PROSPERITY BANCSHARES INC - 10-Q Quarterly Report

FORM 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER: 000-25051

PROSPERITY BANCSHARES, INC.^®

(Exact name of registrant as specified in its charter)

TEXAS

74-2331986

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

Prosperity Bank Plaza

4295 San Felipe

Houston, Texas 77027

(Address of principal executive offices, including zip code)

(713) 693-9300

(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 x No ¨

As of November 5, 2004, there were 22,379,953 shares of the registrant’s Common Stock, par value $1.00 per share, outstanding.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

INDEX TO FORM 10-Q


		Page
PART I - FINANCIAL INFORMATION

Item 1.	Interim Financial Statements	3
	Consolidated Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003 (unaudited)	3
	Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2004 and 2003 (unaudited)	4
	Consolidated Statements of Shareholders’ Equity for the Year Ended December 31, 2003 (unaudited) and for the Nine Months Ended September 30, 2004 (unaudited)	5
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003 (unaudited)	6
	Notes to Interim Consolidated Financial Statements (unaudited)	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	26
Item 4.	Controls and Procedures	26

PART II - OTHER INFORMATION

Item 1.	Legal Proceedings	27
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	27
Item 3.	Defaults upon Senior Securities	27
Item 4.	Submission of Matters to a Vote of Security Holders	27
Item 5.	Other Information	27
Item 6.	Exhibits and Reports on Form 8-K	27
Signatures		28

PART I – FINANCIAL INFORMATION

ITEM 1. INTERIM FINANCIAL STATEMENTS

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)


	September 30, 2004			December 31, 2003
	(Dollars in thousands, except par value and share data)
ASSETS
Cash and due from banks	$	60,874		$	71,983
Federal funds sold		71,995			11,730

Total cash and cash equivalents		132,869			83,713
Interest-bearing deposits in financial institutions		600			262
Available for sale securities, at fair value (amortized cost of $196,259 and $260,533, respectively)		193,396			263,648
Held to maturity securities, at cost (fair value of $1,165,039 and $1,122,451, respectively)		1,160,182			1,113,232
Loans		1,007,420			770,053
Less allowance for credit losses		(12,861	)		(10,345	)

Loans, net		994,559			759,708
Accrued interest receivable		10,140			10,119
Goodwill		150,585			118,012
Core deposit intangibles, net of accumulated amortization of $2,231 and $1,010, respectively		13,300			6,743
Bank premises and equipment, net		36,331			34,299
Other real estate owned		535			246
Other assets		20,817			10,505

TOTAL	$	2,713,314		$	2,400,487

LIABILITIES AND SHAREHOLDERS’ EQUITY
LIABILITIES:
Deposits:
Noninterest-bearing	$	527,845		$	467,389
Interest-bearing		1,799,434			1,616,359

Total deposits		2,327,279			2,083,748
Other borrowings		13,315			11,929
Securities sold under repurchase agreements		28,153			19,007
Accrued interest payable		2,717			2,522
Other liabilities		12,781			3,889
Junior subordinated debentures		59,804			59,804

Total liabilities		2,444,049			2,180,899
SHAREHOLDERS’ EQUITY:
Common stock, $1 par value; 50,000,000 shares authorized; 22,415,541 and 20,966,706 shares issued at September 30, 2004 and December 31, 2003, respectively; 22,378,453 and 20,929,618 shares outstanding at September 30, 2004 and December 31, 2003, respectively		22,416			20,967
Capital surplus		134,160			102,594
Retained earnings		115,157			94,610
Accumulated other comprehensive income (loss) — net unrealized (loss) gain on available for sale securities, net of tax benefit of $1,002 and tax of $1,090, respectively		(1,861	)		2,024
Less treasury stock, at cost, 37,088 shares at September 30, 2004 and December 31, 2003, respectively		(607	)		(607	)

Total shareholders’ equity		269,265			219,588

TOTAL	$	2,713,314		$	2,400,487

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
	(Dollars in thousands, except per share data)
INTEREST INCOME:
Loans, including fees	$	14,760	$	11,675	$	39,222	$	34,630
Securities:
Taxable		13,320		8,758		40,041		28,431
Nontaxable		359		395		1,115		1,228
70% nontaxable preferred dividends		183		452		825		1,327
Federal funds sold.		136		82		238		162
Deposits in financial institutions		5		3		7		14

Total interest income.		28,763		21,365		81,448		65,792

INTEREST EXPENSE:
Deposits		6,316		5,459		17,783		17,074
Junior subordinated debentures		1,044		675		3,011		1,840
Federal funds sold and other borrowings		336		241		889		782

Total interest expense		7,696		6,375		21,683		19,696

NET INTEREST INCOME		21,067		14,990		59,765		46,096
PROVISION FOR CREDIT LOSSES		420		120		660		360

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES		20,647		14,870		59,105		45,736

NONINTEREST INCOME:
Customer service fees		5,237		3,523		14,827		10,148
Other		874		803		1,933		2,022
Gain on sale of securities		—		—		78		—

Total noninterest income		6,111		4,326		16,838		12,170

NONINTEREST EXPENSE:
Salaries and employee benefits		7,147		5,259		20,459		15,943
Net occupancy expense		1,499		1,045		4,055		2,988
Data processing		540		453		1,473		1,728
Core deposit intangible amortization		455		207		1,220		590
Depreciation expense		728		634		2,118		1,855
Other		2,825		2,109		8,395		6,461

Total noninterest expense.		13,194		9,707		37,720		29,565

INCOME BEFORE INCOME TAXES		13,564		9,489		38,223		28,341
PROVISION FOR INCOME TAXES		4,618		3,019		12,852		8,986

NET INCOME	$	8,946	$	6,470	$	25,371	$	19,355

EARNINGS PER SHARE
Basic	$	0.41	$	0.34	$	1.19	$	1.02

Diluted	$	0.40	$	0.34	$	1.18	$	1.01

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(UNAUDITED)


	Common Stock			Capital Surplus			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Total Shareholders’ Equity
	Shares	Amount		Capital Surplus			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Total Shareholders’ Equity
	(Amounts in thousands, except share data)
BALANCE AT DECEMBER 31, 2002	18,903,028	$	18,903	$	60,312		$	72,917		$	2,644		$	(37	)	$	154,739
Net income								26,548									26,548
Net change in unrealized gain (loss) on available for sale securities.											(620	)					(620	)

Total comprehensive income																	25,928

Exercise of stock options	170,638		171		824												995
Refund of escrow shares in connection with the Paradigm acquisition														(570	)		(570	)
Common stock issued in connection with the MainBancorp acquisition	1,499,966		1,500		33,149												34,649
Common stock issued in connection with the FSBNT acquisition	393,074		393		8,538												8,931
Stock option compensation					25												25
Junior subordinated debentures issuance costs					(254	)											(254	)
Cash dividends declared, $0.25 per share								(4,855	)								(4,855	)

BALANCE AT DECEMBER 31, 2003	20,966,706		20,967		102,594			94,610			2,024			(607	)		219,588
Net income								25,371									25,371
Net change in unrealized gain (loss) on available for sale securities											(3,885	)					(3,885	)

Total comprehensive income																	21,486

Exercise of stock options	203,644		204		808												1,012
Stock option compensation					45												45
Common stock issued in connection with the Liberty Bancshares acquisition	1,245,191		1,245		30,713												31,958
Cash dividends declared, $0.225 per share								(4,824	)								(4,824	)

