UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended March 31, 2004

For the transition period from ________________ to ________________

Commission file number 0-30533

TEXAS CAPITAL BANCSHARES, INC.

214/932-6600
(Registrant’s telephone number,
including area code)

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 CORPORATE ISSUERS:

     On April 30, 2004, the number of shares set forth below was outstanding with respect to each of the issuer’s classes of common stock:

Texas Capital Bancshares, Inc.
Form 10-Q
Quarter Ended March 31, 2004

Index

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ITEM 1. FINANCIAL STATEMENTS

TEXAS CAPITAL BANCSHARES, INC.

See accompanying notes to consolidated financial statements.

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TEXAS CAPITAL BANCSHARES, INC.

See accompanying notes to consolidated financial statements.

4

TEXAS CAPITAL BANCSHARES, INC.

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

See accompanying notes to consolidated financial statements.

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TEXAS CAPITAL BANCSHARES, INC.

See accompanying notes to consolidated financial statements.

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TEXAS CAPITAL BANCSHARES, INC.

(1) ACCOUNTING POLICIES

Basis of Presentation

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”). 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.

Stock-Based Compensation

At March 31, 2004, 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 for options is reflected in net income, as all options granted under the plan 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, Accounting for Stock-Based Compensation, to stock-based employee compensation.

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 2004 and 2003, respectively: a risk free interest rate of 3.56% and 2.85%, a dividend yield of 0%, a volatility factor of .286 and .001, and an estimated life of five years.

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(1) ACCOUNTING POLICIES (continued)

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.

(2) EARNINGS PER SHARE

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

(1)

Excludes employee stock options with exercise price equal to or greater than average market price of $15.75 for 2004 and $7.25 for 2003.

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(3) FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

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.

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QUARTERLY FINANCIAL SUMMARY – UNAUDITED

(1)

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

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

Forward Looking Statements

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:

	(1)		Changes in interest rates
	(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
	(7)		Changes in government regulations

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.

Results of Operations

Summary of Performance

The Company recorded net income of $3.9 million or $.15 per diluted common share for the first quarter of 2004 compared to $3.0 million or $.14 per diluted common share for the first quarter of 2003. Return on average equity was 8.96% and return on average assets was .71% for the first quarter of 2004 compared to 9.68% and .67%, respectively, for the first quarter of 2003.

The increase in net income and improvement in return on assets in 2004 are attributed to growth in net interest income, which came from continued earning asset growth, as well as an improvement in net interest margin. The reduction in return on equity resulted from the effect of the $34 million increase in stockholders’ equity from the initial public offering of our common stock completed during the third quarter of 2003. Net interest income for the first quarter of 2004 increased by $4.9 million or 41.7% from $11.7 million to $16.6 million over the first quarter of 2003. The increase in net interest income was due to an increase in average earning assets of $393.9 million or 23.4%, with a 40 basis point increase in net interest margin.

Non-interest income, excluding gain on sale of securities, increased $326,000 or 10.9% compared to the first quarter of 2003. The Company benefited from growth in fees related to deposits and wealth management, and gain on sale of mortgage loans, which is related to our residential mortgage lending division that was started in the third quarter of 2003.

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Non-interest expense increased $4.0 million or 42.1% compared to the first quarter of 2003. Salaries and employee benefits increased by $2.7 million or 51.0%. Total full time employees increased from 224 at March 31, 2003 to 355 at March 31, 2004; the increase related to continued growth, staffing for the new Houston office and the start-up of the residential mortgage lending division.

Net Interest Income

Net interest income was $16.6 million for the first quarter of 2004, compared to $11.7 million for the first quarter of 2003. The increase was due to an increase in average earning assets of $393.9 million as compared to the first quarter of 2003 and a 40 basis point increase in net interest margin. The increase in average earning assets included a $204.6 million increase in average net loans and a $212.8 million increase in average securities. For the quarter ended March 31, 2004, average net loans and securities represented 63% and 37%, respectively, of average earning assets compared to 66% and 32% in the same quarter of 2003. The decrease in loan percentage reflects management’s decision to tighten lending standards beginning in 2001 and continuing during 2003 pending clearer signs of improvement in the U.S. economy. While we continue to apply prudent lending standards, loan growth in the first quarter of 2004 in our core loan portfolio (excluding loans held for sale) totaled $82.0 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 $297.0 million from the first quarter of 2003, which included a $162.4 million increase in interest bearing deposits and a $124.4 million increase in other borrowings. The increase in average borrowings was primarily related to an increase in 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 2.31% for the quarter ended March 31, 2003 to 1.73% for the same period of 2004, reflecting the reduction in market interest rates.

TABLE 1 — VOLUME/RATE ANALYSIS
(Dollars in thousands)

(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 3.23% for the first quarter of 2004 compared to 2.83% for the first quarter of 2003. The increase was due to a slight decrease in the earning asset yield from the first quarter of 2003, and a much larger decrease in the cost of liabilities.

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Non-interest Income

Non-interest income, excluding gain on sale of securities, increased $326,000 compared to the same quarter of 2003. This increase was due to the increase in deposits, which resulted in a higher volume of transactions. Trust fee income increased $156,000, due to continued growth of trust assets in 2003 and 2004. Gain on sale of mortgage loans totaled $463,000 and relates to our newly created residential mortgage lending division. Cash processing fees totaled $587,000 for the first quarter of 2004 compared to $900,000 for the same quarter of 2003. These fees are related to a special project that has occurred in the first quarter of 2002, 2003 and 2004. 2004 fees are lower than 2003 fees due to smaller participation and more competitive pricing.

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.

TABLE 2 – NON-INTEREST INCOME
(Dollars in thousands)

Non-interest Expense

Non-interest expense for the first quarter of 2004 increased $4.0 million or 42.1% compared to the first quarter of 2003. Salaries and employee benefits increased by $2.7 million or 51.0%. Total full time employees increased from 224 at March 31, 2003 to 355 at March 31, 2004. Additional employees include employees hired in the new Houston office, employees in our recently created residential mortgage lending division as well as additional employees in our lending and support functions.

Advertising expense increased $92,000 or 47.7%. Advertising expense for the three months ended March 31, 2004 included $27,000 of direct marketing and branding and $258,000 for the purchase of miles related to the American Airlines AAdvantage® program, compared to $31,000 of direct marketing and branding and $162,000 for the purchase of miles during the same period for 2003.

Net occupancy expense for the three months ended March 31, 2004 increased by $145,000 or 12.2% compared to the same quarter in 2003 and is related to our continued growth, the new Houston office and the start-up of the residential mortgage lending division. Legal and professional expense for the three months ended March 31, 2004 increased $210,000 or 36.3% compared to the same quarter in 2003. Communications and data processing expense for the three months ended March 31, 2004 increased $139,000 or 19.3% compared to the same quarter in 2003. Both increases are due to continued growth.

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TABLE 3 – NON-INTEREST EXPENSE
(Dollars in thousands)

Analysis of Financial Condition

The aggregate loan portfolio at March 31, 2004 increased $73.8 million from December 31, 2003 to $1.39 billion. Commercial loans increased $44.9 million and real estate loans increased $17.4 million. Construction loans and consumer loans increased $18.5 million and $2.8 million, respectively, and leases decreased $1.8 million.

TABLE 4 – LOANS
(Dollars in thousands)

We continue to lend primarily in Texas. As of March 31, 2004, 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 loan and lease pools (primarily commercial and industrial equipment and vehicles), as well as selected loan participations and USDA government guaranteed loans.

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Summary of Loan Loss Experience

The reserve for loan losses, which is available to absorb losses inherent in the loan portfolio, totaled $18.0 million at March 31, 2004, $17.7 million at December 31, 2003 and $15.9 million at March 31, 2003. This represents 1.30%, 1.35% and 1.35% of total loans at March 31, 2004, December 31, 2003 and March 31, 2003, 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 $750,000 for the quarter ended March 2004 and $1.3 million for the same quarter in 2003. These provisions were made to reflect management’s assessment of the risk of loan losses specifically including the significant growth in outstanding loans during each of these periods.

The reserve for loan losses is comprised of specific reserves for impaired loans and an estimate of losses inherent in the portfolio at the balance sheet date, but not yet identified with specified loans. We regularly 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 the Company’s historical loss rates and 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 portfolio credit quality and anticipated future 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 our board of directors for their review, consideration and ratification on a quarterly basis.

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TABLE 5 – SUMMARY OF LOAN LOSS EXPERIENCE
(Dollars in thousands)

(1)

Interim period ratios are annualized.

(2)

Subsequent to March 31, 2004, a $6.0 million past due loan was refinanced resulting in a reduction of total non-performing loans to $7.2 million and increasing the allowance to non-performing loans ratio from 136.42% to 250.05%.

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Non-performing Assets

Non-performing assets include non-accrual loans and leases, accruing loans 90 or more days past due, restructured loans, and other repossessed assets. The table below summarizes our non-accrual loans by type:

At March 31, 2004, we had $6,250,000 in loans past due 90 days and still accruing interest. Subsequent to March 31, 2004, a $6.0 million past due loan was refinanced resulting in a reduction of total non-performing loans. At March 31, 2004, we had $64,000 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 March 31, 2004, approximately $4.0 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.

Liquidity and Capital Resources

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, 2003 and for the three months ended March 31, 2004, 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 March 31, 2004, comprised $1,405.8 million, or 94.0%, 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 March 31, 2004, brokered retail CDs comprised $90.1 million, or 6.0%, of total deposits. Our dependence on retail brokered CDs is limited by our internal funding guidelines, which as of March 31, 2004, limited borrowing from this source to 10-20% of total deposits.

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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 March 31, 2004, our borrowings consisted of a total of $416.4 million of securities sold under repurchase agreements, $90.2 million of downstream federal funds purchased, $15.9 million from customer repurchase agreements, and $2.0 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 March 31, 2004, we had no borrowings from the FHLB. Our unused FHLB borrowing capacity at March 31, 2004 was approximately $200.0 million. As of March 31, 2004, we had unused upstream federal fund lines available from commercial banks of approximately $72.6 million. During the three months ended March 31, 2004, our average other borrowings from these sources were $621.0 million or 28.0% of average assets, which is well within our internal funding guidelines, which limit our dependence on borrowing sources to 25-30% of total assets. The maximum amount of borrowed funds outstanding at any month-end during the first three months of 2004 was $622.5 million, or 27.8%, of total assets.

As of March 31, 2004, our significant fixed and determinable contractual obligations to third parties were as follows:

(1) Excludes interest

     The contractual amount of our financial instruments with off-balance sheet risk expiring by period at March 31, 2004 is presented below: