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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004

Commission file number 000-49928

TEXAS UNITED BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

202 W. COLORADO

LA GRANGE, TEXAS 78945

(Address of principal executive offices including zip code)

(979) 968-8451

(Registrant’s telephone number, including area code)

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

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

As of July 31, 2004, the number of outstanding shares of Common Stock, par value $1.00 per share was 4,024,553.

PART I

FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements.

TEXAS UNITED BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(In thousands, except share data)

See accompanying notes to condensed consolidated financial statements

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TEXAS UNITED BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Earnings

(In thousands, except per share data)

(Unaudited)

See accompanying notes to condensed consolidated financial statements

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TEXAS UNITED BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(In thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements

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TEXAS UNITED BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity

Year Ended December 31, 2003 and

Six Months Ended June 30, 2004

(In thousands, except share and per share amounts)

See accompanying notes to condensed consolidated financial statements

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TEXAS UNITED BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements

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TEXAS UNITED BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The unaudited condensed consolidated financial statements include the accounts of Texas United Bancshares, Inc. (the “Company”) and its wholly-owned subsidiaries Texas United Nevada, Inc. (“TUNI”), State Bank (the “Bank”), and Community Home Loan, Inc. (“CHL”). All material intercompany accounts and transactions have been eliminated in the consolidated report of the Company.

The accompanying unaudited condensed consolidated financial statements were prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal and recurring adjustments, necessary to present fairly the Company’s consolidated financial position at June 30, 2004, the Company’s consolidated results of operations for the three and six months ended June 30, 2004 and 2003, respectively, consolidated cash flows for the six months ended June 30, 2004 and 2003, and consolidated changes in shareholders’ equity for the six months ended June 30, 2004. Interim period results are not necessarily indicative of results of operations or cash flows for a full-year period. The 2003 year-end consolidated balance sheet and statement of changes in shareholders’ equity data were derived from audited financial statements, but do not include all disclosures required by generally accepted accounting principles.

These financial statements and the notes thereto should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2003 appearing in the Company’s Annual Report on Form 10-K for 2003.

2. EARNINGS PER COMMON SHARE

Basic earnings per share (“EPS”) is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income available to common shareholders by the weighted-average number of common shares and potentially dilutive common shares outstanding during the period. Potentially dilutive common shares are computed using the treasury stock method.

The amounts shown above do not give effect to the additional shares that the Company will issue related to the acquisition of GNB Bancshares, Inc. and the public offering as more fully described in Note 9.

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3. INTANGIBLE ASSETS

The gross carrying amount of intangible assets and associated amortization at June 30, 2004 is presented in the following table:

The projections of amortization expense shown below for mortgage servicing rights are based on existing asset balances and the existing interest rate environment as of June 30, 2004. Future amortization expense may be significantly different depending upon changes in the mortgage servicing portfolio, mortgage interest rates and market conditions.

The following table shows the current period and estimated future amortization for intangible assets:

4. STOCK BASED COMPENSATION

The Company accounts for its stock based employee compensation plans on the “intrinsic value method” provided in Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. Because the exercise price of the Company’s employee stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recognized on option plans.

Statement of Financial Accounting Standards (SFAS) No. 123, (SFAS 123) “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” requires pro forma disclosures of net earnings and earnings per share for companies not adopting its fair value accounting method for stock-based employee compensation. The pro forma disclosures below use the fair value method of SFAS 123 to measure compensation expense for stock-based compensation plans.

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5. ACCOUNTING CHANGES

Variable Interest Entities

FIN No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51 (Revised December 2003)” establishes accounting guidance for consolidation of variable interest entities (VIE) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with the VIE. Prior to the implementation of FIN 46, as revised, VIE’s were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The provisions of FIN 46, as revised, were effective immediately for all arrangements entered after January 31, 2003, and were otherwise effective at the end of the first interim or annual period ending after March 15, 2004 unless the VIE is considered a special purpose entity, as to which the effective date was no later than the end of the first reporting period that ended after December 15, 2003.