BALANCE AT SEPTEMBER 30, 2004	22,415,541	$	22,416	$	134,160		$	115,157		$	(1,861	)	$	(607	)	$	269,265

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)


	Nine Months Ended September 30,
	2004			2003
	(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	25,371		$	19,355
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,338			2,445
Provision for credit losses		660			360
Net amortization of discount on investments		3,848			8,210
Loss (gain) on sale of other real estate		14			(22	)
Gain on sale of premises and equipment		(321	)		(244	)
(Increase) decrease in other assets and accrued interest receivable		(5,237	)		78
Increase (decrease) in accrued interest payable and other liabilities		7,088			(4,569	)

Total adjustments		9,390			6,258

Net cash provided by operating activities		34,761			25,613

CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities and principal paydowns of held to maturity securities		203,661			418,359
Purchase of held to maturity securities		(251,278	)		(698,911	)
Proceeds from maturities and principal paydowns of available for sale securities		73,304			108,782
Purchase of available for sale securities		—			(11,949	)
Net (increase) decrease in loans		(39,611	)		33,058
Purchase of bank premises and equipment		(901	)		(3,119	)
Net decrease in interest-bearing deposits in financial institutions		362			286
Proceeds acquired from sale of bank premises, equipment, and other real estate		1,543			1,674
Premium paid for the purchase of Liberty Bancshares		(22,914	)		—
Net liabilities acquired in the purchase of Liberty Bancshares (net of cash acquired of $46,599)		64,115			—
Premium paid for the purchase of Village Bank and Trust, SSB		(12,154	)		—
Net liabilities acquired in the purchase of Village Bank and Trust, SSB (net of cash acquired of $16,120)		8,579			—
Premium paid for the purchase of Dallas Bancshares		—			(2,982	)
Net liabilities acquired in the purchase of Dallas Bancshares (net of cash acquired of $10,517)		—			6,269
Premium paid for the purchase of Abrams Centre National Bancshares		—			(6,992	)
Net liabilities acquired in the purchase of Abrams Centre National Bancshares (net of cash acquired of $38,458)		—			28,203

Net cash provided by (used in) investing activities		24,706			(127,322	)

(Table continued on following page)


	Nine Months Ended September 30,
	2004			2003
	(Dollars in thousands)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease) increase in noninterest-bearing deposits		(405	)		86,975
Net (decrease) increase in interest-bearing deposits		(14,011	)		52,800
Proceeds from the issuance of junior subordinated debentures		—			12,500
Junior subordinated debentures issuance costs		—			(129	)
Net repayments of other borrowings		(1,230	)		(24,202	)
Net increase in securities sold under repurchase agreements		9,146			—
Proceeds from exercise of stock options		1,012			372
Payments of cash dividends		(4,823	)		(3,551	)

Net cash (used in) provided by financing activities		(10,311	)		124,765

NET INCREASE IN CASH AND CASH EQUIVALENTS	$	49,156		$	23,056
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		83,713			80,799

CASH AND CASH EQUIVALENTS, END OF PERIOD	$	132,869		$	103,855

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

1. BASIS OF PRESENTATION

The interim consolidated financial statements include the accounts of Prosperity Bancshares, Inc. ^®(the “Company”) and its wholly-owned subsidiaries, Prosperity Bank ^®(the “Bank”) and Prosperity Holdings of Delaware, L.L.C. All significant inter-company transactions and balances have been eliminated. Prior period data has been restated to reflect the adoption of FIN 46R on January 1, 2004.

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the statements reflect all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows of the Company on a consolidated basis, and all such adjustments are of a normal recurring nature. These financial statements and the notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. Operating results for the nine month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

2. INCOME PER COMMON SHARE

The following table illustrates the computation of basic and diluted earnings per share:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
	(In thousands, except per share amounts)
Net income available to common shareholders	$	8,946	$	6,470	$	25,371	$	19,355

Weighted average common shares outstanding		21,843		18,974		21,250		18,948
Potential dilutive common shares		263		280		278		290

Weighted average common shares and equivalents outstanding		22,106		19,254		21,528		19,238

Basic earnings per common share	$	0.41	$	0.34	$	1.19	$	1.02

Diluted earnings per common share	$	0.40	$	0.34	$	1.18	$	1.01

3. NEW ACCOUNTING STANDARDS

FIN No. 46 “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulleting No. 51.” FIN 46 establishes accounting guidance for consolidation of variable interest entities (VIE) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE. Prior to the implementation of FIN 46, VIE’s were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The provisions of FIN 46 were effective immediately for all arrangements entered into after January 31, 2003, and are otherwise effective at the beginning of the first interim period beginning after December 15, 2003. The Company adopted FIN 46 on July 1, 2003.

In December 2003, the FASB issued FIN 46R, “Consolidation of Variable Interest Entities.” FIN 46R provides guidance on how to identify a variable interest entity and determine when the assets, liabilities, non-controlling interests and results of operations of a variable interest entity need to be included in a company’s consolidated financial statements. A company that holds variable interest in an entity is required to consolidate the entity if the company’s interest in the

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

variable interest entity is such that the company will absorb a majority of the variable interest entity’s expected losses and/or receive a majority of the entity’s expected residual returns, if they occur. As of September 30, 2004, the Company had no investments in variable interest entities requiring consolidation. FIN 46R requires that Prosperity Capital Trust I, Prosperity Capital Trust II, Prosperity Statutory Trust III, Prosperity Statutory Trust IV and Paradigm Capital Trust II be deconsolidated from the consolidated financial statements. The Company adopted FIN 46R on January 1, 2004. After adoption, the trust preferred securities issued by each of the foregoing trusts are no longer shown in the consolidated financial statements. Instead, the junior subordinated debentures issued by the Company to each of these trusts are shown as liabilities in the consolidated balance sheets and interest expense associated with such junior subordinated debentures is shown in the consolidated statements of income.

In May 2004, the EITF reached a consensus on Issue 03-03 (EITF 03-03) “Applicability of EITF Abstracts, Topic No. D-79, ‘Accounting for Retroactive Insurance Contracts Purchased by Entities Other Than Insurance Enterprises,’ to Claims-Made Insurance Policies”. This EITF clarifies that a claims-made insurance policy that provides coverage for specific known claims prior to the policy period contains a retroactive provision that should be accounted for accordingly; either separately, if practicable, or, if not practicable, the claims-made insurance policy should be accounted for entirely as a retroactive contract. The Company adopted the provisions of EITF No. 03-03 on January 1, 2004. The adoption of EITF 03-03 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In March 2004, the EITF reached consensus on Issue 03-01 (EITF 03-01), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-01 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. This Issue specifically addresses whether an investor has the ability and intent to hold an investment until recovery. In addition, Issue 03-01 contains disclosure requirements that provide useful information about impairments that have not been recognized as other-than-temporary for investments with in the scope of this Issue. On September 30, 2004, the Financial Accounting Standards Board deferred the effective date of the Issue’s guidance on how to evaluate and recognize an impairment loss that is other-than-temporary. This Issue’s guidance is pending the issuance of a final FASB Staff Position (“FSP”) relating to the draft FSP EITF Issue 03-01-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” which the Board may issue as early as November. This deferral did not change the disclosure guidance which remains effective for fiscal years ending after December 15, 2003. Matters being considered by the FASB which may impact the Company’s financial reporting include the accounting as a component in determining net income for declines in market value of debt securities which are due solely to changes in market interest rates and the effect of sales of available-for-sale securities which have market values below cost at the time of sale and whether such sale indicates an absence of intent and ability of the investor to hold to a forecasted recovery of the investment’s value to its original cost.

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. The Company adopted SFAS 150 on January 1, 2004 and its adoption did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

4. RECENT DEVELOPMENTS

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

FirstCapital is privately held and operates thirty-two (32) banking offices in and around Corpus Christi, Houston and Victoria, Texas. As of September 30, 2004, FirstCapital had, on a consolidated basis, total assets of $773.6 million, loans of $518.2 million, deposits of $638.9 million and shareholders’ equity of $60.0 million. The acquisition is expected to close in the first quarter of 2005 and is subject to the approval of the Company and FirstCapital shareholders and customary regulatory approvals.

On August 1, 2004, the Company completed its acquisition of Village Bank and Trust, s.s.b. (“Village”), Austin, Texas. Under the terms of the agreement, the Company paid approximately $19.1 million in cash for all of the issued and outstanding capital stock of Village. Village was privately held and operated one (1) banking office in the Lakeway area of Austin, Texas. As of June 30, 2004, Village had total assets of $110.9 million, loans of $79.7 million, deposits of $97.3 million and shareholders’ equity of $10.4 million.

In connection with the purchase, the Company paid a cash premium of $12.2 million, of which $1.0 million was identified as core deposit intangibles. The remaining $11.2 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branch were recorded at their fair values at the acquisition date.

On August 1, 2004, the Company completed its acquisition of Liberty Bancshares, Inc. (“Liberty”), Austin, Texas, pursuant to which Liberty merged into the Company and its wholly owned subsidiary, Liberty Bank, S.S.B., merged into the Bank. Under the terms of the agreement, the Company paid approximately $8.9 million in cash and issued approximately 1.3 million shares of its Common Stock for all of the issued and outstanding capital stock of Liberty and Liberty Bank. and all outstanding stock options of Liberty Bank. Liberty was privately held and operated six (6) banking offices in Austin, Texas. As of June 30, 2004, Liberty had, on a consolidated basis, total assets of $178.7 million, loans of $120.3 million, deposits of $158.9 million and shareholders’ equity of $16.5 million.

In connection with the purchase, the Company paid a cash premium of $27.6 million of which $4.6 million was identified as core deposit intangibles. The remaining $23.0 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

5. GOODWILL AND CORE DEPOSIT INTANGIBLES

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles (CDI) for nine months ended September 30, 2004 were as follows:


	Goodwill			Core Deposit Intangibles
	(Dollars in thousands)
Balance as of December 31, 2003	$	118,012		$	6,743
Amortization		—			(1,220	)
Acquisition of Liberty Bancshares, Inc.		22,914			4,636
Acquisition of Village Bank and Trust, SSB.		11,114			1,040
Core deposit intangibles-First State Bank of North Texas		(1,801	)		1,801
Expenses associated with the acquisition of First State Bank of North Texas		(239	)		—
Core deposit intangibles-MainBancorp		(300	)		300
Expenses associated with the acquisition of MainBancorp		96			—
Adjustments associated with the acquisition of Dallas Bancshares (deferred taxes)		(7	)		—
Adjustments associated with the acquisition of Southwest Bank Holding Company (deferred taxes)		796			—

Balance as of September 30, 2004	$	150,585		$	13,300

The Company initially records the total premium paid on acquisitions at management’s best estimate of goodwill and CDI. Subsequent to the acquisition, a third party valuation of CDI is performed. Adjustments to CDI, if necessary, are appropriately reclassified within goodwill. Net income is decreased by the amortization of CDI which is amortized at an accelerated rate over an eight year period from the acquisition date. Adjustments to estimates of deferred taxes that relate to goodwill are made after reconciliations of the final tax returns are prepared. The reclassifications have no effect on total assets, liabilities, shareholders’ equity or cash flows.

6. NONPERFORMING ASSETS

The Company had $2.6 million in nonperforming assets at September 30, 2004 and $967,000 in nonperforming assets at December 31, 2003, an increase of $1.6 million or 165.0%. The increase in nonperforming assets is primarily due to two commercial loans, assumed from previous acquisitions, being placed on nonaccrual status and an additional two loans, assumed from acquisitions, being classified as accruing loans 90 or more days past due.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

The following table presents information regarding nonperforming assets as of the dates indicated.


	September 30, 2004			December 31, 2003
	(Dollars in thousands)
Nonaccrual loans	$	709		$	2
Restructured loans		—			—
Accruing loans 90 or more days past due		1,238			679

Total nonperforming loans		1,947			681
Repossessed assets		81			40
Other real estate		535			246

Total nonperforming assets	$	2,563		$	967

Nonperforming assets to total loans and other real estate		0.25	%		0.13	%

7. SUBSEQUENT EVENT

The Company has notified Wachovia Trust Company, trustee of Prosperity Capital Trust I (the “Trust”), that the Company intends to redeem on December 31, 2004 (the “Redemption Date”), subject to regulatory approval, the $12.4 million in 9.60% Subordinated Debentures due 2029 issued by the Company to the Trust at a redemption price equal to $12.4 million plus all accrued but unpaid interest up to the Redemption Date. In conjunction with the redemption of the Debentures, the Trust will notify the holders of its 9.60% Cumulative Trust Preferred Securities (“Trust Preferred Securities”) and its 9.60% Common Securities (“Common Securities”) of its intention to redeem on the Redemption Date all 1.2 million of its outstanding Trust Preferred Securities and all 38,000 of its outstanding Common Securities at a redemption price equal to the $10.00 liquidation amount of each security plus all accrued but unpaid distributions up to the Redemption Date.

After redemption of the $12.4 million in Debentures issued to Prosperity Capital Trust I, the Company will have outstanding $47.4 million in junior subordinated debentures issued to the Company’s subsidiary trusts.

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 this quarterly report on 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:

•	changes in interest rates and market prices, which could reduce the Company’s net interest margins, asset valuations and expense expectations;

•	changes in the levels of loan prepayments and the resulting effects on the value of the Company’s loan portfolio;

•

changes in local economic and business conditions which adversely affect the Company’s customers and their ability to transact profitable business with the company, including the ability of the Company’s borrowers to repay their loans according to their terms or a change in the value of the related collateral;

•	increased competition for deposits and loans adversely affecting rates and terms;

•

the timing, impact and other uncertainties of future acquisitions, including the Company’s ability to identify suitable future acquisition candidates, the success or failure in the integration of their operations, and the ability to enter new markets successfully and capitalize on growth opportunities;

•	increased credit risk in the Company’s assets and increased operating risk caused by a material change in commercial, consumer and/or real estate loans as a percentage of the total loan portfolio;

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

•	changes in the availability of funds resulting in increased costs or reduced liquidity;

•	increased asset levels and changes in the composition of assets and the resulting impact on the Company’s capital levels and regulatory capital ratios;

•	the Company’s ability to acquire, operate and maintain cost effective and efficient systems without incurring unexpectedly difficult or expensive but necessary technological changes;

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

•	changes in statutes and government regulations or their interpretations applicable to financial holding companies and the Company’s present and future banking and other subsidiaries, including changes in tax requirements and tax rates;

•	acts of terrorism, an outbreak of hostilities or other international or domestic calamities, weather or other acts of God and other matters beyond the Company’s control; and

•	other risks and uncertainties listed from time to time in the Company’s reports and documents filed with the Securities and Exchange Commission.

