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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------------
(Mark One)
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For The Fiscal Year Ended December 31, 2002
OR
[_] 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 0-25051
PROSPERITY BANCSHARES, INC.(SM)
(Exact name of registrant as specified in its charter)
TEXAS 74-2331986
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4295 SAN FELIPE 77027
HOUSTON, TEXAS (Zip Code)
(Address of principal executive offices)
Registrant's Telephone Number, Including Area Code: (713) 693-9300
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value
$1.00 per share
---------------
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 Act). Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of the Form 10-K or any amendment of this
Form 10-K. [_]
The aggregate market value of the shares of Common Stock held by
non-affiliates, based on the closing price of the Common Stock on the Nasdaq
National Market System on June 30, 2002 was approximately $172,889,401.
As of February 6, 2003, the number of outstanding shares of Common Stock
was 18,903,483.
Documents Incorporated by Reference:
Portions of the Company's Proxy Statement relating to the 2003 Annual
Meeting of Shareholders, which will be filed within 120 days after December 31,
2002, are incorporated by reference into Part III, Items 10-13 of this Form
10-K.
PROSPERITY BANCSHARES, INC.(SM)
2002 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I
Item 1. Business ............................................................................................. 2
General ............................................................................................ 2
Recent Mergers and Acquisitions .................................................................... 3
Recent Developments ................................................................................ 3
Stock split ........................................................................................ 4
Available information .............................................................................. 4
Officers and Associates ............................................................................ 4
Banking Activities ................................................................................. 4
Business Strategies ................................................................................ 5
Competition ........................................................................................ 6
Supervision and Regulation ......................................................................... 6
Item 2. Properties ........................................................................................... 13
Item 3. Legal Proceedings .................................................................................... 16
Item 4. Submission of Matters to a Vote of Security Holders .................................................. 16
PART II
Item 5. Market for Registrant's Common Equity and Related Shareholder Matters ................................ 16
Item 6. Selected Consolidated Financial Data ................................................................. 18
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ................ 20
Overview ........................................................................................... 20
Critical Accounting Policies ....................................................................... 20
Results of Operations .............................................................................. 21
Financial Condition ................................................................................ 25
Item 7A. Quantitative and Qualitative Disclosures about Market Risk ........................................... 38
Item 8. Financial Statements and Supplementary Data .......................................................... 38
Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure ................. 40
PART III
Item 10. Directors and Executive Officers of the Registrant ................................................... 40
Item 11. Executive Compensation ............................................................................... 40
Item 12. Security Ownership of Certain Beneficial Owners and Management ....................................... 40
Item 13. Certain Relationships and Related Transactions ....................................................... 40
Item 14. Controls and Procedures .............................................................................. 40
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K ...................................... 41
Signatures
PART I
Special Cautionary Notice Regarding Forward-Looking Statements
Statements and financial discussion and analysis contained in this
annual report on Form 10-K that are not historical facts are forward-looking
statements made pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Forward-looking statements are based on
assumptions and involve a number of risks and uncertainties, many of which are
beyond the Company's control. Many possible events or factors could affect the
future financial results and performance of the Company and could cause such
results or performance to differ materially from those expressed in the
forward-looking statements. 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.
1
ITEM 1. BUSINESS
General
Prosperity Bancshares, Inc.(SM) (the "Company") was formed in 1983 as a
vehicle to acquire the former Allied Bank in Edna, Texas which was chartered in
1949. 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(SM) ("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 forty (40) full-service
banking locations in the greater Houston metropolitan area and fifteen
contiguous counties situated south and southwest of Houston and extending into
South Texas and two (2) full service banking locations in Dallas, Texas. The
Company's headquarters are located at 4295 San Felipe in Houston, Texas and its
telephone number is (713) 693-9300.
The Company's market consists of the communities served by its locations in
the Greater Houston CMSA, additional locations in eight contiguous counties
located to the south and southwest of Houston and its two banking locations in
Dallas, Texas. The Greater Houston CMSA includes Brazoria, Chambers, Fort Bend,
Galveston, Harris, Liberty, Montgomery and Walker counties. Texas Highway 59
(scheduled to become Interstate Highway 69), which serves as the primary "NAFTA
Highway" linking the interior United States and Mexico, runs directly through
the center of the Company's market area. The increased traffic along this NAFTA
Highway has enhanced economic activity in the Company's market area and created
opportunities for growth. The diverse nature of the economies in each local
market served by the Company provides the Company with a varied customer base
and allows the Company to spread its lending risk throughout a number of
different industries including farming, ranching, petrochemicals, manufacturing,
tourism, recreation and professional service firms and their principals. The
Company's market areas outside of Houston are dominated by either small
community banks or branches of large regional banks. Management believes that
the Company, as one of the few mid-sized financial institutions that combines
responsive community banking with the sophistication of a regional bank holding
company, has a competitive advantage in its market area and excellent growth
opportunities through acquisitions, new Banking Center locations and additional
business development.
Operating under a community banking philosophy, the Company seeks to
develop broad customer relationships based on service and convenience while
maintaining its conservative approach to lending and strong asset quality. The
Company has grown through a combination of internal growth, the acquisition of
community banks, branches of banks and the opening of new banking centers.
Utilizing a low cost of funds and employing stringent cost controls, the Company
has been profitable in every full year of its existence, including the period of
adverse economic conditions in Texas in the late 1980s. From 1988 to 1992, as a
sound and profitable institution, the Company took advantage of this economic
downturn and acquired the deposits and certain assets of failed banks in West
Columbia, El Campo and Cuero, Texas and two failed banks in Houston, which
diversified the Company's franchise and increased its core deposits. The Company
opened a full-service Banking Center in Victoria, Texas in 1993 and the
following year established a Banking Center in Bay City, Texas. The Company
expanded its Bay City presence in 1996 with the acquisition of an additional
branch location from Norwest Bank Texas, and in 1997, the Company acquired the
Angleton, Texas branch of Wells Fargo Bank. In 1998, the Company enhanced its
West Columbia Banking Center with the purchase of a commercial bank branch
located in West Columbia and acquired Union State Bank in East Bernard, Texas.
In 1999, the Company acquired South Texas Bancshares, Inc. and its wholly
owned subsidiary, The Commercial National Bank of Beeville, with locations in
Beeville, Mathis and Goliad, Texas (the "South Texas Acquisition"). The Company
acquired trust powers in connection with the South Texas Acquisition.
Additionally, in September 2000, the Company purchased certain assets and
assumed certain liabilities of five branches of Compass Bank located in El
Campo, Hitchcock, Needville, Palacios and Sweeny, Texas. With the exception of
the El Campo location, the former Compass branches are being operated as
full-service Banking Centers. The El Campo location has been combined with the
Company's El Campo Banking Center. In February 2001, the Company completed a
merger with Commercial Bancshares, Inc., ("Commercial"), whereby Commercial was
merged with the Company and Heritage Bank, Commercial's wholly owned subsidiary,
was merged with the Bank. Heritage Bank had 12 full-service banking locations in
the Houston metropolitan area and in three adjacent counties. The transaction
was accounted for as a pooling of interests and therefore the historical
financial data of the Company has been restated to include the accounts and
operations of Commercial for all periods prior to the effective time of the
Commercial merger.
2
Recent Mergers and Acquisitions
On November 1, 2002, the Company acquired First National Bank of Bay City,
Bay City, Texas (the "FNB Acquisition"), through the merger of FNB with and into
Prosperity Bank for approximately $5.1 million in cash. FNB operated one (1)
location in Bay City, Texas, which was closed and consolidated with Prosperity
Bank's Bay City Banking Center. As of November 1, 2002, FNB had total assets of
$27.1 million, total loans of $8.2 million and total deposits of $23.8 million.
On October 1, 2002, the Company acquired Southwest Bank Holding Company,
Dallas, Texas (the "Southwest Acquisition") for approximately $19.6 million in
cash. Southwest's wholly owned subsidiary, Bank of the Southwest, Dallas, Texas,
became a subsidiary of the Company but was merged into the Bank on January 2,
2003. Southwest was privately held and operated two (2) banking offices in
Dallas, Texas. As of October 1, 2002, Southwest had total assets of $121.9
million, total loans of $58.7 million and total deposits of $108.9 million.
On September 1, 2002, the Company acquired Paradigm Bancorporation, Inc.
(the "Paradigm Acquisition") in a stock transaction for approximately 2.58
million shares of Prosperity common stock for all outstanding shares of
Paradigm. Paradigm operated a total of eleven (11) banking offices - six (6) in
the greater metropolitan Houston area and five (5) in the nearby Southeast Texas
cities of Dayton, Galveston, Mont Belvieu, and Winnie. The Company subsequently
closed three banking offices and consolidated them into existing banking
centers. As of September 1, 2002, Paradigm Bancorporation had total assets of
$248.7 million, total loans of $175.7 million and total deposits of $218.3
million.
In connection with the acquisition of Paradigm, 75,192 shares of Company
Common Stock and cash in lieu of fractional share interests were placed into
escrow to cover possible losses that may be incurred by the Company in the three
year period following completion of the merger with respect to certain specified
loans made by Paradigm prior to execution of the merger agreement. At the end of
the three year period, or sooner if all of these loans are paid in full or
upgraded, the escrow agent will distribute a pro rata portion of the shares and
cash to each of the Paradigm shareholders. While the shares are held in escrow,
the Paradigm shareholders will not receive any dividends paid against the shares
until such time, if any, that the shares are issued.
In the event that during the three year escrow period a specified loan is
either (i) not paid in full or (ii) deemed by the Company in its sole discretion
to continue to be a specified loan based on the performance of the loan and the
financial stability of the borrower, the shares of Common Stock will be used to
compensate the Company for the losses associated with these loans.
On July 12, 2002, the Company acquired The First State Bank, Needville,
Texas (the "First State Acquisition") for approximately $3.7 million in cash.
Prosperity Bank's existing Needville Banking Center has relocated into the
former First State Bank location effective July 15, 2002. As of July 12, 2002,
The First State Bank had total assets of $16.3 million, loans of $5.5 million
and deposits of $14.1 million.
On May 8, 2002, the Company acquired Texas Guaranty Bank, N.A. (the "Texas
Guaranty Acquisition") for approximately $11.8 million in cash. Texas Guaranty
Bank operated three (3) offices in the western portion of Houston, Texas, all of
which became full service banking centers of Prosperity Bank. As of May 8, 2002,
Texas Guaranty Bank had total assets of $74.0 million, loans of $45.7 million
and deposits of $61.8 million.
Recent Developments
On February 3, 2003, the Company announced the signing of a definitive
agreement pursuant to which the Company will acquire Abrams Centre Bancshares,
Dallas, Texas ("Abrams") and its subsidiary, Abrams Centre National Bank, for
approximately $16.3 million in cash. Abrams operates two (2) banking offices in
Dallas, Texas. As of December 31, 2002, Abrams had total assets of $93.6
million, loans of $50.6 million, deposits of $69.0 million and shareholders'
equity of $13.9 million. The transaction is expected to close in the second
quarter 2003 and is subject to approval by regulators and certain closing
conditions.
On March 4, 2003, the Company entered into a definitive agreement with
Dallas Bancshares Corporation, Dallas, Texas ("Dallas"). Pursuant to the
agreement, Dallas Bancshares will merge into the Company and it's wholly owned
subsidiary, BankDallas will merge into the Bank. Under the terms of the
agreement, the Company will pay approximately $7.0 million in cash. Dallas
Bancshares is privately held and operates one (1) banking office in Dallas,
Texas. As of December 31, 2002, BankDallas had total assets of $40.9 million,
loans of $30.6 million, deposits of $36.5 million and shareholders' equity of
$4.3 million. The transaction is expected to close in the second quarter of
2003. The Company will not complete the acquisition unless customary closing
conditions are satisfied or waived,
3
including receipt of the necessary regulatory and shareholder approvals and
consents from applicable regulatory agencies including the Federal Reserve
Board, the Texas Banking Department and the Federal Deposit Insurance
Corporation.
Stock Split
On May 31, 2002, the Company effected a two-for-one stock split in the form
of a 100 percent stock dividend to shareholders of record on May 20, 2002. The
Company issued approximately 8.1 million shares in connection with the split.
All per share and share information has been restated to reflect this split.
Available Information
The Company's website address is www.prosperitybanktx.com. The Company
makes available free of charge on or through its website its annual report on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all
amendments to those reports filed or furnished pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably
practicable after such material is electronically filed with or furnished to the
Securities and Exchange Commission. However, the information found on the
Company's website is not part of this or any other report.
Officers and Associates
The Company's directors and officers are important to the Company's success
and play a key role in the Company's business development efforts by actively
participating in a number of civic and public service activities in the
communities served by the Company, such as the Rotary Club, Lion's Club, Pilot
Club, United Way and Chamber of Commerce. In addition, the Company's Banking
Centers in Bay City, Clear Lake, Cleveland, Dayton, Galveston, Mathis, Medical
Center, River Oaks, Tanglewood and Wharton maintain Community Development
Boards, whose function is to solicit new business, develop customer relations
and provide valuable community knowledge to their respective Banking Center
Presidents or Managers.
The Company has invested heavily in its officers and associates by
recruiting talented officers in its market areas and providing them with
economic incentive in the form of stock options and bonuses based on
cross-selling performance. The senior management team has substantial experience
in both the Houston and Dallas markets and the surrounding communities in which
the Company has a presence. Each Banking Center location is administered by a
local President or Manager with knowledge of the community and lending expertise
in the specific industries found in the community. The Company entrusts its
Banking Center Presidents and Managers with authority and flexibility within
general parameters with respect to product pricing and decision making in order
to avoid the bureaucratic structure of larger banks. The Company operates each
Banking Center as a separate profit center, maintaining separate data with
respect to each Banking Center's 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. Each Banking Center has its own local telephone number, which
enables a customer to be served by a local banker.
As of December 31, 2002, the Company and the Bank had 501 full-time
equivalent associates, 187 of whom were officers of the Bank. The Company
provides medical and hospitalization insurance to its full-time associates. The
Company considers its relations with associates to be excellent. Neither the
Company nor the Bank is a party to any collective bargaining agreement.
Banking Activities
The Company, through the Bank, offers a variety of traditional loan and
deposit products to its customers, which consist primarily of consumers and
small and medium-sized businesses. The Bank tailors its products to the specific
needs of customers in a given market. At December 31, 2002, the Bank maintained
approximately 111,000 separate deposit accounts and 16,500 separate loan
accounts and approximately 20.7% of the Bank's total deposits were
noninterest-bearing demand deposits. For the year ended December 31, 2002, the
Company's average cost of funds was 1.97%.
The Company has been an active mortgage lender, with 1-4 family residential
and commercial mortgage loans comprising 57.5% of the Company's total loans as
of December 31, 2002. The Company also offers loans for automobiles and other
consumer durables, home equity loans, debit cards, personal computer banking and
other cash management services and telebanking. By offering certificates of
deposit, NOW accounts, savings accounts and overdraft protection at competitive
rates, the Company gives its depositors a full range of traditional deposit
products. The Company has successfully introduced the Royal account, which for a
monthly fee provides consumers with a package of benefits including unlimited
free checking, free personalized checks, free travelers checks, free cashier's
checks, free money orders, free ATM or debitcard, imaged statement, free
Advantage Overdraft protection up to $200 on qualifying accounts, free Internet
Banking, discounted Internet Bill Pay and certain travel discounts.
4
The businesses targeted by the Company in its lending efforts are primarily
those that require loans in the $100,000 to $4.0 million range. The Company
offers these businesses a broad array of loan products including term loans,
lines of credit and loans for working capital, business expansion and the
purchase of equipment and machinery, interim construction loans for builders and
owner-occupied commercial real estate loans. For its business customers, the
Company has developed a specialized checking product called Small Business
Checking which provides fixed discounted fees for checking.
Business Strategies
The Company's main objective is to increase deposits and loans through
additional expansion opportunities while maintaining efficiency, individualized
customer service and maximizing profitability. To achieve this objective, the
Company has employed the following strategic goals:
Continue Community Banking Emphasis. The Company intends to continue
operating as a community banking organization focused on meeting the specific
needs of consumers and small and medium-sized businesses in its market areas.
The Company will continue to provide a high degree of responsiveness combined
with a wide variety of banking products and services. The Company staffs its
Banking Centers with experienced bankers with lending expertise in the specific
industries found in the community, giving them authority to make certain pricing
and credit decisions, thereby attempting to avoid the bureaucratic structure of
larger banks.
Increase Loan Volume and Diversify Loan Portfolio. Historically, the
Company has elected to sacrifice some earnings for the historically lower credit
losses associated with home mortgage loans. While maintaining its conservative
approach to lending, the Company plans to emphasize both new and existing loan
products, focusing on growing its home equity, commercial mortgage and
commercial loan portfolios. The Company successfully introduced home equity
lending in 1998. The balance of home equity loans was $23.2 million at December
31, 2002 and $20.5 million at December 31, 2001. During the two-year period from
December 31, 2000 to December 31, 2002, the Company grew its commercial and
industrial loans from $47.0 million to $83.8 million, or 106.0% and its
commercial mortgages from $75.9 million to $184.0 million, or 142.4%. In
addition, the Company targets professional service firms such as legal and
medical practices for both loans secured by owner-occupied premises and personal
loans to their principals.
Continue Strict Focus on Efficiency. The Company plans to maintain its
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. For its
Banking Centers, which the Company operates as independent profit centers, the
Company supplies complete support in the areas of loan review, internal audit,
compliance and training. Management believes that this centralized
infrastructure can accommodate substantial additional growth while enabling the
Company to minimize operational costs through certain economies of scale.
Enhance Cross-Selling. The Company recognizes that its customer base
provides significant opportunities to cross-sell various products and it seeks
to develop broader customer relationships by identifying cross-selling
opportunities. The Company uses incentives and friendly competition to encourage
cross-selling efforts and increase cross-selling results. Officers and
associates have access to each customer's existing and related account
relationships and are better able to inform customers of additional products
when customers visit or call the various Banking Centers or use their drive-in
facilities. In addition, the Company includes product information in monthly
statements and other mailings.
Expand Market Share Through Internal Growth and a Disciplined Acquisition
Strategy. The Company intends to continue seeking opportunities, both inside and
outside its existing markets, to expand either by acquiring existing banks or
branches of banks or by establishing new Banking Centers. All of the Company's
acquisitions have been accretive to earnings immediately and have supplied the
Company with relatively low-cost deposits which have been used to fund the
Company's lending activities. Factors used by the Company to evaluate expansion
opportunities include the similarity in management and operating philosophies,
whether the acquisition will be accretive to earnings and enhance shareholder
value, the ability to achieve economies of scale to improve the efficiency ratio
and the opportunity to enhance the Company's image and market presence.
Maintain Strong Asset Quality. The Company intends to maintain the strong
asset quality that has been representative of its historical loan portfolio. As
the Company diversifies and increases its lending activities, it may face higher
risks of nonpayment and increased risks in the event of economic downturns. The
Company intends, however, to continue to employ the strict underwriting
guidelines and comprehensive loan review process that have contributed to its
low incidence of nonperforming assets and its minimal charge-offs.
