UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

 

FORM 10-K

 

 

TEXAS REGIONAL BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

 

 

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

 

 

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

 

Class A Voting Common, $1.00 Par Value Per Share

(Title of class)

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Sec. 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý Noo

 

Aggregate market value of voting stock held by non-affiliates of the registrant, computed by reference to the closing price of the stock, as of March 5, 2004: $997,555,863

 

Number of shares outstanding of the registrants Class A Voting Common Stock, $1.00 par value, as of March 5, 2004: 29,656,174

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s definitive Proxy Statement for its 2004 Annual Meeting of Stockholders are incorporated into Part III; Items 10-14 of this Form 10-K, to be filed not later than 120 days after the close of the Registrant’s fiscal year.

 

 

PART I

 

ITEM 1. BUSINESS

 

GENERAL

 

Texas Regional Bancshares, Inc. (“Texas Regional” or the “Company”) is a Texas business corporation incorporated in 1983 and headquartered in McAllen, Texas. The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 and as such is registered with the Board of Governors of the Federal Reserve System (“Federal Reserve Board”). Texas Regional Delaware, Inc., incorporated under the laws of Delaware as a wholly owned second tier bank holding company subsidiary, owns Texas State Bank (the “Bank”), the Company’s primary operating subsidiary. The Bank has two active wholly owned subsidiaries: (i) TSB Securities, Inc., incorporated in 1997 to provide full service broker-dealer services and (ii) TSB Properties, Inc., incorporated in 1998 to receive and liquidate foreclosed assets.

 

The Company has grown rapidly through a series of strategic acquisitions. The Company acquired the Rio Grande City and Roma branches of First National Bank of South Texas during 1995. A secondary public offering of 2.5 million shares of the Company’s Class A Voting Common Stock was completed on May 14, 1996. Concurrently, the Company also completed the acquisition of First State Bank & Trust Co., Mission, Texas and The Border Bank, Hidalgo, Texas. On February 19, 1998, the Company acquired Brownsville National Bank, Brownsville, Texas, Texas Bank and Trust, Brownsville, Texas and Bank of Texas, Raymondville, Texas. On October 1, 1999, the Company acquired Harlingen National Bank, Harlingen, Texas.  The Company made its first acquisition outside of the Rio Grande Valley on February 22, 2002 through the acquisition of Riverway Bank, Houston, Texas.  On November 18, 2002, the Company acquired Texas Country Bank, San Juan, Texas and on February 14, 2003, the Company completed the acquisition of Corpus Christi Bancshares, Inc., Bishop, Texas with one additional banking location in Corpus Christi, Texas.

 

At December 31, 2003, the Bank operated thirty-four full-service banking locations. Twenty-eight banking locations are located in the Rio Grande Valley including four banking locations in McAllen (including its main office), four banking locations in Brownsville, four banking locations in Harlingen, three banking locations in Mission, two banking locations in Weslaco, and one banking location each in Edinburg, Hidalgo, La Feria, Mercedes, Palm Valley, Peñitas, Progreso, Raymondville, Rio Grande City, Roma and San Juan. In addition, Texas State Bank operates one banking location each in Bishop, Corpus Christi, Eagle Pass and Sugar Land and two banking locations in Houston. At December 31, 2003, the Company had consolidated total assets of $4,217,936,000, loans held for investment (net of unearned discount) of $2,519,694,000, deposits of $3,516,435,000, and shareholders’ equity of $421,731,000.

 

The Company’s business strategy is to provide its customers with the financial sophistication and breadth of products of a regional bank, while retaining the local appeal and level of service of a community bank. The Board of Directors and management have maintained the Bank’s community orientation by tailoring products and services to meet community and customer needs. Management believes that the Bank is well positioned in its market due to its responsive customer service, the strong community involvement of management and employees, the recent trends in the Texas banking environment and the vitality of the economy in its market areas. Management’s strategy is to provide a business culture in which individual customers and small and medium sized businesses are accorded the highest priority in all aspects of the Company’s operations.

 

For its business customers, the Bank offers checking facilities, certificates of deposit, short-term loans for working capital purposes, construction financing, mortgage loans, term loans for fixed asset and expansion needs and other commercial loans. The services provided for individuals by the Bank include checking accounts, savings accounts, certificates of deposit, individual retirement accounts and consumer loan programs, including installment loans for home repair and for purchases of consumer goods, including automobiles, trucks and boats, and mortgage loans. The Bank also provides travelers checks, money orders and safe deposit facilities, and offers trust services.

 

During 2002, the Bank expanded the services that it provides to third party correspondent banks by acquisition of a data processing facility in Grapevine, Texas. The Bank’s data processing center now serves banks both in North Texas and the Rio Grande Valley, in addition to providing data processing services for all of the Bank’s banking locations.

 

Management believes there may be opportunities to expand by acquiring other banks or by acquiring assets and deposits that will allow the Company to enter other markets or further increase market share in existing markets. Management intends to pursue acquisition opportunities in strategic markets in circumstances in which management believes that its managerial, operational and capital resources will enhance the performance of acquired institutions.

 

COMPETITION

 

At December 31, 2003, substantially all of the Company’s operations were located in the Rio Grande Valley, which consists of Cameron, Hidalgo, Starr and Willacy Counties, and in the greater Houston metropolitan area. Cameron, Hidalgo and Starr Counties are adjacent to the Rio Grande River, which forms part of the border between the United States and Mexico.

 

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Effective with the acquisition of Riverway Bank in Houston, Texas in February 2002, the Company made its first acquisition outside of the Rio Grande Valley. The Company continued expanding outside the Rio Grande Valley with its 2003 acquisition of Corpus Christi Bancshares, Inc., which added banking locations in Bishop and Corpus Christi, Texas, and the opening of a new branch in Eagle Pass, Texas.

 

The Bank encounters intense competition in its commercial banking business, primarily from other banks located in its market areas. The Bank also competes with insurance, finance and mortgage companies, savings and loan institutions, credit unions, money market funds and other financial institutions. Competition is based upon interest rates offered on deposit accounts, interest rates charged on loans and other credit and service charges, the quality and scope of the services rendered, the convenience of banking facilities, and, in the case of loans to commercial borrowers, the banks’ lending limits. A substantial number of the commercial banks in the market areas served by the Bank are branches of much larger organizations affiliated with national, regional or state-wide banking companies which are larger than the Bank in terms of capital, resources and personnel. However, as a major independent community bank headquartered in Texas, management believes that the Company’s community commitment and involvement in its primary market area, as well as its commitment to quality and personalized banking services, are factors that contribute to the Company’s competitiveness.

 

REGULATION AND SUPERVISION

 

In addition to the generally applicable state and federal laws governing businesses and employers, special federal and state laws applicable only to financial institutions and their parent companies extensively regulate the Company and the Bank. Virtually all aspects of the Company’s operations are subject to specific requirements or restrictions and general regulatory oversight, from laws regulating consumer finance transactions, such as the Truth In Lending Act, the Home Mortgage Disclosure Act and the Equal Credit Opportunity Act, to laws regulating collections and confidentiality, such as the Fair Debt Collections Practices Act, the Fair Credit Reporting Act and the Right to Financial Privacy Act. With few exceptions, state and federal banking laws have as their principal objective either the maintenance of the safety and soundness of the federal deposit insurance system or the protection of consumers or classes of consumers, rather than the specific protection of shareholders of the Company.

 

References to statutes, regulations, decisions and interpretations in this Annual Report do not purport to be complete and are qualified in their entirety by reference to the actual text of the relevant statutes, regulations, decisions and interpretations.

 

REGULATION OF THE COMPANY

 

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 (the “BHCA”), as amended, and therefore is subject to regulation and supervision by the Board of Governors of the Federal Reserve System (the “FRB”). In addition, the Company is required to file reports with and to furnish such other information as the FRB may require pursuant to the BHCA, and to subject itself to examination by the FRB. The FRB has the authority to issue bank holding companies orders to cease and desist from unsound practices and violations of conditions imposed by, or violation of agreements with, the FRB. The FRB is also empowered to assess civil penalties against companies or individuals who violate the BHCA or orders or regulations thereunder in amounts up to $1.0 million per day, to order termination of non-approved activities and to order termination of ownership and control of non-approved subsidiaries. Certain violations may also result in criminal penalties. The FRB and the Federal Deposit Insurance Corporation (the “FDIC”), as appropriate, are authorized to exercise comparable authority, under the Federal Deposit Insurance Act (the “FDI Act”) and other statutes, with respect to subsidiary banks.

 

The FRB takes the position that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the FRB’s position that, in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the FRB to be an unsafe and unsound banking practice or a violation of the FRB regulations or both. Changes in the FDI Act made by the Federal Deposit Insurance Corporation Improvement Act of 1991 (the “FDICIA”) now require an undercapitalized institution to submit to the FRB a capital restoration plan with a guaranty, by each company having control of the bank, of the bank’s compliance with the plan.

 

The BHCA and the Change in Bank Control Act, together with regulations promulgated by the FRB, require that, depending on the particular circumstances, either FRB approval must be obtained or notice must be furnished to the FRB and not disapproved prior to any person or company acquiring “control” of a bank holding company, such as the Company, subject to certain exemptions for certain transactions. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control is rebuttably presumed to exist if a person acquires 10% or more but less than 25% of any class of voting securities and either the company has registered securities under

 

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Section 12 of the Exchange Act or no other person will own a greater percentage of that class of voting securities immediately after the transaction. The regulations provide a procedure for challenge of the rebuttable control presumption.

 

As a bank holding company, the Company is required to obtain approval prior to merging or consolidating with any other bank holding company, acquiring all or substantially all of the assets of any bank or acquiring ownership or control of shares of a bank or bank holding company if, after the acquisition, the Company would directly or indirectly own or control 5% or more of the voting shares of such bank or bank holding company.

 

Historically, the Company has been prohibited from acquiring a direct or indirect interest in or control of more than 5% of the voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiary bank, except that FRB has permitted bank holding companies to engage in and own shares of companies engaged in certain activities found by the FRB to be so closely related to banking or managing and controlling banks as to be a proper incident thereto. These activities include, among others, operating a mortgage, finance, credit card, or factoring company; performing certain data processing operations; providing investment and financial advice; acting as an insurance agent for certain types of credit-related insurance; leasing personal property on a full pay out, non-operating basis; and providing certain stock brokerage and investment advisory services. In approving acquisitions or the addition of activities, the FRB has considered whether the acquisition or the additional activities can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that outweigh such possible adverse effects as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. In considering any application for approval of an acquisition or merger, the FRB is also required to consider the financial and managerial resources of the companies and the banks concerned, as well as the applicant’s record of compliance with the Community Reinvestment Act (the “CRA”). The CRA generally requires a financial institution to take affirmative action to ascertain and meet the credit needs of its entire community, including low and moderate income neighborhoods.

 

The Gramm-Leach-Bliley Act (“Gramm-Leach”), enacted by Congress in November 1999, now permits bank holding companies with subsidiary banks meeting certain capital and management requirements to elect to become “financial holding companies”. Beginning in March 2000, financial holding companies may engage in a full range of financial activities, including not only banking, insurance and securities activities, but also merchant banking and additional activities determined to be “financial in nature”. Gramm-Leach also provides that the list of permissible activities will be expanded as necessary for a financial holding company to keep abreast of competitive and technological change.

 

Although it preserves the Federal Reserve as the umbrella supervisor of financial holding companies, Gramm-Leach adopts an administrative approach to regulation that defers to the approval and supervisory requirements of the functional regulators of insurers and insurance agents, broker-dealers, investment companies, and banks. Thus, the various state and federal regulators of a financial holding company’s operating subsidiaries would retain their jurisdiction and authority over the operating entities. As the umbrella supervisor, however, the Federal Reserve has the potential to affect the operations and activities of financial holding companies’ subsidiaries through its power over the financial holding company parent. In addition, Gramm-Leach contains numerous trigger points related to legal noncompliance and other serious problems affecting bank affiliates that could lead to direct Federal Reserve involvement and to the possible exercise of remedial authority affecting both financial holding companies and their affiliated operating companies.

 

By authority of the Board of Directors of the Company, Texas Regional in May 2000 filed a Declaration Electing to be a Financial Holding Company with the Federal Reserve Bank of Dallas. The Declaration became effective in June 2000.

 

The BHCA imposes certain limitations on extensions of credit and other transactions by and between banks that are members of the Federal Reserve System and other banks and non-bank companies in the same holding company. Under the BHCA and the FRB’s regulations, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services.

 

The Company, as an affiliate of the Bank, is subject to certain restrictions regarding transactions between a bank and companies with which it is affiliated. These provisions limit extensions of credit (including guarantees of loans) by the Bank to affiliates, investments in the stock or other securities of the Company by the Bank, and the nature and amount of collateral that the Bank may accept from any affiliate to secure loans extended to the affiliate.

 

REGULATION OF THE BANK

 

The Bank is a state-chartered bank subject to regulation by the Texas Department of Banking. The Bank, whose deposits are insured by the Bank Insurance Fund (the “BIF”) of the FDIC, is also a member of the Federal Reserve System, and therefore the FRB is the primary federal regulator for the Bank.

 

The requirements and restrictions applicable to the Bank under laws of the United States and the State of Texas include (i) the requirement that reserves be maintained, (ii) restrictions on the nature and amount of loans which can be made, (iii) restrictions on the business activities in which the Bank may engage, (iv) restrictions on the payment of dividends to shareholders, and (v) the maintenance of minimum capital requirements.

 

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The Company is dependent upon dividends received from the Bank for discharge of the Company’s obligations and for payment of dividends to the Company’s shareholders. However, the application of minimum capital requirements and other rules and regulations applicable to the Bank restrict the amount of dividends that it may declare without prior regulatory approval. The Texas Banking Department and the FRB can each further limit payment of dividends if the regulatory authority finds that the payment of dividends would constitute an unsafe or unsound practice.

 

The laws of the State of Texas also govern interest rate limitations for the Bank. The maximum annual interest rate that may be charged on most loans made by the Bank is based on doubling the average auction rate, to the nearest 0.25%, for United States Treasury Bills, as computed by the Office of Consumer Credit Commissioner of the State of Texas. However, the maximum rate does not decline below 18% or rise above 24% (except for loans in excess of $250,000 that are made for business, commercial, investment or other similar purposes (excluding agricultural loans), in which case the maximum annual rate may not rise above 28%, rather than 24%). On fixed rate closed-end loans, the maximum non-usurious rate is to be determined at the time the rate is contracted; while on floating rate and open-end loans (such as credit cards), the rate varies over the term of the indebtedness. Federal law has preempted state usury laws (but not late charge limitations) for loans secured by a first lien on residential real property.

 

Banks are affected by the credit policies of other monetary authorities, including the FRB, which regulate the national supply of bank credit. Such regulation influences overall growth of bank loans, investments, and deposits and may also affect interest rates charged on loans and paid on deposits. The monetary policies of the FRB have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

 

FDICIA

 

FDICIA requires that federal bank regulatory authorities take “prompt corrective action” with respect to any depository institution that does not meet specified minimum capital requirements. The applicable regulations establish five capital levels which require or permit the FRB and other regulatory authorities to take supervisory action. The relevant classifications range from “well capitalized” to “critically undercapitalized”. Under these regulations, an institution is considered “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier I risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and it is not subject to an order, written agreement, capital directive, or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. An institution is considered “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a Tier I risk-based capital ratio of 4.0% or greater and a leverage capital ratio of 3.0% or greater (if the institution is rated composite 1 in its most recent report of examination, subject to appropriate federal banking agency guidelines), and the institution does not meet the definition of a “well capitalized” institution. An institution is considered “undercapitalized” if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0%, or a leverage ratio that is less than 4.0% (or a leverage ratio that is less than 3.0% if the institution is rated composite 1 in its most recent report of examination, subject to appropriate federal banking agency guidelines). A “significantly undercapitalized” institution is one which has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0%, or a leverage ratio that is less than 3.0%. A “critically undercapitalized” institution is one that has a ratio of tangible equity to total assets that is equal to or less than 2.0%.

 

With certain exceptions, an institution will be prohibited from making capital distributions or paying management fees if the payment of such distributions or fees will cause the institution to become “undercapitalized”. Furthermore, “undercapitalized” institutions will be required to file capital restoration plans with the appropriate federal regulator. Pursuant to FDICIA, “undercapitalized” institutions also will be subject to restrictions on growth, acquisitions, branching and engaging in new lines of business unless they have an approved capital plan that permits otherwise. The FRB also may, among other things, require an “undercapitalized” institution to issue shares or obligations, which could be voting stock, to recapitalize the institution or, under certain circumstances, to divest itself of any subsidiary.

 

The FRB is authorized to take various enforcement actions against any “significantly undercapitalized” institution and any “undercapitalized institution” that fails to submit an acceptable capital restoration plan or fails to implement a plan accepted by the appropriate agency. These powers include, among other things, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any bank holding company which controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring a new election of directors, and requiring the dismissal of directors and officers. If imposed, these restrictions, either individually or in the aggregate, could have a significant adverse impact on the operations of the Bank.

 

“Critically undercapitalized” institutions may be subject to more extensive control and supervision and the FRB may prohibit any “critically undercapitalized” institution from, among other things, entering into any material transaction not in the ordinary course of business, amending its charter or bylaws, or engaging in certain transactions with affiliates. In addition, “critically undercapitalized” institutions generally will be prohibited from making payments of principal or interest on outstanding subordinated debt. Within 90 days of an institution becoming “critically undercapitalized”, the FRB must appoint a receiver or conservator unless certain findings are made with respect to the prospect for the institution’s continued operation.

 

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Management believes that the Company meets all capital adequacy requirements to which it is subject at December 31, 2003. The Bank’s capital ratios exceeded the minimum requirements for “well capitalized” institutions under the regulatory framework for prompt corrective action at December 31, 2003. As a result, the Company does not believe that FDICIA’s prompt corrective action regulations will have any material effect on the activities or operations of the Bank.  It should be noted, however, that a bank’s capital category is determined solely for the purpose of applying the FDICIA’s prompt corrective action regulations and that the capital category may not constitute an accurate representation of the Bank’s overall financial condition or prospects.

 

FDICIA also requires the FDIC to establish a schedule to increase (over a period of not more than 15 years) the reserve ratio of the BIF, which insures deposits of Texas State Bank, to 1.25% of insured deposits, and impose higher deposit insurance premiums on BIF members, if necessary, to achieve that ratio. FDICIA also requires a risk-based assessment system for deposit insurance premiums commencing January 1, 1994. Since BIF reached its designated reserve ratio in mid-1995, the FDIC adjusted the BIF assessments, so that the assessment rate now in effect ranges from a minimum of zero to a maximum of $0.27 per $100 of deposits.

 

FDICIA contains numerous other provisions, including accounting, auditing and reporting requirements, the termination of the “too big to fail” doctrine except in special cases, regulatory standards in areas such as asset quality, earnings and compensation, and revised regulatory standards for the powers of state chartered banks, real estate lending, bank closures and capital adequacy.

 

DEPOSIT INSURANCE

 

The Deposit Insurance Funds Act of 1996 (the “Funds Act”) was enacted on September 30, 1996. Among its provisions, the Funds Act authorizes the Financing Corporation (the “FICO”) to impose periodic assessments on depository institutions that are members of BIF in addition to institutions that are members of the Savings Association Insurance Fund (the “SAIF”) in order to spread the cost of the interest payments on the outstanding FICO bonds over a larger number of institutions. Until this change in the law, only SAIF-member institutions bore the cost of funding these interest payments.  Thus, BIF-member institutions will share in the cost of financing outstanding FICO bonds.  An institution’s FICO assessments will fluctuate based on a defined rate applied to deposits held in periods after the date the legislation was enacted.  Currently, the FICO BIF annual rate is 1.54 cents for each $100 of qualified deposits.

 

ACQUISITIONS

 

Absent an election to become a financial holding company, the BHCA limits acquisitions by the Company to commercial banks and companies engaged in activities that the Federal Reserve Board has determined to be so closely related to banking as to be a proper incident thereto. The Company’s direct activities are generally limited to furnishing to its subsidiaries services that qualify under the prescribed regulatory tests. Prior Federal Reserve Board approval is required under the BHCA for new activities and acquisitions of most nonbanking companies.

 

The BHCA, the Federal Bank Merger Act and the Texas Banking Code regulate the acquisition of commercial banks. The BHCA requires the prior approval of the Federal Reserve Board for the direct or indirect acquisition of more than five percent of the voting shares of a commercial bank or bank holding company. With respect to the Company’s subsidiary bank, the approval of the Texas Department of Banking is required for branching, purchasing the assets of other banks and for bank mergers.

 

In reviewing bank acquisition and merger applications, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, and the applicant’s record under the Community Reinvestment Act and fair housing laws.

 

The Corporation regularly evaluates acquisition opportunities and regularly conducts due diligence activities in connection with possible acquisitions. As a result, acquisition discussions and, in some cases negotiations, regularly take place and future acquisitions could occur.

 

INTERSTATE BANKING AND BRANCHING LEGISLATION

 

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“IBBEA”) authorizes interstate acquisitions of banks and bank holding companies without geographic limitation beginning one year after enactment. In addition, beginning June 1, 1997 IBBEA authorizes a bank to merge with a bank in another state as long as neither of the states has opted out of interstate branching between the date of enactment of IBBEA and May 31, 1997. IBBEA further provides that states may enact laws permitting interstate bank merger transactions prior to June 1, 1997. A bank may establish a de novo branch in a state in which the bank does not maintain a branch if the state expressly permits de novo branching. Once a bank has established branches in a state through an interstate merger transaction, the bank may establish and acquire additional branches at any location in the state where any bank involved in the merger transaction could have established or acquired branches under applicable federal or state law. A bank that has established a branch in a state through de novo branching may establish and

 

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acquire additional branches in such state in the same manner and to the same extent as a bank having a branch in such state as a result of an interstate merger. If a state opts out of interstate branching within the specified time period, no bank in any other state may establish a branch in the opting out state, whether through an acquisition or de novo.

 

Texas enacted legislation opting out of interstate branching in 1995. However, the decision to opt out was rendered ineffective with the 1998 decision of the United States District Court for the Northern District of Texas affirming the Comptroller of the Currency’s decision to permit an interstate merger involving a Texas national bank. The Texas Legislature responded in 1999 by passing The Interstate Banking and Branching Bill, which became effective September 1, 1999. This legislation provides a framework for interstate branching in Texas, providing for de novo branching by banks headquartered in states offering reciprocity to Texas institutions or institutions authorized to branch in Texas. For banks in other, non-reciprocal states, a five-year minimum age requirement is retained. The legislation also clarifies other provisions of Texas law related to interstate banks operating in Texas, and includes a “super parity” provision which provides a framework for a bank chartered in Texas, upon application, to conduct any of the activities allowed any other state or federal financial institution in the nation.

 

BROKER-DEALER LICENSING REQUIREMENTS

 

Texas State Bank’s subsidiary, TSB Securities, Inc. a broker-dealer registered with and licensed by the National Association of Securities Dealers, Inc. (“NASD”) and the Texas State Securities Board, is subject to reporting requirements and regulatory controls imposed by the NASD and the State Securities Board.

 

ECONOMIC ENVIRONMENT

 

The earnings of the Bank are affected not only by general economic conditions but also by the policies of various governmental regulatory authorities. The FRB regulates the supply of credit in order to influence general economic conditions, primarily through open market operations in United States government obligations, varying the discount rate of financial institution borrowings and varying reserve requirements against financial institutions and their subsidiaries. The deregulation of interest rates has had and is expected to continue to have an impact on the competitive environment in which the Bank operates.

 

Governmental policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. However, the Company cannot accurately predict the nature or extent of any effect that such policies may have on its future business and earnings.

 

PERSONNEL

 

The Company employed 1,284 full-time equivalent employees at December 31, 2003. Employees enjoy a variety of employee benefit programs, including an employee stock ownership plan with 401(k) provisions, medical, accident, group life and long-term disability plans, and paid vacations. The Company’s employees are not unionized, and management believes employee relations to be favorable.

 

ITEM 2. PROPERTIES

 

The executive offices of the Company, as well as the principal banking quarters of Texas State Bank, are housed in an eleven-story office tower located in McAllen, Texas. This building, completed during 1998, also includes space for lease to third party tenants. The Company also owns the Kerria Plaza building, adjacent to the headquarters building. The Company occupies a portion of the building and leases a majority of the space to third party tenants. All of the Company’s banking locations are owned, except for the branches in Roma, Corpus Christi and 1000 Main in Houston. Management believes that it will be desirable in the future to consider the establishment of additional banking locations.

 

ITEM 3. LEGAL PROCEEDINGS

 

The Company’s subsidiary, Texas State Bank, is a party to two cases arising out of a series of lease pool purchase and sale transactions that Riverway Bank engaged in with Commercial Money Center, Inc. and its affiliates (“CMC”), prior to the acquisition of Riverway Bank by the Company. Riverway Bank sold the lease pools to General Electric Capital Corporation (“GECC”) in 2000, and CMC filed for bankruptcy in 2002. One case involves insurers who issued policies providing protection to investors against losses from defaults within the CMC lease pools, and who failed to pay claims of the investors, including GECC. The other case involves allegations by lessees that, among other things, lease transactions were disguised security agreements and that CMC failed to comply with certain California licensing requirements. Outside counsel for the Company has advised that at this stage in the proceedings such counsel cannot offer an opinion as to the probable outcome of the litigation. The Company intends to continue to vigorously contest all of the allegations in each of the lawsuits. Management believes that it is not currently possible to estimate the impact, if any, that the ultimate resolution of these matters will have on the Company’s results of operations, financial position or cash flows. The Company acquired Riverway Holdings, Inc. (“Riverway”) and its subsidiary, Riverway Bank, on February 22, 2002. As provided in the agreement included in the proxy statement sent to the Riverway shareholders, 100,000 shares (165,000 shares following the stock splits and stock dividends effected since date of

 

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acquisition) of Texas Regional were issued and held in escrow pursuant to a holdback escrow agreement pending the outcome of certain contingencies, including these matters. As of December 31, 2003, no shares relating to that agreement have been released.

 

The Company is involved in other routine litigation in the normal course of its business, which in the opinion of management, will not have a material adverse effect on the consolidated financial position, or results of operations of the Company.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

Since March 1994, the Corporation’s Class A Voting Common Stock has traded on The Nasdaq Stock Market^® under the symbol TRBS. The following table shows (i) high and low prices of the Common Stock as provided to the Company by The Nasdaq Stock Market^® for transactions occurring on The Nasdaq Stock Market^® during the past two years, and (ii) the total number of shares involved in such transactions.

 

Quarter Ended								Cash Dividends Declared			Volume Traded
		Price Per Share
		High			Low
March 31, 2002		$	26.55		$	21.82		$	0.097		2,050,576
June 30, 2002		31.90			26.07			0.100			6,295,178
September 30, 2002		33.18			24.92			0.100			3,841,360
December 31, 2002		32.82			26.55			0.109			4,573,764
March 31, 2003		34.63			28.19			0.120			5,910,124
June 30, 2003		36.95			29.75			0.120			6,465,687
September 30, 2003		35.95			30.85			0.120			5,781,058
December 31, 2003		37.95			33.45			0.120			5,900,991

 

On December 31, 2003, there were 892 holders of record of the Company’s Class A Common Stock.

 

During the two years ended December 31, 2003, an aggregate of 90,628 shares purchased by the Texas Regional Bancshares, Inc. Amended and Restated Employee Stock Ownership Plan (with 401(k) provisions) are included in the foregoing table.

 

The final determination of the timing, amount and payment of dividends on the Common Stock is at the discretion of the Company’s Board of Directors. There can be no assurance as to future dividends because they are dependent on future earnings, capital requirements and financial conditions. The Company’s principal source of the funds to pay dividends on the Common Stock is dividends from Texas State Bank. The payment of dividends by the Bank is subject to certain restrictions imposed by federal and state banking laws, regulations and authorities. At December 31, 2003, an aggregate of $92,481,000 was available for payment of dividends by the Bank to the Company under the applicable limitations and without regulatory approval.

 

ITEM 6. SELECTED FINANCIAL DATA

 

The following table sets forth selected consolidated financial data for the Company and its subsidiaries for, and as of, each of the years in the five-year period ended December 31, 2003. This selected financial data has been derived from the consolidated financial statements and accounting records of the Company. The data presented below should be read in conjunction with the consolidated financial statements, related notes and other financial information included herein:

 

9

 

		At / For Years Ended December 31,
Selected Financial Data		2003			2002			2001			2000			1999
		(Amounts in Thousands, Except Per Share Data)
Income Statement Data
Interest Income		$	208,777		$	201,705		$	183,302		$	181,537		$	143,841
Interest Expense		60,385			71,986			83,776			86,513			62,221
Net Interest Income		148,392			129,719			99,526			95,024			81,620
Provision for Loan Losses		13,155			12,331			8,667			8,927			5,432
Noninterest Income		50,255			40,003			29,213			21,574			17,399
Noninterest Expense		91,890			76,159			59,344			53,544			45,888
Income Before Income Tax Expense		93,602			81,232			60,728			54,127			47,699
Income Tax Expense		31,293			27,385			21,306			18,825			16,849
Net Income		$	62,309		$	53,847		$	39,422		$	35,302		$	30,850
Adjusted Net Income (2)		$	62,309		$	53,847		$	41,621		$	37,501		$	32,414
Per Common Share Data
Basic Net Income Per Share (1)		$	2.12		$	1.88		$	1.48		$	1.33		$	1.18
Diluted Net Income Per Share (1)		2.10			1.86			1.47			1.33			1.16
Adjusted Basic Net Income Per Share(2)		2.12			1.88			1.56			1.42			1.24
Adjusted Diluted Net Income Per Share(2)		2.10			1.86			1.55			1.41			1.22
Book Value at End of Period (1)		14.31			12.95			9.90			8.58			7.14
Cash Dividends Declared (1)		0.480			0.406			0.364			0.323			0.284
Dividend Payout Ratio		22.79		%	21.95		%	24.61		%	24.19		%	24.11		%
Weighted Average Shares Outstanding (1)
Basic		29,372			28,613			26,627			26,481			26,152
Diluted		29,699			28,882			26,818			26,641			26,541
Shares Outstanding at End of Period (1)		29,471			29,136			26,788			26,547			26,360
Balance Sheet Data
Total Assets		$	4,217,936		$	3,835,187		$	2,590,812		$	2,426,097		$	2,120,690
Loans Held for Investment		2,519,694			2,267,530			1,710,001			1,587,827			1,374,759
Securities		1,386,224			1,196,079			655,635			621,945			533,948
Interest-Earning Assets		3,930,751			3,534,497			2,366,227			2,216,877			1,913,784
Deposits		3,516,435			3,132,191			2,235,877			2,109,748			1,885,346
Shareholders’ Equity		421,731			377,455			265,259			227,704			188,188
Average Balance Sheet Data
Total Assets		$	4,044,918		$	3,414,940		$	2,489,149		$	2,257,193		$	1,896,880
Loans Held for Investment		2,374,353			2,094,256			1,627,901			1,482,628			1,209,609
Securities		1,297,218			1,003,137			636,257			560,116			488,506
Interest-Earning Assets		3,738,789			3,146,052			2,281,508			2,052,573			1,720,083
Deposits		3,364,405			2,850,216			2,166,106			1,999,028			1,684,730
Shareholders’ Equity		404,254			335,551			250,231			202,498			183,390
Performance Ratios
Return on Average Assets		1.54		%	1.58		%	1.58		%	1.56		%	1.63		%
Return on Average Equity		15.41			16.05			15.75			17.43			16.82
Net Interest Margin(3)		4.05			4.19			4.44			4.71			4.84
Efficiency Ratio		46.26			44.87			46.10			45.92			46.34
Asset Quality Ratios
Nonperforming Assets to Loans Held for Investment and Repossessed Assets		0.82		%	1.12		%	1.27		%	1.08		%	1.04		%
Net Loan Charge-Offs to Average Loans Held for Investment		0.43			0.48			0.43			0.42			0.29
Allowance for Loan Losses to Loans Held For Investment		1.24			1.24			1.23			1.23			1.22
Allowance for Loan Losses to Nonperforming Loans		308.58			189.97			149.99			155.90			200.35
Capital Ratios
Total Risk-Based Capital Ratio		13.94		%	13.77		%	13.54		%	12.35		%	11.94		%
Tier 1 Risk-Based Capital Ratio		12.88			12.67			12.39			11.20			10.79
Leverage Capital Ratio		9.26			8.89			9.05			8.14			7.58
Equity to Assets Ratio		10.00			9.84			10.24			9.39			8.87

 

10

 

(1)   Adjusted to reflect stock splits and stock dividends effected during the periods.