A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these 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 undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless the securities laws require the Company to do so.

RECENT DEVELOPMENTS

The Company has notified Wachovia Trust Company, trustee of Prosperity Capital Trust I (the “Trust”), that the Company intends to redeem on December 31, 2004 (the “Redemption Date”), subject to regulatory approval, the $12,380,000 in 9.60% Subordinated Debentures due 2029 issued by the Company to the Trust at a redemption price equal to $12,380,000 plus all accrued but unpaid interest up to the Redemption Date. In conjunction with the redemption of the Debentures, the Trust will notify the holders of its 9.60% Cumulative Trust Preferred Securities (“Trust Preferred Securities”) and its 9.60% Common Securities (“Common Securities”) of its intention to redeem on the Redemption Date all 1,200,000 of its outstanding Trust Preferred Securities and all 38,000 of its outstanding Common Securities at a redemption price equal to the $10.00 liquidation amount of each security plus all accrued but unpaid distributions up to the Redemption Date.

On October 26, 2004, the Company announced the signing of a definitive agreement with FirstCapital Bankers, Inc. (“FirstCapital”), Corpus Christi, Texas. Under the terms of the agreement, FirstCapital will merge into the Company and subsequently, FirstCapital’s wholly owned subsidiary, FirstCapital Bank, s.s.b. will merge into the Bank. The Company will issue approximately 5.0 million shares of its common stock, subject to adjustment, for all of the issued and outstanding capital stock of FirstCapital. FirstCapital is privately held and operates thirty-two (32) banking offices in and around Corpus Christi, Houston and Victoria, Texas. As of September 30, 2004, FirstCapital had, on a consolidated basis, total assets of $773.6 million, loans of $518.2 million, deposits of $638.9 million and shareholders’ equity of $60.0 million. The acquisition is expected to close in the first quarter of 2005 and is subject to the approval of the Company and FirstCapital shareholders and customary regulatory approvals.

OVERVIEW

Prosperity Bancshares, Inc. ^® (the “Company”) was formed in 1983 as a vehicle to acquire the former Allied Bank in Edna, Texas which was chartered in 1949 as The First National Bank of Edna. The Company is a registered financial holding company that derives substantially all of its revenues and income from the operation of its bank subsidiary, Prosperity Bank^® (“Prosperity Bank^®” or the “Bank”). The Bank provides a broad line of financial products and services to small and medium-sized businesses and consumers. The Bank operates fifty-eight (58) full-service banking locations; with twenty-nine (29) in the Greater Houston Consolidated Metropolitan Statistical Area (“CMSA”), eleven (11) in eight contiguous counties situated south and southwest of Houston and extending into South Texas, (7) seven in Austin, Texas and eleven (11) in the Dallas/Fort Worth area. The Greater Houston CMSA includes Brazoria, Chambers, Fort Bend, Galveston, Harris, Liberty, Montgomery and Waller counties. The Company’s headquarters are located at Prosperity Bank Plaza, 4295 San Felipe in Houston, Texas and its telephone number is (713) 693-9300. The Company’s website address is www.prosperitybanktx.com. Information contained on the Company’s website is not incorporated by reference into this quarterly report on Form 10-Q and information contained on the Company’s website should not be considered as part of this quarterly report on Form 10-Q.

The Company generates the majority of its revenues from interest income on loans, service charges on customer accounts and income from investment in securities. The revenues are offset by interest expense paid on deposits and other

borrowings and non-interest expenses such as administrative and occupancy expenses. Net interest income is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as deposits and borrowings which are used to fund those assets. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and margin. Although the low rate environment has negatively impacted the Company’s net interest margin, the Company has recognized increased net interest income due primarily to the rates paid on interest-bearing liabilities decreasing faster than the rates earned on interest-earning assets and an increase in the volume of interest-earning assets.

Three principal components of the Company’s growth strategy are internal growth, stringent cost control practices and strategic merger transactions. The Company focuses on continual internal growth. Each Banking Center is operated as a separate profit center, maintaining separate data with respect to its net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking Center Presidents and Managers are accountable for performance in these areas and compensated accordingly. The Company also focuses on maintaining stringent cost control practices and policies. The Company has invested significantly in the infrastructure required to centralize many of its critical operations, such as data processing and loan application processing. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale. The Company also intends to continue to seek expansion opportunities. During 2003, the Company acquired eleven (11) banking centers in the Dallas/Fort Worth area and in July 2004, the Company acquired seven (7) banking centers in Austin, Texas. On October 26, 2004 the Company signed a definitive agreement to acquire FirstCapital, which has an additional thirty-two (32) banking centers in and around Corpus Christi, Houston and Victoria.

Total assets were $2.71 billion at September 30, 2004 compared with $2.40 billion at December 31, 2003. Total loans were $1.01 billion at September 30, 2004 compared with $770.1 million at December 31, 2003, an increase of $237.4 million or 30.8%. Total deposits were $2.33 billion at September 30, 2004 compared with $2.08 billion at December 31, 2003. Shareholders’ equity increased $49.7 million or 22.6%, to $269.3 million at September 30, 2004 compared with $219.6 million at December 31, 2003.

CRITICAL ACCOUNTING POLICIES

The Company’s accounting policies are integral to understanding the financial results reported. Accounting policies are described in detail in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. The Company believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity:

Allowance for Credit Losses - The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company’s loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank’s Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company’s commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company’s loan portfolio, current economic changes that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process and other relevant factors. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. Charge-offs occur when loans are deemed to be uncollectible. The allowance for credit losses includes allowance allocations calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS 118, and allowance allocations determined in accordance with SFAS No. 5, “Accounting for Contingencies.”

Valuation of Securities – The Company’s available for sale securities portfolio is reported at fair value. When the fair value of a security is below its amortized cost, and depending on the length of time the condition exists and the extent the fair market value is below amortized cost, additional analysis is performed to determine whether an impairment exists. Available for sale and held to maturity securities are analyzed quarterly for possible other-than-temporary impairment. The analysis considers the financial condition and near-term prospects of the issuer, as well as the value of any security we may have in the investment. Often, the information available to conduct these assessments is limited and rapidly changing, making estimates of fair value subject to judgment. If actual information or conditions are different than estimated, the extent of the impairment of the security may be different than previously estimated, which could have a material effect on our results of operations and financial condition.

RESULTS OF OPERATIONS

Net income available to common shareholders was $8.9 million ($0.40 per common share on a diluted basis) for the quarter ended September 30, 2004 compared with $6.5 million ($0.34 per common share on a diluted basis) for the quarter ended September 30, 2003, an increase in net income of $2.5 million, or 38.3%. The Company posted returns on average common equity of 14.42% and 15.45%, returns on average assets of 1.37% and 1.29% and efficiency ratios of 48.55% and 50.25% for the quarters ended September 30, 2004 and 2003, respectively. The efficiency ratio is not calculated on a tax equivalent basis.

For the nine months ended September 30, 2004, net income available to common shareholders was $25.4 million ($1.18 per common share on a diluted basis) compared with $19.4 million ($1.01 per common share on a diluted basis) for the same period in 2003, an increase in net income of $6.0 million or 31.1%. The Company posted returns on average common equity of 14.49% and 15.83%, returns on average assets of 1.36% and 1.34% and efficiency ratios of 49.29% and 50.74% for the nine months ended September 30, 2004 and 2003, respectively. The efficiency ratio is not calculated on a tax equivalent basis.

Net Interest Income

Net interest income was $21.1 million for the quarter ended September 30, 2004 compared with $15.0 million for the quarter ended September 30, 2003, an increase of $6.1 million, or 40.5%. Net interest income increased as a result of an increase in average interest-earning assets to $2.35 billion for the quarter ended September 30, 2004 from $1.83 billion for the quarter ended September 30, 2003, an increase of $523.8 million, or 28.6%. The increase in average earning assets is primarily attributable to increases in average loans and securities from the quarter ended September 30, 2003 compared to the quarter ended September 30, 2004 resulting from the MainBancorp (“MainBancorp”) and First State Bank of North Texas (“FSBNT”) acquisitions in the fourth quarter of 2003 and the Liberty and Village acquisitions in the third quarter of 2004.

The net interest margin increased to 3.64% for the quarter ended September 30, 2004 compared with 3.39% for the quarter ended September 30, 2003. The rate paid on interest-bearing liabilities decreased 8 basis points from 1.74% for the quarter ended September 30, 2003 to 1.66% for the quarter ended September 30, 2004 while the yield on earning assets increased 22 basis points from 4.67% for the quarter ended September 30, 2003 to 4.89% for the quarter ended September 30, 2004. The average of interest-bearing liabilities increased $386.3 million and the average of interest earning assets increased $523.8 million for the same periods.

Net interest income increased $13.7 million, or 29.7%, to $59.8 million for the nine months ended September 30, 2004 from $46.1 million for the same period in 2003. This increase is mainly attributable to higher average interest-earning assets resulting from an increase in average loans and securities. The net interest margin decreased to 3.61% compared with 3.62% for the same periods principally due to a 19 basis point decrease in the yield on earning assets from 5.00% for the nine months ended September 30, 2003 compared with 4.81% for the nine months ended September 30, 2004, partially offset by a 24 basis point decrease in the rate paid on interest-bearing liabilities from 1.85% for the nine months ended September 30, 2003 compared with 1.61% for the nine months ended September 30, 2004.

The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “rate change.”

The Company adopted FIN 46R on January 1, 2004. FIN 46R requires that Prosperity Capital Trust I, Prosperity Capital Trust II, Prosperity Statutory Trust III, Prosperity Statutory Trust IV and Paradigm Capital Trust II be deconsolidated from the consolidated financial statements. After adoption, the trust preferred securities issued by each of the foregoing trusts are no longer shown in the consolidated financial statements. Instead, the junior subordinated debentures issued by the Company to each of these trusts are shown as liabilities in the consolidated balance sheets and interest expense associated with such junior subordinated debentures is shown in the consolidated statements of income. The interest expense associated with the junior subordinated debentures for the three and nine months ended September 30, 2003 was previously shown as non-interest expense. Prior period data has been restated to reflect the adoption of FIN 46R on January 1, 2004.

The following tables set forth, for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest earned or paid on such amounts, and the average rate earned or paid for the quarters ended September 30, 2004 and 2003 and the nine months ended September 30, 2004 and 2003. The tables also set forth the average rate paid on total interest-bearing liabilities, and the net interest margin on average total interest-earning assets for the same

periods. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield.


	Three Months Ended September 30,
	2004							2003
	Average Outstanding Balance			Interest Earned/ Paid		Average Yield/ Rate (4)		Average Outstanding Balance			Interest Earned/ Paid		Average Yield/ Rate (4)
	(Dollars in thousands)
Assets
Interest-earning assets:
Loans	$	928,375		$	14,760	6.36	%	$	699,382		$	11,675	6.68	%
Securities(1)		1,387,445			13,862	4.00			1,093,201			9,605	3.51
Federal funds sold and other temporary investments		38,437			141	1.47			37,827			85	0.90

Total interest-earning assets		2,354,257			28,763	4.89	%		1,830,410			21,365	4.67	%

Less allowance for credit losses		(11,967	)						(9,254	)

Total interest-earning assets, net of allowance		2,342,290							1,821,156
Noninterest-earning assets		261,885							184,872

Total assets	$	2,604,175						$	2,006,028

Liabilities and shareholders’ equity
Interest-bearing liabilities:
Interest-bearing demand deposits	$	479,891		$	1,245	1.04	%	$	374,638		$	1,004	1.07	%
Savings and money market accounts		513,768			1,064	0.83			399,054			780	0.78
Certificates of deposit		753,910			4,007	2.13			621,971			3,675	2.36
Junior subordinated debentures		59,804			1,044	6.98			40,474			675	6.67
Federal funds purchased and other Borrowings		45,164			336	2.98			30,058			241	3.21

Total interest-bearing liabilities		1,852,537			7,696	1.66	%		1,466,195			6,375	1.74	%

Noninterest-bearing liabilities:
Noninterest-bearing demand deposits		491,471							363,160
Other liabilities		12,024							9,145

Total liabilities		2,356,032							1,838,500

Shareholders’ equity		248,143							167,528

Total liabilities and shareholders’ equity	$	2,604,175						$	2,006,028

Net interest rate spread						3.23	%						2.93	%

Net interest income and margin (2)				$	21,067	3.58	%				$	14,990	3.28	%

Net interest income and margin (tax-equivalent basis) (3)				$	21,452	3.64	%				$	15,503	3.39	%

(1)	Yield is based on amortized cost and does not include any component of unrealized gains or losses.

(2)	The net interest margin is equal to net interest income divided by average interest-earning assets.

(3)	In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax-equivalent adjustment has been computed using a federal income tax rate of 35%.

(4)	Annualized.


	Nine Months Ended September 30,
	2004							2003
	Average Outstanding Balance			Interest Earned/ Paid		Average Yield/ Rate (4)		Average Outstanding Balance			Interest Earned/ Paid		Average Yield/ Rate (4)
	(Dollars in thousands)
Assets
Interest-earning assets:
Loans	$	824,275		$	39,222	6.34	%	$	683,325		$	34,630	6.76	%
Securities(1)		1,403,263			41,981	3.99			1,048,804			30,986	3.94
Federal funds sold and other temporary investments		28,311			245	1.15			22,753			176	1.03

Total interest-earning assets		2,255,849			81,448	4.81	%		1,754,882			65,792	5.00	%

Less allowance for credit losses		(10,948	)						(9,385	)

Total interest-earning assets, net of allowance		2,244,901							1,745,497
Noninterest-earning assets		243,728							178,991

Total assets	$	2,488,629						$	1,924,488

Liabilities and shareholders’ equity
Interest-bearing liabilities:
Interest-bearing demand deposits	$	479,150		$	3,689	1.03	%	$	354,569		$	3,080	1.16	%
Savings and money market accounts		486,330			2,815	0.77			388,987			2,618	0.90
Certificates of deposit		723,885			11,279	2.08			601,476			11,376	2.52
Junior subordinated debentures		59,804			3,011	6.71			36,178			1,840	6.78
Federal funds purchased and other borrowings		41,289			889	2.87			34,574			782	3.02

Total interest-bearing liabilities		1,790,458			21,683	1.61	%		1,415,784			19,696	1.85	%

Noninterest-bearing liabilities:
Noninterest-bearing demand deposits		454,878							335,533
Other liabilities		9,895							10,163

Total liabilities		2,255,231							1,761,480

Shareholders’ equity		233,398							163,008

Total liabilities and shareholders’ equity	$	2,488,629						$	1,924,488

Net interest rate spread						3.20	%						3.15	%
Net interest income and margin(2)				$	59,765	3.53	%				$	46,096	3.50	%

Net interest income and margin (tax-equivalent basis)(3)				$	61,050	3.61	%				$	47,635	3.62	%

(1)	Yield is based on amortized cost and does not include any component of unrealized gains or losses.

(2)	The net interest margin is equal to net interest income divided by average interest-earning assets.

(3)	In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax-equivalent adjustment has been computed using a federal income tax rate of 35%.

(4)	Annualized.

The following tables present the dollar amount of changes in interest income and interest expense for the major components of interest-earning assets and interest-bearing liabilities and distinguish between the increase (decrease) related to outstanding balances and the volatility of interest rates. For purposes of these tables, changes attributable to both rate and volume which cannot be segregated have been allocated to rate.


	Three Months Ended September 30,
	2004 vs. 2003
	Increase (Decrease) Due to
	Volume		Rate			Total
	(Dollars in thousands)
Interest-earning assets:
Loans	$	3,823	$	(738	)	$	3,085
Securities		2,585		1,672			4,257
Federal funds sold and other temporary investments		1		55			56

Total increase in interest income		6,409		989			7,398

Interest-bearing liabilities:
Interest-bearing demand deposits		282		(41	)		241
Savings and money market accounts		224		60			284
Certificates of deposit		780		(448	)		332
Junior subordinated debentures		322		47			369
Federal funds purchased and other borrowings		121		(26	)		95

Total increase (decrease) in interest expense		1,729		(408	)		1,321

Increase in net interest income	$	4,680	$	1,397		$	6,077


	Nine Months Ended September 30,
	2004 vs. 2003
	Increase (Decrease) Due to
	Volume		Rate			Total
	(Dollars in thousands)
Interest-earning assets:
Loans	$	7,143	$	(2,551	)	$	4,592
Securities		10,472		523			10,995
Federal funds sold and other temporary investments		43		26			69

Total increase (decrease) in interest income		17,658		(2,002	)		15,656

Interest-bearing liabilities:
Interest-bearing demand deposits		1,082		(473	)		609
Savings and money market accounts		655		(458	)		197
Certificates of deposit		2,315		(2,412	)		(97	)
Junior subordinated debentures		1,202		(31	)		1,171
Federal funds purchased and other borrowings		152		(45	)		107

Total increase (decrease) in interest expense		5,406		(3,419	)		1,987

Increase in net interest income	$	12,252	$	1,417		$	13,669

Provision for Credit Losses

Management actively monitors the Company’s asset quality and provides specific loss provisions when necessary. Provisions for credit losses are charged to income to bring the total allowance for credit losses to a level deemed appropriate by management of the Company based on such factors as historical credit loss experience, industry diversification of the commercial loan portfolio, the amount of nonperforming loans and related collateral, the volume growth and composition of the loan portfolio, current economic conditions that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the loan portfolio through the internal loan review function and other relevant factors.

Loans are charged-off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the provision for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations.

The Company made a $420,000 provision for credit losses for the quarter ended September 30, 2004 and a $120,000 provision for the quarter ended September 30, 2003. The Company made a $660,000 provision for credit losses for the nine months ended September 30, 2004 and a $360,000 provision for the nine months ended September 30, 2003. Both increases in the provision for credit losses were in response to an increase in nonperforming assets from $967,000 at December 31, 2003 to

$2.6 million at September 30, 2004. The ratio of the allowance for credit losses to end of period nonperforming loans was 660.6% for the nine months ended September 30, 2004 compared with 1,519.1% for the year ended December 31, 2003. For the quarter ended September 30, 2004, net charge-offs were $295,000 compared with net charge-offs of $287,000 for the quarter ended September 30, 2003. Net charge-offs were $509,000 for the nine months ended September 30, 2004 compared with $1.4 million for the nine months ended September 30, 2003.

Noninterest Income

The Company’s primary sources of noninterest income are service charges on deposit accounts, which include insufficient funds charges, and other banking- related service fees. Noninterest income does not include loan origination fees which are recognized over the life of the related loan as an adjustment to yield using the interest method. Banking-related service fees include check cashing fees, official check fees, safe deposit box rent and currency handling fees. Noninterest income totaled $6.1 million for the three months ended September 30, 2004 compared with $4.3 million for the same period in 2003, an increase of $1.8 million, or 41.3%. Noninterest income increased $4.7 million, or 38.4%, to $16.8 million for the nine months ended September 30, 2004 compared with $12.2 million for the same period in 2003. Both increases were primarily due to higher service charges on deposit accounts resulting from the addition of approximately 27,000 deposit accounts obtained in connection with the MainBancorp and FSBNT acquisitions in the fourth quarter of 2003 and the Liberty and Village acquisitions in third quarter of 2004.

The following table presents for the periods indicated the major categories of noninterest income:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
	(Dollars in thousands)
Service charges on deposit accounts	$	5,237	$	3,523	$	14,827	$	10,148
Banking-related service fees		260		192		733		564
Trust and investment income		42		152		155		374
Gain on sale of assets		198		219		308		265
Gain on sale of securities		—		—		78		—
Other noninterest income		374		240		737		819

Total noninterest income	$	6,111	$	4,326	$	16,838	$	12,170

Noninterest Expense

Noninterest expense totaled $13.2 million for the quarter ended September 30, 2004 compared with $9.7 million for the quarter ended September 30, 2003, an increase of $3.5 million, or 35.9%. This increase occurred primarily in salaries and employee benefits, core deposit intangibles amortization and advertising expense which is a component of other expenses. Noninterest expense totaled $37.7 million for the nine months ended September 30, 2004 compared with $29.6 million for the nine months ended September 30, 2003, an increase of $8.2 million, or 27.6%. The increases during both periods are primarily

due to the MainBancorp and FSBNT acquisitions in the fourth quarter of 2003 and the Liberty and Village acquisitions in the third quarter of 2004. The following table presents, for the periods indicated, the major categories of noninterest expense:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
	(Dollars in thousands)
Salaries and employee benefits	$	7,147	$	5,259	$	20,459	$	15,943
Non-staff expenses:
Occupancy and equipment expense		1,244		1,045		3,347		2,988
Depreciation		728		634		2,118		1,855
Data processing		540		453		1,473		1,728
Communications expense		771		634		2,200		1,874
Professional fees		368		162		757		557
Regulatory assessments and FDIC insurance		129		112		385		318
Ad valorem and franchise taxes		299		209		823		605
Core deposit intangibles amortization		456		207		1,220		590
Other		1,512		992		4,938		3,107

Total non-staff expenses		6,047		4,448		17,261		13,622

Total noninterest expense	$	13,194	$	9,707	$	37,720	$	29,565

Salaries and employee benefit expenses were $7.1 million for the quarter ended September 30, 2004 compared with $5.3 million for the quarter ended September 30, 2003, an increase of $1.9 million, or 35.9%. For the nine months ended September 30, 2004, salaries and employee benefit expenses were $20.5 million, an increase of $4.5 million or 28.3% compared with $15.9 million for the nine months ended September 30, 2003. The increases during both periods were principally due to additional staff associated with the MainBancorp and FSBNT acquisitions in 2003 and the Liberty and Village acquisitions in 2004. The number of full-time equivalent (FTE) associates employed by the Company increased from 512 at September 30, 2003 to 653 at September 30, 2004.

Non-staff expenses increased $1.6 million, or 35.9%, to $6.0 million for the quarter ended September 30, 2004 compared with $4.4 million during the same period in 2003. Non-staff expenses increased $3.6 million, or 26.7%, to $17.3 million for the nine months ended September 30, 2004 compared to $13.6 million during the same period in 2003. The increases during both periods were principally due to additional expenses associated with the MainBancorp, FSBNT, Liberty and Village acquisitions, increases in core deposit intangibles amortization related to the 2003 and 2004 acquisitions and increases in advertising expenses which are included as a component of other expenses.

Income Taxes

Income tax expense increased $1.6 million to $4.6 million for the quarter ended September 30, 2004 compared with $3.0 million for the same period in 2003. For the nine months ended September 30, 2004, income tax expense totaled $12.9 million, an increase of $3.9 million or 43.0% compared with $9.0 million for the same period in 2003. Both increases were primarily attributable to higher pretax net earnings for the quarter and nine months ended September 30, 2004 when compared to the same respective periods in 2003.

FINANCIAL CONDITION

Loan Portfolio

Total loans were $1.01 billion at September 30, 2004, an increase of $237.4 million, or 30.8% from $770.1 million at December 31, 2003. At September 30, 2004, loans acquired in the Liberty and Village acquisitions totaled $195.0 million. Period end loans comprised 44.7% of average earning assets at September 30, 2004 compared with 42.1% at December 31, 2003.

The following table summarizes the loan portfolio of the Company by type of loan as of September 30, 2004 and December 31, 2003:


	September 30, 2004				December 31, 2003
	Amount		Percent		Amount		Percent
	(Dollars in thousands)
Commercial and industrial	$	146,054	14.5	%	$	93,989	12.2	%
Real estate:
Construction and land development		97,173	9.6			36,470	4.7
1-4 family residential		268,349	26.6			237,055	30.8
Home equity		32,470	3.2			27,943	3.6
Commercial mortgages		334,050	33.3			260,882	33.9
Farmland		22,475	2.2			15,247	2.0
Multifamily residential		18,613	1.8			20,679	2.7
Agriculture		30,250	3.0			20,693	2.7
Other		2,642	0.3			2,274	0.3
Consumer		55,344	5.5			54,821	7.1

Total loans	$	1,007,420	100.0	%	$	770,053	100.0	%

Nonperforming Assets

The Company generally places a loan on nonaccrual status and ceases accruing interest when the payment of principal or interest is delinquent for 90 days, or earlier in some cases, unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan. The Company generally charges off all loans before attaining nonaccrual status.

The following table presents information regarding nonperforming assets as of the dates indicated.


	September 30, 2004			December 31, 2003
	(Dollars in thousands)
Nonaccrual loans	$	709		$	2
Restructured loans		—			—
Accruing loans 90 or more days past due		1,238			679

Total nonperforming loans		1,947			681
Repossessed assets		81			40
Other real estate		535			246

Total nonperforming assets	$	2,563		$	967

Nonperforming assets to total loans and other real estate		0.25	%		0.13	%

Allowance for Credit Losses

Management actively monitors the Company’s asset quality and provides specific loss allowances when necessary. Loans are charged-off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the allowance for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations. As of September 30, 2004, the allowance for credit losses amounted to $12.9 million, or 1.28% of total loans compared with $10.3 million, or 1.34% of total loans at December 31, 2003.

Set forth below is an analysis of the allowance for credit losses for the nine months ended September 30, 2004 and the year ended December 31, 2003:


	As of and for the Nine Months Ended September 30, 2004			As of and for the Year Ended December 31, 2003
	(Dollars in thousands)
Average loans outstanding	$	824,275		$	697,235

Gross loans outstanding at end of period	$	1,007,420		$	770,053

Allowance for credit losses at beginning of period	$	10,345		$	9,580
Balance acquired with the Liberty and Village acquisitions		2,365			—
Balance acquired with the Abrams, Dallas Bancshares, MainBancorp and FSBNT acquisitions		—			1,900
Provision for credit losses		660			483
Charge-offs:
Commercial and industrial		(88	)		(810	)
Real estate and agriculture		(608	)		(960	)
Consumer		(159	)		(471	)
Recoveries:
Commercial and industrial		153			159
Real estate and agriculture		63			198
Consumer		130			266

Net charge-offs		(509	)		(1,618	)

Allowance for credit losses at end of period	$	12,861		$	10,345

Ratio of allowance to end of period loans		1.28	%		1.34	%
Ratio of charge-offs to average loans		0.06	%		0.23	%
Ratio of allowance to end of period nonperforming loans		660.6	%		1,519.1	%

Securities

Securities totaled $1.35 billion at September 30, 2004 compared with $1.38 billion at December 31, 2003, a decrease of $23.3 million, or 1.7%. At September 30, 2004, securities represented 50.0% of total assets compared with 57.4% of total assets at December 31, 2003.

The following table summarizes the amortized cost of securities as of the dates shown (available-for-sale securities are not adjusted for unrealized gains or losses):


	September 30, 2004		December 31, 2003
	(Dollars in thousands)
U.S. Treasury securities and obligations of U.S. government agencies	$	32,028	$	48,762
70% non-taxable preferred stock		24,004		44,015
States and political subdivisions		46,181		53,738
Collateralized mortgage obligations		230,077		178,487
Mortgage-backed securities		1,013,340		1,032,861
Corporate debt securities		10,518		15,619
Equity securities		293		283

Total	$	1,356,441	$	1,373,765

Bank Premises and Equipment

Premises and equipment, net of accumulated depreciation, totaled $36.3 million and $34.3 million at September 30, 2004 and December 31, 2003, respectively, an increase of $2.0 million or 5.9%. The increase was primarily due to the MainBancorp, FSBNT, Liberty and Village acquisitions.

Deposits

Total deposits were $2.33 billion at September 30, 2004 compared with $2.08 billion at December 31, 2003, an increase of $243.5 million or 11.7%. At September 30, 2004, noninterest-bearing deposits accounted for approximately 22.7% of total deposits compared with 22.4% of total deposits at December 31, 2003. Interest-bearing demand deposits totaled $1.80 billion, or 77.3%, of total deposits at September 30, 2004 compared with $1.62 billion, or 77.6%, of total deposits at December 31, 2003.

The following table summarizes the daily average balances and weighted average rates paid on deposits for the periods presented below:


	For the Nine Months Ended September 30, 2004				For the Year Ended December 31, 2003
	Amount		Rate		Amount		Rate
	(Dollars in thousands)
Interest-bearing checking	$	479,150	1.03	%	$	371,801	1.13	%
Regular savings		109,778	0.57			88,651	0.66
Money market savings		376,552	0.83			317,682	0.92
Time deposits		723,885	2.08			616,353	2.42

Total interest-bearing deposits		1,689,365	1.40			1,394,487	1.62
Noninterest-bearing deposits		454,878	—			354,558	—

Total deposits	$	2,144,243	1.11	%	$	1,749,045	1.29	%

Other Borrowings

Deposits are the primary source of funds for the Company’s lending and investment activities. Occasionally, the Company obtains additional funds from the Federal Home Loan Bank (“FHLB”) and correspondent banks. At September 30, 2004, the Company had $13.3 million in FHLB borrowings and at December 31, 2003 the Company had $11.9 million in FHLB borrowings, all of which consisted of FHLB notes payable. The increase was due to a note payable assumed from Village in connection with the acquisition. The maturity dates on the FHLB notes payable range from the years 2004 to 2023 and have interest rates ranging from 4.64% to 6.48%. FHLB notes payable are secured by a blanket lien on the Bank’s first mortgage loans against one-to-four family residential properties.

At September 30, 2004, the Company had $28.2 million in securities sold under repurchase agreements compared with $19.0 million at December 31, 2003.

At September 30, 2004 and December 31, 2003, the Company had no federal funds purchased.

Junior Subordinated Debentures

At September 30, 2004 and December 31, 2003, the Company had outstanding $59.8 million in junior subordinated debentures issued to the Company’s subsidiary trusts.

Liquidity

Liquidity involves the Company’s ability to raise funds to support asset growth or reduce assets to meet deposit withdrawals and other payment obligations, to maintain reserve requirements and otherwise to operate the Company on an ongoing basis. The Company’s liquidity needs have primarily been met by growth in core deposits and the issuance of junior subordinated debentures. Although access to purchased funds from correspondent banks is available and has been utilized on occasion to take advantage of investment opportunities, the Company does not generally rely on these external funding sources. The cash and federal funds sold position, supplemented by amortizing investment and loan portfolios, have generally created an adequate liquidity position.

Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. As of September 30, 2004 and December 31, 2003, the Company had cash and cash equivalents of $132.9 million and $83.7 million, respectively. The increase in cash and cash equivalents is primarily due to an increase in federal funds sold which resulted from increased deposits and cash acquired through the MainBancorp, FSBNT, Liberty and Village acquisitions.

Contractual Obligations

The following table summarizes the Company’s contractual obligations and other commitments to make future payments as of September 30, 2004 (other than deposit obligations). The Company’s future cash payments associated with its contractual obligations pursuant to its junior subordinated debentures, FHLB notes payable and operating leases as of September 30, 2004 are summarized below. Payments for borrowings do not include interest. Payments related to leases are based on actual payments specified in underlying contracts.


	Payments due in:
	Remaining Fiscal 2004		Fiscal 2005-2006		Fiscal 2007-2008		Thereafter		Total
	(Dollars in thousands)
Junior subordinated debentures	$	—	$	—	$	—	$	59,804	$	59,804
Federal Home Loan Bank notes payable		198		1,694		3,036		8,387		13,315
Operating leases		502		3,397		2,730		3,121		9,750

Total	$	700	$	5,091	$	5,766	$	71,312	$	82,869

Off-Balance Sheet Items

The Company’s commitments associated with outstanding standby letters of credit and commitments to extend credit as of September 30, 2004 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:


	Remaining Fiscal 2004		Fiscal 2005-2006		Fiscal 2007-2008		Thereafter		Total
	(Dollars in thousands)
Standby letters of credit	$	796	$	4,598	$	121	$	—	$	5,515
Commitments to extend credit		18,361		118,990		2,437		43,249		183,037

Total	$	19,157	$	123,588	$	2,558	$	43,249	$	188,552

In the normal course of business, the Company enters into various transactions, which, in accordance with accounting principles generally accepted in the United States, are not included in its consolidated balance sheets. 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, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.

Capital Resources

Total shareholders’ equity was $269.3 million at September 30, 2004 compared with $219.6 million at December 31, 2003, an increase of $49.7 million, or 22.6%. The increase was due primarily to net earnings of $25.4 million and common stock issued in connection with the Liberty acquisition of $32.0 million, partially offset by dividends paid of $4.8 million and a net change in unrealized losses on available for sale securities of $3.9 million for the nine months ended September 30, 2004.

Both the Board of Governors of the Federal Reserve System, with respect to the Company, and the Federal Deposit Insurance Corporation (“FDIC”), with respect to the Bank, have established certain minimum risk-based capital standards that apply to bank holding companies and federally insured banks. The following table sets forth the Company’s total risk-based capital, Tier I risk-based capital, and Tier I to average assets (leverage) ratios as of September 30, 2004:


Consolidated Risk Based Capital Ratios:
Total capital (to risk weighted assets)	15.29	%
Tier I capital (to risk weighted assets)	14.19	%
Tier I capital (to average assets)	6.77	%

As of September 30, 2004, the Bank’s risk-based capital ratios were above the levels required for the Bank to be designated as “well capitalized” by the FDIC. The following table sets forth the Bank’s total risk-based capital, Tier I risk-based capital, and Tier I to average assets (leverage) capital ratios as of September 30, 2004:


Risk Based Capital Ratios (Bank Only):
Total capital (to risk weighted assets)	14.60	%
Tier I capital (to risk weighted assets)	13.49	%
Tier I capital (to average assets)	6.43	%

As discussed in Note 3, the Company adopted FIN 46R on January 1, 2004. FIN 46R requires that trust preferred securities be deconsolidated from the Company’s consolidated financial statements. Trust preferred securities are considered currently in calculating Tier 1 capital ratios. In May 2004, the Federal Reserve released proposed rules for the capital treatment of trust preferred securities. The proposed rules would limit the aggregate amount of trust preferred securities and certain other capital elements to 25% of core capital, net of goodwill. Because the 25% limit currently is calculated without deducting goodwill, the proposal has the effect of reducing the amount of trust preferred securities that the Company can include in Tier I capital. At September 30, 2004, under the proposed rules, approximately $35.7 million of trust preferred securities would count as Tier I capital. The excess amount of trust preferred securities not qualifying for Tier I capital may be included in Tier II capital. This amount is limited to 50% of Tier I capital. There is a three-year transition period for banks to become compliant with the new rules. Additionally, the rules provide that trust preferred securities no longer qualify for Tier I capital within 5 years of their maturity. Assuming the proposed rules were effective at September 30, 2004, the Company’s consolidated capital ratios would have been:


Pro forma Consolidated Risk Based Capital Ratios:
Total capital (to risk weighted assets)	15.29	%
Tier I capital (to risk weighted assets)	12.28	%
Tier I capital (to average assets)	5.86	%

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company manages market risk, which for the Company is primarily interest rate risk, through its Asset Liability Committee which is composed of senior officers of the Company, in accordance with policies approved by the Company’s Board of Directors.

The Company uses simulation analysis to examine the potential effects of market changes on net interest income and market value. The Company considers macroeconomic variables, Company strategy, liquidity and other factors as it quantifies market risk. See the Company’s Annual Report on Form 10-K, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Interest Rate Sensitivity and Liquidity” which was filed on March 12, 2004 for further discussion.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934

(the “Exchange Act”)) are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported to the Company’s management within the time periods specified in the Securities and Exchange Commission’s rules and forms.

Changes in internal controls over financial reporting. There were no changes in the Company’s internal controls over financial reporting that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Not Applicable

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable

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

Not applicable

ITEM 5. OTHER INFORMATION

Not applicable

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

Exhibits:

The following exhibits are filed with this Quarterly Report on Form 10-Q;


Exhibit Number		Description of Exhibit
21.1		Subsidiaries of Prosperity Bancshares, Inc.

31.1		Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

31.2		Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

32.1		Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Reports on Form 8-K

(i)

The Company furnished a Current Report on Form 8-K under Items 7 and 12 of Form 8-K on July 14, 2004 to announce the release of the Company’s earnings for the second quarter 2004.

SIGNATURES

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


		PROSPERITY BANCSHARES, INC. ^SM
		(Registrant)

Date: 11/09/04		/s/ David Zalman
		David Zalman
		Chief Executive Officer/President

Date: 11/09/04		/s/David Hollaway
		David Hollaway
		Chief Financial Officer

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents