Securities and Exchange Commission Washington, D.C. 20549 Form 10-Q Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For Quarter Ended September 30, 2001 Commission file number 0-7275 Cullen/Frost Bankers, Inc. (Exact name of registrant as specified in its charter) Texas 74-1751768 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 100 W. Houston Street, San Antonio, Texas 78205 (Address of principal executive offices) (Zip code) (210) 220-4011 (Registrant's telephone number, including area code) N/A (Former name, former address and former fiscal year, if changed since last report) 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: At October 19, 2001, there were 51,384,172 shares of Common Stock, $.01 par value, outstanding. Part I. Financial Information Item 1. Financial Statements (Unaudited) <TABLE> <CAPTION> Consolidated Statements of Income Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands, except per share amounts) Three Months Ended Nine Months Ended September 30 September 30 ------------------- ------------------- 2001 2000 2001 2000 -------- -------- -------- -------- <S> <C> <C> <C> <C> INTEREST INCOME Loans, including fees $ 82,520 $101,684 $271,156 $290,206 Securities: Taxable 25,708 24,783 72,168 75,886 Tax-exempt 1,903 1,859 5,662 5,511 -------- -------- -------- -------- Total Securities 27,611 26,642 77,830 81,397 Time deposits 72 114 287 384 Federal funds sold and securities purchased under resale agreements 2,864 3,052 8,628 5,152 -------- -------- -------- -------- Total Interest Income 113,067 131,492 357,901 377,139 INTEREST EXPENSE Deposits 26,830 41,529 98,792 114,846 Federal funds purchased and securities sold under repurchase agreements 2,840 4,770 10,619 12,684 Guaranteed preferred beneficial interests in the Corporation's junior subordinated deferrable interest debentures 2,118 2,118 6,356 6 356 Subordinated notes payable and other borrowings 2,039 1,111 3,077 3,755 -------- -------- -------- -------- Total Interest Expense 33,827 49,528 118,844 137,641 -------- -------- -------- -------- Net Interest Income 79,240 81,964 239,057 239,498 Provision for possible loan losses 20,000 3,436 36,031 8,985 -------- -------- -------- -------- Net Interest Income After Provision For Possible Loan Losses 59,240 78,528 203,026 230,513 NON-INTEREST INCOME Trust fees 12,464 12,488 37,307 36,620 Service charges on deposit accounts 17,769 15,212 52,320 44,376 Insurance commissions 4,977 3,828 12,470 6,934 Other service charges, collection and exchange charges, commissions and fees 6,181 5,259 18,780 14,804 Net gain(loss) on securities transactions 80 2 78 (6) Other 7,328 5,618 23,075 22,170 -------- -------- -------- -------- Total Non-Interest Income 48,799 42,407 144,030 124,898 NON-INTEREST EXPENSE Salaries and wages 35,864 35,460 108,185 103,128 Pension and other employee benefits 9,302 7,338 26,552 22,559 Net occupancy of banking premises 7,636 7,050 22,182 20,666 Furniture and equipment 5,779 5,150 18,031 15,435 Intangible amortization 3,732 3,891 11,364 11,665 Other 20,960 19,584 63,327 58,849 -------- -------- -------- -------- Total Non-Interest Expense 83,273 78,473 249,641 232,302 -------- -------- -------- -------- Income Before Income Taxes and Cumulative Effect of Accounting Change 24,766 42,462 97,415 123,109 Income Taxes 8,116 14,704 32,574 42,565 -------- -------- -------- -------- Income Before Cumulative Effect of Accounting Change 16,650 27,758 64,841 80,544 Cumulative effect of change in accounting for derivatives, net of tax 3,010 -------- -------- -------- -------- Net Income $ 16,650 $ 27,758 $ 67,851 $ 80,544 ======== ======== ======== ======== Basic per share: Income before cumulative effect of accounting change $ .32 $ .53 $ 1.26 $ 1.54 Cumulative effect of change in accounting, net of taxes .06 -------- -------- -------- -------- Net Income $ .32 $ .53 $ 1.32 $ 1.54 ======== ======== ======== ======== Diluted per share: Income before cumulative effect of accounting change $ .31 $ .52 $ 1.21 $ 1.50 Cumulative effect of change in accounting, net of taxes .06 -------- -------- -------- -------- Net Income $ .31 $ .52 $ 1.27 $ 1.50 ======== ======== ======== ======== Dividends per common share $ .215 $ .195 $ .625 $ .565 See notes to consolidated financial statements. </TABLE> <TABLE> <CAPTION> Consolidated Balance Sheets Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands, except per share amounts) September 30 December 31 September 30 2001 2000 2000 ---------- ----------- ---------- <S> <C> <C> <C> Assets Cash and due from banks $ 866,342 $ 820,459 $ 685,383 Time deposits 3,267 3,574 5,410 Securities held to maturity 56,064 71,153 74,612 Securities available for sale 1,846,138 1,594,860 1,400,936 Trading account securities 6,906 2,471 230 Federal funds sold and securities purchased under resale agreements 307,525 215,050 248,825 Loans, net of unearned discount of $5,937 at September 30, 2001; $7,349 at December 31, 2000 and $6,787 at September 30, 2000 4,537,556 4,534,645 4,468,818 Less: Allowance for possible loan losses (80,188) (63,265) (59,965) ---------- ---------- ---------- Net loans 4,457,368 4,471,380 4,408,853 Banking premises and equipment 148,968 149,893 146,454 Accrued interest and other assets 419,228 331,532 384,110 ---------- ---------- ---------- Total Assets $8,111,806 $7,660,372 $7,354,813 ========== ========== ========== Liabilities Demand Deposits: Commercial and individual $2,086,805 $1,817,761 $1,722,117 Correspondent banks 246,978 245,734 229,624 Public funds 50,154 55,129 48,300 ---------- ---------- ---------- Total demand deposits 2,383,937 2,118,624 2,000,041 Time Deposits: Savings and Interest-on-Checking 961,343 1,012,790 951,350 Money market deposit accounts 1,837,416 1,774,656 1,759,809 Time accounts 1,258,238 1,275,289 1,245,304 Public funds 284,519 318,331 248,449 ---------- ---------- ---------- Total time deposits 4,341,516 4,381,066 4,204,912 ---------- ---------- ---------- Total deposits 6,725,453 6,499,690 6,204,953 Federal funds purchased and securities sold under repurchase agreements 363,562 363,111 367,372 Accrued interest and other liabilities 139,325 122,316 133,063 Subordinated notes payable and other long-term debt 152,123 3,661 3,695 Guaranteed preferred beneficial interest in the Corporation's junior subordinated deferrable interest debentures, net 98,609 98,568 98,554 ---------- ---------- ---------- Total Liabilities 7,479,072 7,087,346 6,807,637 Shareholders' Equity Common stock, par value $.01 per share 536 536 536 Shares authorized:90,000,000 Shares issued: 53,561,616 Surplus 191,643 187,673 186,827 Retained earnings 476,084 448,006 430,115 Accumulated other comprehensive gain (loss), net of tax 21,198 (4,023) (23,322) Treasury stock(2,007,570; 2,131,534; 1,771,353 shares) (56,727) (59,166) (46,980) ---------- ---------- ---------- Total Shareholders' Equity 632,734 573,026 547,176 ---------- ---------- ---------- Total Liabilities and Shareholders' Equity $8,111,806 $7,660,372 $7,354,813 ========== ========== ========== See notes to consolidated financial statements. </TABLE> <TABLE> <CAPTION> Consolidated Statements of Changes in Shareholders' Equity Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands) Accumulated Other Comprehensive Common Retained Income/(Loss) Treasury Stock Surplus Earnings net of tax Stock Total ------ -------- -------- ----------- ---------- -------- <S> <C> <C> <C> <C> <C> <C> Balance at January 1, 2000 $536 $185,437 $382,168 $(39,110) $(19,720) $509,311 Net income for the twelve months ended December 31, 2000 108,817 108,817 Unrealized gain on securities available for sale of $36,826, net of tax and reclassification adjustment for after-tax losses included in net income of $3 36,829 36,829 Additional minimum pension Liability, net of tax (1,742) (1,742) -------- Total comprehensive income 143,904 -------- Transactions from employee stock purchase plan and options 28 (3,532) 4,031 527 Tax benefit related to exercise of stock options 1,926 1,926 Purchase of treasury stock (44,985) (44,985) Issuance of restricted stock 282 (5) 1,508 1,785 Restricted stock plan deferred compensation, net 112 112 Cash dividend (39,554) (39,554) ---- -------- -------- -------- -------- -------- Balance at December 31, 2000 536 187,673 448,006 (4,023) (59,166) 573,026 Net income for the nine months ended September 30, 2001 67,851 67,851 Unrealized gain on securities available for sale of $25,272 net of tax and reclassification adjustment for after-tax gains included in net income of $51 25,221 25,221 -------- Total comprehensive income 93,072 -------- Transactions from employee stock purchase plan and options (5,735) 4,819 (916) Tax benefit related to exercise of stock options 3,268 3,268 Purchase of treasury stock (4,829) (4,829) Issuance of restricted stock 702 2,449 3,151 Restricted stock plan deferred compensation, net (1,782) (1,782) Cash dividend (32,256) (32,256) ---- -------- -------- -------- -------- -------- Balance at September 30, 2001 $536 $191,643 $476,084 $ 21,198 $(56,727) $632,734 ==== ======== ======== ======== ======== ======== See notes to consolidated financial statements. </TABLE> <TABLE> <CAPTION> Consolidated Statements of Cash Flows Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands) Nine Months Ended September 30 --------------------- 2001 2000 --------- ------- <S> <C> <C> Operating Activities Net income $ 67,851 $ 80,544 Adjustments to reconcile net income to net cash provided by operating activities: Provision for possible loan losses 36,031 8,985 Credit for deferred taxes (4,738) (2,366) Accretion of discounts on loans (1,403) (659) Accretion of securities' discounts (3,883) (2,131) Amortization of securities' premiums 1,811 1,148 Net increase in trading securities (4,435) (229) Net (gain) loss on securities transactions (78) 6 Net gain on sale of assets (1,630) (2,279) Depreciation and amortization 26,681 25,112 Increase in interest receivable (6,827) (7,584) (Decrease) increase in interest payable (5,019) 873 Originations of loans held-for-sale (36,925) (52,313) Proceeds from sales of loans held-for-sale 20,921 60,566 Tax benefit from exercise of employee stock options 3,268 1,081 Net change in other assets and liabilities 20,736 21,342 --------- ------- Net cash provided by operating activities 112,361 132,096 Investing Activities Proceeds from maturities of securities held to maturity 15,012 10,533 Purchases of investment securities (95) Proceeds from sales of securities available for sale 888,522 965,746 Proceeds from maturities of securities available for sale 455,494 218,021 Purchases of securities available for sale (1,554,265) (1,083,331) Purchase of bank-owned life insurance (100,000) Net increase in loans (3,343) (317,149) Net increase in bank premises and equipment (12,835) (14,764) Proceeds from sales of repossessed properties 769 1,360 Net cash and cash equivalents paid for acquisitions (4,954) (724) --------- -------- Net cash used by investing activities (315,600) (220,403) Financing Activities Net increase in demand deposits, IOC accounts, and savings accounts 242,814 240,711 Net (decrease) increase in certificates of deposits (17,051) 10,410 Net increase in short-term borrowings 451 33,913 Net proceeds from issuance of subordinated notes 148,646 Proceeds from employee stock purchase plan and options 3,515 3,729 Purchase of treasury stock (4,829) (33,420) Dividends paid (32,256) (29,526) -------- -------- Net cash provided by financing activities 341,290 225,817 -------- -------- Increase in cash and cash equivalents 138,051 137,510 Cash and cash equivalents at beginning of year 1,039,083 802,108 ---------- -------- Cash and cash equivalents at the end of the period $1,177,134 $ 939,618 ========== ======== Supplemental information: Interest paid $ 113,244 $ 136,768 See notes to consolidated financial statements. </TABLE> Notes to Consolidated Financial Statements Cullen/Frost Bankers, Inc. and Subsidiaries (tables in thousands) Note A - Basis of Presentation The consolidated financial statements include the accounts of Cullen/Frost Bankers, Inc. ("Cullen/Frost" or the "Corporation") and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The consolidated financial statements have not been audited by independent accountants, but in the opinion of management, reflect all adjustments necessary for a fair presentation of the financial position and results of operations. All such adjustments were of a normal and recurring nature. For further information, refer to the consolidated financial statements and footnotes thereto included in Cullen/Frost's Annual Report on Form 10-K for the year ended December 31, 2000. The balance sheet at December 31, 2000 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. Certain reclassifications have been made to make prior periods comparable. Note B - Allowance for Possible Loan Losses An analysis of the transactions in the allowance for possible loan losses is presented below. The amount charged to operating expense is based on management's assessment of the adequacy of the allowance based on estimated probable losses in the loan portfolio. Nine Months Ended September 30 ------------------ (in thousands) 2001 2000 ---------------------------------------------------------------------- Balance at beginning of the period $63,265 $58,345 Provision for possible loan losses 36,031 8,985 Net charge-offs: Losses charged to the allowance (24,414) (9,931) Recoveries 5,306 2,566 ------- ------- Net charge-offs (19,108) (7,365) ------- ------- Balance at the end of period $80,188 $59,965 ======= ======= Note C - Impaired Loans A loan within the scope of SFAS No. 114 is considered impaired when, based on current information and events, it is probable the Corporation will be unable to collect all amounts due according to the contractual terms of the loan agreement, including scheduled principal and interest payments. All impaired loans are included in non-performing assets. At September 30, 2001, the majority of the impaired loans were commercial loans and collectibility was measured based on the value of the collateral. Interest payments on impaired loans are typically applied to principal unless collectibility of the principal amount is fully assured, in which case interest is recognized on the cash basis. Interest revenue recognized on impaired loans for the nine months ended September 30, 2001 was $1.7 million compared to none for the first nine months of 2000. The total allowance for possible loan losses includes activity related to allowances calculated in accordance with SFAS No. 114 and activity related to other loan loss allowances determined in accordance with SFAS No. 5. The following is a summary of loans considered to be impaired: September 30 -------------------- (in thousands) 2001 2000 -------------------------------------------------------------------------- Impaired loans with no valuation reserve $ 9,706 $1,490 Impaired loans with a valuation reserve 31,420 4,545 ------- ------ Total recorded investment in impaired loans $41,126 $6,035 ======= ====== Average recorded investment in impaired loans $20,264 $8,069 Valuation reserve 15,542 1,932 Note D - Common Stock and Earnings Per Common Share A reconciliation of earnings per share follows: <TABLE> <CAPTION> Nine Months Ended Three Months Ended September 30 September 30 ------------------ -------------------- (in thousands, except per share amounts) 2001 2000 2001 2000 --------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Numerators for both basic and diluted earnings per share, net income $67,851 $80,544 $16,650 $27,758 ======= ======= ======= ======= Denominators: Denominators for basic earnings per share, average outstanding common shares 51,581 52,296 51,660 51,976 Dilutive effect of stock options 1,967 1,351 1,844 1,715 ------- ------- ------- ------- Denominator for diluted earnings per share 53,548 53,647 53,504 53,691 ======= ======= ======= ======= Basic per share: Income before cumulative effect of accounting change $ 1.26 $ 1.54 $ .32 $ .53 Cumulative effect of change in accounting, net of taxes .06 ------- ------- ------- ------- Net Income $ 1.32 $ 1.54 $ .32 $ .53 ======= ======= ======= ======= Diluted per share: Income before cumulative effect accounting change $ 1.21 $ 1.50 $ .31 $ .52 Cumulative effect of change in accounting, net of taxes .06 ------- ------- ------- ------- Net Income $ 1.27 $ 1.50 $ .31 $ .52 ======= ======= ======= ======= </TABLE> Note E - Capital The table below reflects various measures of regulatory capital at September 30, 2001 and 2000 for Cullen/Frost. The increase in the total capital ratio from last year resulted primarily from the issuance of $150 million of subordinated notes by Frost National Bank, discussed below. <TABLE> <CAPTION> September 30, 2001 September 30, 2000 ------------------- ------------------ Capital Amount Ratio Amount Ratio --------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Risk-Based Tier 1 Capital $ 587,761 10.43% $ 540,564 10.16% Tier 1 Capital minimum requirement 225,483 4.00 212,728 4.00 Total Capital $ 807,013 14.32% $ 600,529 11.29% Total Capital minimum requirement 450,965 8.00 425,456 8.00 Risk-adjusted assets, net of goodwill $5,637,066 $5,318,197 Leverage ratio 7.53% 7.58% Average equity as a percentage of average assets 7.90 7.44 </TABLE> At September 30, 2001 and 2000, Cullen/Frost's subsidiary bank was considered "well capitalized" as defined by the FDIC Improvement Act of 1991, the highest rating, and Cullen/Frost's capital ratios were in excess of "well capitalized" levels. A financial institution is deemed to be well capitalized if the institution has a total risk-based capital ratio of 10.0 percent or greater, a Tier 1 risk-based capital ratio of 6.0 percent or greater, and a Tier 1 leverage ratio of 5.0 percent or greater, and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. Cullen/Frost and its subsidiary bank currently exceed all minimum capital requirements. Management is not aware of any conditions or events that would have changed the Corporation's capital rating since September 30, 2001. Cullen/Frost is subject to the regulatory capital requirements administered by the Federal Reserve Bank. Regulators can initiate certain mandatory actions, if the Corporation fails to meet the minimum requirements, that could have a direct material effect on the Corporation's financial statements. The Frost National Bank, a wholly-owned subsidiary of Cullen/Frost, issued $150 million of its 6 7/8 percent Subordinated Bank Notes (the "Bank Notes") due 2011, during August of 2001. The Bank Notes pay interest semiannually and are not redeemable prior to maturity. The Bank Notes qualify as Tier 2 capital for both Frost National Bank and the Corporation and are reported as debt on the balance sheet. The Corporation records distributions payable on the Bank Notes as interest expense. The Bank Notes were offered only to accredited investors in denominations of $250 thousand or more under the Office of the Comptroller of the Currency's abbreviated registration procedures set forth in Section 16.6 of Part 16 of 12 C.F.R. Frost National Bank intends to use the proceeds of the sale of these Bank Notes for general corporate purposes. Note F - Income Taxes The following is an analysis of Cullen/Frost's income taxes included in the consolidated statements of operations for the nine-month periods and quarters ended September 30, 2001 and 2000: <TABLE> <CAPTION> Nine Months Ended Three Months Ended September 30 September 30 -------------------- ------------------- (in thousands) 2001 2000 2001 2000 ======================================================================================= <S> <C> <C> <C> <C> Current income tax expense $37,312 $44,931 $11,889 $14,382 Deferred income tax (benefit) credit (4,738) (2,366) (3,773) 322 ------- ------- ------- ------- Income taxes $32,574 $42,565 $ 8,116 $14,704 ======= ======= ======= ======= Current income tax expense related to the cumulative effect of change in accounting for derivatives 1,620 Income tax payments $36,120 $39,665 $17,195 $14,388 Net deferred tax assets at September 30, 2001, were $18.0 million with no valuation allowance. The deferred tax assets were supported by taxes paid in prior years. </TABLE> Note G - Acquisitions Cullen/Frost regularly evaluates acquisition opportunities and conducts due diligence activities in connection with possible acquisitions. As a result, acquisition discussions and, in some cases, negotiations may take place and future acquisitions involving cash, debt or equity securities may occur. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of the Corporation's book value and net income per common share may occur in connection with any future transactions. On August 1, 2001, Frost Insurance Agency ("FIA"), a subsidiary of The Frost National Bank, completed the acquisition of AIS Insurance & Risk Management, an independent insurance agency based in Fort Worth. AIS offers a broad range of commercial insurance for small to mid-size businesses, including property and casualty, employee benefits (health, life and retirement plans), business succession planning and risk management services. Results of operations have been included from the date of acquisition. The transaction is not expected to have a material impact on Cullen/Frost's 2001 results of operations. On July 1, 2000, FIA acquired Nieman Hanks Puryear Partners and Nieman Hanks Puryear Benefits ("Nieman Hanks"), an Austin-based independent insurance agency. Nieman Hanks offers property and casualty insurance, professional and umbrella liability, homeowners and auto insurance, group health, life and disability policies and 401(k) retirement plans and executive planning. Results of operations have been included from the date of acquisition. The Nieman Hanks acquisition did not have a material impact on Cullen/Frost's results of operations for the quarter or year-to-date ended September 30, 2001 and 2000. On April 1, 2000, FIA acquired Wayland Hancock, a Houston-based independent insurance agency. Wayland Hancock offers a full range of life and health insurance, as well as retirement and financial planning, to individuals and businesses. Results of operations have been included from the date of acquisition. This acquisition did not have a material impact on Cullen/Frost's results of operations for the quarter or year-to-date ended September 30, 2001 and 2000. Note H - Accounting for SFAS No. 133 On January 1, 2001 Cullen/Frost adopted SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133). SFAS No. 133 requires the recognition of all derivatives on the balance sheet at fair value. Derivatives that do not meet the specified "hedge" criterion of SFAS No. 133 hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value is immediately recognized in earnings. Cullen/Frost uses derivative