(2)   Represents previously reported net income and net income per common share, adjusted for the exclusion of goodwill amortization, net of tax.  Beginning in 2002, new accounting standards eliminated the amortization of goodwill.

(3)   For analytical purposes, income from tax-exempt assets, primarily securities issued by state and local governments or authorities, is adjusted by an increment that equates tax-exempt income to income from taxable assets (assuming 35% federal income tax rate).  Income on a tax-equivalent basis is not considered to be in accordance with generally accepted accounting principles (“GAAP”).

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Certain statements in this Annual Report on Form 10-K include forward-looking information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the “safe harbor” created by those sections. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: significant increases in competitive pressure in the banking industry; changes in the interest rate environment reducing margins; general economic conditions, either nationally or regionally, becoming less favorable than expected, resulting in, among other things, a deterioration in credit quality and an increase in the provision for possible loan losses; changes in the regulatory environment; changes in business conditions; volatility of rate sensitive deposits; operational risks including data processing system failures or fraud; asset/liability matching risks and liquidity risks; and changes in the securities markets.

 

The following discussion addresses information pertaining to the financial condition and results of operations of Texas Regional Bancshares, Inc. and subsidiaries (the “Company”) that may not be otherwise apparent from a review of the consolidated financial statements and related footnotes. It should be read in conjunction with those statements, as well as with the other information presented throughout the report. In addition to historical information, this discussion and other sections contained in this Annual Report include certain forward-looking statements regarding events and trends which may affect the Company’s future results. Such statements are subject to risks and uncertainties that could cause the Company’s actual results to differ materially. Such factors include, but are not limited to, those described in this discussion and analysis.

 

ACQUISITIONS

 

On February 19, 1998, the Company completed the acquisition of three bank holding companies and their three subsidiary banks. The acquisition of Brownsville Bancshares, Inc. and its subsidiary, Brownsville National Bank, included two banking locations in Brownsville, Cameron County, Texas, with assets of approximately $100.1 million, loans of $42.6 million, deposits of $87.2 million and equity of $12.1 million. The Company achieved this acquisition by the exchange of 984,806 shares of Company stock for all of the outstanding shares of Brownsville Bancshares, Inc. and cancellation of outstanding stock options. Brownsville National Bank merged with and into the Company’s principal subsidiary, Texas State Bank (the “Bank”).

 

The second acquisition was TB&T Bancshares, Inc. and its subsidiary, Texas Bank and Trust of Brownsville, Cameron County, Texas. Texas Bank and Trust of Brownsville had assets of approximately $44.9 million, loans of $21.9 million, deposits of $40.3 million and equity of $4.1 million. This acquisition was achieved by the exchange of 301,483 shares of Company stock for all of the outstanding shares of TB&T Bancshares, Inc. Texas Bank and Trust of Brownsville merged with and into the Bank.

 

The third acquisition was Raymondville Bancorp, Inc. and its subsidiary, Bank of Texas. Bank of Texas was headquartered in Raymondville, Willacy County, Texas, with one additional banking facility in Brownsville, Texas. The shareholder of Raymondville Bancorp, Inc. received cash consideration of $9.6 million in this acquisition, and the Company paid $100,000 in consideration for a covenant not to compete. The Company discharged approximately $330,000 of existing Raymondville Bancorp, Inc. indebtedness. Bank of Texas had assets of approximately $63.9 million, loans of $25.5 million, deposits of $56.5 million and equity of $5.1 million. Bank of Texas was merged with and into the Bank.

 

11

 

The Company accounted for its acquisition of Brownsville Bancshares, Inc. and TB&T Bancshares, Inc. under the pooling-of-interests method of accounting, and as such, the financial information prior to date of acquisition was restated to include the results of operations and financial position of these acquired entities. The Company accounted for its acquisition of Raymondville Bancorp, Inc. under the purchase method of accounting; therefore, the results of operations are included in the consolidated financial statements from the date of acquisition, February 19, 1998.

 

On October 1, 1999, the Company completed the acquisition of Harlingen Bancshares, Inc. and its subsidiary, Harlingen National Bank. The acquisition included its main office and two banking locations in Harlingen, Cameron County, Texas; one banking location in La Feria, Cameron County, Texas; one banking location in Palm Valley, Cameron County, Texas, and one banking location in Mercedes, Hidalgo County, Texas. The shareholders of Harlingen Bancshares, Inc. received aggregate consideration of $34.0 million, including $1.0 million deposited into escrow pending the outcome of certain contingencies. Simultaneously, the shareholders of Harlingen Bancshares, Inc. or their affiliates purchased certain assets of Harlingen Bancshares, Inc. for book value totaling $2.4 million. The Company also agreed to pay $1.0 million over a term of ten years in consideration of a covenant not to compete from certain principals of Harlingen Bancshares, Inc. Harlingen National Bank had assets of approximately $204.2 million, loans of $110.7 million, deposits of $183.6 million and equity of $19.9 million. The Company accounted for the acquisition under the purchase method of accounting; therefore, the results of operations are included in the consolidated financial statements from the date of acquisition, October 1, 1999.

 

On February 22, 2002, the Company completed the acquisition of Riverway Holdings, Inc. and its subsidiary, Riverway Bank located in Houston, Harris County, Texas. The shareholders of Riverway Holdings, Inc. (“Riverway”) received 1,176,226 shares of Texas Regional common stock in exchange for their shares of Riverway common stock. In addition, 100,000 shares (165,000 shares following the stock splits and stock dividends effected since date of acquisition) of Texas Regional were issued and held in escrow pursuant to a holdback escrow agreement pending the outcome of certain contingencies. Riverway had total assets of approximately $681.1 million, loans held for investment of $347.0 million, deposits of $504.6 million and equity of $30.4 million. The Company accounted for the acquisition under the purchase method of accounting; therefore, the results of operations have been included in the consolidated financial statements subsequent to the date of acquisition, February 22, 2002. Riverway Bank merged with and into the Bank.

 

On November 18, 2002, the Company completed the acquisition of San Juan Bancshares, Inc. and its subsidiary, Texas Country Bank located in San Juan, Hidalgo County, Texas, with one additional banking location in Progreso, Hidalgo County, Texas. The shareholders of San Juan Bancshares, Inc. (“San Juan”) received 149,995 shares of Texas Regional common stock in exchange for their shares of San Juan common stock. San Juan had total assets of approximately $49.9 million, loans of $23.0 million, deposits of $44.7 million and equity of $4.3 million. The Company accounted for the acquisition under the purchase method of accounting; therefore, the results of operations have been included in the consolidated financial statements from the date of acquisition, November 18, 2002. Texas Country Bank merged with and into the Bank.

 

On February 14, 2003, the Company completed the acquisition of Corpus Christi Bancshares, Inc. and its subsidiary, The First State Bank located in Bishop, Nueces County, Texas, with one additional banking location in Corpus Christi, Nueces County, Texas. The shareholders of Corpus Christi Bancshares, Inc. (“Corpus Christi”) received 37,128 shares of Texas Regional common stock in exchange for their shares of Corpus Christi common stock not owned by Texas Regional. Texas Regional already owned approximately 32 percent of the shares of Corpus Christi. Corpus Christi had total assets of approximately $33.4 million, loans of $18.4 million, deposits of $29.2 million and equity of $2.3 million. The Company accounted for the acquisition under the purchase method of accounting; therefore, the results of operations have been included in the consolidated financial statements from the date of acquisition, February 14, 2003. The First State Bank merged with and into the Bank.

 

RECENT DEVELOPMENTS

 

On November 19, 2003, the Company and Southeast Texas Bancshares, Inc. jointly executed a definitive agreement for the Company to acquire through merger Southeast Texas Bancshares, Inc. (“Southeast Texas”). Southeast Texas is the privately held bank holding company for Community Bank and Trust, SSB, based in Beaumont, Texas, which operates through 29 branches located throughout a seven county area. As of December 31, 2003, Southeast Texas had total assets of $1,156,406,000. The definitive agreement calls for total consideration of $226,469,000, to be paid 50% to 60% in cash and the balance in newly issued Texas Regional common stock in exchange for all of the outstanding shares of Southeast Texas. The transaction is expected to close in March 2004.

 

OVERVIEW

 

Texas Regional is the only publicly-held bank holding company headquartered in the Rio Grande Valley. Its principal subsidiary, Texas State Bank, offers its customers an array of financial products, while retaining the local appeal and level of service of a community bank. The Company provides full-service banking and personal trust services to individuals, businesses and municipalities in our market areas. These services include commercial and consumer loans, checking, savings and time deposit accounts and trust services. Management believes that the Company is well positioned in its primary market area due to its responsive customer service, the strong community involvement of management and employees, and the vitality of the

 

12

 

economy in its market area. The Company’s strategy is to provide a business culture in which individual customers and small and medium sized businesses are accorded the highest priority in all aspects of the Company’s operation. As of December 31, 2003, the Company had total assets of $4,217,936,000, loans held for investment of $2,519,694,000, deposits of $3,516,435,000 and shareholders’ equity of $421,731,000.

 

The Company’s primary goal is to broaden its customer base, primarily through expanding its network of full-service banking offices while increasing net income per share. The Company currently operates in thirty-four banking locations. Twenty-eight banking locations are in the Rio Grande Valley. In addition, the Company has one banking location in Bishop, Corpus Christi, Eagle Pass and Sugar Land and two banking locations in Houston. In recent years, the Company has grown significantly through a combination of internal growth and acquisitions. Texas State Bank currently holds approximately 28 percent of the market share in the Rio Grande Valley area. The Company’s most significant acquisitions included the 1996 acquisition of First State Bank & Trust Co. in Mission, Texas, and the Border Bank in Hidalgo, Texas, which increased assets by $554,240,000, as well as the 2002 acquisition of Riverway Holdings, Inc. in Houston, Texas, which increased assets by $694,418,000. With the acquisition of Riverway Holdings, Inc. in 2002, the Company made its first acquisition outside of the Rio Grande Valley and has continued to expand outside its primary market area. As a result of a series of acquisitions, the Company’s full-service banking offices have increased from 19 branches at the end of 1998 to 34 at the end of 2003.

 

The Company has entered into an agreement to acquire Southeast Texas Bancshares, Inc. with total assets of $1,156,406,000 as of December 31, 2003, which is expected to close in March 2004. The acquisition of Southeast Texas will give Texas Regional a significant presence in the Beaumont metropolitan area and locations in other areas of east Texas. Furthermore, the acquisition will allow the Company to expand its services and offer title insurance agency services and insurance products to its customers, which are presently being offered by Southeast Texas to its customers. In part because of the acquisition of Southeast Texas, the number of full-service banking offices operated by the Company is expected to exceed 60 by the end of 2004.

 

The Company’s profitability is dependent on managing interest rate spreads, operating expenses and credit risk. Net interest income is the largest component of revenue for the Company. The Company manages interest rate risks through the funds management policy of the Company by offering deposit and/or loan structures that tend to counter the natural rate risk profile of the Company. The Company addresses loan and deposit pricing, the asset and liability mix and interest rate sensitivity on a periodic basis. Although interest rates during 2003 reached record low levels, the Company generated increased earnings by managing interest rate spreads in the decreasing interest rate environment. Despite a decrease in rates during the last two years, net yield on average interest-earning assets has not decreased significantly. The Company evaluates its management of operating expenses through the efficiency ratio, which has ranged from 44.87% to 46.34% during the past five years. The Company manages its credit risk by establishing underwriting guidelines, which address the characteristics of borrowers, industries, geographic locations and risk products. The credit process is controlled by continuous review and credit analysis.

 

EARNINGS SUMMARY

 

Net income was $62,309,000, $53,847,000 and $39,422,000 for the years ended December 31, 2003, 2002 and 2001, respectively, and diluted net income per share was $2.10, $1.86 and $1.47 for these same periods. The growth in net income from 2002 to 2003 resulted primarily from an $18,673,000 increase in net interest income. The increase was primarily generated from loan growth, although the increase was hampered by a decrease in the average prime rate. Furthermore, despite an increase in average deposits from prior year, interest paid on interest-bearing deposits decreased due to a decline in average rates. In addition, salaries and employee benefits increased by $9,589,000 reflecting increases in base salaries, higher staff levels and medical insurance premiums. The Company posted returns on average assets of 1.54%, 1.58% and 1.58% and returns on average equity of 15.41%, 16.05% and 15.75% for the years ended 2003, 2002 and 2001, respectively. The Company’s efficiency ratio was 46.26% in 2003, 44.87% in 2002 and 46.10% in 2001. The efficiency ratio is defined as Noninterest Expense divided by the total of Net Interest Income and Noninterest Income.

 

ANALYSIS OF FINANCIAL CONDITION

 

CASH AND CASH EQUIVALENTS

 

The Company offers a broad range of commercial banking services to individuals and businesses in its service area. It also acts as a correspondent to a number of banks in its service area, providing check clearing, wire transfer, federal funds transactions, loan participations and other correspondent services. The amount of cash and cash equivalents held on any day is significantly influenced by temporary changes in cash items in process of collection. The Company had cash and cash equivalents totaling $100,723,000 at December 31, 2003. By comparison, the Company had $138,539,000 in cash and cash equivalents at December 31, 2002, a decrease of $37,816,000 or 27.3%.

 

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SECURITIES

 

Securities consist of U.S. Treasury, U.S. Government Agency, mortgage-backed and state, county and municipal securities. The Company classifies debt and equity securities into one of three categories: held to maturity, trading or available for sale. At each reporting date, management reassesses the appropriateness of the classification. Investments in debt securities are classified as held to maturity and measured at amortized cost in the consolidated balance sheets only if management has the positive intent and ability to hold those securities to maturity. Securities that are bought and held principally for the purpose of selling them in the near term are classified as trading and measured at fair value in the consolidated balance sheets with unrealized holding gains and losses included in net income. Securities not classified as either held to maturity or trading are classified as available for sale and measured at fair value in the consolidated balance sheets with unrealized holding gains and losses reported in accumulated other comprehensive income, net of applicable income taxes, until realized.

 

At December 31, 2003 and December 31, 2002, no securities were classified as trading. The Company does not currently engage in trading activities or use derivative instruments to control interest rate risk. Even though such activities may be permitted with the approval of the Board of Directors, the Company does not intend to engage in such activities in the immediate future.

 

The following table displays the carrying amount (fair value) of securities available for sale:

 

		December 31,
Securities Available for Sale		2003			2002			2001
		(Dollars in Thousands)
U.S. Treasury		$	6,220		$	727		$	403
U.S. Government Agency		892,505			808,925			419,673
Mortgage-Backed		345,876			283,236			165,614
States and Political Subdivisions		110,089			80,936			59,800
Other		31,124			21,841			9,231
Total		$	1,385,814		$	1,195,665		$	654,721

 

14

 

The following table presents the maturities, amortized cost, estimated fair value and weighted average yields of securities available for sale at December 31, 2003. Mortgage backed securities were allocated based on weighted average life:

 

		Amortized Cost Maturing
Securities Available for Sale		One Year Or Less			After One Through Five Years			After Five Through Ten Years			After Ten Years			Amortized Cost			Estimated Fair Value
		(Dollars in Thousands)
U.S. Treasury		$	704		$	5,495		$	—		$	—		$	6,199		$	6,220
U.S. Government Agency		1,218			867,647			12,457			—			881,322			892,505
Mortgage-Backed		26,661			268,153			50,544			—			345,358			345,876
States and Political Subdivisions		20,440			38,025			39,595			7,793			105,853			110,089
Other		—			2,655			4,994			23,364			31,013			31,124
Total		$	49,023		$	1,181,975		$	107,590		$	31,157		$	1,369,745		$	1,385,814
Weighted Average Yields
(Tax-Equivalent Basis)
U.S. Treasury		2.76		%	2.51		%	—		%	—		%	2.54		%
U.S. Government Agency		1.56			3.43			5.89			—			3.46
Mortgage-Backed		2.85			3.69			3.73			—			3.63
States and Political Subdivisions		4.67			5.07			6.40			7.99			5.70
Other		—			5.68			7.39			3.35			4.20
Total		3.58		%	3.54		%	5.13		%	4.51		%	3.69		%

 

Net unrealized holding gains, net of related tax effect, of $10,356,000 and $22,128,000 at December 31, 2003 and December 31, 2002, respectively, on securities available for sale are reported as a separate component of shareholders’ equity as accumulated other comprehensive income.

 

The following table displays the carrying amount (amortized cost) of securities held to maturity:

 

		December 31,
Securities Held to Maturity		2003			2002			2001
		(Dollars in Thousands)
States and Political Subdivisions		$	410		$	414		$	914
Total		$	410		$	414		$	914

 

The following table presents the maturities, amortized cost, estimated fair value and weighted average yields of securities held to maturity at December 31, 2003:

 

		Amortized Cost Maturing
Securities Held to Maturity		One Year Or Less			After One Through Five Years			After Five Through Ten Years			After Ten Years			Amortized Cost			Estimated Fair Value
		(Dollars in Thousands)
States and Political Subdivisions		$	200		$	210		$	—		$	—		$	410		$	431
Total		$	200		$	210		$	—		$	—		$	410		$	431
Weighted Average Yields
(Tax-Equivalent Basis)
States and Political Subdivisions		9.33		%	9.48		%	—		%	—		%	9.41		%
Total		9.33		%	9.48		%	—		%	—		%	9.41		%

 

All investments in states and political subdivisions are investments in entities within the State of Texas. No single issuer accounted for as much as 10.0% of total shareholders’ equity at December 31, 2003. Of the obligations of states and political subdivisions held by the Company at December 31, 2003, 65.5% were rated A or better by Moody’s Investor Services, Inc. and 80.3% of the non-rated issues or $28,558,000 are local issues purchased in private placement transactions.

 

LOANS

 

The Company manages its credit risk by establishing and implementing strategies and guidelines appropriate to the characteristics of borrowers, industries, geographic locations and risk products. Diversification of risk within each of these areas is a primary objective. Policies and procedures are developed to ensure that loan commitments conform to current strategies and

 

15

 

guidelines. Management continually refines the Company’s credit policies and procedures to address the risks in the current and prospective environment and to reflect management’s current strategic focus. The credit process is controlled with continuous credit review and analysis, and review by internal and external auditors and regulatory authorities. The Company’s loans are widely diversified by borrower and industry group.

 

The Company has collateral management policies in place so that collateral lending of all types is approached on a basis consistent with safe and sound standards. Valuation analysis is utilized to take into consideration the potentially adverse economic conditions under which liquidation could occur. Collateral accepted against the commercial loan portfolio includes accounts receivable and inventory, marketable securities, equipment, agricultural products and real estate. Autos, deeds of trust, life insurance and marketable securities are accepted as collateral for the installment loan portfolio.

 

Management of the Company believes that the Company has benefited from increased loan demand due to passage of the North American Free Trade Agreement (“NAFTA”) and the strong population growth in the Rio Grande Valley. The effects of NAFTA have also increased cross-border trade and industrial development including activity at twin manufacturing plants located on each side of the border (referred to as maquiladoras) which benefit the Rio Grande Valley economy. Management believes that NAFTA will continue to have a positive impact on the Company’s growth and earnings prospects.

 

The majority of the Company’s loans are loans held for investment except for certain mortgage loans originated and intended for sale in the secondary market. Loans held for sale represent 0.95% of total loans at December 31, 2003.

 

International loans are loans to borrowers that are domiciled in a country other than the United States of America. The Company’s total international loans at December 31, 2003 of $44,229,000 represented 1.8% of total loans held for investment.

 

Total loans held for investment of $2,519,694,000 at December 31, 2003 increased $252,164,000 or 11.1% compared to December 31, 2002 levels of $2,267,530,000. Loans held for investment increased $557,529,000 or 32.6% during 2002 compared to levels of $1,710,001,000 at December 31, 2001. The increase in total loans held for investment during 2003 is primarily attributable to an increased volume of business conducted by the Company and reflects growth in all loan categories except Agricultural, Agricultural Mortgage, 1-4 Family Mortgage and Consumer. The following table presents the composition of the loans held for investment portfolio at the end of each of the last five years:

 

Loans Held for Investment Portfolio Composition		December 31,
		2003			2002			2001			2000			1999
		(Dollars in Thousands)
Commercial		$	751,267		$	668,359		$	540,812		$	481,277		$	391,855
Commercial Tax-Exempt		56,717			29,474			13,832			13,213			22,160
Total Commercial		807,984			697,833			554,644			494,490			414,015
Agricultural		62,319			63,522			57,995			71,482			59,437
Real Estate
Construction		308,331			238,686			151,935			143,023			101,376
Commercial Mortgage		991,976			848,404			621,699			536,856			456,507
Agricultural Mortgage		54,593			57,995			49,888			43,725			38,256
1-4 Family Mortgage		177,711			221,962			162,413			173,860			160,786
Total Real Estate		1,532,611			1,367,047			985,935			897,464			756,925
Consumer		116,780			139,128			111,427			124,391			144,382
Total Loans Held for Investment		$	2,519,694		$	2,267,530		$	1,710,001		$	1,587,827		$	1,374,759

 

16

 

The contractual maturity schedule of the loans held for investment portfolio at December 31, 2003 follows:

 

Loans Held for Investment Maturity Schedule		One Year Or Less			After One Year Through Five Years			After Five Years			Total
		(Dollars in Thousands)
Commercial		$	415,937		$	228,503		$	106,827		$	751,267
Commercial Tax-Exempt		30,380			20,949			5,388			56,717
Total Commercial		446,317			249,452			112,215			807,984
Agricultural		51,822			8,673			1,824			62,319
Real Estate
Construction		202,950			80,732			24,649			308,331
Commercial Mortgage		222,424			619,975			149,577			991,976
Agricultural Mortgage		19,750			31,554			3,289			54,593
1-4 Family Mortgage		29,838			103,087			44,786			177,711
Total Real Estate		474,962			835,348			222,301			1,532,611
Consumer		46,545			66,085			4,150			116,780
Total Loans Held for Investment		$	1,019,646		$	1,159,558		$	340,490		$	2,519,694
Variable-Rate Loans		$	577,945		$	642,968		$	264,674		$	1,485,587
Fixed-Rate Loans		441,701			516,590			75,816			1,034,107
Total Loans Held for Investment		$	1,019,646		$	1,159,558		$	340,490		$	2,519,694

 

The Company’s policy on maturity extensions and rollovers is based on management’s assessment of individual loans. Approvals for the extension or renewal of loans without reduction of principal for more than one twelve-month period are generally avoided, unless the loans are fully secured and properly margined by cash or marketable securities, or are revolving lines subject to annual analysis and renewal.

 

NONPERFORMING ASSETS

 

The Company has several procedures in place to assist in maintaining the overall quality of its loan portfolio. The Bank has established underwriting guidelines to be followed by its officers and monitors its delinquency levels for any negative or adverse trends.

 

Nonperforming assets consist of loans and other assets, primarily real estate, acquired in partial or full satisfaction of loan obligations. Nonperforming loans include loans on nonaccrual status or that have been restructured. The Company’s policy generally is to place a loan on nonaccrual status when payment of principal or interest is contractually past due 90 days, or earlier when concern exists as to the ultimate collection of principal and interest. At the time a loan is placed on nonaccrual status, interest previously accrued but uncollected is reversed and charged against current income unless the collateral provides more than adequate margin to ensure collection of that interest. A restructured loan is generally a loan that is accruing interest, but on which concessions in terms have been made as a result of deterioration in the borrower’s financial condition. The Company’s classification of nonperforming loans includes those loans for which management believes collection is doubtful. Management is not aware of any specific borrower relationships that are not reported as nonperforming where management has doubts as to the ability of such borrowers to comply with the present loan repayment terms which would cause nonperforming assets to increase materially.

 

Nonperforming assets of $20,669,000 at December 31, 2003 decreased $4,741,000 or 18.7% compared to December 31, 2002 levels of $25,410,000. Nonperforming assets decreased as a percentage of total assets from 0.66% at December 31, 2002 to 0.49% at December 31, 2003. During 2002, nonperforming assets increased $3,580,000 or 16.4% compared with December 31, 2001 levels of $21,830,000.

 

Nonaccrual loans of $10,122,000 at December 31, 2003 decreased $4,678,000 or 31.6% compared to December 31, 2002 levels of $14,800,000. The decrease resulted primarily from one loan relationship in which $4,079,000 was either charged off or transferred to foreclosed assets. Nonaccrual loans of $14,800,000 at December 31, 2002 was comparable to December 31, 2001 levels of $14,034,000, increasing by only $766,000 or 5.5%.

 

Foreclosed and other assets of $10,547,000 at December 31, 2003 remained comparable to December 31, 2002 levels of $10,610,000 decreasing by only $63,000 or 0.6%. Management actively seeks buyers for all Other Real Estate. See “Noninterest Expense” below.

 

Loans which are contractually past due 90 days or more, which are both well secured or guaranteed by financially responsible third parties and in the process of collection, generally are not placed on nonaccrual status. The amount of such loans past due 90 days or more at December 31, 2003, 2002 and 2001 that are not classified as nonaccrual totaled $8,886,000,

 

17

 

$4,411,000 and $12,164,000, respectively. The increase in accruing loans past due 90 days or more at December 31, 2003 compared to December 31, 2002 was primarily a result of the addition of five relationships totaling $5,857,000. The increase was partially offset by one relationship totaling $1,311,000 transferred to other real estate during 2003. The ratio of nonperforming assets plus accruing loans 90 days or more past due as a percent of loans held for investment and foreclosed and other assets at December 31, 2003 decreased to 1.17% from 1.31% at December 31, 2002 primarily as a result of the increase in loans held for investment.

 

An analysis of the components of nonperforming assets for each of the last five years follows:

 

		December 31,
Nonperforming Assets		2003			2002			2001			2000			1999
		(Dollars in Thousands)
Nonaccrual Loans		$	10,122		$	14,800		$	14,034		$	8,999		$	8,341
Restructured Loans		—			—			—			3,482			—
Nonperforming Loans		10,122			14,800			14,034			12,481			8,341
Foreclosed and Other Assets		10,547			10,610			7,796			4,733			5,958
Total Nonperforming Assets		20,669			25,410			21,830			17,214			14,299
Accruing Loans 90 Days or More Past Due		8,886			4,411			12,164			4,022			2,697
Total Nonperforming Assets and Accruing Loans 90 Days or More Past Due		$	29,555		$	29,821		$	33,994		$	21,236		$	16,996
Nonperforming Loans as a % of Loans Held for Investment		0.40		%	0.65		%	0.82		%	0.79		%	0.61		%
Nonperforming Assets as a % of Loans Held for Investment and Foreclosed and Other Assets		0.82			1.12			1.27			1.08			1.04
Nonperforming Assets as a % of Total Assets		0.49			0.66			0.84			0.71			0.67
Nonperforming Assets Plus Accruing Loans 90 Days or More Past Due as a % of Loans Held for Investment and Foreclosed and Other Assets		1.17			1.31			1.98			1.33			1.23

 

Management regularly reviews and monitors the loan portfolio to identify borrowers experiencing financial difficulties. Management believes that, at December 31, 2003, all such loans had been identified and included in the nonaccrual, renegotiated or 90 days or more past due loan totals reflected in the table above. Management continues to emphasize maintaining a low level of nonperforming assets and returning nonperforming assets to an earning status.

 

ALLOWANCE FOR LOAN LOSSES - CRITICAL ACCOUNTING POLICY

 

Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provision required to maintain an adequate allowance. Estimating the allowance is a critical accounting policy. It is subjective in nature and requires material estimates that may be subject to revision as facts and circumstances warrant. In assessing the adequacy of the allowance, management reviews the size, quality and risks of loans in the portfolio and considers factors such as specific known risks, past experience, the status and amount of nonperforming assets and economic conditions. A specific percentage is allocated to total loans held for investment in good standing and not specifically reserved while additional amounts are added for individual loans considered to have specific loss potential. Loans identified as losses are charged off. In addition, the loan review committee of the Bank reviews the assessments of management in determining the adequacy of the Bank’s allowance for loan losses on a quarterly basis. Based on total allocations, the provision is recorded to maintain the allowance at a level deemed appropriate by management based on probable losses in the loan portfolio. There can be no assurance that future additions or reductions to the allowance will not be necessary.

 

The allowance for loan losses at December 31, 2003 totaled $31,234,000, representing a net increase of $3,118,000 or 11.1% compared to $28,116,000 at December 31, 2002. The increase in the allowance for loan loss is comparable with the growth in the loans held for investment portfolio of 11.1%. Management believes that the allowance for loan losses at December 31, 2003 adequately reflects the probable losses in the loan portfolio. State and federal bank regulatory authorities, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on their judgments of information available to them at the time of their examination.

 

18

 

The following table summarizes the activity in the allowance for loan losses for each of the last five years:

 

		Years Ended December 31,
Allowance for Loan Loss Activity		2003			2002			2001			2000			1999
		(Dollars in Thousands)
Balance at Beginning of Period		$	28,116		$	21,050		$	19,458		$	16,711		$	13,236
Balance from Acquisitions		228			4,732			—			—			1,576
Provision for Loan Losses		13,155			12,331			8,667			8,927			5,432
Charge-Offs
Commercial		6,413			6,989			5,105			4,722			2,279
Agricultural		1,773			60			341			48			106
Real Estate		866			1,897			122			247			192
Consumer		2,358			1,970			1,979			1,992			1,561
Total Charge-Offs		11,410			10,916			7,547			7,009			4,138
Recoveries
Commercial		384			226			112			84			268
Agricultural		57			39			4			441			5
Real Estate		65			106			4			10			48
Consumer		639			548			352			294			284
Total Recoveries		1,145			919			472			829			605
Net Charge-Offs		10,265			9,997			7,075			6,180			3,533
Balance at End of Period		$	31,234		$	28,116		$	21,050		$	19,458		$	16,711
Ratio of Allowance for Loan Losses to Loans Held for Investment, Net of Unearned Discount		1.24		%	1.24		%	1.23		%	1.23		%	1.22		%
Ratio of Allowance for Loan Losses to Nonperforming Loans		308.58			189.97			149.99			155.90			200.35
Ratio of Net Charge-Offs to Average Loans Held for Investment, Net of Unearned Discount		0.43			0.48			0.43			0.42			0.29

 

The allocation of the allowance for loan losses by loan category and the percentage of loans in each category to total loans in the loans held for investment portfolio at the end of each of the last five years follows:

 

		Years Ended December 31,
		2003					2002					2001					2000					1999
Allocation of the Allowance for Loan Losses		Amount			Loans as Percent of Total Loans		Amount			Loans as Percent of Total Loans		Amount			Loans as Percent of Total Loans		Amount			Loans as Percent of Total Loans		Amount			Loans as Percent of Total Loans
		(Dollars in Thousands)
Commercial		$	13,706		32.1	%	$	9,053		30.8	%	$	8,797		32.4	%	$	6,377		31.1	%	$	6,493		30.1	%
Agricultural		876			2.5		2,602			2.8		462			3.4		1,036			4.5		648			4.3
Real Estate		13,213			60.8		13,552			60.3		9,851			57.7		8,444			56.5		7,238			55.1
Consumer		1,338			4.6		1,290			6.1		617			6.5		730			7.9		950			10.5
Environmental		2,101			—		1,619			—		1,323			—		2,871			—		1,382			—
Total		$	31,234		100.0	%	$	28,116		100.0	%	$	21,050		100.0	%	$	19,458		100.0	%	$	16,711		100.0	%

 

PREMISES AND EQUIPMENT, NET

 

Premises and equipment of $107,875,000 at December 31, 2003 increased $18,375,000 or 20.5% compared to $89,500,000 at December 31, 2002. The increase resulted primarily from $4,204,000 of real estate purchased in Sugar Land, Weslaco and Eagle Pass, Texas for future banking locations, as well as $2,805,000 in real estate purchased for the development of an operations center and branch facility in McAllen. In addition, there was an $8,628,000 increase in premises and equipment relating to the new Sugar Land and Edinburg banking locations. Premises and equipment increased by $13,924,000 or 18.4% during 2002 compared to $75,576,000 at December 31, 2001. The increase resulted primarily from $6,891,000 of premises and equipment acquired through the Riverway and San Juan acquisitions and $6,163,000 for the purchase of an aircraft during second quarter 2002.

