TEXAS CAPITAL BANCSHARES INC/TX - 10-Q Quarterly Report

N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

Indicate by checkmark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

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

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

Indicate by check whether the issuer has filed all reports required to be filed by Section 12, 13 or 15(d) of the Securities and Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes o No o

On October 31, 2003, the number of shares set forth below was outstanding with respect to each of the issuer’s classes of common stock:


Part I. Financial Information
	Item 1.	Financial Statements
		Consolidated Statements of Operations - Unaudited	3
		Consolidated Balance Sheets - Unaudited	4
		Consolidated Statements of Changes in Stockholders' Equity - Unaudited	5
		Consolidated Statements of Cash Flows - Unaudited	6
		Notes to Consolidated Financial Statements - Unaudited	7
		Financial Summaries - Unaudited	13
	Item 2.	Management's Discussion and Analysis of Financial Condition and
		Results of Operations	15
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	27
	Item 4.	Controls and Procedures	28
Part II. Other Information
	Item 6.	Exhibits and Reports on Form 8-K	29

TEXAS CAPITAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS — UNAUDITED
(Dollars in thousands except per share data)


	Three Months Ended						Nine Months Ended
	September 30						September 30
	2003			2002			2003			2002

Interest income
Interest and fees on loans	$	16,114		$	14,219		$	46,791		$	39,545
Securities		4,832			3,815			15,517			10,320
Federal funds sold		20			25			150			204
Deposits in other banks		4			3			11			6

Total interest income		20,970			18,062			62,469			50,075
Interest expense
Deposits		5,041			5,617			16,020			15,650
Federal funds purchased		348			402			1,257			1,145
Other borrowings		1,980			1,169			6,805			2,798
Long-term debt		250			—			630			—

Total interest expense		7,619			7,188			24,712			19,593

Net interest income		13,351			10,874			37,757			30,482
Provision for loan losses		475			2,380			3,325			4,359

Net interest income after provision for loan losses		12,876			8,494			34,432			26,123
Non-interest income
Service charges on deposit accounts		856			710			2,596			2,055
Trust fee income		350			235			937			727
Gain on sale of securities		—			1,375			686			1,375
Cash processing fees		—			—			973			993
Bank owned life insurance (BOLI) income		451			144			1,293			144
Mortgage warehouse fees		545			188			1,248			545
Other		310			211			924			680

Total non-interest income		2,512			2,863			8,657			6,519
Non-interest expense
Salaries and employee benefits		5,754			4,163			16,990			12,492
Net occupancy expense		1,265			1,214			3,651			3,767
Advertising and affinity payments		213			448			605			1,010
Legal and professional		744			724			2,253			2,175
Communications and data processing		767			717			2,223			2,117
Franchise taxes		37			34			111			81
Repurchase agreement penalties		—			—			6,262			—
Other		1,703			1,263			4,667			3,701

Total non-interest expense		10,483			8,563			36,762			25,343

Income before income taxes		4,905			2,794			6,327			7,299
Income tax expense (benefit)		1,573			700			(3,893	)		1,828

Net income		3,332			2,094			10,220			5,471
Preferred stock dividends		(149	)		(280	)		(699	)		(817	)

Income available to common stockholders	$	3,183		$	1,814		$	9,521		$	4,654

Earnings per share:
Basic	$	.15		$	.09		$	.47		$	.24
Diluted	$	.14		$	.09		$	.45		$	.24

TEXAS CAPITAL BANCSHARES, INC.
CONSOLIDATED BALANCE SHEETS — UNAUDITED
(Dollars in thousands except per share data)


			September 30,			December 31,
			2003			2002

Assets
Cash and due from banks			$	78,900		$	88,744
Securities, available-for-sale				811,968			553,169
Loans, net				1,108,552			988,019
Loans held for sale				91,686			116,106
Premises and equipment, net				3,695			3,829
Accrued interest receivable and other assets				54,211			41,919
Goodwill, net				1,496			1,496

Total assets			$	2,150,508		$	1,793,282

Liabilities and Stockholders’ Equity
Liabilities:
	Deposits:
		Non-interest bearing	$	295,902		$	238,873
		Interest bearing		1,131,205			957,662

	Total deposits			1,427,107			1,196,535
	Accrued interest payable			2,530			3,826
	Other liabilities			8,178			8,485
	Federal funds purchased			103,726			83,629
	Repurchase agreements			418,605			302,083
	Other borrowings			5,282			63,748
	Long-term debt			20,000			10,000

Total liabilities				1,985,428			1,668,306
Stockholders’ equity:
	Series A convertible preferred stock, $.01 par value, 6%:
		Authorized shares - 10,000,000
		Issued shares - 1,057,142 at December 31, 2002		—			11
	Common stock, $.01 par value:
		Authorized shares - 100,000,000
		Issued shares - 24,523,254 and 18,500,812 at September 30, 2003 and December 31, 2002, respectively		245			185
	Series A-1 non-voting common stock, $.01 par value:
		Issued shares - 304,000 and 695,516 at September 30, 2003 and December 31, 2002, respectively		3			7
	Additional paid-in capital			165,972			131,881
	Accumulated deficit			(3,127	)		(13,347	)
	Treasury stock (shares at cost: 97,246 at September 30, 2003 and December 31, 2002)			(668	)		(668	)
	Deferred compensation			573			573
	Accumulated other comprehensive income			2,082			6,334

Total stockholders’ equity				165,080			124,976

Total liabilities and stockholders’ equity			$	2,150,508		$	1,793,282

TEXAS CAPITAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY — UNAUDITED
(Dollars in thousands except per share data)


		Series A										Series A-1
		Convertible										Non-voting
		Preferred Stock						Common Stock				Common Stock

		Shares			Amount			Shares		Amount		Shares			Amount

Balance at December 31, 2001			753,301		$	8			18,400,310	$	184		741,392		$	7




Comprehensive income:




	Net income		—			—			—		—		—			—




	Change in unrealized gain (loss) on available-for-sale securities, net of tax of $3,683, net of reclassification amount of $1,375		—			—			—		—		—			—




Total comprehensive income




Sale of Series A convertible preferred stock			303,841			3			—		—		—			—




Sale of common stock			—			—			54,626		1		—			—




Preferred dividends			—			—			—		—		—			—




Transfers			—			—			45,876		—		(45,876	)		—




Purchase of treasury stock			—			—			—		—		—			—




Sale of treasury stock			—			—			—		—		—			—

Balance at December 31, 2002			1,057,142			11			18,500,812		185		695,516			7




Comprehensive income:




	Net income		—			—			—		—		—			—




	Change in unrealized gain (loss) on available-for-sale securities, net of taxes of $1,361, net of reclassification amount of $686		—			—			—		—		—			—




Total comprehensive income




Sale of common stock			—			—			3,516,642		35		—			—




Conversion of preferred stock			(1,057,142	)		(11	)		2,114,284		21		—			—




Transfers			—			—			391,516		4		(391,516	)		(4	)




Preferred dividends			—			—			—		—		—			—

Balance at September 30, 2003			—		$	—			24,523,254	$	245		304,000		$	3

[Continued from above table, first column(s) repeated]



																Accumulated
																Other
																Compre-
		Additional						Treasury Stock								hensive
		Paid-in			Accumulated									Deferred		Income
		Capital			Deficit			Shares			Amount			Compensation		(Loss)			Total

Balance at December 31, 2001		$	127,378		$	(20,690	)		(87,516	)	$	(594	)	$	573	$	(507	)	$	106,359




Comprehensive income:




	Net income		—			7,343			—			—			—		—			7,343




	Change in unrealized gain (loss) on available-for-sale securities, net of tax of $3,683, net of reclassification amount of $1,375		—			—			—			—			—		6,841			6,841




Total comprehensive income																				14,184




Sale of Series A convertible preferred stock			5,247			—			—			—			—		—			5,250




Sale of common stock			350			—			—			—			—		—			351




Preferred dividends			(1,097	)		—			—			—			—		—			(1,097	)