The Company has identified TXUI Statutory Trust I (Trust I) and TXUI Statutory Trust II (Trust II) as VIE’s. The Company adopted FIN 46, as revised, in connection with its consolidated financial statements as of and for the year ended December 31, 2003. The adoption of FIN 46, as revised, required the Company to deconsolidate its investment in Trust I because the Company was not the primary beneficiary. Also, the Company recognized as debt the payable to Trust I. Trust II, which was created after adoption of FIN 46, as revised, is also not consolidated.

Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity

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

Mortgage Loan Interest Rate Lock Commitments

The Securities and Exchange Commission staff recently released Staff Accounting Bulletin (SAB) 105, “Loan Commitments Accounted for as Derivative Instruments.” SAB 105 requires that a lender should not consider the expected future cash flows related to loan servicing or include any internally developed intangible assets, such as customer-related intangible assets, in determining the fair value of loan commitments accounted for as derivatives.

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Companies were required to adopt SAB 105 effective no later than for commitments entered into after March 31, 2004. The requirements of SAB 105 apply to the Company’s mortgage loan interest rate lock commitments related to loans held for sale. At June 30, 2004, such commitments with a notional amount of approximately $22.3 million were outstanding at the Bank. The fair value of these commitments is insignificant. The Company adopted SAB 105 as of April 1, 2004, and application of its guidance had no material impact on the Company’s results of operations and financial position.

6. OFF BALANCE SHEET CREDIT COMMITMENTS

In the normal course of business, the Company enters into various transactions, which, in accordance with generally accepted accounting principles, are not included in its consolidated balance sheet. These transactions are referred to as “off balance-sheet commitments.” The Company enters into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit and standby letters of credit, which involve elements of credit risk in excess of the amounts recognized in the consolidated balance sheet. The Company minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures.

The Company enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Customers use credit commitments to ensure that funds will be available for working capital purposes, for capital expenditures and to ensure access to funds at specified terms and conditions. Substantially all of the Company’s commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. Management assesses the credit risk associated with certain commitments to extend credit in determining the level of the allowance for loan losses. Commitments to extend credit totaled $94.8 million at June 30, 2004 and $58.0 million at December 31, 2003.

Standby letters of credit are written conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The Company’s policies generally require that standby letters of credit arrangements contain collateral and debt covenants similar to those contained in loan agreements. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Company would be required to fund the commitment. The maximum potential amount of future payments the Company could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, the Company would be entitled to seek recovery from the customer. Standby letters of credit totaled $3.5 million at June 30, 2004 and $695,000 at December 31, 2003. At June 30, 2004, the outstanding standby letters of credit had a weighted average term of approximately one year. As of June 30, 2004 and December 31, 2003, no liability for the fair value of the Company’s potential obligations under these guarantees has been recorded since the amount is deemed immaterial.

7. CRITICAL ACCOUNTING POLICIES

The Company’s accounting policies are integral to understanding the results reported. The Company believes that of its significant accounting policies, the allowance for loan losses and mortgage servicing rights assets may involve a higher degree of judgment and complexity.

The allowance for loan losses is a valuation allowance for probable losses inherent in the loan portfolio. Loans are charged to the allowance when the loss is confirmed or when a determination is made that a probable loss has occurred on a specific loan. Recoveries are credited to the allowance at the time of recovery. Throughout the year, management estimates the probable level of losses to determine whether the allowance for loan losses is adequate to absorb losses in the existing portfolio. Based on these estimates, an amount is charged to the provision for loan losses and credited to the allowance for loan losses in order to adjust the allowance to a level determined to be adequate to absorb losses. Management’s judgment as to the level of probable losses on existing loans involves the consideration of current economic conditions and their estimated effects on specific borrowers; an evaluation of the existing relationships among loans, potential loan losses and the present level of the allowance; results of examinations of the loan portfolio by regulatory agencies; and management’s internal review of the loan portfolio. In determining the collectability of certain loans, management also considers the fair value of any underlying collateral. The amount ultimately realized may differ from the carrying value of these assets because of economic, operating or other conditions beyond the Company’s control. Please refer to the subsequent discussion of “Allowance for Loan Losses” included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional insight into management’s approach and methodology in estimating the allowance for loan losses.

Mortgage servicing rights assets are established and accounted for based on discounted cash flow modeling

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techniques which require management to make estimates regarding the amount and timing of expected future cash flows, including assumptions about loan repayment rates, loan loss experience, and costs to service, as well as discount rates that consider the risk involved. Because the values of these assets are sensitive to changes in assumptions, the valuation of mortgage servicing rights is considered a critical accounting estimate. Please refer to Note 3 to the Condensed Consolidated Financial Statements above and discussion of “Noninterest Income” included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional insight into management’s approach in estimating transfers and servicing of financial assets.

8. SEGMENT INFORMATION

Beginning in 2004, the Company has two reportable operating segments; commercial banking and mortgage banking. The Bank owns 100% of CHL and operates CHL as a subsidiary of the Bank (refer to “Recent Developments” included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”). The Company reports the financial position and the results of operations on a consolidated basis. The commercial banking and the mortgage banking segments are managed separately because each business requires different marketing strategies and each offers different products and services.

Summarized below is the financial information by operating segment for the three and six-month period ended June 30, 2004 (dollars in thousands):

9. PENDING AND COMPLETED ACQUISITIONS AND STOCK OFFERING

On February 5, 2004, the Bank acquired 100% of CHL and operates CHL as a subsidiary of State Bank. CHL is a mortgage company domiciled in Houston, Texas. Based upon financial information as of December 31, 2003, State Bank acquired $10.9 million in assets and assumed $9.9 million in liabilities. Initial consideration paid was $1.3 million in cash and $200,000 in common stock of the Company. Additional consideration will be paid annually through 2007 based upon the achievement of performance objectives. If all objectives are obtained, State Bank would pay an additional $1.3 million. The size of the acquisition and the amount of assets acquired were not material in relation to the Company’s overall business. Goodwill of $500,000 was recognized with this transaction.

On April 29, 2004, the Company entered into a definitive agreement to acquire GNB Bancshares, Inc., Gainesville, Texas. Pursuant to the terms of the agreement, in exchange for all outstanding shares of GNB capital stock, the Company will pay $18.4 million in cash and issue approximately 1,415,384 shares of its common stock, subject to adjustment in the event that the 20 day average sales price of the Company’s common stock exceeds or falls below certain pre-agreed levels. The Company plans to operate GNB’s wholly-owned subsidiary bank, GNB Financial, n.a., as a separate subsidiary. As of June 30, 2004, on a consolidated basis, GNB had total assets of $223.4 million, total loans of $166.6 million, total deposits of $189.4 million and shareholders’ equity of $19.4 million. The Company expects to complete the acquisition, subject to shareholder and regulatory approval, in September 2004.

        Pursuant to a registration statement on Form S-1 filed with, and declared effective by, the Securities and Exchange Commission, the Company sold 2,000,000 shares of its common stock at $17.00 per share to the public in an underwritten firm commitment offering which closed on August 10, 2004. The Company has also granted the underwriters a 30-day option to purchase an additional 300,000 shares to cover over-allotments, if any. Of the $31.6 million in net proceeds, after deduction of underwriting discounts and commissions and $500,000 in estimated offering expenses, approximately $10.0 million was used to repay the Company’s outstanding line of credit which was used as additional capital to support the acquisition of the additional assets from the Central Bank branches. In addition, approximately $18.4 million of the net proceeds will be used to pay the cash portion of the merger consideration to be paid to GNB shareholders and the balance will be used for general corporate purposes, including contributions to the capital of State Bank, the possible opening of additional branches and the possible acquisition of financial institutions.