instruments to protect against the risk of interest rate movements on the value of certain assets and liabilities or on future cash flows. The Company generally uses interest rate swaps to hedge fair values on certain fixed rate assets and liabilities. Prior to the adoption of SFAS No. 133, the fair value of derivative instruments held by Cullen/Frost were not recorded on the balance sheet. On January 1, 2001, Cullen/Frost adopted SFAS No. 133, and at that time, designated anew certain derivative instruments used for risk management into hedging relationships in accordance with the requirements of SFAS No. 133. Derivative instruments, particularly interest rate swaps, used to hedge changes in the fair value of certain fixed rate loans due to changes in interest rates were formally designated as fair value hedges. As of January 1, 2001, Cullen/Frost also held an interest rate floor with a notional amount of $1 billion. Prior to the adoption of SFAS No. 133,this interest rate floor contract was considered a hedge of interest rate exposure associated with commercial loan accounts in an environment of falling interest rates. This interest rate floor did not meet the criteria for hedge accounting under SFAS No. 133; and therefore, Cullen/Frost accounted for this floor as trading upon adoption of SFAS No. 133. Additionally, one interest rate swap contract historically characterized as a cash-flow type hedge of a pool of commercial floating rate loans also did not meet the criteria for hedge accounting upon adoption of SFAS No. 133. This interest rate swap contract was recorded at fair-value at January 1, 2001 as a trading derivative with an offsetting amount recorded as other comprehensive loss. On March 30, 2001, this interest rate contract matured and the fair value recorded at January 1, 2001 was reversed. The adoption of SFAS No. 133 on January 1, 2001 resulted in an after-tax cumulative effect of accounting change of approximately $3 million being recognized as income in the statement of income and the after-tax cumulative effect of accounting change of approximately $185 thousand recorded as other comprehensive income. The cumulative effect adjustments were determined based on the interpretive guidance issued by the Financial Accounting Standards Board to date. The after-tax cumulative effect of accounting change of approximately $3 million (excluding taxes of $1.6 million) to the statement of income was primarily due to the recording of the fair value of the interest rate floor as there was no intrinsic value to this interest rate floor. Subsequent to the adoption of SFAS No. 133, the interest rate floor was sold with an additional pre-tax gain of approximately $1.1 million recorded in other income above the amount reported in the cumulative effect amount. Cullen/Frost had 39 interest rate swaps with a notional amount of $115.4 million at September 30, 2001 used to hedge changes in the fair value of certain fixed rate loans due to changes in interest rates. These interest rate swaps were formally designated as fair value hedges. Each swap is expected to be highly effective as a fair value hedge for a specific fixed rate commercial loan or lease. Additionally, the Corporation entered into an interest rate swap with a notional amount of $150 million at September 30, 2001 used to hedge the fair value of the fixed rate subordinated debt interest payments, related to the debentures issued in August 2001 (see Note E), over a five year period. As of September 30, 2001, the Corporation recognized an immaterial net pre-tax loss in other non-interest expense, which represents the period change in the ineffective portion of all the fair-value hedges. All interest rate contracts involve the risk of dealing with counterparties and their ability to meet contractual terms. Each counterparty to a swap transaction has a credit rating that is investment grade. The net amount payable or receivable under interest rate swaps/floor is accrued as an adjustment to interest income and these amounts have not been material in 2001 or 2000. SFAS No. 133, as applied to Cullen/Frost's risk management strategies, may increase or decrease reported net income and stockholders' equity prospectively, depending on future levels of interest rates and other variables affecting the fair values of derivative instruments and hedged items, but will have no effect on cash flows or economic risk. Note I - Accounting Changes In September 2000, the FASB issued SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" (SFAS No. 140). SFAS No. 140 replaces SFAS No. 125. The guidance in SFAS No. 140, while not changing most of the guidance originally issued in SFAS No. 125, revises the standards for accounting for securitizations and other transfers of financial assets and collateral and requires certain additional disclosures related to transferred assets. Certain provisions of the statement related to the recognition, reclassification and disclosure of collateral, as well as the disclosure of securitization transactions, became effective for Cullen/Frost for 2000 year-end reporting. Other provisions related to the transfer and servicing of financial assets and the extinguishing of liabilities are effective for transactions occurring after March 31, 2001. Based on current circumstances, the application of the new rules did not have a material impact on the Corporation's results of operations, financial position or liquidity. On July 20, 2001, the FASB issued SFAS No. 141, "Business Combinations", and SFAS No. 142, "Goodwill and Other Intangible Assets." These Statements make significant changes to the accounting for business combinations, goodwill, and intangible assets. SFAS No. 141 eliminates the pooling-of-interests method of accounting for business combinations with limited exceptions for combinations initiated prior to July 1, 2001. In addition, it further clarifies the criteria for recognition of intangible assets separately from goodwill. SFAS No. 141 is effective for business combinations completed after June 30, 2001. SFAS No. 142 discontinues the practice of amortizing goodwill and indefinite lived intangible assets and initiates an annual review for impairment. Impairment would be examined more frequently if certain indicators are encountered. Intangible assets with a determinable useful life will continue to be amortized over that period. The amortization provisions apply to goodwill and intangible assets acquired after June 30, 2001. Accordingly, no amortization of the goodwill associated with Cullen/Frost's acquisition of AIS Insurance & Risk Management has been recorded. Goodwill and intangible assets on the books at June 30, 2001 will be affected when the Corporation adopts the Statement on January 1, 2002. Application of the non-amortization provisions of the Statement is expected to result in additional net income of approximately $7 million per year or approximately $.13 per diluted common share. During 2002, the Corporation will perform the first of the required impairment tests of goodwill as of January 1, 2002 and has not yet determined what the effect of these tests will be on the earnings and financial position of the Corporation. Note J - Operating Segments Cullen/Frost has three reportable operating segments: Banking, the Financial Management Group and Frost Securities Inc. Banking includes both commercial and consumer banking services, as well as the results of Frost Insurance Agency. Commercial services are provided to corporations and other business clients and include a wide array of lending and cash management products. Consumer banking services include direct lending and depository services. The Financial Management Group includes fee based services within private trust, retirement services, and financial management services including personal wealth management, insurance, and brokerage services. Frost Securities Inc., an investment banking subsidiary, began operations in August of 1999. These business units were identified through the products and services that are offered within each unit. Prior period amounts have been reclassified to conform to the current year's presentation. The accounting policies of each reportable segment are the same as those of the Corporation except for the following items, which impact the Banking and Financial Management Group segments. The Corporation uses a match-funded transfer pricing process to assess operating segment performance. Expenses for consolidated back-office operations are allocated to operating segments based on estimated uses of those services. General overhead type expenses such as executive administration, accounting, internal audit, and personnel are allocated based on the direct expense level of the operating segment. Income tax expense for the individual segments is calculated basically at the statutory rate. Parent Company records the tax expense or benefit necessary to reconcile to the consolidated total. <TABLE> <CAPTION> Nine Months Ended: Financial Management Frost Consolidated (in thousands) Banking Group Securities Non-Banks Total ================================================================================================================= <S> <C> <C> <C> <C> <C> September 30, 2001 Revenues from (expenses to) external customers $331,367 $50,401 $ 7,698 $(6,379) $383,087 ---------------------------------------------------------------- Net income (loss) $ 66,632 $ 8,405 $(2,891) $(4,295) $ 67,851 ================================================================ ================================================================================================================ September 30, 2000 Revenues from (expenses to) external customers $315,783 $50,482 $ 4,524 $(6,393) $364,396 ---------------------------------------------------------------- Net income (loss) $ 78,264 $12,155 $(2,380) $(7,495) $ 80,544 ================================================================ Three Months Ended: Financial Management Frost Consolidated (in thousands) Banking Group Securities Non-Banks Total ================================================================================================================= September 30, 2001 Revenues from (expenses to) external customers $111,079 $16,699 $ 2,369 $(2,108) $128,039 ---------------------------------------------------------------- Net income (loss) $ 15,644 $ 2,736 $ (878) $ (852) $ 16,650 ================================================================ ================================================================================================================= June 30, 2001 Revenues from (expenses to) external customers $109,610 $17,242 $ 2,926 $(2,107) $127,671 ---------------------------------------------------------------- Net income (loss) $ 28,114 $ 3,235 $ (958) $(1,730) $ 28,661 ================================================================ ================================================================================================================= September 30, 2000 Revenues from (expenses to) external customers $108,037 $17,074 $ 1,412 $(2,152) $124,371 ---------------------------------------------------------------- Net income (loss) $ 27,240 $ 4,081 $(1,240) $(2,323) $ 27,758 ================================================================ </TABLE> Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Review Cullen/Frost Bankers, Inc. and Subsidiaries (taxable-equivalent basis - tables in thousands) Forward-Looking Statements Certain statements contained in this Quarterly Report on Form 10-Q that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Act"), not withstanding that they are not specifically identified as such. In addition, certain statements in future filings by Cullen/Frost with the Securities and Exchange Commission, in press releases, and in oral and written statements made by or with the approval of the Corporation which are not statements of historical fact also constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans and objectives of Cullen/Frost or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and (iv) statements of assumptions underlying such statements. Words such as "believes", "anticipates", "expects", "intends", "targeted" and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward- looking statements include, but are not limited to: (i) local, regional and international economic conditions and the impact they may have on Cullen/Frost and its customers; (ii) the effects of and changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board; (iii) inflation, interest rate, market and monetary fluctuations; (iv) political instability; (v) acts of war or terrorism; (vi) the timely development and acceptance of new products and services and perceived overall value of these products and services by users; (vii) changes in consumer spending, borrowings and savings habits; (viii) technological changes; (ix) acquisitions and integration of acquired businesses; (x) the ability to increase market share and control expenses; (xi) changes in the competitive environment among financial holding companies; (xii) the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which Cullen/Frost and its subsidiaries must comply; (xiii) the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies as well as the Financial Accounting Standards Board; (xiv) changes in the Corporation's organization, compensation and benefit plans; (xv) the costs and effects of litigation and of unexpected or adverse outcomes in such litigation; (xvi) costs or difficulties related to the integration of the businesses of Cullen/Frost being greater than expected; and (xvii) the Corporation's success at managing the risks involved in the foregoing. Such forward-looking statements speak only as of the date on which such statements are made. Cullen/Frost undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events. Results of Operations The results of operations are included in the material that follows. All balance sheet amounts are presented in averages unless otherwise indicated. Certain reclassifications have been made to make prior periods comparable. Taxable-equivalent adjustments assume a 35 percent federal income tax rate. Dollar amounts in tables are stated in thousands, except for per share amounts. Cullen/Frost reported net income of $16.7 million or $.31 per diluted common share for the quarter ended September 30, 2001 compared to $28.7 million or $.54 per diluted common share for the second quarter of 2001 and net income of $27.8 million or $.52 per diluted common share for the third quarter of 2000. Third quarter 2001 results were impacted by a provision for possible loan losses of $20.0 million that built reserves to $80 million or 1.77 percent of period-end loans. Net income for the nine months ended September 30, 2001 was $67.9 million or $1.27 per diluted common share compared to $80.5 million or $1.50 per diluted common share for the same period of 2000. Results for the nine months ended September 30 2001 were impacted by a provision for possible loan losses of $36.0 million mainly related to two large credits and lower net interest income. Also included in the year-to-date 2001 results was a pre-tax gain of $5.7 million related to the sale of interest rate floors which had been purchased to hedge interest rate exposure in an environment of falling interest rates. Of the gain, $1.1 million was included in other non-interest income, with the remainder included, net of tax, as the cumulative effect of adopting SFAS No. 133, which went into effect January 1, 2001. Results for the nine months ended September 30 2000 were impacted by a $2 million gain from the sale of mortgage servicing rights to GMAC Mortgage Corporation. Excluding the after-tax net impact from the sale of mortgage servicing rights, earnings per diluted common share for the nine months ended September 30, 2000 would have been $1.48. Return on average equity and average assets were 10.50 percent and .83 percent, respectively for the third quarter of 2001. This compares to 20.50 percent and 1.53 percent for the third quarter of 2000. Return on average equity and average assets for the nine months ended September 30, 2001 were 14.94 percent and 1.18 percent compared to 20.52 percent and 1.52 percent for the same period of 2000. <TABLE> <CAPTION> Summary of Operations ------------------------------------------------- Three Months Ended Nine Months Ended ---------------------------- September 30 2001 2000 ------------------ ------------------- -------- 2001 2000 Sept.30 June 30 Sept. 30 ------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> Taxable-equivalent net interest income $242,596 $242,870 $80,420 $80,367 $83,063 Taxable-equivalent adjustment 3,539 3,372 1,180 1,169 1,099 -------- -------- ------- ------- ------- Net interest income 239,057 239,498 79,240 79,198 81,964 Provision for possible loan losses 36,031 8,985 20,000 1,000 3,436 Non-Interest income: Net gain (loss) on securities transactions 78 (6) 80 (12) 2 Other 143,952 124,904 48,719 48,485 42,405 -------- -------- ------- ------- ------- Total non-interest income 144,030 124,898 48,799 48,473 42,407 Non-Interest expense: Goodwill amortization 6,036 5,843 2,005 2,012 1,993 Other intangible amortization 5,328 5,822 1,727 1,740 1,898 Other 238,277 220,637 79,541 80,015 74,582 -------- -------- ------- ------- ------- Total non-interest expense 249,641 232,302 83,273 83,767 78,473 -------- -------- ------- ------- ------- Income before income taxes and cumulative effect of accounting change 97,415 123,109 24,766 42,904 42,462 Income taxes 32,574 42,565 8,116 14,243 14,704 -------- -------- ------- ------- ------- Income before cumulative effect of accounting change 64,841 80,544 16,650 28,661 27,758 Cumulative effect of change in accounting for derivatives, net of tax 3,010 -------- -------- ------- ------- ------- Net income $ 67,851 $ 80,544 $16,650 $28,661 $27,758 ======== ======== ======= ======= ======= Net income per diluted common share: $ 1.27 $ 1.50 $ .31 $ .54 $ .52 Return on Average Assets 1.18% 1.52% .83% 1.50% 1.53% Return on Average Equity 14.94 20.52 10.50 19.09 20.50 </TABLE> Results of Segment Operations Cullen/Frost's operations are managed along three major Operating Segments: Banking, the Financial Management Group and Frost Securities Inc. ("FSI"), the investment banking subsidiary started in August of 1999. A description of each business and the methodologies used to measure financial performance are described in Note J to the Consolidated Financial Statements on page 12. The following table summarizes net income (loss) by Operating Segment for the nine months and three months ended September 30, 2001 and 2000. <TABLE> <CAPTION> Three Months Ended Nine Months Ended ------------------------------- September 30 2001 2000 ------------------- ------------------- -------- (in thousands) 2001 2000 Sept. 30 June 30 Sept. 30 ========================================================================================= <S> <C> <C> <C> <C> <C> Banking $66,632 $78,264 $15,644 $28,114 $27,240 Financial Management Group 8,405 12,155 2,736 3,235 4,081 Frost Securities Inc. (2,891) (2,380) (878) (958) (1,240) Non-Banks (4,295) (7,495) (852) (1,730) (2,323) ------------------- ------------------------------ Consolidated net income $67,851 $80,544 $16,650 $28,661 $27,758 =================== ============================== </TABLE> Banking net income was $15.6 million for the third quarter of 2001 and was down $12.5 million, or 44.4 percent, from the second quarter of 2001. The decrease from the second quarter was the result of a provision of $20.0 million, which built the loan loss reserve to $80 million or 1.77 percent of period end loans, compared to a provision of $1.0 million in the previous quarter. Comparing third quarter this year with the same quarter a year ago, net income was down $11.6 million, or 42.6 percent. The provision was $16.6 million higher than the $3.4 million recorded during the third quarter of last year. Partially offsetting the higher provision for loan loss were higher service charges on deposits, up $2.6 million or 16.9 percent for the third quarter compared with the same period last year. For the nine months ended September 30, 2001 net income was $66.6 million, down $11.6 million or 14.9 percent compared with the same period of 2000. This decline was the result of a provision for possible loan losses of $36.0 million, mainly related to two large credits, compared with a provision of $9.0 million in the same period of 2000. The impact of the increased provision was partially offset by higher service charges on deposits, up $7.9 million or 17.9 percent for the nine- month period compared with the same period last year, and the pre-tax gain of $5.7 million related to the sale of interest rate floors which had been purchased to hedge interest rate exposure in an environment of falling interest rates. Of the gain, $1.1 million was included in other non-interest income, with the remainder included, net of tax, as the cumulative effect of adopting SFAS No. 133, which went into effect January 1, 2001. The Financial Management Group ("FMG") net income for the third quarter of 2001 was $2.7 million, and was down $499 thousand from the previous quarter and $1.3 million from the same quarter of 2000. Most of the decrease from the second quarter of 2001 was due to lower trust fees, down $406 thousand or 3.1 percent, reflecting the seasonal effects of tax fees received in the second quarter and the impact of lower oil and gas prices on oil and gas fees. The decrease of $1.3 million from the third quarter last year was due to higher expenses, including overhead allocations and higher salaries and benefits, combined with lower net interest margin due to lower funds transfer pricing as rates have fallen. Net income for the first nine months of 2001 for FMG was $8.4 million, down $3.8 million from the same period of 2000, due to higher expenses for overhead allocations, salaries and benefits offset by increased revenues from trust fees, mutual fund fees and money market income. Frost Securities recorded a net loss of $878 thousand for the third quarter of this year, down from a loss of $1.0 million in the previous quarter and down $362 thousand from the loss of $1.2 million in the third quarter of 2000. The comparable loss for the nine months ended September 30, 2001 was $2.9 million up $511 thousand from the $2.4 million loss in the first nine months of 2000. The loss in the current year was impacted by adverse market conditions and further impacted by expenses as the company continued to expand this business segment. Revenues were up $1.0 million or 67.8 percent for the third quarter of 2001 compared to the same quarter of 2000, and $3.2 million or 70.2 percent for the nine-month periods, driven primarily by equities sales commissions. Non-interest expenses were up 16.7 percent to $3.7 million for the current quarter over the same quarter last year, and 50.4 percent to $12.1 million for the nine-month periods. These increases were due to increased staffing, expenses related to business development and increased outside professional services. Staffing at September 30, 200l included 50 employees compared to 43 at September 30, 2000. Most of the reduction in the operating loss for non-banks in the first nine months of 2001 was due to a decrease in expenses relating to incentive based compensation. Net Interest Income Net interest margin was 4.80 percent for the third quarter of 2001 compared to 5.00 percent and 5.33 percent for the second quarter of 2001 and third quarter of 2000, respectively. The net interest spread of 4.11 percent decreased 12 basis points from the second quarter of 2001 and decreased 18 basis points from the third quarter of 2000. The Federal Reserve has lowered interest rates nine times and 400 basis points since the beginning of the year, including 75 basis points during the third quarter and 50 basis points on October 2nd. These lower interest rates have resulted in lower net interest income for the Corporation due to its asset sensitive balance sheet. Also as rates have fallen, deposit mixes have shifted toward higher rate products negatively impacting the net interest margin. <TABLE> <CAPTION> Change in Net Interest Income (Taxable-Equivalent) ------------------------------------------------------------ Third Quarter Third Quarter First Nine Months 2001 2001 2001 vs. vs. vs. Third Quarter Second Quarter First Nine Months 2000 2001 2000 -------------- -------------- ------------------ Amount Amount Amount --------------------------------------------------------------------------------------- <S> <C> <C> <C> Due to volume $ 3,002 $ 1,245 $6,339 Due to interest rate spread (5,645) (1,192) (6,613) ------- ------- ------ $(2,643) $ 53 $ (274) ======= ======= ====== </TABLE> Non-Interest Income <TABLE> <CAPTION> Three Months Ended Nine Months Ended -------------------------------- September 30 2001 2000 ----------------- --------------------- -------- 2001 2000 Sept. 30 June 30 Sept. 30 ------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> Trust fees $ 37,307 $ 36,620 $12,464 $12,837 $12,488 Service charges on deposit accounts 52,320 44,376 17,769 18,051 15,212 Insurance commissions 12,470 6,934 4,977 3,598 3,828 Other service charges, collection and exchange charges, commission and fees 18,780 14,804 6,181 6,665 5,259 Net gain (loss) on securities transactions 78 (6) 80 (12) 2 Other 23,075 22,170 7,328 7,334 5,618 -------- -------- ------- ------- ------- Total $144,030 $124,898 $48,799 $48,473 $42,407 ======== ======== ======= ======= ======= </TABLE> For the third quarter 2001... Total non-interest income was up $326 thousand or .7 percent compared to the second quarter of 2001 and up $6.4 million, or 15.1 percent compared to the third quarter of 2000. Trust fees were down $373 thousand or 2.9 percent compared to the second quarter of 2001 and flat compared to the third quarter of 2000. Trust income was down from the second quarter 2001 due to a decrease in oil and gas fees, as oil and gas prices have declined, and lower tax fees, historically higher in the second quarter. Approximately 77 percent and 100 percent of the decrease in market value from the prior quarter and the same quarter a year ago, respectively, was related to non-discretionary assets while the number of accounts increased in both comparisons to the prior quarters. The market value of trust assets at the end of the third quarter of 2001 was $12.4 billion, down $735 million and $539 million from the second quarter of 2001 and third quarter of 2000, respectively. Trust assets were comprised of discretionary assets of $5.6 billion and non-discretionary assets of $6.8 billion compared to $5.6 billion and $7.3 billion, respectively, a year ago. Service charges on deposit accounts for the third quarter of 2001 decreased $282 thousand or 1.6 percent from the second quarter of this year. This decrease was mainly due to lower revenues associated with commercial accounts. When compared to the third quarter of 2000 service charges increased by $2.6 million or 16.8 percent. The increase from the third quarter of last year is primarily attributable to higher revenues associated with commercial accounts as well as an increase in individual account fees and higher overdraft fees. The increase in commercial service charges is due to higher treasury management services, up approximately 14 percent from the comparable quarter last year and a lower earnings credit rate, which results in more payment for services through the payment of fees rather than through balances. The increase in individual accounts resulted from the simplification of deposit account offerings while providing Cullen/Frost customers with better value. Insurance commissions were up $1.4 million or 38.3 percent compared to the second quarter of 2001 and up $1.1 million or 30.0 percent compared to the third quarter of 2000. The increase from the second quarter of 2001 was due to the timing of renewals and the effect of the AIS acquisition. The increase from the third quarter a year ago was the result of continued selling efforts by Frost Insurance Agency through the maturing of acquisitions, higher premium levels and the impact of the recently acquired AIS insurance agency. Other service charges were down $484 thousand or 7.3 percent compared to the previous quarter and up $922 thousand or 17.5 percent from the same quarter a year ago. The decrease from the prior quarter resulted from volatile market conditions compounded by the effects of the September 11, 2001 tragedy. The growth in equity sales commission revenue at Frost Securities accounted for the increase when compared to the third quarter a year ago. Other non-interest income remained flat when compared to the previous quarter this year and up $1.7 million or 30.4 percent when compared to the third quarter a year ago. During the second quarter of 2001, Cullen/Frost purchased bank owned life insurance on certain of its employees and is the beneficiary on these policies. The increase in cash surrender value during the third quarter of 2001 was $1.4 million and was recorded in other non-interest income. This increase along with higher revenues received on larger balances held by the provider of the Corporation's official checks program were the primary reasons for the increase from the third quarter a year ago. For the nine months ended September 30, 2001... Non-interest income was up $19.1 million or 15.3 percent compared to the same period last year. Trust income increased $687 thousand or 1.9 percent from the same period a year ago, primarily in oil and gas fees and investment fees. Service charges on deposits increased $7.9 million or 17.9 percent compared to the same period one year ago. This increase can be attributed to higher revenues associated with both commercial and individual accounts and higher overdraft fees offset by lower NSF charges. The increase in commercial service charges is primarily the result of higher treasury management services and a lower earnings credit rate, which results in more payment for services through the payment of fees rather than through balances. The increase in individual accounts resulted from the simplification of deposit account offerings while providing Cullen/Frost customers with better value. Insurance commissions increased $5.5 million or 79.8 percent compared to the same period ago. The increase from a year ago was the result of the insurance acquisitions made in the third quarter of 2001 and the third and second quarters of 2000 and the impact of continued selling efforts. Other service charge income increased $4.0 million or 26.9 percent from the same period last year. The primary contributor to this was growth in equity sales commission revenue at Frost Securities. Other income was up $905 thousand or 4.1 percent compared to the same period last year. The increase was partially related to the bank owned life insurance program initiated in the second quarter of 2001. Also adding to the increase from a year ago were higher revenues received on larger balances held by the provider of the Corporation's official checks program. These increases were offset somewhat by the $2 million non-recurring pre-tax gain from the sale of the mortgage servicing rights in the second quarter of 2000 and lower gains on the sale of student loans. Non-Interest Expense <TABLE> <CAPTION> Three Months Ended Nine Months Ended ------------------------------- September 30 2001 2000 ------------------ -------------------- --------- 2001 2000 Sept. 30 June 30 Sept. 30 ----------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Salaries and wages $108,185 $103,128 $35,864 $36,711 $35,460 Pension and other employee benefits 26,552 22,559 9,302 8,339 7,338 Net occupancy of banking premises 22,182 20,666 7,636 7,343 7,050 Furniture and equipment 18,031 15,435 5,779 6,240 5,150 Intangible amortization 11,364 11,665 3,732 3,752 3,891 Other 63,327 58,849 20,960 21,382 19,584 -------- -------- ------- ------- ------- Total $249,641 $232,302 $83,273 $83,767 $78,473 ======== ======== ======= ======= ======= </TABLE> For the third quarter 2001... Non-interest expense was down $494 thousand, which was flat compared to last quarter, and increased $4.8 million or 6.1 percent compared to the third quarter of 2000. Salaries and wages decreased $847 thousand or 2.3 percent compared with the second quarter of 2001 and were up $404 thousand or 1.1 percent from the third quarter of 2000. The decrease from the second quarter of 2001 was primarily related to lower bonus incentive compensation during the third quarter of 2001. The increase from the third quarter last year is primarily related to increases at Frost Insurance Agency and Frost Securities (acquisition related for insurance and new hires for investment banking). Pension and employee benefits were up $1.0 million or 11.5 percent compared to last quarter and up $2.0 million or 26.8 percent compared to the third quarter of 2000. The increase from the previous quarter was a result of higher medical expenses. The increase from a year ago is due primarily to higher medical expenses and higher retirement plan expense. Net occupancy of banking premises expenses was up $293 thousand or 4.0 percent from the second quarter of 2001 and up $586 thousand or 8.3 percent from the third quarter of 2000. The increase from the second quarter of 2001 and third quarter a year ago was related to new locations, general building maintenance and utility expenses. Furniture and equipment expense was down $461 thousand or 7.4 percent from the second quarter of 2001 and increased by $629 thousand or 12.2 percent from the third quarter of 2000. The decrease from the previous quarter was due to lower service contracts, while the increase from the third quarter a year ago was due to higher software maintenance and amortization partially related to the Corporation's enhanced web site introduced in November of 2000. Other non-interest expenses were down $422 thousand or 2.0 percent from the second quarter of 2001 and up $1.4 million or 7.0 percent from the third quarter of 2000. The decrease from the previous quarter was due to lower professional expenses, public relations and travel expenses. The increase from the third quarter a year ago was related to higher professional and advertising expenses primarily related to the Corporation's fee business expansion efforts, as well as Federal Reserve service charges due to the lower rate environment. For the nine months ended September 30, 2001... Total non-interest expense was up $17.3 million or 7.5 percent compared to the same period one year ago. Salaries and wages were up $5.1 million, or 4.9 percent, compared to the same period a year ago primarily related to Frost Securities and acquisitions made by Frost Insurance Agency. Pension and other benefits increased $4.0 million or 17.7 percent from the same period last year primarily due to higher retirement plan expense, higher payroll taxes and higher medical expenses. Net occupancy of banking premises was up $1.5 million or 7.3 percent compared to a year ago. The increase was related to new locations, general building maintenance and utility expenses. Furniture and equipment expense increased $2.6 million or 16.8 percent due to higher software maintenance and amortization partially related to the Corporation's enhanced web site introduced in November of 2000. Other non-interest expenses increased $4.5 million or 7.6 percent primarily due to higher professional, advertising, and travel expenses related to the Corporation's fee business expansion efforts, as well as Federal Reserve service charges due to the lower rate environment. Income Taxes Cullen/Frost's effective tax rate for the second and third quarters of 2001 approximated 33 percent. The effective tax rate for the third quarter of 2000 approximated 35 percent. The decrease in the effective tax rate in the third quarter of 2001 compared to the third quarter of 2000 was mainly due to an increase in tax-exempt income resulting from the purchase of bank owned life insurance. Cash Earnings Cullen/Frost has historically paid cash and used the purchase method of accounting for the majority of its acquisitions, which has resulted in the creation of intangible assets. These intangible assets are deducted from capital in the determination of regulatory capital. Thus, "cash" or "tangible" earnings represents regulatory capital generated during the year and can be viewed as net income excluding intangible amortization, net of tax. While the definition of "cash" or "tangible" earnings may vary by company, the Corporation believes this definition is appropriate as it measures the per share growth of regulatory capital, which impacts the amount available for dividends and acquisitions. The following table reconciles reported earnings to net income excluding intangible amortization ("cash" earnings): <TABLE> <CAPTION> Nine Months Ended -------------------------------------------------------------------- September 2001 September 2000 -------------------------------- -------------------------------- Reported Intangible "Cash" Reported Intangible "Cash" Earnings Amortization Earnings Earnings Amortization Earnings ------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Income before income taxes and cumulative effect of accounting change $97,415 $11,364 $108,779 $123,109 $11,665 $134,774 Income taxes 32,574 2,464 35,038 42,565 2,552 45,117 ------- ------- -------- -------- ------- -------- Income before cumulative effect of accounting change 64,841 8,900 73,741 80,544 9,113 89,657 Cumulative effect of accounting change, net of tax 3,010 3,010 ------- ------- -------- -------- ------- -------- Net income $67,851 $ 8,900 $ 76,751 $ 80,544 $ 9,113 $ 89,657 ======= ======= ======== ======== ======= ======== Net income per diluted common share $ 1.27 $ .16 $ 1.43 $ 1.50 $ .17 $ 1.67 Return on assets 1.18% 1.33%* 1.52% 1.69%* Return on equity 14.94 16.90** 20.52 22.85** * Calculated as A/B ** Calculated as A/C Sept. 2001 Sept. 2000 ----------------- ---------- ---------- (A) Net income before intangible amortization (including goodwill and core deposit intangibles, net of tax) $ 76,751 $ 89,657 (B) Total average assets 7,694,142 7,077,968 (C) Average shareholders' equity 607,344 524,193 Three Months Ended -------------------------------------------------------------------- September 2001 June 2001 -------------------------------- -------------------------------- Reported Intangible "Cash" Reported Intangible "Cash" Earnings Amortization Earnings Earnings Amortization Earnings ------------------------------------------------------------------------------------------- Income before income taxes $24,766 $3,732 $28,498 $42,904 $3,752 $46,656 Income taxes 8,116 802 8,918 14,243 809 15,052 ------- ------ ------- ------- ------ ------- Net income $16,650 $2,930 $19,580 $28,661 $2,943 $31,604 ======= ====== ======= ======= ====== ======= Net income per common share $ .31 $ .06 $ .37 $ .54 $ .05 $ .59 Return on assets .83% .98%* 1.50% 1.65%* Return on equity 10.50 12.35** 19.09 21.05** * Calculated as A/B ** Calculated as A/C Sept. 2001 June 2001 ----------------- ---------- ---------- (A) Net income before intangible amortization (including goodwill and core deposit intangibles, net of tax) $ 19,580 $ 31,604 (B) Total average assets 7,956,541 7,680,715 (C) Average shareholders' equity 628,954 602,201 Three Months Ended -------------------------------- September 2000 -------------------------------- Reported Intangible "Cash" Earnings Amortization Earnings -------------------------------------------------------------- Income before income taxes $42,462 $3,891 $46,353 Income taxes 14,704 851 15,555 ------- ------ ------- Net income $27,758 $3,040 $30,798 ======= ====== ======= Net income per common share $ .52 $ .05 $ .57 Return on assets 1.53% 1.69%* Return on equity 20.50 22.74 ** * Calculated as A/B ** Calculated as A/C Sept. 2000 ---------- (A) Net income before intangible amortization (including goodwill and core deposit intangibles, net of tax) $ 30,797 (B) Total average assets 7,238,470 (C) Average shareholders' equity 538,762 </TABLE> Cullen/Frost's cash earnings for the nine months and three months ending September 30, 2001 were $73.7 million or $1.43 per diluted common share and $19.6 million or $.37 per diluted common share, respectively. Cash earnings return on assets and return on equity for the third quarter of 2001 were .98 percent and 12.35 percent, respectively. Balance Sheet Average assets for the third quarter 2001 were $8.0 billion up $718 million or 9.9 percent from the third quarter of 2000. Total deposits averaged $6.6 billion for the current quarter, up $528 million or 8.7 percent when compared to the third quarter of 2000. This growth was influenced by one major customer of the bank where deposits increased related to the clearing of payments for mortgage refinances. Excluding the impact of this customer, the growth from the second quarter of 2000 would have been 6.3 percent. Average loans for the third quarter of 2001 were $4.5 billion. This was down $47 million or 1.0 percent compared with the second quarter of 2001. Average loans were up $107 million or 2.4 percent from the third quarter of last year or up 6.0 percent excluding the combined impact of mortgage lending and indirect loans which have been discontinued. Loans <TABLE> <CAPTION> 2001 2000 ------------------------ --------------------------- Loan Portfolio Percentage Period-End Balances September 30 of Total December 31 September 30 --------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Commercial and industrial $1,944,545 42.8% $1,848,926 $1,815,325 Consumer: Indirect 81,834 1.8 136,914 157,049 Other 362,363 8.0 341,534 355,282 Real estate 2,093,052 46.1 2,129,431 2,076,849 Other 61,699 1.4 85,189 71,100 Unearned discount (5,937) (.1) (7,349) (6,787) ---------- ----- ---------- ---------- Total Loans $4,537,556 100.0% $4,534,645 $4,468,818 ========== ===== ========== ========== </TABLE> At September 30, 2001 period-end loans totaled $4.5 billion, which was flat with the previous quarter and up 1.5 percent from the same period last year. Period-end loans would have been up 5.3 percent and up 8.7 percent, respectively, from the second quarter of 2001 and third quarter of 2000 excluding the combined impact of residential mortgage loans, indirect loans and purchased shared national credits. As indicated below, purchased shared national credits outstanding have decreased during 2001, which has affected loan volumes. At September 30, 2001, purchased shared national credits had decreased $29 million from June 30, 2001 and $87 million from year end 2000. Increases in direct consumer loans and commercial and industrial loans have offset some of these decreases. At September 30, 2001, Cullen/Frost had approximately $229 million of purchased shared national credits outstanding, which was down from $258 million at June 30, 2001 and $316 million at year-end 2000. These participations are done in the normal course of business to meet the needs of the Corporation's customers. General corporate policy towards participations is to lend to companies either headquartered in or having significant operations within our markets. In addition, Cullen/Frost must have an existing banking relationship or the expectation of broadening the relationship with other bank products. Approximately 25 percent of the outstanding balance of shared national credits purchased are energy related, with the remainder diversified throughout various industries. Real Estate Loans Real estate loans at September 30, 2001 were $2.1 billion or 46.1 percent of period-end loans compared to 46.5 percent a year ago. Commercial real estate mortgages represented 46.6 percent of the total real estate loan portfolio at quarter end. Combined all categories of commercial real estate loans increased $47 million and were offset by a $52 million decrease in 1-4 family residential mortgages, which were impacted by Cullen/Frost's withdrawal from mortgage origination. Approximately 57 percent of all commercial real estate loans are owner occupied or have a major tenant (National or Regional company) which historically has resulted in lower risk, provides financial stability and is less susceptible to economic swings. At September 30, 2001, real estate loans 90 days past due (excluding non- accrual loans) were $5.3 million, compared with $9.4 million at June 30, 2001, and $2.1 million at September 30, 2000. <TABLE> <CAPTION> 2001 2000 ------------------------ ------------ Real Estate Loans Percentage Period-End Balances September 30 of Total September 30 -------------------------------------------------------------------------------- <S> <C> <C> <C> Construction: Commercial $ 384,755 18.4% $ 357,201 Consumer 48,817 2.3 45,761 Land: Commercial 137,909 6.6 138,397 Consumer 7,605 .4 9,939 Commercial real estate mortgages 975,278 46.6 955,408 1-4 Family residential 267,911 12.8 319,795 Consumer real estate 270,777 12.9 250,348 ---------- ------ ---------- $2,093,052 100.0% $2,076,849 ========== ====== ========== Non-accrual $ 6,609 .3% $ 3,539 </TABLE> Mexico Cullen/Frost's cross border outstandings to Mexico, excluding $14.6 million in loans secured by assets held in the United States, totaled $30 thousand at September 30, 2001 compared to $74 thousand at June 30, 2001 and none at September 30, 2000. There were no Mexican-related loans on non- performing status at September 30, 2001 or September 30, 2000. Non-Performing Assets <TABLE> <CAPTION> NON-PERFORMING ASSETS -------------------------- Real September 30, 2001 Estate Other Total --------------------------------------------------------------------------- <S> <C> <C> <C> Non-accrual $6,609 $38,868 $45,477 Foreclosed assets 2,930 174 3,104 ------ ------- ------- Total $9,539 $39,042 $48,581 ====== ======= ======= As a percentage of total non-performing assets 19.6% 80.4% 100.0% </TABLE> Non-performing assets totaled $48.6 million at September 30, 2001, which was up 145.6 percent from $19.8 million at September 30, 2000 and up 88.9 percent from $25.7 million at June 30, 2001. The increase from the second quarter included an $18 million loan to a private company in the marketing and advertising field, an industry dramatically affected by the terroristic attack on September 11, 2001. Non-performing assets as a percentage of total loans and foreclosed assets increased to 1.07 percent at September 30, 2001 from .44 percent one year ago. Non-performing assets as a percentage of total assets were .60 percent for the third quarter of 2001 compared to .27 percent for the third quarter of 2000. Foreclosed assets consist of property which has been formally repossessed. Foreclosed assets are valued at the lower of the loan balance or estimated fair value, less estimated selling costs, at the time of foreclosure. Write-downs occurring at foreclosure are charged against the allowance for possible loan losses. On an ongoing basis, properties are appraised as required by market indications and applicable regulations. Write-downs are provided for subsequent declines in value. Expenses related to maintaining foreclosed properties are included in other non-interest expense. The after-tax impact (assuming a 35 percent marginal tax rate) of lost interest from non-performing assets was approximately $531 thousand for the third quarter of 2001, compared to approximately $307 thousand for the second quarter of 2001 and approximately $342 thousand for the third quarter of 2000. For the nine months ended September 30, 2000, the after-tax impact (assuming a 35 percent marginal tax rate) was approximately $1.3 million compared to approximately $938 thousand for the comparable period last year. Accruing loans past due are summarized below: <TABLE> <CAPTION> ACCRUING LOANS PAST DUE --------------------------------------- September 30 December 31 September 30 2001 2000 2000 -------------------------------------------------------------------------------- <S> <C> <C> <C> 30 to 89 days $48,568 $43,671 $39,525 90 days or more 10,967 7,972 15,942 ------- ------- ------- Total $59,535 $51,643 $55,467 ======= ======= ======= </TABLE> Allowance for Possible Loan Losses The allowance for possible loan losses was $80.2 million or 1.77 percent of period-end loans at September 30, 2001, compared to $60.0 million or 1.34 percent at September 30, 2000 and $65.3 million or 1.44 percent at June 30, 2001. The increase in the allowance for possible loan losses was reflective of the increased uncertainty in the economy since the terrorist acts of September 11, 2001 and the specific effect on an $18 million loan to a private company in the marketing and advertising field, an industry dramatically affected by those events. A specific $10 million reserve was assigned to that loan after the events of September 11, 2001. The allowance for possible loan losses as a percentage of non-accrual loans was 165 percent at September 30, 2001, compared to 347 percent at September 30, 2000 and 285 percent at the end of the second quarter of 2001. Cullen/Frost recorded a $20.0 million provision for possible loan losses during the third quarter of 2001. This compares to a $3.4 million provision for possible loan losses during the third quarter of 2000 and $1.0 million for the second quarter of 2001. Net charge-offs in the third quarter of 2001 totaled $5.1 million, compared to net charge-offs of $2.4 million and net recoveries of $189 thousand for the third quarter of 2000 and for the second quarter of 2001, respectively. <TABLE> <CAPTION> NET CHARGE-OFFS (RECOVERIES) ---------------------------- 2001 2000 ------------------ ------- Third Second Third Quarter Quarter Quarter -------------------------------------------------------------------------------- <S> <C> <C> <C> Real estate $ (36) $ (688) $ (18) Commercial and industrial 4,172 84 1,859 Consumer 932 387 599 Other, including foreign (2) 28 (4) ------- ------- ------- $ 5,066 $ (189) $ 2,436 ======= ======= ======= Provision for possible loan losses $20,000 $ 1,000 $ 3,436 Allowance for possible loan losses 80,188 65,254 59,965 </TABLE> Capital and Liquidity At September 30, 2001, shareholders' equity was $632.7 million compared to $547.2 million at September 30, 2000 and $612.4 million at June 30, 2001. Activity in the shareholders equity account during 2001 includes earnings of $67.9 million offset by $32.3 million of dividends paid. In addition, Cullen/Frost had an unrealized gain on securities available for sale, net of deferred taxes, of $21.2 million as of September 30, 2001, compared to an unrealized loss of $4.0 million as of December 31, 2000, which had the effect of increasing capital by $25.2 million since year-end 2000. Currently, under regulatory requirements, the unrealized gain or loss on securities available for sale is not included in the calculation of risk-based capital and leverage ratios. See page seven for a discussion of the Corporation's regulatory capital ratios. Cullen/Frost paid a cash dividend of $.215 per common share for the third and second quarters of 2001 compared to $.195 per common share in the second quarter of 2000. This equates to a dividend payout ratio of 66.8 percent and 38.7 percent for the third and second quarters of 2001, respectively. The dividend payout ratio for the third quarter of 2000 was 36.5 percent. For the nine months ended September 30, 2001 and 2000 the dividend payout ratio was 47.5 percent and 36.7 percent, respectively. Funding sources available at the holding company level include a $7.5 million short-term line of credit. There were no borrowings outstanding from this source at September 30, 2001 or 2000. During the third quarter of 2001, Frost National Bank issued $150 million of subordinated notes that will bear interest at 6 7/8 percent per annum and will mature on August 1, 2011. For additional information regarding these notes see the footnotes to the financial statements on page eight. Asset liquidity is provided by cash and assets which are readily marketable or pledgeable or which will mature in the near future. Liquid assets include cash, short-term time deposits in banks, securities available for sale, maturities and cash flows from securities held to maturity, and Federal funds sold and securities purchased under resale agreements. Liability liquidity is provided by access to funding sources which include core depositors and correspondent banks in Cullen/Frost's natural trade area which maintain accounts with and sell Federal funds to The Frost National Bank, as well as Federal funds purchased and securities sold under repurchase agreements from upstream banks. The liquidity position of Cullen/Frost is continuously monitored and adjustments are made to the balance between sources and uses of funds as deemed appropriate. <TABLE> <CAPTION> Consolidated Average Balance Sheets and Interest Income Analysis-Year-to-Date Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands - taxable-equivalent basis) September 30, 2001 September 30, 2000 --------------------------- ---------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Cost Balance Expense Cost ---------- -------- ------ ---------- -------- ------ <S> <C> <C> <C> <C> <C> <C> ASSETS Time deposits $ 6,745 $ 287 5.68% $ 6,936 $ 384 6.40% Securities: U.S. Treasury 45,464 1,948 5.73 129,835 5,809 5.98 U.S. Government agencies and corporations 1,425,980 68,776 6.43 1,325,399 67,962 6.84 States and political subdivisions Tax-exempt 164,980 8,810 7.12 150,454 8,451 7.49 Taxable 3,182 155 6.50 3,426 171 6.66 Other 32,984 1,304 5.27 35,009 2,027 7.72 ---------- -------- --------- -------- Total securities 1,672,590 80,993 6.46 1,644,123 84,420 6.85 Federal funds sold and securities purchased under resale agreements 270,059 8,628 4.21 106,658 5,152 6.35 Loans, net of unearned discount 4,545,098 271,532 7.99 4,317,342 290,555 8.99 ---------- -------- ---------- -------- Total Earning Assets and Average Rate Earned 6,494,492 361,440 7.43 6,075,059 380,511 8.36 Cash and due from banks 767,839 613,854 Allowance for possible loan losses (64,876) (58,907) Banking premises and equipment 150,369 145,787 Accrued interest and other assets 346,318 302,175 ---------- ---------- Total Assets $7,694,142 $7,077,968 ========== ========== LIABILITIES Demand deposits: Commercial and individual $1,815,459 $1,622,448 Correspondent banks 249,026 228,159 Public funds 38,623 31,889 ---------- --------- Total demand deposits 2,103,108 1,882,496 Time deposits: Savings and Interest-on-Checking 961,374 3,130 .44 965,764 4,796 .66 Money market deposit accounts 1,814,830 40,593 2.99 1,672,797 55,412 4.42 Time accounts 1,276,059 46,688 4.89 1,232,830 46,701 5.06 Public funds 300,426 8,381 3.73 233,001 7,937 4.55 ---------- -------- --------- -------- Total time deposits 4,352,689 98,792 3.03 4,104,392 114,846 3.74 ---------- --------- Total deposits 6,455,797 5,986,888 Federal funds purchased and securities sold under repurchase agreements 363,020 10,619 3.86 312,473 12,684 5.33 Guaranteed preferred beneficial interests in the Corporation's junior subordinated deferrable interest debentures, net 98,589 6,356 8.60 98,535 6,356 8.60 Subordinated notes and other long-term debt, net 35,810 1,684 6.27 3,797 143 5.04 Other borrowings 31,864 1,393 5.85 72,810 3,612 6.63 ---------- -------- ---------- -------- Total Interest-Bearing Funds and Average Rate Paid 4,881,972 118,844 3.25 4,592,007 137,641 4.00 ---------- -------- ---- ---------- -------- ---- Accrued interest and other liabilities 101,718 79,272 ---------- ---------- Total Liabilities 7,086,798 6,553,775 SHAREHOLDERS' EQUITY 607,344 524,193 ---------- ---------- Total Liabilities and Shareholders' Equity $7,694,142 $7,077,968 ========== ========== Net interest income $242,596 $242,870 ======== ======== Net interest spread 4.18% 4.36% ==== ==== Net interest income to total average earning assets 4.99% 5.34% ==== ==== The above information is shown on a taxable-equivalent basis assuming a 35% tax rate. Non- accrual loans are included in the average loan amounts outstanding for these computations. </TABLE> <TABLE> <CAPTION> Consolidated Average Balance Sheets and Interest Income Analysis-By Quarter Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands - taxable-equivalent basis) September 30, 2001 June 30, 2001 --------------------------- -------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Cost Balance Expense Cost ---------- -------- ------ ---------- -------- ------ <S> <C> <C> <C> <C> <C> <C> ASSETS Time deposits $ 6,104 $ 72 4.67% $ 7,751 $ 99 5.11% Securities: U.S. Treasury 17,738 164 3.66 17,028 192 4.52 U.S. Government agencies and corporations 1,596,137 25,251 6.33 1,337,607 21,427 6.41 States and political subdivisions Tax-exempt 168,484 2,959 7.03 163,453 2,908 7.12 Taxable 2,796 46 6.53 3,388 55 6.46 Other 29,426 254 3.46 32,751 469 5.73 ---------- -------- ---------- ------- Total securities 1,814,581 28,674 6.32 1,554,227 25,051 6.45 Federal funds sold and securities purchased under resale agreements 331,845 2,864 3.38 315,871 3,520 4.41 Loans, net of unearned discount 4,512,277 82,637 7.27 4,559,623 90,157 7.93 ---------- -------- ---------- -------- Total Earning Assets and Average Rate Earned 6,664,807 114,247 6.81 6,437,472 118,827 7.40 Cash and due from banks 820,091 806,665 Allowance for possible loan losses (65,561) (65,728) Banking premises and equipment 150,157 150,376 Accrued interest and other assets 387,047 351,930 ---------- ---------- Total Assets $7,956,541 $7,680,715 ========== ========== LIABILITIES Demand deposits: Commercial and individual $1,955,445 $1,828,870 Correspondent banks 262,399 248,370 Public funds 40,859 35,709 ---------- ---------- Total demand deposits 2,258,703 2,112,949 Time deposits: Savings and Interest-on-Checking 962,999 588 .24 970,673 1,115 .46 Money market deposit accounts 1,839,010 10,571 2.28 1,824,869 12,857 2.83 Time accounts 1,268,349 13,355 4.18 1,276,765 15,741 4.95 Public funds 297,830 2,316 3.09 293,816 2,709 3.70 ---------- ------- ---------- ------- Total time deposits 4,368,188 26,830 2.44 4,366,123 32,422 2.98 ---------- ------- ---------- ------- Total deposits 6,626,891 6,479,072 Federal funds purchased and securities sold under repurchase agreements 366,360 2,840 3.03 360,786 3,417 3.75 Guaranteed preferred beneficial interests in the Corporation's junior subordinated deferrable interest debentures, net 98,602 2,118 8.60 98,589 2,119 8.60 Subordinated notes and other long-term debt, net 99,678 1,575 6.32 3,060 47 6.17 Other borrowings 32,338 464 3.03 31,405 455 5.81 ---------- ------- ---------- ------- Total Interest-Bearing Funds and Average Rate Paid 4,965,166 33,827 2.70 4,859,963 38,460 3.17 ---------- ------- ---- ---------- ------- ---- Accrued interest and other liabilities 103,718 105,602 ---------- ---------- Total Liabilities 7,327,587 7,078,514 SHAREHOLDERS' EQUITY 628,954 602,201 ---------- ---------- Total Liabilities and Shareholders' Equity $7,956,541 $7,680,715 ========== ========== Net interest income $ 80,420 $ 80,367 ======== ======== Net interest spread 4.11% 4.23% ==== ==== Net interest income to total average earning assets 4.80% 5.00% ==== ==== The above information is shown on a taxable-equivalent basis assuming a 35% tax rate. Non- accrual loans are included in the average loan amounts outstanding for these computations. </TABLE> <TABLE> <CAPTION> Consolidated Average Balance Sheets and Interest Income Analysis-By Quarter Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands - taxable-equivalent basis) March 31, 2001 December 31, 2000 ---------------------------- --------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Cost Balance Expense Cost ---------- -------- ------ ---------- -------- ------ <S> <C> <C> <C> <C> <C> <C> ASSETS Time deposits $ 6,383 $ 116 5.37% $ 8,092 $ 121 5.96% Securities: U.S. Treasury 102,556 1,592 6.29 131,205 2,107 6.39 U.S. Government agencies and corporations 1,341,398 22,098 6.59 1,369,655 23,281 6.80 States and political subdivisions Tax-exempt 162,943 2,943 7.22 155,761 2,835 7.28 Taxable 3,368 55 6.50 3,319 55 6.59 Other 36,858 580 6.30 36,443 590 6.42 ---------- -------- ---------- -------- Total securities 1,647,123 27,268 6.63 1,696,383 28,868 6.80 Federal funds sold and securities purchased under resale agreements 160,578 2,244 5.59 202,699 3,354 6.47 Loans, net of unearned discount 4,563,963 98,738 8.77 4,458,675 103,971 9.28 ---------- -------- ---------- -------- Total Earning Assets and Average Rate Earned 6,378,047 128,366 8.14 6,365,849 136,314 8.52 Cash and due from banks 675,168 646,062 Allowance for possible loan losses (63,316) (60,396) Banking premises and equipment 150,581 147,372 Accrued interest and other assets 311,015 304,500 ---------- ---------- Total Assets $7,451,495 $7,403,387 ========== ========== LIABILITIES Demand deposits: Commercial and individual $1,658,802 $1,678,877 Correspondent banks 236,020 226,760 Public funds 39,282 35,241 ---------- ---------- Total demand deposits 1,934,104 1,940,878 Time deposits: Savings and Interest-on-Checking 950,311 1,427 .61 948,065 1,548 .65 Money market deposit accounts 1,780,012 17,166 3.91 1,795,348 21,125 4.68 Time accounts 1,283,226 17,592 5.56 1,257,464 17,797 5.63 Public funds 309,713 3,355 4.39 302,853 3,542 4.65 ---------- -------- ---------- -------- Total time deposits 4,323,262 39,540 3.71 4,303,730 44,012 4.07 ---------- -------- ---------- -------- Total deposits 6,257,366 6,244,608 Federal funds purchased and securities sold under repurchase agreements 361,864 4,362 4.82 368,071 5,205 5.53 Guaranteed preferred beneficial interests in the Corporation's junior subordinated deferrable interest debentures, net 98,575 2,119 8.60 98,561 2,119 8.60 Long-term notes payable 3,637 62 6.92 3,683 61 6.63 Other borrowings 31,843 474 6.04 34,750 530 6.07 ---------- -------- ---------- -------- Total Interest-Bearing Funds and Average Rate Paid 4,819,181 46,557 3.91 4,808,795 51,927 4.29 ---------- -------- ---- ---------- -------- ---- Accrued interest and other liabilities 107,756 93,988 ---------- ---------- Total Liabilities 6,861,041 6,843,661 SHAREHOLDERS' EQUITY 590,454 559,726 ---------- ---------- Total Liabilities and Shareholders' Equity $7,451,495 $7,403,387 ========== ========== Net interest income $ 81,809 $84,387 ======== ======= Net interest spread 4.23% 4.23% ==== ==== Net interest income to total average earning assets 5.18% 5.28% ==== ==== The above information is shown on a taxable-equivalent basis assuming a 35% tax rate. Non- accrual loans are included in the average loan amounts outstanding for these computations. </TABLE> <TABLE> <CAPTION> Consolidated Average Balance Sheets and Interest Income Analysis-By Quarter Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands - taxable-equivalent basis) September 30, 2000 --------------------------- Interest Average Income/ Yield/ Balance Expense Cost ---------- -------- ------ <S> <C> <C> <C> ASSETS Time deposits $ 6,903 $ 114 6.60% Securities: U.S. Treasury 133,932 2,108 6.26 U.S. Government agencies and corporations 1,287,967 22,080 6.86 States and political subdivisions Tax-exempt 154,421 2,847 7.38 Taxable 3,354 56 6.65 Other 35,608 569 6.39 ---------- -------- Total securities 1,615,282 27,660 6.85 Federal funds sold and securities purchased under resale agreements 182,310 3,052 6.55 Loans, net of unearned discount 4,405,125 101,765 9.19 ---------- -------- Total Earning Assets and Average Rate Earned 6,209,620 132,591 8.50 Cash and due from banks 632,534 Allowance for possible loan losses (59,170) Banking premises and equipment 147,221 Accrued interest and other assets 308,265 ---------- Total Assets $7,238,470 ========== LIABILITIES Demand deposits: Commercial and individual $1,662,944 Correspondent banks 242,942 Public funds 34,598 ---------- Total demand deposits 1,940,484 Time deposits: Savings and Interest-on-Checking 945,462 1,559 .66 Money market deposit accounts 1,739,909 20,255 4.63 Time accounts 1,238,874 16,909 5.43 Public funds 234,320 2,806 4.76 ---------- -------- Total time deposits 4,158,565 41,529 3.97 ---------- -------- Total deposits 6,099,049 Federal funds purchased and securities sold under repurchase agreements 332,446 4,770 5.61 Guaranteed preferred beneficial interests in the Corporation's junior subordinated deferrable interest debentures, net 98,547 2,118 8.60 Long-term notes payable 6,270 73 4.67 Other borrowings 78,701 1,038 5.25 ---------- -------- Total Interest-Bearing Funds and Average Rate Paid 4,674,529 49,528 4.21 ---------- -------- ---- Accrued interest and other liabilities 84,695 ---------- Total Liabilities 6,699,708 SHAREHOLDERS' EQUITY 538,762 ---------- Total Liabilities and Shareholders' Equity $7,238,470 ========== Net interest income $ 83,063 ======== Net interest spread 4.29% ==== Net interest income to total average earning assets 5.33% ==== The above information is shown on a taxable-equivalent basis assuming a 35% tax rate. Non- accrual loans are included in the average loan amounts outstanding for these computations. Consolidated Average Balance Sheets and Interest Income Analysis-By Quarter </TABLE> Item 3. Quantitative and Qualitative Disclosures About Market Risks Market risk is the potential loss arising from adverse changes in the fair value of a financial instrument due to the changes in market rates and prices. In the ordinary course of business, Cullen/Frost's market risk is primarily interest rate risk. The Corporation's interest rate sensitivity and liquidity are monitored by its Asset/Liability Management Committee on an ongoing basis. The Committee seeks to avoid fluctuating net interest margins and to maintain consistent growth of net interest income through periods of changing interest rates. A variety of measures are used to provide for a comprehensive view of the magnitude of interest rate risk, the distribution of risk, level of risk over time and exposure to changes in certain interest rate relationships. Cullen/Frost utilizes an earnings simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on the projected net interest income and net income over the ensuing 12 month period. The model was used to measure the impact on net interest income, relative to a base case scenario, of rates increasing ratably 200 basis points and decreasing 50 basis points over the next 12 months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the repricing and maturity characteristics of the existing and projected balance sheet. All off-balance sheet financial instruments such as derivatives are included in the model. Other interest rate-related risks such as prepayment, basis and option risk are also considered. The resulting model simulations show that a 200 basis point increase in rates will result in a positive variance in net interest income of 5.6 percent relative to the base case over the next 12 months; while a decrease of 50 basis points will result in a negative variance in net interest income of 1.7 percent. This compares to the year-end 2000 estimate when a 200 basis points increase in rates resulted in a positive variance in net interest income of 0.9 percent relative to the base case over the next 12 months; while a decrease of 200 basis points resulted in a negative variance in net interest income of 1.8 percent. The Corporation's trading portfolio is immaterial and as such separate quantitative disclosure is not presented. Cullen/Frost continuously monitors and manages the balance between interest rate-sensitive assets and liabilities. The Corporation's objective is to manage the impact of fluctuating market rates on net interest income within acceptable levels. In order to meet this objective, the Corporation may lengthen or shorten the duration of assets or liabilities or enter into derivative contracts to mitigate potential market risk. Part II: Other Information Item 6. Exhibits and Reports on Form 8-K (a) Exhibits None (b) Reports on Form 8-K During the quarter ended September 30, 2001, two Current Reports on Form 8-K, dated July 27, 2001 and August 1, 2001, respectively, were filed with the Commission by the Corporation. Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Cullen/Frost Bankers, Inc. (Registrant) Date: October 24, 2001 By:/S/Phillip D. Green ----------------------- Phillip D. Green Group Executive Vice President and Chief Financial Officer (Duly Authorized Officer and Principal Accounting Officer) 17 21