Transfers			—			—			—			—			—		—			—




Purchase of treasury stock			—			—			(14,144	)		(103	)		—		—			(103	)




Sale of treasury stock			3			—			4,414			29			—		—			32

Balance at December 31, 2002			131,881			(13,347	)		(97,246	)		(668	)		573		6,334			124,976




Comprehensive income:




	Net income		—			10,220			—			—			—		—			10,220




	Change in unrealized gain (loss) on available-for-sale securities, net of taxes of $1,361, net of reclassification amount of $686		—			—			—			—			—		(4,252	)		(4,252	)




Total comprehensive income																				5,968




Sale of common stock			34,800			—			—			—			—		—			34,835




Conversion of preferred stock			(10	)		—			—			—			—		—			—




Transfers			—			—			—			—			—		—			—




Preferred dividends			(699	)		—			—			—			—		—			(699	)

Balance at September 30, 2003		$	165,972		$	(3,127	)		(97,246	)	$	(668	)	$	573	$	2,082		$	165,080

TEXAS CAPITAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS — UNAUDITED
(Dollars in thousands)


			Nine Months Ended
			September 30
			2003			2002

Operating activities
Net income			$	10,220		$	5,471
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
	Provision for loan losses			3,325			4,359
	Depreciation and amortization			1,060			1,299
	Amortization and accretion on securities			7,803			1,258
	Bank owned life insurance (BOLI) income			(1,293	)		(144	)
	Gain on sale of securities			(686	)		(1,375	)
	Originations of loans held for sale			(1,899,622	)		(744,241	)
	Proceeds from sales of loans held for sale			1,924,496			711,952
	Impact of reversing valuation allowance			(5,929	)		—
	Changes in operating assets and liabilities:
		Accrued interest receivable and other assets		(4,840	)		(3,947	)
		Accrued interest payable and other liabilities		961			(2,429	)

Net cash provided by (used in) operating activities				35,495			(27,797	)
Investing activities
Purchases of available-for-sale securities				(609,127	)		(329,361	)
Proceeds from sales of available-for-sale securities				42,914			41,471
Maturities and calls of available-for-sale securities				9,700			4,700
Principal payments received on securities				283,782			49,723
Net increase in loans				(124,701	)		(122,832	)
Purchase of premises and equipment, net				(768	)		(129	)
Purchase of BOLI				—			(25,000	)

Net cash used in investing activities				(398,200	)		(381,428	)
Financing activities
Net increase in checking, money market and savings accounts				200,619			83,473
Net increase in certificates of deposit				29,953			150,042
Sale of common stock				34,835			193
Net other borrowings				58,056			201,489
Net federal funds purchased				20,097			3,000
Sale of preferred stock				—			5,250
Purchase of treasury stock, net				—			(70	)
Trust preferred				10,000			—
Dividends paid				(699	)		(563	)

Net cash provided by financing activities				352,861			442,814

Net increase (decrease) in cash and cash equivalents				(9,844	)		33,589
Cash and cash equivalents at beginning of period				88,744			56,620

Cash and cash equivalents at end of period			$	78,900		$	90,209

Supplemental disclosures of cash flow information:
	Cash paid during the period for interest		$	25,919		$	20,162
	Cash paid during the period for income taxes			5,720			—
Non-cash transactions:
	Transfers from loans/leases to other repossessed assets			230			342
	Transfers from loans/leases to premises and equipment			158			279

TEXAS CAPITAL BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — UNAUDITED

The accounting and reporting policies of Texas Capital Bancshares, Inc. (the “Company”) conform to accounting principles generally accepted in the United States and to generally accepted practices within the banking industry. The Consolidated Financial Statements of the Company include the accounts of the Company and its subsidiary, Texas Capital Bank, National Association (the “Bank”). The Company owns all of the outstanding common securities of Texas Capital Bancshares Statutory Trust I, a Connecticut business trust, and Texas Capital Statutory Trust II, a Delaware statutory trust. Certain prior period balances have been reclassified to conform with the current period presentation.

The consolidated interim financial statements have been prepared without audit. Certain information and footnote disclosures presented in accordance with accounting principles generally accepted in the United States have been condensed or omitted. In the opinion of management, the interim financial statements include all normal and recurring adjustments and the disclosures made are adequate to make interim financial information not misleading.

In December 2002, the Financial Accounting Standards Board issued FASB Statement No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. Statement 148 amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition to Statement 123’s fair value method of accounting for stock-based employee compensation. Statement 148 also amends the disclosure provisions of Statement 123 and APB Opinion No. 28, Interim Financial Reporting, to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. While the Statement does not amend Statement 123 to require companies to account for employee stock options using the fair value method, the disclosure provisions of Statement 148 are applicable to all companies with stock-based employee compensation, regardless of whether they account for that compensation using the fair value method of Statement 123 or the intrinsic value method of Opinion 25. The Company adopted the disclosure provisions of Statement 148 effective December 31, 2002.

At September 30, 2003, the Company had a stock-based employee compensation plan. The Company accounts for the plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123 to stock-based employee compensation.


		Three months ended September 30						Nine months ended September 30
(Dollars in thousands)		2003			2002			2003			2002

Net income:
	Net income as reported	$	3,332		$	2,094		$	10,220		$	5,471
	Add: Total stock based employee compensation recorded		45			20			286			20
	Deduct: Total stock based employee compensation expense determined under fair value based method for all awards		(204	)		(184	)		(759	)		(483	)

Pro forma net income		$	3,173		$	1,930		$	9,747		$	5,008

The fair value of these options was estimated at the date of grant using a Black-Scholes value option pricing model with the following weighted average assumptions used for 2003 and 2002, respectively: a risk free interest rate of 3.33% and 4.07%, a dividend yield of 0%, a volatility factor of .387 and .001, and an estimated life of five years.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

Financial Accounting Standards Board Interpretation (FIN) No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others — an Interpretation of FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 34. FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002, and were adopted in our financial statements for the year ended December 31, 2002. Implementation of the remaining provisions of FIN 45 did not have a significant impact on our 2003 financial statements.

FIN No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51. FIN 46 establishes accounting guidance for consolidation of variable interest entities (VIE) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE entity is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE. Prior to the implementation of FIN 46, VIE’s were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The provisions of FIN 46 were effective immediately for all arrangements entered into after January 31, 2003, and are otherwise effective at the beginning of the first interim or annual period ending after December 15, 2003. Texas Capital Statutory Trust II was formed subsequent to January 31, 2003 for the purpose of issuing $10 million of trust preferred securities and accordingly is currently subject to the requirements of FIN 46. Texas Capital Bancshares Statutory Trust I was formed prior to January 31, 2003 to issue $10 million of trust preferred securities and will be subject to FIN 46 in the fourth quarter of 2003. We currently believe the continued consolidation of Texas Capital Statutory Trust II is appropriate under FIN 46. However, the application of FIN 46 to this type of trust is an emerging issue and a possible unintended consequence of FIN 46 is the deconsolidation of these trusts. The deconsolidation of Texas Capital Bancshares Statutory Trust I and Texas Capital Statutory Trust II would not have a material effect on our consolidated balance sheet or our consolidated statement of operations. In July 2003, the Board of Governors of the Federal Reserve System issued a supervisory letter instructing bank holding companies to continue to include the trust preferred

securities in their Tier I capital for regulatory capital purposes until notice is given to the contrary. The Federal Reserve intends to review the regulatory implications of any accounting treatment changes and, if necessary or warranted, provide further appropriate guidance. There can be no assurance that the Federal Reserve will continue to allow institutions to include trust preferred securities in Tier I capital for regulatory capital purposes. As of September 30, 2003, assuming we were not allowed to include the $20 million in trust preferred securities issued by Texas Capital Bancshares Statutory Trust I and Texas Capital Statutory Trust II in Tier 1 capital, the Corporation would still exceed the regulatory required minimums for capital adequacy purposes.

SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133, Accounting for Derivative Instruments and Hedging Activities. The amendments (i) reflect decisions of the Derivatives Implementation Group; (ii) reflect decisions made by the Financial Accounting Standards Board in conjunction with other projects dealing with financial instruments; and (iii) address implementation issues related to the application of the definition of a derivative. SFAS 149 also modified various other existing pronouncements to conform with the changes made to SFAS 133. SFAS 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003, with all provisions applied prospectively. Adoption of SFAS 149 on July 1, 2003 did not have a significant impact on our financial statements.

SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies, measures and discloses in its financial statements certain financial instruments with characteristics of both liabilities and equity. SFAS 150 requires that an issuer classify financial instruments that are within its scope as a liability, in most circumstances. Such financial instruments include (i) financial instruments that are issued in the form of shares that are mandatorily redeemable; (ii) financial instruments that embody an obligation to repurchase the issuer’s equity shares, or are indexed to such an obligation, and that require the issuer to settle the obligation by transferring assets; (iii) financial instruments that embody an obligation that the issuer may settle by issuing a variable number of its equity shares, if, at inception, the monetary value of the obligation is predominately based on a fixed amount, variations in something other than the fair value of the issuer’s equity shares or variations inversely related to changes in the fair value of the issuer’s equity shares; and (iv) certain freestanding financial instruments. SFAS 150 is effective for contracts entered into or modified after May 31, 2003, and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of SFAS 150 on July 1, 2003 did not have a significant impact on our financial statements.

The following table presents the computation of basic and diluted earnings per share (dollars in thousands except per share data):


			Three months ended September 30						Nine months ended September 30
			2003			2002			2003			2002

Numerator:
	Net income		$	3,332		$	2,094		$	10,220		$	5,471
	Preferred stock dividends			(149	)		(280	)		(699	)		(817	)

Numerator for basic earnings per share-income available to common stockholders				3,183			1,814			9,521			4,654
Effective of dilutive securities:
	Preferred stock dividends²			149			—			699			—

Numerator for dilutive earnings per share-income available to common stockholders and assumed conversion			$	3,332		$	1,814		$	10,220		$	4,654

Denominator:
	Denominator for basic earnings per share-weighted average shares			21,924,855			19,148,908			20,120,056			19,140,206
	Effective of dilutive securities:
		Employee stock options¹		1,137,947			573,922			580,593			332,666
		Convertible preferred stock²		1,103,104			—			1,773,521			—

Dilutive potential common shares				2,241,051			573,922			2,354,114			332,666

Denominator for dilutive earnings per share-adjusted weighted average shares and assumed conversions				24,165,906			19,722,830			22,474,170			19,472,872

Basic earnings per share			$	.15		$	.09		$	.47		$	.24
Diluted earnings per share			$	.14		$	.09		$	.45		$	.24

(1)

Excludes employee stock options with exercise price greater than current market price.

(2)

Effects of convertible preferred stock are anti-dilutive and are not included in September 2002. Effects of convertible preferred stock are dilutive and are included in September 2003.

During prior reporting periods, the Company has operated two principal lines of business under the Bank: the traditional bank and BankDirect, an internet only bank. During the third quarter of 2003, a new chief financial officer joined the Company. In connection with the addition to executive management and the assignment of responsibility for BankDirect to the new executive, the Company has re-evaluated its reportable segments and determined that BankDirect should not be reported as a separate line of business. Historically, while BankDirect has always been a division of the Bank, not a separate legal entity, the business strategy and operating results of BankDirect were previously reviewed by the Company as a business segment in assessing the performance and making decisions about financial, marketing and staffing resource allocations to BankDirect. Over the past two years, BankDirect has evolved primarily into an internet-based funding and services channel for the Bank and become less significant to the overall business and funding strategies of the Company. The deposit products and other services offered by BankDirect are substantially identical to those offered to other Bank customers. Accordingly, BankDirect is now evaluated by management in a manner similar to other funding sources and services of the Bank, rather than a clearly distinct business segment. Based on the foregoing, we have concluded that the Company currently has only one principal line of business that would be reportable as a segment: the Bank. We have restated our 2002 segment information consistent with the 2003 presentation.

Reportable segment reconciliation to the Consolidated Financial Statements for the three month and nine month periods ended September 30, 2003 are as follows (dollars in thousands):

Reportable segment reconciliation to the Consolidated Financial Statements for the three month and nine month periods ended September 30, 2002 are as follows (dollars in thousands):

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit which involve varying degrees of credit risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the borrower.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s credit-worthiness on a case-by-case basis.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.


		For the three months ended								For the three months ended
		September 30, 2003								September 30, 2002

		Average		Revenue/			Yield/			Average		Revenue/			Yield/
		Balance		Expense (1)			Rate			Balance		Expense (1)			Rate

Assets
Taxable securities		$	652,082	$	4,832			2.94	%	$	304,724	$	3,815			4.97	%
Federal funds sold			8,090		20			0.98	%		5,903		25			1.68	%
Deposits in other banks			1,118		4			1.42	%		621		3			1.92	%
Loans			1,275,311		16,114			5.01	%		1,000,356		14,219			5.64	%
	Less reserve for loan losses		17,573		—			—			12,871		—			—

Loans, net of reserve			1,257,738		16,114			5.08	%		987,485		14,219			5.71	%

Total earning assets			1,919,028		20,970			4.34	%		1,298,733		18,062			5.52	%
Cash and other assets			143,765								69,876

Total assets		$	2,062,793							$	1,368,609

Liabilities and Stockholders’ Equity
Transaction deposits		$	64,137	$	102			0.63	%	$	52,478	$	123			0.93	%
Savings deposits			477,158		1,466			1.22	%		352,364		1,880			2.12	%
Time deposits			548,288		3,473			2.51	%		451,391		3,614			3.18	%

Total interest bearing deposits			1,089,583		5,041			1.84	%		856,233		5,617			2.60	%
Other borrowings			527,658		2,328			1.75	%		227,420		1,571			2.74	%
Long-term debt			20,000		250			4.96	%		—		—			—

Total interest bearing liabilities			1,637,241		7,619			1.85	%		1,083,653		7,188			2.63	%
Demand deposits			269,891								156,950
Other liabilities			9,592								8,417
Stockholders’ equity			146,069								119,589

Total liabilities and stockholders’ equity		$	2,062,793							$	1,368,609

Net interest income				$	13,351							$	10,874
Net interest income to earning assets								2.76	%							3.32	%

Provision for loan losses					475								2,380
Non-interest income					2,512								2,863
Non-interest expense					10,483								8,563

Income before taxes					4,905								2,794
Income tax expense					1,573								700

Net income				$	3,332							$	2,094

Earnings per share:
	Net income
	Basic			$	.15							$	.09
	Diluted			$	.14							$	.09
Return on average equity					9.05	%							6.95	%
Return on average assets					.64	%							.61	%
Equity to assets					7.08	%							8.74	%

(1)

The loan averages include loans on which the accrual of interest has been discontinued and are stated net of unearned income.


