function to Administaff.

Risk Factors

      Our business is subject to certain risks. See “Cautionary Note Regarding Forward-Looking Information” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, contained in this report for a discussion of certain of these risks.

Executive Officers of the Registrant

      The names, ages as of December 31, 2004, recent business experience and positions or offices held by each of the executive officers of Franklin Bank Corp are as follows:

Available Information

      The company makes available, free of charge through its website, its reports on Forms 10-K, 10-Q and 8-K, and amendments to those reports as soon as reasonably practicable after such reports are filed with or furnished to the SEC. Additionally, we have adopted and posted on our website a code of ethics that applies to our directors, executive officers and employees, including our principal executive officer and principal financial officer. Our website also includes our corporate governance guidelines, code of ethics and business conduct and the charters for our audit committee, compensation committee and our corporate governance and nominating committee. The address for our website is http://www.bankfranklin.com. The contents of our website are not part of this report.

      We sub-lease our home office located at 9800 Richmond Avenue, Houston, Texas. We also lease branch offices located at 3720 Jefferson Street, 3401 Northland Drive, 3103 Bee Caves Road and the central Texas regional office at 3724 Jefferson Street in Austin, Texas, 109 Cypress Creek Road in Cedar Park, Texas, 4410 Williams Dr. in Georgetown, Texas and at 515 E Loop 28, Longview, Texas. Our central Texas regional office relocated to 4515 Seton Center Parkway, Austin, Texas during the first quarter of 2005. We own branch offices located at 501 E. Commerce, Jacksonville, Texas, 4803 Old Bullard Road and 2507 University in Tyler, Texas, 107 E. South St., Rusk, Texas, 1412 Judson Rd., Longview, Texas, 617 S. Palestine, Athens, Texas, 1A S. Market St., Carthage, Texas, 1015 N. Church St., Palestine, Texas, 499 Hwy. 71 W., Bastrop, Texas, 406 Main Street, Smithville, Texas, 601 E. Cedar Creek Parkway, Seven Points, Texas, 1101 N.W. 2nd Street, Kerens, Texas, 1716 W. Main Street and 127 South Gun Barrel Lane, Gun Barrel City, Texas and Highway 274 South, Tool, Texas. We also own a shopping center in Kingsland, Texas that has approximately 50,000 square feet of which the bank occupies approximately 16,000 square feet. We believe that suitable alternative or additional space will be available in the future on commercially reasonable terms as needed.

      The nature of our business causes us to be involved in routine legal proceedings from time to time. We do not believe that any pending legal proceedings will have a material adverse effect on our business, financial condition, results of operations or cash flows.

      No matters were submitted to a vote of security holders during the fourth quarter of 2004.

PART II

Common Stock Market Prices and Dividends

      Our stock trades on the NASDAQ National Market System under the symbol “FBTX”. The following table sets forth the high and low closing stock prices of our stock for each quarter since it began trading on the NASDAQ on December 18, 2003.

      As of March 1, 2005, there were 21,895,785 shares issued and outstanding held by approximately 2,870 beneficial owners. The last reported sales price of our common stock on March 1, 2005 was $16.93 per share.

      There were no dividends declared during 2004 or 2003. We currently do not intend to pay dividends on our common stock.

Recent Sales of Unregistered Securities

      The following is a summary of the transactions by the company during the period covered by this report and not previously reported on Form 8-K or Form 10-Q, involving sales of the company’s securities that were not registered under the Securities Act of 1933, as amended, or Securities Act.

      Pursuant to its 2004 Long-Term Incentive Plan, the company granted an aggregate of: 369,220 options in April 2004 entitling their holders to purchase one share of its common stock at an exercise price of $16.57 per share (subject to adjustments); 6,000 options in June 2004 entitling their holder to purchase one share of its common stock at an exercise price of $15.81 per share (subject to adjustments); and 5,000 options in August 2004 entitling their holder to purchase one share of its common stock at an exercise price of $16.08 per share (subject to adjustments).

      None of the transactions described above involved any underwriters, underwriting discounts or commissions, or any public offering, and the company believes that each transaction, if deemed to be a sale of a security, was exempt from the registration requirements of the Securities Act by virtue of Section 4(2) thereof or Rule 701 thereunder pursuant to compensatory benefit plans and contracts relating to compensation as provided under such Rule 701. The recipients of securities in each such transaction represented their intention to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof and acknowledged that the securities were issued in a transaction nor registered under the

Securities Act, such securities were restricted as to transfers and appropriate legends were affixed to the share certificates and instruments issued in such transactions.

Stock-Based Compensation

      Information regarding stock-based compensation awards outstanding and available for future grants as of December 31, 2004, segregated between stock-based compensation plans approved by shareholders and stock-based compensation plans not approved by shareholders, is presented in the table below. Additional information regarding stock-based compensation plans is presented in Note 13, Employee Benefits, and Note 14, Related Parties, in the notes to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, all of which is included elsewhere in this report.

      You should read the selected financial data in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the notes to those financial statements appearing elsewhere in this report. Financial information for the years ended December 31, 2001 and 2000 represent activity for the bank only prior to our acquisition. All of the company’s acquisitions were accounted for using the purchase method. Accordingly, the operating results of the acquired companies are included with the company’s results of operations beginning on their date of acquisition.

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:

      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:

      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. These potential future transactions may be effected quickly, may occur at any time and may be significant in size relative to our existing assets and operations. No assurance may be given that we will be able to successfully complete any such transactions. 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.

Overview

      We were formed in August 2001 and began our banking operations in April 2002 with our acquisition of the bank. Since April 2002, we have grown from $61.3 million in assets to $3.5 billion at December 31, 2004, expanded our community banking offices to 23 from two, established our corporate office where we provide many of our banking services, expanded our commercial lending regional offices to Arizona, Florida, Pennsylvania, Detroit, and Dallas, Texas, and initiated a mortgage banking business with 56 retail mortgage offices in 20 states throughout the United States and three wholesale offices in Texas, California and Tennessee.

      Our historical financial results reflect the development of our business. During 2002, we incurred the non-interest expense related to our expansion and the infrastructure cost necessary to support the expansion. At the end of 2002 and throughout 2003, we began to acquire and originate loans and other earning assets, which have increased our revenues to a level commensurate with the expenses that we incurred in our development stage. During 2004, we have continued to see the results from the execution of our business strategy as our asset and revenue growth have offset the ongoing cost of executing our business strategy. We have achieved improved levels of profitability as our businesses have begun to generate earning assets and revenues that exceed their ongoing operating expenses. We will continue to make additional investments in our businesses to expand the range of our product lines and services.

Critical Accounting Policies

      Our significant accounting policies are described in the notes to our consolidated financial statements which are included elsewhere in this report. Certain of these 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 at the time of the estimate. However, actual results could differ significantly from these estimates and assumptions which could have a material impact on our financial condition and results of operations. Our critical accounting policies are described below.

      We maintain our allowance for credit losses at the amount estimated by management to be sufficient to absorb probable losses based on available information. Our estimates of credit losses meet the criteria for accrual of loss contingencies in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies,” as amended by SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” When analyzing the appropriateness of the allowance for credit losses, we 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 process of evaluating the adequacy of the allowance for credit losses has two basic elements: first, the identification of problem loans based on current operating financial information and fair value of the underlying collateral property; and second, a methodology for estimating general credit loss reserves. For loans classified as “watch,” “special mention,” “substandard” or “doubtful,” whether analyzed and provided for individually or as part of pools, we record all estimated credit losses at the time the loan is classified. In order to facilitate the establishment of our general allowance for credit losses, we have established a risk grade classification system for components of our loan portfolio that do not have homogeneous terms, such as commercial loans. This system grades loans based on credit and collateral support for each loan. The grades range from one, which represents the least possible risk to us, to eight, for doubtful loans. Each credit grade has a general minimum credit allowance factor established for each type of loan. We use this general credit allowance factor in establishing our allowance for credit losses. We establish the credit loss allowance through a systematic methodology whereby each loan is assigned a credit grade at origination. We establish the allowance for credit losses by using the credit allowance factor for the individual loan, based on the risk classification, and providing as the allowance for credit loss the product of the loan balance times the credit allowance factor over the initial twelve months of the loan’s term. For homogeneous loans, such as single-family mortgage and consumer loans, we utilize the frequency and severity of losses for the asset class and the delinquency status in determining the credit allowance factor. The allowance for credit losses is determined by multiplying the portfolio balance by the credit allowance factor for the portfolio and providing the resulting amount ratably over twelve months. When available information confirms specific loans, or portions of those loans, to be uncollectible, we charge off those amounts against the allowance for credit losses. Even after loans are charged off, we continue reasonable collection efforts until the potential for recovery is exhausted. See “— Credit Quality — Allowance for Credit Losses.”

