1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ---------------------- (Mark One) FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Fiscal Year Ended December 31, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 0-25051 PROSPERITY BANCSHARES, INC. (Exact name of registrant as specified in its charter) TEXAS 74-2331986 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 3040 POST OAK BLVD. 77056 HOUSTON, TEXAS (Zip Code) (Address of principal executive offices) Registrant's Telephone Number, Including Area Code: (713) 993-0002 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $1.00 per share Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment of this Form 10-K. [ ] As of February 23, 2000, the number of outstanding shares of Common Stock was 5,217,825. As of such date, the aggregate market value of the shares of Common Stock held by non-affiliates, based on the closing price of the Common Stock on the Nasdaq National Market System on such date, was approximately $63,837,479. DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Company's Proxy Statement relating to the 2000 Annual Meeting of Shareholders, which will be filed within 120 days after December 31, 1999, are incorporated by reference into Part III, Items 10-13 of this Form 10-K.
2 PROSPERITY BANCSHARES, INC. 1999 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS <TABLE> <CAPTION> PART I <S> <C> <C> Item 1. Business.....................................................................................1 General......................................................................................1 Bank Activities..............................................................................2 Business Strategies..........................................................................3 Recent Acquisition...........................................................................4 Competition..................................................................................4 Associates...................................................................................4 Supervision and Regulation...................................................................4 Item 2. Properties..................................................................................10 Item 3. Legal Proceedings...........................................................................12 Item 4. Submission of Matters to a Vote of Security Holders.........................................12 PART II Item 5. Market for Registrant's Common Equity and Related Shareholder Matters.......................12 Item 6. Selected Consolidated Financial Data........................................................13 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.......15 Overview....................................................................................15 Results of Operations.......................................................................15 Financial Condition.........................................................................19 Year 2000 Compliance........................................................................31 Item 7A. Quantitative and Qualitative Disclosures about Market Risk..................................32 Item 8. Financial Statements and Supplementary Data.................................................32 Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure........34 PART III Item 10. Directors and Executive Officers of the Registrant..........................................34 Item 11. Executive Compensation......................................................................34 Item 12. Security Ownership of Certain Beneficial Owners and Management..............................34 Item 13. Certain Relationships and Related Transactions..............................................34 Part IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.............................34 </TABLE>
3 PART I SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS Statements and financial discussion an analysis contained in this Annual Report on Form 10-K that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions for the Private Litigation Reform Act of 1995. Forward-looking statements describe the Company's future plans, strategies and expectations, are based on assumptions and involve a number of risks and uncertainties, many of which are beyond the Company's control. The important factors that could cause actual results to differ materially from the forward-looking statements include, without limitation: o changes in interest rates and market prices, which could reduce the Company's net interest margins, asset valuations and expense expectations; o changes in the levels of loan prepayments and the resulting effects on the value of the Company's loan portfolio; o changes in local economic and business conditions which adversely affect the Company's customers and their ability to transact profitable business with the Company, including the ability of its borrowers to repay their loans according to their terms or a change in the value of the related collateral; o increased competition for deposits and loans adversely affecting rates and terms; o the timing, impact and other uncertainties of the Company's future acquisitions, including the Company's ability to identify suitable future acquisition candidates, the success or failure in the integration of their operations, and the Company's ability to enter new markets successfully and capitalize on growth opportunities; o increased credit risk in the Company's assets and increased operating risk caused by a material change in commercial, consumer and/or real estate loans as a percentage of the total loan portfolio; o the failure of assumptions underlying the establishment of and provisions made to the allowance for credit losses; o changes in the availability of funds resulting in increased costs or reduced liquidity; o increased asset levels and changes in the composition of assets and the resulting impact on the Company's capital levels and regulatory capital ratios; o the Company's ability to acquire, operate and maintain cost effective and efficient systems without incurring unexpectedly difficult or expensive but necessary technological changes (including changes to address Year 2000 data systems issues); o the loss of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensations levels; and o changes in statutes and government regulations or their interpretations applicable to bank holding companies and the Company's present and future banking and other subsidiaries, including changes in tax requirements and tax rates. The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise. ITEM 1. BUSINESS GENERAL Prosperity Bancshares, Inc. (the "Company") was formed in 1983 as a vehicle to acquire the former Allied Bank in Edna, Texas which was chartered in 1949. The Company derives substantially all of its income from its wholly-owned bank subsidiary, First Prosperity Bank (the "Bank"), which has 15 full-service banking locations ("Banking Centers") in the greater Houston metropolitan area and nine contiguous counties situated south and southwest of Houston and extending into South Texas. The Company's headquarters are located at 3040 Post Oak Boulevard in Houston, Texas and its telephone number is (713) 993-0002. 1
4 Operating under a community banking philosophy, the Company seeks to develop broad customer relationships based on service and convenience while maintaining its conservative approach to lending and strong asset quality. The Company has grown through a combination of internal growth, the acquisition of community banks and the opening of new banking centers. Utilizing a low cost of funds and employing stringent cost controls, the Company has been profitable in every full year of its existence, including the period of adverse economic conditions in Texas in the late 1980s. From 1988 to 1992, as a sound and profitable institution, the Company took advantage of this economic downturn and acquired the deposits and certain assets of failed banks in West Columbia, El Campo and Cuero, Texas and two failed banks in Houston, which diversified the Company's franchise and increased its core deposits. The Company opened a full-service Banking Center in Victoria, Texas in 1993 and the following year established a Banking Center in Bay City, Texas. The Company expanded its Bay City presence in 1996 with the acquisition of an additional branch location from Norwest Bank Texas, and in 1997, the Company acquired the Angleton, Texas branch of Wells Fargo Bank (the "Angleton Acquisition"). In 1998, the Company enhanced its West Columbia Banking Center with the purchase of a commercial bank branch located in West Columbia and acquired Union State Bank in East Bernard, Texas, (the "Union Acquisition"). In addition, effective October 1, 1999, the Company acquired South Texas Bancshares, Inc. and its wholly owned subsidiary, The Commercial National Bank of Beeville ("CNB"), with locations in Beeville, Mathis and Goliad, Texas (the "South Texas Acquisition"). The Company believes that this acquisition will not only expand market presence and market share in South Texas, but also enable it to achieve certain cost efficiencies and savings. Additionally, the Company acquired trust powers in connection with the South Texas Acquisition, and plans to offer trust services to customers through all of its Banking Centers in 2000. At September 30, 1999, South Texas Bancshares had total assets of $142.7 million, total loans of $33.7 million and total deposits of $126.5 million. As a result of the addition of these acquisitions and internal growth, the Company's assets have increased from $54.2 million at the end of 1987 to $608.7 million as of December 31, 1999 and its deposits have increased from $46.0 million to $534.8 million in that same period. The Company's primary market consists of the communities served by its three locations in the greater Houston metropolitan area and its 12 locations in nine contiguous counties located to the south and southwest of Houston. Texas Highway 59 (scheduled to become Interstate Highway 69), which serves as the primary "NAFTA Highway" linking the interior United States and Mexico, runs directly through the center of the Company's market area. The increased traffic along this NAFTA Highway has enhanced economic activity in the Company's market area and created opportunities for growth. The diverse nature of the economies in each local market served by the Company provides the Company with a varied customer base and allows the Company to spread its lending risk throughout a number of different industries including farming, ranching, petrochemicals, manufacturing, tourism, recreation and professional service firms and their principals. The Company's market areas outside of Houston are dominated by either small community banks or branches of large regional banks. Management believes that the Company, as one of the few mid-sized financial institutions that combines responsive community banking with the sophistication of a regional bank holding company, has a competitive advantage in its market area and excellent growth opportunities through acquisitions, new branch locations and additional business development. The Company's directors and officers are important to the Company's success and play a key role in the Company's business development efforts by actively participating in a number of civic and public service activities in the communities served by the Company, such as the Rotary Club, Lion's Club, Pilot Club, United Way and Chamber of Commerce. In addition, the Company's Banking Centers in Bay City, Beeville, Clear Lake, Cuero, Edna, Meyerland, Post Oak and Victoria maintain Community Development Boards, whose function is to solicit new business, develop customer relations and provide valuable community knowledge to their respective Banking Center Presidents. The Company has invested heavily in its officers and associates by recruiting talented officers in its market areas and providing them with economic incentive in the form of stock options and bonuses based on cross-selling performance. The senior management team has substantial experience in both the Houston markets and the surrounding communities in which the Company has a presence. Each Banking Center location is administered by a local President with knowledge of the community and lending expertise in the specific industries found in the community. The Company entrusts its Banking Center Presidents with authority and flexibility within general parameters with respect to product pricing and decision making in order to avoid the bureaucratic structure of larger banks. The Company operates each Banking Center as a separate profit center, maintaining separate data with respect to each Banking Center's net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking Center Presidents are accountable for performance in these areas and compensated accordingly. Each Banking Center has its own local telephone number, which enables a customer to be served by a local banker. BANK ACTIVITIES The Company offers a variety of traditional loan and deposit products to its customers, which consist primarily of consumers and small and medium-sized businesses. The Company tailors its products to the specific needs of customers in a given market. At December 31, 1999 the Company maintained approximately 45,000 separate deposit accounts and 6,200 separate loan accounts and 2
5 approximately 21.2% of the Company's total deposits were noninterest-bearing demand deposits. For the period ended December 31, 1999, the Company's average cost of funds was 2.96%. The Company has been an active mortgage lender, with 1-4 family residential and commercial mortgage loans comprising 60.8% of the Company's total loans as of December 31, 1999. The Company also offers loans for automobiles and other consumer durables, home equity loans, debit cards, personal computer banking and other cash management services and telebanking. By offering certificates of deposit, NOW accounts, savings accounts and overdraft protection at competitive rates, the Company gives its depositors a full range of traditional deposit products. The Company has successfully introduced the Sunburst account, which for a monthly fee provides consumers with a package of benefits including unlimited free checking, personalized checks, credit card protection, free travelers checks, cashier's checks, money orders and certain travel discounts. The businesses targeted by the Company are primarily those that require loans in the $100,000 to $3.0 million range. The Company offers these businesses a broad array of loan products including term loans, lines of credit and loans for working capital, business expansion and the purchase of equipment and machinery, interim construction loans for builders and owner-occupied commercial real estate loans. For its business customers, the Company has developed a specialized checking product called Business 10 Checking which provides discounted fees for checking and normal account analysis. BUSINESS STRATEGIES The Company's main objective is to increase deposits and loans through additional expansion opportunities while maintaining efficiency, individualized customer service and maximizing profitability. To achieve this objective, the Company has employed the following strategic goals: Continue Community Banking Emphasis. The Company intends to continue operating as a community banking organization focused on meeting the specific needs of consumers and small and medium-sized businesses in its market areas. The Company will continue to provide a high degree of responsiveness combined with a wide variety of banking products and services. The Company staffs its Banking Centers with experienced bankers with lending expertise in the specific industries found in the community, giving them authority to make certain pricing and credit decisions, thereby attempting to avoid the bureaucratic structure of larger banks. Increase Loan Volume and Diversify Loan Portfolio. Historically, the Company has elected to sacrifice some earnings for the historically lower credit losses associated with home mortgage loans. While maintaining its conservative approach to lending, the Company plans to emphasize both new and existing loan products, focusing on growing its home equity and commercial loan portfolios. Among new loan products, the Company successfully introduced home equity lending in 1998, which contributed $3.2 million in new loans during 1999 and had a balance of $11.3 million at December 31, 1999. The Company has also increased its number of loans to finance the construction of commercial owner-occupied real estate and loans to commercial businesses for accounts receivable financing and other purposes. The Company is also targeting professional service firms such as legal and medical practices for both loans secured by owner-occupied premises and personal loans to their principals. As an outgrowth of its traditional mortgage lending activity, the Company is making more jumbo mortgage loans, particularly in the Houston area. Continue Strict Focus on Efficiency. The Company plans to maintain its stringent cost control practices and policies. The Company has invested significantly in the infrastructure required to centralize many of its critical operations, such as data processing and loan application processing. For its Banking Centers, which the Company operates as independent profit centers, the Company supplies complete support in the areas of loan review, internal audit, compliance and training. The Company maintains a Products Committee which provides support in the areas of product development, marketing and pricing. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale. Enhance Cross-Selling. The Company recognizes that its customer base provides significant opportunities to cross-sell various products and it seeks to develop broader customer relationships by identifying cross-selling opportunities. The Company uses incentives and friendly competition to encourage cross-selling efforts, and increase cross-selling results. To assist with cross-selling efforts the Company has updated its technology to help officers and associates identify cross-selling opportunities. Using data, which includes existing and related account relationships, the Company's officers and associates inform customers of additional products when customers visit or call the various Banking Centers or use their drive-in facilities. In addition, the Company includes product information in monthly statements and other mailouts. The products most frequently targeted for cross-selling include auto loans, mortgage loans, home equity loans, checking accounts, savings accounts, certificates of deposit, individual retirement accounts, direct deposit accounts, personal computer banking and safe deposit boxes. 3
6 Expand Market Share Through Internal Growth and a Disciplined Acquisition Strategy. The Company intends to continue seeking opportunities, both inside and outside its existing markets, to expand either by acquiring existing banks or branches of banks or by establishing new branches. All of the Company's acquisitions have been accretive to earnings immediately and have supplied the Company with relatively low-cost deposits which have been used to fund the Company's lending activities. Factors used by the Company to evaluate expansion opportunities include the similarity in management and operating philosophies, whether the acquisition will be accretive to earnings and enhance shareholder value, the ability to achieve economies of scale to improve the efficiency ratio and the opportunity to enhance the Company's image and market presence. Maintain Strong Asset Quality. The Company intends to maintain the strong asset quality that has been representative of its historical loan portfolio. As the Company diversifies and increases its lending activities, it may face higher risks of nonpayment and increased risks in the event of economic downturns. The Company intends, however, to continue to employ the strict underwriting guidelines and comprehensive loan review process that have contributed to its low incidence of nonperforming assets and its minimal charge-offs. RECENT ACQUISITION The Company actively pursues an acquisition strategy designed to increase efficiency, market share and return to shareholders. As part of this strategy, on October 1, 1999, the Company acquired South Texas Bancshares and its wholly-owned subsidiary CNB for aggregate cash consideration of $23,350,000. The South Texas Acquisition provides the Company with a presence in Beeville, a community of 18,000 located in Bee County, Mathis, a community of 5,800 located in San Patricio County, and Goliad, a community of 3,000 located in Goliad County. The Company's significantly higher lending limit is expected to create lending opportunities in the market that South Texas Bancshares was unable to take advantage of prior to the acquisition. Similar to its previous acquisitions, management believes that the South Texas Acquisition will enable the Company to achieve certain economies of scale and savings from the operation of the newly acquired banking offices as additional Banking Centers. CNB offered conventional consumer and commercial products and services, including interest and noninterest-bearing depository accounts and commercial, industrial, consumer, agricultural and real estate lending. As of September 30, 1999, CNB had total assets of $142.7 million, total loans of $33.7 million and total deposits of $126.5 million. COMPETITION The banking business is highly competitive, and the profitability of the Company depends principally on the Company's ability to compete in its market areas. The Company competes with other commercial banks, savings banks, savings and loan associations, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking firms, asset-based nonbank lenders and certain other nonfinancial entities, including retail stores which may maintain their own credit programs and certain governmental organizations which may offer more favorable financing than the Company. The Company has been able to compete effectively with other financial institutions by emphasizing customer service, technology and responsive decision-making with respect to loans; by establishing long-term customer relationships and building customer loyalty; and by providing products and services designed to address the specific needs of its customers. Competition from both financial and nonfinancial institutions is expected to continue. Under the Gramm-Leach-Bliley Act, effective March 11, 2000, securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. The Gramm-Leach-Bliley Act may significantly change the competitive environment in which the Company and its subsidiaries conduct business. See "-Supervision and Regulation-The Company". The financial services industry is also likely to become even more competitive as further technological advances enable more companies to provide financial services. These technological advances may diminish the importance of depository institutions and other financial intermediaries in the transfer of funds between parties. ASSOCIATES As of December 31, 1999, the Company and the Bank had 185 full-time equivalent associates, 83 of whom were officers of the Bank. The Company provides medical and hospitalization insurance to its full-time associates. The Company considers its relations with associates to be excellent. Neither the Company nor the Bank is a party to any collective bargaining agreement. SUPERVISION AND REGULATION The supervision and regulation of bank holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds of the Federal Deposit Insurance Corporation ("FDIC") and the banking system as a whole, and not for the protection of the bank holding company shareholders or creditors. The banking agencies have broad enforcement 4
7 power over bank holding companies and banks including the power to impose substantial fines and other penalties for violations of laws and regulations. The following description summarizes some of the laws to which the Company and the Bank are subject. References herein to applicable statutes and regulations are brief summaries thereof, do not purport to be complete, and are qualified in their entirety by reference to such statutes and regulations. The Company believes that it is in compliance in all material respects with these laws and regulations. THE COMPANY The Company is a bank holding company registered under the Bank Holding Company Act of 1956, as amended ("BHCA"), and it is subject to supervision, regulation and examination by the Board of Governors of the Federal Reserve System ("Federal Reserve Board"). The BHCA and other federal laws subject bank holding companies to particular restrictions on the types of activities in which they may engage, and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and regulations. Regulatory Restrictions on Dividends; Source of Strength. It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization's expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company's ability to serve as a source of strength to its banking subsidiaries. Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each of its banking subsidiaries and commit resources to their support. Such support may be required at times when, absent this Federal Reserve Board policy, a holding company may not be inclined to provide it. As discussed below, a bank holding company in certain circumstances could be required to guarantee the capital plan of an undercapitalized banking subsidiary. In the event of a bank holding company's bankruptcy under Chapter 11 of the U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is required to cure immediately any deficit under any commitment by the debtor holding company to any of the federal banking agencies to maintain the capital of an insured depository institution, and any claim for breach of such obligation will generally have priority over most other unsecured claims. Financial Modernization. Under the BHCA, bank holding companies generally may not acquire a direct or indirect interest in or control of more than 5% of the voting shares of any company that is not a bank or bank holding company or from engaging in activities other than those of banking, managing or controlling banks or furnishing services to or performing services for its subsidiaries, except that it may engage in, directly or indirectly, certain activities that the Federal Reserve Board determined to be closely related to banking or managing and controlling banks as to be a proper incident thereto. However, on November 12, 1999, President Clinton signed into law the Gramm-Leach-Bliley Act which eliminated the barriers to affiliations among banks, securities firms, insurance companies and other financial service providers. The Gramm-Leach-Bliley Act, effective March 11, 2000, permits bank holding companies to become financial holding companies and thereby affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. The Gramm-Leach-Bliley Act defines "financial in nature" to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. Under the Gramm-Leach-Bliley Act, a bank holding company may become a financial holding company by filing a declaration with the Federal Reserve Board if each of its subsidiary banks is well capitalized under the FDICIA prompt corrective action provisions, is well managed, and has at least a satisfactory rating under the Community Reinvestment Act of 1977 ("CRA"). While the Federal Reserve Board will serve as the "umbrella" regulator for financial holding companies and has the power to examine banking organizations engaged in new activities, regulation and supervision of activities which are financial in nature or determined to be incidental to such financial activities will be handled along functional lines. Accordingly, activities of subsidiaries of a financial holding company will be regulated by the agency or authorities with the most experience regulating that activity as it is conducted in a financial holding company. 5
8 Safe and Sound Banking Practices. Bank holding companies are not permitted to engage in unsafe and unsound banking practices. The Federal Reserve Board's Regulation Y, for example, generally requires a holding company to give the Federal Reserve Board prior notice of any redemption or repurchase of its own equity securities, if the consideration to be paid, together with the consideration paid for any repurchases or redemptions in the preceding year, is equal to 10% or more of the company's consolidated net worth. The Federal Reserve Board may oppose the transaction if it believes that the transaction would constitute an unsafe or unsound practice or would violate any law or regulation. Depending upon the circumstances, the Federal Reserve Board could take the position that paying a dividend would constitute an unsafe or unsound banking practice. The Federal Reserve Board has broad authority to prohibit activities of bank holding companies and their nonbanking subsidiaries which represent unsafe and unsound banking practices or which constitute violations of laws or regulations, and can assess civil money penalties for certain activities conducted on a knowing and reckless basis, if those activities caused a substantial loss to a depository institution. The penalties can be as high as $1.0 million for each day the activity continues. Anti-Tying Restrictions. Bank holding companies and their affiliates are prohibited from tying the provision of certain services, such as extensions of credit, to other services offered by a holding company or its affiliates. Capital Adequacy Requirements. The Federal Reserve Board has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies. Under the guidelines, specific categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a "risk-weighted" asset base. The guidelines require a minimum total risk-based capital ratio of 8.0% (of which at least 4.0% is required to consist of Tier 1 capital elements). Total capital is the sum of Tier 1 and Tier 2 capital. As of December 31, 1999, the Company's ratio of Tier 1 capital to total risk-weighted assets was 14.35% and its ratio of total capital to total risk-weighted assets was 16.71%. SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - FINANCIAL CONDITION - CAPITAL RESOURCES." In addition to the risk-based capital guidelines, the Federal Reserve Board uses a leverage ratio as an additional tool to evaluate the capital adequacy of bank holding companies. The leverage ratio is a company's Tier 1 capital divided by its average total consolidated assets. Certain highly rated bank holding companies may maintain a minimum leverage ratio of 3.0%, but other bank holding companies may be required to maintain a leverage ratio of up to 200 basis points above the regulatory minimum. As of December 31, 1999, the Company's leverage ratio was 6.28%. The federal banking agencies' risk-based and leverage ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria, assuming that they have the highest regulatory rating. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. Federal Reserve Board guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Imposition of Liability for Undercapitalized Subsidiaries. Bank regulators are required to take "prompt corrective action" to resolve problems associated with insured depository institutions whose capital declines below certain levels. In the event an institution becomes "undercapitalized," it must submit a capital restoration plan. The capital restoration plan will not be accepted by the regulators unless each company having control of the undercapitalized institution guarantees the subsidiary's compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution's holding company is entitled to a priority of payment in bankruptcy. The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution's assets at the time it became undercapitalized or the amount necessary to cause the institution to be "adequately capitalized." The bank regulators have greater power in situations where an institution becomes "significantly" or "critically" undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates. Acquisitions by Bank Holding Companies. The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. In approving bank acquisitions by bank holding companies, the Federal Reserve Board is required to consider the financial and 6
9 managerial resources and future prospects of the bank holding company and the banks concerned, the convenience and needs of the communities to be served, and various competitive factors. Control Acquisitions. The Change in Bank Control Act prohibits a person or group of persons from acquiring "control" of a bank holding company unless the Federal Reserve Board has been notified and has not objected to the transaction. Under a rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% of more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Company, would, under the circumstances set forth in the presumption, constitute acquisition of control of the Company. In addition, any entity is required to obtain the approval of the Federal Reserve Board under the BHCA before acquiring 25% (5% in the case of an acquiror that is a bank holding company) or more of the outstanding Common Stock of the Company, or otherwise obtaining control or a "controlling influence" over the Company. THE BANK The Bank is a Texas-chartered banking association, the deposits of which are insured by the Bank Insurance Fund ("BIF"). The Bank is not a member of the Federal Reserve System; therefore, the Bank is subject to supervision and regulation by the FDIC and the Texas Banking Department. Such supervision and regulation subject the Bank to special restrictions, requirements, potential enforcement actions and periodic examination by the FDIC and the Texas Banking Department. Because the Federal Reserve Board regulates the bank holding company parent of the Bank, the Federal Reserve Board also has supervisory authority which directly affects the Bank. Equivalence to National Bank Powers. The Texas Constitution, as amended in 1986, provides that a Texas-chartered bank has the same rights and privileges that are or may be granted to national banks domiciled in Texas. To the extent that the Texas laws and regulations may have allowed state-chartered banks to engage in a broader range of activities than national banks, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") has operated to limit this authority. FDICIA provides that no state bank or subsidiary thereof may engage as principal in any activity not permitted for national banks, unless the institution complies with applicable capital requirements and the FDIC determines that the activity poses no significant risk to the insurance fund. In general, statutory restrictions on the activities of banks are aimed at protecting the safety and soundness of depository institutions. Financial Modernization. Under the Gramm-Leach-Bliley Act, a national bank may establish a financial subsidiary and engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting as principal, insurance company portfolio investment, real estate development, real estate investment and annuity issuance. To do so, a bank must be well capitalized, well managed and have a CRA rating of satisfactory or better. Subsidiary banks of a financial holding company or national banks with financial subsidiaries must remain well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of the financial in nature subsidiary or subsidiaries. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a CRA rating of satisfactory of better. Although the powers of state chartered banks are not specifically addressed in the Gramm-Leach-Bliley Act, Texas-chartered banks such as the Bank, will have the same if not greater powers as national banks through the parity provision contained in the Texas Constitution. Branching. Texas law provides that a Texas-chartered bank can establish a branch anywhere in Texas provided that the branch is approved in advance by the Texas Banking Department. The branch must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers. Restrictions on Transactions with Affiliates and Insiders. Transactions between the Bank and its nonbanking subsidiaries, including the Company, are subject to Section 23A of the Federal Reserve Act. In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties. It also limits the amount of advances to third parties which are collateralized by the securities or obligations of the Company or its subsidiaries. Affiliate transactions are also subject to Section 23B of the Federal Reserve Act which generally requires that certain transactions between the Bank and its affiliates be on terms substantially the same, or at least as favorable to the Bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons. 7
10 The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to herein as "insiders") contained in the Federal Reserve Act and Regulation O apply to all insured institutions and their subsidiaries and holding companies. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. These loans cannot exceed the institution's total unimpaired capital and surplus, and the FDIC may determine that a lesser amount is appropriate. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions. Restrictions on Distribution of Subsidiary Bank Dividends and Assets. Dividends paid by the Bank have provided a substantial part of the Company's operating funds and for the foreseeable future it is anticipated that dividends paid by the Bank to the Company will continue to be the Company's principal source of operating funds. Capital adequacy requirements serve to limit the amount of dividends that may be paid by the Bank. Under federal law, the Bank cannot pay a dividend if, after paying the dividend, the Bank will be "undercapitalized." The FDIC may declare a dividend payment to be unsafe and unsound even though the Bank would continue to meet its capital requirements after the dividend. Because the Company is a legal entity separate and distinct from its subsidiaries, its right to participate in the distribution of assets of any subsidiary upon the subsidiary's liquidation or reorganization will be subject to the prior claims of the subsidiary's creditors. In the event of a liquidation or other resolution of an insured depository institution, the claims of depositors and other general or subordinated creditors are entitled to a priority of payment over the claims of holders of any obligation of the institution to its shareholders, including any depository institution holding company (such as the Company) or any shareholder or creditor thereof. Examinations. The FDIC periodically examines and evaluates insured banks. Based on such an evaluation, the FDIC may revalue the assets of the institution and require that it establish specific reserves to compensate for the difference between the FDIC-determined value and the book value of such assets. The Texas Banking Department also conducts examinations of state banks but may accept the results of a federal examination in lieu of conducting an independent examination. Audit Reports. Insured institutions with total assets of $500 million or more must submit annual audit reports prepared by independent auditors to federal and state regulators. In some instances, the audit report of the institution's holding company can be used to satisfy this requirement. Auditors must receive examination reports, supervisory agreements and reports of enforcement actions. In addition, financial statements prepared in accordance with generally accepted accounting principles, management's certifications concerning responsibility for the financial statements, internal controls and compliance with legal requirements designated by the FDIC, and an attestation by the auditor regarding the statements of management relating to the internal controls must be submitted. For institutions with total assets of more than $3 billion, independent auditors may be required to review quarterly financial statements. FDICIA requires that independent audit committees be formed, consisting of outside directors only. The committees of such institutions must include members with experience in banking or financial management, must have access to outside counsel, and must not include representatives of large customers. Capital Adequacy Requirements. The FDIC has adopted regulations establishing minimum requirements for the capital adequacy of insured institutions. The FDIC may establish higher minimum requirements if, for example, a bank has previously received special attention or has a high susceptibility to interest rate risk. The FDIC's risk-based capital guidelines generally require state banks to have a minimum ratio of Tier 1 capital to total risk-weighted assets of 4.0% and a ratio of total capital to total risk-weighted assets of 8.0%. The capital categories have the same definitions for the Bank as for the Company. As of December 31, 1999, the Bank's ratio of Tier 1 capital to total risk-weighted assets was 14.37% and its ratio of total capital to total risk-weighted assets was 15.48%. SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF OPERATION OF THE COMPANY - FINANCIAL CONDITION - CAPITAL RESOURCES." The FDIC's leverage guidelines require state banks to maintain Tier 1 capital of no less than 5.0% of average total assets, except in the case of certain highly rated banks for which the requirement is 3.0% of average total assets. The Texas Banking Department has issued a policy which generally requires state chartered banks to maintain a leverage ratio (defined in accordance with federal capital guidelines) of 6%. As of December 31, 1999, the Bank's ratio of Tier 1 capital to average total assets (leverage ratio) was 6.29%. SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF OPERATION OF THE COMPANY - FINANCIAL CONDITION - CAPITAL RESOURCES." Corrective Measures for Capital Deficiencies. The federal banking regulators are required to take "prompt corrective action" with respect to capital-deficient institutions. Agency regulations define, for each capital category, the levels at which institutions are "well capitalized," "adequately capitalized," "under capitalized," "significantly under capitalized" and "critically under capitalized." A "well capitalized" bank has a total risk-based capital ratio of 10.0% or higher; a Tier 1 risk-based capital ratio of 6.0% or higher; a leverage ratio of 5.0% or higher; and is not subject to any written agreement, order or directive requiring it to maintain a specific capital level for any capital measure. An "adequately capitalized" bank has a total risk-based capital ratio of 8.0% or higher; a Tier 1 8
11 risk-based capital ratio of 4.0% or higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing significant growth); and does not meet the criteria for a well capitalized bank. A bank is "under capitalized" if it fails to meet any one of the ratios required to be adequately capitalized. The Bank is classified as "well capitalized" for purposes of the FDIC's prompt corrective action regulations. In addition to requiring undercapitalized institutions to submit a capital restoration plan, agency regulations contain broad restrictions on certain activities of undercapitalized institutions including asset growth, acquisitions, branch establishment and expansion into new lines of business. With certain exceptions, an insured depository institution is prohibited from making capital distributions, including dividends, and is prohibited from paying management fees to control persons if the institution would be undercapitalized after any such distribution or payment. As an institution's capital decreases, the FDIC's enforcement powers become more severe. A significantly undercapitalized institution is subject to mandated capital raising activities, restrictions on interest rates paid and transactions with affiliates, removal of management and other restrictions. The FDIC has only very limited discretion in dealing with a critically undercapitalized institution and is virtually required to appoint a receiver or conservator. Banks with risk-based capital and leverage ratios below the required minimums may also be subject to certain administrative actions, including the termination of deposit insurance upon notice and hearing, or a temporary suspension of insurance without a hearing in the event the institution has no tangible capital. Deposit Insurance Assessments. The Bank must pay assessments to the FDIC for federal deposit insurance protection. The FDIC has adopted a risk-based assessment system as required by FDICIA. Under this system, FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification. Institutions assigned to higher risk classifications (that is, institutions that pose a greater risk of loss to their respective deposit insurance funds) pay assessments at higher rates than institutions that pose a lower risk. An institution's risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. In addition, the FDIC can impose special assessments in certain instances. The current range of BIF assessments is between 0% and 0.27% of deposits. The FDIC established a process for raising or lowering all rates for insured institutions semi-annually if conditions warrant a change. Under this system, the FDIC has the flexibility to adjust the assessment rate schedule twice a year without seeking prior public comment, but only within a range of five cents per $100 above or below the premium schedule adopted. Changes in the rate schedule outside the five cent range above or below the current schedule can be made by the FDIC only after a full rulemaking with opportunity for public comment. On September 30, 1996, President Clinton signed into law an act that contained a comprehensive approach to re-capitalizing the Savings Association Insurance Fund ("SAIF") and to assure the payment of the Financing Corporation's ("FICO") bond obligations. Under this new act, banks insured under the BIF are required to pay a portion of the interest due on bonds that were issued by FICO to help shore up the ailing Federal Savings and Loan Insurance Corporation in 1987. The BIF-rate was required to equal one-fifth of the SAIF rate through year-end 1999, or until the insurance funds merged, whichever occurred first. Thereafter, BIF and SAIF payers will be assessed pro rata for the FICO bond obligations. With regard to the assessment for the FICO obligation, for the fourth quarter 1999, the BIF rate was .01184% of deposits and the SAIF rate was .05920% of deposits, and for the first quarter of 2000, both the BIF and SAIF rates are .02120% of deposits. Enforcement Powers. The FDIC and the other federal banking agencies have broad enforcement powers, including the power to terminate deposit insurance, impose substantial fines and other civil and criminal penalties and appoint a conservator or receiver. Failure to comply with applicable laws, regulations and supervisory agreements could subject the Company or its banking subsidiaries, as well as officers, directors and other institution-affiliated parties of these organizations, to administrative sanctions and potentially substantial civil money penalties. The appropriate federal banking agency may appoint the FDIC as conservator or receiver for a banking institution (or the FDIC may appoint itself, under certain circumstances) if any one or more of a number of circumstances exist, including, without limitation, the fact that the banking institution is undercapitalized and has no reasonable prospect of becoming adequately capitalized; fails to become adequately capitalized when required to do so; fails to submit a timely and acceptable capital restoration plan; or materially fails to implement an accepted capital restoration plan. The Texas Banking Department also has broad enforcement powers over the Bank, including the power to impose orders, remove officers and directors, impose fines and appoint supervisors and conservators. Brokered Deposit Restrictions. Adequately capitalized institutions cannot accept, renew or roll over brokered deposits except with a waiver from the FDIC, and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew, or roll over brokered deposits. 9
12 Cross-Guarantee Provisions. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") contains a "cross-guarantee" provision which generally makes commonly controlled insured depository institutions liable to the FDIC for any losses incurred in connection with the failure of a commonly controlled depository institution. Community Reinvestment Act. The CRA and the regulations issued thereunder are intended to encourage banks to help meet the credit needs of their service area, including low and moderate income neighborhoods, consistent with the safe and sound operations of the banks. These regulations also provide for regulatory assessment of a bank's record in meeting the needs of its service area when considering applications to establish branches, merger applications and applications to acquire the assets and assume the liabilities of another bank. FIRREA requires federal banking agencies to make public a rating of a bank's performance under the CRA. In the case of a bank holding company, the CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction. Consumer Laws and Regulations. In addition to the laws and regulations discussed herein, the Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, and the Fair Housing Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part of their ongoing customer relations. INSTABILITY AND REGULATORY STRUCTURE Various legislation, such as the Gramm-Leach-Bliley Act which expanded the powers of banking institutions and bank holding companies, and proposals to overhaul the bank regulatory system and limit the investments that a depository institution may make with insured funds, is from time to time introduced in Congress. Such legislation may change banking statutes and the operating environment of the Company and its banking subsidiaries in substantial and unpredictable ways. The Company cannot determine the ultimate effect that the Gramm-Leach-Bliley Act will have, or the effect that any potential legislation, if enacted, or implementing regulations with respect thereto, would have, upon the financial condition or results of operations of the Company or its subsidiaries. EXPANDING ENFORCEMENT AUTHORITY One of the major additional burdens imposed on the banking industry by FDICIA is the increased ability of banking regulators to monitor the activities of banks and their holding companies. In addition, the Federal Reserve Board and FDIC are possessed of extensive authority to police unsafe or unsound practices and violations of applicable laws and regulations by depository institutions and their holding companies. For example, the FDIC may terminate the deposit insurance of any institution which it determines has engaged in an unsafe or unsound practice. The agencies can also assess civil money penalties, issue cease and desist or removal orders, seek injunctions, and publicly disclose such actions. FDICIA, FIRREA and other laws have expanded the agencies' authority in recent years, and the agencies have not yet fully tested the limits of their powers. EFFECT ON ECONOMIC ENVIRONMENT The policies of regulatory authorities, including the monetary policy of the Federal Reserve Board, have a significant effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the Federal Reserve Board to affect the money supply are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid for deposits. Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on the business and earnings of the Company and its subsidiaries cannot be predicted. ITEM 2. PROPERTIES The Company conducts business at 15 full-service banking locations. The Company's headquarters are located at 3040 Post Oak Boulevard, Houston, Texas. The Company owns all of the buildings in which its Banking Centers are located other than the Post Oak, Meyerland and Victoria Banking Centers. The lease terms of the Post Oak, Meyerland and Victoria Banking Centers expire in 10
13 July 2002, October 2003, and December 2001, respectively. The expiration dates do not include the renewal option periods, which may be available. The following table sets forth specific information on each such location; <TABLE> <CAPTION> Location Address Deposits at December 31,1999 -------- ------- ---------------------------- (Dollars in thousands) <S> <C> <C> Angleton 116 South Velasco $31,103 Angleton, TX 77516 Bay City-North 1600 Seventh St. $15,379 Bay City, TX 77404 Bay City-South 3700 Avenue F $28,308 Bay City, TX 77404 Beeville (1) 100 South Washington $81,330 Beeville, TX 78102 Clear Lake 100 West Medical Center Blvd. $30,297 Webster, TX 77598 Cuero 106 North Esplanade $23,005 Cuero, TX 77954 East Bernard 700 Church St. $68,884 East Bernard, TX 77435 Edna 102 North Wells $34,714 Edna, TX 77962 El Campo 1301 North Mechanic $53,580 El Campo, TX 77437 Goliad 145 North Jefferson $13,110 Goliad, TX 77963 Mathis 103 North Highway 359 $28,373 Mathis, TX 78368 Meyerland 8801 West Loop South $22,058 Houston, TX 77252 Post Oak 3040 Post Oak Blvd. Suite 150 $48,885 Houston, TX 77056 Victoria 2702 North Navarro $14,173 Victoria, TX 77903 West Columbia 510 East Brazos $41,557 West Columbia, TX 77486 </TABLE> - ------------------ (1) The Beeville Banking Center consists of the main office located at 100 South Washington and a drive-thru facility located approximately one-half mile from the main office. 11