		For the nine months ended								For the nine months ended
		September 30, 2003								September 30, 2002

		Average		Revenue/			Yield/			Average		Revenue/			Yield/
		Balance		Expense (1)			Rate			Balance		Expense (1)			Rate

Assets
Taxable securities		$	606,535	$	15,517			3.42	%	$	262,584	$	10,320			5.25	%
Federal funds sold			16,823		150			1.19	%		15,813		204			1.72	%
Deposits in other banks			1,007		11			1.46	%		316		6			2.54	%
Loans			1,201,507		46,791			5.21	%		927,936		39,545			5.70	%
	Less reserve for loan losses		16,215		—			—			12,903		—			—

Loans, net of reserve			1,185,292		46,791			5.28	%		915,033		39,545			5.78	%

Total earning assets			1,809,657		62,469			4.62	%		1,193,746		50,075			5.61	%
Cash and other assets			136,016								70,165

Total assets		$	1,945,673							$	1,263,911

Liabilities and Stockholders’ Equity
Transaction deposits		$	62,082	$	335			0.72	%	$	50,177	$	366			0.98	%
Savings deposits			422,293		4,735			1.50	%		340,706		4,981			1.95	%
Time deposits			549,498		10,950			2.66	%		414,413		10,303			3.32	%

Total interest bearing deposits			1,033,873		16,020			2.07	%		805,296		15,650			2.60	%
Other borrowings			506,709		8,062			2.13	%		193,711		3,943			2.72	%
Long-term debt			16,374		630			5.14	%		—		—			—

Total interest bearing liabilities			1,556,956		24,712			2.12	%		999,007		19,593			2.62	%
Demand deposits			243,773								142,130
Other liabilities			10,990								7,485
Stockholders’ equity			133,954								115,289

Total liabilities and stockholders’ equity		$	1,945,673							$	1,263,911

Net interest income				$	37,757							$	30,482
Net interest income to earning assets								2.79	%							3.41	%

Provision for loan losses					3,325								4,359
Non-interest income					8,657								6,519
Non-interest expense					36,762								25,343

Income before taxes					6,327								7,299
Income tax expense (benefit)					(3,893	)							1,828

Net income				$	10,220							$	5,471

Earnings per share:
	Net income
	Basic			$	.47							$	.24
	Diluted			$	.45							$	.24
Return on average equity					10.20	%							6.34	%
Return on average assets					.70	%							.58	%
Equity to assets					6.88	%							9.12	%

(1)

The loan averages include loans on which the accrual of interest has been discontinued and are stated net of unearned income.

Statements and financial analysis contained in this document that are not historical facts are forward looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward looking statements describe our future plans, strategies and expectations and are based on certain assumptions. As a result, these forward looking statements involve substantial risks and uncertainties, many of which are beyond our control. The important factors that could cause actual results to differ materially from the forward looking statements include the following:

(2)

Changes in the levels of loan prepayments, which could affect the value of our loans or investment securities

(3)

Changes in general economic and business conditions in areas or markets where we compete

(4)

Competition from banks and other financial institutions for loans and customer deposits

(5)

The failure of assumptions underlying the establishment of and provisions made to the allowance for credit losses

(6)

The loss of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensation levels

We have no obligation to update or revise any forward looking statements as a result of new information or future events. In light of these assumptions, risks and uncertainties, the events discussed in any forward looking statements in this quarterly report might not occur.

The Company recorded net income of $3.3 million or $.14 per diluted common share for the third quarter of 2003 compared to $2.1 million or $.09 per diluted common share for the third quarter of 2002. Return on average equity was 9.05% and return on average assets was .64% for the third quarter of 2003 compared to 6.95% and .61%, respectively, for the third quarter of 2002.

The increase in net income and continued improvement in returns on equity and assets in 2003 are attributed to growth in net interest income and improved efficiency. Net interest income for the third quarter of 2003 increased by $2.5 million or 22.8% from $10.9 million to $13.4 million over the third quarter of 2002. The increase in net interest income was due to an increase in average earning assets of $620.3 million or 47.8%, which offset a 56 basis point decrease in net interest margin.

Non-interest income, excluding gain on sale of securities, increased $1.0 million or 68.8% compared to the third quarter of 2002. The Company benefited from growth in fees related to deposits, wealth management, BOLI, and mortgage warehousing.

Non-interest expense increased $1.9 million or 22.4% compared to the third quarter of 2002. Salaries and employee benefits increased by $1.6 million or 38.2%. Total full time employees increased from 214 at September 30, 2002 to 271 at September 30, 2003; the increase related primarily to staffing for the new Houston office and the start-up of the residential mortgage origination group.

Basic and diluted earnings per share for the nine months ended September 30, 2003 were $0.47 and $0.45, respectively. Excluding the impact of reversing the valuation allowance, unwinding penalties and separation expense in the second quarter, basic and diluted income per share for the nine months ended September 30, 2003 would have been $0.40 and $0.39, respectively. Income per share excluding the impact of reversing the valuation allowance, unwinding penalties and separation expense is a non-GAAP financial measure. Please see the following discussion of why we believe this non-GAAP financial measure is useful to management and investors and the following table for a reconciliation of income per share excluding impact of reversing the valuation allowance, unwinding penalties and separation expense to income per share, which is the most directly comparable financial measure presented in accordance with GAAP.

Management believes that income per share excluding the impact of reversing the deferred tax asset valuation allowance, unwinding penalties relating to the unwinding of repurchase agreements prior to maturity and separation expense associated with the resignation of a senior officer, which is a non-GAAP financial measure, is useful to investors and to management because it provides additional information that more closely reflects our intrinsic operating performance and growth. Reversal of the entire valuation allowance was based on our assessment of our ability to generate earnings to allow the deferred tax assets to be realized which is supported by our current earnings trends. We unwound certain repurchase agreements, incurring the unwinding penalties, in order to take advantage of historical lows in interest rates, which had decreased on similar repurchase agreements by approximately 1.4% since the time we entered into the original repurchase agreements. Although we have experienced employee separations in the past, this was the first separation with an executive who had entered into an employment agreement with us. We currently have only four other employees with employment agreements. Since we have not had any reversals of valuation allowances, unwinding penalties or separation expenses related to employees who have employment agreements in our operating history, we believe that this non-GAAP financial measure is useful to investors and to management to understand the development of our income per share results since our founding and to help in comparing our intrinsic operating performance in different periods. Management also uses these measures internally to evaluate our performance and manage our results. This measurement should not be regarded as a replacement for the corresponding GAAP measure.

The following table reconciles income per share excluding the impact of reversing the valuation allowance, unwinding penalties and separation expense to income per share, which is the most directly comparable financial measure presented in accordance with GAAP.

Reconciliation of GAAP to income per share, excluding the impact of reversing the valuation allowance, unwinding penalties and separation expense.


(Dollars in thousands except per share data)	Three months			Nine months
	ended			ended
	September 30,			September 30,
	2003			2003

	(Unaudited)
Net income as reported	$	3,332		$	10,220
Repurchase agreement unwinding penalties		—			6,262
Executive separation		—			250
Tax effect of repurchase agreement unwinding penalties and separation costs		—			(2,120	)
Impact of reversing deferred tax asset valuation allowance		—			(5,929	)

Net income excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense		3,332			8,683
Preferred stock dividends		(149	)		(699	)

Numerator used to calculate basic income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense		3,183			7,984
Effect of dilutive securities		149			699

Numerator used to calculate diluted income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense	$	3,332		$	8,683

Denominator used for GAAP and basic income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense		21,924,855			20,120,056
Denominator used for GAAP and diluted income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense		24,165,906			22,474,170
Basic income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense	$	.15		$	.40
Diluted income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense	$	.14		$	.39

Net interest income was $13.4 million for the third quarter of 2003, compared to $10.9 million for the third quarter of 2002. The increase was due to an increase in average earning assets of $620.3 million as compared to the third quarter of 2002, which offset a 56 basis point decrease in net interest margin. The increase in average earning assets included a $270.3 million increase in average net loans and a $347.4 million increase in average securities. For the quarter ended September 30, 2003, average net loans and securities represented 66% and 34%, respectively, of average earning assets compared to 76% and 23% in the same quarter of 2002. The decrease in loan percentage reflects management’s decision to tighten lending standards beginning in 2001 and continuing during 2002 pending clearer signs of improvement in the U.S. economy. While we continue to apply prudent lending standards, loan growth in the third quarter of 2003 in our core loan portfolio (excluding loans held for sale) totaled $35 million. Our securities percentage has increased as we have continued to use additional securities to increase our earnings and improve our return on equity by taking advantage of market spreads.

Average interest bearing liabilities increased $553.6 million from the third quarter of 2002, which included a $233.4 million increase in interest bearing deposits and a $300.2 million increase in other borrowings. The increase in interest bearing deposits includes the purchase of deposit accounts from Bluebonnet Savings Bank, FSB in August 2003. The increase in average borrowings was primarily related to an increase in federal funds purchased and securities sold under repurchase agreements, and was used to supplement deposits in funding loan growth and securities purchases. The average cost of interest bearing liabilities decreased from 2.63% for the quarter ended September 30, 2002 to 1.85% for the same period of 2003, reflecting the reduction in market interest rates and a $112.9 million increase in average non-interest bearing deposits.

Net interest income was $37.8 million for the nine months ended September 30, 2003, compared to $30.5 million for the same period of 2002. The increase was due to an increase in average earning assets of $615.9 million as compared to 2002, which offset a 62 basis point decrease in net interest margin. The increase in average earning assets included a $270.3 million increase in average net loans and a $344.0 million increase in average securities. For the nine months ended September 30, 2003, average net loans and securities represented 65% and 34%, respectively, of average earning assets compared to 77% and 22% in the same period in 2002. The decrease in loan percentage reflected management’s decision to tighten lending standards beginning in 2001 and continuing during 2002 pending clearer signs of improvement in the U.S. economy. While we continue to apply prudent lending standards, loan growth in the third quarter of 2003 in our core loan portfolio (excluding loans held for sale) totaled $35 million. Our securities percentage has increased as we have continued to use additional securities to increase our earnings and improve our return on equity by taking advantage of market spreads.

Average interest bearing liabilities increased $557.9 million from the nine months ended September 30, 2002, which included a $228.6 million increase in interest bearing deposits and a $313.0 million increase in other borrowings. Average other borrowings were 26.0% of average total assets for the nine months ended September 30, 2003 compared to 15.3% for the same period in 2002. The increase in average other borrowings was primarily related to an increase in federal funds purchased and securities sold under repurchase agreements, and was used to supplement deposits in funding loan growth and securities purchases. The average cost of interest bearing liabilities decreased from 2.62% for the nine months ended September 30, 2002 to 2.12% for the same period in 2003, reflecting the reduction in market interest rates and a $101.6 million increase in average non-interest bearing deposits.


		Three months ended								Nine months ended
		September 30, 2003/2002								September 30, 2003/2002

					Change Due To⁽¹⁾								Change Due To⁽¹⁾

		Change			Volume		Yield/Rate			Change			Volume		Yield/Rate

Interest income:
	Securities	$	1,017		$	4,349	$	(3,332	)	$	5,197		$	13,518	$	(8,321	)
	Loans		1,895			3,908		(2,013	)		7,246			11,658		(4,412	)
	Federal funds sold		(5	)		9		(14	)		(54	)		13		(67	)
	Deposits in other banks		1			2		(1	)		5			13		(8	)

Total			2,908			8,268		(5,360	)		12,394			25,202		(12,808	)
Interest expense:
	Transaction deposits		(21	)		27		(48	)		(31	)		87		(118	)
	Savings deposits		(414	)		666		(1,080	)		(246	)		1,193		(1,439	)
	Time deposits		(141	)		776		(917	)		647			3,359		(2,712	)
	Borrowed funds		1,007			2,212		(1,205	)		4,749			6,704		(1,955	)

Total			431			3,681		(3,250	)		5,119			11,343		(6,224	)

Net interest income		$	2,477		$	4,587	$	(2,110	)	$	7,275		$	13,859	$	(6,584	)

(1)

Changes attributable to both volume and yield/rate are allocated to both volume and yield/rate on an equal basis.

Net interest margin, the ratio of net interest income to average earning assets, was 2.76% for the third quarter of 2003 compared to 3.32% for the third quarter of 2002. The decrease was due primarily to the falling rate environment in which our balance sheet was asset sensitive, largely due to the concentration of assets in variable rate loans. In addition, a larger portion of our assets was invested in securities, which generally have a lower yield than loans.

Non-interest income, excluding gain on sale of securities, increased $1.0 million compared to the same quarter of 2002. Service charges on deposit accounts increased $146,000. This increase was due to the increase in deposits, which resulted in a higher volume of transactions. Trust fee income increased $115,000, due to continued growth of trust assets in 2003. BOLI income for the quarter ended September 30, 2003 was $451,000 compared to $144,000 for the same period in 2002. Our BOLI investment originated in August 2002. The current policy provides life insurance for 25 executives, naming us as beneficiary. Mortgage warehouse fees increased by $357,000 due to the continued growth in the mortgage warehouse business as a result of favorable mortgage rates and growth in our customer base.

Non-interest income increased $2.1 million, or 32.8%, in the nine months ended September 30, 2003 compared to the same period in 2002. Service charges on deposit accounts increased $541,000 for the nine months ended September 30, 2003 as compared to the same period in 2002. This increase was due to the significant increase in non-interest deposits, which resulted in a higher volume of transactions. Trust fee income increased $210,000 due to continued growth of trust assets during the nine month period ended September 30, 2003. During the nine month period ended September 30, 2003, we had gain on sale of securities of $686,000 compared to $1,375,000 during the same period in 2002 due to our ability to realize substantial profits from sales of fixed-rate debt securities as a result of rapid declines in overall interest rates. Cash processing fees totaled $973,000 for the nine months ended September 30, 2003, which is comparable to the same period in 2002. These fees were related to a special project that occurred during the first quarter of 2003 and 2002 and will not be recurring in future quarters of 2003. We had BOLI income of $1.3 million during the first nine months of 2003 compared to $144,000 during the same period in 2002. Our BOLI investment originated in August 2002. The current policy provides life insurance for 25 executives, naming us as beneficiary. Mortgage warehouse fees increased by $703,000 for the nine months ended September 30, 2003 as a result of favorable mortgage rates and growth in our customer base.

While management expects continued growth in non-interest income, the future rate of growth could be affected by increased competition from nationwide and regional financial institutions. In order to achieve continued growth in non-interest income, we may need to introduce new products or enter into new markets. Any new product introduction or new market entry would likely place additional demands on capital and managerial resources.


	Three Months Ended				Nine months Ended
	September 30				September 30
	2003		2002		2003		2002

Service charges on deposit accounts	$	856	$	710	$	2,596	$	2,055
Trust fee income		350		235		937		727
Gain on sale of securities		—		1,375		686		1,375
Cash processing fees		—		—		973		993
Bank owned life insurance (BOLI) income		451		144		1,293		144
Mortgage warehouse fees		545		188		1,248		545
Other		310		211		924		680

Total non-interest income	$	2,512	$	2,863	$	8,657	$	6,519

Non-interest expense for the third quarter of 2003 increased $1.9 million or 22.4% compared to the third quarter of 2002. Salaries and employee benefits increased by $1.6 million or 38.2%. Total full time employees increased from 214 at September 30, 2002 to 271 at September 30, 2003. Additional employees include employees hired in the recently opened Houston office, employees in our recently created residential mortgage origination group as well as some additional employees in our lending and support functions.

Advertising expense decreased $235,000 or 52.5%. Advertising expense for the three months ended September 30, 2003 included $37,000 of direct marketing and branding for the traditional bank and $176,000 for the purchase of miles related to the American Airlines AAdvantage® program, compared to $264,000 of direct marketing and branding for the traditional bank and $184,000 for the purchase of miles during the same period for 2002.

Net occupancy expense for the three months ended September 30, 2003 increased by $51,000 or 4.2% compared to the same quarter in 2002. Communications and data processing expense for the three months ended September 30, 2003 increased $50,000 or 7.0% compared to the same quarter in 2002. Both increases are due to continued growth.