5
Competition
The banking business is highly competitive, and the profitability of the
Company depends principally on its ability to compete in its market areas. The
Company competes with other commercial banks, savings banks, savings and loan
associations, credit unions, finance companies, mutual funds, insurance
companies, brokerage and investment banking firms, asset-based nonbank lenders
and certain other nonfinancial entities, including retail stores which may
maintain their own credit programs and certain governmental organizations which
may offer more favorable financing than the Company. The Company has been able
to compete effectively with other financial institutions by emphasizing customer
service, technology and responsive decision-making with respect to loans; by
establishing long-term customer relationships and building customer loyalty; and
by providing products and services designed to address the specific needs of its
customers. Under the Gramm-Leach-Bliley Act, securities firms and insurance
companies that elect to become financial holding companies may acquire banks and
other financial institutions. The Gramm-Leach-Bliley Act may significantly
change the competitive environment in which the Company and its subsidiaries
conduct business.
Supervision and Regulation
The supervision and regulation of bank holding companies and their
subsidiaries is intended primarily for the protection of depositors, the deposit
insurance funds of the Federal Deposit Insurance Corporation ("FDIC") and the
banking system as a whole, and not for the protection of the bank holding
company shareholders or creditors. The banking agencies have broad enforcement
power over bank holding companies and banks including the power to impose
substantial fines and other penalties for violations of laws and regulations.
The following description summarizes some of the laws to which the Company
and the Banks are subject. References herein to applicable statutes and
regulations are brief summaries thereof, do not purport to be complete, and are
qualified in their entirety by reference to such statutes and regulations. The
Company believes that it is in compliance in all material respects with these
laws and regulations.
The Company
The Company is a financial holding company registered under the
Gramm-Leach-Bliley Act and a bank holding company registered under the Bank
Holding Company Act of 1956, as amended ("BHCA"). Accordingly, the Company is
subject to supervision, regulation and examination by the Board of Governors of
the Federal Reserve System ("Federal Reserve Board"). The Gramm-Leach-Bliley
Act, the BHCA and other federal laws subject financial and bank holding
companies to particular restrictions on the types of activities in which they
may engage, and to a range of supervisory requirements and activities, including
regulatory enforcement actions for violations of laws and regulations.
Regulatory Restrictions on Dividends; Source of Strength. It is the policy
of the Federal Reserve Board that bank holding companies should pay cash
dividends on common stock only out of income available over the past year and
only if prospective earnings retention is consistent with the organization's
expected future needs and financial condition. The policy provides that bank
holding companies should not maintain a level of cash dividends that undermines
the bank holding company's ability to serve as a source of strength to its
banking subsidiaries.
Under Federal Reserve Board policy, a bank holding company is expected to
act as a source of financial strength to each of its banking subsidiaries and
commit resources to their support. Such support may be required at times when,
absent this Federal Reserve Board policy, a holding company may not be inclined
to provide it. As discussed below, a bank holding company in certain
circumstances could be required to guarantee the capital plan of an
undercapitalized banking subsidiary.
In the event of a bank holding company's bankruptcy under Chapter 11 of the
U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is required
to cure immediately any deficit under any commitment by the debtor holding
company to any of the federal banking agencies to maintain the capital of an
insured depository institution. Any claim for breach of such obligation will
generally have priority over most other unsecured claims.
Scope of Permissable Activities. Under the BHCA, bank holding companies
generally may not acquire a direct or indirect interest in or control of more
than 5% of the voting shares of any company that is not a bank or bank holding
company or from engaging in activities other than those of banking, managing or
controlling banks or furnishing services to or performing services for its
subsidiaries, except that it may engage in, directly or indirectly, certain
activities that the Federal Reserve Board determined to be
6
closely related to banking or managing and controlling banks as to be a proper
incident thereto. In approving acquisitions or the addition of activities, the
Federal Reserve considers whether the acquisition or the additional activities
can reasonably be expected to produce benefits to the public, such as greater
convenience, increased competition, or gains in efficiency, that outweigh such
possible adverse effects as undue concentration of resources decreased or unfair
competition, conflicts of interest or unsound banking practices.
However, the Gramm-Leach-Bliley Act, effective March 11, 2000, eliminated
the barriers to affiliations among banks, securities firms, insurance companies
and other financial service providers and permits bank holding companies to
become financial holding companies and thereby affiliate with securities firms
and insurance companies and engage in other activities that are financial in
nature. The Gramm-Leach-Bliley Act defines "financial in nature" to include
securities underwriting, dealing and market making; sponsoring mutual funds and
investment companies; insurance underwriting and agency; merchant banking
activities; and activities that the Federal Reserve Board has determined to be
closely related to banking. No regulatory approval will be required for a
financial holding company to acquire a company, other than a bank or savings
association, engaged in activities that are financial in nature or incidental to
activities that are financial in nature, as determined by the Federal Reserve
Board.
Under the Gramm-Leach-Bliley Act, a bank holding company may become a
financial holding company by filing a declaration with the Federal Reserve Board
if each of its subsidiary banks is well capitalized under the Federal Deposit
Insurance Corporation Improvement Act ("FDICIA") prompt corrective action
provisions, is well managed, and has at least a satisfactory rating under the
Community Reinvestment Act of 1977 ("CRA"). The Company received approval to
become a financial holding company on April 18, 2000.
While the Federal Reserve Board will serve as the "umbrella" regulator for
financial holding companies and has the power to examine banking organizations
engaged in new activities, regulation and supervision of activities which are
financial in nature or determined to be incidental to such financial activities
will be handled along functional lines. Accordingly, activities of subsidiaries
of a financial holding company will be regulated by the agency or authorities
with the most experience regulating that activity as it is conducted in a
financial holding company.
Safe and Sound Banking Practices. Bank holding companies are not permitted
to engage in unsafe and unsound banking practices. The Federal Reserve Board's
Regulation Y, for example, generally requires a holding company to give the
Federal Reserve Board prior notice of any redemption or repurchase of its own
equity securities, if the consideration to be paid, together with the
consideration paid for any repurchases or redemptions in the preceding year, is
equal to 10% or more of the company's consolidated net worth. The Federal
Reserve Board may oppose the transaction if it believes that the transaction
would constitute an unsafe or unsound practice or would violate any law or
regulation. Depending upon the circumstances, the Federal Reserve Board could
take the position that paying a dividend would constitute an unsafe or unsound
banking practice.
The Federal Reserve Board has broad authority to prohibit activities of
bank holding companies and their nonbanking subsidiaries which represent unsafe
and unsound banking practices or which constitute violations of laws or
regulations, and can assess civil money penalties for certain activities
conducted on a knowing and reckless basis, if those activities caused a
substantial loss to a depository institution. The penalties can be as high as
$1.0 million for each day the activity continues.
Anti-Tying Restrictions. Bank holding companies and their affiliates are
prohibited from tying the provision of certain services, such as extensions of
credit, to other services offered by a holding company or its affiliates.
Capital Adequacy Requirements. The Federal Reserve Board has adopted a
system using risk-based capital guidelines to evaluate the capital adequacy of
bank holding companies. Under the guidelines, specific categories of assets are
assigned different risk weights, based generally on the perceived credit risk of
the asset. These risk weights are multiplied by corresponding asset balances to
determine a "risk-weighted" asset base. The guidelines require a minimum total
risk-based capital ratio of 8.0% (of which at least 4.0% is required to consist
of Tier 1 capital elements). Total capital is the sum of Tier 1 and Tier 2
capital. As of December 31, 2002, the Company's ratio of Tier 1 capital to total
risk-weighted assets was 14.10% and its ratio of total capital to total
risk-weighted assets was 15.30%. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Financial Condition - Capital
Resources."
7
In addition to the risk-based capital guidelines, the Federal Reserve Board
uses a leverage ratio as an additional tool to evaluate the capital adequacy of
bank holding companies. The leverage ratio is a company's Tier 1 capital divided
by its average total consolidated assets. Certain highly rated bank holding
companies may maintain a minimum leverage ratio of 3.0%, but other bank holding
companies are required to maintain a leverage ratio of 4.0%. As of December 31,
2002, the Company's leverage ratio was 6.56%.
The federal banking agencies' risk-based and leverage ratios are minimum
supervisory ratios generally applicable to banking organizations that meet
certain specified criteria, assuming that they have the highest regulatory
rating. Banking organizations not meeting these criteria are expected to operate
with capital positions well above the minimum ratios. The federal bank
regulatory agencies may set capital requirements for a particular banking
organization that are higher than the minimum ratios when circumstances warrant.
Federal Reserve Board guidelines also provide that banking organizations
experiencing internal growth or making acquisitions will be expected to maintain
strong capital positions substantially above the minimum supervisory levels,
without significant reliance on intangible assets.
Imposition of Liability for Undercapitalized Subsidiaries. Bank regulators
are required to take "prompt corrective action" to resolve problems associated
with insured depository institutions whose capital declines below certain
levels. In the event an institution becomes "undercapitalized," it must submit a
capital restoration plan. The capital restoration plan will not be accepted by
the regulators unless each company having control of the undercapitalized
institution guarantees the subsidiary's compliance with the capital restoration
plan up to a certain specified amount. Any such guarantee from a depository
institution's holding company is entitled to a priority of payment in
bankruptcy.