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On May 3, 2004, the Company entered into a definitive agreement to purchase the loans and premises and assume the deposit liabilities of the Caldwell, Texas and Lexington, Texas branches of Central Bank, Houston, Texas. Under the terms of the agreement, the Company agreed to pay a premium of 8.02% of total deposits and $800,000 for the related real property and improvements and the related furniture, fixtures and equipment. Because the title work and survey for the Caldwell location was not complete at July 30, 2004, the planned closing date, the definitive agreement was amended to defer the acquisition of the Caldwell real estate and related improvements until a survey and title commitment could be delivered by Central Bank and reviewed and approved by the Company. Pending acquisition of the property at the agreed price of $395,000, the Company entered into a 60-day lease of the facility for a nominal rent.

Except for the Caldwell facility, the acquisition was completed on July 30, 2004. On such date, deposits at both branches totaled $99.2 million and loans totaled $33.1 million. Based on these totals, the Company paid approximately $8.4 million to acquire these branches, not including the $395,000 purchase price for the Caldwell facility.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Special Cautionary Notice Regarding Forward-looking Statements

Statements and financial discussion and analysis contained in the Form 10-Q that are not historical facts are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and are including this statement for purposes of invoking these safe harbor provisions. These forward-looking statements include information about possible or assumed future results of the Company’s operations or performance. When the Company uses any of the words “believe,” “expect”, “anticipate”, “estimate”, “continue”, “intend”, “may”, “will”, “should”, or similar expressions, identifies these forward-looking statements. Many possible factors or events could affect the future financial results and performance of the Company and could cause those financial results or performance to differ materially from those expressed in the forward-looking statement. These possible events or factors include, without limitation:

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A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen the assumptions or bases in good faith and that they are reasonable. However, the Company cautions you that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material. The Company will not update these statements unless the securities laws require us to do so.

Pending and Completed Acquisitions. On February 5, 2004, the Bank acquired 100% of Community Home Loan, Inc. (“CHL”) and operates CHL as a subsidiary of State Bank. CHL is a mortgage company domiciled in Houston, Texas. Based upon financial information as of December 31, 2003, State Bank acquired $10.9 million in assets and assumed $9.9 million in liabilities. Initial consideration paid was $1.3 million in cash and $200,000 in common stock of the Company. Additional consideration will be paid annually through 2007 based upon the achievement of performance objectives. If all objectives are obtained, State Bank would pay an additional $1.3 million. The size of the acquisition and the amount of assets acquired were not material in relation to the Company’s overall business. Goodwill of $500,000 was recognized with this transaction.

On April 29, 2004, the Company entered into a definitive agreement to acquire GNB Bancshares, Inc., Gainesville, Texas. Pursuant to the terms of the agreement, in exchange for all outstanding shares of GNB capital stock, the Company will pay $18.4 million in cash and issue approximately 1,415,384 shares of its common stock, subject to adjustment in the event that the 20 day average sales price of the Company’s common stock exceeds or falls below certain pre-agreed levels. The Company plans to operate GNB’s wholly-owned subsidiary bank, GNB Financial, n.a., as a separate subsidiary. As of June 30, 2004, on a consolidated basis, GNB had total assets of $223.4 million, total loans of $166.6 million, total deposits of $189.4 million and shareholders’ equity of $19.4 million. The Company expects to complete the acquisition, subject to shareholder and regulatory approval, in September 2004.

On May 3, 2004, the Company entered into a definitive agreement to purchase the loans and premises and assume the deposit liabilities of the Caldwell, Texas and Lexington, Texas branches of Central Bank, Houston, Texas. Under the terms of the agreement, the Company agreed to pay a premium of 8.02% of total deposits and $800,000 for the related real property and improvements and the related furniture, fixtures and equipment. Because the title work and survey for the Caldwell location was not complete at July 30, 2004, the planned closing date, the definitive agreement was amended to defer the acquisition of the Caldwell real estate and related improvements until a survey and title commitment could be delivered by Central Bank and reviewed and approved by the Company. Pending acquisition of the property at the agreed price of $395,000, the Company entered into a 60-day lease of the facility for a nominal rent.

Except for the Caldwell facility, the acquisition was completed on July 30, 2004. On such date, deposits at both branches totaled $99.2 million and loans totaled $33.1 million. Based on these totals, the Company paid approximately $8.4 million to acquire these branches, not including the $395,000 purchase price for the Caldwell facility.

Recent Developments. Pursuant to a registration statement on Form S-1 filed with, and declared effective by, the Securities and Exchange Commission, the Company sold 2,000,000 shares of its common stock at $17.00 per share to the public in an underwritten firm commitment offering which closed on August 10, 2004. The Company has also granted the underwriters a 30-day option to purchase an additional 300,000 shares to cover over-allotments, if any. Of the $31.6 million in net proceeds, after deduction of underwriting discounts and commissions and $500,000 in estimated offering expenses, approximately $10.0 million was used to repay the Company’s outstanding line of credit which was used as additional capital to support the acquisition of the additional assets from the Central Bank branches. In addition, approximately $18.4 million of the net proceeds will be used to pay the cash portion of the merger consideration to be paid to GNB shareholders and the balance will be used for general corporate purposes, including contributions to the capital of State Bank, the possible opening of additional branches and the possible acquisition of financial institutions.

The Company has $1.5 million in outstanding loans to a borrower that filed Chapter 11 bankruptcy on August 3, 2004. The loan is secured by eight parcels of real property with an aggregate appraised value of approximately $3.5 million. While management believes that the collateral is adequate security for this loan, there can be no assurance that the Company will be able to sell the real property in a timely manner or for the appraised value.

General. The Company is a bank holding company formed in 1995 as a bank holding company for State Bank, which was chartered in 1906. The Company adopted its current name, Texas United Bancshares, Inc., in June 1998 after the merger of South Central Texas Bancshares, Inc. with and into the Company, which was then named Premier Bancshares, Inc. The Company derives substantially all of its net income from its wholly-owned subsidiary State Bank. At June 30, 2004, through State Bank, the Company had 18 full service banking centers and three loan production offices serving 11 counties in primarily between the Houston, Austin and San Antonio metropolitan areas in central and south central Texas. In addition, the Company has eight loan production offices of CHL located in Houston and San Antonio.

        Net earnings for the three months ended June 30, 2004 was $1.5 million, an increase of 7.4% compared with $1.4 million for the same period in 2003. The increase in net earnings was a combined result of higher net interest income and increased non-interest income, partially offset by higher non-interest expense. Net earnings for the six months ended June 30, 2004 was $3.1 million, representing an increase of 21.3% compared with $2.5 million for the same period in 2003. This increase was primarily due to gains on the sale of mortgage loans generated by CHL, a decrease in the provision for loan losses and an increase in net interest income, partially offset by a decrease in mortgage servicing revenue and lower securities gains compared with the same period in 2003. Basic and diluted earnings per share (EPS) for the three months ended June 30, 2004 were $0.37 and $0.36 compared with $0.35 and $0.34 for the same period in 2003. For the six months ended June 30, 2004, basic and diluted EPS were $0.76 and $0.73, respectively, compared with $0.64 and $0.61 respectively, for the same period in 2003.

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At June 30, 2004, total assets were $751.6 million compared with $637.7 million at December 31, 2003. The $113.9 million or 17.9% increase in total assets over December 31, 2003 was primarily attributable to increases in investment securities, net loans and loans held for sale. At June 30, 2004, net loans, including loans held for sale, were $431.0 million compared with $380.4 million at December 31, 2003. Total deposits at June 30, 2004 were $567.4 million compared to $501.1 million at December 31, 2003. The $66.3 million or 13.2% increase in deposits compared with December 31, 2003 is primarily attributed to internal growth. Shareholders’ equity at June 30, 2004 was $37.6 million compared with $38.0 million at December 31, 2003. The $417,000 or 1.1% decrease is attributed to deterioration in the fair market value on available-for-sale securities included in accumulated other comprehensive income partially offset by earnings retention. The Company’s return on average assets was 0.90% for the six months ended June 30, 2004, compared with 0.85% for the same period in 2003. The return on average shareholders’ equity was 15.73% for the six months ended June 30, 2004, up from 13.48% for the same period in 2003.

Net Interest Income. For the three months ended June 30, 2003, net interest income, before the provision for loan losses, increased by 8.9% to $7.1 million from $6.6 million in the same period in 2003. The increase was primarily due to the increased volumes in loans and investment securities and the strategic lowering of the cost of funds in relation to the decrease in rates on earning assets. This has resulted in slightly lower yields on earning assets partially offset by lower rates paid for interest-bearing liabilities. For the three months ended June 30, 2004 and 2003, the net interest margin decreased by 53 basis points to 4.46% from 4.99% and the net interest spread decreased by 46 basis points to 4.22% from 4.68%, respectively.

For the six months ended June 30, 2004, net interest income, before the provision for loan losses, increased by 7.6% to $13.8 million compared with $12.8 million over the same period in 2003. For the six months ended June 30, 2004 and 2003, the net interest margins and spreads decreased by 42 basis points to 4.57% from 4.99% and by 35 basis points to 4.34% from 4.69%, respectively. The decrease of the net interest margin was a combined result of lower yields in investments and loan balances, and a decrease in the cost of funds.

Interest income for the three months ended June 30, 2004 was $9.9 million compared with $9.3 million for the same period in 2003. As compared to the three months ended June 30, 2003, the average total loan volumes for the three months ended June 30, 2004 increased by $56.9 million or 15.5%, while the average yields on average total loan volumes decreased 85 basis points to 7.57%. Average total investment volumes for the three month ended June 30, 2004 increased by $61.8 million or 39.3% compared with the same period in 2003, while the average yields on average investments decreased by 33 basis points. For the three months ended June 30, 2004, compared to the same period in 2003, the yield on total average earning assets decreased by 88 basis points to 6.18%.

Interest income for the six months ended June 30, 2004 was $19.1 million compared with $18.3 million for the same period in 2003. In a period of decreasing interest rates, this increase was maintained through growth in average earning assets. As compared to the six months ended June 30, 2003, the average total loan volumes for the six month period ended June 30, 2004 increased by $35.2 million or 9.4%, while the average yields on average total loans decreased by 63 basis points to 7.64%. Compared with the six months ended June 30, 2003, average total investment volumes for the six months ended June 30, 2004 increased by $54.9 million or 38.4%, while the average yields on average investment securities decreased by 46 basis points. For the six months ended June 30, 2004 compared with the same period in 2003, the yield on total average earning assets decreased by 78 basis points to 6.33%.

Interest expense increased for the three months ended June 30, 2004 by $47,000 or 1.7% to $2.8 million, compared with $2.7 million for the same period in 2003. The increased interest expense was the result of higher average interest-bearing deposit volumes coupled with overall lower interest rates paid on those deposits. Compared with the three month period ended June 30, 2003, average interest bearing deposit volumes for the three months ended June 30, 2004 increased by $72.9 million or 19.1%, while the average rates paid on interest-bearing deposits decreased by 26 basis points to 1.8%.

For the six months ended June 30, 2004, interest expense decreased by $144,000 or 2.6% to $5.3 million compared with $5.5 million for the same period in 2003. The decreased interest expense was mainly the result of lower interest rates paid on deposits. The decrease in rates in the comparative six month periods was greater than the decrease in rates during the comparative three month periods. Compared with the six months ended June 30, 2003, average interest-bearing deposit volumes increased by $64.8 million or 17.3%, while the average rates paid on interest-bearing deposits decreased by 34 basis points to 1.8%.

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The following tables set forth for the periods indicated an analysis of net interest income by each major category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding and the interest earned or paid on such amounts. The tables also set forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities and the net interest margin on average total interest-earning assets for the same periods. All average balances are daily average balances and nonaccruing loans have been included in the table as loans carrying a zero yield.