Non-interest expense for the nine months ended September 30, 2003 increased $11.4 million, or 45.1%, compared to the same period of 2002. This increase included $6.3 million in penalties related to our restructuring of the maturities and pricing of our repurchase agreements in June 2003 in order to take advantage of historical lows in interest rates, which had decreased on similar repurchase agreements by approximately 1.4% since the time we entered into the original repurchase agreements. We unwound approximately $139 million in repurchase agreements prior to their maturities and entered into new repurchase agreements with respect to a significant portion of that amount, with the remainder replaced with overnight funds. A significant portion of these overnight funds were replaced with deposits when we completed our planned acquisition of the outstanding deposit accounts of Bluebonnet Savings Bank FSB, which occurred in August 2003. Salaries and employee benefits increased by $4.5 million or 36.0%. Total full time employees increased from 214 at September 30, 2002 to 271 at September 30, 2003. Also included in salaries and benefits for the nine months ended September 30, 2003, is $250,000 in separation costs related to the resignation of a senior officer in the second quarter. In addition, we experienced losses related to forged checks of approximately $300,000 in the first nine months of 2003. We have taken steps to attempt to reduce these types of losses in the future.

Net occupancy expense for the nine months ended September 30, 2003 decreased by $116,000, or 3.1%, due to a decrease in depreciation as many of our fixed assets are becoming fully depreciated.

Advertising expense for the nine months ended September 30, 2003 decreased $405,000, or 40.1%, compared to 2002. Advertising expense for the nine months ended September 30, 2003 included $99,000 of direct marketing and branding for the traditional bank and $506,000 for the purchase of miles related to the American Airlines AAdvantage® program compared to direct marketing and branding of $553,000 and $457,000 for the purchases of American Airlines miles during the same period in 2002. Our direct marketing may increase as we seek to further develop our brand, reach more of our target customers and expand in our target markets. Legal and professional expenses increased $78,000 or 3.6%, mainly related to continued legal expenses incurred with our non-performing loans and leases. Communications and data processing expense for the nine months ended September 30, 2003 increased $106,000, or 5.0%, due to growth in our loan and deposit base and increased staff.


	Three Months Ended				Nine months Ended
	September 30				September 30
	2003		2002		2003		2002

Salaries and employee benefits	$	5,754	$	4,163	$	16,990	$	12,492
Net occupancy expense		1,265		1,214		3,651		3,767
Advertising and affinity payments		213		448		605		1,010
Legal and professional		744		724		2,253		2,175
Communications and data processing		767		717		2,223		2,117
Franchise taxes		37		34		111		81
Repurchase agreement penalties		—		—		6,262		—
Other		1,703		1,263		4,667		3,701

Total non-interest expense	$	10,483	$	8,563	$	36,762	$	25,343

The Company had a gross deferred tax asset of $7.8 million at September 30, 2003. In 2003, as a result of our reassessment of our ability to generate sufficient earnings to allow the utilization of our deferred tax assets, we believe it is more likely than not that the deferred tax assets will be realized. Accordingly, in compliance with Statement of Financial Accounting Standards No. 109, we reversed the valuation allowance and certain related tax reserves during the quarter ended June 30, 2003.

The aggregate loan portfolio at September 30, 2003 increased $98.6 million from December 31, 2002 to $1.2 billion. Commercial loans increased $46.0 million and real estate loans increased $28.3 million. Construction loans increased $59.9 million and leases and consumer loans decreased $4.8 million and $6.4 million, respectively.

We continue to lend primarily in Texas. As of September 30, 2003, a substantial majority of the principal amount of the loans in our portfolio was to businesses and individuals in Texas. This geographic concentration subjects the loan portfolio to the general economic conditions within this area. We originate substantially all of the loans in our portfolio, except in certain instances we have purchased individual leases and lease pools (primarily commercial and industrial equipment and vehicles), as well as selected loan participations and USDA government guaranteed loans.

The reserve for loan losses, which is available to absorb losses inherent in the loan portfolio, totaled $17.3 million at September 30, 2003, $14.5 million at December 31, 2002 and $13.8 million at September 30, 2002. This represents 1.41%, 1.30% and 1.31% of total loans at September 30, 2003, December 31, 2002 and September 30, 2002, respectively.

The provision for loan losses is a charge to earnings to maintain the reserve for loan losses at a level consistent with management’s assessment of the loan portfolio in light of current economic conditions and market trends. The Company recorded a provision of $475,000 for the quarter ended September 2003 and $2.4 million for the same quarter in 2002. These provisions were made to reflect management’s assessment of the risk of loan losses specifically including risk associated with the continued rapid growth in the loan portfolio and the unseasoned nature of the current portfolio.

The reserve for loan losses is comprised of specific reserves assigned to classified loans and general reserves. We continuously evaluate our reserve for loan losses to maintain an adequate level to absorb estimated loan losses inherent in the loan portfolio. Factors contributing to the determination of specific reserves include the credit worthiness of the borrower, changes in the value of pledged collateral, and general economic conditions. All loan commitments rated substandard or worse and greater than $1,000,000 are specifically reviewed and a specific allocation is assigned based on the losses expected to be realized from those loans. For purposes of determining the general reserve, the portfolio is segregated by product types to recognize differing risk profiles among categories, and then further segregated by credit grades. Credit grades are assigned to all loans greater than $50,000. Each credit grade is assigned a risk factor, or reserve allocation percentage. These risk factors are multiplied by the outstanding principal balance and risk-weighted by product type to calculate the required reserve. A similar process is employed to calculate that portion of the required reserve assigned to unfunded loan commitments.

The reserve allocation percentages assigned to each credit grade have been developed based on an analysis of historical loss rates at selected peer banks, adjusted for certain qualitative factors. Qualitative adjustments for such things as general economic conditions, changes in credit policies and lending standards, and changes in the trend and severity of problem loans, can cause the estimation of future losses to differ from past experience. The unallocated portion of the general reserve serves to compensate for additional areas of uncertainty and considers industry trends. In addition, the reserve considers the results of reviews performed by independent third party reviewers as reflected in their confirmations of assigned credit grades within the portfolio.

The methodology used in the periodic review of reserve adequacy, which is performed at least quarterly, is designed to be dynamic and responsive to changes in actual credit losses. The changes are reflected in the general reserve and in specific reserves as the collectibility of larger classified loans is continuously recalculated with new information. As our portfolio matures, historical loss ratios are being closely monitored, and our reserve adequacy will rely primarily on our loss history. Currently, the review of reserve adequacy is performed by executive management and presented to the Board of Directors for their review, consideration and ratification on a quarterly basis.


		Nine months ended			Nine months ended			Year ended
		September 30,			September 30,			December 31,
		2003			2002			2002

Beginning balance		$	14,538		$	12,598		$	12,598
Loans charged-off:
	Commercial		50			2,085			2,096
	Real estate		200			—			—
	Consumer		2			6			11
	Leases		511			1,042			1,740

Total			763			3,133			3,847
Recoveries:
	Commercial		78			—			42
	Consumer		—			11			—
	Leases		98			9			116

Total recoveries			176			20			158

Net charge-offs			587			3,113			3,689
Provision for loan losses			3,325			4,359			5,629

Ending balance		$	17,276		$	13,844		$	14,538

Reserve for loan losses to loans outstanding at end of period			1.41	%		1.31	%		1.30	%
Net charge-offs to average loans¹			.07	%		.45	%		.38	%
Provision for loan losses to average loans¹			.37	%		.63	%		.58	%
Recoveries to gross charge-offs			23.07	%		.64	%		4.11	%
Reserve as a multiple of net charge-offs			29.4x			4.5x			3.9x
Non-performing and renegotiated loans:
	Loans past due (90 days)	$	1,095		$	1,686		$	135
	Non-accrual		11,026			6,474			2,776

Total		$	12,121		$	8,160		$	2,911

Reserve as a percent of non-performing and renegotiated loans			142.53	%		169.66	%		499.42	%

Non-performing assets include non-accrual loans and leases, accruing loans 90 or more days past due, restructured loans, and other repossessed assets. We had non-accrual loans and leases of $11,026,000, $2,776,000 and $6,474,000 at September 30, 2003, December 31, 2002 and September 30, 2002, respectively. At September 30, 2003, our non-accrual loans and leases consisted of $4,350,000 in commercial loans, $4,762,000 in construction loans, $375,000 in real estate loans, $115,000 in consumer loans and $1,424,000 in leases. At December 31, 2002, our non-accrual loans and leases consisted of $641,000 in commercial loans, $1,367,000 in real estate, $26,000 in consumer loans and $742,000 in leases. At September 30, 2003, we had $1,095,000 in loans past due 90 days and still accruing interest which are fully guaranteed by the U.S. Government. At September 30, 2003, we had $189,000 in other repossessed assets.

Generally, we place loans on non-accrual when there is a clear indication that the borrower’s cash flow may not be sufficient to meet payments as they become due, which is generally when a loan is 90 days past due. When a loan is placed on non-accrual status, all previously accrued and unpaid interest is reversed. Interest income is subsequently recognized on a cash basis as long as the remaining unpaid principal amount of the loan is deemed to be fully collectible. If collectibility is questionable, then cash payments are applied to principal. As of September 30, 2003, approximately $8 million of our non-accrual loans were earning on a cash basis.

A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due (both principal and interest) according to the terms of the loan agreement. Reserves on impaired loans are measured based on the present value of the expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral.

In general terms, liquidity is a measurement of our ability to meet our cash needs. Our objective in managing our liquidity is to maintain our ability to meet loan commitments, purchase securities or repay deposits and other liabilities in accordance with their terms, without an adverse impact on our current or future earnings. Our liquidity strategy is guided by policies, which are formulated and monitored by our senior management and our bank’s Balance Sheet Management Committee (BSMC), and which take into account the marketability of assets, the sources and stability of funding and the level of unfunded commitments. We regularly evaluate all of our various funding sources with an emphasis on accessibility, stability, reliability and cost-effectiveness. For the year ended December 31, 2002 and for the nine months ended September 30, 2003, our principal source of funding has been our customer deposits, supplemented by our short-term and long-term borrowings, primarily from securities sold under repurchase agreements and federal funds purchased from our downstream correspondent bank relationships (which consist of banks that are considered to be smaller than our bank).

Since early 2001, our liquidity needs have primarily been fulfilled through growth in our core customer deposits. Our goal is to obtain as much of our funding as possible from deposits of these core customers, which as of September 30, 2003, comprised $1,285.7 million, or 90.0%, of total deposits. These deposits are generated principally through development of long-term relationships with customers and stockholders and our retail network which is mainly through BankDirect, our internet banking facility.

In addition to deposits from our core customers, we also have access to incremental deposits through brokered retail certificates of deposit, or CDs. As of September 30, 2003, brokered retail CDs comprised $141.4 million, or 10.0%, of total deposits. Our dependence on retail brokered CDs is limited by our internal funding guidelines, which as of September 30, 2003, limited borrowing from this source to 10-20% of total deposits.

Additionally, we have borrowing sources available to supplement deposits and meet our funding needs. These borrowing sources include federal funds purchased from our downstream correspondent bank relationships (which consist of banks that are smaller than our bank) and from our upstream correspondent bank relationships (which consist of banks that are larger than our bank), securities sold under repurchase agreements, treasury, tax and loan notes, and advances from the Federal Home Loan Bank, or FHLB. As of September 30, 2003, our borrowings consisted of a total of $401.2 million of securities sold under repurchase agreements, $103.7 million of downstream federal funds purchased, $17.5 million from customer repurchase agreements, and $5.3 million of treasury, tax and loan notes. Credit availability from the FHLB is based on our bank’s financial and operating condition and borrowing collateral we hold with the FHLB. At September 30, 2003, we had no borrowings from the FHLB. Our unused FHLB borrowing capacity at September 30, 2003 was approximately $450.0 million. As of September 30, 2003, we had unused upstream federal fund lines available from commercial banks of approximately $72.6 million. During the nine months ended September 30, 2003, our average other borrowings from these sources were $506.7 million or 26.0% of average assets, which is well within our internal funding guidelines, which limit our dependence on borrowing sources to 25-30% of total assets. In September 2003, we unwound approximately $139 million of these term repurchase agreements and replaced a significant portion of that amount with new securities repurchase agreements subject to lower interest rates, with the remainder replaced with overnight funds. A significant portion of these overnight funds were replaced with deposits when we completed our acquisition of the outstanding deposits accounts of Bluebonnet Savings Bank, FSB in August 2003. The maximum amount of borrowed funds outstanding at any month-end during the first nine months of 2003 was $546.3 million, or 26.8%, of total assets.

As of September 30, 2003, our contractual obligations and commercial commitments, other than deposit liabilities, were as follows:


(Dollars in thousands)			After One		After Three
	Within		but Within		but Within		After Five
	One Year		Three Years		Five Years		Years		Total

Federal funds purchased	$	103,726	$	—	$	—	$	—	$	103,726
Securities sold under repurchase agreements		163,652		226,300		11,200		—		401,152
Customer repurchase agreements		17,453		—		—		—		17,453
Treasury, tax and loan notes		5,282		—		—		—		5,282
Operating lease obligations		3,150		9,604		7,457		1,289		21,500
Long-term debt		—		—		—		20,000		20,000

Total contractual obligations	$	293,263	$	235,904	$	18,657	$	21,289	$	569,113

The contractual amount of our financial instruments with off-balance sheet risk expiring by period at September 30, 2003 is presented below:

Due to the nature of our unfunded loan commitments, including unfunded lines of credit, the amounts presented in the table above do not necessarily represent amounts that we anticipate funding in the periods presented above.

Our equity capital averaged $134.0 million for the nine months ended September 30, 2003 as compared to $115.3 million for the same period in 2002. This increase reflects our retention of net earnings during this period and the IPO proceeds. We have not paid any cash dividends on our common stock since we commenced operations and have no plans to do so in the near future.

The Securities and Exchange Commission (SEC) recently issued guidance for the disclosure of “critical accounting policies.” The SEC defines “critical accounting policies” as those that are most important to the presentation of a company’s financial condition and results, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

We follow financial accounting and reporting policies that are in accordance with generally accepted accounting principles generally accepted in the United States. The more significant of these policies are summarized in Note 1 to the consolidated financial statements in our 2002 Form 10K filed with the SEC. Not all these significant accounting policies require management to make difficult, subjective, or complex judgments. However, the policies noted below could be deemed to meet the SEC’s definition of critical accounting policies.

Management considers the policies related to the allowance for loan losses as the most critical to the financial statement presentation. The total allowance for loan losses includes activity related to allowances calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 5, Accounting for Contingencies. The allowance for loan losses is established through a provision for loan losses charged to current earnings. The amount maintained in the allowance reflects management’s continuing evaluation of the loan losses inherent in the loan portfolio. The allowance for loan losses is comprised of specific reserves assigned to certain classified loans and general reserves. Factors contributing to the determination of specific reserves include the credit-worthiness of the borrower, and more specifically, changes in the expected future receipt of principal and interest payments and/or in the value of pledged collateral. A reserve is recorded when the carrying amount of the loan exceeds the discounted estimated cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. For purposes of determining the general reserve, the portfolio is segregated by product types in order to recognize differing risk profiles among categories, and then further segregated by credit grades. See “Summary of Loan Loss Experience” for further discussion of the risk factors considered by management in establishing the allowance for loan losses.

Management considers the policies related to income taxes to be critical to the financial statement presentation. The Company utilizes the liability method in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based upon the difference between the values of the assets and liabilities as reflected in the financial statements and their related tax basis using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. As changes in tax law or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. A valuation reserve is provided against deferred tax assets unless it is more likely than not that such deferred tax assets will be realized.