The aggregate liability of the holding company of an undercapitalized bank
is limited to the lesser of 5% of the institution's assets at the time it became
undercapitalized or the amount necessary to cause the institution to be
"adequately capitalized." The bank regulators have greater power in situations
where an institution becomes "significantly" or "critically" undercapitalized or
fails to submit a capital restoration plan. For example, a bank holding company
controlling such an institution can be required to obtain prior Federal Reserve
Board approval of proposed dividends, or might be required to consent to a
consolidation or to divest the troubled institution or other affiliates.
Acquisitions by Bank Holding Companies. The BHCA requires every bank
holding company to obtain the prior approval of the Federal Reserve Board before
it may acquire all or substantially all of the assets of any bank, or ownership
or control of any voting shares of any bank, if after such acquisition it would
own or control, directly or indirectly, more than 5% of the voting shares of
such bank. In approving bank acquisitions by bank holding companies, the Federal
Reserve Board is required to consider the financial and managerial resources and
future prospects of the bank holding company and the banks concerned, the
convenience and needs of the communities to be served, and various competitive
factors.
Control Acquisitions. The Change in Bank Control Act prohibits a person or
group of persons from acquiring "control" of a bank holding company unless the
Federal Reserve Board has been notified and has not objected to the transaction.
Under a rebuttable presumption established by the Federal Reserve Board, the
acquisition of 10% or more of a class of voting stock of a bank holding company
with a class of securities registered under Section 12 of the Exchange Act, such
as the Company, would, under the circumstances set forth in the presumption,
constitute acquisition of control of the Company.
In addition, any entity is required to obtain the approval of the Federal
Reserve Board under the BHCA before acquiring 25% (5% in the case of an acquirer
that is a bank holding company) or more of the outstanding Common Stock of the
Company, or otherwise obtaining control or a "controlling influence" over the
Company.
The Bank
The Bank is a Texas-chartered banking association, the deposits of which
are insured by the Bank Insurance Fund ("BIF"). The Bank is not a member of the
Federal Reserve System; therefore, the Bank is subject to supervision and
regulation by the FDIC and the Texas Banking Department. Such supervision and
regulation subject the Bank to special restrictions, requirements, potential
enforcement actions and periodic examination by the FDIC and the Texas Banking
Department. Because the Federal Reserve Board regulates the bank holding company
parent of the Bank, the Federal Reserve Board also has supervisory authority
which directly affects the Bank.
Equivalence to National Bank Powers. The Texas Constitution, as amended in
1986, provides that a Texas-chartered bank has the same rights and privileges
that are or may be granted to national banks domiciled in Texas. To the extent
that the Texas laws and regulations may have allowed state-chartered banks to
engage in a broader range of activities than national banks, the Federal Deposit
Insurance Corporation Improvement Act of 1991 ("FDICIA") has operated to limit
this authority. FDICIA provides that no
8
state bank or subsidiary thereof may engage as principal in any activity not
permitted for national banks, unless the institution complies with applicable
capital requirements and the FDIC determines that the activity poses no
significant risk to the insurance fund. In general, statutory restrictions on
the activities of banks are aimed at protecting the safety and soundness of
depository institutions.
Financial Modernization. Under the Gramm-Leach-Bliley Act, a national bank
may establish a financial subsidiary and engage, subject to limitations on
investment, in activities that are financial in nature, other than insurance
underwriting as principal, insurance company portfolio investment, real estate
development, real estate investment and annuity issuance. To do so, a bank must
be well capitalized, well managed and have a CRA rating of satisfactory or
better. Subsidiary banks of a financial holding company or national banks with
financial subsidiaries must remain well capitalized and well managed in order to
continue to engage in activities that are financial in nature without regulatory
actions or restrictions, which could include divestiture of the financial in
nature subsidiary or subsidiaries. In addition, a financial holding company or a
bank may not acquire a company that is engaged in activities that are financial
in nature unless each of the subsidiary banks of the financial holding company
or the bank has a CRA rating of satisfactory of better.
Although the powers of state chartered banks are not specifically addressed
in the Gramm-Leach-Bliley Act, Texas-chartered banks such as the Bank, will have
the same if not greater powers as national banks through the parity provision
contained in the Texas Constitution.
Branching. Texas law provides that a Texas-chartered bank can establish a
branch anywhere in Texas provided that the branch is approved in advance by the
Texas Banking Department. The branch must also be approved by the FDIC, which
considers a number of factors, including financial history, capital adequacy,
earnings prospects, character of management, needs of the community and
consistency with corporate powers.
Restrictions on Transactions with Affiliates and Insiders. Transactions
between the Bank and its nonbanking subsidiaries, including the Company, are
subject to Section 23A of the Federal Reserve Act. In general, Section 23A
imposes limits on the amount of such transactions, and also requires certain
levels of collateral for loans to affiliated parties. It also limits the amount
of advances to third parties which are collateralized by the securities or
obligations of the Company or its subsidiaries.
Affiliate transactions are also subject to Section 23B of the Federal
Reserve Act which generally requires that certain transactions between the Bank
and its affiliates be on terms substantially the same, or at least as favorable
to the Bank, as those prevailing at the time for comparable transactions with or
involving other nonaffiliated persons.
The restrictions on loans to directors, executive officers, principal
shareholders and their related interests (collectively referred to herein as
"insiders") contained in the Federal Reserve Act and Regulation O apply to all
insured institutions and their subsidiaries and holding companies. These
restrictions include limits on loans to one borrower and conditions that must be
met before such a loan can be made. There is also an aggregate limitation on all
loans to insiders and their related interests. These loans cannot exceed the
institution's total unimpaired capital and surplus, and the FDIC may determine
that a lesser amount is appropriate. Insiders are subject to enforcement actions
for knowingly accepting loans in violation of applicable restrictions.
Restrictions on Distribution of Subsidiary Bank Dividends and Assets.
Dividends paid by the Bank have provided a substantial part of the Company's
operating funds and for the foreseeable future it is anticipated that dividends
paid by the Bank to the Company will continue to be the Company's principal
source of operating funds. Capital adequacy requirements serve to limit the
amount of dividends that may be paid by the Bank. Under federal law, the Bank
cannot pay a dividend if, after paying the dividend, the Bank will be
"undercapitalized." The FDIC may declare a dividend payment to be unsafe and
unsound even though the Bank would continue to meet its capital requirements
after the dividend. Because the Company is a legal entity separate and distinct
from its subsidiaries, its right to participate in the distribution of assets of
any subsidiary upon the subsidiary's liquidation or reorganization will be
subject to the prior claims of the subsidiary's creditors. In the event of a
liquidation or other resolution of an insured depository institution, the claims
of depositors and other general or subordinated creditors are entitled to a
priority of payment over the claims of holders of any obligation of the
institution to its shareholders, including any depository institution holding
company (such as the Company) or any shareholder or creditor thereof.
9
Examinations. The FDIC periodically examines and evaluates insured banks.
Based on such an evaluation, the FDIC may revalue the assets of the institution
and require that it establish specific reserves to compensate for the difference
between the FDIC-determined value and the book value of such assets. The Texas
Banking Department also conducts examinations of state banks but may accept the
results of a federal examination in lieu of conducting an independent
examination.
Audit Reports. Insured institutions with total assets of $500 million or
more must submit annual audit reports prepared by independent auditors to
federal and state regulators. In some instances, the audit report of the
institution's holding company can be used to satisfy this requirement. Auditors
must receive examination reports, supervisory agreements and reports of
enforcement actions. In addition, financial statements prepared in accordance
with generally accepted accounting principles, management's certifications
concerning responsibility for the financial statements, internal controls and
compliance with legal requirements designated by the FDIC, and an attestation by
the auditor regarding the statements of management relating to the internal
controls must be submitted. For institutions with total assets of more than $3
billion, independent auditors may be required to review quarterly financial
statements. FDICIA requires that independent audit committees be formed,
consisting of outside directors only. The committees of such institutions must
include members with experience in banking or financial management, must have
access to outside counsel, and must not include representatives of large
customers.
Capital Adequacy Requirements. The FDIC has adopted regulations
establishing minimum requirements for the capital adequacy of insured
institutions. The FDIC may establish higher minimum requirements if, for
example, a bank has previously received special attention or has a high
susceptibility to interest rate risk.
The FDIC's risk-based capital guidelines generally require state banks to
have a minimum ratio of Tier 1 capital to total risk-weighted assets of 4.0% and
a ratio of total capital to total risk-weighted assets of 8.0%. The capital
categories have the same definitions for the Bank as for the Company. As of
December 31, 2002, the Bank's ratio of Tier 1 capital to total risk-weighted
assets was 13.71% and its ratio of total capital to total risk-weighted assets
was 14.91%. See "Management's Discussion and Analysis of Financial Condition and
Result of Operation of the Company - Financial Condition - Capital Resources."
The FDIC's leverage guidelines require state banks to maintain Tier 1
capital of no less than 4.0% of average total assets, except in the case of
certain highly rated banks for which the requirement is 3.0% of average total
assets. The Texas Banking Department has issued a policy which generally
requires state chartered banks to maintain a leverage ratio (defined in
accordance with federal capital guidelines) of 6.0% . As of December 31, 2002,
the Bank's ratio of Tier 1 capital to average total assets (leverage ratio) was
6.26%.
Corrective Measures for Capital Deficiencies. The federal banking
regulators are required to take "prompt corrective action" with respect to
capital-deficient institutions. Agency regulations define, for each capital
category, the levels at which institutions are "well capitalized," "adequately
capitalized," "under capitalized," "significantly under capitalized" and
"critically under capitalized." A "well capitalized" bank has a total risk-based
capital ratio of 10.0% or higher; a Tier 1 risk-based capital ratio of 6.0% or
higher; a leverage ratio of 5.0% or higher; and is not subject to any written
agreement, order or directive requiring it to maintain a specific capital level
for any capital measure. An "adequately capitalized" bank has a total risk-based
capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or
higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated
a composite 1 in its most recent examination report and is not experiencing
significant growth); and does not meet the criteria for a well capitalized bank.
A bank is "under capitalized" if it fails to meet any one of the ratios required
to be adequately capitalized. The Bank is classified as "well capitalized" for
purposes of the FDIC's prompt corrective action regulations.
In addition to requiring undercapitalized institutions to submit a capital
restoration plan, agency regulations contain broad restrictions on certain
activities of undercapitalized institutions including asset growth,
acquisitions, branch establishment and expansion into new lines of business.
With certain exceptions, an insured depository institution is prohibited from
making capital distributions, including dividends, and is prohibited from paying
management fees to control persons if the institution would be undercapitalized
after any such distribution or payment.
As an institution's capital decreases, the FDIC's enforcement powers become
more severe. A significantly undercapitalized institution is subject to mandated
capital raising activities, restrictions on interest rates paid and transactions
with affiliates, removal of management and other restrictions. The FDIC has only
very limited discretion in dealing with a critically undercapitalized
institution and is virtually required to appoint a receiver or conservator.
10
Banks with risk-based capital and leverage ratios below the required
minimums may also be subject to certain administrative actions, including the
termination of deposit insurance upon notice and hearing, or a temporary
suspension of insurance without a hearing in the event the institution has no
tangible capital.
Deposit Insurance Assessments. The Bank must pay assessments to the FDIC
for federal deposit insurance protection. The FDIC has adopted a risk-based
assessment system as required by FDICIA. Under this system, FDIC-insured
depository institutions pay insurance premiums at rates based on their risk
classification. Institutions assigned to higher risk classifications (that is,
institutions that pose a greater risk of loss to their respective deposit
insurance funds) pay assessments at higher rates than institutions that pose a
lower risk. An institution's risk classification is assigned based on its
capital levels and the level of supervisory concern the institution poses to the
regulators. In addition, the FDIC can impose special assessments in certain
instances. The current range of BIF assessments is between 0% and 0.27% of
deposits.
The FDIC established a process for raising or lowering all rates for
insured institutions semi-annually if conditions warrant a change. Under this
system, the FDIC has the flexibility to adjust the assessment rate schedule
twice a year without seeking prior public comment, but only within a range of
five cents per $100 above or below the premium schedule adopted. Changes in the
rate schedule outside the five cent range above or below the current schedule
can be made by the FDIC only after a full rulemaking with opportunity for public
comment.
On September 30, 1996, President Clinton signed into law an act that
contained a comprehensive approach to re-capitalizing the Savings Association
Insurance Fund ("SAIF") and to assure the payment of the Financing Corporation's
("FICO") bond obligations. Under this new act, banks insured under the BIF are
required to pay a portion of the interest due on bonds that were issued by FICO
to help shore up the ailing Federal Savings and Loan Insurance Corporation in
1987. The BIF-rate was required to equal one-fifth of the SAIF rate through
year-end 1999, or until the insurance funds merged, whichever occurred first.
Thereafter, BIF and SAIF payers will be assessed pro rata for the FICO bond
obligations. With regard to the assessment for the FICO obligation, for the
fourth quarter 2002, both the BIF and SAIF rates were .00170% of deposits.
Enforcement Powers. The FDIC and the other federal banking agencies have
broad enforcement powers, including the power to terminate deposit insurance,
impose substantial fines and other civil and criminal penalties and appoint a
conservator or receiver. Failure to comply with applicable laws, regulations and
supervisory agreements could subject the Company or its banking subsidiaries, as
well as officers, directors and other institution-affiliated parties of these
organizations, to administrative sanctions and potentially substantial civil
money penalties. The appropriate federal banking agency may appoint the FDIC as
conservator or receiver for a banking institution (or the FDIC may appoint
itself, under certain circumstances) if any one or more of a number of
circumstances exist, including, without limitation, the fact that the banking
institution is undercapitalized and has no reasonable prospect of becoming
adequately capitalized; fails to become adequately capitalized when required to
do so; fails to submit a timely and acceptable capital restoration plan; or
materially fails to implement an accepted capital restoration plan. The Texas
Banking Department also has broad enforcement powers over the Bank, including
the power to impose orders, remove officers and directors, impose fines and
appoint supervisors and conservators.
Brokered Deposit Restrictions. Adequately capitalized institutions cannot
accept, renew or roll over brokered deposits except with a waiver from the FDIC,
and are subject to restrictions on the interest rates that can be paid on such
deposits. Undercapitalized institutions may not accept, renew, or roll over
brokered deposits.
Cross-Guarantee Provisions. The Financial Institutions Reform, Recovery and
Enforcement Act of 1989 ("FIRREA") contains a "cross-guarantee" provision which
generally makes commonly controlled insured depository institutions liable to
the FDIC for any losses incurred in connection with the failure of a commonly
controlled depository institution.
Community Reinvestment Act. The CRA and the regulations issued thereunder
are intended to encourage banks to help meet the credit needs of their service
area, including low and moderate income neighborhoods, consistent with the safe
and sound operations of the banks. These regulations also provide for regulatory
assesent of a bank's record in meeting the needs of its service area when
considering applications to establish branches, merger applications and
applications to acquire the assets and assume the liabilities of another bank.
FIRREA requires federal banking agencies to make public a rating of a bank's
performance under the CRA. In the case of a bank holding company, the CRA
performance record of the banks involved in the transaction are reviewed in
connection with the filing of an application to acquire ownership or control of
shares or assets of a bank or to merge with any other bank holding company. An
unsatisfactory record can substantially delay or block the transaction.
11
Consumer Laws and Regulations. In addition to the laws and regulations
discussed herein, the Bank is also subject to certain consumer laws and
regulations that are designed to protect consumers in transactions with banks.
While the list set forth herein is not exhaustive, these laws and regulations
include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds
Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity
Act, and the Fair Housing Act, among others. These laws and regulations mandate
certain disclosure requirements and regulate the manner in which financial
institutions must deal with customers when taking deposits or making loans to
such customers. The Bank must comply with the applicable provisions of these
consumer protection laws and regulations as part of their ongoing customer
relations.
The USA Patriot Act of 2001. The Uniting and Strengthening America by
Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of
2001 ("USA Patriot Act") was enacted in October 2001. The USA Patriot Act is
intended to strengthen U.S. law enforcement's and the intelligence communities'
ability to work cohesively to combat terrorism on a variety of fronts. The
potential impact of the USA Patriot Act on financial institutions of all kinds
is significant and wide ranging. The USA Patriot Act contains sweeping
anti-money laundering and financial transparency laws and requires various
regulations, including: (i) due diligence requirements for financial
institutions that administer, maintain, or manage private bank accounts or
correspondent accounts for non-U.S. persons; (ii) standards for verifying
customer identification at account opening; (iii) rules to promote cooperation
among financial institutions, regulators and law enforcement entities in
identifying parties that may be involved in terrorism or money laundering; (iv)
reports by nonfinancial trades and business filed with the Treasury Department's
Financial Crimes Enforcement Network for transactions exceeding $10,000; and (v)
filing of suspicious activities reports involving securities by brokers and
dealers if they believe a customer may be violating U.S. laws and regulations.
Privacy. In addition to expanding the activities in which banks and bank
holding companies may engage, the Gramm-Leach-Bliley Act also imposed new
requirements on financial institutions with respect to customer privacy. The
Gramm-Leach-Bliley Act generally prohibits disclosure of customer information to
non-affiliated third parties unless the customer has been given the opportunity
to object and has not objected to such disclosure. Financial institutions are
further required to disclose their privacy policies to customers annually.
Financial institutions, however, will be required to comply with state law if it
is more protective of customer privacy than the Gramm-Leach-Bliley Act.
Instability and Regulatory Structure
Various legislation, such as the Gramm-Leach-Bliley Act which expanded the
powers of banking institutions and bank holding companies, and proposals to
overhaul the bank regulatory system and limit the investments that a depository
institution may make with insured funds, is from time to time introduced in
Congress. Such legislation may change banking statutes and the operating
environment of the Company and its banking subsidiaries in substantial and
unpredictable ways. The Company cannot determine the ultimate effect that the
Gramm-Leach-Bliley Act will have, or the effect that any potential legislation,
if enacted, or implemented regulations with respect thereto, would have, upon
the financial condition or results of operations of the Company or its
subsidiaries.
Expanding Enforcement Authority
One of the major additional burdens imposed on the banking industry by
FDICIA is the increased ability of banking regulators to monitor the activities
of banks and their holding companies. In addition, the Federal Reserve Board and
FDIC are possessed of extensive authority to police unsafe or unsound practices
and violations of applicable laws and regulations by depository institutions and
their holding companies. For example, the FDIC may terminate the deposit
insurance of any institution which it determines has engaged in an unsafe or
unsound practice. The agencies can also assess civil money penalties, issue
cease and desist or removal orders, seek injunctions, and publicly disclose such
actions. FDICIA, FIRREA and other laws have expanded the agencies' authority in
recent years, and the agencies have not yet fully tested the limits of their
powers.
Effect on Economic Environment
The policies of regulatory authorities, including the monetary policy of
the Federal Reserve Board, have a significant effect on the operating results of
bank holding companies and their subsidiaries. Among the means available to the
Federal Reserve Board to affect the money supply are open market operations in
U.S. government securities, changes in the discount rate on member bank
borrowings, and changes in reserve requirements against member bank deposits.
These means are used in varying combinations to influence overall growth and
distribution of bank loans, investments and deposits, and their use may affect
interest rates charged on loans or paid for deposits.
12
Federal Reserve Board monetary policies have materially affected the
operating results of commercial banks in the past and are expected to continue
to do so in the future. The nature of future monetary policies and the effect of
such policies on the business and earnings of the Company and its subsidiaries
cannot be predicted.
ITEM 2. PROPERTIES
The Company conducts business at 42 full-service banking locations. The
Company's headquarters are located at 4295 San Felipe, Houston, Texas. The
Company owns all of the buildings in which its Banking Centers are located other
than the following:
Banking Center Expiration Date of Lease
---------------- --------------------------
Bellaire ...................... October 2007
City West ..................... November 2003
Copperfield ................... April 2005
Downtown ...................... October 2012
Fairfield ..................... May 2005
Galveston ..................... November 2005
Gladebrook .................... October 2010
Medical Center ................ February 2005
Post Oak ...................... June 2007
River Oaks .................... December 2004
Waugh ......................... February 2011
The expiration dates of the leases listed above do not include the renewal
option periods which may be available. The following table sets forth specific
information on each of the Company's locations:
Location Address Deposits at December 31, 2002
-------- ------- -----------------------------
(Dollars in thousands)
Aldine 1906 Aldine Bender $ 17,923
Houston, TX 77032
Angleton 116 South Velasco 43,830
Angleton, TX 77516
Bay City (1) 1600 Seventh St. 72,068
Bay City, TX 77404
Beeville (2) 100 South Washington 68,983
Beeville, TX 78102
Bellaire 6800 West Loop South Suite 100 29,168
Bellaire, TX 77401
Camp Wisdom 3515 W. Camp Wisdom Road 35,173
Dallas, TX 75237
CityWest 2500 CityWest Blvd. 15,694
Houston, TX 77042
Clear Lake 100 West Medical Center Blvd. 44,128
Webster, TX 77598
Cleveland 104 West Crockett 62,099
Cleveland, TX 77237
13
Location Address Deposits at December 31, 2002
-------- ------- -----------------------------
(Dollars in thousands)
Copperfield 8686 Highway 6 North $ 2,171
Houston, TX 77095
Cuero 106 North Esplanade 26,616
Cuero, TX 77954
Cypress 25820 U.S. 290 35,158
Cypress, TX 77429
Dayton 106 North Main 63,769
Dayton, TX 77535
Downtown 777 Walker, Suite L140 9,904
Houston, TX 77002
East Bernard 700 Church St. 56,455
East Bernard, TX 77435
Edna 102 North Wells 62,133
Edna, TX 77962
El Campo 1301 North Mechanic 99,468
El Campo, TX 77437
Fairfield 15050 Fairfield Village Square Dr. 6,666
Cypress, TX 77433
Galveston 2424 Market St. 4,225
Galveston, TX 77550
Gladebrook 3934 FM 1960 West, Suite 100 35,853
Houston, TX 77068
Goliad 145 North Jefferson 12,455
Goliad, TX 77963
Highway 6-West 1070 Highway 6 South 7,858
Houston, TX 77077
Hitchcock 8300 Highway 6 11,121
Hitchcock, TX 77563
Liberty 520 Main St. 55,081
Liberty, TX 77575
Magnolia 18935 FM 1488 28,710
Magnolia, TX 77355
Mathis 103 North Highway 359 27,526
Mathis, TX 78368
Medical Center 7505 South Main St., Suite 100 25,515
Houston, TX 77030
14
Location Address Deposits at December 31, 2002
-------- ------- -----------------------------
(Dollars in thousands)
Memorial 12602 Memorial Drive $ 22,912
Houston, TX 77024
Mont Belvieu 10305 Eagle Drive 6,753
Mont Belvieu, TX 77580
Needville(3) 9022 Main St. 26,635
Needville, TX 77461
Palacios 600 Henderson 24,774
Palacios, TX 77465
Post Oak 3040 Post Oak Blvd. Suite 150 76,047
Houston, TX 77056
River Oaks 4295 San Felipe 114,752
Houston, TX 77027
Sweeny 206 North McKinney 12,395
Sweeny, TX 77480
Tanglewood 5707 Woodway 10,387
Houston, TX 77057
Victoria 2702 North Navarro 44,039
Victoria, TX 77901
Waugh 55 Waugh Drive 29,025
Houston, TX 77007
West Columbia 510 East Brazos 48,612
West Columbia, TX 77486
Westmoreland 2415 S. Westmoreland Rd. 71,678
Dallas, TX 75211
Wharton 143 West Burleson 71,769
Wharton, TX 77488
Winnie 146 Spur 5 10,748
Winnie, TX 77665
Woodcreek 2828 FM 1960 East 56,335
Houston, TX 77073
- ------------------
(1) The Bay City Banking Center consists of the main office located at 1600
Seventh Street and a drive-thru facility located approximately one- quarter
mile from the main office.
(2) The Beeville Banking Center consists of the main office located at 100
South Washington and a drive-thru facility located approximately one- half
mile from the main office.
(3) The Company is currently constructing a new facility for the Needville
Banking Center located at 13325 Highway 36, Needville, Texas 77461. The
building is expected to be completed by the end of 2003.
15
ITEM 3. LEGAL PROCEEDINGS
Neither the Company nor the Bank is currently a party to any material legal
proceeding.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of 2002.
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The Company's Common Stock began trading on November 12, 1998 and is listed
on the Nasdaq National Market System under the symbol "PRSP". Prior to that
date, the Common Stock was privately held and not listed on any public exchange
or actively traded. As of February 6, 2003, there were 18,903,483 shares
outstanding and 536 shareholders of record. The number of beneficial owners is
unknown to the Company at this time.
The following table presents the high and low sales prices for the Common
Stock reported on the Nasdaq National Market during the two years ended December
31, 2002:
2002 High Low
---- ---- ---
Fourth Quarter ................ $19.950 $15.280
Third Quarter ................. 19.950 15.000
Second Quarter ................ 18.590 15.550
First Quarter ................. 16.275 13.475
2001 High Low
---- ---- ---
Fourth Quarter ................ $13.870 $11.930
Third Quarter ................. 13.935 10.750
Second Quarter ................ 12.610 8.750
First Quarter ................. 11.313 9.375
Dividends
On May 31, 2002, the Company effected a two-for-one stock split in the form
of a 100 percent stock dividend to shareholders of record on May 20, 2002. The
Company issued approximately 8.1 million shares in connection with the split.
All per share and share information has been restated to reflect this split.
Holders of Common Stock are entitled to receive dividends when, as and if
declared by the Company's Board of Directors out of funds legally available
therefor. While the Company has declared dividends on its Common Stock since
1994, and paid quarterly dividends aggregating $0.22 per share in 2002 and
$0.195 per share in 2001, there is no assurance that the Company will continue
to pay dividends in the future.
The principal source of cash revenues to the Company is dividends paid by
the Bank with respect to the Bank's capital stock. There are certain
restrictions on the payment of such dividends imposed by federal and state
banking laws, regulations and authorities. Under federal law, the Bank cannot
pay a dividend if it will cause the Bank to be "undercapitalized." The Bank is
also subject to risk-based capital rules that restrict its ability to pay
dividends. The risk-based capital rules set a specific schedule for achieving
minimum capital levels in relation to risk-weighted assets. Regulatory
authorities can impose stricter limitations on the ability of the Bank to pay
dividends if they consider the payment to be an unsafe or unsound practice.
16
The cash dividends paid per share by quarter for the Company's last two
fiscal years were as follows:
2002 2001
---- ----
Fourth quarter ............... $0.055 $0.050
Third quarter ................ 0.055 0.050
Second quarter ............... 0.055 0.050
First quarter ................ 0.055 0.045
Securities Authorized for Issuance under Equity Compensation Plans
The Company currently has two stock option plans, both of which were
approved by the Company's shareholders. The following table provides information
as of December 31, 2002 regarding the Company's equity compensation plans under
which the Company's equity securities are authorized for issuance:
Number of securities
remaining available for
future issuance under
Number of securities to equity compensation
be issued upon exercise Weighted-average plans (excluding
of outstanding options, exercise price of securities reflected
Plan category warrants and rights outstanding options in column (a))
- ----------------------------- ------------------------- ------------------- -----------------------
Equity compensation plans
approved by security holders .......... 684,153(1) $ 7.88 541,000
Equity compensation plans not
approved by security holders .......... -- -- --
--------------- --------- -----------
Total ............................. 684,153 $ 7.88 541,000
(1) Includes (a) 29,673 shares which may be issued upon exercise of options
outstanding assumed by the Company in connection with the acquisition of
Paradigm Bancorporation, Inc. at a weighted average exercise price of $10.66 and
(b) 2,480 shares which may be issued upon exercise of options outstanding
assumed by the Company in connection with the merger with Commercial Bancshares,
Inc. at a weighted-average exercise price of $5.16.
17
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data for, and as of the end
of, each of the years in the five-year period ended December 31, 2002 are
derived from and should be read in conjunction with the Company's consolidated
financial statements and the notes thereto and the information contained in
"Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations." The consolidated financial statements as of December 31, 2002
and 2001 and for each of the years in the three-year period ended December 31,
2002 and the report thereon of Deloitte & Touche LLP are included elsewhere in
this document. The historical financial data of the Company has been restated to
include the accounts and operations of Commercial Bancshares, Inc. for all
periods prior to February 23, 2001. All per share data has been restated to
include the two-for-one stock split effective May 31, 2002.
As of and for the Years Ended December 31,
------------------------------------------------------------------
2002 2001 2000 1999 1998
---------- --------- ---------- --------- ---------
(Dollars in thousands, except per share data)
Income Statement Date:
Interest income .................................... $ 80,742 $ 76,520 $ 70,079 $ 56,458 $ 46,026
Interest expense ................................... 25,931 35,785 35,564 26,189 21,923
---------- ---------- ---------- ---------- ---------
Net interest income ............................. 54,811 40,735 34,515 30,269 24,103
Provision for credit losses ........................ 1,010 700 275 420 264
---------- ---------- ---------- ---------- ---------
Net interest income after provision
for credit losses ............................. 53,801 40,035 34,240 29,849 23,839
Noninterest income ................................. 11,528 8,590 7,760 6,151 4,808
Noninterest expense ................................ 34,453 30,295(1) 26,767 21,822 17,989
---------- ---------- ---------- ---------- ---------
Income before taxes ............................. 30,876 18,330(1) 15,233 14,178 10,658
Provision for income taxes ......................... 9,555 5,372(1) 4,532 4,747 3,577
---------- ---------- ---------- ---------- ---------
Net income ......................................... $ 21,321 $ 12,958(1) $ 10,701 $ 9,431 $ 7,081
========== ============= ========== ========== =========
Per Share Data(2):
Basic earnings per share ........................... $ 1.25 $ 0.80(3) $ 0.67 $ 0.59 $ 0.51
Diluted earnings per share ......................... 1.22 0.79(3) 0.65 0.58 0.50
Book value per share ............................... 8.19 5.47 4.98 4.32 3.88
Cash dividends declared ............................ 0.22 0.195 0.18 0.10 0.10
Dividend payout ratio .............................. 18.13% 24.39% 25.75% 19.10% 33.82%
Weighted average shares outstanding (basic)
(in thousands) .................................. 17,122 16,172 16,064 15,972 13,832
Weighted average shares outstanding (diluted)
(in thousands) .................................. 17,442 16,498 16,454 16,408 14,230
Shares outstanding at end of period
(in thousands) .................................. 18,896 16,210 16,144 15,990 15,946
Balance Sheet Data (at period end):
Total assets ....................................... $1,822,256 $1,262,325 $1,146,140 $1,027,631 $ 800,158
Securities ......................................... 950,317 752,322 586,952 514,983 455,202
Loans .............................................. 679,559 424,400 411,203 366,803 276,106
Allowance for credit losses ........................ 9,580 5,985 5,523 5,031 3,682
Total deposits ..................................... 1,586,611 1,123,397 1,033,546 878,589 714,365
Borrowings and notes payable ....................... 37,939 18,080 13,931 53,119 17,508
Total shareholders' equity ......................... 154,739 88,725 80,333 69,025 61,781
Company-obligated mandatorily redeemable
preferred securities of subsidiary
trusts (4) ...................................... 33,000 27,000 12,000 12,000 --
Average Balance Sheet Data:
Total assets ....................................... $1,469,860 $1,191,190 $1,045,882 $ 875,781 $ 700,410
Securities ......................................... 818,362 666,241 550,431 465,788 392,026
Loans .............................................. 524,885 419,553 383,054 319,178 238,855
Allowance for credit losses ........................ 7,350 5,586 5,245 4,272 2,994
Total deposits .................................... 1,300,884 1,061,195 920,526 767,879 628,557
Total shareholders' equity ......................... 114,234 85,319 72,952 64,911 47,574
Company-obligated mandatorily redeemable
preferred securities of subsidiary
trusts (4) ...................................... 28,750 18,875 12,000 1,500 --
(Table continued on next page)
18
As of and for the Years Ended December 31,
----------------------------------------------------------------
2002 2001 2000 1999 1998
--------- -------- -------- -------- -------
(Dollars in thousands, except per share data)
Performance Ratios:
Return on average assets ............................... 1.45% 1.09%(5) 1.02% 1.08% 1.01%
Return on average equity ............................... 18.66 15.19(5) 14.67 14.53 14.88
Net interest margin (tax-equivalent) (6) ............... 4.16 3.86 3.69 3.77 3.75
Efficiency ratio(7) .................................... 50.36 60.14(5) 62.29 59.29 61.72
Asset Quality Ratios(8):
Nonperforming assets to total loans and
other real estate ................................... 0.38% 0.00% 0.32% 0.34% 0.14%
Net loan charge-offs (recoveries)
to average loans .................................... 0.08 0.06 (0.04) (0.11) (0.08)
Allowance for credit losses to total
loans ............................................... 1.41 1.41 1.34 1.37 1.33
Allowance for credit losses to
nonperforming loans(9) .............................. 408.53 n/m(10) 700.89 657.65 941.69
Capital Ratios(8):
Leverage ratio ......................................... 6.56% 7.57% 6.17% 6.17% 6.59%
Average shareholders' equity to average
total assets ........................................ 8.52 7.16 6.98 7.41 6.79
Tier 1 risk-based capital ratio ........................ 14.10 18.34 13.80 13.89 15.06
Total risk-based capital ratio ......................... 15.30 19.52 14.93 15.74 16.14
- ------------------
(1) Certain income statement data for the year ended December 31, 2001
includes the merger-related expenses of $2.4 million, net of tax.
(2) Adjusted for a two-for one stock split effective May 31, 2002 and a
four-for-one stock split effective September 10, 1998.
(3) Earnings per share amounts for the year ended December 31, 2001 include
the merger-related expenses of $2.4 million.
(4) Consists of $12.0 million of trust preferred securities of Prosperity
Capital Trust I due November 12, 2029, $15.0 million of trust preferred
securities of Prosperity Statutory Trust II due July 31, 2031 and $6.0
million of trust preferred securities of Paradigm Capital Trust II due
February 20, 2031.
(5) Selected performance ratios for the year ended December 31, 2001 include
the merger-related expenses of $2.4 million.
(6) Calculated on a tax-equivalent basis using a 35% federal income tax rate
for the years ended December 31, 2002 and 2001 and a 34% federal income tax
rate for the years ended December 31, 1998, 1999 and 2000.
(7) Calculated by dividing total noninterest expense, excluding securities
losses and credit loss provisions, by net interest income plus
noninterest income. The interest expense related to debentures issued by
the Company in connection with the issuance by subsidiary trusts of trust
preferred securities is treated as interest expense for this calculation.
Additionally, taxes are not part of this calculation.
(8) At period end, except for net loan charge-offs to average loans and
average shareholders' equity to average total assets, which is for periods
ended at such dates.
(9) Nonperforming loans consist of nonaccrual loans, loans contractually past
due 90 days or more, restructured loans and any other loan management deems
nonperforming.
(10) Amount not meaningful. Nonperforming assets totaled $1,000 at December 31,
2001.
19
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Management's Discussion and Analysis of Financial Condition and Results
of Operations analyzes the major elements of the Company's balance sheets and
statements of income. This section should be read in conjunction with the
Company's consolidated financial statements and accompanying notes and other
detailed information appearing elsewhere in this Annual Report on Form 10-K. The
Commercial Merger was accounted for as a pooling of interests and therefore the
historical financial data of the Company has been restated to include the
accounts and operations of Commercial for all periods prior to February 23,
2001.
For the Years Ended December 31, 2002, 2001 and 2000
Overview
Net income was $21.3 million, $13.0 million and $10.7 million for the
years ended December 31, 2002, 2001 and 2000, respectively, and diluted earnings
per share were $1.22, $0.79 and $0.65, respectively, for these same periods.
Earnings growth during both 2002 and 2001 resulted principally from an increase
in loan volume and acquisitions, including the Paradigm Acquisition and the
Commercial Merger. The Company posted returns on average assets of 1.45%, 1.09%
and 1.02% and returns on average equity of 18.66%, 15.19% and 14.67% for the
years ended December 31, 2002, 2001 and 2000, respectively. The Company posted
returns on average assets excluding amortization of goodwill and core deposit
intangibles and related tax expense of 1.46%, 1.18% and 1.12% and returns on
average equity excluding amortization of goodwill and core deposit intangibles
and related tax expense of 18.82%, 16.55% and 16.08% for the years ended
December 31, 2002, 2001 and 2000, respectively. The Company's efficiency ratio
was 50.36% in 2002, 60.14% in 2001 and 62.29% in 2000. The Company's efficiency
ratio excluding amortization of goodwill and core deposit intangibles was 50.06%
in 2002, 57.29% in 2001 and 59.47% in 2000.
Total assets at December 31, 2002, 2001 and 2000 were $1.822 billion,
$1.262 billion and $1.146 billion, respectively. Total deposits at December 31,
2002, 2001 and 2000 were $1.587 billion, $1.123 billion, and $1.034 billion,
respectively, with deposit growth in each period resulting from acquisitions and
internal growth. Total loans were $679.6 million at December 31, 2002, an
increase of $255.2 million or 60.1% from $424.4 million at the end of 2001.
Total loans were $411.2 million at year-end 2000. At December 31, 2002, the
Company had $2.3 million in nonperforming loans and its allowance for credit
losses was $9.6 million. Shareholders' equity was $154.7 million, $88.7 million
and $80.3 million at December 31, 2002, 2001 and 2000, respectively.
On February 23, 2001, the Company completed its merger with Commercial
Bancshares, Inc. As a result of the Commercial Merger, the Company issued an
aggregate of 5,537,220 (after two for one stock split) shares of its Common
Stock to the holders of Commercial common stock. In connection with the
Commercial Merger, the Company incurred approximately $2.4 million in pretax
merger-related expenses and other charges (the "Special Charge"). The
transaction was accounted for as a pooling of interests and therefore the
historical financial data of the Company has been restated to include the
accounts and operations of Commercial for all periods prior to the effective
time of the Commercial Merger.
On May 31, 2002, the Company effected a two-for-one stock split in the
form of a 100 percent stock dividend to shareholders of record on May 20, 2002.
The Company issued approximately 8.1 million shares in connection with the
split. All per share and share information has been restated to reflect this
split.
Critical Accounting Policies
The Company's accounting policies are integral to understanding the
results reported. Accounting policies are described in detail in Note 1 to the
consolidated financial statements. 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. Charge-offs occur when loans are deemed to be uncollectable.
20
Results of Operations
Net Interest Income
The Company's operating results depend primarily on its net interest
income, which is the difference between interest income on interest-earning
assets, including securities and loans, and interest expense incurred on
interest-bearing liabilities, including deposits and other borrowed funds.
Interest rate fluctuations, as well as changes in the amount and type of earning
assets and liabilities, combine to affect net interest income. 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."
2002 versus 2001. Net interest income for the year ended December 31,
2002 was $54.8 million compared with $40.7 million for the year ended December
31, 2001, an increase of $14.1 million or 34.6%. The improvement in net interest
income for 2002 was principally due to an increase in total average
interest-earning assets and a decrease in the rate paid on interest-bearing
liabilities that exceeded the decrease in the yield on interest-earning assets
by 94 basis points. Average interest-earning assets increased $247.9 million
from $1.116 billion at December 31 2001 to $1.364 billion at December 31, 2002.
Total cost of interest-bearing liabilities decreased 160 basis points from 3.99%
at December 31, 2001 to 2.39% at December 31, 2002. Total yield on
interest-earning assets decreased 66 basis points from 6.58% at December 31,
2001 to 5.92% at December 31, 2002. The net interest margin on a tax-equivalent
basis increased 30 basis points to 4.16% at December 31, 2002 from 3.86% at
December 31, 2001.
2001 versus 2000. Net interest income for the year ended December 31,
2001 was $40.7 million compared with $34.5 million for the year ended December
31, 2000, an increase of $6.2 million or 18.0%. The improvement in net interest
income for 2001 was principally due to an increase in total average
interest-earning assets and a decrease in the rate paid on interest-bearing
liabilities that exceeded the decrease in the yield on interest-earning assets
by 22 basis points. Average interest-earning assets increased $144.9 million
from $971.4 million at December 31 2000 to $1.116 billion at December 31, 2001.
Total cost of interest-bearing liabilities decreased 58 basis points from 4.57%
at December 31, 2000 to 3.99% at December 31, 2001. Total yield on
interest-earning assets decreased 36 basis points from 7.21% at December 31,
2000 to 6.85% at December 31, 2001. The net interest margin on a tax-equivalent
basis increased 17 basis points to 3.86% at December 31, 2001 from 3.69% at
December 31, 2000.
21
The following table presents for the periods indicated the total dollar
amount of average balances, interest income from average interest-earning assets
and the resultant yields, as well as the interest expense on average
interest-bearing liabilities, expressed both in dollars and rates. 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.
Years Ended December 31,
---------------------------------------------------------------------------------------------------
2002 2001 2000
------------------------------- ------------------------------- ----------------------------------
Average Interest Average Average Interest Average Average Interest Average
Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
Balance Paid Rate Balance Paid Rate Balance Paid Rate
---------- -------- --------- ---------- ------ -------- ---------- ------ ------
(Dollars in thousands)
Assets
Interest-earning assets:
Loans ........................ $ 524,885 $ 38,330 7.30% $ 419,553 $ 34,731 8.28% $ 383,054 $ 33,599 8.77%
Securities(1) ................ 818,362 42,104 5.14 666,241 40,353 6.06 550,431 33,978 6.17
Federal funds sold and
other temporary
investments ................. 20,956 308 1.47 30,478 1,436 4.71 37,929 2,502 6.60
---------- ---------- ---------- ---------- ---------- ----------
Total interest-earning
assets .................... 1,364,203 80,742 5.92% 1,116,272 76,520 6.58% 971,414 70,079 7.21%
---------- ---------- ----------
Less allowance for
credit losses ............... (7,350) (5,586) (5,245)
---------- ---------- ----------
Total interest-earning
assets, net of
allowance ................. 1,356,853 1,110,686 966,169
Noninterest-earning assets ... 113,007 80,504 79,713
---------- ---------- ----------
Total assets ............... $1,469,860 $1,191,190 $1,045,882
========== ========== ==========
Liabilities and
shareholders' equity
Interest-bearing liabilities:
Interest-bearing demand
deposits .................... $ 249,045 $ 3,162 1.27% 199,077 $ 4,529 2.27% $ 185,486 $ 6,346 3.42%
Savings and money
market accounts ............. 315,717 5,219 1.65 252,576 7,978 3.16 220,266 8,628 3.92
Certificates of deposit ...... 505,796 16,595 3.28 428,314 22,273 5.20 339,580 18,577 5.47
Federal funds purchased
and other borrowings ........ 16,435 955 5.81 17,219 1,005 5.84 32,333 2,013 6.23
---------- ---------- ---------- ---------- ---------- ----------
Total interest-bearing
liabilities ............... 1,086,993 25,931 2.39% 897,186 35,785 3.99% 777,665 35,564 4.57%
---------- ---------- ---------- ---------- ---------- ----------
Noninterest-bearing
liabilities:
Noninterest-bearing
demand deposits ............. 230,326 181,228 175,194
Company obligated
mandatorily redeemable
trust preferred
securities of subsidiary
trusts ...................... 28,750 18,875 12,000
Other liabilities ............ 9,557 8,582 8,071
---------- ---------- ----------
Total liabilities .......... 1,355,626 1,105,871 972,930
---------- ---------- ----------
Shareholders' equity ........... 114,234 85,319 72,952
---------- ---------- ----------
Total liabilities and
shareholders' equity ...... $1,469,860 $1,191,190 $1,045,882
========== ========== ==========
Net interest rate spread ....... 3.53% 2.86% 2.64%
Net interest income and
margin(2) ..................... $ 54,811 4.02% $ 40,735 3.65% $ 34,515 3.55%
========== ========== ==========
Net interest income and
margin (tax-equivalent
basis)(3) ..................... $ 56,734 4.16% $ 43,057 3.86% $ 35,890 3.69%
========== ========== ==========
- ------------------------------------------
(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% for the years ended December 31, 2002 and December 31, 2001 and
34% for the period ended December 31, 2000 and other applicable effective
tax rates.
22
The following table presents the dollar amount of changes in interest
income and interest expense for the major components of interest-earning assets
and interest-bearing liabilities and distinguishes between the increase
(decrease) related to higher outstanding balances and the volatility of interest
rates. For purposes of this table, changes attributable to both rate and volume
which cannot be segregated have been allocated to rate.
Years Ended December 31,
--------------------------------------------------------------------
2002 vs. 2001 2001 vs. 2000
-------------------------------- --------------------------------
Increase Increase
(Decrease) (Decrease)
Due to Due to
-------------------- --------------------
Volume Rate Total Volume Rate Total
-------- -------- -------- -------- -------- --------
(Dollars in thousands)
Interest-earning assets:
Loans .................................................... $ 8,719 $ (5,120) $ 3,599 $ 3,201 $ (2,069) $ 1,132
Securities ............................................... 9,214 (7,463) 1,751 7,149 (774) 6,375
Federal funds sold and other temporary
investments ........................................... (449) (679) (1,128) (492) (574) (1,066)
-------- -------- -------- -------- -------- --------
Total increase (decrease) in interest income .......... 17,484 (13,262) 4,222 9,858 (3,417) 6,441
-------- -------- -------- -------- -------- --------
Interest-bearing liabilities:
Interest-bearing demand deposits ......................... 1,137 (2,504) (1,367) 465 (2,282) (1,817)
Savings and money market accounts ........................ 1,994 (4,753) (2,759) 1,266 (1,916) (650)
Certificates of deposit .................................. 4,029 (9,707) (5,678) 4,854 (1,158) 3,696
Federal funds purchased and other borrowings ............. (46) (4) (50) (941) (67) (1,008)
-------- -------- -------- -------- -------- --------
Total increase (decrease) in interest expense ........ 7,114 (16,968) (9,854) 5,644 (5,423) 221
-------- -------- -------- -------- -------- --------
Increase in net interest income ............................. $ 10,370 $ 3,706 $ 14,076 $ 4,214 $ 2,006 $ 6,220
======== ======== ======== ======== ======== ========
Provision for Credit Losses
The Company's provision for credit losses is established through charges to
income in the form of the provision in order to bring the Company's allowance
for credit losses to a level deemed appropriate by management based on the
factors discussed under "Financial Condition - Allowance for Credit Losses". The
allowance for credit losses at December 31, 2002 was $9.6 million, representing
1.41% of outstanding loans. The provision for credit losses for the year ended
December 31, 2002 was $1.0 million compared with $700,000 for the year ended
December 31, 2001. The increase of $310,000 was primarily due to an increase in
net loan charge-offs for the year ended December 31, 2002. At December 31, 2002,
the Company had $396,000 in net loan charge-offs compared with $239,000 in net
loan charge-offs during 2001. The provision for credit losses for the year ended
December 31, 2001 was $700,000 compared with $275,000 in 2000. Net loan
recoveries were $171,000 in 2000.
Noninterest Income
The Company's primary sources of noninterest income are service charges on
deposit accounts and other banking service related fees. Loan origination fees
are recognized over the life of the related loan as an adjustment to yield using
the interest method. In 2002, noninterest income totaled $11.5 million, an
increase of $2.9 million or 34.