      In connection with our mortgage banking activities, we enter into interest rate lock commitments with loan applicants whereby the interest rate on the loan is guaranteed for a certain period of time while the application is in the approval process, which we refer to as the “locked pipeline.” In accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” interest rate lock commitments are derivative financial instruments and changes in their fair value are required to be reported in current earnings. The fair value of interest rate lock commitments is determined as of the date the interest rate is locked and is 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. Generally, we base the change in the value of the underlying mortgages on quoted market prices of publicly traded mortgage backed securities. Management estimates the amount of loans expected to close by applying a “fall-out” ratio for commitments that expire. This estimate is based on the historical data for loans

with similar characteristics as well as current market conditions. We record changes in the fair value as gains or losses on sales of single family loans on the consolidated statements of operations.

      Goodwill represents the excess of the purchase price over the fair value of net assets acquired. In accordance with SFAS No. 142 “Goodwill and Other Intangible Assets,” goodwill is not amortized but is evaluated for impairment at least annually. Goodwill is tested for impairment using quoted market prices and transactions involving similar types of institutions to determine if the fair value of our assets, net of liabilities, exceeds the carrying amount. If the fair value of our net assets is determined to be less than the carrying amount, goodwill would be written down through a charge to operations.

Significant Transactions

      On December 4, 2004, we acquired Cedar Creek for approximately $23.9 million, including $11.3 million in cash, $12.3 million in shares of our common stock, valued at $18.37 per share and $288,000 in direct acquisition costs through December 31, 2004. Cedar Creek was a Texas-based bank holding company with approximately $107.3 million in assets and $96.7 million in deposits at the time of acquisition. The acquisition of Cedar Creek expanded our presence in our east Texas market.

      On February 29, 2004, we acquired Lost Pines for approximately $7.2 million including $308,000 in direct acquisition costs. Lost Pines was a Texas-based bank holding company with approximately $40.2 million in assets and $36.3 million in deposits at the date of the acquisition. The acquisition of Lost Pines expanded our presence in our central Texas market.

      On December 30, 2003, we acquired Jacksonville for approximately $68.6 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. Jacksonville operated nine community banking branches in east Texas.

      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 included $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 central Texas market.

      In November 2002, we issued 8,000,000 shares of our common stock at $10.00 per share in an offering that was exempt from the registration requirements of the Securities Act. Related issuance costs of $5.6 million are included as a reduction to paid-in capital on our consolidated statement of stockholders’ equity. In connection with the offering, 2,353,320 shares of our outstanding common stock were classified as Class B common stock and the shares issued in the offering were classified as Class A common stock. We used the net proceeds from the offering for general corporate purposes. On November 4, 2003, our Class B common stock was converted into Class A common stock. All of the Class A common stock was classified into common stock at the time of our initial public offering in December 2003.

      Also in November 2002, we formed Franklin Bank Capital Trust I. The trust issued, in a private offering, $20 million of variable rate trust preferred securities that currently pays 5.64% annually and resets quarterly to 3-month LIBOR plus 3.35%, and invested the proceeds in variable rate junior subordinated notes, or junior notes, issued by us. In addition, we invested $619,000 in variable rate common securities of the trust. We can

redeem the junior notes at our option at par plus accrued and unpaid interest beginning in November 2007. The junior notes mature in November 2032.

      On April 9, 2002, we acquired Franklin Bank for total consideration of $11.2 million, including $1.4 million in cash, $8.9 million in shares of our common stock valued at $10.00 per share, and $905,000 in acquisition costs. Prior to our acquisition of the bank, we had assets of approximately $488,000. After the acquisition we had assets of approximately $61.3 million, deposits of $47.3 million and stockholders’ equity of $14.3 million. This acquisition gave us the platform on which we have built our business.

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 to purchase single family loans. The company’s mortgage banking activities, which generate gains on sales of single family loans and mortgage-backed securities and loan fees, also contribute to our net income.

      The results from operations for the years ended December 31, 2004, 2003 and 2002 include Cedar Creek beginning on December 4, 2004, Lost Pines beginning March 1, 2004, Jacksonville beginning on December 31, 2003, Highland beginning on May 1, 2003 and Franklin Bank beginning on April 10, 2002. The results of operations for the years ended December 31, 2001 and 2000 are the results of Franklin Bank prior to our acquisition. During these periods, the bank operated as a local community bank.

      Net income was $23.1 million, or $1.07 per diluted share, for the year ended December 31, 2004, compared to $3.2 million, or $0.29 per diluted share, for the year ended December 31, 2003. This increase is due to growth in our single family and commercial loan portfolios, a higher net yield on interest-earning assets, and the acquisition of Jacksonville.

      Net interest income. Net interest income is the amount of interest earned on our assets in excess of interest incurred on our liabilities. The net yield on interest-earning assets, or net yield, represents net interest income expressed as a percentage of our average interest-earning assets. The table below sets forth information regarding our average interest-earning assets and average interest-bearing liabilities and the related income and expense and weighted average yields. Average balances for the years ended December 31, 2004 and 2003 are based on daily average balances, except for Cedar Creek for the period December 4, 2004 through December 31, 2004, Lost Pines for the period March 1, 2004 until it was converted to our systems on July 23, 2004, Jacksonville for the period January 1, 2004 until it was converted to our systems on March 12, 2004 and Highland for the period May 1, 2003 until it was converted to our general systems on May 23, 2003, whose average balances are calculated using average monthly balances.

      Interest income and interest expense are impacted both by changes in the volume of interest-earning assets and interest-bearing liabilities and by changes in yields and rates. The table below analyzes the impact of changes in volume (changes in average outstanding balances multiplied by the prior period’s rate) and changes in rate (changes in rate multiplied by the prior period’s average balance) from 2003 to 2004. Changes that are impacted by a combination of rate and volume are allocated proportionately to both changes in volume and changes in rate. For purposes of calculating the changes in our net interest income, non-performing assets are included in the appropriate balance and shown as a rate difference.

      Net interest income increased $46.3 million to $65.7 million for the year ended December 31, 2004, from $19.4 million for the year ended December 31, 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. Purchases of single family loans totaled $1.8 billion during 2004 and are primarily made up of adjustable rate mortgages with an initial interest rate reset of three to five years and annual resets thereafter. Additionally, during 2004 we opened three regional commercial lending offices, bringing our total commercial lending offices to six at December 31, 2004. Through our commercial lending offices we originated $1.2 billion in new loans during the year ended December 31, 2004. The net yield rose 58 basis points, from 1.77% for the year ended December 31, 2003 to 2.35% for the year ended December 31, 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 following table details our interest income and non-interest expense by product:

      Of our products, only the community banking products incur interest expense. Community banking accounted for $10.5 million, or 20%, of total interest expense for the year ended December 31, 2004 and $2.6 million, or 12%, of our total interest expense for the year ended December 31, 2003.

      Provision for credit losses. The provision for credit losses is the periodic cost of maintaining an adequate allowance to cover probable losses. The table below sets forth the activity in our allowance for credit losses.

      The provision for credit losses increased $1.1 million, to $2.1 million for the year ended December 31, 2004, as compared to $1.0 million for the year ended December 31, 2003. The increase in the allowance for credit losses was primarily due to the increase in the size of the commercial loan portfolio. The decrease in the single family loan provision is due to the results of our migration analysis on our single family loans that showed that the loss exposure had decreased from our analysis in the prior year. We base our provision for loan losses on single family loans from this analysis. Management believes that the allowance for credit losses is adequate to cover known and inherent risks in the loan portfolio.

      Charge-offs for the year ended December 31, 2004 were $730,000 and primarily relate to a residential construction loan and small business loans. The residential construction loan charge-off totaled $193,000 and was foreclosed in June 2004. The small business loans charge-off totaled $257,000.

      See Note 1 to the consolidated financial statements for a further discussion of our allowance for credit losses.

      Non-interest income. The following table sets forth the composition of our non-interest income.

      Non-interest income increased $7.8 million to $12.6 million for the year ended December 31, 2004, compared to $4.8 million for the year ended December 31, 2003. 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 bank.

      Gains on sales of single family loans increased $1.6 million during the year ended December 31, 2004 as compared to the same period a year ago. We originate loans through our retail and wholesale mortgage offices, as described under “Item 1. Business-Business Activities-Mortgage Banking-Retail Mortgage Origination,” with the intention of selling the majority of loans originated, including the related servicing. During the year ended December 31, 2004, we sold $825.5 million of single family loans, resulting in a gain of $3.6 million. We had gains totaling $98,000 on interest rate lock commitments during the year ended December 31, 2004 related to commitments totaling $25.6 million, excluding loans expected to be transferred to our portfolio and after considering the amount of interest rate lock commitments expected to expire prior to closing the related mortgage loan. See “— Critical Accounting Policies — Rate Lock Commitments” above. Additionally, we had a gain totaling $58,000 on forward delivery contracts, totaling $16.9 million, entered into to hedge the interest rate lock commitments. Loans sold totaling $459.5 million were from our held for investment portfolio to reduce the re-pricing risk on single family loans whose first interest rate repricing is five years after origination in this portfolio and to reduce our exposure in California. Sales of single family loans during the year ended December 31, 2003, totaled $149.6 million, resulting in a gain of $2.1 million. The gain on sale of securities for the year ended December 31, 2004 totaled $229,000, including $137,000 related to the sale of $15.8 million of mortgage-backed securities and $92,000 related to the sale of $15.3 million of agency notes. Mortgage-backed securities sold totaling $6.8 million and the agency notes sold came from the Jacksonville acquisition. The gain on sale of securities for the year ended December 31, 2003 totaled $859,000, related to the sale of $36.2 million of mortgage-backed securities and $111,000 related to the sale of a $10.0 million U.S. Treasury security.

      Loan fee income increased $3.9 million during the year ended December 31, 2004 to $5.0 million, from $1.1 million during the year ended December 31, 2003. Under certain circumstances we will act as a mortgage broker to facilitate the origination of single family loans in the name of other financial institutions for a fee. Mortgage broker fees totaled $4.4 million during the year ended December 31, 2004, as compared to $1.1 million during the year ended December 31, 2003. Loan servicing fees increased during the year ended December 31, 2004 as compared to the year ended December 31, 2003 due to an increase in the size of the portfolio of loans we service for other institutions, from $117.8 million at December 31, 2003 to $168.3 million at December 31, 2004.

      Deposit fees and charges, which are primarily comprised of fees and service charges on community banking deposit accounts, increased $2.3 million during the year ended December 31, 2004, to $2.5 million, from $191,000 during the year ended December 31, 2003. This increase relates to overdraft fees, services charges on checking accounts and fees charged for other banking related services and is directly related to an increase in our customer base. The number of transaction accounts rose from 13,158 at December 31, 2003 to

25,407 at December 31, 2004. This growth came from our acquisitions of Lost Pines on February 29, 2004 and Cedar Creek on December 4, 2004 and successful marketing efforts including competitive pricing, newspaper advertising and direct mail. Additionally, we opened two new community banking offices in central Texas during the year ended December 31, 2004. Transaction accounts for the year ended December 31, 2003 include those acquired from Jacksonville on December 30, 2003. We did not realize any fees or service charges from these accounts until 2004.

      Other non-interest income is primarily comprised of ancillary income on non-deposit customer services provided, rental income earned on owned properties and income related to mortgage banker finance activities. The increase in other non-interest income was due to the acquisitions of Jacksonville and Highland, which contributed an additional $268,000 during the year ended December 31, 2004 as compared to the year ended December 31, 2003. Income related to mortgage banker finance activities increased during the year ended December 31, 2004, which was the first full year we offered this product. Additionally, non-interest income includes the reversal of the credit mark for $227,000 on a loan acquired in the Franklin acquisition due to the loan’s payment in full during the year ended December 31, 2004.

      Non-interest expense. The following table details the components of our non-interest expense (in thousands).

      Non-interest expense increased $22.5 million during the year ended December 31, 2004, to $40.7 million, from $18.2 million during the year ended December 31, 2003. This increase is due to the acquisitions of Jacksonville, Lost Pines and Highland and the overall growth of the bank.

      Salaries and benefits increased $11.0 million during the year ended December 31, 2004, to $20.1 million, from $9.1 million during the year ended December 31, 2003. The number of full time equivalent employees at December 30, 2004 totaled 548, compared to 399 at December 31, 2003. Included in headcount for the year ended December 31, 2003 were 100 employees acquired with the Jacksonville merger on December 30, 2003, for which we did not incur any compensation expense during 2003. The increase in headcount during the year ended December 31, 2004 includes 69 from the Lost Pines and Cedar Creek acquisitions, 41 from our mortgage production offices and 15 from growth in our commercial lending business. Partially offsetting the increase in compensation expense was $1.9 million in restricted stock compensation awarded to certain key employees in connection with our initial public offering during 2003.

      Data processing expense increased $2.3 million during the year ended December 31, 2004, to $3.6 million, from $1.3 million during the year ended December 31, 2003. Higher data processing costs represent 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 and Lost Pines.

      Occupancy expense increased $1.8 million during the year ended December 31, 2004, to $3.5 million, from $1.7 million for the year ended December 31, 2003. This increase is due to the acquisitions of Jacksonville, Lost Pines and Highland, which added nine, two and one community banking offices, respectively. Additionally, we expanded our corporate offices in Houston, Texas, added two community banking offices in central Texas, added three commercial lending offices and expanded our mortgage banking

business, increasing the number of retail and wholesale offices from 36 at December 31, 2003 to 59 at December 31, 2004.

      Professional fees are primarily comprised of legal fees, directors’ fees and expenses, fees incurred for our outside auditors and fees paid for our outsourced mortgage banking activities, including appraisals, underwriting and post-closing services. Also included in professional fees are consulting fees paid to Ranieri & Co., Inc. In November 2002, we entered into a three-year consulting agreement with Ranieri & Co., Inc., as part of which we granted it an option to purchase 570,000 shares of our common stock and agreed to pay a $500,000 annual fee for consulting activities. See Note 14 to the Notes to the Consolidated Financial Statements under Item 8. The fair value of the options were recognized over the life of the consulting agreement pursuant to SFAS No. 123, “Accounting for Stock Based Compensation.” Professional fees increased $701,000 during the year ended December 31, 2004, to $3.8 million, from $3.1 million during the year ended December 31, 2003. This increase primarily relates to higher audit fees resulting from increased services, including compliance with the Sarbanes-Oxley Act of 2002. Additionally, legal fees have increased due to a lawsuit relating to construction lending activities that occurred prior to our acquisition of Franklin. Partially offsetting this increase was a decline in costs associated with the consulting agreement with Ranieri & Co, Inc. Pursuant to the consulting agreement, the options fully vested upon the completion of the registration of our common stock during December 2003 and the remaining fair value of the option was recognized in the consolidated statement of operations during the year ended December 31, 2003.

      Loan expense increased $1.5 million during the year ended December 31, 2004, to $2.4 million, from $913,000 during the year ended December 31, 2003. This increase is due to an increase in mortgage banking activity from originations, purchases and sales of single family loans during 2004 as compared to 2003.

      Amortization of intangibles increased $733,000 during the year ended December 31, 2004, to $588,000, compared to a reduction in expense of $145,000 during the year ended December 31, 2003. The reduction in expense during 2003 includes the reversal of $237,000 of estimated core deposit intangible amortization. During 2003, the core deposit intangible study related to the Franklin acquisition, which was originally estimated on the asset and liability tables for the first quarter of 2002 published by the OTS, was finalized, based on the actual deposits acquired. The estimate using the OTS tables valued the core deposit intangible at $1.6 million, as compared to the core deposit intangible study valuation of $204,000. Goodwill was adjusted for the difference between the estimated and the amount that resulted from the core deposit intangible study. Additionally, amortization of intangibles increased during the year ended December 31, 2004, as compared to the year ended December 31, 2003, due to the amortization of the core deposit intangible from the Jacksonville, Lost Pines and Highland acquisitions.

      Other non-interest expense increased $4.4 million during the year ended December 31, 2004, to $6.6 million, compared to $2.2 million during the year ended December 31, 2003. This increase includes higher marketing, insurance, office supplies, postage and courier expenses incurred to support our growth and expansion.

      Net income was $3.2 million for the year ended December 31, 2003, compared to a net loss of $726,000 for the year ended December 31, 2002. During the year ended December 31, 2003, we focused on expanding the bank’s business activities and increasing its overall profitability. The net loss reported for the year ended December 31, 2002 reflects the costs we incurred as we began to implement our business strategy.

      Net interest income. The table below sets forth information regarding our average interest-earning assets and average interest-bearing liabilities and the related income and expense and weighted average yields. Average balances for the year ended December 31, 2003 are based on daily average balances, except for

Highland for the period May 1, 2003 until it was converted to our general ledger on May 23, 2003, and average balances for the year ended December 31, 2002, which are based on average monthly balances.