14 ITEM 3. LEGAL PROCEEDINGS Neither the Company nor the Bank is currently a party to any material legal proceeding. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1999. PART II. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The Company's Common Stock began trading on November 12, 1998 and is listed on the Nasdaq National Market System ("Nasdaq NMS") under the symbol "PRSP". Prior to that date, the Common Stock was privately held and not listed on any public exchange or actively traded. The Company had a total of 5,195,325 shares outstanding at December 31, 1999. As of February 23, 2000, there were 207 shareholders of record. The number of beneficial owners is unknown to the Company at this time. The following table presents the high and low sales prices for the Common Stock reported on the NASDAQ NMS during the two years ended December 31, 1999: <TABLE> <CAPTION> 1999 High Low ----- ----- ------ <S> <C> <C> Fourth Quarter.......................... $17.875 $14.000 Third Quarter........................... 16.875 13.875 Second Quarter.......................... 15.000 12.313 First Quarter........................... 13.250 12.063 1998 ---- Fourth Quarter (since November 12, 1998)...................... 12.625 12.000 </TABLE> Holders of Common Stock are entitled to receive dividends when, as and if declared by the Company's Board of Directors out of funds legally available therefor. While the Company has declared dividends on its Common Stock since 1994, and paid quarterly dividends aggregating $0.20 per share in 1999, there is no assurance that the Company will continue to pay dividends in the future. The principal source of cash revenues to the Company is dividends paid by the Bank with respect to the Bank's capital stock. There are certain restrictions on the payment of such dividends imposed by federal and state banking laws, regulations and authorities. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" AND "BUSINESS - SUPERVISION AND REGULATION - THE BANK". The cash dividends paid per share (adjusted for a four for one stock split effective September 10, 1998) by quarter were as follows: <TABLE> <CAPTION> 1999 1998 ----- ----- <S> <C> <C> Fourth quarter.................... $0.05 $0.05 Third quarter...................... 0.05 0.05 Second quarter..................... 0.05 0.05 First quarter...................... 0.05 0.05 </TABLE> 12
15 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The following selected consolidated financial data for, and as of the end of, each of the years in the five-year period ended December 31, 1999 are derived from and should be read in conjunction with the consolidated financial statements of the Company and the Notes thereto, appearing elsewhere in this Annual Report on Form 10-K, and the information contained in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." The consolidated financial statements as of December 31, 1999 and 1998 and for each of the years in the three-year period ended December 31, 1999 and the report thereon of Deloitte & Touche LLP are included elsewhere in this document. <TABLE> <CAPTION> As of and for the Years Ended December 31, -------------------------------------------------------- 1999 1998 1997 1996 1995 -------- -------- -------- -------- -------- <S> <C> <C> <C> <C> <C> (Dollars in thousands, except per share data) INCOME STATEMENT DATA: Interest income ............................. $ 31,412 $ 23,422 19,970 $ 16,841 $ 14,738 Interest expense ............................ 13,033 10,128 9,060 7,923 6,904 -------- -------- -------- -------- -------- Net interest income ...................... 18,379 13,294 10,910 8,918 7,834 Provision for credit losses ................. 280 239 190 230 175 -------- -------- -------- -------- -------- Net interest income after provision for credit losses ...................... 18,099 13,055 10,720 8,688 7,659 Noninterest income .......................... 3,521 2,492 2,264 1,897 1,489 Noninterest expense ......................... 12,138 9,058 7,836 6,634 6,046 -------- -------- -------- -------- -------- Income before taxes ...................... 9,482 6,489 5,148 3,951 3,102 Provision for income taxes .................. 3,008 2,029 1,586 1,240 781 -------- -------- -------- -------- -------- Net income .................................. $ 6,474 $ 4,460 $ 3,562 $ 2,711 $ 2,321 ======== ======== ======== ======== ======== PER SHARE DATA(1): Basic earnings per share .................... $ 1.25 $ 1.08 $ 0.94 $ 0.77 $ 0.66 Diluted earnings per share .................. 1.20 1.04 0.92 0.76 0.66 Book value per share ........................ 8.33 8.01 6.22 5.36 4.68 Tangible book value per share (2) ........... 4.63 6.14 4.81 4.21 3.95 Cash dividends declared ..................... 0.20 0.20 0.15 0.10 0.10 Dividend payout ratio ....................... 16.02% 23.70% 16.11% 12.95% 15.12% Weighted average shares outstanding (basic) (in thousands) ........................... 5,186 4,116 3,778 3,513 3,514 Weighted average shares outstanding (diluted) (in thousands) ........................... 5,392 4,309 3,864 3,560 3,523 Shares outstanding at end of period (in thousands) ........................... 5,195 5,173 3,990 3,510 3,514 BALANCE SHEET DATA (AT PERIOD END): Total assets ................................ $608,673 $436,312 $320,143 $293,988 $233,492 Securities .................................. 312,671 227,744 167,868 147,564 117,505 Loans ....................................... 223,505 170,478 120,578 113,382 88,797 Allowance for credit losses ................. 2,753 1,850 1,016 923 753 Total deposits .............................. 534,756 390,659 291,516 270,866 214,534 Borrowings and notes payable ................ 15,700 2,437 2,800 3,267 1,517 Total shareholders' equity .................. 43,266 41,435 24,818 18,833 16,458 AVERAGE BALANCE SHEET DATA: Total assets ................................ $485,757 $354,851 $304,086 $257,205 $224,701 Securities .................................. 241,543 178,416 157,677 127,607 119,857 Loans ....................................... 193,687 143,196 117,586 104,534 81,631 Allowance for credit losses ................. 2,146 1,271 961 820 669 Total deposits .............................. 438,623 323,045 278,377 236,334 207,321 Total shareholders' equity .................. 42,745 27,933 21,821 17,646 14,916 </TABLE> (Table continued on next page) 13
16 <TABLE> <CAPTION> As of and for the Years Ended December 31, ---------------------------------------------------------- 1999 1998 1997 1996 1995 -------- -------- -------- -------- -------- (Dollars in thousands, except per share data) <S> <C> <C> <C> <C> <C> PERFORMANCE RATIOS: Return on average assets ....................... 1.33% 1.26% 1.17% 1.05% 1.03% Return on average equity ....................... 15.15 15.97 16.32 15.36 15.56 Net interest margin (tax-equivalent) (3) ....... 4.18 4.13 4.02 3.91 3.96 Efficiency ratio(4) ............................ 55.13 57.38 59.48 61.34 64.85 ASSET QUALITY RATIOS(5): Nonperforming assets to total loans and other real estate ........................... 0.00% 0.00% 0.00% 0.00% 0.00% Net loan (recoveries) charge-offs to average loans ............................ (0.03) 0.05 0.08 0.06 0.01 Allowance for credit losses to total loans ....................................... 1.23 1.09 0.84 0.81 0.85 Allowance for credit losses to nonperforming loans(6) ...................... -- -- -- -- -- CAPITAL RATIOS(5): Leverage ratio ................................. 6.28% 7.58% 6.30% 5.45% 6.05% Average shareholders' equity to average total assets ................................ 8.80 7.87 7.18 6.86 6.64 Tier 1 risk-based capital ratio ................ 14.35 18.02 14.94 13.11 14.99 Total risk-based capital ratio ................. 16.71 19.08 15.73 13.89 15.79 </TABLE> - ----------------------------- (1) Adjusted for a four-for-one stock split effective September 10, 1998. (2) Calculated by dividing total assets, less total liabilities and goodwill, by shares outstanding at end of period. (3) Calculated on a tax-equivalent basis using a 34% federal income tax rate. (4) Calculated by dividing total noninterest expense, excluding securities losses and credit loss provisions, by net interest income plus noninterest income. The interest expense related to debentures issued by the Company in connection with the issuance by a subsidiary trust of trust preferred securities, is treated as interest expense for this calculation. Additionally, taxes are not part of this calculation. (5) At period end, except for net loan charge-offs to average loans and average shareholders' equity to average total assets, which is for periods ended at such dates. (6) Nonperforming loans consist of nonaccrual loans, loans contractually past due 90 days or more and restructured loans. The Company had no significant nonperforming loans at any of the dates indicated. 14
17 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company's balance sheets and statements of income. This section should be read in conjunction with the Company's financial statements and accompanying notes and other detailed information appearing elsewhere in this Annual Report on Form 10-K. FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 OVERVIEW Net income was $6.5 million, $4.5 million and $3.6 million for the years ended December 31, 1999, 1998 and 1997, respectively, and diluted earnings per share were $1.20, $1.04, and $0.92 for these same periods. Earnings growth from both 1997 to 1998 and 1998 to 1999 resulted principally from an increase in loan volume and acquisitions, including the South Texas Acquisition and the Union Acquisition. The Company posted returns on average assets of 1.33%, 1.26% and 1.17% and returns on average equity of 15.15%, 15.97% and 16.32% for the years ended December 31, 1999, 1998 and 1997, respectively. The Company posted returns on average assets excluding amortization of goodwill of 1.46%, 1.37%, and 1.30% and returns on average equity excluding amortization of goodwill of 16.57%, 17.38%, and 18.17% for the years ended December 31, 1999, 1998 and 1997, respectively. The Company's efficiency ratio was 55.13% in 1999, 57.38% in 1998, and 59.48% in 1997. The Company's efficiency ratio excluding amortization of goodwill was 51.85% in 1999, 54.21% in 1998, and 56.43% in 1997. Total assets at December 31, 1999, 1998 and 1997 were $608.7 million, $436.3 million and $320.1 million, respectively. Total deposits at December 31, 1999, 1998 and 1997 were $534.8 million, $390.7 million, and $291.5 million, respectively, with deposit growth in each period resulting from acquisitions and internal growth. Total loans were $223.5 at December 31, 1999, an increase of $53.0 million or 31.1% from $170.5 million at the end of 1998. Total loans were $120.6 million at year-end 1997. At December 31, 1999, the Company had no nonperforming loans and its allowance for credit losses was $2.8 million. Shareholders' equity was $43.3 million, $41.4 million, and $24.8 million at December 31, 1999, 1998 and 1997, respectively. RESULTS OF OPERATIONS Net Interest Income Net interest income represents the amount by which interest income on interest-earning assets, including securities and loans, exceeds interest expense incurred on interest-bearing liabilities, including deposits and other borrowed funds. Net interest income is the principal source of the Company's earnings. Interest rate fluctuations, as well as changes in the amount and type of earning assets and liabilities, combine to affect net interest income. The Company's net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a "volume change." It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a "rate change." 1999 versus 1998. Net interest income for 1999 was $18.4 million, compared with $13.3 million for 1998, an increase of $5.1 million or 38.3%. The improvement in net interest income for 1999 was mainly due to an increase in total average interest-earning assets and a decrease in funding costs. Average interest-earning assets increased $121.4 million from $328.3 million to $449.7 million in 1999. Total funding costs decreased 24 basis points from 3.96% in 1998 to 3.72% in 1999. For 1999, the net interest margin on a tax-equivalent basis increased five basis points to 4.18% from 4.13% in 1998. 1998 versus 1997. Net interest income for 1998 was $13.3 million, compared with $10.9 million for 1997, an increase of $2.4 million or 22.0%. The improvement in net interest income for 1998 was mainly due to an increase in total average interest-earning assets and a decrease in funding costs. Average interest-earning assets increased $49.5 million from $278.8 million to $328.3 million in 1998. Total funding costs decreased eight basis points from 4.04% in 1997 to 3.96% in 1998. For 1998, the net interest margin on a tax-equivalent basis increased 11 basis points to 4.13% from 4.02% in 1997. 15
18 The following table presents for the periods indicated the total dollar amount of average balances, interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Nonaccruing loans have been included in the tables as loans carrying a zero yield. <TABLE> <CAPTION> Years Ended December 31, --------------------------------------------------------------------------------------- 1999 1998 1997 ----------------------------- ---------------------------- ---------------------------- Average Interest Average Average Interest Average Average Interest Average Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Balance Paid Rate Balance Paid Rate Balance Paid Rate ----------- --------- ----- ---------- -------- ------- --------- ------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> ASSETS Interest-earning assets: Loans ................................... $ 193,687 16,386 8.46% $ 143,196 $ 12,282 8.58% 117,586 $ 10,205 8.68% Securities(1) ........................... 241,543 14,292 5.92 178,416 10,834 6.07 157,677 9,572 6.07 Federal funds sold and other temporary investments ............................ 14,491 734 5.00 6,676 306 4.58 3,545 193 5.44 --------- --------- --------- --------- --------- -------- Total interest-earning assets ......... 449,721 31,412 6.98% 328,288 23,422 7.13% 278,808 19,970 7.16% --------- --------- --------- Less allowance for credit losses ........ (2,146) (1,271) (961) --------- --------- --------- Total interest-earning assets, net of allowance ......................... 447,575 327,017 277,847 Noninterest-earning assets ............. 38,182 27,834 26,239 --------- --------- --------- Total assets .......................... $ 485,757 $ 354,851 $ 304,086 ========= ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing liabilities: Interest-bearing demand deposits ........ $ 54,396 $ 862 1.58% $ 41,710 $ 670 1.61 $ 42,898 915 2.13% Savings and money market accounts ....... 125,015 4,103 3.28 83,428 2,838 3.40 64,448 2,158 3.35 Certificates of deposit ................. 169,417 8,006 4.73 128,097 6,485 5.06 113,669 5,785 5.09 Federal funds purchased and other borrowings ............................. 1,169 62 5.23 2,267 135 5.96 3,030 202 6.67 --------- --------- --------- --------- --------- --------- Total interest-bearing liabilities .......................... 349,997 13,033 3.72% 255,502 10,128 3.96% 224,045 9,060 4.04% --------- --------- --------- --------- --------- --------- Noninterest-bearing liabilities: Noninterest-bearing demand deposits ..... 89,795 69,810 57,362 Company obligated mandatorily redeemable trust preferred securities of subsidiary trust .................................. 1,500 -- -- Other liabilities ....................... 1,720 1,606 858 --------- --------- --------- Total liabilities ..................... 443,012 326,918 282,265 --------- --------- --------- Shareholders' equity ...................... 42,745 27,933 21,821 --------- --------- --------- Total liabilities and shareholders' equity ............................... $ 485,757 $ 354,851 304,086 ========= ========= ========= Net interest rate spread .................. 3.26% 3.17% 3.12% Net interest income and margin(2) ......... $ 18,379 4.09% $ 13,294 4.05% $ 10,910 3.91% ========= ========= ========= Net interest income and margin (tax-equivalent basis)(3) ................ $ 18,781 4.18% $ 13,571 4.13% $ 11,222 4.02% ========= ========= ========= </TABLE> - ---------------- (1) Yield is based on amortized cost and does not include any component of unrealized gains or losses. (2) The net interest margin is equal to net interest income divided by average interest-earning assets. (3) In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax-equivalent adjustment has been computed using a federal income tax rate of 34% and other applicable effective tax rates. 16
19 The following schedule presents the dollar amount of changes in interest income and interest expense for the major components of interest-earning assets and interest-bearing liabilities and distinguishes between the increase (decrease) related to higher outstanding balances and the volatility of interest rates. For purposes of this table, changes attributable to both rate and volume which cannot be segregated have been allocated to rate. <TABLE> Years Ended December 31, -------------------------------------------------------------- 1999 vs. 1998 1998 vs. 1997 ---------------------------- ------------------------------ Increase Increase (Decrease) (Decrease) Due to Due to ------------------ ------------------ Volume Rate Total Volume Rate Total ------- ------- ------- ------- ------- ------- <S> <C> <C> <C> <C> <C> <C> (Dollars in thousands) Interest-earning assets: Loans............................................... $ 4,331 $ (227) $ 4,104 $ 2,223 $ (146) $ 2,077 Securities ......................................... 3,833 (375) 3,458 1,259 3 1,262 Federal funds sold and other temporary investments .................................... 353 75 428 170 (57) 113 ------- ------- ------- ------- ------- ------- Total increase (decrease) in interest income.... 8,517 (527) 7,990 3,652 (200) 3,452 ------- ------- ------- ------- ------- ------- Interest-bearing liabilities: Interest-bearing demand deposits ................... 204 (12) 192 (25) (220) (245) Savings and money market accounts .................. 1,415 (150) 1,265 636 44 680 Certificates of deposit ............................ 2,092 (571) 1,521 734 (34) 700 Federal funds purchased and other borrowings ....... (64) (9) (73) (51) (16) (67) ------- ------- ------- ------- ------- ------- Total increase (decrease) in interest expense... 3,647 (742) 2,905 1,294 (226) 1,068 ------- ------- ------- ------- ------- ------- Increase in net interest income........................ $ 4,870 $ 215 $ 5,085 $ 2,358 $ 26 $ 2,384 ======= ======= ======= ======= ======= ======= </TABLE> Provision for Credit Losses The Company's provision for credit losses is established through charges to income in the form of the provision in order to bring the Company's allowance for credit losses to a level deemed appropriate by management based on the factors discussed under "-Financial Condition - Allowance for Credit Losses". The allowance for credit losses at December 31, 1999 was $2.8 million, representing 1.23% of outstanding loans. The provision for credit losses for the year ended December 31, 1999 was $280,000 compared with $239,000 for the year ended December 31, 1998. The increased provision was made by the Company in response to the increase in its loan portfolio, its increased legal lending limit and the changing risk profile in its loan portfolio. The provision for credit losses for the year ended December 31, 1998 was $239,000 compared with $190,000 in 1997. Net loans recovered in 1999 were $57,000 compared with net loans charged off of $66,000 in 1998 and $97,000 in 1997. Noninterest Income Noninterest income is an important source of revenue for financial institutions. The Company's primary sources of non-interest income are service charges on deposit accounts and other banking service related fees. In 1999, noninterest income totaled $3.5 million, an increase of $1.0 million or 41.3% versus $2.5 million in 1998. The increase was primarily due to the South Texas Acquisition and an increase in insufficient funds charges. Noninterest income for 1998 was $2.5 million, a $228,000 or 10.1% increase from $2.3 million in 1997, resulting largely from an increase in income due to the Union and Angleton Acquisitions and an increase in customer service fees. 17
20 The following table presents for the periods indicated the major categories of noninterest income: <TABLE> <CAPTION> Years Ended December 31, --------------------------------------- 1999 1998 1997 ------ ------- ----- <S> <C> <C> <C> (Dollars in thousands) Service charges on deposit accounts...................... $3,010 $2,173 $2,062 Other noninterest income................................. 511 319 202 ------ ------- ------ Total noninterest income.............................. $3,521 $2,492 $2,264 ====== ====== ====== </TABLE> Noninterest Expense For the years ended 1999, 1998 and 1997, noninterest expense totaled $12.1 million, $9.1 million and $7.8 million, respectively. The Company's efficiency ratio showed a positive trend over this period as it was reduced from 59.48% in 1997 to 55.13% in 1999. This reduction reflects the Company's continued success in controlling operating expenses and integrating the South Texas, Union and Angleton Acquisitions. The following table presents for the periods indicated the major categories of noninterest expense: <TABLE> <CAPTION> Years Ended December 31, ---------------------------------------- 1999 1998 1997 ------- -------- ----- <S> <C> <C> <C> (Dollars in thousands) Salaries and employee benefits................................ $ 6,198 $ 4,541 $ 3,968 Non-staff expenses: Net occupancy expense................................. 666 535 488 Depreciation expense.................................. 689 523 431 Data processing....................................... 880 807 642 Professional fees..................................... 245 112 97 Regulatory assessments and FDIC insurance............. 109 73 63 Ad valorem and franchise taxes........................ 213 200 164 Goodwill amortization................................. 715 500 402 Minority expense-trust preferred securities........... 142 -- -- Other................................................. 2,281 1,767 1,581 ------ ------- ------ Total noninterest expense..................... $12,138 $ 9,058 $7,836 ======= ======= ====== </TABLE> For 1999, noninterest expense totaled $12.1 million, an increase of $3.0 million or 33.0% over $9.1 million in 1998. Salaries and employee benefits for 1999 totaled $6.2 million, an increase of $1.7 million or 37.8% over $4.5 million for 1998. Other operating expenses of $2.3 million represented an increase of $514,000 or 29.1% compared with $1.8 million in 1998. These increases were principally due to the Union and South Texas Acquisitions. Total noninterest expenses in 1998 were $9.1 million, an 16.7% increase over the 1997 level of $7.8 million primarily due to the Union and Angleton Acquisitions. Salaries and employee benefits in 1998 increased by 12.5% from $4.0 million to $4.5 million. The increase was principally due to additional staff associated with the Union and Angleton Acquisitions. Income Taxes The amount of federal income tax expense is influenced by the amount of taxable income, the amount of tax-exempt income, the amount of nondeductible interest expense and the amount of other nondeductible expenses. For the year ended December 31, 1999, income tax expense was $3.0 million compared with $2.0 million for the year ended December 31, 1998 and $1.6 million for the year ended December 31, 1997. The effective tax rate in the years ended 1999, 1998, and 1997 was 31.7%, 31.3%, and 30.8%, respectively. Impact of Inflation The effects of inflation on the local economy and on the Company's operating results have been relatively modest for the past several years. Since substantially all of the Company's assets and liabilities are monetary in nature, such as cash, securities, loans and 18
21 deposits, their values are less sensitive to the effects of inflation than to changing interest rates, which do not necessarily change in accordance with inflation rates. The Company tries to control the impact of interest rate fluctuations by managing the relationship between its interest rate sensitive assets and liabilities. See "- Financial Condition - Interest Rate Sensitivity and Liquidity." FINANCIAL CONDITION Loan Portfolio At December 31, 1999, total loans were $223.5 million, an increase of $53.0 million or 31.1% from $170.5 million at December 31, 1998. The growth in the loan portfolio was due to strong loan demand and the South Texas Acquisition. At December 31, 1999, total loans were 41.8% of deposits and 36.7% of total assets. At December 31, 1998, total loans were 43.6% of deposits and 39.1% of total assets. Loans increased 41.4% during 1998 from $120.6 million at December 31, 1997 to $170.5 million at December 31, 1998. The loan growth during 1998 was due to continued strong loan demand, especially in the real estate area and agriculture areas. The following table summarizes the Company's loan portfolio by type of loan as of the dates indicated: <TABLE> <CAPTION> December 31, ----------------------------------------------------------------------------------------0 1999 1998 1997 1996 ------------------- ------------------- ------------------ ------------------- Amount Percent Amount Percent Amount Percent Amount Percent -------- -------- -------- -------- -------- -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> <C> <C> <C> Commercial and industrial ........ $ 28,279 12.7% $ 16,972 9.9% $ 11,611 9.6% $ 10,633 9.4% Real estate: Construction and land development ................... 4,015 1.8 1,727 1.0 6,453 5.3 5,021 4.4 1-4 family residential .......... 97,359 43.5 80,062 47.0 53,625 44.5 49,845 44.0 Home equity ..................... 11,343 5.1 8,077 4.7 NA NA NA NA Commercial mortgages ............ 38,752 17.3 22,240 13.1 16,277 13.5 14,376 12.7 Farmland ........................ 7,404 3.3 6,148 3.6 5,804 4.8 5,468 4.8 Multifamily residential ......... 1,837 0.8 1,090 0.6 937 0.8 1,068 0.9 Agriculture ...................... 12,735 5.7 14,107 8.3 6,359 5.3 5,686 5.0 Consumer ......................... 21,781 9.8 20,055 11.8 19,512 16.2 21,285 18.8 -------- -------- -------- -------- -------- -------- -------- -------- Total loans ............... $223,505 100.0% $170,478 100.0% $120,578 100.0% $113,382 100.0% ======== ======== ======== ======== ======== ======== ======== ======== <CAPTION> ------------------- 1995 ------------------- Amount Percent -------- -------- <S> <C> <C> Commercial and industrial ........ $ 10,445 11.8 Real estate: Construction and land development ................... 2,507 2.8 1-4 family residential .......... 40,331 45.4 Home equity ..................... NA NA Commercial mortgages ............ 12,835 14.5 Farmland ........................ 3,989 4.5 Multifamily residential ......... 716 0.8 Agriculture ...................... 4,666 5.2 Consumer ......................... 13,308 15.0 -------- -------- Total loans ............... $ 88,797 100.0% ======== ======== </TABLE> The lending focus of the Company is on 1-4 family residential, agricultural, small and medium-sized business and consumer loans. The Company offers a variety of commercial lending products including term loans and lines of credit. The Company also offers a broad range of short to medium-term commercial loans, primarily collateralized, to businesses for working capital (including inventory and receivables), business expansion (including acquisitions of real estate and improvements) and the purchase of equipment and machinery. Historically, the Company has originated loans for its own account and has not securitized its loans. The purpose of a particular loan generally determines its structure. All loans in the 1-4 family residential category were originated by the Company. Loans from $300,000 to $750,000 are evaluated and acted upon by an officers' loan committee, which meets weekly. Loans above that amount must be approved by the Directors Loan Committee, which meets monthly. In nearly all cases, the Company's commercial loans are made in the Company's primary market area and are underwritten on the basis of the borrower's ability to service such debt from income. As a general practice, the Company takes as collateral a lien on any available real estate, equipment or other assets owned by the borrower and obtains a personal guaranty of the borrower. Working capital loans are primarily collateralized by short-term assets whereas term loans are primarily collateralized by long-term assets. As a result, commercial loans involve additional complexities, variables and risks and require more thorough underwriting and servicing than other types of loans. In addition to commercial loans secured by real estate, the Company makes commercial mortgage loans to finance the purchase of real property, which generally consists of real estate with completed structures. The Company's commercial mortgage loans are secured by first liens on real estate, typically have variable interest rates and amortize over a ten to 15 year period. Payments on loans secured by such properties are often dependent on the successful operation or management of the properties. Accordingly, repayment of these loans may be subject to adverse conditions in the real estate market or the economy to a greater extent than other types of loans. The Company seeks to minimize these risks in a variety of ways, including giving careful consideration to the property's operating history, future operating projections, current and projected occupancy, location and physical condition in 19
22 connection with underwriting these loans. The underwriting analysis also includes credit verification, appraisals and a review of the financial condition of the borrower. Additionally, a significant portion of the Company's lending activity has consisted of the origination of 1-4 family residential mortgage loans collateralized by owner-occupied properties located in the Company's market areas. The Company offers a variety of mortgage loan products which generally are amortized over five to 25 years. Loans collateralized by 1-4 family residential real estate generally have been originated in amounts of no more than 89% of appraised value or have mortgage insurance. The Company requires mortgage title insurance and hazard insurance. The Company has elected to keep all 1-4 family residential loans for its own account rather than selling such loans into the secondary market. By doing so, the Company is able to realize a higher yield on these loans; however, the Company also incurs interest rate risk as well as the risks associated with nonpayments on such loans. The Company makes loans to finance the construction of residential and, to a limited extent, nonresidential properties. Construction loans generally are secured by first liens on real estate and have floating interest rates. The Company conducts periodic inspections, either directly or through an agent, prior to approval of periodic draws on these loans. Underwriting guidelines similar to those described above are also used in the Company's construction lending activities. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of a project under construction, and the project is of uncertain value prior to its completion. Because of uncertainties inherent in estimating construction costs, the market value of the completed project and the effects of governmental regulation on real property, it can be difficult to accurately evaluate the total funds required to complete a project and the related loan to value ratio. As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If the Company is forced to foreclose on a project prior to completion, there is no assurance that the Company will be able to recover all of the unpaid portion of the loan. In addition, the Company may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time. While the Company has underwriting procedures designed to identify what it believes to be acceptable levels of risks in construction lending, no assurance can be given that these procedures will prevent losses from the risks described above. Consumer loans made by the Company include direct "A"-credit automobile loans, recreational vehicle loans, boat loans, home improvement loans, home equity loans, personal loans (collateralized and uncollateralized) and deposit account collateralized loans. The terms of these loans typically range from 12 to 120 months and vary based upon the nature of collateral and size of loan. Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws may limit the amount which can be recovered on such loans. The Company provides agricultural loans for short-term crop production, including rice, cotton, milo and corn, farm equipment financing and agricultural real estate financing. The Company evaluates agricultural borrowers primarily based on their historical profitability, level of experience in their particular agricultural industry, overall financial capacity and the availability of secondary collateral to withstand economic and natural variations common to the industry. Because agricultural loans present a higher level of risk associated with events caused by nature, the Company routinely makes on-site visits and inspections in order to monitor and identify such risks. The contractual maturity ranges of the commercial and industrial and construction and land development portfolios and the amount of such loans with predetermined interest rates and floating rates in each maturity range as of December 31, 1999 are summarized in the following table: <TABLE> <CAPTION> December 31, 1999 ----------------------------------------------- After One One Year Through After Five or Less Five Years Years Total -------- ---------- ---------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> Commercial and industrial .................. $ 16,397 $ 6,548 $ 5,334 $ 28,279 Construction and land development .......... 3,956 34 25 4,015 -------- -------- -------- -------- Total ........................ $ 20,353 $ 6,582 $ 5,359 $ 32,294 ======== ======== ======== ======== Loans with a predetermined interest rate ... $ 8,218 $ 3,428 $ 2,245 $ 13,891 Loans with a floating interest rate ........ 12,135 3,154 3,114 18,403 -------- -------- -------- -------- Total ........................ $ 20,353 $ 6,582 $ 5,359 $ 32,294 ======== ======== ======== ======== </TABLE> 20
23 Nonperforming Assets The Company has several procedures in place to assist it in maintaining the overall quality of its loan portfolio. The Company has established underwriting guidelines to be followed by its officers. The Company also monitors its delinquency levels for any negative or adverse trends. There can be no assurance, however, that the Company's loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions. The Company requires appraisals on loans secured by real estate. With respect to potential problem loans, an evaluation of the borrower's overall financial condition is made to determine the need, if any, for possible write-downs or appropriate additions to the allowance for credit losses. The Company generally places a loan on nonaccrual status and ceases accruing interest when the payment of principal or interest is delinquent for 90 days, or earlier in some cases, unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan. The Company generally charges off all loans before attaining nonaccrual status. The Company's conservative lending approach, as well as a healthy local economy, has resulted in strong asset quality. The Company had no nonperforming assets as of December 31, 1999, $5,000 in nonperforming assets as of December 31, 1998, and no nonperforming assets in 1997. The following table presents information regarding nonperforming assets at the dates indicated: <TABLE> <CAPTION> December 31, ------------------------------------------------------ 1999 1998 1997 1996 1995 ------ ------ ------ ------ ------ (Dollars in thousands) <S> <C> <C> <C> <C> <C> Nonaccrual loans ........................... $ -- $ 5 $ -- $ -- $ -- Restructured loans ......................... -- -- -- -- -- Other real estate .......................... -- -- -- -- -- ------ ------ ------ ------ ------ Total nonperforming assets .......... $ -- $ 5 $ -- $ -- $ -- ====== ====== ====== ====== ====== Nonperforming assets to total loans and other real estate ................... 0.00% 0.00% 0.00% 0.00% 0.00% </TABLE> Allowance for Credit Losses The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company's loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank's Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company's commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company's loan portfolio, current economic changes that may affect the borrower's ability to pay and the value of collateral, the evaluation of the Company's loan portfolio through its internal loan review process and other relevant factors. Charge-offs occur when loans are deemed to be uncollectible. Although the Company does not determine the total allowance based upon the amount of loans in a particular type or category, risk elements attributable to particular loan types or categories are considered in assessing the quality of individual loans. Some of the risk elements include: (i) in the case of 1-4 family residential mortgage loans, the borrower's ability to repay the loan, including a consideration of the debt to income ratio and employment and income stability, the loan to value ratio, and the age, condition and marketability of collateral; (ii) for non-farm non-residential loans and multifamily residential loans, the debt service coverage ratio (income from the property in excess of operating expenses compared to loan payment requirements), operating results of the owner in the case of owner-occupied properties, the loan to value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type; (iii) for agricultural real estate loans, the experience and financial capability of the borrower, projected debt service coverage of the operations of the borrower and loan to value ratio; (iv) for construction and land development loans, the perceived feasibility of the project including the ability to sell developed lots or improvements constructed for resale or ability to lease property constructed for lease, the quality and nature of contracts for presale or preleasing, if any, experience and ability of the developer and loan to value ratio; (v) for commercial and 21
24 industrial loans, the operating results of the commercial, industrial or professional enterprise, the borrower's business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral; and (vi) for non-real estate agricultural loans, the operating results, experience and financial capability of the borrower, historical and expected market conditions and the value, nature and marketability of collateral. In addition, for each category, the Company considers secondary sources of income and the financial strength and credit history of the borrower and any guarantors. The Company follows a loan review program to evaluate the credit risk in the loan portfolio. Through the loan review process, the Company maintains an internally classified loan list which, along with the delinquency list of loans, helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for credit losses. Loans classified as "substandard" are those loans with clear and defined weaknesses such as a highly-leveraged position, unfavorable financial ratios, uncertain repayment sources or poor financial condition, which may jeopardize recoverability of the debt. Loans classified as "doubtful" are those loans which have characteristics similar to substandard accounts but with an increased risk that a loss may occur, or at least a portion of the loan may require a charge-off if liquidated at present. Loans classified as "loss" are those loans which are in the process of being charged off. In addition to the internally classified loan list and delinquency list of loans, the Company maintains a separate "watch list" which further aids the Company in monitoring loan portfolios. Watch list loans have one or more deficiencies that require attention in the short term or pertinent ratios of the loan account that have weakened to a point where more frequent monitoring is warranted. These loans do not have all of the characteristics of a classified loan (substandard or doubtful) but do show weakened elements compared with those of a satisfactory credit. The Company reviews these loans to assist in assessing the adequacy of the allowance for credit losses. In order to determine the adequacy of the allowance for credit losses, management considers the risk classification or delinquency status of loans and other factors, such as collateral value, portfolio composition, trends in economic conditions and the financial strength of borrowers. Management establishes specific allowances for loans which management believes require reserves greater than those allocated according to their classification or delinquent status. An unallocated allowance is also established based on the Company's historical charge-off experience. The Company then charges to operations a provision for credit losses to maintain the allowance for credit losses at an adequate level determined by the foregoing methodology. For the year ended December 31, 1999, net recoveries totaled $57,000 or (0.03)% of average loans outstanding for the period, compared with net charge-offs of $66,000 or 0.05% of average loans during 1998. The Company's net charge-offs totaled $97,000 or 0.08% of average loans outstanding in 1997. During 1999, the Company recorded a provision for credit losses of $280,000 compared with $239,000 for 1998. At December 31, 1999, the allowance for credit losses totaled $2.8 million, or 1.23% of total loans. The Company made a provision for credit losses of $239,000 during 1998 compared with a provision of $190,000 for 1997. At December 31, 1998, the allowance aggregated $1.9 million, or 1.09% of total loans. At December 31, 1997, the allowance was $1.0 million, or 0.84% of total loans. 22
25 The following table presents, for the periods indicated, an analysis of the allowance for credit losses and other related data: <TABLE> <CAPTION> Years Ended December 31, -------------------------------------------------------------------- 1999 1998 1997 1996 1995 -------- -------- -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> Average loans outstanding ...................... $193,687 $143,196 $117,586 $104,534 $ 81,631 ======== ======== ======== ======== ======== Gross loans outstanding at end of period ....... $223,505 $170,478 $120,578 $113,382 $ 88,797 ======== ======== ======== ======== ======== Allowance for credit losses at beginning of period ......................... $ 1,850 $ 1,016 $ 923 $ 753 $ 588 Balance acquired with the South Texas and Union Acquisitions, respectively ............ 566 661 -- -- -- Provision for credit losses .................... 280 239 190 230 175 Charge-offs: Commercial and industrial ................... (13) (--) (26) (9) (6) Real estate and agriculture ................. (43) (14) (47) (--) (2) Consumer .................................... (55) (67) (57) (64) (24) Recoveries: Commercial and industrial ................... 34 5 15 -- -- Real estate and agriculture ................. 117 -- 7 -- 3 Consumer .................................... 17 10 11 13 19 -------- -------- -------- -------- -------- Net recoveries (charge-offs) ................... 57 (66) (97) (60) (10) Allowance for credit losses at end of period ... $ 2,753 $ 1,850 $ 1,016 $ 923 $ 753 ======== ======== ======== ======== ======== Ratio of allowance to end of period loans ....................................... 1.23% 1.09% 0.84% 0.81% 0.85% Ratio of net (recoveries) charge-offs to average loans ............................... (0.03) 0.05 0.08 0.06 0.01 Ratio of allowance to end of period nonperforming loans ......................... -- -- -- -- -- </TABLE> 23
26 The following tables describe the allocation of the allowance for credit losses among various categories of loans and certain other information for the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which future losses may occur. The total allowance is available to absorb losses from any segment of loans. <TABLE> <CAPTION> December 31, ------------------------------------------------- 1999 1998 ----------------------- ---------------------- Percent of Percent of Loans to Loans to Amount Total Loans Amount Total Loans -------- ----------- -------- ----------- (Dollars in thousands) <S> <C> <C> <C> <C> Balance of allowance for credit losses applicable to: Commercial and industrial ....................... $ 57 12.7% $ 18 9.9% Real estate ..................................... 62 71.8 70 70.0 Agriculture ..................................... 22 5.7 40 8.3 Consumer ........................................ 7 9.8 1 11.8 Unallocated ..................................... 2,605 -- 1,721 -- -------- -------- -------- -------- Total allowance for credit losses ....... $ 2,753 100.0% $ 1,850 100.0% ======== ======== ======== ======== </TABLE> <TABLE> <CAPTION> December 31, ----------------------------------------------------------------------- 1997 1996 1995 --------------------- --------------------- --------------------- Percent of Percent of Percent of Loans to Loans to Loans to Amount Total Loans Amount Total Loans Amount Total Loans -------- ----------- -------- ----------- -------- ----------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> <C> Balance of allowance for credit losses applicable to: Commercial and industrial ...................... $ 41 9.6% $ 9 9.4% $ 7 11.8% Real estate .................................... 59 68.9 34 66.8 27 68.0 Agriculture .................................... -- 5.3 -- 5.0 -- 5.2 Consumer ....................................... 51 16.2 6 18.8 6 15.0 Unallocated .................................... 865 -- 874 -- 713 -- -------- -------- -------- -------- -------- -------- Total allowance for credit losses ................................. $ 1,016 100.0% $ 923 100.0% $ 753 100.0% ======== ======== ======== ======== ======== ======== </TABLE> Where management is able to identify specific loans or categories of loans where specific amounts of reserve are required, allocations are assigned to those categories. Federal and state bank regulators also require that a bank maintain a reserve that is sufficient to absorb an estimated amount of unidentified potential losses based on management's perception of economic conditions, loan portfolio growth, historical charge-off experience and exposure concentrations. While the Company's recent rate of charge-offs is low, management is aware that the Company has been operating in an extremely beneficial economic environment. Management, along with a number of economists, has perceived during the past year and increasing instability in the national and Southeast Texas economies and a worldwide economic slowdown that could contribute to job losses and otherwise adversely affect a broad variety of business sectors. In addition, as the Company has grown, its aggregate loan portfolio has increased and since the Company has made a decision to diversify its loan portfolio into areas other than 1-4 family residential mortgage loans, the risk profile of the Company's loans has increased. By virtue of its increased capital levels, the Company is able to make larger loans, thereby increasing the possibility of one bad loan having a larger adverse impact than before. Accordingly, management believes that the maintenance of an unallocated reserve in the current amount is prudent and consistent with regulatory requirements. 24
27 The Company believes that the allowance for credit losses at December 31, 1999 is adequate to cover losses inherent in the portfolio as of such date. There can be no assurance, however, that the Company will not sustain losses in future periods, which could be substantial in relation to the size of the allowance at December 31, 1999. Securities The Company uses its securities portfolio both as a source of income and as a source of liquidity. At December 31, 1999, investment securities totaled $316.7 million, an increase of $89.5 million, or 39.4%, from $227.2 million at December 31, 1998. At December 31, 1999, securities represented 52.0% of total assets compared with 52.2% of total assets at December 31, 1998. The following table summarizes the amortized cost of securities as of the dates shown (available-for-sale securities are not adjusted for unrealized gains or losses): <TABLE> <CAPTION> December 31, -------------------------------------------------------- 1999 1998 1997 1996 1995 -------- -------- -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> U.S. Treasury securities and obligations of U.S. government agencies ........... $182,438 $128,603 $ 83,160 $ 60,830 $ 42,147 70% non-taxable preferred stock .......... 4,049 -- -- -- -- Mortgage-backed securities ............... 88,664 66,651 64,168 59,382 41,278 States and political subdivisions ........ 29,321 19,048 11,829 13,042 15,753 Collateralized mortgage obligations ...... 12,267 12,914 8,749 14,341 18,411 -------- -------- -------- -------- -------- Total ............................. $316,739 $227,216 $167,906 $147,595 $117,589 ======== ======== ======== ======== ======== </TABLE> The following table summarizes the contractual maturity of securities and their weighted average yields (available-for-sale securities are not adjusted for unrealized gains or losses): <TABLE> <CAPTION> December 31, 1999 --------------------------------------------------------------------- After One Year After Five Years but but Within One Within Five Within Ten Year Years Years ------------------- ------------------- ------------------- Amount Yield Amount Yield Amount Yield -------- -------- -------- -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> <C> U.S. Treasury securities and obligations of U.S. government agencies ............. $ 12,572 5.57% $138,923 6.19% $ 30,943 6.35% Mortgage-backed securities ............... 3,589 5.78 23,565 6.28 13,538 6.70 States and political subdivisions ........ 2,087 4.57 13,348 4.47 5,324 4.84 70% non-taxable preferred stock .......... -- -- -- -- -- -- Qualified Zone Academy Bond (QZAB) ....... -- -- -- -- -- -- Collateralized mortgage obligations ...... -- -- -- -- 613 5.54 -------- -------- -------- Total ................................. $ 18,248 5.77% $175,836 6.25% $ 50,418 6.54% ======== ======== ======== ======== ======== ======== <CAPTION> ------------------------------------------ After Ten Years Total ------------------- ------------------- Amount Yield Total Yield -------- -------- -------- -------- <S> <C> <C> <C> <C> U.S. Treasury securities and obligations of U.S. government agencies ............. $ -- --% $182,438 6.17% Mortgage-backed securities ............... 47,972 6.41 88,664 6.39 States and political subdivisions ........ 562 5.75 21,321 4.61 70% non-taxable preferred stock .......... 4,049 8.00 4,049 8.00 Qualified Zone Academy Bond (QZAB) ....... 8,000 2.00 8,000 2.00 Collateralized mortgage obligations ...... 11,654 7.04 12,267 6.97 -------- -------- Total ................................. $ 72,237 6.80% $316,739 6.39% ======== ======== ======== ======== </TABLE> The tax-exempt states and political subdivisions are not calculated on a tax equivalent basis. On a tax equivalent basis, the yield on states and political subdivisions would have been 6.98% at December 31, 1999. The QZAB bond generates a tax credit of 7.18%, which is included in gross income. The following table summarizes the carrying value by classification of securities as of the dates shown: <TABLE> <CAPTION> December 31, ------------------------------------------------------------ 1999 1998 1997 1996 1995 -------- -------- -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> Available-for-sale ..... $224,782 $113,828 $ 38,612 $ 49,342 $ 35,452 Held-to-maturity ....... 87,889 113,916 129,256 98,222 82,053 -------- -------- -------- -------- -------- Total ........... $312,671 $227,744 $167,868 $147,564 $117,505 ======== ======== ======== ======== ======== </TABLE> 25
28 At December 31, 1999, securities totaled $312.7 million, an increase of $85.0 million, or 37.3%, from $227.7 million at December 31, 1998, as the Company invested excess deposits from the South Texas Acquisition. At December 31, 1999, securities represented 58.5% of total deposits and 51.4% of total assets. Securities increased $59.9 million or 35.7%, from $167.9 million at December 31, 1997 to $227.7 million at December 31, 1998, as the Company invested excess deposits from the Union Acquisition. The following tables present the amortized cost and fair value of securities classified as available-for-sale at December 31, 1999 and 1998: <TABLE> <CAPTION> December 31, 1999 December 31, 1998 ------------------------------------------- ------------------------------------------- Gross Gross Gross Gross Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair Cost Gains Losses Value Cost Gains Losses Value --------- ---------- ---------- -------- --------- ---------- ---------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> <C> <C> <C> U.S. Treasury securities and obligations of U.S. government agencies ............ $151,399 $ 61 $ 3,165 $148,295 $ 67,864 $ 285 $ 58 $ 68,091 Mortgage-backed securities ............... 49,438 47 1,222 48,263 30,578 98 176 30,500 Collateralized mortgage obligations ...... 11,729 261 63 11,927 10,832 166 26 10,972 70% non-taxable preferred stock .......... 4,049 -- 49 4,000 States and political subdivisions ........ 12,235 64 2 12,297 4,026 239 -- 4,265 -------- -------- -------- -------- -------- -------- -------- -------- Total ................................ $228,850 $ 433 $ 4,501 $224,782 $113,300 $ 788 $ 260 $113,828 ======== ======== ======== ======== ======== ======== ======== ======== </TABLE> The following tables present the amortized cost and fair value of securities classified as held-to-maturity at December 31, 1999 and 1998: <TABLE> <CAPTION> December 31, 1999 December 31, 1998 ------------------------------------------- ------------------------------------------- Gross Gross Gross Gross Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair Cost Gains Losses Value Cost Gains Losses Value --------- ---------- ---------- -------- --------- ---------- ---------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> <C> <C> <C> U.S. Treasury securities and obligations of U.S. government agencies ............ $ 31,039 $ 22 $ 253 $ 30,808 $ 60,739 $ 572 $ 2 $ 61,309 Mortgage-backed securities ............... 39,226 22 391 38,857 36,074 265 100 36,239 States and political subdivisions ........ 17,086 52 155 16,983 15,022 376 3 15,395 Collateralized mortgage obligations ...... 538 -- 2 536 2,081 -- 3 2,078 -------- -------- -------- -------- -------- -------- -------- -------- Total ................................ $ 87,889 $ 96 $ 801 $ 87,184 $113,916 $ 1,213 $ 108 $115,021 ======== ======== ======== ======== ======== ======== ======== ======== </TABLE> Mortgage-backed securities are securities that have been developed by pooling a number of real estate mortgages and which are principally issued by federal agencies such as the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. These securities are deemed to have high credit ratings, and minimum regular monthly cash flows of principal and interest are guaranteed by the issuing agencies. At December 31, 1999, 54.1% of the mortgage-backed securities held by the Company had contractual final maturities of more than ten years with a weighted average life of 5.0 years. However, unlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, mortgage-backed securities provide cash flows from regular principal and interest payments and principal prepayments throughout the lives of the securities. Mortgage-backed securities which are purchased at a premium will generally suffer decreasing net yields as interest rates drop because home owners tend to refinance their mortgages. Thus, the premium paid must be amortized over a shorter period. Therefore, these securities purchased at a discount will obtain higher net yields in a decreasing interest rate environment. As interest rates rise, the opposite will generally be true. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal and consequently, the average life of this security will not be unduly shortened. If interest rates begin to fall, prepayments will increase. At the date of purchase, the Company is required to classify debt and equity securities into one of three categories: held-to-maturity, trading or available-for-sale. At each reporting date, the appropriateness of the classification is reassessed. Investments in debt securities are classified as held-to-maturity and measured at amortized cost in the financial statements only if management has the positive intent and ability to hold those securities to maturity. Securities that are bought and held principally for the purpose of selling them in the near term are classified as trading and measured at fair value in the financial statements with unrealized gains and 26
29 losses included in earnings. Investments not classified as either held-to-maturity or trading are classified as available-for-sale and measured at fair value in the financial statements with unrealized gains and losses reported, net of tax, in a separate component of shareholders' equity until realized. Deposits The Company offers a variety of deposit accounts having a wide range of interest rates and terms. The Company's deposits consist of demand, savings, money market and time accounts. The Company relies primarily on competitive pricing policies and customer service to attract and retain these deposits. The Company does not have or accept any brokered deposits. Total deposits at December 31, 1999 were $534.8 million, an increase of $144.1 million, or 36.9% from $390.7 million at December 31, 1998. The increase is attributable to the South Texas Acquisition in the fourth quarter of 1999 and internal growth. Noninterest-bearing deposits of $113.5 million at December 31, 1999 increased $28.5 million, or 33.5% from $85.0 million at December 31, 1998. Noninterest-bearing deposits as of December 31, 1998 were $85.0 million compared with $61.4 million at December 31, 1997. Interest-bearing deposits at December 31, 1999 were $421.2 million, up $115.5 million or 37.8% from $305.7 million at December 31, 1998. Interest-bearing deposits at December 31, 1998 of $305.7 million represented a $75.6 million or 32.9% increase from $230.1 million at December 31, 1997. Total deposits at December 31, 1997 were $291.5 million. The daily average balances and weighted average rates paid on deposits for each of the years ended December 31, 1999, 1998 and 1997 are presented below: <TABLE> <CAPTION> Years Ended December 31, --------------------------------------------------------------------------- 1999 1998 1997 --------------------- --------------------- --------------------- Amount Rate Amount Rate Amount Rate -------- -------- -------- -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> <C> Interest-bearing checking ................ $ 54,396 1.58% $ 41,710 1.61% $ 42,898 2.13% Regular savings .......................... 15,296 2.43 10,640 2.45 9,215 2.32 Money market savings ..................... 109,719 3.40 72,788 3.54 55,233 3.50 Time deposits ............................ 169,417 4.73 128,097 5.06 113,669 5.09 -------- -------- -------- -------- -------- -------- Total interest-bearing deposits ... 348,828 3.72 253,235 3.95 221,015 4.01 Noninterest-bearing deposits ............. 89,795 -- 69,810 -- 57,362 -- -------- -------- -------- -------- -------- -------- Total deposits .................... $438,623 2.96% $323,045 3.09% $278,377 3.18% ======== ======== ======== ======== ======== ======== </TABLE> The following table sets forth the amount of the Company's certificates of deposit that are $100,000 or greater by time remaining until maturity: <TABLE> <CAPTION> December 31, 1999 ---------------------- (Dollars in thousands) <S> <C> Three months or less ........................... $25,163 Over three through six months .................. 11,564 Over six through 12 months ..................... 17,849 Over 12 months ................................. 5,373 ------- Total ......................................... $59,949 ======= </TABLE> Other Borrowings Deposits are the primary source of funds for the Company's lending and investment activities. Occasionally, the Company obtains additional funds from the Federal Home Loan Bank ("FHLB") and correspondent banks. At December 31, 1999, the Company had FHLB borrowings of $5.7 million compared with $2.4 million at December 31, 1998 and $2.8 million at December 31, 1997. The Company had federal funds purchased of $10.0 million at December 31, 1999 compared with no federal funds purchased at December 31, 1998 or 1997. At December 31, 1999, 1998, and 1997 the Company had no outstanding borrowings under a revolving line of credit extended by a commercial bank. 27
30 Interest Rate Sensitivity and Liquidity The Company's Asset Liability and Funds Management Policy provides management with the necessary guidelines for effective funds management, and the Company has established a measurement system for monitoring its net interest rate sensitivity position. The Company manages its sensitivity position within established guidelines. Interest rate risk is managed by the Asset Liability Committee ("ALCO"), which is composed of senior officers of the Company, in accordance with policies approved by the Company's Board of Directors. The ALCO formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, the ALCO considers the impact on earnings and capital of the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. The ALCO meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, the ALCO reviews liquidity, cash flow flexibility, maturities of deposits and consumer and commercial deposit activity. Management uses two methodologies to manage interest rate risk: (i) an analysis of relationships between interest-earning assets and interest-bearing liabilities; and (ii) an interest rate shock simulation model. The Company has traditionally managed its business to reduce its overall exposure to changes in interest rates. The Company manages its exposure to interest rates by structuring its balance sheet in the ordinary course of business. The Company does not enter into instruments such as leveraged derivatives, interest rate swaps, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk. An interest rate sensitive asset or liability is one that, within a defined time period, either matures or experiences an interest rate change in line with general market interest rates. The management of interest rate risk is performed by analyzing the maturity and repricing relationships between interest-earning assets and interest-bearing liabilities at specific points in time ("GAP") and by analyzing the effects of interest rate changes on net interest income over specific periods of time by projecting the performance of the mix of assets and liabilities in varied interest rate environments. Interest rate sensitivity reflects the potential effect on net interest income of a movement in interest rates. A company is considered to be asset sensitive, or having a positive GAP, when the amount of its interest-earning assets maturing or repricing within a given period exceeds the amount of its interest-bearing liabilities also maturing or repricing within that time period. Conversely, a company is considered to be liability sensitive, or having a negative GAP, when the amount of its interest-bearing liabilities maturing or repricing within a given period exceeds the amount of its interest-earning assets also maturing or repricing within that time period. During a period of rising interest rates, a negative GAP would tend to affect net interest income adversely, while a positive GAP would tend to result in an increase in net interest income. During a period of falling interest rates, a negative GAP would tend to result in an increase in net interest income, while a positive GAP would tend to affect net interest income adversely. 28
31 The following table sets forth an interest rate sensitivity analysis for the Company at December 31, 1999: <TABLE> <CAPTION> Volumes Subject to Repricing Within --------------------------------------------------------------------- 0-30 31-180 181-365 After days days days one year Total ---------- ---------- ---------- ---------- ---------- (Dollars in thousands) Interest-earning assets: <S> <C> <C> <C> <C> <C> Securities (gross of unrealized loss of $4,067) ... $ 27,331 $ 21,190 $ 19,769 $ 248,449 $ 316,739 Loans ............................................. 44,457 25,385 21,367 132,296 223,505 Federal funds sold ................................ 16,100 -- -- -- 16,100 ---------- ---------- ---------- ---------- ---------- Total interest-earning assets ............... 87,888 46,575 41,136 380,745 556,344 ---------- ---------- ---------- ---------- ---------- Interest-bearing liabilities: Demand, money market and savings deposits ....................................... 218,060 -- -- -- 218,060 Certificates of deposit and other time deposits .................................. 21,368 90,626 61,502 29,686 203,182 Federal funds purchased and FHLB advances ....................................... 15,700 -- -- -- 15,700 ---------- ---------- ---------- ---------- ---------- Total interest-bearing liabilities .......... 255,128 90,626 61,502 29,686 436,942 ---------- ---------- ---------- ---------- ---------- Period GAP ..................................... $ (167,240) $ (44,051) $ (20,366) $ 351,059 $ 119,402 Cumulative GAP ................................. $ (167,240) $ (211,291) $ (231,657) $ 119,402 Period GAP to total assets ..................... (27.48)% (7.24)% 3.35% 57.68% Cumulative GAP to total assets ................. (27.48)% (34.71)% (38.06)% 19.62% </TABLE> Shortcomings are inherent in any GAP analysis since certain assets and liabilities may not move proportionally as interest rates change. In addition to GAP analysis, the Company uses an interest rate risk simulation model and shock analysis to test the interest rate sensitivity of net interest income and the balance sheet, respectively. Contractual maturities and repricing opportunities of loans are incorporated in the model as are prepayment assumptions, maturity data and call options within the investment portfolio. Assumptions based on past experience are incorporated into the model for nonmaturity deposit accounts. Based on the Company's December 31, 1999 simulation analysis, the Company estimates that a 100 basis point rise or decline in rates over the next 12 month period would have an impact of less than 1.25% on its net interest income for the period. The change is relatively small, despite the Company's liability sensitive GAP position. The Company estimates that a 200 basis point rise in rates would have an impact of approximately (7.77)% on its net interest income while a 200 basis point decline over the same period would have an impact of approximately 0.67% on its net interest income. The results are primarily from the behavior of demand, money market and savings deposits. The Company has found that historically interest rates on these deposits change more slowly in a rising rate environment than in a declining rate environment. This assumption is incorporated into the simulation model and is generally not fully reflected in a GAP analysis. As a financial institution, the Company's primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of the Company's assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which have a short term to maturity. Based upon the nature of the Company's operations, the Company is not subject to foreign exchange or commodity price risk. The Company does not own any trading assets. The Company's exposure to market risk is reviewed on a regular basis. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent, and that the goal is to identify and accept the risks. Liquidity involves the Company's ability to raise funds to support asset growth or reduce assets to meet deposit withdrawals and other payment obligations, to maintain reserve requirements and otherwise to operate the Company on an ongoing basis. During the past three years, the Company's liquidity needs have primarily been met by growth in core deposits, as previously discussed. Although access to purchased funds from correspondent banks is available and has been utilized on occasion to take advantage of investment opportunities, the Company does not generally rely on these external funding sources. The cash and federal funds sold position, supplemented by amortizing investment and loan portfolios, have generally created an adequate liquidity position. 29
32 Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. As of December 31, 1999, the Company had cash and cash equivalents of $36.8 million, up from $18.2 million, at December 31, 1998. The increase was mainly due to an increase in federal funds sold. Capital Resources Capital management consists of providing equity to support both current and future operations. The Company is subject to capital adequacy requirements imposed by the Federal Reserve Board and the Bank is subject to capital adequacy requirements imposed by the FDIC and the Texas Banking Department. Both the Federal Reserve Board and the FDIC have adopted risk-based capital requirements for assessing bank holding company and bank capital adequacy. These standards define capital and establish minimum capital requirements in relation to assets and off-balance sheet exposure, adjusted for credit risk. The risk-based capital standards currently in effect are designed to make regulatory capital requirements more sensitive to differences in risk profiles among bank holding companies and banks, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate relative risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items. The risk-based capital standards issued by the Federal Reserve Board require all bank holding companies to have "Tier 1 capital" of at least 4.0% and "total risk-based" capital (Tier 1 and Tier 2) of at least 8.0% of total risk-adjusted assets. "Tier 1 capital" generally includes common shareholders' equity and qualifying perpetual preferred stock together with related surpluses and retained earnings, less deductions for goodwill and various other intangibles. "Tier 2 capital" may consist of a limited amount of intermediate-term preferred stock, a limited amount of term subordinated debt, certain hybrid capital instruments and other debt securities, perpetual preferred stock not qualifying as Tier 1 capital, and a limited amount of the general valuation allowance for loan losses. The sum of Tier 1 capital and Tier 2 capital is "total risk-based capital." The Federal Reserve Board has also adopted guidelines which supplement the risk-based capital guidelines with a minimum ratio of Tier 1 capital to average total consolidated assets ("leverage ratio") of 3.0% for institutions with well diversified risk, including no undue interest rate exposure; excellent asset quality; high liquidity; good earnings; and that are generally considered to be strong banking organizations, rated composite 1 under applicable federal guidelines, and that are not experiencing or anticipating significant growth. Other banking organizations are required to maintain a leverage ratio of at least 4.0% to 5.0%. These rules further provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels and comparable to peer group averages, without significant reliance on intangible assets. Pursuant to FDICIA, each federal banking agency revised its risk-based capital standards to ensure that those standards take adequate account of interest rate risk, concentration of credit risk and the risks of nontraditional activities, as well as reflect the actual performance and expected risk of loss on multifamily mortgages. The Bank is subject to capital adequacy guidelines of the FDIC that are substantially similar to the Federal Reserve Board's guidelines. Also pursuant to FDICIA, the FDIC has promulgated regulations setting the levels at which an insured institution such as the Bank would be considered "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." Under the FDIC's regulations, the Bank is classified "well capitalized" for purposes of prompt corrective action. SEE "BUSINESS - SUPERVISION AND REGULATION - THE COMPANY" AND " - THE BANK." Shareholders' equity increased to $43.3 million at December 31, 1999 from $41.4 million at December 31, 1998, an increase of $1.9 million or 4.6%. This increase was primarily the result of net income of $6.5 million offset by dividends paid on the Common Stock of $1.0 million and a change in unrealized loss on available for sale securities of $3.0 million. During 1998, shareholders' equity increased by $16.6 million or 66.9% from $24.8 million at December 31, 1997 due primarily to net income of $4.5 million, $12.8 million from the Company's Initial Public Offering, offset by dividends of $1.1 million. 30
33 The following table provides a comparison of the Company's and the Bank's leverage and risk-weighted capital ratios as of December 31, 1999 to the minimum and well capitalized regulatory standards: <TABLE> <CAPTION> To Be Well Capitalized Minimum Required Under Prompt for Capital Corrective Action Actual Ratio at Adequacy Purposes Provisions December 31, 1999 ----------------- ---------------------- ----------------- <S> <C> <C> <C> THE COMPANY Leverage ratio......................... 3.00%(1) N/A 6.28% Tier 1 risk-based capital ratio........ 4.00% N/A 14.35% Total risk-based capital ratio......... 8.00% N/A 16.71% THE BANK Leverage ratio......................... 3.00%(2) 5.00% 6.29% Tier 1 risk-based capital ratio........ 4.00% 6.00% 14.37% Total risk-based capital ratio......... 8.00% 10.00% 15.48% </TABLE> - -------------------- (1) The Federal Reserve Board may require the Company to maintain a leverage ratio of up to 200 basis points above the required minimum. (2) The FDIC may require the Bank to maintain a leverage ratio of up to 200 basis points above the required minimum. YEAR 2000 COMPLIANCE General. The Year 2000 risk involves computer programs and computer software that are not able to perform without interruption into the Year 2000. If computer systems do not correctly recognize the date change from December 31, 1999 to January 1, 2000, computer applications that rely on the date field could fail or create erroneous results. Such erroneous results could affect interest, payment or due dates or cause the temporary inability to process transactions, send invoices or engage in similar normal business activities. If these issues are not addressed by the Company, its suppliers and its borrowers, there could be a material adverse impact on the Company's financial condition or results of operations. State of Readiness. The Company formally initiated its Year 2000 project and plan in November 1997 to insure that its operational and financial systems would not be adversely affected by Year 2000 problems. The Company formed a Year 2000 project team and the Board of Directors and management supported all compliance efforts and allocated the necessary resources to ensure completion. An inventory of all systems and products (including both information technology ("IT") and non-informational technology ("non-IT") systems) that could be affected by the Year 2000 date change was developed, verified and categorized as to its importance to the Company and an assessment of all major IT and critical non-IT systems was completed. This assessment involved inputting test data which simulated the Year 2000 date change into such IT systems and reviewing the system output for accuracy. The Company's assessment of critical non-IT systems involved reviewing such systems to determine whether they were date dependent. Based on such assessment, the Company believed that none of its critical non-IT systems were date dependent. The software for the Company's systems is provided through service bureaus and software vendors. The Company contacted all of its third party vendors and software providers and required them to demonstrate and represent that the products provided were Year 2000 compliant and a program of testing compliance was planned. The Company's service bureau, which performs substantially all of the Company's data processing functions, warranted in writing that its software was Year 2000 compliant and pursuant to applicable regulatory guidelines the Company reviewed the results of user group tests performed by the service provider to verify this assertion. The Company believes it would have recourse against the service provider for actual damages incurred by the Company in the event the service provider breaches this warranty. In addition, the FDIC reviewed the Company's compliance with Year 2000 issues on several occasions. Risks Related to Third Parties. The impact of Year 2000 noncompliance by third parties with which the Company transacts business cannot be accurately gauged. The Company identified its largest dollar deposit (aggregate deposits over $500,000) and loan ($250,000 or more) customers and, based on information available to the Company, conducted a preliminary evaluation to determine which of those customers would likely be affected by Year 2000 issues. The Company then surveyed those customers deemed at risk to determine their readiness with respect to Year 2000 issues, including their awareness of Year 2000 issues, plans to address such issues and progress with respect to such plans. The responses indicated that the customers were aware of Year 2000 issues, were in the process of updating their systems and informed the Company that they believed they would be ready for the Year 2000 date change by the end of 1999. With respect to depositors, the Company maintained additional cash on hand in the event of excess withdrawals. With respect to borrowers, the Company's loan documents included a Year 2000 disclosure form and an addendum to the loan agreement in which the borrower represented and warranted its Year 2000 compliance to the Company. 31
34 Transition Into the Year 2000. The Company suffered no failures in any system or product upon the date change from December 31, 1999 to January 1, 2000. In addition, management is not aware of any vendor used by the Company for data processing or related services which experienced a material failure of its product or service due to a Year 2000 related problem. The Company was also subject to risks associated with Year 2000 noncompliance by its customers. Management is not aware of any customer which suffered losses related to a Year 2000 problem which would adversely affect that customer's financial condition or its ability to repay any outstanding loan it has from the Company. Costs of Compliance. The Company budgeted $10,000 to address Year 2000 issues. As of February 15, 2000, the Company incurred expenses of less than $10,000 in relation to Year 2000. While the Company believes that it will incur no additional material expenses related to the Year 2000 issue, there can be no assurance that the Company will not be impacted by a Year 2000 related problem which occurs after the date hereof or by the failure of a third party to achieve proper Year 2000 compliance. Ongoing Plans. Although many of the critical dates related to potential Year 2000 related problems have passed, experts predict that Year 2000 related failures could occur throughout the year, such as on February 29, 2000 and December 31, 2000. Accordingly, the Company's Year 2000 project team will continue to monitor the Company's IT and non-IT systems and attempt to identify any potential problems during the course of the year. In addition, the Company will continue to monitor the Year 2000 compliance of the third parties with which the Company transacts business. Contingency Plans. The Company continues to maintain its contingency plans with respect to Year 2000 related issues and believes that if its own systems should fail, it could convert to a manual entry system for a period of time without significant losses. The Company believes that any mission critical systems could be recovered and operating within seven days. In the event that the Federal Reserve is unable to handle electronic funds transfers and check clearing, the Company does not expect the impact to be material to its financial condition or results of operations as long as it is able to utilize an alternative electronic funds transfer and clearing source. As part of it contingency planning, the Company reviewed its loan customer base and the potential impact on capital of Year 2000 noncompliance. Based upon such review, using what it considered to be a reasonable worst case scenario, the Company assumed that certain of its commercial borrowers whose businesses are most likely to be affected by Year 2000 noncompliance would be unable to repay their loans, resulting in charge-offs of loan amounts in excess of collateral values. If such were the case, the Company believes that it is unlikely that its exposure would exceed $100,000, although there are no assurances that this amount will not be substantially higher. The Company does not believe that this amount is material enough for it to adjust its current methodology for making provisions to the allowance for credit losses. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For information regarding the market risk of the Company's financial instruments, see "ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION - FINANCIAL CONDITION - INTEREST RATE SENSITIVITY AND LIQUIDITY". The Company's principal market risk exposure is to changes in interest rates. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements, the reports thereon, the notes thereto and supplementary data commence at page F-1 of this Annual Report on Form 10-K. 32
35 The following table presents certain unaudited quarterly financial information concerning the Company's results of operations for each of the two years ended December 31, 1999. The information should be read in conjunction with the historical Consolidated Financial Statements of the Company and the Notes thereto appearing elsewhere in this Annual Report on Form 10-K. <TABLE> <CAPTION> CONSOLIDATED QUARTERLY FINANCIAL DATA OF THE COMPANY Quarter Ended 1999 ------------------------------------------------------- (unaudited) December 31 September 30 June 30 March 31 ----------- ------------ -------- -------- (Dollars in thousands, except per share data) <S> <C> <C> <C> <C> Interest income ............................. $ 9,549 $ 7,310 $ 7,308 $ 7,245 Interest expense ............................ 3,944 2,959 3,019 3,111 -------- -------- -------- -------- Net interest income .................... 5,605 4,351 4,289 4,134 Provision for credit losses ................. 75 75 65 65 -------- -------- -------- -------- Net interest income after provision .... 5,530 4,276 4,224 4,069 Noninterest income .......................... 1,286 789 743 703 Noninterest expense ......................... 3,969 2,734 2,761 2,674 -------- -------- -------- -------- Income before income taxes ............. 2,847 2,331 2,206 2,098 Provision for income taxes .................. 895 746 703 664 -------- -------- -------- -------- Net income ............................. $ 1,952 $ 1,585 $ 1,503 $ 1,434 ======== ======== ======== ======== Earnings per share: Basic .................................. $ 0.38 $ 0.31 $ 0.29 $ 0.28 ======== ======== ======== ======== Diluted ................................ $ 0.36 $ 0.29 $ 0.28 $ 0.27 ======== ======== ======== ======== </TABLE> <TABLE> <CAPTION> Quarter Ended 1998 ------------------------------------------------------- (unaudited) December 31 September 30 June 30 March 31 ----------- ------------ -------- -------- (Dollars in thousands, except per share data) <S> <C> <C> <C> <C> Interest income ............................. $ 6,910 $ 5,641 $ 5,597 $ 5,274 Interest expense ............................ 3,019 2,395 2,412 2,302 -------- -------- -------- -------- Net interest income .................... 3,891 3,246 3,185 2,972 Provision for credit losses ................. 24 70 75 70 -------- -------- -------- -------- Net interest income after provision .... 3,867 3,176 3,110 2,902 Noninterest income .......................... 667 586 622 617 Noninterest expense ......................... 2,609 2,195 2,148 2,106 -------- -------- -------- -------- Income before income taxes ............. 1,925 1,567 1,584 1,413 Provision for income taxes .................. 603 487 499 440 -------- -------- -------- -------- Net income .................................. $ 1,322 $ 1,080 $ 1,085 $ 973 ======== ======== ======== ======== Earnings per share: Basic .................................. $ 0.29 $ 0.27 $ 0.27 $ 0.24 ======== ======== ======== ======== Diluted ................................ 0.28 0.26 0.27 0.24 ======== ======== ======== ======== </TABLE> 33
36 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no disagreements with accountants on any matter of accounting principles or practices or financial statement disclosures during the two year period ended December 31, 1999. PART III. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information under the captions "Election of Directors," "Continuing Directors and Executive Officers" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive Proxy Statement relating to its 2000 Annual Meeting of Shareholders (the "2000 Proxy Statement") is incorporated herein by reference in response to this item. ITEM 11. EXECUTIVE COMPENSATION The information under the caption "Executive Compensation and Other Matters" in the 2000 Proxy Statement is incorporated herein by reference in response to this item. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the caption "Beneficial Ownership of Common Stock by Management of the Company and Principal Shareholders" in the 2000 Proxy Statement is incorporated herein by reference in response to this item. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the caption "Interests of Management and Others in Certain Transactions" in the 2000 Proxy Statement is incorporated herein by reference in response to this item. PART IV. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Reference is made to the Financial Statements, the reports thereon, the Notes thereto and supplementary data commencing at page F-1 of this Annual Report on Form 10-K. Set forth below is a list of such Financial Statements: Independent Auditors' Report Consolidated Balance Sheets as of December 31, 1999 and 1998 Consolidated Statements of Income for the Years Ended December 31, 1999, 1998, and 1997 Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 1999, 1998 and 1997 Consolidated Statements of Cash Flows for the Years Ended December 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements FINANCIAL STATEMENT SCHEDULES All supplemental schedules are omitted as inapplicable or because the required information is included in the Consolidated Financial Statements or Notes thereto. 34
37 EXHIBITS Each exhibit marked with an asterisk is filed with this Annual Report on Form 10-K. Exhibit Number Description ------- ----------- 2.1 - Agreement and Plan of Reorganization by and between the Company and South Texas Bancshares, Inc. dated June 17, 1999 (incorporated herein by reference to Exhibit 2.1 to the Company's Form 10-Q for the quarter ended June 30, 1999). 2.2 - Agreement and Plan of Reorganization dated June 5, 1998 by and among the Company, First Prosperity Bank and Union State Bank (incorporated herein by reference to Exhibit 10.4 to the Company's Registration Statement on Form S-1 (Registration No. 333-63267) (the "Registration Statement")). 3.1 - Amended and Restated Articles of Incorporation of the Company (incorporated herein by reference to Exhibit 3.1 to the Registration Statement. 3.2 - Amended and Restated Bylaws of the Company (incorporated herein by reference to Exhibit 3.2 to the Registration Statement). 4.1 - Specimen form of certificate evidencing the Common Stock (incorporated herein by reference to Exhibit 4 to the Registration Statement). 4.2 - Form of Indenture by and between the Company and First Union Trust Company, N.A. (incorporated herein by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-89481)). 4.3 - Form of Subordinated Debenture (included as an exhibit to Exhibit 4.2). 4.4 - Form of Trust Preferred Securities Guarantee Agreement by and between the Company and First Union Trust Company, N.A. (incorporated herein by reference to Exhibit 4.7 of the Company's Registration Statement of Form S-1 (Registration No. 333-89481)). 10.1 - Prosperity Bancshares, Inc. 1995 Stock Option Plan (incorporated herein by reference to Exhibit 10.1 to the Registration Statement). 10.2 - Prosperity Bancshares, Inc. 1998 Stock Incentive Plan (incorporated herein by reference to Exhibit 10.2 to the Registration Statement). 10.3 - Employment Agreements (incorporated herein by reference to Exhibit 10.3 to the Registration Statement). 10.5 - Loan Agreement dated December 27, 1997 between the Company and Norwest Bank Minnesota, National Association (incorporated herein by reference to Exhibit 10.5 to the Registration Statement). 21* - Subsidiaries of Prosperity Bancshares, Inc. 23.1* - Consent of Deloitte & Touche LLP. 27* - Financial Data Schedule. 35
38 REPORTS ON FORM 8-K The Company filed a Current Report on Form 8-K under Item 2 of Form 8-K on October 15, 1999 to report its acquisition of South Texas Bancshares, Inc. The Company filed Amendment No. 1 to that Current Report on Form 8-K on November 8, 1999 to file the financial statements related to such acquisition. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, PROSPERITY BANCSHARES, INC., HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN THE CITY OF HOUSTON AND STATE OF TEXAS ON MARCH 8, 2000. PROSPERITY BANCSHARES, INC. BY: /s/ TRACY T. RUDOLPH TRACY T. RUDOLPH CHAIRMAN OF THE BOARD PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT IN THE INDICATED CAPACITIES ON MARCH 8, 2000. <TABLE> <CAPTION> Signature Positions --------- --------- <S> <C> /s/ TRACY T. RUDOLPH Chairman of the Board (principal --------------------------------------- executive officer) Tracy T. Rudolph /s/ DAVID HOLLAWAY Chief Financial Officer (principal --------------------------------------- financial officer and principal David Hollaway accounting officer) /s/ HARRY BAYNE Director --------------------------------------- Harry Bayne /s/ JAMES A. BOULIGNY Director --------------------------------------- James A. Bouligny /s/ J.T. HERIN Director --------------------------------------- J.T. Herin /s/ CHARLES M. SLAVIK Director --------------------------------------- Charles M. Slavik /s/ HARRISON STAFFORD Director --------------------------------------- Harrison Stafford /s/ ROBERT STEELHAMMER Director --------------------------------------- Robert Steelhammer /s/ DAVID ZALMAN Director --------------------------------------- David Zalman </TABLE> 36
39 TABLE OF CONTENTS TO FINANCIAL STATEMENTS <TABLE> <CAPTION> Page ---- <S> <C> Prosperity Bancshares, Inc. Independent Auditors' Report................................................. F-2 Consolidated Balance Sheets as of December 31, 1999 and 1998................ F-3 Consolidated Statements of Income for the Years Ended December 31, 1999, 1998 and 1997..................................................... F-4 Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 1999, 1998 and 1997............................ F-5 Consolidated Statements of Cash Flows for the Years Ended December 31, 1999, 1998 and 1997........................................ F-6 Notes to Consolidated Financial Statements................................... F-8 </TABLE> F-1
40 INDEPENDENT AUDITORS' REPORT To the Shareholders and Board of Directors of Prosperity Bancshares, Inc. and Subsidiaries: We have audited the accompanying consolidated balance sheets of Prosperity Bancshares, Inc. and subsidiaries (collectively, the "Company") as of December 31, 1999 and 1998, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Prosperity Bancshares, Inc. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with generally accepted accounting principles. Deloitte & Touche LLP February 4, 2000 Houston, Texas F-2
41 PROSPERITY BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS <TABLE> <CAPTION> December 31, -------------------------- 1999 1998 ---------- ---------- (Dollars in thousands) ASSETS <S> <C> <C> Cash and due from banks (Note 3) ................................. $ 20,658 $ 18,243 Federal funds sold ............................................... 16,100 -- Interest-bearing deposits in financial institutions .............. -- 99 Available for sale securities, at fair value (amortized cost of $228,850 and $113,300, respectively) (Note 4) .............. 224,782 113,828 Held to maturity securities, at cost (fair value of $87,184 and $115,021, respectively) (Note 4) .......................... 87,889 113,916 Loans (Notes 5, 6) ............................................... 223,505 170,478 Less allowance for credit losses (Note 7) ........................ (2,753) (1,850) ---------- ---------- Loans, net ......................................... 220,752 168,628 Accrued interest receivable ...................................... 5,013 3,990 Goodwill, net of accumulated amortization of $3,792 and $3,077, respectively ............................ 19,229 9,690 Bank premises and equipment, net (Note 8) ........................ 9,751 6,105 Other assets ..................................................... 4,499 1,813 ---------- ---------- TOTAL ............................................................ $ 608,673 $ 436,312 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY LIABILITIES: Deposits (Note 9): Noninterest-bearing ....................................... $ 113,514 $ 84,976 Interest-bearing .......................................... 421,242 305,683 ---------- ---------- Total deposits ..................................... 534,756 390,659 Federal funds purchased (Note 10) ............................. 10,000 -- Other borrowings (Note 10) .................................... 5,700 2,437 Accrued interest payable ...................................... 1,554 1,081 Other liabilities ............................................. 1,397 700 ---------- ---------- Total liabilities .................................. 553,407 394,877 COMMITMENTS AND CONTINGENCIES (Notes 12 and 16) COMPANY-OBLIGATED MANDITORILY REDEEMABLE TRUST PREFERRED SECURITIES OF SUBSIDIARY TRUST (Note 20) ............................................... 12,000 -- SHAREHOLDERS' EQUITY (Notes 14, 17, and 18): Common stock, $1 par value; 50,000,000 shares authorized; 5,198,901 and 5,176,401, shares issued at December 31, 1999 and 1998, respectively; 5,195,325 and 5,172,825 shares outstanding at December 31, 1999 and 1998, respectively .............................................. 5,199 5,176 Capital surplus ............................................... 15,880 16,477 Retained earnings ............................................. 24,889 19,452 Accumulated other comprehensive income -- net unrealized gains (losses) on available for sale securities, net of tax benefit of $1,383 and tax of $179, respectively ..................................... (2,684) 348 Less treasury stock, at cost, 3,576 shares .................... (18) (18) ---------- ---------- Total shareholders' equity ......................... 43,266 41,435 ---------- ---------- TOTAL ............................................................ $ 608,673 $ 436,312 ========== ========== </TABLE> See notes to consolidated financial statements. F-3
42 PROSPERITY BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME <TABLE> <CAPTION> For the Years Ended December 31, -------------------------------------- 1999 1998 1997 -------- -------- -------- (Dollars in thousands, except per share data) <S> <C> <C> <C> INTEREST INCOME: Loans, including fees ............................... $ 16,386 $ 12,282 $ 10,206 Securities: Taxable .......................................... 13,323 10,152 8,950 Nontaxable ....................................... 933 682 605 70% nontaxable preferred dividends ............... 36 -- -- Federal funds sold .................................. 734 299 193 Deposits in financial institutions .................. -- 7 16 -------- -------- -------- Total interest income .......................... 31,412 23,422 19,970 -------- -------- -------- INTEREST EXPENSE: Deposits ............................................ 12,971 9,993 8,858 Note payable and federal funds purchased ........................................ 2 24 132 Other ............................................... 60 111 70 -------- -------- -------- Total interest expense ......................... 13,033 10,128 9,060 -------- -------- -------- NET INTEREST INCOME .................................... 18,379 13,294 10,910 PROVISION FOR CREDIT LOSSES (Note 7) ................... 280 239 190 -------- -------- -------- NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES ................................... 18,099 13,055 10,720 -------- -------- -------- NONINTEREST INCOME: Customer service fees ............................... 3,010 2,173 2,062 Other ............................................... 511 319 202 -------- -------- -------- Total noninterest income ....................... 3,521 2,492 2,264 -------- -------- -------- NONINTEREST EXPENSE: Salaries and employee benefits (Note 15) ........................................ 6,198 4,541 3,968 Net occupancy expense ............................... 666 535 488 Data processing ..................................... 880 807 642 Goodwill amortization ............................... 715 500 402 Depreciation expense ................................ 689 523 431 Minority interest trust preferred securities ........ 142 -- -- Other ............................................... 2,848 2,152 1,905 -------- -------- -------- Total noninterest expense ...................... 12,138 9,058 7,836 -------- -------- -------- INCOME BEFORE INCOME TAXES ............................. 9,482 6,489 5,148 PROVISION FOR INCOME TAXES (Note 13) ................... 3,008 2,029 1,586 -------- -------- -------- NET INCOME ............................................. $ 6,474 $ 4,460 $ 3,562 ======== ======== ======== EARNINGS PER SHARE (Note 1): Basic ............................................... $ 1.25 $ 1.08 $ 0.94 ======== ======== ======== Diluted ............................................. $ 1.20 $ 1.04 $ 0.92 ======== ======== ======== </TABLE> See notes to consolidated financial statements. F-4
43 PROSPERITY BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY <TABLE> <CAPTION> Accumulated Other Comprehensive Income -- Net Unrealized Loss Common Stock on Available ------------------------ Capital Retained for Sale Shares Amount Surplus Earnings Securities ---------- ---------- ---------- ---------- ------------ (Amounts in thousands, except share data) <S> <C> <C> <C> <C> <C> BALANCE AT JANUARY 1, 1997 ............... 3,513,884 $ 3,513 $ 2,298 $ 13,061 $ (20) Net income .......................... 3,562 Net change in unrealized loss on available for sale securities ..... (4) Total comprehensive income .......... Sale of treasury stock .............. Issuance of common stock ............ 480,000 480 2,520 Cash dividends declared, $0.15 per share ......................... (574) ---------- ---------- ---------- ---------- ---------- BALANCE AT DECEMBER 31, 1997 ............. 3,993,884 3,993 4,818 16,049 (24) Net income .......................... 4,460 Net change in unrealized loss on available for sale securities ..... 372 Total comprehensive income .......... Sale of common stock ................ 1,182,517 1,183 11,659 Cash dividends declared, $0.20 per share ......................... (1,057) ---------- ---------- ---------- ---------- ---------- BALANCE AT DECEMBER 31, 1998 ............. 5,176,401 5,176 16,477 19,452 348 Net income .......................... 6,474 Net change in unrealized loss on available for sale securities ..... (3,032) Total comprehensive income .......... Sale of common stock ................ 22,500 23 76 Trust preferred issuance costs ...... (560) Initial public offering costs ....... (113) Cash dividends declared, $0.20 per share ......................... (1,037) ---------- ---------- ---------- ---------- ---------- BALANCE AT DECEMBER 31, 1999 ............. 5,198,901 $ 5,199 $ 15,880 $ 24,889 $ (2,684) ========== ========== ========== ========== ========== <CAPTION> Total Treasury Shareholders' Stock Equity ---------- ------------- <S> <C> <C> BALANCE AT JANUARY 1, 1997 ............... $ (19) $ 18,833 Net income .......................... 3,562 Net change in unrealized loss on available for sale securities ..... (4) ---------- Total comprehensive income .......... 3,558 ---------- Sale of treasury stock .............. 1 1 Issuance of common stock ............ 3,000 Cash dividends declared, $0.15 per share ......................... (574) ---------- ---------- BALANCE AT DECEMBER 31, 1997 ............. (18) 24,818 Net income .......................... 4,460 Net change in unrealized loss on available for sale securities ..... 372 ---------- Total comprehensive income .......... 4,832 ---------- Sale of common stock ................ 12,842 Cash dividends declared, $0.20 per share ......................... (1,057) ---------- ---------- BALANCE AT DECEMBER 31, 1998 ............. (18) 41,435 Net income .......................... 6,474 Net change in unrealized loss on available for sale securities ..... (3,032) ---------- Total comprehensive income .......... 3,442 ---------- Sale of common stock ................ 99 Trust preferred issuance costs ...... (560) Initial public offering costs ....... (113) Cash dividends declared, $0.20 per share ......................... (1,037) ---------- ---------- BALANCE AT DECEMBER 31, 1999 ............. $ (18) $ 43,266 ========== ========== </TABLE> See notes to consolidated financial statements. F-5
44 PROSPERITY BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS <TABLE> <CAPTION> For the Years Ended December 31, ------------------------------------ 1999 1998 1997 -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income .......................................... $ 6,474 $ 4,460 $ 3,562 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization ..................... 1,404 1,023 833 Provision for credit losses ....................... 280 239 190 Net amortization of premium/ discount on investments ........................ 202 236 340 Loss on sale of real estate acquired by foreclosure ......................... -- 2 2 Increase in accrued interest receivable ........... (13) (624) (297) Increase in other assets .......................... (946) (180) (396) Increase (Decrease) in accrued interest payable and other liabilities ......... 79 217 (80) -------- -------- -------- Total adjustments ............................... 1,006 913 592 -------- -------- -------- Net cash provided by operating activities ....... 7,480 5,373 4,154 -------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturities and principal paydowns of held to maturity securities ............................... 53,047 54,725 35,405 Purchase of held to maturity securities ............. (4,525) (15,983) (66,766) Proceeds from maturities and principal paydowns of available for sale securities ............................... 15,418 24,109 14,206 Purchase of available for sale securities ........... (87,070) (81,729) (3,497) Net increase in loans ............................... (19,228) (28,433) (7,482) Net proceeds from sale of real estate acquired by foreclosure .................... -- 38 187 Purchase of bank premises and equipment ............. (414) (343) (743) Net decrease in interest-bearing deposits in financial institutions ......................... 99 99 198 Premium paid for Angleton branch .................... -- -- (1,990) Net liabilities acquired in purchase of Angleton branch (net of acquired cash of $565) ............................ -- -- 28,647 Premium paid for South Texas Bancshares ............. (10,255) -- -- Net liabilities acquired in purchase of South Texas Bancshares (net of acquired cash of $12,271) .................................. 22,526 -- -- Premium paid for West Columbia branch ............... -- (250) -- Net liabilities acquired in purchase of West Columbia branch (net of acquired cash of $84) .......................... -- 5,799 -- Premium paid for purchase of East Bernard branch ............................................ -- (4,297) -- Net liabilities acquired in purchase of East Bernard branch (net of acquired cash of $16,602) .................................. -- 3,134 -- -------- -------- -------- Net cash used in investing activities ........... (30,402) (43,131) (1,835) -------- -------- -------- </TABLE> (Table continued on following page) F-6
45 PROSPERITY BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS <TABLE> <CAPTION> For the Years Ended December 31, ------------------------------------ 1999 1998 1997 -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in noninterest-bearing deposits .......................................... $ 6,531 $ 13,881 $ 1,210 Net increase (decrease) in interest-bearing deposits ......................... 11,254 13,327 (9,861) Proceeds from line of credit ........................ -- 2,000 -- Repayments of line of credit ........................ -- (2,000) (3,266) Proceeds (repayments ) of other borrowings (net) ................................. 13,263 (364) 2,800 Proceeds from the issuance of trust preferred securities ............................ 12,000 -- -- Initial public offering costs ....................... (113) Trust preferred issuance costs ..................... (560) -- -- Proceeds from the issuance of common stock ...................................... 99 12,842 3,000 Sale of treasury stock .............................. -- -- 1 Payments of cash dividends .......................... (1,037) (1,057) (575) -------- -------- -------- Net cash provided by (used in) financing activities ......................... 41,437 38,629 (6,691) -------- -------- -------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS .................................... $ 18,515 $ 871 $ (4,372) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ........................................... 18,243 17,372 21,744 -------- -------- -------- CASH AND CASH EQUIVALENTS, END OF PERIOD .............................................. $ 36,758 $ 18,243 $ 17,372 ======== ======== ======== INCOME TAXES PAID ...................................... $ 2,437 $ 1,882 $ 1,681 ======== ======== ======== INTEREST PAID .......................................... $ 12,560 $ 9,755 $ 9,039 ======== ======== ======== NONCASH INVESTING ACTIVITIES: The Company acquired certain real estate through foreclosure of collateral on loans totaling approximately $0, $0, and $189 during the years ended December 31, 1999, 1998, and 1997, respectively. </TABLE> See notes to consolidated financial statements. F-7
46 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES NATURE OF OPERATIONS -- Prosperity Bancshares, Inc. ("Bancshares") and its subsidiaries, Prosperity Holdings, Inc. ("Holdings") and First Prosperity Bank (the "Bank") (collectively referred to as the "Company") provide retail and commercial banking services. The Bank operates fifteen branch banking offices in South Central Texas, with three locations in Houston and twelve locations south, and southwest of Houston in Angleton, Bay City, Beeville, Cuero, East Bernard, Edna, El Campo, Goliad, Mathis, West Columbia and Victoria. PRINCIPLES OF CONSOLIDATION -- The consolidated financial statements include the accounts of Bancshares and its wholly owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation. The accounting and reporting policies of the Company conform to generally accepted accounting principles ("GAAP") and the prevailing practices within the banking industry. A summary of significant accounting and reporting policies is as follows: USE OF ESTIMATES -- The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. SECURITIES -- Securities held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts. Management has the positive intent and the Company has the ability to hold these assets as long-term securities until their estimated maturities. Under certain circumstances (including the deterioration of the issuer's creditworthiness or a change in tax law or statutory or regulatory requirements), securities may be sold or transferred to another portfolio. Securities available for sale are carried at fair value. Unrealized gains and losses are excluded from earnings and reported, net of tax, as a separate component of shareholders' equity until realized. Securities within the available for sale portfolio may be used as part of the Company's asset/liability strategy and may be sold in response to changes in interest risk, prepayment risk or other similar economic factors. Declines in the fair value of individual held-to-maturity and available-for-sale securities below their cost that are other than temporary would result in write-downs of the individual securities to their fair value. The related write-downs would be included in earnings as realized losses. Premiums and discounts are amortized and accreted to operations using the level-yield method of accounting, adjusted for prepayments as applicable. The specific identification method of accounting is used to compute gains or losses on the sales of these assets. Interest earned on these assets is included in interest income. LOANS -- Loans are stated at the principal amount outstanding, net of unearned discount and fees. Unearned discount relates principally to consumer installment loans. The related interest income for multipayment loans is recognized principally by the "sum of the digits" method which records interest in proportion to the declining outstanding balances of the loans; for single payment loans, such income is recognized using the straight-line method. Effective January 1, 1995, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure." SFAS No. 114 applies to all impaired loans, with the exception of groups of smaller-balance homogeneous loans that are collectively evaluated for impairment. A loan is defined as impaired by SFAS No. 114 if, based on current information and events, it is probable that a creditor will be unable to collect all amounts due, both interest and principal, according to the contractual terms of the loan agreement. Specifically, SFAS No. 114 requires that the allowance for credit losses related to impaired loans be determined based on the difference of carrying value of loans and the present value of expected cash flows discounted at the loan's effective interest rate or, as a practical expedient, the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Prior to the adoption of SFAS No. 114, the Company's methodology for determining the adequacy of the allowance for credit losses did not incorporate the concept of the time value of money and the expected future interest cash flow. F-8
47 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) As permitted by SFAS No. 118, interest revenue received on impaired loans continues to be either applied against principal or realized as interest revenue, according to management's judgment as to the collectibility of principal. Adoption of these pronouncements, SFAS Nos. 114 and 118, had no impact on the Company's consolidated financial statements including the level of the allowance for credit losses. OTHER REAL ESTATE -- Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value at the date of foreclosure establishing a new cost basis. After foreclosure, valuations are periodically performed by management and the real estate is carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in the net gain/loss and carrying costs of other real estate. NONREFUNDABLE FEES AND COSTS ASSOCIATED WITH LENDING ACTIVITIES - Loan origination fees are recognized over the life of the related loan as an adjustment to yield using the interest method. Generally, loan commitment fees are deferred, except for certain retrospectively determined fees, and recognized as an adjustment of yield by the interest method over the related loan life or, if the commitment expires unexercised, recognized in income upon expiration of the commitment. NONPERFORMING LOANS AND PAST DUE LOANS -- Included in the nonperforming loan category are loans which have been categorized by management as nonaccrual because collection of interest is doubtful and loans which have been restructured to provide a reduction in the interest rate or a deferral of interest or principal payments. When the payment of principal or interest on a loan is delinquent for 90 days, or earlier in some cases, the loan is placed on nonaccrual status unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan. If the decision is made to continue accruing interest on the loan, periodic reviews are made to confirm the accruing status of the loan. When a loan is placed on nonaccrual status, interest accrued during the current year prior to the judgment of uncollectibility is charged to operations. Interest accrued during prior periods is charged to allowance for credit losses. Generally, any payments received on nonaccrual loans are applied first to outstanding loan amounts and next to the recovery of charged-off loan amounts. Any excess is treated as recovery of lost interest. Restructured loans are those loans on which concessions in terms have been granted because of a borrower's financial difficulty. Interest is generally accrued on such loans in accordance with the new terms. ALLOWANCE FOR CREDIT LOSSES -- The allowance for credit losses is a valuation allowance available for losses incurred on loans. All losses are charged to the allowance when the loss actually occurs or when a determination is made that such a loss is probable. Recoveries are credited to the allowance at the time of recovery. Throughout the year, management estimates the probable level of losses to determine whether the allowance for credit losses is adequate to absorb losses in the existing portfolio. Based on these estimates, an amount is charged to the provision for credit losses and credited to the allowance for credit losses in order to adjust the allowance to a level determined to be adequate to absorb losses. Management's judgment as to the level of losses on existing loans involves the consideration of current and anticipated economic conditions and their potential effects on specific borrowers; an evaluation of the existing relationships among loans, probable credit losses and the present level of the allowance; results of examinations of the loan portfolio by regulatory agencies; and management's internal review of the loan portfolio. In determining the collectibility of certain loans, management also considers the fair value of any underlying collateral. The amounts ultimately realized may differ from the carrying value of these assets because of economic, operating or other conditions beyond the Company's control. Estimates of credit losses involve an exercise of judgment. While it is possible that in the short term the Company may sustain losses which are substantial in relation to the allowance for credit losses, it is the judgment of management that the allowance for credit losses reflected in the consolidated balance sheets is adequate to absorb probable losses that exist in the current loan portfolio. PREMISES AND EQUIPMENT -- Premises and equipment are carried at cost less accumulated depreciation. Depreciation expense is computed principally using the straight-line method over the estimated useful lives of the assets which range from three to 30 years. F-9
48 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) AMORTIZATION OF GOODWILL -- Goodwill is amortized using the straight-line method over a period of 15 to 25 years. Goodwill is periodically assessed for impairment. INCOME TAXES -- Bancshares files a consolidated federal income tax return. The Bank computes federal income taxes as if it filed a separate return and remits to, or is reimbursed by, Bancshares based on the portion of taxes currently due or refundable. Deferred tax assets and liabilities are recognized for the estimated tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. STOCK-BASED COMPENSATION -- The Company accounts for its employee stock options using the intrinsic value-based method and makes pro forma disclosures of net income and earnings per share using the fair value-based method (see Note 14). STATEMENTS OF CASH FLOWS -- For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks as well as federal funds sold that mature in three days or less. RECLASSIFICATIONS -- Certain reclassifications have been made to 1998 and 1997 balances to conform to the current year presentation. All reclassifications have been applied consistently for the periods presented. EARNINGS PER SHARE -- SFAS No. 128, "Earnings Per Share," requires presentation of basic and diluted earnings per share. Basic earnings per share has been computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding for the reporting period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Net income per common share for all periods presented has been calculated in accordance with SFAS 128. Outstanding stock options issued by the Company represent the only dilutive effect reflected in diluted weighted average shares. The following table illustrates the computation of basic and diluted earnings per share after effect of stock split (see Note 17): <TABLE> <CAPTION> December 31, ------------------------------------------------------------ 1999 1998 1997 ---------------- ---------------- ---------------- Per Per Per Share Share Share Amount Amount Amount Amount Amount Amount ------ ------ ------ ------ ------ ------ (Dollars in thousands, except per share data) <S> <C> <C> <C> <C> <C> <C> Net income ............................. $6,474 $4,460 $3,562 Basic -- Weighted average shares outstanding ....................... 5,186 $ 1.25 4,116 $ 1.08 3,778 $ 0.94 ====== ====== ====== Diluted: Weighted average shares outstanding ....................... 5,186 4,116 3,778 Effect of dilutive securities -- options ........................... 206 193 86 ------ ------ ------ Total ............................... 5,392 $ 1.20 4,309 $ 1.04 3,864 $ 0.92 ====== ====== ====== ====== ====== ====== </TABLE> RECENTLY ISSUED ACCOUNTING STANDARDS -- Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income" requires that all components of comprehensive income and total comprehensive income be reported on one of the following: (1) the statement of income, (2) the statement of shareholders' equity, or (3) a separate statement of comprehensive income. Comprehensive income is comprised of net income and all changes to shareholders' equity, except those due to investments by owners (changes in paid-in capital) and distributions to owners (dividends). The Company adopted this statement effective January 1, 1998 and has elected to report comprehensive income in the consolidated statements of shareholders' equity. F-10
49 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Other comprehensive income consists of unrealized gains and losses on available for sale securities. For the year ended December 31, 1999 and 1998, the change in net unrealized loss on available for sale securities is reported in the consolidated statement of shareholders' equity. SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" establishes new standards for public companies to report information about their operating segments, products and services, geographic areas and major customers. The statement is effective for financial statements issued for periods beginning after December 15, 1997. The Company has adopted SFAS No. 131 effective January 1, 1998. Adoption had no material effect on the consolidated financial statements. SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" establishes accounting and reporting standards for derivative instruments and requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. This statement is effective for periods beginning after June 15, 2000. Management believes the implementation of this pronouncement will not have a material effect on the Company's financial statements. 2. ACQUISITIONS Effective October 1, 1999, the Company acquired all of the outstanding shares of South Texas Bancshares. In connection with the acquisition, The Commercial National Bank of Beeville, a wholly-owned subsidiary of South Texas Bancshares, was merged into the Bank. The Company purchased $33.7 million in loans, $126.5 million in deposits, and $2.7 in real property and fixed assets in connection with this acquisition. In connection with the purchase, the Company paid a cash premium of approximately $10.3 million. This premium was recorded as goodwill and will be amortized on a straight-line basis over 25 years. The acquisition was partially financed with proceeds from the 1997 common stock issuance (see Note 17). The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired bank were recorded at their fair values at the acquisition date. The following summarized proforma information assumes the South Texas Bancshares acquisition had occurred on January 1, 1998: <TABLE> <CAPTION> Year Ended December 31, ----------------------------------- 1999 1998 -------- -------- (Dollars in thousands, except per share data) <S> <C> <C> Net interest income ............... $ 22,022 $ 18,317 Net earnings ...................... 7,418 6,012 Earnings per share (diluted) ...... 1.38 1.40 </TABLE> Effective October 1, 1998, the Company purchased $21.5 million in loans, $66.1 million in deposits, and $292,000 in real property and fixed assets from Union State Bank in East Bernard, Texas. In connection with the purchase, the Company paid a cash premium of approximately $4.3 million. This premium was recorded as goodwill and will be amortized on a straight-line basis over 25 years. The acquisition was partially financed with proceeds from the 1997 common stock issuance (see Note 17). The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired bank were recorded at their fair values at the acquisition date. On February 27, 1998, the Company purchased for cash certain assets and liabilities and all deposits and related accrued interest payable of Community State Bank in West Columbia. The Company acquired $103,000 in loans, and $5.9 million in deposits. The Company paid a cash premium of $250,000 which is being amortized over fifteen years using the straight-line method. The acquisition was accounted for using the purchase method of accounting. F-11
50 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) During March 1997, the Company entered into a purchase and assumption agreement with another bank to purchase certain assets and to assume certain deposit accounts and related accrued interest payable of a branch located in Angleton, Texas. Effective June 20, 1997, the Company purchased approximately $723,000 in real property and fixed assets and assumed deposits, including unpaid accrued interest, totaling approximately $29,370,000. In connection with the purchase, the Company paid a cash premium of approximately $1,990,000. This premium was recorded as goodwill and is being amortized on a straight-line basis over 15 years. The acquisition was partially financed with proceeds from the 1997 common stock issuance (see Note 17). The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branch were recorded at their fair values at the acquisition date. 3. CASH AND DUE FROM BANKS The Bank is required by the Federal Reserve Bank to maintain average reserve balances. "Cash and due from banks" in the consolidated balance sheets includes amounts so restricted of approximately $5,487,000 and $5,399,000 at December 31, 1999 and 1998. 4. SECURITIES The amortized cost and fair value of debt securities are as follows: <TABLE> <CAPTION> December 31, 1999 ------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Carrying Cost Gains Losses Value Value --------- ---------- ---------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> AVAILABLE FOR SALE U.S. Treasury securities and obligations of U.S. government agencies ............................ $151,399 $ 61 $ 3,165 $148,295 $148,295 70% non-taxable preferred stock ........ 4,049 -- 49 4,000 4,000 States and political subdivisions ...... 12,235 64 2 12,297 12,297 Collateralized mortgage obligations .... 11,729 261 63 11,927 11,927 Mortgage-backed securities ............. 49,438 47 1,222 48,263 48,263 -------- -------- -------- -------- -------- Total .................................. $228,850 $ 433 $ 4,501 $224,782 $224,782 ======== ======== ======== ======== ======== HELD TO MATURITY U.S. Treasury securities and obligations of U.S. government agencies ............................ $ 31,039 $ 22 $ 253 $ 30,808 $ 31,039 States and political subdivisions ...... 17,086 52 155 16,983 17,086 Collateralized mortgage obligations .... 538 -- 2 536 538 Mortgage-backed securities ............. 39,226 22 391 38,857 39,226 -------- -------- -------- -------- -------- Total .................................. $ 87,889 $ 96 $ 801 $ 87,184 $ 87,889 ======== ======== ======== ======== ======== </TABLE> F-12
51 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) <TABLE> <CAPTION> December 31, 1998 ------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Carrying Cost Gains Losses Value Value --------- ---------- ---------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> <C> AVAILABLE FOR SALE U.S. Treasury securities and obligations of U.S. government agencies ............................ $ 67,864 $ 285 $ 58 $ 68,091 $ 68,091 States and political subdivisions ...... 4,026 239 4,265 4,265 Collateralized mortgage obligations .... 10,832 166 26 10,972 10,972 Mortgage-backed securities ............. 30,578 98 176 30,500 30,500 -------- -------- -------- -------- -------- Total .................................. $113,300 $ 788 $ 260 $113,828 $113,828 ======== ======== ======== ======== ======== HELD TO MATURITY U.S. Treasury securities and obligations of U.S. government agencies ............................ $ 60,739 $ 572 $ 2 $ 61,309 $ 60,739 States and political subdivisions ...... 15,022 376 3 15,395 15,022 Collateralized mortgage obligations ......................... 2,081 3 2,078 2,081 Mortgage-backed securities ............. 36,074 265 100 36,239 36,074 -------- -------- -------- -------- -------- Total .................................. $113,916 $ 1,213 $ 108 $115,021 $113,916 ======== ======== ======== ======== ======== </TABLE> The amortized cost and fair value of debt securities at December 31, 1999, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. <TABLE> <CAPTION> December 31, 1999 ------------------------------------------------------ Held to Maturity Available for Sale ------------------------ ------------------------ Amortized Fair Amortized Fair Cost Value Cost Value --------- -------- --------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> Due in one year or less ................ $ 7,139 $ 7,142 $ 7,520 $ 7,510 Due after one year through five years ............................... 37,677 37,381 114,595 112,734 Due after five years through ten years ............................... 3,308 3,268 32,958 31,771 Due after ten years .................... -- -- 12,612 12,576 -------- -------- -------- -------- Subtotal ............................... 48,124 47,791 167,685 164,591 Mortgage-backed securities and collateralized mortgage obligations ......................... 39,765 39,393 61,165 60,191 -------- -------- -------- -------- Total .................................. $ 87,889 $ 87,184 $228,850 $224,782 ======== ======== ======== ======== </TABLE> There were no sales of held to maturity or available for sale investments in debt securities during 1999, 1998 and 1997. The Company does not own securities of any one issuer (other than the U.S. government and its agencies) for which aggregate adjusted cost exceeds 10% of the consolidated shareholders' equity at December 31, 1999 and December 31, 1998. Securities with amortized costs of approximately $89,803,569 and $68,245,999 and a fair value of approximately $88,204,172 and $68,698,655 at December 31, 1999 and 1998, respectively, were pledged to secure public deposits and for other purposes required or permitted by law. F-13
52 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 5. LOANS The loan portfolio consists of various types of loans made principally to borrowers located in Southeast Texas and is classified by major type as follows (rounded): <TABLE> <CAPTION> December 31, ------------------------------------- 1999 1998 ----------- ----------- (Dollars in thousands) <S> <C> <C> Commercial and industrial............................ $ 28,279 $ 16,972 Real estate: Construction and land development.................................. 4,015 1,727 I-4 family residential............................ 97,359 80,062 Home equity....................................... 11,343 8,077 Commercial mortgages.............................. 38,752 22,240 Farmland.......................................... 7,404 6,148 Multi-family residential.......................... 1,837 1,090 Agriculture.......................................... 12,735 14,107 Consumer............................................. 22,020 20,711 ----------- ----------- Total................................................ 223,744 171,134 Less unearned discount............................... 239 656 ----------- ----------- Total................................................ $ 223,505 $ 170,478 =========== =========== </TABLE> The contractual maturity ranges of the commercial and industrial and construction and land development portfolios and the amount of such loans with predetermined interest rates and floating rates in each maturity range are summarized in the following table: <TABLE> <CAPTION> December 31, 1999 ----------------------------------------------------- After One One Year Through After Five or Less Five Years Years Total -------- ---------- ---------- -------- (Dollars in thousands) <S> <C> <C> <C> <C> Commercial and industrial .............. $ 16,397 $ 6,548 $ 5,334 $ 28,279 Construction and land development ...... 3,956 34 25 4,015 -------- -------- -------- -------- Total .................... $ 20,353 $ 6,582 $ 5,359 $ 32,294 ======== ======== ======== ======== Loans with a predetermined interest rate ................................ $ 8,218 $ 3,428 $ 2,245 $ 13,891 Loans with a floating interest rate ................................ 12,135 3,154 3,114 18,403 -------- -------- -------- -------- Total .................................. $ 20,353 $ 6,582 $ 5,359 $ 32,294 ======== ======== ======== ======== </TABLE> As discussed in Note 1, the Bank adopted SFAS No. 114 and 118 effective January 1, 1995. Adoption of these statements had no impact on the Company's financial statements including the level of the allowance for credit losses. Instead, it resulted only in a reallocation of the existing allowance for credit losses. As of December 31, 1999 and 1998, loans outstanding to directors, officers and their affiliates were approximately $5,248,000 and $2,283,000, respectively. In the opinion of management, all transactions entered into between the Company and such related parties have been, and are, in the ordinary course of business, made on the same terms and conditions as similar transactions with unaffiliated persons. F-14
53 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) An analysis of activity with respect to these related-party loans is as follows: <TABLE> <CAPTION> Year Ended December 31, ----------------------------------- 1999 1998 --------- --------- (Dollars in thousands) <S> <C> <C> Beginning balance.................................. $ 2,283 $ 2,469 New loans and reclassified related loans........... 4,356 2,061 Repayments......................................... (1,391) (2,247) --------- --------- Ending balance..................................... $ 5,248 $ 2,283 ========= ========= </TABLE> 6. NONPERFORMING LOANS AND PAST DUE LOANS The Company had no nonaccrual loans, no 90 days or more past due loans, and no restructured loans at December 31, 1999, The Company had $5,000 in nonaccrual loans and no 90 days or more past due or restructured loans at December 31, 1998. 7. ALLOWANCE FOR CREDIT LOSSES An analysis of activity in the allowance for credit losses is as follows: <TABLE> <CAPTION> Year Ended December 31, ---------------------------------------- 1999 1998 1997 -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> Balance at beginning of year ......................... $ 1,850 $ 1,016 $ 923 Balance acquired with South Texas Bancshares and Union Acquisitions, respectively ........ 566 661 -- Addition -- provision charged to operations .................................. 280 239 190 Net (charge-offs) and recoveries: Loans charged off ....................... (111) (81) (130) Loan recoveries ......................... 168 15 33 -------- -------- -------- Total net recoveries (charge-offs) ................... 57 (66) (97) -------- -------- -------- Balance at end of period ............................. $ 2,753 $ 1,850 $ 1,016 ======== ======== ======== </TABLE> F-15
54 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 8. PREMISES AND EQUIPMENT Premises and equipment are summarized as follows: <TABLE> <CAPTION> Year Ended December 31, ----------------------- 1999 1998 -------- -------- (Dollars in thousands) <S> <C> <C> Land ................................... $ 1,282 $ 1,024 Buildings .............................. 8,874 5,706 Furniture, fixtures and equipment ...... 3,482 2,551 Construction in progress ............... 6 32 -------- -------- Total .................................. 13,644 9,313 Less accumulated depreciation .......... 3,893 3,208 -------- -------- Premises and equipment, net ............ $ 9,751 $ 6,105 ======== ======== </TABLE> 9. DEPOSITS Included in interest-bearing deposits are certificates of deposit in amounts of $100,000 or more. These certificates and their remaining maturities at December 31, 1999 were as follows: <TABLE> <CAPTION> December 31,1999 ---------------- (Dollars in thousands) <S> <C> Three months or less...................................... $ 25,163 Greater than three through six months..................... 11,564 Greater than six through twelve months.................... 17,849 Thereafter................................................ 5,373 -------- Total..................................................... $ 59,949 ======== </TABLE> Interest expense for certificates of deposit in excess of $100,000 was approximately $2,153,000, $1,492,000, and $1,264,000, for the years ended December 31, 1999, 1998 and 1997, respectively. The Company has no brokered deposits and there are no major concentrations of deposits. 10. NOTE PAYABLE AND OTHER BORROWINGS NOTE PAYABLE -- During December 1997, Bancshares entered into an agreement with a bank to borrow up to $8,000,000 under a reducing, revolving line of credit (the "Line"). The purpose of the Line is to provide funding for potential acquisitions in the future. The maximum amount available under the Line is reduced by $1,142,857 each year beginning December 1998 with all amounts due and payable on December 31, 2004. The Line bears interest, payable quarterly, at the Federal Funds Rate plus 2.75%. The Line is collateralized by 100% of the issued and outstanding common shares of Holdings and the Bank. At December 31, 1999 and 1998, Bancshares had no outstanding borrowings under the Line. During 1997, Bancshares paid off the outstanding balance under a similar agreement (the "Old Line") with a bank. OTHER BORROWINGS - At December 31, 1999, Federal Home Loan Bank ("FHLB") advances totaled $5,700,000 with a floating interest rate of 5.30%. At December 31, 1998, FHLB advances totaled $2,435,000 with a floating interest rate of 5.55%. The advances under the FHLB line of credit are secured by a blanket pledge of the Bank's one-to-four family mortgages. F-16
55 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) FEDERAL FUNDS PURCHASED - At December 31, 1999, the Company had $10,000,000 in federal funds purchased compared with no federal funds purchased at December 31, 1998. 11. INTEREST RATE RISK The Company is principally engaged in providing real estate, consumer and commercial loans, with interest rates that are both fixed and variable. These loans are primarily funded through short-term demand deposits and longer-term certificates of deposit with variable and fixed rates. The fixed real estate loans are more sensitive to interest rate risk because of their fixed rates and longer maturities. 12. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK In the normal course of business, the Company is a party to various financial instruments with off-balance-sheet risk to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of these instruments reflect the extent of the Company's involvement in particular classes of financial instruments. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making these commitments and conditional obligations as it does for on-balance-sheet instruments. The following is a summary of the various financial instruments entered into by the Company: <TABLE> <CAPTION> December 31, -------------------------- 1999 1998 --------- -------- (Dollars in thousands) <S> <C> <C> Financial instruments whose contract amounts represent credit risk: Commitments to extend credit.................. $ 27,007 $ 19,698 Standby letters of credit..................... 445 233 </TABLE> At December 31, 1999, approximately $10.3 million of commitments to extend credit have fixed rates ranging from 4.75% to 15.00%. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amounts disclosed above do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company evaluates customer creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by the Company upon extension of credit, is based on management's credit evaluation of the customer. F-17
56 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 13. INCOME TAXES The components of the provision for federal income taxes are as follows: <TABLE> <CAPTION> Year Ended December 31, ---------------------------------------- 1999 1998 1997 -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> Current .................................... $ 3,097 $ 2,106 $ 1,634 Deferred ................................... (89) (77) (48) -------- -------- -------- Total ...................................... $ 3,008 $ 2,029 $ 1,586 ======== ======== ======== </TABLE> The provision for federal income taxes differs from the amount computed by applying the federal income tax statutory rate on income as follows: <TABLE> <CAPTION> Year Ended December 31, ---------------------------------------- 1999 1998 1997 -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> Taxes calculated at statutory rate ......... $ 3,224 $ 2,206 $ 1,750 Increase (decrease) resulting from: Tax-exempt interest ................ (359) (275) (251) Amortization of goodwill ........... 138 54 57 Other, net ......................... 5 44 30 -------- -------- -------- Total ...................................... $ 3,008 $ 2,029 $ 1,586 ======== ======== ======== </TABLE> Deferred tax assets and liabilities are as follows: <TABLE> <CAPTION> December 31, ------------------------ 1999 1998 -------- -------- (Dollars in thousands) <S> <C> <C> Deferred tax assets - Allowance for credit losses .................... $ -- $ 284 Unrealized loss on available for sale securities ................................ 1,383 -- Other .......................................... 4 4 -------- -------- Total deferred tax assets .............................. 1,387 288 -------- -------- Deferred tax liabilities: Allowance for credit losses .................... $ (363) $ -- Accretion on investments ....................... (249) (206) Bank premises and equipment .................... (1,145) (192) Unrealized gain on available for sale securities .................................. -- (179) -------- -------- Total deferred tax liabilities ......................... (1,757) (577) -------- -------- Net deferred tax liabilities ........................... $ (370) $ (289) ======== ======== </TABLE> 14. STOCK INCENTIVE PROGRAM During 1995 the Company's Board of Directors approved a stock option plan (the "Plan") for executive officers and key associates to purchase common stock of Bancshares. On May 31, 1995, the Company granted 260,000 options, after stock split, (see F-18
57 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Note 17) which vest over a ten-year period beginning on the date of grant. The options were granted at an average exercise price of $4.40 (after stock split). Compensation expense was not recognized for the stock options because the options had an exercise price approximating the fair value of Bancshares' common stock at the date of grant. The maximum number of options available for grant under the Plan is 340,000 (after stock split). <TABLE> <CAPTION> Year Ended December 31, -------------------------------------------------------------------------- 1999 1998 1997 ---------------------- --------------------- --------------------- Weighted- Weighted- Weighted- Number Average Number Average Number Average of Exercise of Exercise of Exercise Options Price Options Price Options Price -------- --------- -------- --------- -------- --------- <S> <C> <C> <C> <C> <C> <C> Options outstanding, beginning of period ... 320,000 $ 4.71 260,000 $ 4.40 260,000 $ 4.40 Options granted ............................ 12,000 12.75 60,000 6.25 -- -- Options exercised .......................... (22,500) 4.40 -- -- -- -- -------- -------- -------- -------- -------- -------- Options outstanding, end of period ......... 309,500 $ 4.96 320,000 $ 4.71 260,000 $ 4.40 ======== ======== ======== ======== ======== ======== </TABLE> At December 31, 1999, there were 22,900 options exercisable under the Plan. During 1999, 22,500 options were exercised. On May 4, 1999, the Company granted 12,000 options under the Plan. The options were granted at an exercise price of $12.75. Compensation expense was not recorded for the stock options because the exercise price approximated the fair value of common stock at the date of grant. On February 10, 1998, the Company granted 60,000 options under the Plan. The options were granted at an exercise price of $6.25 (after stock split). Compensation expense was not recorded for the stock options because the exercise price approximated the fair value of common stock at the date of grant. The weighted-average fair value of the stock options on the grant date was $0.39, $0.81, and $2.85 in 1995, 1998 and 1999 respectively. The weighted-average remaining contractual life of options outstanding as of December 31, 1999 was 5.42, 8.17, and 9.42 years for 1995, 1998, and 1999 respectively. The fair value of each stock options was estimated using an option-pricing model with the following assumptions: (1) 1995 options-risk-free interest rate of 6.49%; dividend yield of 4.54%; and an expected life of 6.5 years (2) 1998 options-risk-free interest rate of 5.87%; dividend yield of 3.20%; and an expected life of 6.5 years (3) 1999 options- risk-free interest rate of 5.765%; dividend yield of 1.57%; and an expected life of 4.5 years. If compensation expense had been recorded based on the fair value at the grant date for awards consistent with SFAS No. 123, the Company's net income would have been $6,461,344, $4,449,936, and $ 3,555,480 for the years ended December 31, 1999, 1998 and 1997, respectively. Diluted earnings per share would have been $1.20, $1.03 and $0.92 for the years ended December 31, 1999, 1998 and 1997, respectively. 15. PROFIT SHARING PLAN The Company has adopted a profit sharing plan pursuant to Section 401(k) of the Internal Revenue Code whereby participants may contribute up to 15% of their compensation. Matching contributions are made at the discretion of the Company. Such matching contributions were approximately $184,000, $112,000, and $87,000, for the years ended December 31, 1999, 1998 and 1997, respectively. F-19
58 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 16. COMMITMENTS Leases -- A summary of noncancelable future operating lease commitments as of December 31, 1999 follows: <TABLE> <S> <C> 2000............................................ $ 222,492 2001............................................ 222,492 2002............................................ 223,398 2003............................................ 224,304 2004............................................ 224,304 ------------ Total........................................... $ 1,116,990 ============ </TABLE> It is expected that in the normal course of business, expiring leases will be renewed or replaced by leases on other property or equipment. Rent expense under all noncancelable operating lease obligations aggregated approximately $226,000 for the year ended 1999, $193,000 for the year ended December 31, 1998 and $191,000 for the year ended December 31, 1997. Litigation - The Company has been named as a defendant in various legal actions arising in the normal course of business. In the opinion of management, after reviewing such claims with outside counsel, resolution of such matters will not have a materially adverse impact on the consolidated financial statements. 17. SHAREHOLDERS' EQUITY During 1998, the Company had an Initial Public Offering selling 1,182,517 shares. Net proceeds of $12,840,890 were used to fund general corporate purposes, including support of balance sheet growth, future acquisitions and to repay certain indebtedness incurred in the acquisition of Union State Bank. On September 10, 1998, the Company effected a four for one common stock split in the form of a common stock dividend (the "Stock Split"). All share and per share information for common stock has been restated to reflect the Stock Split. In September 1998, the Company increased the number of authorized shares of common stock from 1,000,000 to 50,000,000 and authorized 20,000,000 shares of preferred stock with a par value of $1. During 1997, the Company sold 480,000 shares of common stock at $6.25 per share, after stock split, which approximated the book value of the Company at the time of the sale. Proceeds to the Company totaling $3,000,000 were used to fund the acquisition of a branch (Note 2) and to repay borrowings under a line of credit arrangement with a bank (Note 10). Dividends paid by Bancshares and the Bank are subject to restrictions by certain regulatory agencies. There was an aggregate of approximately $11.8 million and $11.9 million available for payment of dividends by Bancshares and by the Bank to Bancshares, respectively, at December 31, 1999 under these restrictions. Dividends paid by Bancshares during the years ended December 31, 1999 and 1998 were $1.0 million and $1.1 million, respectively. There were no dividends paid by the Bank to Bancshares during the year ended 1999. Dividends paid by the Bank to Bancshares during the year ended December 31, 1998 was $995,000. 18. REGULATORY MATTERS The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Any institution that fails to meet its minimum capital requirements is subject to actions by regulators that could have a direct material effect on the Company's and the Bank's financial statements. Under the capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines based on the Bank's assets, liabilities and certain off- balance-sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and the Bank's classification under the regulatory framework for prompt corrective action are also subject to qualitative judgements by the regulators about the components, risk weightings and other factors. To meet the capital adequacy requirements, the Company and the Bank must maintain minimum capital amounts and ratios F-20
59 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) as defined in the regulations. Management believes, as of December 31, 1999 and 1998, that the Company and the Bank met all capital adequacy requirements to which they are subject. At December 31, 1999, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table. There have been no conditions or events since that notification which management believes have changed the Bank's category. The following is a summary of the Company's and the Bank's capital ratios at December 31, 1999 and 1998 (in thousands): <TABLE> <CAPTION> To Be Well Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions -------------------- -------------------- ------------------ Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- <S> <C> <C> <C> <C> <C> <C> CONSOLIDATED:0 AS OF DECEMBER 31, 1999: Total Capital (to Risk Weighted Assets) ........... $ 41,473 16.71% $ 19,855 8.0% N/A N/A Tier I Capital (to Risk Weighted Assets) ........... $ 35,627 14.35% $ 9,927 4.0% N/A N/A Tier I Capital (to Average Assets) ................. $ 35,627 6.28% $ 17,011 3.0% N/A N/A AS OF DECEMBER 31, 1998: Total Capital (to Risk Weighted Assets) ........... $ 33,248 19.08% $ 13,937 8.0% N/A N/A Tier I Capital (to Risk Weighted Assets) ........... $ 31,398 18.02% $ 6,969 4.0% N/A N/A Tier I Capital (to Average Assets) ................. $ 31,398 7.58% $ 12,422 3.0% N/A N/A </TABLE> <TABLE> <CAPTION> To Be Well Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions -------------------- -------------------- ------------------ Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- <S> <C> <C> <C> <C> <C> <C> BANK ONLY: AS OF DECEMBER 31, 1999: Total Capital (to Risk Weighted Assets) ........... $ 38,391 15.48% $ 19,836 8.0% $ 24,796 10.0% Tier I Capital (to Risk Weighted Assets) ........... $ 35,637 14.37% $ 9,918 4.0% $ 14,877 6.0% Tier I Capital (to Average Assets) ................. $ 35,637 6.29% $ 17,004 3.0% $ 28,341 5.0% AS OF DECEMBER 31, 1998: Total Capital (to Risk Weighted Assets) ........... $ 22,516 12.93% $ 13,934 8.0% $ 17,417 10.0% Tier I Capital (to Risk Weighted Assets) ........... $ 20,666 11.87% $ 6,967 4.0% $ 10,450 6.0% Tier I Capital (to Average Assets) ................. $ 20,666 4.99% $ 12,419 3.0% $ 20,698 5.0% </TABLE> 19. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS Disclosures of the estimated fair value amounts of financial instruments have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in F-21
60 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a material effect on the estimated fair value amounts. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: CASH AND CASH EQUIVALENTS -- For these short-term instruments, the carrying amount is a reasonable estimate of fair value. SECURITIES -- For securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. LOAN RECEIVABLES -- For certain homogeneous categories of loans (such as some residential mortgages and other consumer loans), fair value is estimated by discounting the future cash flows using the risk-free Treasury rate for the applicable maturity, adjusted for servicing and credit risk. The carrying value of variable rate loans approximates fair value because the loans reprice frequently to current market rates. DEPOSIT LIABILITIES -- The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. LONG-TERM DEBT AND OTHER BORROWINGS -- Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS -- The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the present creditworthiness of the counterparties. The estimated fair values of the Company's interest-earning financial instruments are as follows (in thousands): <TABLE> <CAPTION> December 31, ----------------------------------------------------------- 1999 1998 -------------------------- -------------------------- Carrying Fair Carrying Fair Amount Value Amount Value ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> Financial assets: Cash and due from banks...................... $ 20,658 $ 20,658 $ 18,243 $ 18,243 Federal funds sold and other temporary investments................................ 16,100 16,100 -- -- Interest-bearing deposits in financial institutions..................... -- -- 99 99 Held to maturity securities.................. 87,889 87,184 113,916 115,021 Available for sale securities................ 224,782 224,782 113,828 113,828 Loans........................................ 223,505 236,306 170,478 186,874 Less allowance for credit losses............. (2,753) (2,753) (1,850) (1,850) ----------- ----------- ----------- ----------- Total................................................ $ 570,181 $ 582,277 $ 414,714 $ 432,215 =========== =========== =========== =========== Financial liabilities: Deposits..................................... $ 534,756 $ 535,106 $ 390,659 $ 391,590 Federal funds purchased and other borrowings.................................. 15,700 15,700 2,437 2,437 ----------- ----------- ----------- ----------- Total................................................ $ 550,456 $ 550,806 $ 393,096 $ 394,027 =========== =========== =========== =========== </TABLE> The differences in fair value and carrying value of commitments to extend credit and standby letters of credit were not material at December 31, 1999 and 1998. F-22
61 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) The fair value estimates presented herein are based on pertinent information available to management as of the dates indicated. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amounts presented herein. 20. TRUST PREFERRED SECURITIES In November 1999, the Company formed Prosperity Capital Trust I, a trust formed under the laws of the State of Delaware (the "Trust"). The Trust issued $12.0 million of 9.60% Trust Preferred Securities and invested the proceeds thereof in the 9.60% Junior Subordinated Deferrable Interest Debentures (the "Junior Subordinated Debentures") issued by the Company. The Junior Subordinated Debentures will mature on November 17, 2029, which date may be shortened to a date not earlier than November 17, 2004, if certain conditions are met (including the Company having received prior approval of the Federal Reserve and any other required regulatory approvals). The Trust Preferred Securities will be subject to mandatory redemption if the Junior Subordinated Debentures are repaid by the Company. The Junior Subordinated Debentures may be prepaid if certain events occur, including a change in the tax status or regulatory capital treatment of the Trust Preferred Securities. In each case, redemption will be made at par, plus the accrued and unpaid distributions thereon through the redemption date. 21. PARENT COMPANY ONLY FINANCIAL STATEMENTS PROSPERITY BANCSHARES, INC. (PARENT COMPANY ONLY) BALANCE SHEETS <TABLE> <CAPTION> December 31, --------------------------------- 1999 1998 --------- --------- (Dollars in thousands) ASSETS <S> <C> <C> Cash................................................. $ 2,993 $ 10,688 Investment in subsidiaries........................... 47,268 25,323 Investment in Prosperity Capital Trust I............. 380 -- Goodwill, net........................................ 4,914 5,380 Other assets......................................... 233 49 --------- --------- TOTAL................................................ $ 55,788 $ 41,440 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY LIABILITIES: Accrued interest payable and other liabilities.. $ 142 $ 5 Junior subordinated debentures.................. 12,380 -- --------- --------- Total liabilities......................... 12,522 5 --------- --------- SHAREHOLDERS' EQUITY: Common stock.................................... 5,199 5,176 Capital surplus................................. 15,880 16,477 Retained earnings............................... 24,889 19,452 Unrealized losses on available for sale securities, net of tax............... (2,684) 348 Less treasury stock, at cost (3,576 shares at December 31, 1999 and 1998, respectively)..... (18) (18) --------- --------- Total shareholders' equity............... 43,266 41,435 --------- --------- TOTAL................................................ $ 55,788 $ 41,440 ========= ========= </TABLE> F-23
62 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) PROSPERITY BANCSHARES, INC. (PARENT COMPANY ONLY) STATEMENTS OF INCOME <TABLE> <CAPTION> For the Years Ended December 31, ---------------------------------------------------- 1999 1998 1997 ---------- ----------- ----------- (Dollars in thousands) <S> <C> <C> <C> OPERATING INCOME: Dividends from subsidiaries.......... $ -- $ 995 $ 2,922 OPERATING EXPENSE: Interest expense..................... -- 24 120 Amortization of goodwill............. 466 463 392 Minority expense trust preferred securities......................... 142 -- -- Other expenses....................... 72 69 66 ---------- ----------- ----------- Total operating expense........ 680 556 578 ---------- ----------- ----------- INCOME BEFORE INCOME TAX BENEFIT AND EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES............................ (680) 439 2,344 FEDERAL INCOME TAX BENEFIT................. 178 136 137 ---------- ----------- ----------- INCOME BEFORE EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES................ (502) 575 2,481 EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES........................... 6,976 3,885 1,081 ---------- ----------- ----------- NET INCOME................................. $ 6,474 $ 4,460 $ 3,562 ========== =========== ========== </TABLE> F-24
63 PROSPERITY BANCSHARES, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) PROSPERITY BANCSHARES, INC. (PARENT COMPANY ONLY) STATEMENTS OF CASH FLOWS <TABLE> <CAPTION> For the Years Ended December 31, ------------------------------------ 1999 1998 1997 -------- -------- -------- (Dollars in thousands) <S> <C> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income ............................................ $ 6,474 $ 4,460 $ 3,562 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed earnings of subsidiaries ................................... (6,976) (3,885) (1,081) Amortization of goodwill ............................ 466 463 392 (Increase) in other assets .......................... (183) (38) (6) Accrued interest payable ............................ 142 -- -- (Decrease) increase in other liabilities ............ (6) -- 4 -------- -------- -------- Total adjustments ............................... (6,557) (3,460) (691) -------- -------- -------- Net cash flows (used in) provided by operating activities .................... (83) 1,000 2,871 -------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Premiums paid for branch acquisitions ................. -- (250) (1,990) Capital contribution to subsidiary ................... (380) (2,000) -- -------- -------- -------- Net cash flows used in investing activities ....................... (380) (2,250) (1,990) -------- -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Repayment of line of credit ........................... -- (2,000) (3,267) Proceeds from line of credit .......................... -- 2,000 -- Issuance of common stock .............................. 99 12,842 3,000 Initial public offering costs ......................... (113) Trust preferred securities issuance cost .............. (560) Payments of cash dividends ............................ (1,037) (1,057) (574) Transfer to Bank ...................................... (18,000) Proceeds from issuance of junior subordinated debentures ........................... 12,380 -- -- Sale of treasury stock ................................ -- -- 1 -------- -------- -------- Net cash flows (used in) provided by financing activities .................... (7,612) 11,785 (840) -------- -------- -------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS .................................. (7,695) 10,535 41 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ............................................. 10,688 153 112 -------- -------- -------- CASH AND CASH EQUIVALENTS, END OF PERIOD ................................................ $ 2,993 $ 10,688 $ 153 ======== ======== ======== </TABLE> F-25
64 EXHIBIT INDEX <TABLE> <CAPTION> EXHIBIT NUMBER DESCRIPTION ------- ----------- <S> <C> 2.1 - Agreement and Plan of Reorganization by and between the Company and South Texas Bancshares, Inc. dated June 17, 1999 (incorporated herein by reference to Exhibit 2.1 to the Company's Form 10-Q for the quarter ended June 30, 1999). 2.2 - Agreement and Plan of Reorganization dated June 5, 1998 by and among the Company, First Prosperity Bank and Union State Bank (incorporated herein by reference to Exhibit 10.4 to the Company's Registration Statement on Form S-1 (Registration No. 333-63267) (the "Registration Statement")). 3.1 - Amended and Restated Articles of Incorporation of the Company (incorporated herein by reference to Exhibit 3.1 to the Registration Statement. 3.2 - Amended and Restated Bylaws of the Company (incorporated herein by reference to Exhibit 3.2 to the Registration Statement). 4.1 - Specimen form of certificate evidencing the Common Stock (incorporated herein by reference to Exhibit 4 to the Registration Statement). 4.2 - Form of Indenture by and between the Company and First Union Trust Company, N.A. (incorporated herein by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-89481)). 4.3 - Form of Subordinated Debenture (included as an exhibit to Exhibit 4.2). 4.4 - Form of Trust Preferred Securities Guarantee Agreement by and between the Company and First Union Trust Company, N.A. (incorporated herein by reference to Exhibit 4.7 of the Company's Registration Statement of Form S-1 (Registration No. 333-89481)). 10.1 - Prosperity Bancshares, Inc. 1995 Stock Option Plan (incorporated herein by reference to Exhibit 10.1 to the Registration Statement). 10.2 - Prosperity Bancshares, Inc. 1998 Stock Incentive Plan (incorporated herein by reference to Exhibit 10.2 to the Registration Statement). 10.3 - Employment Agreements (incorporated herein by reference to Exhibit 10.3 to the Registration Statement). 10.5 - Loan Agreement dated December 27, 1997 between the Company and Norwest Bank Minnesota, National Association (incorporated herein by reference to Exhibit 10.5 to the Registration Statement). 21* - Subsidiaries of Prosperity Bancshares, Inc. 23.1* - Consent of Deloitte & Touche LLP. 27* - Financial Data Schedule. </TABLE>