 

19

 

GOODWILL

 

Goodwill of $29,856,000 at December 31, 2003 increased $1,355,000 or 4.8% compared to $28,501,000 at December 31, 2002. The increase is attributable to $1,355,000 in goodwill added with the Corpus Christi acquisition. Goodwill of $28,501,000 at December 31, 2002 increased $4,245,000 or 17.5% compared to $24,256,000 at December 31, 2001. The increase during 2002 compared to 2001 resulted from $4,245,000 in goodwill added with the Riverway acquisition. In accordance with Financial Accounting Standards Board Statement No. 142 (“Statement 142”), “Goodwill and Other Intangible Assets”, the Company discontinued the amortization of goodwill effective January 1, 2002.

 

IDENTIFIABLE INTANGIBLES, NET

 

Identifiable intangibles of $15,263,000 at December 31, 2003 decreased $3,191,000 or 17.3% compared to $18,454,000 at December 31, 2002. Identifiable intangibles decreased primarily due to amortization of $3,370,000 for the year ended December 31, 2003, as well as a $395,000 downward adjustment relating to the San Juan core deposit intangible. The decrease was partially offset by the addition of a $551,000 core deposit intangible relating to the Corpus Christi acquisition. Identifiable intangibles of $18,454,000 at December 31, 2002 increased $6,712,000 or 57.2% compared to $11,742,000 at December 31, 2001. The increase in 2002 resulted from $9,268,000 in core deposit intangibles added with the Riverway and San Juan acquisitions. In addition, $849,000 was added in data processing intangibles as a result of the Grapevine data operations center (“Grapevine”) acquisition during first quarter 2002. Core deposit intangibles added with the 2003 and 2002 acquisitions are being amortized over their estimated useful life of 10 years.

 

DEPOSITS

 

Total deposits of $3,516,435,000 at December 31, 2003 increased $384,244,000 or 12.3% compared to December 31, 2002 levels of $3,132,191,000, which increased $896,314,000 or 40.1% compared to December 31, 2001 levels of $2,235,877,000. The increase in total deposits is primarily attributable to the vitality of the Rio Grande Valley as well as the expansion into the Bishop, Corpus Christi and Houston markets. Total non-interest bearing deposits of $536,211,000 at December 31, 2003 represented an increase of $90,233,000 or 20.2% compared to December 31, 2002 and increased $115,114,000 or 34.8% compared to December 31, 2001. Total public funds deposits (consisting of Public Funds Demand Deposits, Savings, Money Market Checking and Savings and Time Deposits) of $982,567,000 at December 31, 2003 increased $164,002,000 or 20.0% compared to $818,565,000 at December 31, 2002. The Bank actively seeks consumer and commercial deposits, including deposits from correspondent banks and public funds deposits.

 

The following table presents the composition of total deposits at the end of the last three years:

 

		December 31,
Deposit Composition		2003			2002			2001
		(Dollars in Thousands)
Demand Deposits
Commercial and Individual		$	530,754		$	441,775		$	326,733
Public Funds		5,457			4,203			4,131
Total Demand Deposits		536,211			445,978			330,864
Interest-Bearing Deposits
Savings
Commercial and Individual		146,836			139,157			117,732
Public Funds		400			374			310
Money Market Checking and Savings
Commercial and Individual		575,689			514,907			436,846
Public Funds		388,747			323,735			124,241
Time Deposits
Commercial and Individual		1,280,589			1,217,787			906,535
Public Funds		587,963			490,253			319,349
Total Interest-Bearing Deposits		2,980,224			2,686,213			1,905,013
Total Deposits		$	3,516,435		$	3,132,191		$	2,235,877
Weighted Average Rate on Interest-Bearing Deposits		1.63		%	2.23		%	3.13		%

 

20

 

Time deposits of $100,000 or more are solicited from markets served by the Bank and are not sought through brokered sources. Time deposits continue to be a significant source of funds. The following table presents the maturities of time deposits of $100,000 or more as of December 31, 2003:

 

Maturities of Time Deposits of $100,000 or More

(Dollars in Thousands)
Three Months or Less		$	519,455
After Three through Six Months		247,780
After Six through Twelve Months		315,333
After Twelve Months		215,871
Total		$	1,298,439
Weighted Average Rate on Time Deposits of $100,000 or More		2.18		%

 

Mexico is a part of the trade territory of the Company and foreign deposits from Mexican sources have traditionally been a source of funding. Foreign deposits increased by 2.5% as compared to 11.3% internal growth in total deposits. These deposits are received and paid in U.S. dollars.

 

The following table presents foreign deposits, primarily from Mexican sources:

 

		December 31,
Foreign Deposits		2003			2002
		(Dollars in Thousands)
Demand Deposits		$	21,641		$	17,516
Interest-Bearing Deposits
Savings		18,675			20,621
Money Market Checking and Savings		42,302			40,657
Time Deposits Under $100,000		78,759			81,361
Time Deposits of $100,000 or more		226,997			218,796
Total Interest-Bearing Deposits		366,733			361,435
Total Foreign Deposits		$	388,374		$	378,951
Percent of Total Deposits		11.04		%	12.10		%
Weighted Average Rate on Foreign Deposits		1.52		%	2.21		%

 

SHAREHOLDERS’ EQUITY AND CAPITAL RESOURCES

 

Shareholders’ equity increased by $44,276,000 or 11.7% during the year ended December 31, 2003 primarily due to comprehensive income of $50,537,000 less cash dividends of $14,202,000. Comprehensive income for the period included net income of $62,309,000 and net change in unrealized gains and losses on securities available for sale, net of tax, of $11,772,000.

 

21

 

Bank holding companies are required to maintain capital ratios in accordance with guidelines adopted by the Federal Reserve Board. The guidelines are commonly known as Risk-Based Capital Guidelines. The table below reflects various measures of regulatory capital:

 

Regulatory Capital Ratios		Actual					For Capital Adequacy Purposes					To Be Well Capitalized Under Prompt Corrective Action Provision
(Dollars in Thousands)		Amount			Ratio		Amount			Ratio		Amount			Ratio
Texas Regional Bancshares, Inc.
As of December 31, 2003
Total Capital (to Risk-Weighted Assets)		$	411,360		13.94	%	$	236,074		8.00	%	$	295,092		10.00	%
Tier I Capital (to Risk-Weighted Assets)		380,126			12.88		118,037			4.00		177,055			6.00
Tier I Capital (to Average Assets)		380,126			9.26		164,120			4.00		205,149			5.00
As of December 31, 2002
Total Capital (to Risk-Weighted Assets)		$	350,334		13.77	%	$	203,474		8.00	%	$	254,342		10.00	%
Tier I Capital (to Risk-Weighted Assets)		322,218			12.67		101,737			4.00		152,605			6.00
Tier I Capital (to Average Assets)		322,218			8.89		145,004			4.00		181,255			5.00
Texas State Bank
As of December 31, 2003
Total Capital (to Risk-Weighted Assets)		$	387,344		13.14	%	$	235,890		8.00	%	$	294,863		10.00	%
Tier I Capital (to Risk-Weighted Assets)		356,110			12.08		117,945			4.00		176,918			6.00
Tier I Capital (to Average Assets)		356,110			8.68		164,021			4.00		205,026			5.00
As of December 31, 2002
Total Capital (to Risk-Weighted Assets)		$	328,630		12.93	%	$	203,267		8.00	%	$	254,084		10.00	%
Tier I Capital (to Risk-Weighted Assets)		300,514			11.83		101,634			4.00		152,451			6.00
Tier I Capital (to Average Assets)		300,514			8.29		144,938			4.00		181,173			5.00

 

At December 31, 2003, the Company and the Bank met the criteria for classification as a “well-capitalized” institution under the prompt corrective action rules promulgated under the Federal Deposit Insurance Act. Designation as a well-capitalized institution under these regulations does not constitute a recommendation or endorsement of the Company or the Bank by Federal bank regulators.

 

ANALYSIS OF RESULTS OF OPERATIONS

 

NET INCOME

 

Net income was $62,309,000 in 2003, compared to $53,847,000 in 2002 and $39,422,000 in 2001. The increase in net income in 2003 from 2002 by $8,462,000 or 15.7% was primarily due to an increase in interest-earning assets, net realized gains on securities available for sale and service charge income. The increase was partially offset by an increase of $9,589,000 in salaries and employee benefits. Net income per diluted common share was $2.10, $1.86 and $1.47 for the years ended December 31, 2003, 2002 and 2001, respectively. Return on assets averaged 1.54%, 1.58% and 1.58%, while return on shareholders’ equity averaged 15.41%, 16.05% and 15.75% for the years ended December 31, 2003, 2002 and 2001, respectively.

 

22

 

NET INTEREST INCOME

 

The following table presents for the periods indicated the total dollar amount of interest income from average interest-earning assets and the resultant yields, reported on a tax-equivalent basis, and the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Comparing net interest income on a tax-equivalent basis is standard practice in the financial services industry. Average balances are derived from average daily balances and the yields and costs are established by dividing income or expense by the average balance of the asset or liability.

 

Income and yield on interest-earning assets include amounts to convert tax-exempt income to a taxable-equivalent basis, assuming a 35% effective tax rate for 2003, 2002 and 2001:

 

		Years Ended December 31,
		2003								2002								2001
Tax-Equivalent Basis (1)		Average Balance			Interest			Yield/ Rate		Average Balance			Interest			Yield/ Rate		Average Balance			Interest			Yield/ Rate
		(Dollars in Thousands)
Assets
Interest-Earning Assets
Loans Held for Sale		$	38,851		$	2,407		6.20	%	$	36,789		$	2,203		5.99	%	$	—		$	—		—	%
Loans Held for Investment
Commercial		801,638			49,122			6.13		674,185			43,991			6.53		581,152			48,657			8.37
Real Estate		1,443,196			102,903			7.13		1,278,651			97,660			7.64		929,310			84,656			9.11
Consumer		129,519			11,143			8.60		141,420			13,253			9.37		117,439			13,173			11.22
Total Loans Held for Investment		2,374,353			163,168			6.87		2,094,256			154,904			7.40		1,627,901			146,486			9.00
Securities
Taxable		1,207,813			40,619			3.36		934,907			42,008			4.49		585,266			34,369			5.87
Tax-Exempt		89,405			5,428			6.07		68,230			4,569			6.70		50,991			3,582			7.02
Total Securities		1,297,218			46,047			3.55		1,003,137			46,577			4.64		636,257			37,951			5.96
Interest-Bearing and Time Deposits		13,098			177			1.35		974			49			5.03		1,622			85			5.24
Federal Funds Sold		15,269			170			1.11		10,896			174			1.60		15,728			539			3.43
Total Interest-Earning Assets		3,738,789			$	211,969		5.67	%	3,146,052			$	203,907		6.48	%	2,281,508			$	185,061		8.11	%
Cash and Due from Banks		119,668								102,207								74,054
Premises and Equipment, Net		100,183								85,336								75,669
Other Assets		116,861								107,935								78,469
Allowance for Loan Losses		(30,583		)						(26,590		)						(20,551		)
Total Assets		$	4,044,918							$	3,414,940							$	2,489,149
Liabilities
Interest-Bearing Liabilities
Savings		$	146,985		$	673		0.46	%	$	130,281		$	1,547		1.19	%	$	114,498		$	2,089		1.82	%
Money Market Checking and Savings		895,764			8,532			0.95		747,591			11,140			1.49		514,456			14,202			2.76
Time Deposits		1,813,085			44,328			2.44		1,575,186			51,986			3.30		1,231,729			65,001			5.28
Total Savings and Time Deposits		2,855,834			53,533			1.87		2,453,058			64,673			2.64		1,860,683			81,292			4.37
Other Borrowed Money		246,256			6,852			2.78		205,405			7,313			3.56		50,972			2,484			4.87
Total Interest-Bearing Liabilities		3,102,090			$	60,385		1.95	%	2,658,463			$	71,986		2.71	%	1,911,655			$	83,776		4.38	%
Demand Deposits		508,571								397,158								305,423
Other Liabilities		30,003								23,768								21,840
Total Liabilities		3,640,664								3,079,389								2,238,918
Shareholders’ Equity		404,254								335,551								250,231
Total Liabilities and Shareholders’ Equity		$	4,044,918							$	3,414,940							$	2,489,149
Net Interest Income (1)					$	151,584							$	131,921							$	101,285
Tax-Equivalent Adjustment					3,192								2,202								1,759
Net Interest Income, As Reported					$	148,392							$	129,719							$	99,526
Net Yield on Total Interest-Earning Assets (1)								4.05	%							4.19	%							4.44	%

 

(1) For analytical purposes, income from tax-exempt assets, primarily securities issued by state and local governments or authorities, is adjusted by an increment that equates tax-exempt income to income from taxable assets (assuming a 35% tax rate). Income on a tax-equivalent basis is not considered to be in accordance with GAAP.

 

23

 

Net interest income, reported on a tax-equivalent basis, increased $19,663,000 or 14.9% to $151,584,000 in 2003 compared to $131,921,000 in 2002. The increase in net interest income was largely due to growth of 18.8% in average interest-earning assets, which rose to $3,738,789,000 in 2003 compared to $3,146,052,000 in 2002. However, the increase was partially offset by lower yields on interest-earning assets resulting from decreases in market rates. The loan yield for 2003 decreased as a result of a decrease in the average prime rate from 4.68% in 2002 to 4.12% in 2003. In addition, the decrease in securities yield in 2003 compared to 2002 resulted from the sale or maturity of higher yielding securities and the reinvesting of the proceeds into lower yielding securities. The decrease in the rate paid on interest-bearing liabilities during 2003 was primarily attributable to the general decrease in average short-term interest rates. The net interest margin decreased to 4.05% in 2003 compared to 4.19% in 2002.

 

Tax-equivalent net interest income was $131,921,000 for 2002, an increase of $30,636,000 or 30.2% compared to 2001. The increase in net interest income was largely due to growth of 37.9% in average interest-earning assets, which rose to $3,146,052,000 in 2002 compared to $2,281,508,000 in 2001. The increase in average interest-earning assets resulted from continued emphasis on loan growth, as well as the Riverway and San Juan acquisitions during first and fourth quarter 2002, respectively. Although average interest-earning assets increased substantially, the growth in interest income was only 10.2% as a result of interest rate reductions driven by the Federal Reserve monetary policy during 2001. The loan yield for 2002 decreased as a result of a decrease in the average prime rate from 6.91% in 2001 to 4.68% in 2002. In addition, the decrease in securities yield in 2002 compared to 2001 resulted from the sale or maturity of higher yielding securities and the reinvesting of the proceeds into lower yielding securities. The decrease in the rate paid on interest-bearing liabilities during 2002 was primarily attributable to the general decrease in average short-term interest rates. The net interest margin decreased to 4.19% in 2002 compared to 4.44% in 2001.

 

The net interest income and the yield on average earning assets were reduced by interest foregone on impaired loans. If interest on those loans had been accrued at the original contractual rates, additional interest income would have totaled $1,298,000, $1,752,000 and $2,582,000 for the years ended December 31, 2003, 2002 and 2001, respectively. The amount of interest income on impaired loans included in net income for cash payments received was $258,000 in 2003, $371,000 in 2002 and $241,000 in 2001.