We had a gross deferred tax asset of $7.8 million at September 30, 2003. In 2003, as a result of a reassessment of our ability to generate sufficient earnings to allow the utilization of our deferred tax assets, we believe it is more likely than not that the deferred tax assets will be realized. Accordingly, in compliance with SFAS No. 109, we reversed the valuation allowance and certain related tax reserves during the period.

Market risk is a broad term for the risk of economic loss due to adverse changes in the fair value of a financial instrument. These changes may be the result of various factors, including interest rates, foreign exchange rates, commodity prices, or equity prices. Additionally, the financial instruments subject to market risk can be classified either as held for trading purposes or held for other than trading.

The Company is subject to market risk primarily through the effect of changes in interest rates on its portfolio of assets held for purposes other than trading. The effect of other changes, such as foreign exchange rates, commodity prices, and/or equity prices do not pose significant market risk to the Company.

The responsibility for managing market risk rests with the BSMC, which operates under policy guidelines established by the Board of Directors. The negative acceptable variation in net interest revenue due to a 200 basis point increase or decrease in interest rates is generally limited by these guidelines to +/- 10%. These guidelines also establish maximum levels for short-term borrowings, short-term assets, and public and brokered deposits. They also establish minimum levels for unpledged assets, among other things. Compliance with these guidelines is the ongoing responsibility of the BSMC, with exceptions reported to the full Board of Directors on a quarterly basis.

We perform a sensitivity analysis to identify interest rate risk exposure on net interest income. We quantify and measure interest rate risk exposure using a model to dynamically simulate the effect of changes in net interest income relative to changes in interest rates over the next twelve months based on three interest rate scenarios. These are a “most likely” rate scenario and two “shock test” scenarios.

The “most likely” rate scenario is based on the consensus forecast of future interest rates published by independent sources. These forecasts incorporate future spot rates and relevant spreads of instruments that are actively traded in the open market. The Federal Reserve’s Federal Funds target affects short-term borrowing; the prime lending rate and the London Interbank Offering Rate are the basis for most of our variable-rate loan pricing.

The 10-year mortgage rate is also monitored because of its effect on prepayment speeds for mortgage-backed securities. These are our primary interest rate exposures. We are currently not using derivatives to manage our interest rate exposure.

The two “shock test” scenarios assume a sustained parallel 200 basis point increase or decrease, respectively, in interest rates. As short-term rates have continued to fall since 2001 we could not assume interest rate changes of 200 basis points as the results of the decreasing rates scenario would be negative rates. Therefore, our “shock test” scenarios with respect to decreases in rates now assume a decrease of 100 basis points in the current interest rate environment. We will continue to evaluate these scenarios as interest rates change, until short term rates rise above 2.0%.

Our interest rate risk exposure model incorporates assumptions regarding the level of interest rate or balance changes on indeterminable maturity deposits (demand deposits, interest bearing transaction accounts and savings accounts) for a given level of market rate changes. These assumptions have been developed through a combination of historical analysis and future expected pricing behavior. Changes in prepayment behavior of mortgage-backed securities, residential, and commercial mortgage loans in each rate environment are captured using industry estimates of prepayment speeds for various coupon segments of the portfolio. The impact of planned growth and new business activities is factored into the simulation model.

The estimated changes in interest rates on net interest income are within guidelines established by our Board of Directors for all interest rate scenarios.

The simulations used to manage market risk are based on numerous assumptions regarding the effect of changes in interest rates on the timing and extent of repricing characteristics, future cash flows, and customer behavior. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies, among other factors.

We expect our balance sheet will continue to be asset sensitive over the next twelve months, largely due to the concentration of assets in variable rate loans. If, as we expect will occur, interest rates rise in 2004, this asset-sensitivity will tend to result in an increase in our interest margin, all other factors being equal. In the event of a rising rate environment, management may choose to fund investment securities purchased with term liabilities/deposits to lock in a return. Investment securities are generally held in the “available-for-sale” category so that gains and losses can be realized as appropriate. At certain times, we use the “held-to-maturity” category if we are not planning to sell these securities before maturity.

Our management, including our chief executive officer and chief financial officer have evaluated the Company’s disclosure controls and procedures as of September 30, 2003 and concluded that those disclosure controls and procedures are effective. There have been no changes in the Company’s internal controls or in other factors known to the Company that could significantly affect these controls subsequent to their evaluation, nor any corrective actions with regard to significant deficiencies and material weaknesses. While the Company believes that its existing disclosure controls and procedures have been effective to accomplish these objectives, the Company intends to continue to examine, refine and formalize its disclosure controls and procedures and to monitor ongoing developments in this area.


			31.1			Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

			31.2			Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

			32.1			Certification of Chief Executive Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.

			32.2			Certification of Chief Financial Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.

Current report filed on Form 8-K regarding Item 5 (Other Events and Regulation FD Disclosure) and Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits) dated August 4, 2003.

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


Exhibit Number

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.

32.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.


x		Quarterly Report pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934.

For the quarterly period ended September 30, 2003

o		Transition Report pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934.

For the transition period from to


Delaware (State or other jurisdiction of incorporation or organization)		75-2679109 (I.R.S. Employer Identification Number)

2100 McKinney Avenue, Suite 900, Dallas, Texas, U.S.A. (Address of principal executive officers)		75201 (Zip Code)


	ITEM 1. FINANCIAL STATEMENTS
		CONSOLIDATED STATEMENTS OF OPERATIONS — UNAUDITED
		CONSOLIDATED BALANCE SHEETS — UNAUDITED
		CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY — UNAUDITED
		CONSOLIDATED STATEMENTS OF CASH FLOWS — UNAUDITED
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — UNAUDITED
		QUARTERLY FINANCIAL SUMMARY — UNAUDITED
	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 4. CONTROLS AND PROCEDURES
PART II — OTHER INFORMATION
	ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
EXHIBIT INDEX
EX-31.1 Certification of CEO Pursuant to Sec. 302
EX-31.2 Certification of CFO Pursuant to Sec. 302
EX-32.1 Certification of CEO Pursuant to Sec. 906
EX-32.2 Certification of CFO Pursuant to Sec. 906


		Three months ended September 30, 2003

		Net Interest			Provision for		Non-interest		Non-interest
		Income			Loan Losses		Income		Expense

Total Bank		$	13,601		$	475	$	2,512	$	10,164
Unallocated items:
	Holding company		(250	)		—		—		319

The Company consolidated		$	13,351		$	475	$	2,512	$	10,483


		Nine months ended September 30, 2003

		Net Interest			Provision for		Non-interest		Non-interest
		Income			Loan Losses		Income		Expense

Total Bank		$	38,387		$	3,325	$	8,657	$	35,629
Unallocated items:
	Holding company		(630	)		—		—		1,133

The Company consolidated		$	37,757		$	3,325	$	8,657	$	36,762

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Common Stock	24,634,044
Series A-1 Non-voting Common Stock	304,000


		Three months ended September 30, 2002

		Net Interest		Provision for		Non-interest		Non-interest
		Income		Loan Losses		Income		Expense

Total Bank		$	10,874	$	2,380	$	2,863	$	8,410
Unallocated items:
	Holding company		—		—		—		153

The Company consolidated		$	10,874	$	2,380	$	2,863	$	8,563


		Nine months ended September 30, 2002

		Net Interest		Provision for		Non-interest		Non-interest
		Income		Loan Losses		Income		Expense

Total Bank		$	30,482	$	4,359	$	6,519	$	24,767
Unallocated items:
	Holding company		—		—		—		576

The Company consolidated		$	30,482	$	4,359	$	6,519	$	25,343


ITEM 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


	Anticipated Impact Over the Next Twelve Months
	as Compared to Most Likely Scenario

	200 bp Increase		100 bp Decrease
	September 30, 2003		September 30, 2003

Change in net interest income	$	11,736	$	(7,934	)


		TEXAS CAPITAL BANCSHARES, INC.

Date: November 14, 2003		/s/ Peter Bartholow

		Peter Bartholow Chief Financial Officer (Duly authorized officer and principal financial officer)