 

The following table presents the effects of changes in volume, rate and rate/volume on interest income and interest expense for major categories of interest-earning assets and interest-bearing liabilities. Nonaccrual loans are included in assets, thereby reducing yields (see “Nonperforming Assets”). The allocation of the rate/volume variance has been made pro-rata on the percentage that volume and rate variances produce in each category. An analysis of changes in net interest income follows:

 

		Increase (Decrease)
		Year Ended December 31, 2003 Compared to 2002												Year Ended December 31, 2002 Compared to 2001
Tax-Equivalent Basis (1)		Net Change			Due to Change in						Rate/ Volume			Net Change			Due to Change in						Rate/ Volume
					Volume			Rate									Volume			Rate
		(Dollars in Thousands)
Interest Income
Loans Held for Sale		$	204		$	124		$	77		$	3		$	2,203		$	2,203		$	—		$	—
Loans Held for Investment		8,264			20,727			(11,100		)	(1,363		)	8,418			41,964			(26,076		)	(7,470		)
Securities
Taxable		(1,389		)	12,253			(10,564		)	(3,078		)	7,639			20,532			(8,071		)	(4,822		)
Tax-Exempt		859			1,419			(430		)	(130		)	987			1,211			(167		)	(57		)
Interest-Bearing and Time Deposits		128			610			(36		)	(446		)	(36		)	(34		)	(3		)	1
Federal Funds Sold		(4		)	70			(53		)	(21		)	(365		)	(165		)	(288		)	88
Total Interest Income		8,062			35,203			(22,106		)	(5,035		)	18,846			65,711			(34,605		)	(12,260		)
Interest Expense
Deposits		(11,140		)	10,633			(18,889		)	(2,884		)	(16,619		)	25,881			(32,237		)	(10,263		)
Other Borrowed Money		(461		)	1,454			(1,602		)	(313		)	4,829			7,526			(669		)	(2,028		)
Total Interest Expense		(11,601		)	12,087			(20,491		)	(3,197		)	(11,790		)	33,407			(32,906		)	(12,291		)
Net Interest Income Before Allocation of Rate/Volume		19,663			23,116			(1,615		)	(1,838		)	30,636			32,304			(1,699		)	31
Allocation of Rate/Volume		—			(1,907		)	69			1,838			—			(1,839		)	1,870			(31		)
Changes in Net Interest Income		$	19,663		$	21,209		$	(1,546	)	$	—		$	30,636		$	30,465		$	171		$	—

 

(1)   For analytical purposes, income from tax-exempt assets, primarily securities issued by state and local governments or authorities, is adjusted by an increment that equates tax-exempt income to income from taxable assets (assuming a 35% effective federal income tax rate). Income on a tax-equivalent basis is not considered to be in accordance with GAAP.

 

24

 

PROVISION FOR LOAN LOSSES – CRITICAL ACCOUNTING POLICY

 

The Company recorded a provision for loan losses of $13,155,000 for 2003 compared to $12,331,000 for 2002 and $8,667,000 for 2001. The increase in the provision is primarily attributable to the Company’s continuing review of the adequacy of the loan loss allowance and growth in the loan portfolio. Net charge-offs totaled $10,265,000 and $9,997,000 for 2003 and 2002, respectively, and decreased to 0.43% of average loans held for investment in 2003 compared to 0.48% of average loans held for investment in 2002. Net charge-offs were $7,075,000 or 0.43% of average loans held for investment in 2001. The increase in net charge-offs in 2002 is primarily attributable to $3,153,000 charged off on a loan relationship.

 

Management charges provisions for loan losses to earnings to bring the total allowance for loan losses to a level deemed appropriate based on estimated probable losses in the loan portfolio. Management bases its decision on many factors which include historical experience, the volume and type of lending conducted by the Company, the amount of nonperforming assets, regulatory policies, generally accepted accounting principles, and general economic conditions, particularly as they relate to the Company’s lending area. For additional information on charge-offs and recoveries and the aggregate provision for loan losses, see the “Allowance for Loan Losses - Critical Accounting Policy” section of this Report.

 

NONINTEREST INCOME

 

Noninterest Income totaled $50,255,000 for 2003 compared to $40,003,000 for 2002 and $29,213,000 for 2001. Excluding net realized gains on sales of securities available for sale, Noninterest Income increased $4,197,000 or 11.9% in 2003 compared to 2002 and $7,501,000 or 27.1% in 2002 compared to 2001. The Noninterest Income growth in 2003 resulted primarily from an increase in total service charges and net realized gains on sales of securities available for sale.

 

Total Service Charges were $31,155,000 for 2003 compared to $25,640,000 for 2002 and $20,472,000 for 2001. The increase in Total Service Charges in 2003 by $5,515,000 or 21.5% compared to 2002 was generated from deposit growth combined with  an increase of $3,994,000 in non-sufficient check and return item charges. During July 2003, non-sufficient fund item charges increased from $25 per item to $30 per item. The increase in Total Service Charges during 2002 by $5,168,000 or 25.2% is primarily due an increase in deposits primarily resulting from acquisitions and an increase of $3,266,000 in non-sufficient check and return item charges.

 

Trust Service Fees were $2,870,000 for 2003 compared to $2,730,000 for 2002 and $2,494,000 for 2001. The increase in Trust Service Fees during 2003 by $140,000 or 5.1% is attributable to an increase in the average market value of trust accounts managed by 1.3%. The fair market value of assets managed was $495,593,000 at December 31, 2003 compared to $491,087,000 at December 31, 2002. In addition, the Trust Service Fees increased by $236,000 or 9.5% in 2002 compared to 2001 primarily due to an increase in the average market value of trust accounts managed by 16.7%. The fair market value of assets managed at December 31, 2001 was $441,000,000. Assets held by the trust department of the Bank in fiduciary or agency capacities are not assets of the Company and are not included in the consolidated balance sheets.

 

Net Realized Gains on Sales of Securities Available for Sale were $10,840,000 for 2003 compared to $4,785,000 for 2002 and $1,496,000 for 2001. During 2003, bond prices generally rose and the Company sold various securities that had unrealized gains and were likely to be called through May 2005. The Company sold various securities in 2002 and 2001 that had unrealized gains and were likely to be called during the latter half of the year and the first half of the following year.

 

Data Processing Service Fees of $7,293,000 for 2003 increased $889,000 or 13.9% compared to $6,404,000 for 2002. Data processing fees increased due to an increase in the volume of transactions for three data processing clients. The data processing contracts stipulate an increase in monthly fees based on volume levels. Data Processing Service Fees of $6,404,000 in 2002 increased by $3,210,000 or 100.5% compared to $3,194,000 in 2001 primarily due to the acquisition of the Grapevine data processing center and related data processing contracts during first quarter 2002. The number of data processing clients as of December 31, 2003, 2002 and 2001 was 26, 25, and 8, respectively.

 

Loan Servicing Loss, Net of $4,830,000 for 2003 increased $3,157,000 compared to a $1,673,000 loss for 2002. Although servicing and related fees totaled $2,295,000 in 2003, amortization of mortgage servicing rights of $5,545,000 and an addition to the valuation allowance of mortgage servicing rights of $1,580,000 resulted in a net loss in 2003. Loan Servicing Loss, Net totaled $1,673,000 for 2002. Although servicing and related fees totaled $2,498,000 in 2002, amortization of mortgage servicing rights of $2,488,000 and an addition to the valuation allowance of mortgage servicing rights of $1,683,000 resulted in a net loss in 2002. Amortization in excess of servicing fees during 2003 and 2002 was the result of faster than expected prepayments on the serviced mortgage loan portfolio. The mortgage servicing activity was acquired with the Riverway acquisition during first quarter 2002. The carrying value of mortgage servicing rights was $10,401,000 and $15,264,000 at December 31, 2003 and 2002, respectively.

 

Other Noninterest Income of $2,927,000 for 2003 increased $810,000 or 38.3% compared to $2,117,000 reported for 2002. The increase in Other Noninterest Income during 2003 was primarily due to a $936,000 increase in gains recognized on the sale of loans held for sale. Other Noninterest Income in 2002 of $2,117,000 increased $560,000 or 36.0% compared to

 

25

 

$1,557,000 reported for 2001. The increase in Other Noninterest Income during 2002 was primarily due to $663,000 in gains recognized on the sale of loans held for sale. This was partially offset by a $340,000 loss recognized on the disposal of obsolete computer equipment during second quarter 2002. In addition, the Company received a $100,000 sign up bonus in 2002 for changing the company used for customer check orders.

 

NONINTEREST EXPENSE

 

Noninterest Expense of $91,890,000 for 2003 increased $15,731,000 or 20.7% compared to $76,159,000 for 2002. Noninterest Expense for 2002 increased $16,815,000 or 28.3% compared to $59,344,000 for 2001. The increase in 2003 resulted primarily from higher personnel costs attributable in part to an increase in the number of banking locations. The efficiency ratio of expense to total revenue was 46.26% for 2003 compared to 44.87% for 2002 and 46.10% for 2001. The efficiency ratio is defined as Noninterest Expense divided by the total of Net Interest Income and Noninterest Income.

 

Salaries and Employee Benefits, the largest category of Noninterest Expense, were $47,582,000 in 2003, $37,993,000 in 2002 and $27,933,000 in 2001. The increase in 2003 over 2002 by $9,589,000 or 25.2% reflects increases in base salaries and higher levels of staff. The number of average full-time equivalent employees increased by 15.0% in 2003 from 2002. Employee medical insurance premiums increased $1,941,000 or 43.0% compared to 2002. The increase resulted primarily from the full impact of the May 2002 change in non-officer employee’s medical insurance coverage. In May 2002, the Company began paying 100% of non-officer employee’s medical insurance, up from 50% paid in prior periods. The increase in 2002 over 2001 by $10,060,000 or 36.0% reflects increases in base salaries and higher levels of staff, including staff acquired as a result of the Riverway, San Juan, and Grapevine acquisitions. The number of average full-time equivalent employees increased by 14.9% in 2002 from 2001. Officer bonuses also increased from $422,000 in 2001 to $861,000 in 2002. In addition, the change in employee medical insurance coverage in May 2002 contributed to medical insurance premiums increasing by $2,110,000 or 87.8% compared to 2001. At the end of 2003, the Company had approximately 1,284 full-time equivalent employees, compared to 1,155 at year end 2002 and 950 at year end 2001. Salaries and Employee Benefits averaged 1.18% of average assets in 2003 compared to 1.11% in 2002 and 1.12% in 2001.

 

Net Occupancy Expense of $6,848,000 for 2003 increased $1,401,000 or 25.7% compared to $5,447,000 in 2002. The increase in 2003 was primarily attributable to an increase of $584,000 in building lease expense resulting from lease expense on the 1000 Main banking center in Houston and the Corpus Christi banking center, as well as lease expense on the temporary banking facility used while the permanent banking facility was being built in Sugar Land. Net Occupancy Expense of $5,447,000 for 2002 increased $1,089,000 or 25.0% compared to $4,358,000 in 2001. The increase was primarily attributable to occupancy expenses incurred at the Houston and Grapevine locations acquired during first quarter 2002.

 

Equipment Expense of $10,510,000 for 2003 increased $1,870,000 or 21.6% compared to $8,640,000 for 2002. The increase in 2003 compared to 2002 was primarily due to an increase of $1,093,000 or 22.5% in depreciation expense on furniture, fixtures and equipment resulting from a 14.3% increase in the related asset accounts. In addition, equipment service contract expenses increased by $348,000 or 15.7%. During 2002, Equipment Expense increased $2,075,000 or 31.6% compared to $6,565,000 for 2001. The increase in 2002 compared to 2001 was primarily due to an increase of $1,109,000 or 29.5% in depreciation expense on furniture, fixtures and equipment resulting from a 40.4% increase in the related asset accounts. In addition, equipment service contract expenses increased by $586,000 or 36.1%.

 

Other Real Estate Expense, Net, includes rental income from foreclosed properties, gain or loss on sale of other real estate properties and direct expenses of foreclosed real estate including property taxes, maintenance costs and write-downs. Write-downs of other real estate are required if the fair value of an asset acquired in a loan foreclosure subsequently declines below its carrying value. Other Real Estate Expense, Net was $734,000 in 2003, increasing by $243,000 or 49.5% compared to $491,000 for 2002. The increase was primarily attributable to a decrease of $209,000 in net gains on sale of other real estate properties compared to 2002. Other Real Estate Expense, Net of $491,000 for 2002 decreased $622,000 or 55.9% compared to $1,113,000 reported for 2001. The decrease was attributable to a $542,000 decrease in expenses on a foreclosed property resulting primarily from a $369,000 write down of machinery and equipment compared to the previous year. Management is actively seeking buyers for all Other Real Estate.

 

Amortization of Goodwill was $0 for 2003 and 2002. The Company adopted Financial Accounting Standards Board Statement 142 as of January 1, 2002 and no longer amortizes goodwill. Amortization of Goodwill was $2,294,000 in 2001.

 

Amortization of Identifiable Intangibles of $3,370,000 for 2003 was comparable to $3,432,000 for 2002. Amortization of Identifiable Intangibles of $3,432,000 for 2002 increased $1,298,000 or 60.8% compared to $2,134,000 recorded for 2001. The increase is a result of amortization of $1,421,000 on intangibles added with the Riverway, San Juan and Grapevine acquisitions.

 

Other Noninterest Expense of $22,846,000 for 2003 increased by $2,690,000 or 13.3% compared to $20,156,000 for 2002. The increase for 2003 over 2002 was primarily attributable to an increase in the volume of business conducted by the Company. Other Noninterest Expense of $20,156,000 for 2002 increased by $5,209,000 or 34.8% compared to $14,947,000 for

 

26

 

2001. The increase for 2002 over 2001 was primarily attributable to an increased volume of business, primarily due to the 2002 acquisitions.

 

A detailed summary of Noninterest Expense during the last three years follows:

 

(Dollars in Thousands)		2003			2002			2001
Salaries and Wages		$	35,260		$	28,916		$	22,105
Employee Benefits		12,322			9,077			5,828
Total Salaries and Employee Benefits		47,582			37,993			27,933
Net Occupancy Expense		6,848			5,447			4,358
Equipment Expense		10,510			8,640			6,565
Other Real Estate Expense, Net
Rental Income		(535		)	(638		)	(737		)
(Gain) Loss on Sale		(21		)	(230		)	188
Expenses		1,200			1,283			1,641
Write-Downs		90			76			21
Total Other Real Estate Expense, Net		734			491			1,113
Amortization of Goodwill		—			—			2,294
Amortization of Identifiable Intangibles		3,370			3,432			2,134
Other Noninterest Expense
Advertising and Public Relations		3,755			2,697			2,297
Data Processing and Check Clearing		3,470			2,812			2,016
Director Fees		523			485			405
Franchise Tax		254			215			155
Insurance		559			532			350
FDIC Insurance		517			529			400
Legal		1,764			1,367			1,148
Professional Fees		2,909			3,283			1,825
Postage, Delivery and Freight		1,695			1,541			1,064
Printing, Stationery and Supplies		2,345			2,199			1,700
Telephone		948			880			716
Other Losses		829			815			983
Miscellaneous Expense		3,278			2,801			1,888
Total Other Noninterest Expense		22,846			20,156			14,947
Total Noninterest Expense		$	91,890		$	76,159		$	59,344

 

INCOME TAX EXPENSE

 

The Company recorded income tax expense of $31,293,000 for 2003 compared to $27,385,000 for 2002 and $21,306,000 for 2001. The changes in income tax expense are due primarily to changes in the level of pretax income. The Company’s effective tax rate for 2003 was 33.4% compared to 33.7% for 2002 and 35.1% for 2001. The decrease in the effective tax rate in 2002 compared to 2001 is due to the Bank no longer amortizing goodwill beginning in 2002, which was nondeductible for income tax purposes.

 

CAPITAL AND LIQUIDITY

 

Bank holding companies are required to maintain capital ratios in accordance with guidelines adopted by the Federal Reserve Board. The guidelines are commonly known as Risk-Based Capital Guidelines. On December 31, 2003, the Company exceeded all applicable capital requirements, having a total risk-based capital ratio of 13.94%, a Tier I risk-based capital ratio of 12.88% and a leverage ratio of 9.26%.

 

Liquidity management assures that adequate funds are available to meet deposit withdrawals, loan demand and maturing liabilities. Insufficient liquidity can result in higher costs of obtaining funds, while excessive liquidity can lead to a decline in earnings due to the cost of foregoing alternative investments. The ability to renew and acquire additional deposit liabilities is a major source of liquidity. The Company’s principal sources of funds are primarily within the local markets of the Bank and consist of deposits, interest and principal payments on loans and securities, sales of loans and securities and borrowings.

 

Cash and assets which are readily marketable, or which can be pledged, or which will mature in the near future, provide asset liquidity. These include cash, interest-bearing deposits, federal funds sold, time deposits, U.S. Treasury, U.S. Government

 

27

 

Agency and mortgage-backed securities. At December 31, 2003, the Company’s liquidity ratio, defined as cash, U.S. Treasury, U.S. Government Agency, mortgage-backed securities, interest-bearing deposits, time deposits and federal funds sold as a percentage of deposits, was 37.9% compared to 38.3% at December 31, 2002 and 30.3% at December 31, 2001.

 

Liability liquidity is provided by access to core funding sources, principally various customers’ interest-bearing and noninterest-bearing deposit accounts in the Company’s trade area. The Company does not have, nor does it solicit, brokered deposits. Federal funds purchased and short-term borrowings are additional sources of liquidity. At December 31, 2003, the Company had lines of credit totaling $60,000,000 with correspondent banks for short-term liquidity needs. In addition, the Company had available credit of approximately $208,094,000 from the Federal Home Loan Bank, of which $153,000,000 was advanced at December 31, 2003. These sources of liquidity are short-term in nature and are used, as necessary, to fund asset growth and meet short-term liquidity needs.

 

At December 31, 2003, the Company had outstanding commitments to extend credit of approximately $536,267,000, commercial letters of credit of $1,500,000, standby letters of credit of $80,068,000, and credit card guarantees of $1,342,000. In addition, the Company had construction commitments of $804,000.

 

During 2003, funds for $988,089,000 of securities purchases and $250,538,000 of net growth in the loans held for investment portfolio came from various sources, including $783,175,000 in proceeds from maturing and sold securities, a net increase in deposits of $355,022,000 and $120,959,000 from operating activities.

 

The Company is dependent on dividend and interest income from the Bank and the sale of stock for its liquidity. Applicable Federal Reserve Board regulations provide that bank holding companies are permitted by regulatory authorities to pay cash dividends on their common or preferred stock if consolidated earnings and consolidated capital are within regulatory guidelines. At December 31, 2003, an aggregate of $92,481,000 was available for payment of dividends by the Bank to the Company under the applicable limitations and without regulatory approval.

 

EFFECTS OF INFLATION

 

Financial institutions are impacted differently by inflation than are industrial companies. While industrial and manufacturing companies generally have significant investments in inventories and fixed assets, financial institutions ordinarily do not have such investments. As a result, financial institutions are generally in a better position than industrial companies to respond to inflationary trends by monitoring the spread between interest costs and interest income yields through adjustments of maturities and interest rates of assets and liabilities. In addition, inflation tends to increase demand for loans from financial institutions as industrial companies attempt to maintain a constant level of goods in inventory and assets. As consumers of goods and services, financial institutions are affected by inflation as prices increase, causing an increase in costs of salaries, employee benefits, occupancy expense and similar items.

 

CONTRACTUAL CASH OBLIGATIONS AND COMMERCIAL COMMITMENTS

 

The following table presents contractual cash obligations of the Company as of December 31, 2003:

 

		Payments due by Period
Contractual Cash Obligations		Total			Less than One Year			One to Three Years			Four to Five Years			After Five Years
		(Dollars in Thousands)
Federal Funds Purchased and Securities Sold Under Repurchase Agreements		$	91,565		$	74,897		$	16,668		$	—		$	—
Federal Home Loan Bank Advances		153,000			153,000			—			—			—
Trust Preferred Securities		15,000			—			—			—			15,000
Operating Leases		9,883			739			1,186			960			6,998
Construction Commitments		804			804			—			—			—
Total Contractual Cash Obligations		$	270,252		$	229,440		$	17,854		$	960		$	21,998

 

28

 

The following table presents contractual commercial commitments of the Company as of December 31, 2003:

 

					Amount of Commitment Expiration Per Period
Commercial Commitments		Unfunded Commitments			Less than One Year			One to Three Years			Four to Five Years			After Five Years
		(Dollars in Thousands)
Lines of Credit		$	536,267		$	327,437		$	159,261		$	20,565		$	29,004
Commercial Letters of Credit		1,500			1,500			—			—			—
Standby Letters of Credit		80,068			76,885			2,841			342			—
Credit Card Guarantees		1,342			418			915			9			—
Total Commercial Commitments		$	619,177		$	406,240		$	163,017		$	20,916		$	29,004

 

CRITICAL ACCOUNTING POLICY

 

The Company considers its Allowance for Loan Losses and related provision for loan losses policy as a policy critical to the sound operations of the Bank. The Company provides for loan losses each period by an amount resulting from both (a) an estimate by management of probable loan losses that occurred during the period and (b) the ongoing adjustment of prior estimates of probable losses occurring in prior periods. The provision for loan losses increases the allowance for loan losses which is netted against loans held for investment on the consolidated balance sheets. As losses are confirmed, the loan is written down, reducing the allowance for loan losses. See “Allowance for Loan Losses - Critical Accounting Policy” and “Provision for Loan Losses - Critical Accounting Policy” contained herein and “Allowance for Loan Losses” included in Note 1 of the Notes to Consolidated Financial Statements for further information regarding the Company’s provision and allowance for loan losses policy.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

 

 Market risk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices and equity prices. The primary market risk to which the Company is exposed is interest rate risk. Interest rate risk occurs when assets and liabilities reprice at different times as interest rates change. For example, if fixed-rate loans are funded with floating-rate deposits, the spread between loan and deposit rates will decline or turn negative if rates increase. Other types of market risk, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company’s business activities. The Company’s interest rate risk arises from transactions entered into for purposes other than trading. The Company does not currently engage in trading activities or use derivative instruments to control interest rate risk. Even though such activities may be permitted with the approval of the Board of Directors, the Company does not intend to engage in such activities in the immediate future.

 

Interest rate risk is managed within the funds management policy of the Company. The principal objectives of the funds management policy are to avoid fluctuating net interest margins and to maintain consistent growth of net interest income through periods of changing interest rates. The Board of Directors oversees implementation of strategies to control interest rate risk. The Company may take steps to alter its net sensitivity position by offering deposit and/or loan structures that tend to counter the natural rate risk profile of the Company. Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed. Because of the volatility of market rates and uncertainties, there can be no assurance of the effectiveness of management programs to achieve a targeted moderation of risk.

 

In order to measure earnings and fair value sensitivity to changing rates, the Company utilizes three different measurement tools including static gap analysis, simulation earnings, and market value sensitivity (fair value at risk). The primary analytical tool used by the Company to quantify interest rate risk is a simulation model to project changes in net interest income that result from forecast changes in interest rates. This analysis estimates a percentage of change in net interest income from the stable rate scenario under scenarios of rising and falling market interest rates over a twelve month time horizon. The prime rate serves as a “driver” and is made to rise (or fall) evenly in 100 basis point increments over the 12-month forecast interval. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the repricing and maturity characteristics of the existing and projected balance sheet.

 

29

 

The following table summarizes the simulated change in net interest income over a 12-month period as of December 31, 2003 and December 31, 2002:

 

Changes in Interest		Estimated Net			Increase (Decrease) in Net Interest Income
Rates (Basis Points)		Interest Income			Amount			Percent
		(Dollars in Thousands)
December 31, 2003
+100		$	173,992		$	9,637		5.9	%
-		164,355			—			—
-100		158,866			(5,489		)	(3.3	)
December 31, 2002
+100		154,527			1,856			1.2
-		152,671			—			—
-100		150,664			(2,007		)	(1.3	)

 

All the measurements of risk described above are made based upon the Company’s business mix and interest rate exposures at the particular point in time. An immediate 100 basis point decline in interest rates is a hypothetical rate scenario, used to calibrate risk, and does not necessarily represent management’s current view of future market developments. Because of uncertainties as to the extent of customer behavior, refinance activity, absolute and relative loan and deposit pricing levels, competitor pricing and market behavior, product volumes and mix, and other unexpected changes in economic events impacting movements and volatility in market rates, there can be no assurance that simulation results are reliable indicators of net interest income under such conditions.

 

The interest rate sensitivity gap represents the dollar amount of difference between rate sensitive assets and rate sensitive liabilities within a given time period (“GAP”). A GAP ratio is determined by dividing rate sensitive assets by rate sensitive liabilities. A ratio of 1.0 indicates a perfectly matched position, in which case the effect on net interest income due to interest rate movements would be zero.

 

The following table summarizes interest rate sensitive assets and liabilities by their repricing dates at December 31, 2003:

 

Interest Rate Sensitivity Analysis		0-3 Months			4-6 Months			7-12 Months			1-5 Years			Over 5 Years			Total
		(Dollars in Thousands)
Loans Held for Investment		$	1,653,735		$	111,206		$	162,345		$	516,591		$	75,817		$	2,519,694
Loans Held for Sale		24,078			—			—			—			—			24,078
Securities
Available for Sale		4,881			28,151			17,432			1,193,915			141,435			1,385,814
Held to Maturity		—			—			200			210			—			410
Interest-Bearing and Time Deposits		651			93			3			8			—			755
Total Interest-Bearing Assets		1,683,345			139,450			179,980			1,710,724			217,252			3,930,751
Savings		147,236			—			—			—			—			147,236
Money Market Checking and Savings Accounts		964,436			—			—			—			—			964,436
Time Deposits		684,161			368,373			461,112			353,990			916			1,868,552
Other Borrowed Money		217,897			5,000			10,000			16,668			10,000			259,565
Total Interest-Bearing Liabilities		2,013,730			373,373			471,112			370,658			10,916			3,239,789
Rate Sensitivity GAP (1)		$	(330,385	)	$	(233,923	)	$	(291,132	)	$	1,340,066		$	206,336		$	690,962
Cumulative Rate Sensitivity GAP		$	(330,385	)	$	(564,308	)	$	(855,440	)	$	484,626		$	690,962
Ratio of Cumulative Rate Sensitivity GAP to Total Assets		(7.83		)%	(13.38		)%	(20.28		)%
Ratio of Cumulative Rate Sensitive Interest-Earning Assets to Cumulative Rate Sensitive Interest-Bearing Liabilities		0.84:1			0.76:1			0.70:1

 

(1) Rate sensitive interest-earning assets less rate sensitive interest-bearing liabilities.

 

30

 

CURRENT ACCOUNTING ISSUES

 

In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51”. This interpretation is intended to achieve more consistent application of consolidation policies to variable interest entities (“VIE”) and, thus, to improve comparability between enterprises engaged in similar activities even if some of those activities are conducted through VIEs. Including the assets, liabilities and results of activities of VIEs in the consolidated financial statements of their primary beneficiaries will provide more complete information about the resources, obligations, risk and opportunities of the consolidated enterprise. FIN 46 applies immediately to VIEs created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. It applies in the first fiscal or interim period beginning after June 15, 2003, to VIEs in which an enterprise holds a variable interest that was acquired before February 1, 2003. However, in December 2003, the FASB revised FIN 46, delaying the effective dates for certain entities created before February 1, 2003, and making other amendments to clarify application of the guidance. For potential variable interest entities other than any Special Purpose Entities (“SPE”), the revised FIN 46 (“FIN 46R”) is now required to be applied no later than the end of the first fiscal year or interim reporting period ending after March 15, 2004. The original guidance under FIN 46 is still applicable; however, for all SPEs created prior to February 1, 2003, application is required at the end of the first interim or annual reporting period ending after December 15, 2003. FIN 46R may be applied prospectively with a cumulative-effect adjustment as of the date it is first applied, or by restating previously issued financial statements with a cumulative-effect adjustment as of the beginning of the first year restated. FIN 46R also requires certain disclosures of an entity’s relationship with variable interest entities. The Company will adopt FIN 46R for non-SPE entities as of March 31, 2004.

 

FIN 46R will have an impact on the Company’s consolidated financial statements resulting from the deconsolidation of the business trusts utilized to issue the Company’s trust preferred securities. The consolidated financial statements will reflect an equity investment in the trusts and an increase to other borrowed money by the same amount. If FIN 46R had been adopted as of December 31, 2003, the Company’s consolidated balance sheet would have included an asset of $465,000 representing our investment in the business trusts and an offsetting increase to other borrowed money. In addition, both other noninterest income and interest expense would have increased by $40,000, resulting in no change to net income. The deconsolidation of the business trusts will be reflected in the Company’s March 31, 2004 consolidated financial statements. As part of its planned acquisition of Southeast Texas Bancshares, Inc., the Company in February 2004 sold an additional $50 million of trust preferred securities to partly finance the cash portion of the purchase price. Adoption of FIN 46R will also impact the accounting for the issuance of the additional trust preferred securities.

 

In April 2003, the Financial Accounting Standards Board issued Statement No. 149 (“Statement 149”), “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. Statement 149 amends Financial Accounting Standards Board Statement No. 133 (“Statement 133”), “Accounting for Derivative Instruments and Hedging Activities” and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. Statement 149 improves financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative contains a financing component, amends the definition of underlying to conform to the language in FASB Interpretation No. 45, and amends certain other existing pronouncements. Statement 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. However, the provisions of Statement 149 that relate to Statement 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. The adoption of Statement 149 did not have a material impact on the Company’s consolidated financial statements.

 

In May 2003, the Financial Accounting Standards Board issued Statement No. 150 (“Statement 150”), “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”. Statement 150 requires certain financial instruments that have characteristics of both liabilities and equity to be classified as a liability on the balance sheet. Prior to the issuance of Statement 150, the Company classified trust preferred securities as other borrowed money on the consolidated balance sheets and its related interest cost as interest expense on the consolidated statements of income and comprehensive income, which is consistent with the requirements of Statement 150. Statement 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Statement 150 will be effected by reporting the cumulative effect of a change in accounting principle for contracts created before the issuance date and still existing at the beginning of that interim period. The adoption of Statement 150 did not have an impact on the Company’s consolidated financial statements.

 

In December 2003, the Financial Accounting Standards Board issued Statement No. 132 (Revised 2003) (“Statement 132R”), “Employers’ Disclosures about Pensions and Other Postretirement Benefits, an amendment of FASB Statements No. 87, 88, and 106”. Statement 132R amends Statement No. 87, “Employers’ Accounting for Pensions”, Statement No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits” and Statement No.

 

31

 

106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions”. However, the Statement does not change the recognition and measurement requirements of those Statements. Statement 132R retains the disclosure requirements contained in Financial Accounting Standards Board Statement 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits, an amendment of FASB Statements No. 87, 88, and 106”, which it replaces and requires additional disclosures about assets, obligations, cash flow and net periodic benefit cost. The adoption of Statement 132R did not have an impact on the Company’s consolidated financial statements.

 

FOURTH QUARTER RESULTS

 

The fourth quarter net income for 2003 of $15,944,000 or $0.54 per diluted common share reflected an increase of $2,026,000 or 14.6% compared to $13,918,000 or $0.47 per diluted common share for fourth quarter 2002.

 

Net interest income, on a tax-equivalent basis, of $40,899,000 for fourth quarter 2003 increased $5,910,000 or 16.9% compared to $34,989,000 for fourth quarter 2002. Average interest-earning assets increased by $423,591,000 or 12.4% to $3,852,519,000 for the three months ended December 31, 2003 compared to the same period in 2002. The increase in average interest-earning assets resulted from continued emphasis on loan growth, as well an increase in securities available for sale funded by deposit growth. Although average interest-earning assets increased by 12.4%, the growth in interest income was hampered by interest rate reductions driven by the Federal Reserve monetary policy. Net interest margin for fourth quarter 2003 was 4.21% compared to 4.05% for fourth quarter 2002.

 

The provision for loan losses for fourth quarter 2003 totaled $3,184,000 compared to $3,676,000 for fourth quarter 2002, reflecting a decrease of $492,000 or 13.4%. The decrease in the provision is primarily attributable to our continual review of the adequacy of our loan loss allowance. Net charge-offs of $1,874,000 for fourth quarter 2003 decreased $912,000 or 32.7% compared to $2,786,000 for fourth quarter 2002.

 

Noninterest income of $10,963,000 for fourth quarter 2003 increased $1,148,000 or 11.7% compared to $9,815,000 for fourth quarter 2002. The majority of the increase is attributable to an increase of $1,124,000 in non-sufficient check and return item charges resulting from deposit growth, as well as an increase in non-sufficient fund item charges from $25 per item to $30 per item during July 2003.

 

Noninterest expense of $23,787,000 for fourth quarter 2003 increased $3,856,000 or 19.3% compared to $19,931,000 for fourth quarter 2002, primarily due to an increase in salaries and employee benefits and other noninterest expense. The efficiency ratio of expense to total revenue averaged 46.72% for fourth quarter 2003 compared to 45.13% for fourth quarter 2002.

 

The fourth quarter net income for 2003 of $15,944,000 or $0.54 per diluted common share was comparable to $15,569,000 or $0.52 per diluted common share for third quarter 2003, reflecting an increase of $375,000 or 2.4%. Net interest income, on a tax-equivalent basis, of $40,899,000 for fourth quarter 2003 increased $2,860,000 or 7.5% compared to $38,039,000 for third quarter 2003, reflecting a continued increase in volume of earning assets. Average earning assets of $3,852,519,000 for fourth quarter 2003 increased $63,375,000 or 1.7% compared to $3,789,144,000 for third quarter 2003. The fourth quarter 2003 net interest margin of 4.21% compared to 3.98% in third quarter 2003.

 

The provision for loan losses for fourth quarter 2003 of $3,184,000 decreased $667,000 or 17.3% compared to $3,851,000 reported for third quarter 2003. The decrease in the provision is attributable to our continual review of the adequacy of the loan loss allowance. Net charge-offs of $1,874,000 for fourth quarter 2003 decreased $1,419,000 or 43.1% compared to net charge-offs of $3,293,000 for third quarter 2003.

 

Noninterest income of $10,963,000 for fourth quarter 2003 decreased $2,278,000 or 17.2% compared to $13,241,000 for third quarter 2003. The decrease was primarily attributable a $1,854,000 decrease in net realized gains on sales of securities available for sale during fourth quarter 2003 compared to third quarter 2003.

 

Noninterest expense of $23,787,000 for fourth quarter 2003 was comparable to $23,267,000 for third quarter 2003, increasing by $520,000 or 2.2%. The efficiency ratio of expense to total revenue averaged 46.72% for fourth quarter 2003 compared to 46.18% for third quarter 2003.

 

The nonperforming loans at December 31, 2003 of $10,122,000 was comparable to $10,561,000 for September 30, 2003, decreasing by $439,000 or 4.2%.

 

32

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

INDEPENDENT AUDITORS’ REPORT

 

The Board of Directors and Shareholders
Texas Regional Bancshares, Inc.:

 

We have audited the accompanying consolidated balance sheets of Texas Regional Bancshares, Inc. and subsidiaries (the “Company”) as of December 31, 2003 and 2002, the related consolidated statements of income and comprehensive income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Texas Regional Bancshares, Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Notes 1 and 5 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets in 2002.

 

	/s/  KPMG LLP
Austin, Texas
January 16, 2004

 

33

 

CONSOLIDATED FINANCIAL STATEMENTS

 

Texas Regional Bancshares, Inc. and Subsidiaries
Consolidated Balance Sheets

 

		December 31,
(Dollars in Thousands, Except Share Data)		2003			2002
Assets
Cash and Due From Banks		$	100,167		$	124,125
Interest-Bearing Deposits at Other Banks		556			614
Federal Funds Sold		—			13,800
Total Cash and Cash Equivalents		100,723			138,539
Time Deposits		199			299
Securities Available for Sale, at Fair Value		1,385,814			1,195,665
Securities Held to Maturity, at Amortized Cost (Fair Value of $431 in 2003 and $451 in 2002)		410			414
Loans Held for Sale		24,078			56,175
Loans Held for Investment, Net of Unearned Discount of $261 in 2003 and $1,109 in 2002		2,519,694			2,267,530
Less: Allowance for Loan Losses		(31,234		)	(28,116		)
Net Loans Held for Investment		2,488,460			2,239,414
Premises and Equipment, Net		107,875			89,500
Accrued Interest Receivable		27,740			27,781
Other Real Estate		8,785			9,159
Goodwill		29,856			28,501
Identifiable Intangibles, Net		15,263			18,454
Other Assets		28,733			31,286
Total Assets		$	4,217,936		$	3,835,187
Liabilities
Deposits
Demand		$	536,211		$	445,978
Savings		147,236			139,531
Money Market Checking and Savings		964,436			838,642
Time Deposits		1,868,552			1,708,040
Total Deposits		3,516,435			3,132,191
Other Borrowed Money		259,565			293,518
Accounts Payable and Accrued Liabilities		20,205			32,023
Total Liabilities		3,796,205			3,457,732
Commitments and Contingencies (Notes 7, 11, 12 and 20)
Shareholders’ Equity
Preferred Stock; $1.00 Par Value, 10,000,000 Shares Authorized; None Issued and Outstanding		—			—
Common Stock – Class A; $1.00 Par Value, 50,000,000 Shares Authorized; Issued and Outstanding 29,470,659 Shares in 2003 and 26,488,153 Shares in 2002		29,471			26,488
Paid-In Capital		278,131			186,169
Retained Earnings		103,773			142,670
Accumulated Other Comprehensive Income		10,356			22,128
Total Shareholders’ Equity		421,731			377,455
Total Liabilities and Shareholders’ Equity		$	4,217,936		$	3,835,187

 

The accompanying notes are an integral part of the consolidated financial statements.

 

34

 

Texas Regional Bancshares, Inc. and Subsidiaries
Consolidated Statements of Income and Comprehensive Income

 

		Years Ended December 31,
(Dollars in Thousands, Except Per Share Data)		2003			2002			2001
Interest Income
Loans Held for Sale		$	2,407		$	2,203		$	—
Loans Held for Investment, Including Fees		161,978			154,370			146,017
Securities
Taxable		40,619			42,008			34,369
Tax-Exempt		3,426			2,901			2,292
Interest-Bearing and Time Deposits		177			49			85
Federal Funds Sold		170			174			539
Total Interest Income		208,777			201,705			183,302
Interest Expense
Deposits		53,533			64,673			81,292
Federal Funds Purchased and Securities Sold Under Repurchase Agreements		3,410			3,972			2,248
Federal Home Loan Bank Advances		2,057			1,838			236
Trust Preferred Securities		1,275			1,126			—
Subordinated Debentures		110			377			—
Total Interest Expense		60,385			71,986			83,776
Net Interest Income Before Provision for Loan Losses		148,392			129,719			99,526
Provision for Loan Losses		13,155			12,331			8,667
Net Interest Income After Provision for Loan Losses		135,237			117,388			90,859
Noninterest Income
Service Charges on Deposit Accounts		24,920			20,430			16,965
Other Service Charges		6,235			5,210			3,507
Trust Service Fees		2,870			2,730			2,494
Net Realized Gains on Sales of Securities Available for Sale		10,840			4,785			1,496
Data Processing Service Fees		7,293			6,404			3,194
Loan Servicing Loss, Net		(4,830		)	(1,673		)	—
Other Noninterest Income		2,927			2,117			1,557
Total Noninterest Income		50,255			40,003			29,213
Noninterest Expense
Salaries and Employee Benefits		47,582			37,993			27,933
Net Occupancy Expense		6,848			5,447			4,358
Equipment Expense		10,510			8,640			6,565
Other Real Estate Expense, Net		734			491			1,113
Amortization of Goodwill		—			—			2,294
Amortization of Identifiable Intangibles		3,370			3,432			2,134
Other Noninterest Expense, Net		22,846			20,156			14,947
Total Noninterest Expense		91,890			76,159			59,344
Income Before Income Tax Expense		93,602			81,232			60,728
Income Tax Expense		31,293			27,385			21,306
Net Income		62,309			53,847			39,422
Other Comprehensive Income (Loss), Net of Tax
Net Unrealized Gains (Losses) on Securities Available for Sale
Net Unrealized Holding Gains (Losses) Arising During Period		(4,726		)	22,654			5,718
Less: Reclassification Adjustment for Net Realized Gains Included in Net Income		7,046			3,110			972
Total Other Comprehensive Income (Loss)		(11,772		)	19,544			4,746
Comprehensive Income		$	50,537		$	73,391		$	44,168
Net Income Per Common Share
Basic		$	2.12		$	1.88		$	1.48
Diluted		2.10			1.86			1.47

 

The accompanying notes are an integral part of the consolidated financial statements.

 

35

 

Texas Regional Bancshares, Inc. and Subsidiaries
Consolidated Statements of Changes in Shareholders’ Equity

 

(Dollars in Thousands)		Common Stock - Class A			Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Shareholders’ Equity
Balance, December 31, 2000		$	16,091		$	134,084		$	79,691		$	(2,162	)	$	227,704
Net Income		—			—			39,422			—			39,422
Net Change in Unrealized Gains and Losses on  Securities Available for Sale, Net of Tax and Reclassification Adjustment		—			—			—			4,746			4,746
Total Comprehensive Income		—			—			39,422			4,746			44,168
Exercise of Stock Options, 145,935 Shares of  Class A Common Stock		145			2,129			—			—			2,274
Tax Effect of Nonqualified Stock Options Exercised and Disqualifying Dispositions on Qualified Stock Options		—			814			—			—			814
Class A Common Stock Cash Dividends - $0.364 per share		—			—			(9,701		)	—			(9,701		)
Balance, December 31, 2001		16,236			137,027			109,412			2,584			265,259
Net Income		—			—			53,847			—			53,847
Net Change in Unrealized Gains and Losses on Securities Available for Sale, Net of Tax and Reclassification Adjustment		—			—			—			19,544			19,544
Total Comprehensive Income		—			—			53,847			19,544			73,391
Exercise of Stock Options, 176,306 Shares  of Class A Common Stock		176			4,154			—			—			4,330
Three-For-Two Stock Split		8,749			—			(8,770		)	—			(21		)
Tax Effect of Nonqualified Stock Options  Exercised and Disqualifying Dispositions on  Qualified Stock Options		—			806			—			—			806
Purchase of Riverway Holdings, Inc.		1,177			39,603			—			—			40,780
Purchase of San Juan Bancshares, Inc.		150			4,579			—			—			4,729
Class A Common Stock Cash Dividends - $0.406 per share		—			—			(11,819		)	—			(11,819		)
Balance, December 31, 2002		26,488			186,169			142,670			22,128			377,455
Net Income		—			—			62,309			—			62,309
Net Change in Unrealized Gains and Losses on Securities Available for Sale, Net of Tax and Reclassification Adjustment		—			—			—			(11,772		)	(11,772		)
Total Comprehensive Income		—			—			62,309			(11,772		)	50,537
Exercise of Stock Options, 277,914 Shares  of Class A Common Stock		278			5,522			—			—			5,800
Tax Effect of Nonqualified Stock Options  Exercised and Disqualifying Dispositions on Qualified Stock Options		—			1,033			—			—			1,033
10 percent Stock Dividend		2,668			84,292			(87,004		)	—			(44		)
Purchase of Corpus Christi Bancshares, Inc.		37			1,115			—			—			1,152
Class A Common Stock Cash Dividends -  $0.480 per share		—			—			(14,202		)	—			(14,202		)
Balance, December 31, 2003		$	29,471		$	278,131		$	103,773		$	10,356		$	421,731

 

The accompanying notes are an integral part of the consolidated financial statements.

 

36

 

Texas Regional Bancshares, Inc. and Subsidiaries
Consolidated Statements of Cash Flows

 

		Years Ended December 31,
(Dollars in Thousands)		2003			2002			2001
Cash Flows from Operating Activities
Net Income		$	62,309		$	53,847		$	39,422
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities
Depreciation, Amortization and Accretion		29,517			17,562			10,081
Provision for Loan Losses		13,155			12,331			8,667
Provision for Estimated Losses on Other Real Estate and Other Assets		237			121			30
Increase in Valuation Allowance for Mortgage Servicing Rights		1,580			1,683			—
Net Realized Gains on Sale of Securities Available for Sale		(10,840		)	(4,785		)	(1,496		)
(Gain) Loss on Sale of Other Assets		106			(9		)	34
(Gain) Loss on Sale of Other Real Estate		(21		)	(230		)	188
(Gain) Loss on Disposal of Premises and Equipment		(11		)	336			85
Gain on Sale of Loans Held for Sale		(1,599		)	(663		)	—
Net (Increase) Decrease in Loans Held for Sale		33,696			(6,242		)	—
Deferred Tax Benefit		(3,292		)	(1,820		)	(1,511		)
(Increase) Decrease in Accrued Interest Receivable and Other Assets		(3,986		)	(1,436		)	781
Increase (Decrease) in Accounts Payable and Accrued Liabilities		108			(2,096		)	(3,294		)
Net Cash Provided by Operating Activities		120,959			68,599			52,987
Cash Flows from Investing Activities
Net Decrease in Time Deposits at Other Banks		100			292			1,581
Proceeds from Sales of Securities Available for Sale		504,843			365,757			145,601
Proceeds from Maturing Securities Available for Sale		278,327			161,428			356,888
Proceeds from Maturing Securities Held to Maturity		5			500			732
Purchases of Securities Available for Sale		(988,089		)	(785,695		)	(530,406		)
Loan Originations and Advances, Net		(250,538		)	(203,084		)	(136,180		)
Recoveries of Charged-Off Loans		1,145			919			472
Proceeds from Sale of Premises and Equipment		25			38			89
Purchases of Premises and Equipment		(27,052		)	(15,510		)	(5,057		)
Proceeds from Sale of Other Real Estate		2,846			962			2,161
Proceeds from Sale of Other Assets		1,197			1,052			982
Purchase of Data Processing Contracts		—			(849		)	—
Net Cash Provided by Mergers		5,883			28,447			—
Net Cash Used in Investing Activities		(471,308		)	(445,743		)	(163,137		)
Cash Flows from Financing Activities
Net Increase in Demand Deposits, Savings, Money Market Checking and Savings Accounts		204,480			140,132			125,773
Net Increase in Time Deposits		150,542			206,904			356
Net Increase (Decrease) in Other Borrowed Money		(34,403		)	79,695			6,480
Cash Dividends Paid on Class A Common Stock		(13,842		)	(11,059		)	(9,696		)
Cash Paid in Lieu of Fractional Shares		(44		)	(21		)	—
Proceeds from Sale of Common Stock		5,800			4,330			2,274
Net Cash Provided by Financing Activities		312,533			419,981			125,187
Increase (Decrease) in Cash and Cash Equivalents		(37,816		)	42,837			15,037
Cash and Cash Equivalents at Beginning of Year		138,539			95,702			80,665
Cash and Cash Equivalents at End of Year		$	100,723		$	138,539		$	95,702
Supplemental Disclosures of Cash Flow Information
Interest Paid		$	61,523		$	72,206		$	85,769
Income Taxes Paid		33,558			28,520			21,694
Supplemental Schedule of Noncash Investing and Financing Activities
Foreclosure and Repossession in Partial Satisfaction of Loans Receivable		8,359			6,301			7,753
Financing Provided for Sales of Other Real Estate		1,857			1,606			1,294
Net Decrease in Securities Trades Not Settled		(1,357		)	(1,198		)	(2,452		)
Net Increase in Dividends Payable		360			760			5
The Company acquired Riverway Bancshares, Inc. and its subsidiary, Riverway Bank, on February 22, 2002. Assets acquired and liabilities assumed were as follows:
Fair Value of Assets Acquired Including Goodwill		—			694,418			—
Fair Value of Liabilities Assumed		—			653,638			—
Fair Value of Stock Issued		—			40,780			—
The Company acquired San Juan Bancshares, Inc. and its subsidiary, Texas Country Bank, on November 18, 2002. Assets acquired and liabilities assumed were as follows:
Fair Value of Assets Acquired		—			50,915			—
Fair Value of Liabilities Assumed		—			46,186			—
Fair Value of Stock Issued		—			4,729			—
The Company acquired Corpus Christi Bancshares, Inc. and its subsidiary,
The First State Bank, on February 14, 2003.  Assets acquired and liabilities assumed are as follows:
Fair Value of Assets Acquired Including Goodwill		31,067			—			—
Fair Value of Liabilities Assumed		29,915			—			—
Fair Value of Stock Issued		1,152			—			—

 

The accompanying notes are an integral part of the consolidated financial statements.

 

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