1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 Form 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR ENDED DECEMBER 31, 1998 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 0-12247 SOUTHSIDE BANCSHARES, INC. (Exact name of registrant as specified in its charter) TEXAS 75-1848732 (State of incorporation) (I.R.S. Employer Identification No.) 1201 S. BECKHAM, TYLER, TEXAS 75701 (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including area code: (903) 531-7111 Securities registered pursuant to Section 12(b) of the Act: Name of each exchange Title of each class on which registered ------------------- --------------------- NONE NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK (Title of Class) Indicate by check mark whether the registrant (l) 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 this Form 10-K or any amendment to this Form 10-K. [X] As of March 9, 1999, 3,685,775 shares of common stock of Southside Bancshares, Inc. were outstanding. The aggregate market value of common stock held by nonaffiliates of the registrant as of January 31, 1999 was $49,000,940. DOCUMENTS INCORPORATED BY REFERENCE Registrant's Proxy Statement to be filed for the Annual Meeting of Shareholders to be held April 28, 1999. (Part III) ================================================================================
2 PART I ITEM 1. BUSINESS GENERAL Southside Bancshares, Inc. (the "Company") is a Texas corporation organized in 1982 that serves as a bank holding company for Southside Bank (the "Bank"), a Texas-chartered bank organized in 1960. The Company owns all of the capital stock of Southside Delaware Financial Corporation, a Delaware corporation ("Southside Delaware"), that in turn owns all of the capital stock of the Bank. The Company and the Bank are headquartered in Tyler, Texas, which is located approximately 90 miles east of Dallas, Texas and 90 miles west of Shreveport, Louisiana. The Bank has the largest deposit base in the Tyler metropolitan area, which has a population of approximately 166,000, and is the largest independent bank headquartered in East Texas. At December 31, 1998, the Company had total assets of $876.3 million, loans of $319.7 million, deposits of $515.0 million, and shareholders' equity of $46.4 million. The Bank is a community-focused financial institution that offers a full range of financial services to individuals, businesses and nonprofit organizations in its primary market area. These services include consumer and commercial loans, deposit accounts, trust services, safe deposit services and brokerage services. The Bank's consumer loan services include 1-4 family residential mortgage loans and home improvement loans, automobile loans and other installment loans. The Bank also offers its own credit card and began offering home equity loans in January 1998 when a new Texas law first permitting such loans took effect. Commercial loan services include short-term working capital loans for inventory and accounts receivable, short and medium-term loans for equipment or other business capital expansion and commercial real estate loans. The Bank also offers construction loans primarily for owner-occupied 1-4 family residential and commercial real estate. The Bank offers a variety of deposit accounts having a wide range of interest rates and terms, including savings, money market, interest and noninterest bearing checking accounts and certificate accounts. The Bank's trust services include investment, management, administration and advisory services, primarily for individuals and to a lesser extent partnerships and corporations. At December 31, 1998, the Bank's trust department managed approximately $148 million of trust assets. Through its 25%-owned securities brokerage affiliate, BSC Securities, L.C., the Bank offers full retail investment services to its customers. In early 1997, the Company formed a consumer finance subsidiary, Countywide Loans, Inc. ("Countywide"), to provide basic financial services such as small loans, check cashing and money orders to individuals. The Bank considers its primary market area to be all of Smith and Gregg Counties, Texas, and to a lesser extent portions of adjoining counties. The principal economic activities in the Bank's market area include the retail, distribution, manufacturing, medical services, education and oil and gas industries. The Bank serves this market through eleven full service branch locations, including six branches located in grocery stores. The branches are located in and around Tyler and Longview. The Company opened two branches in 1998 in Longview, Texas, a city located approximately 35 miles east of Tyler in adjoining Gregg County. A native Longview banking veteran joined the Bank to lead the Company in its expansion into the Longview market area. The Company's television and radio advertising has extended into this market area for several years, providing the Bank name recognition in the Greater Longview area. The Bank also maintains three drive up facilities, and Countywide maintains one sales location. The Bank's customers may also access various banking services through 19 automated teller machines ("ATMs") owned by the Bank and ATMs owned by others, through debit cards, and through the Bank's automated telephone and electronic banking products that allow the Bank's customers to apply for loans, access account information and conduct various transactions from their telephones and computers. 1
3 The Company reported net income of $5.3 million and $5.0 million and diluted earnings per share of $1.46 and $1.36 for the years ended December 31, 1998 and 1997, respectively. The Company instituted a cash dividend in 1970 and has paid dividends each year since that time. The Company and the Bank are subject to comprehensive regulation, examination and supervision by the Board of Governors of the Federal Reserve System (the "FRB"), the Texas Department of Banking (the "TDB") and the Federal Depository Insurance Corporation (the "FDIC"), and are subject to numerous laws and regulations relating to the extension of credit and making of loans to individuals. The administrative offices of the Company are located at 1201 S. Beckham, Tyler, Texas 75701, and the telephone number is 903-531-7111. The Company's website can be found at www.southside.com. MARKET AREA The Company's market area is primarily Smith and Gregg Counties in East Texas. During 1998, the Company opened two branches in Gregg County. While the Gregg County market area is expected to grow during the coming years, at present, Tyler, Texas in Smith County, represents the Company's primary market area. Tyler's industry base is a diverse mix that includes oil and gas, manufacturing, distribution, conventions and tourism, as well as retirement relocation, to name a few. All of these support a growing regional system of medical service, retail and education centers. Tyler is home to several nationally recognized health care systems. Tyler hospitals represent all major specialties and employ over 6,000 individuals. In 1996, Target Stores chose a location in the greater Tyler area along Interstate 20 for its $80 million distribution center that will employ approximately 900 workers. This facility began operations in mid 1998. LENDING ACTIVITIES The Company's main objective is to seek attractive lending opportunities in East Texas, primarily in Smith and Gregg Counties. Substantially all of the Bank's loans are made to borrowers who live in and conduct business in East Texas. Total loans as of December 31, 1998 increased $23.7 million or 8.0% while the average balance was up $29.7 million or 10.8% when compared to 1997. Real estate loans as of December 31, 1998 increased $29.5 million or 20.7% from December 31, 1997. Loans to individuals decreased $11.8 million or 12.9% from December 31, 1997 and commercial loans increased $6.0 million or 9.7%. The increase in real estate loans is due to a stronger real estate market, lower interest rates and an increased commitment by the Company to residential mortgage lending. Commercial loans increased as a result of commercial growth in the Company's market area. Loans to individuals decreased due to a decision by management that effective January 2, 1998, the Company exited its indirect dealer loan line of business to concentrate more on direct automobile loans. In the portfolio, loans dependent upon private household income represent a significant concentration. Due to the number of customers involved who work in all sectors of the local economy, the Company believes the risk in this portion of the portfolio is adequately spread throughout the economic community. The aggregate amount of loans that the Bank is permitted to make under applicable bank regulations to any one borrower, including related entities, is 25% of unimpaired capital and surplus. The Bank's legal lending limit at December 31, 1998 was $7.5 million. The Bank's largest loan relationship at December 31, 1998 was approximately $4.4 million. The average yield on loans for the year ended December 31, 1998 decreased slightly to 8.56% from 8.68% for the year ended December 31, 1997. This decrease was reflective of the repricing characteristics of the loans and the decrease in lending rates during 1998. 2
4 LOANS TO AFFILIATED PARTIES In the normal course of business, the Company's subsidiary, Southside Bank, makes loans to certain of the Company's, as well as its own, officers, directors, employees and their related interests. As of December 31, 1998 and 1997, these loans totaled $9.1 million and $8.6 million or 19.6% and 21.6% of Shareholders' Equity, respectively. Such loans are made in the normal course of business at normal credit terms, including interest rate and collateral requirements and do not represent more than normal credit risks contained in the rest of the loan portfolio for loans of similar types. LOAN PORTFOLIO COMPOSITION AND ASSOCIATED RISK For purposes of this discussion, the Company's loans are divided into three categories: Real Estate Loans, Commercial Loans, and Loans to Individuals. REAL ESTATE LOANS Real estate loans are divided into three categories: 1-4 Family Residential Mortgage Lending, Construction Loans and Commercial Real Estate Loans. Real estate loans represent the Company's greatest concentration of loans. However, the amount of risk associated with this group of loans is mitigated in part due to the type of loans involved. At December 31, 1998, the vast majority of the Company's real estate loans were collateralized by properties located in Smith and Gregg Counties. Of the $171.9 million in real estate loans, $93.2 million or 54.2% represent loans collateralized by residential dwellings that are primarily owner occupied. Historically, the amount of losses suffered on this type of loan has been significantly less than those on other properties. A significant portion of the remaining real estate loans are collateralized primarily with owner occupied commercial real estate. The Company's loan policy requires appraisal prior to funding any real estate loans and also outlines the requirements for appraisals on renewals. The real estate market in the late 1980s in Texas, and more specifically in East Texas, experienced a significant decline in market value. During the 1990s, new appraisals of real estate in the Company's market area indicate improved overall real estate values for residential and commercial properties. Due to the volume of real estate loans contained in the Company's portfolio which are collateralized by owner occupied properties, and the appraisal and other real estate lending policies in place that indicate the value of the collateral for these loans, management does not consider the potential impact of these loans on the loan loss reserve to be excessive, even though real estate loans constitute the largest percentage of loans outstanding. Management also pursues an aggressive policy of reappraisal on any real estate loan that becomes troubled and potential exposures are recognized and reserved for as soon as they are identified. However, the slow pace of absorption for certain types of properties could adversely affect the volume of nonperforming real estate loans held by the Company. 1-4 Family Residential Mortgage Lending Residential loan originations are generated by the Company's in-house originations staff, marketing efforts, present customers, walk-in customers and referrals from real estate agents, mortgage brokers and builders. The Company focuses its lending efforts primarily on the origination of loans secured by first mortgages on owner-occupied, 1-4 family residences. Substantially all of the Company's 1-4 family residential mortgage originations are secured by properties located in Smith and Gregg Counties, Texas. Historically, the Company has sold a portion of its loan originations to secondary market investors pursuant to ongoing purchase commitments. 3
5 The Company's fixed rate 1-4 family residential mortgage loans generally have maturities ranging from seven to 30 years. These loans are typically fully amortizing with monthly payments sufficient to repay the total amount of the loan. The Company also makes seven to 30 year amortizing loans with a balloon feature, typically due in seven years or less. The Company reviews information concerning the income, financial condition, employment and credit history when evaluating the creditworthiness of the applicant. In November 1997, Texas voters approved a change to the Texas Constitution allowing home equity loans. The Company began offering this form of real estate lending beginning January 1, 1998 when the law became effective. The Company has established underwriting and pricing guidelines for this lending area. Construction Loans The Company's construction loans are secured by property located primarily in the Company's market area. The Company's emphasis for construction loans is directed toward properties that will be owner occupied. Occasionally, construction loans for projects built on speculation are financed, but these typically have substantial secondary sources of repayment. The Company's construction loans to individuals generally have fixed interest rates during the construction period. Construction loans to individuals are typically made in connection with the granting of the permanent loan on the property. Commercial Real Estate Loans In determining whether to originate commercial real estate loans, the Company generally considers such factors as the financial condition of the borrower and the debt service coverage of the property. Commercial real estate loans are made at both fixed and adjustable interest rates for terms generally up to 20 years. Commercial real estate loans primarily include commercial office buildings, retail, medical and warehouse facilities, hotels and churches. The majority of these loans, with the exception of those for hotels and churches, are collateralized by owner occupied properties. COMMERCIAL LOANS The Company's commercial loans are diversified to meet most business needs. Loan types include short-term working capital loans for inventory and accounts receivable and short and medium-term loans for equipment or other business capital expansion. Management does not consider there to be any material concentration of risk in any one industry type, other than medical, in this loan category since no industry classification represents over 10% of loans. The medical community represents a concentration of risk in the Company's Commercial loan and Commercial Real Estate loan portfolio (see "Market Area"). Risk in the medical community is mitigated because it is spread among multiple practice types and multiple specialties. Commercial loans traditionally generate the largest volume of loan losses in the portfolio. In its commercial business loan underwriting, the Company assesses the creditworthiness, ability to repay, and the value and liquidity of the collateral being offered. Terms are generally granted commensurate with the useful life of the collateral offered. LOANS TO INDIVIDUALS The Bank is a major consumer lender in its trade territory and has been for many years. The majority of consumer loans outstanding are those secured by vehicles, including the "indirect" vehicle loan portfolio, which at December 31, 1998 was approximately $25 million. The indirect vehicle loans on the Company's books were originated through automobile dealers but 4
6 underwritten directly by the Company using the same underwriting guidelines used for its direct vehicle loans. However, due to market forces that were contributing to declining profit margins on indirect vehicle loans, the Company exited the indirect vehicle loan program effective January 2, 1998 to concentrate on direct vehicle loans. Direct vehicle loans accounted for approximately $52 million at December 31, 1998. Additionally, the Company makes loans for a full range of other consumer purposes, which may be secured or unsecured depending on the credit quality and purpose of the loan. Other major categories for the remainder of the portfolio include loans secured by boats and cash or equivalently secured loans. At this point, the economy in the Bank's trade territory appears stable. One area of concern is the high nationwide personal bankruptcy rate. Management expects this trend to have some adverse effect on the Company's net charge-offs. Most of the Company's loans to individuals are collateralized, which management believes will limit the exposure in this area should current bankruptcy trends continue. Consumer loan terms vary according to the type and value of collateral, length of contract and creditworthiness of the borrower. The underwriting standards employed by the Company for consumer loans include an application, a determination of the applicant's payment history on other debts, with greatest weight being given to payment history with the Company, and an assessment of the borrower's ability to meet existing obligations and payments on the proposed loan. Although creditworthiness of the applicant is a primary consideration, the underwriting process also includes a comparison of the value of the collateral, if any, in relation to the proposed loan amount. LOAN PORTFOLIO COMPOSITION The following table sets forth loan totals by category for the years presented: <TABLE> <CAPTION> December 31, ---------------------------------------------------------------- 1998 1997 1996 1995 1994 ----------- ----------- ------------ ----------- ----------- (in thousands) <S> <C> <C> <C> <C> <C> Real Estate Loans: Construction.............................. $ 10,509 $ 10,299 $ 7,821 $ 4,558 $ 6,118 1-4 Family Residential.................... 93,215 76,243 62,356 49,909 38,563 Other..................................... 68,140 55,802 57,198 54,436 53,881 Commercial Loans............................. 67,977 61,972 51,307 44,217 39,707 Loans to Individuals......................... 79,882 91,719 79,485 75,658 62,721 ----------- ----------- ----------- ----------- ----------- Total Loans............................... $ 319,723 $ 296,035 $ 258,167 $ 228,778 $ 200,990 =========== =========== =========== =========== =========== </TABLE> The following table represents loan maturities and sensitivity to changes in interest rates. The amounts of total loans outstanding at December 31, 1998, which, based on remaining scheduled repayments of principal, are due in (1) one year or less*, (2) more than one year but less than five years, and (3) more than five years*, are shown in the following table. The amounts due after one year are classified according to the sensitivity to changes in interest rates. <TABLE> <CAPTION> After One Due in One but within After Five Year or Less Five Years Years ---------------- ---------------- ---------------- (in thousands) <S> <C> <C> <C> Construction Loans......................................... $ 7,851 $ 2,437 $ 221 Real Estate Loans-Other.................................... 42,298 62,063 56,994 Commercial Loans........................................... 48,235 17,451 2,291 All Other Loans............................................ 38,666 40,785 431 ---------------- ---------------- ---------------- Total Loans.......................................... $ 137,050 $ 122,736 $ 59,937 ================ ================ ================ </TABLE> 5
7 <TABLE> <S> <C> Loans with Maturities After One Year for Which: Interest Rates are Fixed or Predetermined $ 182,241 Interest Rates are Floating or Adjustable $ 20,542 </TABLE> * The volume of commercial loans due within one year reflects the Company's general policy of limiting such loans to a short-term maturity. Loans are shown net of unearned discount. Nonaccrual loans are reflected in the due after five years column. LOAN LOSS EXPERIENCE AND RESERVE FOR LOAN LOSSES The loan loss reserve in place at the end of each year is based on the most current review of the loan portfolio at that time. Several methods are used to maintain the review in the most current manner. First, the servicing officer has the primary responsibility for updating significant changes in a customer's financial position. Accordingly, each officer prepares status updates on any credit deemed to be experiencing repayment difficulties which, in the officer's opinion, would place the collection of principal or interest in doubt. Second, an internal review officer from the Company is responsible for an ongoing review of the Company's entire loan portfolio with specific goals set for the volume of loans to be reviewed on an annual basis. Third, Southside Bank is regulated and examined by both the FDIC and/or the Texas Department of Banking on an annual basis. At each review of a credit, a subjective analysis methodology is used to grade the respective loan. Categories of grading vary in severity to include loans which do not appear to have a significant probability of loss at the time of review to grades which indicate a probability that the entire balance of the loan will be uncollectible. If full collection of the loan balance appears unlikely at the time of review, estimates or appraisals of the collateral securing the debt are used to allocate the necessary reserves. A list of loans which are graded as having more than the normal degree of risk associated with them is maintained by the internal review officer. This list is updated on a periodic basis, but no less than quarterly by the servicing officer in order to properly allocate necessary reserves and keep management informed on the status of attempts to correct the deficiencies noted in the credit. In addition to maintaining an ongoing review of the loan portfolio, the internal review officer maintains a history of the loans that have been charged-off without first being identified as problems. This history is used to determine the amount of nonspecifically allocated reserve necessary, in addition to the portion which is specifically allocated by loan. As of December 31, 1998, the Company's review of the loan portfolio indicates that a loan loss reserve of $3.6 million is adequate. The table on the following page summarizes the average amount of net loans outstanding; changes in the reserve for loan losses arising from loans charged-off and recoveries on loans previously charged-off; additions to the reserve which have been charged to operating expense; the ratio of net loans charged-off to average loans outstanding; and an allocation of the reserve for loan loss. 6
8 LOAN LOSS EXPERIENCE AND RESERVE FOR LOAN LOSSES <TABLE> <CAPTION> Years Ended December 31, -------------------------------------------------------------- 1998 1997 1996 1995 1994 ---------- ---------- ---------- ---------- ---------- (dollars in thousands) <S> <C> <C> <C> <C> <C> Average Net Loans Outstanding.......................... $ 304,255 $ 274,577 $ 243,925 $ 209,141 $ 196,436 ========== ========== ========== ========== ========== Balance of Reserve for Loan Loss at Beginning of Period................................ $ 3,370 $ 3,249 $ 3,317 $ 3,137 $ 2,846 ---------- ---------- ---------- ---------- ---------- Loan Charge-Offs: Real Estate-Construction............................... Real Estate-Other...................................... (175) (36) (6) Commercial Loans....................................... (405) (525) (70) (61) (129) Loans to Individuals................................... (769) (704) (768) (502) (395) ---------- ---------- ---------- ---------- ---------- Total Loan Charge-Offs ................................ (1,349) (1,229) (838) (599) (530) ---------- ---------- ---------- ---------- ---------- Recovery on Loans Previously Charged off: Real Estate-Construction............................... 10 Real Estate-Other...................................... 36 14 7 272 93 Commercial Loans....................................... 90 133 78 546 326 Loans to Individuals................................... 202 188 185 261 152 ---------- ---------- ---------- ---------- ---------- Total Recovery of Loans Previously Charged-Off......... 328 345 270 1,079 571 ---------- ---------- ---------- ---------- ---------- Net Loan (Charge-Offs) Recoveries...................... (1,021) (884) (568) 480 41 Additions (Reductions) to Reserve Charged (Credited) to Operating Expense............ 1,215 1,005 500 (300) 250 ---------- ---------- ---------- ---------- ---------- Balance at End of Period............................... $ 3,564 $ 3,370 $ 3,249 $ 3,317 $ 3,137 ========== ========== ========== ========== ========== Ratio of Net Charge-Offs (Recoveries) to Average Loans Outstanding....................... .34% .32% .23% (.23%) (.02%) ========== ========== ========== ========== ========== </TABLE> Allocation of Reserve for Loan Loss (dollars in thousands): <TABLE> <CAPTION> December 31, ------------------------------------------------------------------------------------------------------ 1998 1997 1996 1995 1994 ----------------- ---------------- ----------------- ---------------- ----------------- % of % of % of % of % of Amount Total Amount Total Amount Total Amount Total Amount Total ------- ------ ------ ----- ------ ----- ------ ----- ------ ----- <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Real Estate-Construction $ 52 1.5% $ 52 1.5% $ 39 1.2% $ 23 .7% $ 31 1.0% Real Estate-Other ...... 1,291 36.2% 1,087 32.3% 1,059 32.6% 1,209 36.4% 1,127 35.9% Commercial Loans ....... 1,182 33.2% 1,181 35.0% 1,129 34.7% 1,059 31.9% 1,059 33.8% Loans to Individuals ... 1,017 28.5% 1,040 30.9% 948 29.2% 934 28.2% 835 26.6% Unallocated ............ 22 .6% 10 .3% 74 2.3% 92 2.8% 85 2.7% ------ ----- ------ ----- ------ ----- ------ ----- ------ ----- Balance at End of Period $3,564 100% $3,370 100% $3,249 100% $3,317 100% $3,137 100% ====== ===== ====== ===== ====== ===== ====== ===== ====== ===== </TABLE> See "Consolidated Financial Statements - Note 4. Loans and Reserve for Possible Loan Losses." 7
9 NONPERFORMING ASSETS Nonperforming assets consist of delinquent loans over 90 days past due, nonaccrual loans, other real estate owned and restructured loans. Nonaccrual loans are those loans which are more than 90 days delinquent and collection in full of both the principal and interest is in doubt. Additionally, some loans that are not delinquent may be placed on nonaccrual status due to doubts about full collection of principal or interest. When a loan is categorized as nonaccrual, the accrual of interest is discontinued and the accrued balance is reversed for financial statement purposes. Other Real Estate Owned (OREO) represents real estate taken in full or partial satisfaction of debts previously contracted. Previously included in the appropriate categories of nonperforming assets were loans meeting the in-substance foreclosure criteria. As a result of the adoption of Statement of Financial Accounting Standard No. 114, "Accounting by Creditors for Impairment of a Loan" (FAS114), effective January 1, 1995, the Company reclassified in-substance foreclosed assets in these categories to loans. These loans had balances of $807,000 for December 31, 1994. The OREO consists primarily of raw land. The Company is actively marketing all properties and none are being held for investment purposes. Restructured loans represent loans which have been renegotiated to provide a reduction or deferral of interest or principal because of deterioration in the financial position of the borrowers. Categorization of a loan as nonperforming is not in itself a reliable indicator of potential loan loss. Other factors, such as the value of collateral securing the loan and the financial condition of the borrower must be considered in judgments as to potential loan loss. The following table of nonperforming assets is classified according to bank regulatory call report guidelines: <TABLE> <CAPTION> NONPERFORMING ASSETS (dollars in thousands) December 31, ------------------------------------------------------ 1998 1997 1996 1995 1994 ------ ------ ------ ------ ------ <S> <C> <C> <C> <C> <C> Loans 90 Days Past Due: Real Estate ................ $ 412 $ 454 $ 214 $ 266 $ 51 Loans to Individuals ....... 44 232 170 203 52 Commercial ................. 120 56 88 183 59 ------ ------ ------ ------ ------ 576 742 472 652 162 Loans on Nonaccrual: Real Estate ................ 2 108 646 486 424 Loans to Individuals ....... 263 177 113 116 179 Commercial ................. 167 1,059 774 654 24 ------ ------ ------ ------ ------ 432 1,344 1,533 1,256 627 Restructured Loans: Real Estate ................ 197 214 230 243 563 Loans to Individuals ....... 222 189 108 49 51 Commercial ................. 54 32 62 44 43 ------ ------ ------ ------ ------ 473 435 400 336 657 Total Nonperforming Loans ..... 1,481 2,521 2,405 2,244 1,446 Other Real Estate Owned ....... 195 364 273 273 1,134 Repossessed Assets ............ 326 206 262 240 256 ------ ------ ------ ------ ------ Total Nonperforming Assets .... $2,002 $3,091 $2,940 $2,757 $2,836 ====== ====== ====== ====== ====== Percentage of Total Assets .... .2% .5% .6% .6% .7% Percentage of Loans and Leases, Net of Unearned Income ..... .6% 1.0% 1.1% 1.2% 1.4% </TABLE> 8
10 Total nonperforming assets decreased $1,089,000 between December 31, 1997 and December 31, 1998. Nonperforming assets as a percentage of assets decreased .3% from the previous year and as a percentage of loans decreased .4%. Nonperforming assets represent a drain on the earning ability of the Company. Earnings losses are due both to the loss of interest income and the costs associated with maintaining the OREO, for taxes, insurance and other operating expenses. In addition to the nonperforming assets, at December 31, 1998 in the opinion of management, the Company had $296,000 of loans identified as potential problem loans. A potential problem loan is a loan where information about possible credit problems of the borrower is known, causing management to have serious doubts about the ability of the borrower to comply with the present loan repayment terms and may result in a future classification of the loan in one of the nonperforming asset categories. The following is a summary of the Company's recorded investment in loans (primarily nonaccrual loans) for which impairment has been recognized in accordance with FAS114 (in thousands): <TABLE> <CAPTION> Valuation Carrying Total Allowance Value ------------ ------------ ------------ <S> <C> <C> <C> Real Estate Loans...................................................... $ 2 $ $ 2 Commercial Loans....................................................... 167 32 135 Loans to Individuals................................................... 263 49 214 ------------ ------------ ------------ Balance at December 31, 1998........................................... $ 432 $ 81 $ 351 ============ ============ ============ </TABLE> <TABLE> <CAPTION> Valuation Carrying Total Allowance Value ------------ ------------ ------------ <S> <C> <C> <C> Real Estate Loans...................................................... $ 108 $ 27 $ 81 Commercial Loans....................................................... 1,059 185 874 Loans to Individuals................................................... 177 12 165 ------------ ------------ ------------ Balance at December 31, 1997........................................... $ 1,344 $ 224 $ 1,120 ============ ============ ============ </TABLE> For the years ended December 31, 1998 and 1997, the average recorded investment in impaired loans was approximately $665,000 and $1,450,000, respectively. During the year ended December 31, 1998, the amount of interest income reversed on impaired loans placed on nonaccrual and the amount of interest income subsequently recognized on the cash basis was not material. The net amount of interest recognized on loans that were nonaccruing or restructured during the year was $94,000, $110,000 and $97,000 for the years ended December 31, 1998, 1997 and 1996, respectively. If these loans had been accruing interest at their original contracted rates, related income would have been $113,000, $336,000 and $216,000 for the years ended December 31, 1998, 1997 and 1996, respectively. The following is a summary of the Allowance for Losses on Other Real Estate Owned for the years presented (in thousands): <TABLE> <CAPTION> Years Ended December 31, --------------------------------- 1998 1997 -------------- -------------- <S> <C> <C> Balance at beginning of year................................................ $ 672 $ 946 Disposition of OREO..................................................... (14) (274) -------------- -------------- Balance at end of year...................................................... $ 658 $ 672 ============== ============== </TABLE> 9
11 SECURITIES ACTIVITY The securities portfolio of the Company plays a primary role in management of the interest rate sensitivity of the Company and, therefore, is managed in the context of the overall balance sheet. The Securities portfolio generates a substantial percentage of the Company's interest income and serves as a necessary source of liquidity. The Company accounts for debt and equity securities as follows: Held to Maturity (HTM). Debt securities that management has the positive intent and ability to hold until maturity are classified as held to maturity and are carried at their remaining unpaid principal balance, net of unamortized premiums or unaccreted discounts. Premiums are amortized and discounts are accreted using the level interest yield method over the estimated remaining term of the underlying security. Available for Sale (AFS). Debt and equity securities that will be held for indefinite periods of time, including securities that may be sold in response to changes in market interest or prepayment rates, needs for liquidity and changes in the availability of and the yield of alternative investments are classified as available for sale. These assets are carried at market value. Market value is determined using published quotes as of the close of business. Unrealized gains and losses are excluded from earnings and reported net of tax as a separate component of shareholders' equity until realized. Prudent management of the investment securities portfolio serves to optimize portfolio yields. Management attempts to deploy investable funds into instruments which are expected to increase the overall return of the portfolio given the current assessment of economic and financial conditions. Average Securities increased $143.8 million or 78.8% during the year ended December 31, 1998 compared to 1997. Beginning in the second quarter and continuing through the fourth quarter, the Company leveraged the balance sheet to offset the interest expense associated with the Trust Preferred Securities issued. The leverage strategy consisted of borrowing long and short-term funds from FHLB Dallas and investing the funds primarily in municipal and mortgage-backed securities. This accounted for the increase in Average Securities. The mix of Average Securities between taxable and tax-exempt securities remained unchanged at 78.8% taxable and 21.2% tax-exempt for the years ended 1998 and 1997. Average Other Interest Earning Assets, consisting primarily of Federal Funds Sold, increased $.5 million or 18.6% during the year ended December 31, 1998 compared to 1997. The mix of taxable securities reflected an increase in Mortgage-backed Securities. Average Mortgage-backed Securities represented 69.4% of the total securities portfolio for 1998 compared to 66.3% for 1997. The combined Investment Securities, Mortgage-backed Securities, and Marketable Equity Securities portfolio increased to $488.0 million on December 31, 1998, compared to $216.5 million on December 31, 1997, an increase of $271.5 million or 125.4%. Mortgage-backed Securities increased $199.6 million or 141.1% during 1998 when compared to 1997. State and Political Subdivisions increased $42.9 million or 90.0% during 1998. U.S. Treasury securities decreased during 1998 compared to 1997 by $.8 million or 3.8%, U.S. Government Agency securities increased $20.3 million or 1,413.9% and Other Stocks and Bonds increased $9.5 million or 156.6% in 1998 compared to 1997 due to increased purchases of FHLB stock. During 1997 and 1998 a barbell approach was primarily used with respect to securities purchased, i.e., the majority of the securities purchased included short duration premium mortgage-backed securities balanced with longer duration municipal securities. Municipal securities were selected for the longer duration portion of the portfolio due to the fact that when treasury rates increase, municipal rates typically increase 66% as much as treasury rates due to the tax-free status of the municipals. This created the same duration as would have been obtained by purchasing intermediate duration securities. During the second half of 1997 10
12 and 1998 rates decreased and the yield curve flattened as the spread between the two year treasury yield and thirty year treasury yield narrowed. The Company continued to use the barbell approach during most of 1997 and 1998, however some intermediate term securities were purchased during 1998. In order to maintain the barbell strategy, a continued change in the securities portfolio mix was required and resulted in the changes discussed above during 1997 and 1998. The increase in U.S. Agency securities occurred primarily in December 1998 as short-term agency securities were purchased to pledge as collateral for a public funds account, which accumulates large balances during the time period December through February each year. The market value of the Securities portfolio at December 31, 1998 was $488.0 million, which represented a net unrealized gain on that date of $7.4 million. The net unrealized gain was comprised of $8.4 million in unrealized gains and $1.0 million of unrealized losses. Net unrealized gains and losses on securities available for sale, which is a component of Shareholders' Equity on the consolidated balance sheet, can fluctuate significantly as a result of changes in interest rates. Because management cannot predict the future direction of interest rates, the effect on Shareholders' Equity in the future cannot be determined; however, this risk is monitored closely through the use of shock tests on the available for sale securities portfolio using an array of interest rate assumptions. In October 1995, the Financial Accounting Standards Board issued an implementation guide to FAS115 which allowed entities to reclassify their securities among the three categories provided in FAS115. There were no securities transferred from AFS to HTM or sales from the HTM portfolio during the years ended December 31, 1998 or 1997. The following table sets forth the carrying amount of Investment Securities, Mortgage-backed Securities and Marketable Equity Securities at December 31, 1998 and 1997 (in thousands): <TABLE> <CAPTION> December 31, -------------------------------------------- Available for Sale: 1998 1997 ------------------- -------------------- <S> <C> <C> U. S. Treasury .................................................... $ 19,198 $ 19,956 U. S. Government Agencies.......................................... 21,377 631 Mortgage-backed Securities: Direct Govt. Agency Issues...................................... 229,707 93,981 Other Private Issues............................................ 103,487 33,770 State and Political Subdivisions................................... 90,533 47,658 Other Stocks and Bonds............................................. 15,510 6,044 ------------------- -------------------- Total........................................................ $ 479,812 $ 202,040 =================== ==================== </TABLE> <TABLE> <CAPTION> December 31, -------------------------------------------- Held to Maturity: 1998 1997 ------------------- -------------------- <S> <C> <C> U. S. Government Agencies.......................................... $ 347 $ 804 Mortgage-backed Securities: Direct Govt. Agency Issues...................................... 7,810 13,662 ------------------- -------------------- Total........................................................ $ 8,157 $ 14,466 =================== ==================== </TABLE> 11
13 The maturities classified according to the sensitivity to changes in interest rates of the December 31, 1998 securities portfolio and the weighted yields are presented below. Tax-exempt obligations are shown on a taxable equivalent basis. Mortgage-backed securities are classified according to repricing frequency and cash flows from street estimates of principal prepayments. <TABLE> <CAPTION> MATURING OR REPRICING ------------------------------------------------------------------------------------------ (dollars in thousands) After 1 But After 5 But Within 1 Yr. Within 5 Yrs. Within 10 Yrs. After 10 Yrs ------------------- -------------------- -------------------- ------------------- Available For Sale: Amount Yield Amount Yield Amount Yield Amount Yield ----------- ----- ---------- ----- --------- ------ -------- ----- <S> <C> <C> <C> <C> <C> <C> <C> <C> U.S. Treasury....................... $ 19,198 5.10% $ $ $ U.S. Government Agencies............ 54 9.00% 6,097 5.62% 13,463 5.28% 1,763 6.89% Mortgage-backed Securities.......... 86,644 5.81% 173,299 5.84% 54,207 5.90% 19,044 6.14% State and Political Subdivisions.... 1,384 8.48% 4,240 7.90% 10,001 7.82% 74,908 7.48% Other Stocks and Bonds.............. 13,871 3.17% 1,339 6.31% 300 3.06% ---------- --------- --------- -------- Total.......................... $ 121,151 5.43% $ 184,975 5.88% $ 77,671 6.04% $ 96,015 7.19% ========== =========== ========= ======== </TABLE> <TABLE> <CAPTION> MATURING OR REPRICING ------------------------------------------------------------------------------------------ (dollars in thousands) After 1 But After 5 But Within 1 Yr. Within 5 Yrs. Within 10 Yrs. After 10 Yrs -------------------- ---------------------- ------------------- -------------------- Held to Maturity: Amount Yield Amount Yield Amount Yield Amount Yield ---------- ----- ----------- ------- ----------- ----- ----------- ----- <S> <C> <C> <C> <C> <C> <C> <C> U.S. Government Agencies......... $ 347 5.42% $ $ $ Mortgage-backed Securities....... 5,728 5.28% 2,082 5.88% ---------- ----------- ----------- ----------- Total............................ $ 6,075 5.29% $ 2,082 5.88% $ $ ========== =========== =========== =========== </TABLE> DEPOSITS AND BORROWED FUNDS Deposits provide the Company with its primary source of funds. The increase of $52.4 million or 11.3% in Total Deposits during 1998 provided the Company with funds for the growth in loans and a portion of the growth in securities. Time Deposits increased $17.9 million or 7.9% during 1998 compared to 1997. Noninterest Bearing Demand Deposits increased during 1998 $23.8 million or 24.2%. Interest Bearing Demand Deposits increased during 1998 $9.1 million or 7.5% and Saving Deposits increased $1.5 million or 9.2%. The latter three categories, which are considered the lowest cost deposits, comprised 52.6% of total deposits at December 31, 1998 compared to 51.1% at December 31, 1997. The increase in Total Deposits is reflective of overall bank growth and branch expansion and was the primary source of funding the increase in Loans. 12
14 The following table sets forth the Company's deposits by category for the years ended December 31, 1998 and 1997: <TABLE> <CAPTION> Years Ended December 31, ------------------------------------------ 1998 1997 ---------------- ------------------ (in thousands) <S> <C> <C> Noninterest Bearing Demand Deposits.................................... $ 122,440 $ 98,592 Interest Bearing Demand Deposits....................................... 130,940 121,861 Savings Deposits....................................................... 17,649 16,155 Time Deposits.......................................................... 244,005 226,066 ----------------- ------------------ Total Deposits................................................. $ 515,034 $ 462,674 ================= ================== </TABLE> Short-term Obligations, consisting primarily of FHLB Dallas advances and Federal Funds Purchased, increased $89.2 million or 258.2% during 1998 when compared to 1997. This increase reflects a strategically planned increase in balance sheet leverage to achieve certain Asset/Liability Management committee ("ALCO")objectives. Long-term Obligations primarily consisting of FHLB Dallas advances and Junior Subordinated Debentures increased in 1998 to $176.0 million or a 516.6% increase compared to $28.5 million in 1997. The advances were obtained from FHLB Dallas to fund long-term loans and as part of a strategically planned increase in balance sheet leverage to achieve certain ALCO objectives. FHLB Dallas advances are collateralized by FHLB Dallas stock, nonspecified real estate loans and securities. On May 18, 1998, the Company through its wholly-owned subsidiary, Southside Capital Trust (the "Trust Issuer") sold 2,000,000 Preferred Securities at a liquidation amount of $10 per Preferred Security for an aggregate amount of $20,000,000. It has a distribution rate of 8.50% per annum payable at the end of each calendar quarter. During the year ended December 31, 1998 total certificates of deposit of $100,000 or more increased $13.8 million or 17.9% from December 31, 1997. This increase was due to overall bank growth and an increase in Public Funds. The table below sets forth the maturity distribution of certificates of deposit of $100,000 or more issued by the Company at December 31, 1998 and 1997 (in thousands): <TABLE> <CAPTION> December 31, 1998 December 31, 1997 -------------------------------------------- -------------------------------------------- Time Other Time Other Certificates Time Certificates Time of Deposit Deposit Total of Deposit Deposit Total ------------- ------------ ------------- ------------ ------------ ------------- <S> <C> <C> <C> <C> <C> <C> Three months or less................ $ 20,201 $ 29,930 $ 50,131 $ 14,971 $ 21,047 $ 36,018 Over three to six months............ 10,201 6,564 16,765 9,810 6,000 15,810 Over six to twelve months........... 13,560 13,560 11,038 11,038 Over twelve months.................. 10,380 10,380 14,193 14,193 ------------- ------------ ------------- ------------ ------------ ------------- Total....................... $ 54,342 $ 36,494 $ 90,836 $ 50,012 $ 27,047 $ 77,059 ============= ============ ============= ============ ============ ============= </TABLE> 13
15 THE BANKING INDUSTRY IN TEXAS The banking industry is affected by general economic conditions such as interest rates, inflation, recession, unemployment and other factors beyond the Company's control. During the mid to late 1980's, declining oil prices had an indirect effect on the Company's business, and the deteriorating real estate market caused a significant portion of the increase in the Company's nonperforming assets during that period. During the early 1990's a mild recovery appeared to be underway in East Texas and much of the nation. This recovery continued into 1997 and 1998 and at this time the economic activity in the State and East Texas appears to be stable to improving with some growth areas resulting. One area of concern is the declining price of oil. During the last ten years the East Texas economy has diversified, decreasing the overall impact of declining oil prices, however, the East Texas economy is still affected by the oil industry. Another area of concern continues to be the personal bankruptcy rate occurring nationwide and in East Texas. Management expects this trend to have some effect on the Company's net charge-offs. Management of the Company, however, cannot predict whether current economic conditions will improve, remain the same or decline. COMPETITION The activities engaged in by the Company and its subsidiary, Southside Bank, are highly competitive. Financial institutions such as savings and loan associations, credit unions, consumer finance companies, insurance companies, brokerage companies and other financial institutions with varying degrees of regulatory restrictions compete more vigorously for a share of the financial services market. Brokerage companies continue to become more competitive in the financial services arena and pose an ever increasing challenge to banks. Legislative changes also greatly affect the level of competition the Company faces. During 1998 federal legislation allowed credit unions to expand their membership criteria. This will allow credit unions to use their expanded membership capabilities combined with tax-free status to compete more fiercely for traditional bank business. Because banks do not enjoy a tax-free status, credit unions will have a competitive advantage. Currently, the Company must compete against some institutions located in East Texas and elsewhere in the Company's service area which have capital resources and legal loan limits substantially in excess of those available to the Company and Southside Bank. The Company expects the competition it faces to continue to increase. EMPLOYEES At December 31, 1998, the Company employed approximately 299 full time equivalent persons. None of the employees are represented by any unions or similar groups, and the Company has not experienced any type of strike or labor dispute. The Company considers its relationship with its employees to be good. 14
16 EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company and Southside Bank as of December 31, 1998, were as follows: B. G. Hartley (Age 69), Chairman of the Board of the Company since 1983. He was elected President of the Company in 1982. He also serves as Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Southside Bank, having served in these capacities since the Bank's inception in 1960. Sam Dawson (Age 51), President, Secretary and Director of the Company. President, Chief Operations Officer and Director of the Company's subsidiary, Southside Bank since 1996. He became an officer of the Company in 1982 and of Southside Bank during 1975. Robbie N. Edmonson (Age 66), Vice Chairman of the Board of the Company. He is currently Vice Chairman of the Board and Chief Administrative Officer of the Company's subsidiary, Southside Bank. He joined Southside Bank as a vice president in 1968. Jeryl Story (Age 47), Senior Executive Vice President - Loan Administration and Director of the Company's subsidiary, Southside Bank, since 1996. He joined Southside Bank in 1979 as an officer in Loan Documentation. Lee R. Gibson (Age 42), Executive Vice President and Chief Accounting Officer of the Company and Executive Vice President and Director of the Company's subsidiary, Southside Bank. He became an officer of the Company in 1985 and of Southside Bank during 1984. Titus E. Jones (Age 54), Executive Vice President of the Company's subsidiary, Southside Bank, since 1987. He joined Southside Bank in 1965. Lonny R. Uzzell (Age 45), Executive Vice President of the Company's subsidiary, Southside Bank. He joined Southside Bank in 1981 as an officer in Marketing. H. Andy Wall (Age 58), Executive Vice President of the Company's subsidiary, Southside Bank, since 1984. He joined Southside Bank in 1968 and became an officer in 1969. James F. Deakins (Age 65), Senior Vice President - Loan Review of the Company since 1988. He joined Southside Bank in 1987 as a Vice President in commercial lending. All the individuals named above serve in their capacity as officers of the Company and/or Southside Bank at the pleasure of each entities' Board of Directors. SUPERVISION AND REGULATION Banking is a complex, highly regulated industry. The primary goals of the bank regulatory scheme are to maintain a safe and sound banking system and to facilitate the conduct of sound monetary policy. In furtherance of these goals, Congress has created several largely autonomous regulatory agencies and enacted numerous laws that govern banks, bank holding companies and the banking industry. The descriptions of and references to the statutes and regulations below are brief summaries and do not purport to be complete. The descriptions are qualified in their entirety by reference to the specific statutes and regulations discussed. 15
17 THE COMPANY As bank holding companies under the Bank Holding Company Act of 1956, as amended (the "BHC Act"), the Company and Southside Delaware are registered with and subject to regulation by the FRB. The Company and Southside Delaware are required to file annual and other reports with, and furnish information to, the FRB, which makes periodic inspections of the Company and Southside Delaware. The BHC Act provides that a bank holding company must obtain the prior approval of the FRB for the acquisition of more than 5% of the voting stock or substantially all the assets of any bank or bank holding company. In addition, the BHC Act restricts the extension of credit to any bank holding company by its subsidiary bank. The BHC Act also provides that, with certain exceptions, a bank holding company may not (i) engage in any activities other than those of banking or managing or controlling banks and other authorized subsidiaries or (ii) own or control more than 5% of the voting shares of any company that is not a bank. The FRB has deemed certain limited activities to be closely related to banking and therefore permissible for a bank holding company to engage in. In approving acquisitions by bank holding companies of banks and companies engaged in banking-related activities, the FRB considers whether the performance of any such activity by an affiliate of the holding company can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh such possible adverse effects as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The FRB has cease-and-desist powers over bank holding companies and their nonbanking subsidiaries where their actions would constitute a serious threat to the safety, soundness or stability of a subsidiary bank. Federal regulatory agencies also have authority to regulate debt obligations (other than commercial paper) issued by bank holding companies. This authority includes the power to impose interest ceilings and reserve requirements on such debt obligations. A bank holding company and its subsidiaries are also prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. Federal banking law generally provides that a bank holding company may acquire or establish banks in any state of the United States, subject to certain aging and deposit concentration limits. In addition, Texas banking laws permit a bank holding company which owns stock of a bank located outside the State of Texas (an "Out-of-State Bank Holding Company") to acquire a bank or bank holding company located in Texas. Such acquisition may occur only if the Texas bank to be directly or indirectly controlled by the Out-of-State Bank Holding Company has existed and continuously operated as a bank for a period of at least five years. In any event, however, a bank holding company may not own or control banks in Texas, the deposits of which would exceed 20% of the total deposits of all federally-insured deposits in Texas. The FRB has promulgated capital adequacy regulations to which all bank holding companies that have assets in excess of $150 million are subject. The FRB's capital adequacy regulations are based upon a risk based capital determination, whereby a bank holding company's capital adequacy is determined in light of the risk, both on and off-balance sheet, contained in the company's assets. Different categories of assets are assigned risk weightings and, based thereon, are counted at a percentage (from 0% to 100%) of their book value. The regulations divide capital between Tier 1 capital (core capital) and Tier 2 capital. For a bank holding company, Tier 1 capital consists primarily of common stock, noncumulative perpetual preferred stock, related surplus, minority interests in consolidated subsidiaries and a limited amount of qualifying cumulative preferred securities such as the Preferred Securities. Goodwill and certain other intangibles are excluded from Tier 1 capital. Tier 2 capital consists of varying percentages of the reserve for loan losses, all other types of preferred stock not included in Tier 1 capital, hybrid capital instruments and term subordinated debt. Investments in and loans to unconsolidated banking and finance subsidiaries that constitute capital of those subsidiaries are excluded from capital. The sum of Tier 1 and Tier 2 16
18 capital constitutes qualifying total capital. The Tier 1 component must comprise at least 50% of qualifying total capital. The FRB risk-based capital standards contemplate that evaluation of capital adequacy will take account of a wide range of other factors, including overall interest rate exposure; liquidity, funding and market risks; the quality and level of earnings; investment, loan portfolio, and other concentrations of credit; certain risks arising from nontraditional activities; the quality of loans and investments; the effectiveness of loan and investment policies; and management's overall ability to monitor and control financial and operating risks including the risks presented by concentrations of credit and nontraditional activities. In addition, the FRB has established minimum Leverage Ratio (Tier 1 capital to quarterly average total assets) guidelines for bank holding companies and banks. These guidelines provide for a minimum Leverage Ratio of 3% for bank holding companies and banks that meet certain specified criteria, including having the highest regulatory rating. All other banking organizations are required to maintain a Leverage Ratio of at least 3% plus an additional cushion of 100 to 200 basis points. The 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 level, without significant reliance on intangible assets. Furthermore, the guidelines indicate that the FRB will continue to consider a "Tangible Tier 1 Leverage Ratio" in evaluating proposals for expansion or new activities. The Tangible Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not deducted from Tier 1 capital, to quarterly average total assets. As of December 31, 1998, the FRB had not advised the Company of any specific minimum Tangible Tier 1 Leverage Ratio applicable to it. As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, the Company's ability to pay cash dividends depends upon the cash dividends it receives from the Bank through Southside Delaware. The Company's only significant sources of income are (i) dividends paid by the Bank and (ii) the tax savings, if any, that result from the filing of consolidated income tax returns for the Company, Southside Delaware and the Bank. The Company must pay all of its operating expenses from funds received by it from the Bank. Therefore, shareholders may receive dividends from the Company only to the extent that funds are available after payment of the Company's operating expenses. Consistent with its policy regarding bank holding companies serving as a source of financial strength for their subsidiary banks, the FRB has stated that, as a matter of prudent banking, a bank holding company generally should not maintain a rate of cash dividends unless its net income available to common stockholders has been sufficient to fully fund the dividends, and the prospective rate of earnings retention appears consistent with the bank holding company's capital needs, asset quality and overall financial condition. In addition, the Company is subject to certain restrictions on the payment of dividends as a result of the requirement that it maintain an adequate level of capital as described above. THE BANK The Bank is subject to various requirements and restrictions under the laws of the United States and the State of Texas, and to regulation, supervision and regular examination by the TDB and the FDIC. The TDB and the FDIC have the power to enforce compliance with applicable banking statutes and regulations. Such requirements and restrictions include requirements to maintain reserves against deposits, restrictions on the nature and amount of loans that may be made and the interest that may be charged thereon and restrictions relating to investments and other activities of the Bank. Transactions with Affiliates. With respect to the federal legislation applicable to the Bank, the Federal Reserve Act, as amended by the Competitive Equality Banking Act of 1987, prohibits the Bank from engaging in specified transactions (including, for example, loans) with certain affiliates unless the terms and conditions of such transactions are substantially the same or at least 17
19 as favorable to the Bank as those prevailing at the time for comparable transactions with or involving other nonaffiliated entities. In the absence of such comparable transactions, any transaction between the Bank and its affiliates must be on terms and under circumstances, including credit standards, that in good faith would be offered or would apply to nonaffiliated companies. In addition, certain transactions, referred to as "covered transactions," between the Bank and its affiliates may not exceed 10% of the Bank's capital and surplus per affiliate and an aggregate of 20% of its capital and surplus for covered transactions with all affiliates. Certain transactions with affiliates, such as loans, also must be secured by collateral of specific types and amounts. Finally, the Bank is prohibited from purchasing low quality assets from an affiliate. Every company under common control with the Bank, including the Company and Southside Delaware, are deemed to be affiliates of the Bank. Loans to Insiders. Federal law also constrains the types and amounts of loans that the Bank may make to its executive officers, directors and principal shareholders. Among other things, such loans must be approved by the Bank's board of directors in advance and must be on terms and conditions as favorable to the Bank as those available to an unrelated person. Regulation of Lending Activities. Loans made by the Bank are also subject to numerous federal and state laws and regulations, including the Truth-In-Lending Act, Federal Consumer Credit Protection Act, the Texas Consumer Credit Code, the Texas Consumer Protection Code, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and adjustable rate mortgage disclosure requirements. Remedies to the borrower and penalties to the Bank are provided for failure of the Bank to comply with such laws and regulations. The scope and requirements of such laws and regulations have expanded significantly in recent years. Branch Banking. Pursuant to the Texas Finance Code, all banks located in Texas are authorized to branch statewide. Accordingly, a bank located anywhere in Texas has the ability, subject to regulatory approval, to establish branch facilities near any of the Bank's facilities and within its market areas. If other banks were to establish branch facilities near the Bank or any of its facilities, it is uncertain whether such branch facilities would have a materially adverse effect on the business of the Bank. In addition, in 1994 Congress adopted the Reigle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Reigle Act"). That statute provides for nationwide interstate banking and branching. However, during 1995, the Texas legislature elected to opt out of the branching provisions under the Reigle Act until 1999, which effectively prohibits out of state banks from opening branches in Texas until at least 1999. Similarly, banks located in Texas are generally prohibited from opening branches outside of Texas. The Texas legislature will revisit that issue during the 1999 session. Therefore, interstate branching will continue to be prohibited in Texas until at least 1999. Governmental Monetary Policies. The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the FRB. Changes in the discount rate on member bank borrowings, control of borrowings, open market operations, the imposition of and changes in reserve requirements against member banks, deposits and assets of foreign branches, the imposition of and changes in reserve requirements against certain borrowings by banks and their affiliates and the placing of limits on interest rates which member banks may pay on time and savings deposits are some of the instruments of monetary policy available to the FRB. Those monetary policies influence to a significant extent the overall growth of bank loans, investments and deposits and the interest rates charged on loans or paid on time and savings deposits. The nature of future monetary policies and the effect of such policies on the future business and earnings of the Bank, therefore, cannot be predicted accurately. Dividends. All dividends paid by the Bank are paid to the Company, the sole indirect shareholder of the Bank, through Southside Delaware. The general dividend policy of the Bank is to pay dividends at levels consistent with maintaining liquidity and preserving applicable capital ratios 18
20 and servicing obligations of the Company. The dividend policy of the Bank is subject to the discretion of the board of directors of the Bank and will depend upon such factors as future earnings, financial conditions, cash needs, capital adequacy, compliance with applicable statutory and regulatory requirements and general business conditions. The ability of the Bank, as a Texas banking association, to pay dividends is restricted under applicable law and regulations. The Bank generally may not pay a dividend reducing its capital and surplus without the prior approval of the Texas Banking Commissioner. All dividends must be paid out of net profits then on hand, after deducting expenses, including losses and provisions for loan losses. Additionally, the FDIC has the right to prohibit the payment of dividends by a bank where such payment is deemed to be an unsafe and unsound banking practice. The Bank is also subject to certain restrictions on the payment of dividends as a result of the requirements that it maintain an adequate level of capital in accordance with guidelines promulgated from time to time by the FDIC. The exact amount of future dividends on the stock of the Bank will be a function of the profitability of the Bank in general and applicable tax rates in effect from year to year. The Bank's ability to pay dividends in the future will directly depend on its future profitability, which cannot be accurately estimated or assured. Capital Adequacy. In 1983, Congress enacted the International Lending Supervision Act, which, among other things, directed the FDIC to establish minimum levels of capital for banks and to require banks to achieve and maintain adequate capital. Pursuant to this authority, the FDIC has promulgated capital adequacy regulations to which all state nonmember banks, such as the Bank, are subject. These requirements are substantially similar to the FRB requirements promulgated with respect to bank holding companies. FIRREA. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") includes various provisions that affect or may affect the Bank. Among other matters, FIRREA generally permits bank holding companies to acquire healthy thrifts as well as failed or failing thrifts. FIRREA removed certain cross-marketing prohibitions previously applicable to thrift and bank subsidiaries of a common holding company. Furthermore, a multibank holding company may now be required to indemnify the federal deposit insurance fund against losses it incurs with respect to such company's affiliated banks, which in effect makes a bank holding company's equity investments in healthy bank subsidiaries available to the FDIC to assist such company's failing or failed bank subsidiaries. In addition, pursuant to FIRREA, any depository institution that has been chartered less than two years, is not in compliance with the minimum capital requirements of its primary federal banking regulator or is otherwise in a troubled condition must notify its primary federal banking regulator of the proposed addition of any person to the board of directors or the employment of any person as a senior executive officer of the institution at least 30 days before such addition or employment becomes effective. During such 30-day period, the applicable federal banking regulatory agency may disapprove of the addition or employment of such director or officer. The Bank is not subject to any such requirements. FIRREA also expanded and increased civil and criminal penalties available for use by the appropriate regulatory agency against certain "institution-affiliated parties" primarily including (i) management, employees and agents of a financial institution, as well as (ii) independent contractors such as attorneys and accountants and others who participate in the conduct of the financial institution's affairs and who cause or are likely to cause more than minimum financial loss to or a significant adverse affect on the institution, who knowingly or recklessly violate a law or regulation, breach a fiduciary duty or engage in unsafe or unsound practices. Such practices can include the failure of an institution to timely file required reports or the submission of inaccurate reports. Furthermore, FIRREA authorizes the appropriate banking agency to issue cease and desist orders that may, among other things, require affirmative action to correct any harm resulting from a 19
21 violation or practice, including restitution, reimbursement, indemnifications or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets or take other action as determined by the ordering agency to be appropriate. FDICIA. The FDIC Improvement Act of 1991 ("FDICIA") made a number of reforms addressing the safety and soundness of the deposit insurance system, supervision of domestic and foreign depository institutions, and improvement of accounting standards. This statute also limited deposit insurance coverage, implemented changes in consumer protection laws and provided for least-cost resolution and prompt regulatory action with regard to troubled institutions. FDICIA requires every bank with total assets in excess of $500 million to have an annual independent audit made of the bank's financial statements by a certified public accountant to verify that the financial statements of the bank are presented in accordance with generally accepted accounting principles and comply with such other disclosure requirements as prescribed by the FDIC. FDICIA also places certain restrictions on activities of banks depending on their level of capital. FDICIA divides banks into five different categories, depending on their level of capital. Under regulations recently adopted by the FDIC, a bank is deemed to be "well capitalized" if it has a total Risk-Based Capital Ratio of 10% or more, a Core Capital Ratio of 6% or more and a Leverage Ratio of 5% or more, and if the bank is not subject to an order or capital directive to meet and maintain a certain capital level. Under such regulations, a bank is deemed to be "adequately capitalized" if it has a total Risk-Based Capital Ratio of 8% or more, a Core Capital Ratio of 4% or more and a Leverage Ratio of 4% or more (unless it receives the highest composite rating at its most recent examination and is not experiencing or anticipating significant growth, in which instance it must maintain a Leverage Ratio of 3% or more). Under such regulations, a bank is deemed to be "undercapitalized" if it has a total Risk-Based Capital Ratio of less than 8%, a Core Capital Ratio of less than 4% or a Leverage Ratio of less than 4%. Under such regulations, a bank is deemed to be "significantly undercapitalized" if it has a Risk-Based Capital Ratio of less than 6%, a Core Capital Ratio of less than 3% and a Leverage Ratio of less than 3%. Under such regulations, a bank is deemed to be "critically undercapitalized" if it has a Leverage Ratio of less than or equal to 2%. A bank may be reclassified to be in a capitalization category that is next below that indicated by its actual capital position (but not to "critically undercapitalized") if it receives a less-than-satisfactory examination rating by its examiners with respect to its asset quality, management, earnings or liquidity that has not been corrected, or it is determined that the bank is in an unsafe or unsound condition or engaged in an unsafe or unsound practice. In addition, if a state nonmember bank is classified as undercapitalized, the bank is required to submit a capital restoration plan to the FDIC. Pursuant to FDICIA, an undercapitalized bank is prohibited from increasing its assets, engaging in a new line of business, acquiring any interest in any company or insured depository institution, or opening or acquiring a new branch office, except under certain circumstances, including the acceptance by the FDIC of a capital restoration plan for the bank. Furthermore, if a state nonmember bank is classified as undercapitalized, the FDIC may take certain actions to correct the capital position of the bank. If a bank is classified as significantly undercapitalized, the FDIC is required to take one or more prompt corrective actions. These actions include, among other things, requiring: sales of new securities to bolster capital, improvements in management, limits on interest rates paid, prohibitions on transactions with affiliates, termination of certain risky activities and restrictions on compensation paid to executive officers. If a bank is classified as critically undercapitalized, FDICIA requires the bank to be placed into conservatorship or receivership within 90 days, unless the FDIC determines that other action would better achieve the purposes of FDICIA regarding prompt corrective action with respect to undercapitalized banks. 20
22 The capital classification of a bank affects the frequency of examinations of the bank and impacts the ability of the bank to engage in certain activities and affects the deposit insurance premiums paid by the bank. Under FDICIA, the FDIC is required to conduct a full-scope, on-site examination of every bank at least once every twelve months. An exception to this rule provides that banks that (i) have assets of less than $100 million, (ii) are categorized as "well capitalized," (iii) are found to be well managed with a composite rating of "outstanding" and (iv) have not been subject to a change in control during the last twelve months, need only be examined by the FDIC once every eighteen months. Under FDICIA, banks may be restricted in their ability to accept brokered deposits, depending on their capital classification. "Well capitalized" banks are permitted to accept brokered deposits, but all banks that are not well capitalized are not permitted to accept such deposits. The FDIC may, on a case-by-case basis, permit banks that are adequately capitalized to accept brokered deposits if the FDIC determines that acceptance of such deposits would not constitute an unsafe or unsound banking practice with respect to the bank. The federal banking agencies have established guidelines, effective August 9, 1995, which prescribe standards for depository institutions relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and management compensation. The agencies may require an institution which fails to meet the standards set forth in the guidelines to submit a compliance plan. The agencies are also currently proposing standards for asset quality and earnings. The Company cannot predict what effect such guidelines will have on the Bank. Deposit Insurance. Under the FDIC's risk-based insurance assessment system, each insured bank is placed in one of nine "assessment risk classifications" based on its capital classification and the FDIC's consideration of supervisory evaluations provided by the institution's primary federal regulator. Each insured bank's insurance assessment rate is then determined by the risk category in which it has been classified by the FDIC. There is currently a 27 basis point spread between the highest and lowest assessment rates, so that banks classified as strongest by the FDIC are subject in 1998 to 0% assessment, and banks classified as weakest by the FDIC are subject to an assessment rate of .27%. In addition to its insurance assessment, each insured bank is subject in 1998 to a debt service assessment of $.012 per one hundred dollars of deposits to help recapitalize the Savings Association Insurance Fund of the FDIC. Under these assessment criteria, the Bank is required to pay annual deposit premiums to BIF in the amount of $.012 per hundred dollars of deposits. The Bank's deposit insurance assessments may increase or decrease depending upon the risk assessment classification to which the Bank is assigned by the FDIC. Any increase in insurance assessments could have an adverse effect on the Bank's earnings. Management of the Company and the Bank cannot predict what other legislation might be enacted or what other regulations might be adopted or the effects thereof. The foregoing is an attempt to summarize some of the relevant laws, rules and regulations governing banks and bank holding companies but does not purport to be a complete summary of all applicable laws, rules and regulations governing banks and bank holding companies. 21
23 CAPITAL GUIDELINES Southside Bank is regulated by the Texas Department of Banking (the "TDB") and the Federal Deposit Insurance Corporation (the "FDIC"). The State requires Southside Bank to maintain capital at a minimum of 6% of total assets. The FDIC requires minimum levels of Tier 1 capital and risk-based capital for FDIC-insured institutions. The FDIC requires a minimum leverage ratio of 3% of adjusted total assets for the highest rated banks. Other banks are required to meet a leverage standard of 4% or more, determined on a case-by-case basis. On December 31, 1998, the minimum ratio for qualifying total risk-based capital was 8% of which 4% must be Tier 1 capital. Southside Bank's actual capital to total assets and risk-based capital ratios at December 31, 1998 were in excess of the minimum requirements. Also see discussion of "Capital Resources" under Item 7. USURY LAWS Texas usury laws limit the rate of interest that may be charged by state banks. Certain Federal laws provide a limited preemption of Texas usury laws. The maximum rate of interest that Southside Bank may charge on direct business loans under Texas law varies between 18% per annum and (i) 28% per annum for business and agricultural loans above $250,000 or (ii) 24% per annum for other direct loans. Texas floating usury ceilings are tied to the 26-week United States Treasury Bill Auction rate. Other ceilings apply to open-end credit card loans and dealer paper purchased by Southside Bank. A Federal statute removes interest ceilings under usury laws for loans by Southside Bank which are secured by first liens on residential real property. ECONOMIC ENVIRONMENT The monetary policies of regulatory authorities, including the Board, have a significant effect on the operating results of bank holding companies and their subsidiaries. The Board regulates the national supply of bank credit. Among the means available to the Board are open market operations in United States Government Securities, changes in the discount rate on member bank borrowings, changes in reserve requirements against member and nonmember bank deposits, and loans and limitations on interest rates which member banks may pay on time or demand deposits. These methods are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits. Their use may affect interest rates charged on loans or paid for deposits. Also see discussion of "Banking Industry in Texas" above. 22
24 ITEM 2. PROPERTIES The Company completed expansion and remodeling of the Gentry Parkway branch facility during 1998. Remodeling of the annex building, immediately across the parking lot from the bank headquarters, is expected to be completed during 1999. The Company purchased property in Longview, Texas at 2001 Judson Road during 1998. Construction of a permanent branch facility at this location will begin during 1999. Southside Bank owns the following properties: o A two story building in Tyler, Texas, at 1201 South Beckham Avenue and the property adjacent to the main bank building, known as the Southside Bank Annex. These properties house the executive offices of Southside Bancshares, Inc.. o Property and a building directly adjacent to the building housing the Southside Bank Annex. The building is referred to as the Operations Annex, where various back office lending and accounts payable operations are located. o Land and building located at 1010 East First Street in Tyler where Motor Bank facilities are located. o 4.05 acres of land located at the intersection of South Broadway and Grande Boulevard in Tyler. The tract is occupied by Southside Bank's South Broadway branch, which currently provides a full line of banking services. o Property on South Broadway near the South Broadway branch where Motor Bank facilities are located. o Nineteen Automatic Teller Machines (ATM) facilities located throughout Smith and Gregg Counties. o Building located in the downtown square of Tyler which houses Southside Bank's Downtown branch, providing a full line of banking services. o Gentry Parkway branch and motor bank facility. o Property at 2001 Judson Road in Longview, Texas, where the Company will construct a permanent branch facility complete with Motor Bank facilities. 23
25 ITEM 3. LEGAL PROCEEDINGS Southside Bank is party to legal proceedings arising in the normal conduct of business. Management of the Company believes that such litigation is not material to the financial position or results of the operations of the Company or Southside Bank. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the three months ended December 31, 1998, there were no meetings, annual or special, of the shareholders of the Company. No matters were submitted to a vote of the shareholders, nor were proxies solicited by management or any other person. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION The Company's common stock began trading on the Nasdaq National Market on May 14, 1998 under the symbol "SBSI." Prior to that the Company's common stock was not actively traded on any established public trading market. The high/low prices shown below represent the closing prices on the Nasdaq National Market for the period from May 14, 1998 to December 31, 1998. Prior to May 14, 1998 high/low prices shown below were acquired from shareholders voluntarily advising the transfer agent. Accordingly, the market information is incomplete. However, the per share prices listed below are, to the Company's knowledge, generally representative of transactions for the periods reported. During the third quarter of 1998, 1997 and 1996, the Company declared and paid a 5% stock dividend. Stock prices listed below have been adjusted to give retroactive recognition to stock dividends. <TABLE> <CAPTION> Year Ended 1st qtr. 2nd qtr. 3rd qtr. 4th qtr. - ----------------------- ------------------- ------------------- ------------------ ------------------ <S> <C> <C> <C> <C> December 31, 1998 $ 20.47 - 16.90 $ 27.38 - 20.83 $ 25.72 - 17.00 $ 20.00 - 17.00 December 31, 1997 $ 16.67 - 16.67 $ 16.90 - 16.67 $ 16.90 - 16.90 $ 16.90 - 16.67 </TABLE> See "Item 7. Capital Resources" for a discussion of the Company's common stock repurchase program. STOCKHOLDERS There were approximately 1,143 holders of record of the Company's common stock, the only class of equity securities currently issued and outstanding, as of February 26, 1999. DIVIDENDS Cash dividends declared and paid were $.40 per share for the years ended December 31, 1998, 1997 and 1996. Stock dividends of 5% were also declared and paid during each of the years ended December 31, 1998, 1997 and 1996. The Company has paid a cash dividend at least once every year since 1970. Future dividends will depend on the Company's earnings, financial condition and other factors which the Board of Directors of the Company considers to be relevant. 24
26 ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected financial data regarding the Company's results of operations and financial position for, and as of the end of, each of the fiscal years in the five-year period ended December 31, 1998. This information should be read in conjunction with "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations," as set forth in this report (in thousands, except per share data). <TABLE> <CAPTION> As of and For the Years Ended December 31, ---------------------------------------------------------------- 1998 1997 1996 1995 1994 ----------- ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> <C> Investment Securities............................ $ 132,794 $ 71,835 $ 57,825 $ 76,919 $ 82,720 =========== =========== =========== =========== =========== Mortgage-backed and Related Securities........... $ 341,004 $ 141,413 $ 114,356 $ 99,407 $ 88,080 =========== =========== =========== =========== =========== Loans, Net of Allowance for Loan Loss............ $ 316,159 $ 292,665 $ 254,918 $ 225,461 $ 197,853 =========== =========== =========== =========== =========== Total Assets..................................... $ 876,329 $ 571,189 $ 482,755 $ 448,673 $ 426,221 =========== =========== =========== =========== =========== Deposits......................................... $ 515,034 $ 462,674 $ 425,950 $ 388,308 $ 385,102 =========== =========== =========== =========== =========== Long-term Obligations............................ $ 176,027 $ 28,547 $ 9,096 $ 13,686 $ 7,997 =========== =========== =========== =========== =========== Interest & Deposit Service Income................ $ 49,030 $ 39,168 $ 34,593 $ 32,342 $ 28,822 =========== =========== =========== =========== =========== Net Income....................................... $ 5,351 $ 5,006 $ 4,205 $ 4,532 $ 3,519 =========== =========== =========== =========== =========== Net Income Per Common Share-Basic................ $ 1.52 $ 1.40 $ 1.17 $ 1.27 $ .98 =========== =========== =========== =========== =========== Net Income Per Common Share-Diluted.............. $ 1.46 $ 1.36 $ 1.15 $ 1.25 $ .97 =========== =========== =========== =========== =========== Cash Dividends Declared Per Common Share......... $ .40 $ .40 $ .40 $ .35 $ .25 =========== =========== =========== =========== =========== </TABLE> 25
27 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis provides a comparison of the Company's results of operations for the years ended December 31, 1998, 1997 and 1996 and financial condition as of December 31, 1998 and 1997. This discussion should be read in conjunction with the financial statements and related notes. All share data has been adjusted to give retroactive recognition to stock dividends. FORWARD-LOOKING INFORMATION Certain statements of other than historical fact that are contained in this document and in written material, press releases and oral statements issued by or on behalf of the Company may be considered to be "forward-looking statements" as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements may include words such as "expect," "estimate," "project," "anticipate," "should," "intend," "probability," "risk," "target," "objective" and similar expressions. Forward-looking statements are subject to significant risks and uncertainties and the Company's actual results may differ materially from the results discussed in the forward-looking statements. For example, certain market risk disclosures are dependent on choices about key model characteristics and assumptions and are subject to various limitations. See "Item 1 - Business" and "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations." By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future. As a result, actual income gains and losses could materially differ from those that have been estimated. Other factors that could cause actual results to differ materially from forward-looking statements include, but are not limited to general economic conditions, either nationally or in the State of Texas, legislation or regulatory changes which adversely affect the businesses in which the Company is engaged, changes in the interest rate environment which reduce interest margins, significant increases in competition in the banking and financial services industry, changes in consumer spending, borrowing and saving habits, technological changes, the Company's ability to increase market share and control expenses, the effect of compliance with legislation or regulatory changes, the effect of changes in accounting policies and practices and the costs and effects of unanticipated litigation. 26
28 FINANCIAL CONDITION Total assets increased $305.1 million or 53.4% to $876.3 million at December 31, 1998 from $571.2 million at December 31, 1997. The increase was primarily attributable to a $271.5 million increase in the securities portfolio and a $23.5 million increase in net loans. The securities portfolio totaled $488.0 million at December 31, 1998 compared to $216.5 million at December 31, 1997. Beginning in the second quarter of 1998 and continuing through the fourth quarter ended December 31, 1998, the Company leveraged the balance sheet to offset interest expense associated with Trust Preferred Securities issued by the Company during May 1998. The leverage strategy consisted of borrowing long and short-term funds from FHLB Dallas and investing the funds primarily in municipal and mortgage-backed securities. During 1997 and 1998 a barbell approach was primarily used with respect to securities purchased, i.e., the majority of the securities purchased included short duration premium mortgage-backed securities balanced with longer duration municipal securities. Municipal securities were selected for the longer duration portion of the portfolio due to the fact that when treasury rates increase, municipal rates typically increase 66% as much as treasury rates due to the tax-free status of the municipals. This created the same duration as would have been obtained by purchasing intermediate duration securities. During the second half of 1997 and 1998 rates decreased and the yield curve flattened as the spread between the two year treasury yield and thirty year treasury yield narrowed. The Company continued to use the barbell approach during most of 1997 and 1998, however some intermediate term securities were purchased during 1998. In order to maintain the barbell strategy, a continued change in the securities portfolio mix was required and resulted in the changes discussed above during 1997 and 1998. At December 31, 1998, net loans were $316.2 million compared to $292.7 million at December 31, 1997. The increase in loans and securities was funded primarily by Federal Home Loan Bank ("FHLB") Dallas advances and retail deposit growth. Nonperforming assets at December 31, 1998 totaled $2.0 million, representing .2% of total assets, compared to $3.1 million or .5% of total assets at December 31, 1997. Nonaccruing loans decreased to $.4 million and the ratio of nonaccruing loans to total loans decreased to .1% at December 31, 1998 as compared to $1.3 million or .5% at December 31, 1997. Real estate owned decreased to $195,000 at December 31, 1998 from $364,000 at December 31, 1997. Deposits increased $52.3 million to $515.0 million at December 31, 1998 from $462.7 million at December 31, 1997. FHLB Dallas advances were $274.0 million at December 31, 1998, a $216.5 million increase from $57.5 million at December 31, 1997. Other borrowings at December 31, 1998 and 1997 totaled $25.7 million and $5.5 million, respectively, and at December 31, 1998 consisted of $5.7 million short-term borrowings and $20 million of Long-term Junior Subordinated Debentures. On May 18, 1998, the Company through its wholly-owned subsidiary, Southside Capital Trust (the "Trust Issuer") sold 2,000,000 Preferred Securities at a liquidation amount of $10 per Preferred Security for an aggregate amount of $20,000,000. It has a distribution rate of 8.50% per annum payable at the end of each calendar quarter. Shareholders' equity at December 31, 1998 totaled $46.4 million compared to $39.9 million at December 31, 1997. The increase primarily reflects the net income recorded for the year ended December 31, 1998 and the increase in the accumulated other comprehensive income of $3.4 million, partially offset by the repurchase of 71,426 shares of the outstanding stock at an average price of $19.58 per share and the declaration of cash dividends. 27
29 RESULTS OF OPERATIONS The following table presents average balance sheet amounts and average yields for the years ended December 31, 1998, 1997 and 1996. The information should be reviewed in conjunction with the other financial statements. Two major components affecting the Company's earnings are the Interest Earning Assets and Interest Bearing Liabilities. A summary of Average Interest Earning Assets and Interest Bearing Liabilities is set forth below, together with the average yield on the Interest Earning Assets and the average cost of the Interest Bearing Liabilities. <TABLE> <CAPTION> AVERAGE BALANCES AND YIELDS (dollars in thousands) Years Ended ----------------------------------------------------------------------------------------------- December 31, 1998 December 31, 1997 December 31, 1996 ------------------------------ ------------------------------ ----------------------------- AVG. AVG. AVG. AVG. AVG. AVG. ASSETS BALANCE INTEREST YIELD BALANCE INTEREST YIELD BALANCE INTEREST YIELD - ------ --------- --------- ----- --------- ---------- ----- --------- --------- ------ <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> INTEREST EARNING ASSETS: Loans(1)........................ $ 304,255 $ 26,051 8.56% $ 274,577 $ 23,847 8.68% $ 243,925 $ 21,314 8.74% Securities: Inv. Sec. (Taxable)(3).......... 22,974 1,316 5.73% 20,294 1,238 6.10% 24,416 1,476 6.05% Inv. Sec. (Tax-Exempt)(2)(3).... 69,270 5,270 7.61% 38,768 3,049 7.86% 37,094 2,805 7.56% Mortgage-backed Sec.(3) ........ 226,359 12,116 5.35% 120,977 7,729 6.39% 105,465 6,756 6.41% Marketable Equity Sec........... 7,700 449 5.83% 2,415 129 5.34% 2,179 119 5.46% Interest Earning Deposits....... 962 60 6.24% 602 34 5.65% 381 21 5.51% Federal Funds Sold.............. 2,462 137 5.56% 2,285 129 5.65% 3,547 188 5.30% --------- --------- --------- --------- --------- --------- Total Interest Earning Assets.. 633,982 45,399 7.16% 459,918 36,155 7.86% 417,007 32,679 7.84% --------- --------- --------- NONINTEREST EARNING ASSETS: Cash and Due From Banks........ 23,744 23,945 22,160 Bank Premises and Equipment.... 17,781 14,693 12,325 Other Assets................... 10,982 9,483 7,620 Less: Allowance for Loan Loss (3,492) (3,355) (3,282) --------- --------- --------- Total Assets................... $ 682,997 $ 504,684 $ 455,830 ========= ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY: INTEREST BEARING LIABILITIES: Savings Deposits.............. $ 17,280 467 2.70% $ 16,173 446 2.76% $ 15,105 417 2.76% Time Deposits................. 220,421 11,605 5.26% 206,873 11,000 5.32% 190,094 10,083 5.30% Interest Bearing Demand Deposits............ 125,004 3,413 2.73% 117,496 3,265 2.78% 111,950 3,093 2.76% Short-term Interest Bearing Liabilities........ 66,786 3,513 5.26% 14,222 773 5.44% 2,671 132 4.94% Long-term Interest Bearing Liabilities-FHLB Dallas.... 84,836 4,701 5.54% 12,151 721 5.93% 12,010 672 5.60% Long-term Junior Subordinated Debentures.... 12,383 1,048 8.50% --------- --------- --------- --------- --------- --------- Total Interest Bearing Liabilities......... 526,710 24,747 4.70% 366,915 16,205 4.42% 331,830 14,397 4.34% --------- --------- --------- NONINTEREST BEARING LIABILITIES: Demand Deposits................ 105,779 94,005 85,453 Other Liabilities.............. 10,417 6,873 4,788 --------- --------- --------- Total Liabilities.............. 642,906 467,793 422,071 SHAREHOLDERS' EQUITY........... 40,091 36,891 33,759 --------- --------- --------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY.......... $ 682,997 $ 504,684 $ 455,830 ========= ========= ========= NET INTEREST INCOME............ $ 20,652 $ 19,950 $ 18,282 ========= ========= ========= NET YIELD ON AVERAGE EARNING ASSETS................ 3.26% 4.34% 4.38% ===== ===== ===== </TABLE> (1) Loans are shown net of unearned discount. Interest on loans includes fees on loans which are not material in amount. (2) Interest income includes taxable-equivalent adjustments of $1,722, $988 and $907 as of December 31, 1998, 1997 and 1996, respectively. (3) For the purpose of calculating the average yield, the average balance of securities is presented at historical cost. Note: For the years ended December 31, 1998, 1997 and 1996, loans totaling $432, $1,344 and $1,533, respectively, were on nonaccrual status. The policy is to reverse previously accrued but unpaid interest on nonaccrual loans; thereafter, interest income is recorded to the extent received when appropriate. 28
30 ANALYSIS OF CHANGES IN INTEREST INCOME AND INTEREST EXPENSE The following tables set forth the dollar amount of increase (decrease) in interest income and interest expense resulting from changes in the volume of interest earning assets and interest bearing liabilities and from changes in yields (in thousands): <TABLE> <CAPTION> Years Ended December 31, 1998 Compared to 1997 ----------------------------------------- Average Average Increase Volume Yield (Decrease) ------------ ------------ ------------ <S> <C> <C> <C> INTEREST INCOME: Loans............................................................... $ 2,545 $ (341) $ 2,204 Investment Securities (Taxable)..................................... 145 (67) 78 Investment Securities (Tax-Exempt) (1).............................. 2,324 (103) 2,221 Mortgage-backed Securities.......................................... 5,812 (1,425) 4,387 Marketable Equity Securities........................................ 307 13 320 Federal Funds Sold.................................................. 10 (2) 8 Interest Earning Deposits........................................... 23 3 26 ------------ ----------- ----------- Total Interest Income............................................ 11,166 (1,922) 9,244 ------------ ----------- ----------- INTEREST EXPENSE: Savings Deposits.................................................... 30 (9) 21 Time Deposits....................................................... 712 (107) 605 Interest Bearing Demand Deposits.................................... 206 (58) 148 Federal Funds Purchased and Other Interest Bearing Liabilities..................................... 2,764 (24) 2,740 FHLB Dallas Advances................................................ 4,024 (44) 3,980 Long-term Junior Subordinated Debentures............................ 1,048 1,048 ------------ ----------- ----------- Total Interest Expense........................................... 8,784 (242) 8,542 ------------ ----------- ----------- Net Interest Earnings............................................... $ 2,382 $ (1,680) $ 702 ============ =========== =========== </TABLE> <TABLE> <CAPTION> Years Ended December 31, 1997 Compared to 1996 ----------------------------------------- Average Average Increase Volume Yield (Decrease) ------------- ------------ ------------- <S> <C> <C> <C> INTEREST INCOME: Loans............................................................... $ 2,663 $ (130) $ 2,533 Investment Securities (Taxable)..................................... (252) 14 (238) Investment Securities (Tax-Exempt) (1).............................. 172 72 244 Mortgage-backed Securities.......................................... 991 (18) 973 Marketable Equity Securities........................................ 13 (3) 10 Federal Funds Sold.................................................. (72) 13 (59) Interest Earning Deposits........................................... 12 1 13 ------------ ----------- ----------- Total Interest Income............................................ 3,527 (51) 3,476 ------------ ----------- ----------- INTEREST EXPENSE: Savings Deposits.................................................... 29 29 Time Deposits....................................................... 892 25 917 Interest Bearing Demand Deposits.................................... 154 18 172 Federal Funds Purchased and Other Interest Bearing Liabilities..................................... 627 14 641 FHLB Dallas Advances................................................ 8 41 49 ------------ ----------- ----------- Total Interest Expense........................................... 1,710 98 1,808 ------------ ----------- ----------- Net Interest Earnings............................................... $ 1,817 $ (149) $ 1,668 ============ =========== =========== </TABLE> (1) Interest yields on securities which are nontaxable for Federal Income Tax purposes are presented on a taxable equivalent basis. NOTE: Volume/Yield variances (change in volume times change in yield) have been allocated to amounts attributable to changes in volumes and to changes in yields in proportion to the amounts directly attributable to those changes. 29
31 The Company's results of operations are dependent primarily on net interest income, which is the difference between the income earned on its loan, securities and investment portfolios and its cost of funds, consisting of the interest paid on deposits and borrowings. Results of operations are also affected by the Company's noninterest income, provision for loan losses and noninterest expenses. General economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities, also significantly affect the Company's results of operations. Future changes in applicable law, regulations or government policies may also have a material impact on the Company. Comparison of Operating Results for the years ending December 31, 1998 compared to December 31, 1997 OVERVIEW During the year ended December 31, 1998, the Company's net income increased $.3 million or 6.9% to $5.3 million, from $5.0 million for the same period in 1997. The increase in net income was primarily attributable to an increase in noninterest income which was partially offset by an increase in noninterest expense and provision for loan losses. The results of operations of the Company are primarily those of the Bank. NET INTEREST INCOME Net interest income is the principal source of a financial institution's earnings stream and represents the difference or spread between interest and fee income generated from interest earning assets and the interest expense paid on deposits and borrowed funds. Fluctuations in interest rates as well as volume and mix changes in interest earning assets and interest bearing liabilities materially impact net interest income. Net interest income decreased slightly for the year ended December 31, 1998 $32,000 or .2% compared to the same period in 1997. During the second, third and fourth quarters, the Company leveraged the balance sheet to offset the interest expense associated with the Trust Preferred Securities issued. The leverage strategy produced a resulting spread for the leveraged portion of the balance sheet which was significantly less than the Company's previous average. Additionally, during the second, third and fourth quarters, prepayments on the Company's mortgage-backed securities increased. This resulted in additional amortization expense for the premium mortgage-backed securities and was a factor in net interest income decreasing. In addition, during the third quarter as rates decreased and prepayment concerns increased, the bank increased the amortization of a portion of the premium on specific mortgage-backed securities in the portfolio. Also decreasing net interest income was the significant increase during 1998 of tax-free municipal securities. These securities have lower coupons, but reduce federal income tax expense. Interest income for the year ended December 31, 1998 increased $8.5 million or 24.2% to $43.7 million compared to the same period in 1997. The increased interest income in 1998 was attributable to the increase in Average Interest Earning Assets during the year which was partially offset by a decrease in the Average Interest rate earned. Average Interest Earning Assets, totaling $634.0 million at December 31, 1998, increased $174.1 million or 37.8% over December 31, 1997 primarily as a result of increases in Average Investment and Mortgage-backed securities, and to a lesser extent, Average Loans. During the year ended December 31, 1998, the mix of the Company's Interest Earning Assets reflected an increase in Loans compared to the prior year end as Loans averaged 48.0% of Total Average Interest Earning Assets compared to 59.7% during 1997, a direct result of the leverage strategy adopted by the Company. Securities averaged 51.5% of the total and Other Interest Earning Asset categories averaged .5% for December 31, 1998. During 1997 the comparable mix was 39.7% in Securities and .6% in the Other Interest Earning Asset categories. The overall yield on Investment and Mortgage-backed securities decreased 79 basis points to 5.87% during 1998 compared to the same period in 1997. This was a result of overall lower interest rates, increased prepayment speeds on premium mortgage-backed securities which lead to increased amortization expense and 30
32 an increase for the year ended December 31, 1998 in the average tax-free municipal securities portfolio. The average yield on the Average Interest Earning Assets decreased 70 basis points during the year ended December 31, 1998 as compared to 1997 primarily as a result of the decrease in the average yield on securities discussed above. The increase in interest income on Loans of $2.2 million or 9.2% was the result of the increase in Average Loans during 1998. Interest income on securities increased $6.3 million in 1998 or 56.2% compared to 1997 primarily due to the increase in the Average Securities during 1998 which more than offset the decrease in the average yield. The increase in interest expense for the year ended December 31, 1998 of $8.5 million or 52.7% was attributable to an increase in Average Interest Bearing Liabilities of $159.8 million or 43.6% along with the increase in the average rate paid on Interest Bearing Liabilities of 28 basis points. The average rate paid increased due to an average increase in the ratio of the higher interest bearing liabilities during 1998. Average Time Deposits increased $13.5 million or 6.5% while the average rate paid decreased 6 basis points along with an increase in Average Interest Bearing Demand Deposits of $7.5 million or 6.4% and an increase in Average Savings Deposits of $1.1 million or 6.8%. Average Noninterest Bearing Demand Deposits increased during 1998 $11.8 million or 12.5%. The latter three categories, which are considered the lowest cost deposits, comprised 53.0% of total average deposits during the year ended December 31, 1998 compared to 52.4% during 1997 and 52.8% during 1996. The increase in Average Total Deposits is reflective of overall bank growth and branch expansion and was the primary source of funding the increase in Average Loans. Average Long-term and Short-term Interest Bearing Liabilities other than deposits increased $137.6 million or 521.9%, a direct result of the Company's leverage strategy, and contributed to the higher interest expense in 1998 and were the primary source of funding the increase in Average Investment and Mortgage-backed securities. The following table sets forth the Company's deposit averages by category for the years ended December 31, 1998, 1997 and 1996: <TABLE> <CAPTION> COMPOSITION OF DEPOSITS (dollars in thousands) Years Ended December 31, ---------------------------------------------------------------- 1998 1997 1996 -------------------- -------------------- -------------------- AVG. AVG. AVG. AVG. AVG. AVG. BALANCE RATE BALANCE RATE BALANCE RATE --------- ----- --------- ----- --------- ------ <S> <C> <C> <C> <C> <C> <C> Noninterest Bearing Demand Deposits.............. $ 105,779 N/A $ 94,005 N/A $ 85,453 N/A Interest Bearing Demand Deposits................. 125,004 2.73% 117,496 2.78% 111,950 2.76% Savings Deposits................................. 17,280 2.70% 16,173 2.76% 15,105 2.76% Time Deposits.................................... 220,421 5.26% 206,873 5.32% 190,094 5.30% --------- --------- --------- Total Deposits.............................. $ 468,484 3.31% $ 434,547 3.39% $ 402,602 3.38% ========= ========= ========= </TABLE> Average Long-term Junior Subordinated Debentures increased $12.4 million or 100.0%, a result of the sale of 2,000,000 Preferred Securities on May 18, 1998 at a liquidation amount of $10 per Preferred Security for an aggregate amount of $20,000,000. It has a distribution rate of 8.50% per annum payable at the end of each calendar quarter. PROVISION FOR LOAN LOSSES The provision for loan losses for December 31, 1998 was $1.2 million compared to $1.0 million for December 31, 1997. For the year ended December 31, 1998, the Company's subsidiary, Southside Bank, had net charge-offs of loans of $1.0 million, an increase of 15.5% compared to December 31, 1997. For the year ended December 31, 1997, net charge-offs on loans were $.9 million. 31
33 The increase in net charge-offs for 1998 occurred primarily as a result of the increase in loans over the past four years which have grown $118.7 million, $73.3 million of which were real estate loans, and increased bankruptcies which caused the charge-offs for loans to individuals to remain consistent with last year's charge off level. As of December 31, 1998, the Company's review of the loan portfolio indicates that a loan loss reserve of $3.6 million is adequate. NONINTEREST INCOME Noninterest income is an important source of earnings. The Company intends to maximize noninterest income in the future by looking for new fee income services to provide customers and by continuing to review service charge schedules and by competitively and profitably pricing those services. The following schedule lists the accounts from which noninterest income was derived, gives totals for these accounts for the year ended December 31, 1998 and the comparable year ended December 31, 1997 and indicates the percentage changes (dollars in thousands): <TABLE> <CAPTION> Years Ended December 31, ----------------------------- Percent 1998 1997 Change ------------- ------------- -------- <S> <C> <C> <C> Deposit services.................................................. $ 5,353 $ 4,001 33.8% Gain on sales of securities available for sale.................... 1,260 233 440.8% Trust income...................................................... 528 397 33.0% Other............................................................. 1,162 1,035 12.3% ------------- ------------- Total noninterest income.......................................... $ 8,303 $ 5,666 46.5% ============= ============= </TABLE> Noninterest income consists of revenues generated from a broad range of financial services and activities including fee based services. Total noninterest income for the year ended December 31, 1998 increased 46.5% or $2.6 million compared to 1997. Securities gains increased $1.0 million or 440.8% from 1997. Of the $1,260,000 in net securities gains from the AFS portfolio in 1998, there were $1,321,000 in realized gains and $61,000 in realized losses. The Company sold securities out of its AFS portfolio to accomplish Asset Liability Committee (ALCO) and investment portfolio objectives aimed at maximizing the total return of the securities portfolio. During the third quarter, Southside sold longer term municipal securities and higher collateral mortgage-backed securities and replaced them primarily with lower collateral mortgage-backed securities in an effort to reduce the overall risk of prepayments. Sales of securities available for sale were the result of changes in economic conditions and a change in the mix of the securities portfolio. The increase in deposit services income of $1.4 million or 33.8% was a result of the introduction of a new overdraft privilege program in June 1997, increased numbers of deposit accounts and increased deposit activity. Trust income increased $131,000 or 33.0% due to growth in the Trust department. Other noninterest income increased $.1 million or 12.3% primarily as a result of increases in mortgage servicing release fees income. 32
34 NONINTEREST EXPENSE The following schedule lists the accounts which comprise noninterest expense, gives totals for these accounts for the year ended December 31, 1998 and the comparable year ended December 31, 1997 and indicates the percentage changes: <TABLE> <CAPTION> Years Ended December 31, ----------------------------- Percent 1998 1997 Change ------------- ------------- -------- (in thousands) <S> <C> <C> <C> Salaries and employee benefits.................................... $ 11,318 $ 9,889 14.5% Net occupancy expense............................................. 2,370 2,089 13.5% Equipment expense................................................. 457 414 10.4% Advertising, travel and entertainment............................. 1,124 1,006 11.7% Supplies.......................................................... 461 440 4.8% Postage........................................................... 352 331 6.3% Other............................................................. 3,361 2,759 21.8% ------------ ------------ Total noninterest expense......................................... $ 19,443 $ 16,928 14.9% ============ ============ </TABLE> Noninterest expense for the year ended December 31, 1998 increased $2.5 million or 14.9% when compared to the year ended December 31, 1997. Salaries and employee benefits increased $1.4 million or 14.5% due to several factors. Direct salary expense and payroll taxes increased $1.3 million as a result of personnel additions to staff the three new branches opened in 1998, overall bank growth and pay increases. Retirement expense increased $155,000 or 29.5% for the year ended December 31, 1998. Net occupancy expense increased $.3 million or 13.5% for the year ended December 31, 1998 compared to the same period in 1997, largely due to higher real estate taxes, depreciation expense and associated operating costs as a result of the three new branches opened in 1998. Equipment expense increased $43,000 or 10.4% for the year ended December 31, 1998 when compared to 1997 due to increased equipment usage at the three new branch locations opened in 1998 and increased equipment costs associated with equipment maintenance. Advertising expense increased $118,000 or 11.7% for the year ended December 31, 1998 compared to the same period in 1997. The increase occurred due to increases in direct advertising during 1998 as a result of the opening of the three new branches in 1998 and new products introduced in 1998. Donations also increased during the year ended December 31, 1998 and are included in this total. Other expense increased $.6 million or 21.8% during the year ended December 31, 1998 compared to 1997. The increase was due primarily to consulting fees paid in relation to the introduction of the overdraft privilege product, increased ATM fees and telephone expense due to added locations. In addition, trust and legal fees increased due to bank asset and transaction growth. INCOME TAXES Income tax expense was $1.2 million for the year ended December 31, 1998 and represented a $.5 million or 27.5% decrease from the year ended December 31, 1997. The effective tax rate as a percentage of pre-tax income was 18.6% in 1998, 25.2% in 1997 and 25.5% in 1996. The decrease in the effective tax rate for 1998 was primarily a result of lower pre-tax income due to the increase in interest income from tax-free municipal securities. 33
35 December 31, 1997 compared to December 31, 1996 OVERVIEW During the year ended December 31, 1997, the Company's net income increased $.8 million or 19.0% to $5.0 million, from $4.2 million for the same period in 1996. The increase in net income was primarily attributable to an increase in net interest income and noninterest income which was partially offset by an increase in noninterest expense and provision for loan losses. The results of operations of the Company are primarily those of the Bank. NET INTEREST INCOME Net interest income increased for the year ended December 31, 1997 $1.6 million or 9.1% compared to the same period in 1996. Interest income for the year ended December 31, 1997 increased $3.4 million or 10.7% to $35.2 million compared to the same period in 1996. The increased interest income in 1997 was attributable to the increase in Average Interest Earning Assets during the year. Average Interest Earning Assets, totaling $459.9 million at December 31, 1997, increased $42.9 million or 10.3% over December 31, 1996 primarily as a result of increases in Average Loans. During the year ended December 31, 1997 the mix of the Company's Interest Earning Assets reflected an increase in Loans compared to the prior year end as Loans averaged 59.7% of Total Average Interest Earning Assets compared to 58.5% during 1996. Securities averaged 39.7% of the total and Other Interest Earning Asset categories averaged .6% for December 31, 1997. During 1996 the comparable mix was 40.6% in Securities and .9% in the Other Interest Earning Asset categories. The average yield on the Average Interest Earning Assets increased 2 basis points during the year ended December 31, 1997 as compared to 1996. The increase in interest income on Loans of $2.5 million or 11.9% was the result of the increase in Average Loans during 1997. Interest income on securities increased $.9 million in 1997 or 8.9% compared to 1996 primarily due to the increase in the Average Securities during 1997. The increase in interest expense for the year ended December 31, 1997 of $1.8 million or 12.6% was attributable to an increase in Average Interest Bearing Liabilities of $35.1 million or 10.6% along with the increase in the average rate paid on Interest Bearing Liabilities of 8 basis points. Average Time Deposits increased $16.8 million or 8.8% while the average rate paid increased 2 basis points along with an increase in Average Interest Bearing Demand Deposits of $5.5 million or 5.0% and an increase in Average Savings Deposits of $1.1 million or 7.1%. Average Noninterest Bearing Demand Deposits increased during 1997 $8.6 million or 10.0%. The latter three categories, which are considered the lowest cost deposits, comprised 52.4% of total average deposits during the year ended December 31, 1997 compared to 52.8% during 1996 and 54.3% during 1995. The increase in Average Total Deposits is reflective of overall bank growth and branch expansion and was the primary source of funding the increase in Average Loans. Average Long-term and Short-term Interest Bearing Liabilities other than deposits increased $11.7 million or 79.6% which contributed to the higher interest expense in 1997. PROVISION FOR LOAN LOSSES The provision for loan losses for December 31, 1997 and 1996 was $1.0 million and $.5 million, respectively. For the year ended December 31, 1997, the Company's subsidiary, Southside Bank, had net charge-offs of loans of $.9 million, an increase of 55.6% compared to December 31, 1996. For the year ended December 31, 1996, net charge-offs on loans were $.6 million. The increase in net charge-offs for 1997 occurred primarily as a result of the increase in loans over the past four years which have grown $112 million, increased bankruptcies which caused the charge-offs for loans to individuals to remain consistent with last year's increased level and three commercial loans which comprised the majority of the increase in charge-offs for commercial loans. 34
36 NONINTEREST INCOME Total noninterest income for the year ended December 31, 1997 increased 37.1% or $1.5 million compared to 1996. Securities gains increased $.1 million or 76.5% from 1996. Of the $233,000 in net securities gains from the AFS portfolio in 1997, there were $376,000 in realized gains and $143,000 in realized losses. The Company sold securities out of its AFS portfolio to accomplish ALCO and investment portfolio objectives aimed at maximizing the total return of the securities portfolio. The increase in deposit services income of $1.2 million or 41.8% was a result of the introduction of a new overdraft privilege program, increased numbers of deposit accounts and increased deposit activity. Other noninterest income increased $.1 million or 15.1% primarily as a result of increases in credit life commissions and mortgage servicing release fees. NONINTEREST EXPENSE Noninterest expense for the year ended December 31, 1997 increased $1.6 million or 10.2% when compared to the year ended December 31, 1996. Salaries and employee benefits increased $.5 million or 5.4% due to several factors. Higher direct salary expense including payroll taxes represented $.8 million was offset by lower retirement expense. The increase is reflective of personnel additions to staff the three new branches opened in the second half of 1996, overall bank growth and pay increases. Health insurance expense increased $28,000 or 3.2% in 1997 compared to the same period in 1996. Retirement expense decreased $.3 million or 34.1% for the year ended December 31, 1997. Net occupancy expense increased $.3 million or 19.4% for the year ended December 31, 1997 compared to the same period in 1996, largely due to higher real estate taxes, depreciation expense and associated operating costs as a result of the three new branches opened in 1996 and the expansion of the bank headquarters completed during 1997. Equipment expense increased $.1 million or 29.0% for the year ended December 31, 1997 when compared to 1996 due to increased equipment usage at the three new branch locations opened in 1996 and increased equipment costs associated with equipment maintenance. Advertising expense increased $.1 million or 5.2% for the year ended December 31, 1997 compared to the same period in 1996. The increase occurred due to increases in direct advertising during 1997 as a result of the opening of the three new branches in 1996 and new products introduced in 1997. Donations also increased during the year ended December 31, 1997 and are included in this total. Other expense increased $.5 million or 24.2% during the year ended December 31, 1997 compared to 1996. The increase was due primarily to increased professional fees paid during 1997 for additional internal auditing, data processing programming, compliance reviews, loan loss reviews and consulting fees paid in relation to the introduction of the overdraft privilege product. INCOME TAXES Income tax expense was $1.7 million for the year ended December 31, 1997 and represented a $.3 million or 17.5% increase from the year ended December 31, 1996. The increased income tax expense was primarily a result of higher pre-tax income. MANAGEMENT OF LIQUIDITY Liquidity management involves the ability to convert assets to cash with a minimum of loss. The Company must be capable of meeting its obligations to its customers at any time. This means addressing (1) the immediate cash withdrawal requirements of depositors and other funds providers; (2) the funding requirements of all lines and letters of credit; and (3) the short-term credit needs of 35
37 customers. Liquidity is provided by short-term investments that can be readily liquidated with a minimum risk of loss. Cash, Interest Earning Deposits, Federal Funds Sold and short-term investments with maturities or repricing characteristics of one year or less continue to be a substantial percentage of total assets. At December 31, 1998, these investments were 19.2% of Total Assets, as compared with 18.7% for December 31, 1997, and 18.2% for December 31, 1996. Liquidity is further provided through the matching, by time period, of rate sensitive interest earning assets with rate sensitive interest bearing liabilities. The Company has two lines of credit for the purchase of federal funds. A $15.0 million and $10.0 million unsecured line of credit has been established with Nationsbank and Texas Independent Bank, respectively. INTEREST RATE RISK The primary objective of monitoring the Company's interest rate sensitivity, or risk, is to provide management the tools necessary to manage the balance sheet to minimize adverse changes in net interest income as a result of changes in the direction and level of interest rates. Federal Reserve Board monetary control efforts, the effects of deregulation and legislative changes have been significant factors affecting the task of managing interest rate sensitivity positions in recent years. Interest rate sensitivity is a function of the repricing characteristics of the Company's portfolio of assets and liabilities. These repricing characteristics are the time frames at which interest earning assets and interest bearing liabilities are subject to changes in interest rates either at repricing replacement or maturity. Sensitivity is measured as the difference between the volume of assets and liabilities in the Company's current portfolio that are subject to repricing in future time periods. The differences are referred to as interest sensitivity gaps and are usually calculated separately for various segments of time and on a cumulative basis. Any excess of assets or liabilities results in an interest sensitivity gap. A positive gap denotes net asset sensitivity and a negative gap represents net liability sensitivity. The table on page 38 shows interest sensitivity gaps for four different intervals as of December 31, 1998. The interest rate risk inherent in assets and liabilities may be determined by analyzing the extent to which such assets and liabilities are "interest rate sensitive" and by measuring an institution's interest rate sensitivity "gap." An asset or liability is said to be interest rate sensitive within a defined time period if it matures or reprices within that period. The difference or mismatch between the amount of interest-earning assets maturing or repricing within a defined period and the amount of interest-bearing liabilities maturing or repricing within the same period is defined as the interest rate sensitivity gap. An institution is considered to have a negative gap if the amount of interest-bearing liabilities maturing or repricing within a specified time period exceeds the amount of interest-earning assets maturing or repricing within the same period. If more interest-earning assets than interest-bearing liabilities mature or reprice within a specified period, then the institution is considered to have a positive gap. Accordingly, in a rising interest rate environment in an institution with a negative gap, the cost of its rate sensitive liabilities would theoretically rise at a faster pace than the yield on its rate sensitive assets, thereby diminishing future net interest income. In a falling interest rate environment, a negative gap would indicate that the cost of rate sensitive liabilities would decline at a faster pace than the yield on rate sensitive assets and improve net interest income. For an institution with a positive gap, the reverse would be expected. In an attempt to manage its exposure to changes in interest rates, management closely monitors the Company's exposure to interest rate risk. Management maintains an asset/liability committee which meets regularly and reviews the Company's interest rate risk position and makes recommendations for adjusting this position. In addition, the Board reviews on a monthly basis the Company's asset/liability position. The following table provides information about the Company's financial instruments that are sensitive to changes in interest rates. Except for the effects of prepayments and scheduled principal amortization on mortgage related assets, the table presents principal cash flows and related weighted 36
38 average interest rates by the contractual term to maturity. Nonaccrual loans are not included in the Loan totals. All instruments are classified as other than trading. <TABLE> <CAPTION> EXPECTED MATURITY DATE (dollars in thousands) Year Ending December 31, ------------------------------------------------------------------------------------------------------- Fair 1999 2000 2001 2002 2003 Thereafter Total Value ---------- ---------- ---------- ---------- ---------- ---------- -------- ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Fixed Rate Loans ......... $ 84,627 $ 45,884 $ 35,799 $ 21,962 $ 19,091 $ 59,505 $266,868 $268,815 8.65% 8.83% 8.98% 8.52% 8.32% 8.08% 8.56% Adjustable Rate Loans .... 31,881 2,987 1,285 3,904 1,618 10,748 52,423 52,423 8.87% 8.95% 8.78% 9.46% 9.68% 8.94% 8.95% Mortgage-backed Securities ............... 87,472 67,324 50,020 33,764 24,273 78,151 341,004 341,004 5.81% 5.82% 5.84% 5.85% 5.87% 5.93% 5.85% Investments and Other Interest Earning Assets... 35,474 3,068 675 4,535 3,398 100,435 147,585 147,585 4.48% 7.50% 7.77% 5.63% 6.60% 7.20% 6.49% Total Interest Earning Assets ........... $ 239,454 $ 119,263 $ 87,779 $ 64,165 $ 48,380 $ 248,839 $807,880 $809,827 7.02% 7.10% 7.18% 6.97% 7.01% 7.09% 7.07% Savings Deposits.......... $ 2,353 $ 1,177 $ $ $ $ 14,119 $ 17,649 $ 17,649 2.56% 2.56% 2.56% 2.56% NOW Deposits.............. 9,424 4,712 56,540 70,676 70,728 1.97% 1.97% 1.97% 1.97% Money Market Deposits..... 8,036 4,017 48,211 60,264 60,263 3.39% 3.39% 3.39% 3.39% Certificates of Deposit... 200,821 25,832 5,291 7,369 4,645 47 244,005 244,888 5.02% 5.49% 5.58% 5.98% 5.28% 5.36% 5.12% FHLB Dallas Advances...... 94,201 4,069 40,863 25,287 26,417 83,190 274,027 261,240 5.09% 5.94% 5.03% 5.25% 5.33% 5.28% 5.19% Other Borrowings.......... 5,691 20,000 25,691 25,691 4.85% 8.50% 7.69% Total Interest Bearing Liabilities....... $ 320,526 $ 39,807 $ 46,154 $ 32,656 $ 31,062 $ 222,107 $692,312 $680,459 4.89% 4.82% 5.09% 5.41% 5.32% 4.14% 4.70% </TABLE> Residential fixed rate loans are assumed to have annual payment rates between 4% and 15% of the portfolio. Commercial and multi-family real estate loans are assumed to prepay at an annualized rate between 4% and 15%. Consumer loans are assumed to prepay at an annualized rate between 8% and 15%. Fixed and adjustable rate mortgage-backed securities, including Collateralized Mortgage Obligations ("CMOs") and Real Estate Mortgage Investment Conduits ("REMICs"), have annual payment assumptions ranging from 20% to 40%. Premium mortgage-backed securities have interest rate risk associated with prepayment of principal. If overall rates trend down, mortgages may prepay faster causing the yield to decline on the premium mortgage-backed securities. If rates increase, mortgages may prepay slower, increasing the yield and average life of premium mortgage-backed securities. 37
39 The Company assumes 80% of savings accounts, transaction accounts and Money Market accounts at December 31, 1998, are core deposits and are, therefore, expected to roll-off after five years. The remaining savings accounts are assumed to roll-off over the first eighteen months. No roll-off rate is applied to certificates of deposit. Fixed maturity deposits reprice at maturity. In evaluating the Company's exposure to interest rate risk, certain limitations inherent in the method of analysis presented in the foregoing table must be considered. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable rate mortgages, have features which restrict changes in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table. Finally, the ability of many borrowers to service their debt may decrease in the event of an interest rate increase. The Company considers all of these factors in monitoring its exposure to interest rate risk. The following table sets forth certain information as of December 31, 1998 with respect to rate sensitive assets and liabilities and interest sensitivity gap (dollars in thousands): <TABLE> <CAPTION> Rate Sensitive Assets (RSA) 1-3 Mos. 4-12 Mos. 1-5 Yrs. Over 5 Yrs. Total ------------- ----------- ------------ ----------- ------------ <S> <C> <C> <C> <C> <C> <C> Loans(1)................................. $ 81,737 $ 55,313 $ 122,736 $ 59,505 $ 319,291 Securities............................... 43,397 83,829 187,057 173,686 487,969 Other Interest Earning Assets......................... 620 620 ------------- ----------- ------------ ----------- ------------ Total Rate Sensitive Assets.............. $ 125,754 $ 139,142 $ 309,793 $ 233,191 $ 807,880 ============= =========== ============ =========== ============ Rate Sensitive Liabilities (RSL) Interest Bearing Deposits................ $ 95,192 $ 125,442 $ 53,043 $ 118,917 $ 392,594 Other Interest Bearing Liabilities.................... 99,002 890 96,636 103,190 299,718 ------------- ----------- ------------ ----------- ------------ Total Rate Sensitive Liabilities......... $ 194,194 $ 126,332 $ 149,679 $ 222,107 $ 692,312 ============= =========== ============ =========== ============ Gap (2).................................. (68,440) 12,810 160,114 11,084 115,568 Cumulative Gap........................... (68,440) (55,630) 104,484 115,568 Cumulative Ratio of RSA to RSL................................. .65 .83 1.22 1.17 1.17 Gap/Total Earning Assets................. (8.5%) 1.6% 19.8% 1.4% 14.3% - ------------------------------------------------------------------------------------------------------------------- </TABLE> (1) Amount is equal to total loans net of unearned discount less nonaccrual loans at December 31, 1998. (2) Gap equals Total RSA minus Total RSL. The Asset Liability Management Committee of Southside Bank closely monitors the desired gap along with various liquidity ratios to insure a satisfactory liquidity position for the Company. Rates have fluctuated several hundred basis points during the last five years. During this time, NOW, MMDA and Savings rates have moved very little. Therefore, when considering rate sensitivity, management does not consider NOW, Savings and 50% of MMDA to be one day interest rate sensitive. Management puts these deposits in the over 5 year category for purposes of internal evaluation. As a result of reclassifying these deposits, management considers the Company to be well matched. Management continually evaluates the condition of the economy, the pattern of market interest rates and other economic data to determine the types of investments that should be 38
40 made and at what maturities. Using this analysis, management from time to time assumes calculated interest sensitivity gap positions to maximize net interest income based upon anticipated movements in the general level of interest rates. Regulatory authorities also monitor the Bank's gap position along with other liquidity ratios. In addition, the Bank utilizes a simulation model to determine the impact of net interest income under several different interest rate scenarios. By utilizing this technology, the Bank can determine changes that need to be made to the asset and liability mixes to minimize the change in net interest income under these various interest rate scenarios. CAPITAL RESOURCES Total Shareholders' Equity at December 31, 1998, of $46,413,000 increased 16.2% or $6,467,000 from December 31, 1997 and represented 5.3% of total assets at December 31, 1998 compared to 7.0% at December 31, 1997. The decrease in the percent of Shareholders' Equity to Total Assets is a result of the leverage strategy adopted by the Company during 1998. Net income for 1998 of $5,351,000 was the major contributor to the increase in Shareholders' Equity at December 31, 1998 along with a net increase in unrealized gains of $3,396,000 on securities available for sale. In addition, the Company issued $347,000 in common stock (21,160 shares) through the Company's dividend reinvestment plan and incentive stock option plan and exercised $38,000 of treasury stock (6,000 shares). Decreases to Shareholders' Equity consisted of $1,359,000 in dividends paid and the purchase of $1,398,000 in treasury stock (71,426 shares). The Company purchased treasury stock pursuant to a common stock repurchase plan instituted in late 1994. Under the repurchase plan, the Board of Directors establishes, on a quarterly basis, total dollar limitations and price per share for stock to be repurchased. The Board reviews this plan in conjunction with the capital needs of the Company and Southside Bank and may, at its discretion, modify or discontinue the plan. During the third quarter of 1998, the Company issued a 5% stock dividend, which had no net effect on Shareholders' Equity. The Company's dividend policy requires that any cash dividend payments made by the Company not exceed consolidated earnings for that year. Shareholders should not anticipate a continuation of the cash dividend simply because of the implementation of a dividend reinvestment program. The payment of dividends will depend upon future earnings, the financial condition of the Company, and other related factors. The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of Total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 1998, that the Bank meets all capital adequacy requirements to which it is subject. To be categorized as well capitalized, the Bank must maintain minimum Total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following table: 39
41 <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> As of December 31, 1998: Total Capital (to Risk Weighted Assets)........ $ 63,962 14.86% > = $34,435 > = 8.0% > = $43,044 > = 10.0% Tier 1 Capital (to Risk Weighted Assets)........ $ 54,280 12.61% > = $17,218 > = 4.0% > = $25,827 > = 6.0% Tier 1 Capital (to Average Assets) (1).......... $ 54,280 6.76% > = $32,108 > = 4.0% > = $40,135 > = 5.0% As of December 31, 1997: Total Capital (to Risk Weighted Assets)........ $ 41,965 12.89% > = $26,038 > = 8.0% > = $32,547 > = 10.0% Tier 1 Capital (to Risk Weighted Assets)........ $ 38,595 11.86% > = $13,019 > = 4.0% > = $19,528 > = 6.0% Tier 1 Capital (to Average Assets) (1).......... $ 38,595 7.25% > = $21,283 > = 4.0% > = $26,604 > =5.0% </TABLE> (1) Refers to quarterly average assets as calculated by bank regulatory agencies. The table below summarizes key equity ratios for the Company for the years ended December 31, 1998, 1997 and 1996. <TABLE> <CAPTION> Years Ended December 31, ---------------------------------- 1998 1997 1996 ------ ------ ------ <S> <C> <C> <C> Percentage of Net Income to: Average Total Assets............................................... .78% .99% .92% Average Shareholders' Equity....................................... 13.35% 13.57% 12.46% Percentage of Dividends Declared Per Common Share to Net Income Per Common Share-Basic......................... 26.32% 28.57% 34.19% Percentage of Dividends Declared Per Common Share to Net Income Per Common Share-Diluted....................... 27.40% 29.41% 34.78% Percentage of Average Shareholders' Equity to Average Total Assets..................................... 5.87% 7.31% 7.41% </TABLE> YEAR 2000 COMPLIANCE (Y2K) In May 1997, the Federal Financial Institutions Examination Council ("FFIEC") issued an interagency statement to the chief executive officers of all federally supervised financial institutions regarding Y2K project management awareness. The FFIEC has highly prioritized Y2K compliance in order to avoid major disruptions to the operations of financial institutions and the country's financial systems when the new century results in two digit dates for the year being below the prior year's value. The FFIEC statement provides guidance to financial institutions, providers of data services, and all examining personnel of the federal banking agencies regarding the Y2K issue. The federal banking agencies have been conducting Y2K compliance examinations, and the failure to implement an adequate Y2K program can be identified as an unsafe and unsound banking practice. The FDIC has established an examination procedure which contains three categories of ratings: 40
42 "Satisfactory," "Needs Improvement," and "Unsatisfactory." Institutions that receive a Y2K rating of Unsatisfactory may be subject to formal enforcement action, supervisory agreements, cease and desist orders, civil money penalties, or the appointment of a conservator. In addition, federal banking agencies will be taking into account Y2K compliance programs when reviewing applications and may deny an application based on Y2K related issues. Y2K ISSUE The Y2K issue concerns the potential impact of historic computer software code that only utilizes two digits to represent the calendar year (e.g. "98" for "1998"). Software so developed, and not corrected, could produce inaccurate or unpredictable results commencing upon January 1, 2000, when current and future dates present a lower two digit year number than dates in the prior century. The Company, similar to most financial services providers, is significantly subject to the potential impact of the Y2K issue due to the nature of financial information. Potential impacts to the Company may arise from software, computer hardware, and other equipment both within the Company's direct control and outside of the Company's ownership, yet with which the Company electronically or operationally interfaces. Financial institution regulators have intensively focused upon Y2K exposures, issuing guidance concerning the responsibilities of senior management and directors. Y2K testing and certification is being addressed as a key safety and soundness issue in conjunction with regulatory exams. In order to address the Y2K issue, the Company has developed and implemented a five phase plan divided into the following major components: 1. awareness 2. assessment 3. renovation 4. validation 5. implementation The Company has completed the first two phases of the plan with customer awareness ongoing and is currently working internally and with external vendors on the final three phases. Other important segments of the Y2K plan are to identify those loan customers whose possible lack of Y2K preparedness might expose the Bank to financial loss, and to highlight any servicers of purchased loans or securities which might present Y2K operating problems. The Board of Directors has established a Y2K subcommittee to monitor progress with achieving and certifying Y2K compliance. In addition, the Company has utilized external consulting firms to assist with its Y2K program. The Company's current plan is to complete the Y2K project by March 31, 1999. Following its completion of the assessment phase, the Company determined that a significant portion of its computer hardware and software did not require updating or replacement to achieve Y2K compliance. The Company has limited internally generated programmed software coding to correct, as substantially all of the software utilized by the Company is purchased or licensed from external providers. The Company has determined that it has little to no exposure to contingencies related to the Y2K issue for products it has sold. The Company initiated formal communications with all of its significant suppliers and customers to determine the extent to which the Company is vulnerable to those third parties' failure to remediate their own Y2K issues. The Company requested third party vendors represent their products and services to be Y2K compliant and that they have a program to test for that compliance. Significant suppliers have been contacted and where applicable their products successfully tested. All testing, communications and correspondence indicates the necessary levels of concern and planning for their own Y2K readiness. 41
43 At this time, the Company cannot estimate the additional cost, if any, that might develop in relation to significant suppliers and customers. The Company is prepared to curtail credit availability to customers identified as having material exposure to the Y2K issue. However, the Company's ability to exercise such curtailment may be limited by various factors, including existing legal agreements and potential concerns regarding lender liability. The Company's total Y2K estimated project cost, which is based upon currently available information, includes expenses for the review and testing of third parties, including government entities. However, there can be no guarantee that the hardware, software, and systems of such third parties will be without unfavorable Y2K issues and, therefore, not present a material adverse impact upon the Company. Y2K compliance costs incurred during 1998 totaled approximately $316,000, the majority of which was related to hardware and software acquisitions. This figure does not include the implicit costs associated with the reallocation of internal staff hours to Y2K project related efforts. At this time management currently estimates additional Y2K compliance costs, which are expensed on a current period basis except for fixed asset purchases, at between $150,000 and $200,000. The estimated costs associated with the Y2K project have decreased from the original estimate. The Company's testing indicates less hardware purchases will be required than originally estimated. This range of cost does not include normal ongoing costs for computer hardware (including ATM's) and software that would be replaced in the next year even without the presence of the Y2K issue in conjunction with the Company's ongoing programs for updating and expanding its delivery infrastructure. The aforementioned Y2K project cost estimate may change as the Company progresses in its Y2K program and obtains additional information associated with and conducts further testing concerning third parties. At this time, no significant projects have been delayed as a result of the Company's Y2K effort. Despite the Company's activities in regards to the Y2K issue, there can be no assurance that partial or total systems interruptions or the costs necessary to update hardware and software would not have a material adverse effect upon the Company's business, financial condition, results of operations and business prospects. OTHER ACCOUNTING ISSUES On June 15, 1998, the Financial Accounting Standards Board (FASB) issued Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (FAS133). FAS133 is effective for all fiscal quarters of all fiscal years beginning after June 15, 1999 (January 1, 2000 for the Company). FAS133 requires that all derivative instruments be recorded on the balance at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. Management of the Company anticipates that the adoption of FAS133 will not have a significant effect on the Company's results of operations or its financial position. EFFECTS OF INFLATION The consolidated financial statements of the Company, and their related notes, have been prepared in accordance with generally accepted accounting principles, that require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time and due to inflation. The impact of inflation is reflected in the increased cost of the Company's operations. Unlike many industrial companies, nearly all of the assets and liabilities of the Company are monetary. As a result, interest rates have a greater impact on the Company's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services. 42
44 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is set forth in Part IV. ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS OF THE REGISTRANT Certain of the information required under this item appears beginning on page 2 of the Company's definitive proxy statement for the Annual Meeting of Shareholders to be held April 28, 1999, and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required under this item appears beginning on page 6 of the Company's definitive proxy statement for the Annual Meeting of Shareholders to be held April 28, 1999, and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required under this item beginning on page 2 of the Company's definitive proxy statement for the Annual Meeting of Shareholders to be held April 28, 1999, and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required under this item beginning on page 11 of the Company's definitive proxy statement for the Annual Meeting of Shareholders to be held April 28, 1999, and is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements The following consolidated financial statements of Southside Bancshares, Inc. and its subsidiaries are filed as part of this report. Consolidated Balance Sheets as of December 31, 1998 and 1997. Consolidated Statements of Income for the years ended December 31, 1998, 1997 and 1996. Consolidated Statements of Shareholders' Equity for the years ended December 31, 1998, 1997 and 1996. Consolidated Statements of Cash Flow for the years ended December 31, 1998, 1997 and 1996. Notes to Consolidated Financial Statements. 43
45 2. Financial Statement Schedules All schedules are omitted because they are not applicable or not required, or because the required information is included in the consolidated financial statements or notes thereto. 3. Exhibits <TABLE> <CAPTION> Exhibit No. -------- <S> <C> 3 (a)(i) - Articles of Incorporation as amended and in effect on December 31, 1992, of SoBank, Inc. (now named Southside Bancshares, Inc.)(filed as Exhibit 3 to the Registrant's Form 10-K for the year ended December 31, 1992, and incorporated herein). 3 (a)(ii) - Articles of Amendment effective May 9, 1994 to Articles of Incorporation of SoBank, Inc. (now named Southside Bancshares, Inc.) (filed as Exhibit 3(a)(ii) to the Registrant's Form 10-K for the year ended December 31, 1994, and incorporated herein). 3 (b) - Bylaws as amended and in effect on March 23, 1995 of Southside Bancshares, Inc. (filed as Exhibit 3(b) to the Registrant's Form 10-K for the year ended December 31, 1994, and incorporated herein). ** 10 (a)(i) - Deferred Compensation Plan for B. G. Hartley effective February 13, 1984, as amended June 28, 1990 and December 15, 1994 (filed as Exhibit 10(a)(i) to the Registrant's Form 10-K for the year ended December 31, 1994, and incorporated herein). ** 10 (a)(ii) - Deferred Compensation Plan for Robbie N. Edmonson effective February 13, 1984, as amended June 28, 1990 and March 16, 1995 (filed as Exhibit 10(a)(ii) to the Registrant's Form 10-K for the year ended December 31, 1995, and incorporated herein). ** 10 (b) - Officers Long-term Disability Income Plan effective June 25, 1990 (filed as Exhibit 10(b) to the Registrant's Form 10-K for the year ended June 30, 1990, and incorporated herein). ** 10 (c) - Retirement Plan Restoration Plan for the subsidiaries of SoBank, Inc. (now named Southside Bancshares, Inc.)(filed as Exhibit 10(c) to the Registrant's Form 10-K for the year ended December 31, 1992, and incorporated herein). ** 10 (d) - Incentive Stock Option Plan effective April 1, 1993 of SoBank, Inc. (now named Southside Bancshares, Inc.) (filed as Exhibit 10(d) to the Registrant's Form 10-K for the year ended December 31, 1994, and incorporated herein). ** 10 (e) - Form of Deferred Compensation Agreements dated June 30, 1994 with each of Titus Jones and Andy Wall as </TABLE> 44
46 <TABLE> <S> <C> amended November 13, 1995. (filed as Exhibit 10(e) to the Registrant's Form 10-K for the year ended December 31, 1995, and incorporated herein). ** 10 (f) - Form of Deferred Compensation Agreements dated June 30, 1994 with each of Sam Dawson, Lee Gibson and Jeryl Story as amended October 15, 1997 and Form of Deferred Compensation Agreement dated October 15, 1997 with Lonny Uzzell. * 21 - Subsidiaries of the Registrant. * 23 - Consent of Independent Accountants. * 27 - Financial Data Schedule for the year ended December 31, 1998. </TABLE> * Filed herewith. ** Compensation plan, benefit plan or employment contract or arrangement. (b) Reports on Form 8-K Registrant did not file any Form 8-K's during the three months ended December 31, 1998. 45
47 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SOUTHSIDE BANCSHARES, INC. BY: /s/ B. G. HARTLEY -------------------------------------- B. G. Hartley, Chairman of the Board and Director (Principal Executive Officer) /s/ LEE R. GIBSON -------------------------------------- Lee R. Gibson, CPA, Executive Vice President (Principal Financial DATED: March 11, 1999 Officer and Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. <TABLE> <CAPTION> Signature Title Date --------- ----- ---- <S> <C> <C> /s/ B. G. HARTLEY Chairman of the Board March 11, 1999 ------------------------------------- and Director (B. G. Hartley) /s/ ROBBIE N. EDMONSON Vice Chairman of the Board March 11, 1999 ------------------------------------- and Director (Robbie N. Edmonson) /s/ SAM DAWSON President and Secretary March 11, 1999 ------------------------------------- and Director (Sam Dawson) /s/ FRED E. BOSWORTH Director March 11, 1999 ------------------------------------- (Fred E. Bosworth) /s/ HERBERT C. BUIE Director March 11, 1999 ------------------------------------- (Herbert C. Buie) /s/ ROLLINS CALDWELL Director March 11, 1999 ------------------------------------- (Rollins Caldwell) /s/ W. D. (JOE) NORTON Director March 11, 1999 ------------------------------------- (W. D. (Joe) Norton) /s/ WILLIAM SHEEHY Director March 11, 1999 ------------------------------------- (William Sheehy) </TABLE> 46
48 Report of Independent Accountants To the Shareholders and Board of Directors Southside Bancshares, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income and shareholders' equity and of cash flow present fairly, in all material respects, the financial position of Southside Bancshares, Inc. and its subsidiaries at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. 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 of these statements in accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PRICEWATERHOUSECOOPERS LLP PricewaterhouseCoopers LLP Dallas, Texas February 26, 1999 47
49 SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts) <TABLE> <CAPTION> December 31, December 31, 1998 1997 -------------- -------------- ASSETS <S> <C> <C> Cash and due from banks........................................................... $ 41,372 $ 36,593 Investment securities: Available for sale............................................................. 132,447 71,031 Held to maturity............................................................... 347 804 -------------- ------------- Total Investment securities.................................................. 132,794 71,835 Mortgage-backed and related securities: Available for sale............................................................. 333,194 127,751 Held to maturity............................................................... 7,810 13,662 -------------- ------------- Total Mortgage-backed securities............................................. 341,004 141,413 Marketable equity securities: Available for sale............................................................. 14,171 3,258 Loans: Loans, net of unearned discount............................................... 319,723 296,035 Less: reserve for loan losses................................................. (3,564) (3,370) -------------- ------------- Net Loans.................................................................... 316,159 292,665 Premises and equipment, net....................................................... 19,166 17,627 Other real estate owned, net...................................................... 195 364 Interest receivable............................................................... 6,065 3,918 Deferred tax asset................................................................ 504 Other assets...................................................................... 5,403 3,012 -------------- ------------- TOTAL ASSETS................................................................. $ 876,329 $ 571,189 ============== ============= LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Noninterest bearing............................................................ $ 122,440 $ 98,592 Interest bearing............................................................... 392,594 364,082 -------------- ------------- Total Deposits............................................................... 515,034 462,674 Short-term obligations: Federal funds purchased........................................................ 4,168 3,884 FHLB Dallas Advances........................................................... 118,000 29,000 Other obligations.............................................................. 1,523 1,647 -------------- ------------- Total Short-term obligations................................................. 123,691 34,531 Long-term obligations: FHLB Dallas Advances........................................................... 156,027 28,547 Guaranteed Preferred Beneficial Interest in the Company's Junior Subordinated Debentures................................................. 20,000 -------------- ------------- Total Long-term obligations.................................................. 176,027 28,547 Deferred tax liability............................................................ 1,184 Other liabilities................................................................. 13,980 5,491 -------------- ------------- TOTAL LIABILITIES............................................................ 829,916 531,243 -------------- ------------- Commitments and Contingencies (Note 14 and 15) Shareholders' equity: Common stock: ($2.50 par, 6,000,000 shares authorized, 3,685,775 and 3,496,269 shares issued)........................................ 9,214 8,740 Paid-in capital................................................................ 24,198 21,290 Retained earnings.............................................................. 11,391 10,414 Treasury stock (182,176 and 116,750 shares at cost)............................ (3,158) (1,820) Accumulated other comprehensive income......................................... 4,768 1,322 -------------- ------------- TOTAL SHAREHOLDERS' EQUITY.................................................. 46,413 39,946 -------------- ------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY.................................. $ 876,329 $ 571,189 ============== ============= </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 48
50 SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share data) <TABLE> <CAPTION> Years Ended December 31, ------------------------------------- 1998 1997 1996 ----------- ----------- ---------- <S> <C> <C> <C> Interest income Loans..................................................................... $ 26,051 $ 23,847 $ 21,314 Investment securities..................................................... 4,864 3,299 3,374 Mortgage-backed and related securities.................................... 12,116 7,729 6,756 Marketable equity securities.............................................. 449 129 119 Other interest earning assets............................................. 197 163 209 ----------- ----------- ---------- Total interest income............................................... 43,677 35,167 31,772 ----------- ----------- ---------- Interest expense Deposits.................................................................. 15,485 14,711 13,593 Short-term obligations.................................................... 3,513 773 132 Long-term obligations..................................................... 5,749 721 672 ----------- ----------- ---------- Total interest expense.............................................. 24,747 16,205 14,397 ----------- ----------- ---------- Net interest income.......................................................... 18,930 18,962 17,375 Provision for loan losses.................................................... 1,215 1,005 500 ----------- ----------- ---------- Net interest income after provision for loan losses.......................... 17,715 17,957 16,875 ----------- ----------- ---------- Noninterest income Deposit services.......................................................... 5,353 4,001 2,821 Gain on sales of securities available for sale............................ 1,260 233 132 Trust income.............................................................. 528 397 281 Other..................................................................... 1,162 1,035 899 ----------- ----------- ---------- Total noninterest income............................................ 8,303 5,666 4,133 ----------- ----------- ---------- Noninterest expense Salaries and employee benefits............................................ 11,318 9,889 9,382 Net occupancy expense..................................................... 2,370 2,089 1,749 Equipment expense......................................................... 457 414 321 Advertising, travel & entertainment....................................... 1,124 1,006 956 Supplies.................................................................. 461 440 436 Postage................................................................... 352 331 301 Other..................................................................... 3,361 2,759 2,221 ----------- ----------- ---------- Total noninterest expense........................................... 19,443 16,928 15,366 ----------- ----------- ---------- Income before federal tax expense............................................ 6,575 6,695 5,642 ----------- ----------- ---------- Provision (benefit) for federal tax expense Current................................................................... 1,496 1,914 1,648 Deferred.................................................................. (272) (225) (211) ----------- ----------- ---------- Total income taxes.................................................. 1,224 1,689 1,437 ----------- ----------- ---------- Net Income................................................................... $ 5,351 $ 5,006 $ 4,205 =========== =========== ========== Net Income Per Common Share Basic..................................................................... $ 1.52 $ 1.40 $ 1.17 Diluted................................................................... $ 1.46 $ 1.36 $ 1.15 </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 49
51 SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in thousands) <TABLE> <CAPTION> Accumulated Other Total Comprehensive Common Paid in Retained Treasury Comprehensive Shareholders' Income Stock Capital Earnings Stock Income Equity ---------- --------- ---------- --------- --------- ---------- ----------- <S> <C> <C> <C> <C> <C> <C> <C> Balance at December 31, 1997................ $ $ 8,740 $ 21,290 $ 10,414 $ (1,820) $ 1,322 $ 39,946 Net Income.................................. 5,351 5,351 5,351 Other comprehensive income, net of tax Unrealized gains on securities, net of reclassification adjustment (see disclosure below)........................ 3,396 3,396 3,396 Minimum pension liability adjustment........ 50 50 50 --------- Comprehensive income........................ $ 8,797 ========= Common stock issued (21,160 shares)......... 53 294 347 FAS109 - Incentive Stock Options (ISO's).... 42 42 Dividends paid on common stock.............. (1,359) (1,359) Purchase of 71,426 shares of treasury stock........................... (1,398) (1,398) Exercise of 6,000 shares of ISO's........... (22) 60 38 Stock dividend.............................. 421 2,572 (2,993) --------- --------- --------- -------- ------- --------- Balance at December 31, 1998................ $ 9,214 $ 24,198 $ 11,391 $ (3,158) $ 4,768 $ 46,413 ========= ========== ========= ======== ======= ========= Disclosure of reclassification amount: Unrealized holding gains arising during period................................... $ 4,228 Less: reclassification adjustment for gains included in net income............. (832) --------- Net unrealized gains on securities.......... $ 3,396 ========= Balance at December 31, 1996................ $ $ 8,290 $ 18,501 $ 9,628 $ (777) $ 842 $ 36,484 Net Income.................................. 5,006 5,006 5,006 Other comprehensive income, net of tax Unrealized gains on securities, net of reclassification adjustment (see disclosure below)........................ 445 445 445 Minimum pension liability adjustment........ 35 35 35 --------- Comprehensive income........................ $ 5,486 ========= Common stock issued (18,430 shares)......... 46 280 326 FAS109 - Incentive Stock Options (ISO's).... 43 43 Dividends paid on common stock.............. (1,316) (1,316) Purchase of 65,464 shares of treasury stock........................... (1,154) (1,154) Exercise of 11,700 shares of ISO's.......... (34) 111 77 Stock dividend.............................. 404 2,466 (2,870) --------- --------- --------- -------- ------- --------- Balance at December 31, 1997................ $ 8,740 $ 21,290 $ 10,414 $ (1,820) $ 1,322 $ 39,946 ========= ========= ========= ========= ========= ========= Disclosure of reclassification amount: Unrealized holding gains arising during period................................... $ 599 Less: reclassification adjustment for gains included in net income............. (154) --------- Net unrealized gains on securities.......... $ 445 ========= </TABLE> 50
52 SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (continued) (in thousands) <TABLE> <CAPTION> Accumulated Other Total Comprehensive Common Paid in Retained Treasury Comprehensive Shareholders' Income Stock Capital Earnings Stock Income Equity ------------- --------- ---------- ----------- --------- ------------ ------------ <S> <C> <C> <C> <C> <C> <C> <C> Balance at December 31, 1995................ $ $ 7,853 $ 16,209 $ 9,123 $ (486) $ 653 $ 33,352 Net Income.................................. 4,205 4,205 4,205 Other comprehensive income, net of tax Unrealized gains on securities, net of reclassification adjustment (see disclosure below)........................ 309 309 309 Minimum pension liability adjustment........ (120) (120) (120) --------- Comprehensive income........................ $ 4,394 ========= Common stock issued (19,557 shares)......... 49 259 308 FAS109 - Incentive Stock Options (ISO's).... 16 16 Dividends paid on common stock.............. (1,258) (1,258) Purchase of 27,648 shares of treasury stock........................... (425) (425) Exercise of 14,083 shares of ISO's.......... (37) 134 97 Stock dividend.............................. 388 2,017 (2,405) --------- --------- ---------- -------- --------- --------- Balance at December 31, 1996................ $ 8,290 $ 18,501 $ 9,628 $ (777) $ 842 $ 36,484 ========= ========= ========== ======== ========= ========= Disclosure of reclassification amount: Unrealized holding gains arising during period................................... $ 396 Less: reclassification adjustment for gains included in net income............. (87) --------- Net unrealized gains on securities.......... $ 309 ========= </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 51
53 SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW (in thousands) <TABLE> <CAPTION> Years Ended December 31, --------------------------------------- 1998 1997 1996 ------------ ------------ ------------ <S> <C> <C> <C> OPERATING ACTIVITIES: Net income................................................................. $ 5,351 $ 5,006 $ 4,205 Adjustments to reconcile net cash provided by operations: Depreciation ............................................................ 1,397 1,215 1,025 Amortization of premium.................................................. 5,229 1,589 1,225 Accretion of discount and loan fees...................................... (660) (780) (737) Provision for loan losses................................................ 1,215 1,005 500 FAS109-Incentive stock options........................................... 42 43 16 Gain on sale of securities available for sale............................ (1,260) (233) (132) Gain on sale of assets................................................... (51) (12) (6) Gain on sale of other real estate owned.................................. (32) Increase in interest receivable.......................................... (2,147) (618) (205) (Increase) decrease in other assets...................................... (2,270) 923 (964) Increase in deferred tax asset........................................... (87) (225) (210) Increase in interest payable............................................. 558 598 103 Increase (decrease) in other payables.................................... 7,883 167 (2,586) ----------- ----------- ---------- Net cash provided by operating activities............................ 15,168 8,678 2,234 INVESTING ACTIVITIES: Proceeds from sale of investment securities available for sale........... 62,413 31,037 19,928 Proceeds from sale of mortgage-backed securities available for sale...... 46,515 37,247 18,991 Proceeds from maturities of investment securities available for sale..... 10,322 16,366 33,920 Proceeds from maturities of mortgage-backed securities available for sale 79,121 33,389 18,529 Proceeds from maturities of investment securities held to maturity....... 457 936 941 Proceeds from maturities of mortgage-backed securities held to maturity 5,899 10,214 10,398 Purchases of investment securities available for sale.................... (130,138) (61,370) (35,098) Purchases of mortgage-backed securities available for sale............... (333,304) (108,788) (63,353) Purchases of marketable equity securities available for sale............. (10,913) (1,038) (108) Net increase in loans.................................................... (26,521) (39,900) (31,144) Purchases of premises and equipment...................................... (3,096) (5,153) (3,070) Proceeds from sale of premises and equipment............................. 212 17 25 Proceeds from sale of repossessed assets................................. 1,617 1,015 1,165 Proceeds from sale of other real estate owned............................ 275 98 ----------- ----------- ---------- Net cash used in investing activities................................ (297,141) (85,930) (28,876) </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 52
54 SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW (continued) (in thousands) <TABLE> <CAPTION> Years Ended December 31, --------------------------------------- 1998 1997 1996 ----------- ------------ ------------ <S> <C> <C> <C> FINANCING ACTIVITIES: Net increase in demand and savings accounts................................ $ 41,944 $ 24,443 $ 16,332 Net increase in certificates of deposit.................................... 10,416 12,281 21,310 Proceeds from FHLB advances................................................ 404,800 58,900 Repayment of FHLB advances................................................. (188,320) (10,449) (4,590) Issuance of guaranteed preferred beneficial interest in the company's junior subordinated debentures......................... 20,000 Net increase (decrease) in federal funds purchased......................... 284 (916) 200 Proceeds from the issuance of common stock................................. 347 326 308 Purchase of treasury stock................................................. (1,398) (1,154) (425) Sale of treasury stock..................................................... 38 77 97 Dividends paid............................................................. (1,359) (1,316) (1,258) ----------- ----------- ---------- Net cash provided by financing activities............................ 286,752 82,192 31,974 ----------- ----------- ---------- Net increase in cash and cash equivalents.................................. 4,779 4,940 5,332 Cash and cash equivalents at beginning of year............................. 36,593 31,653 26,321 ----------- ----------- ---------- Cash and cash equivalents at end of year................................... $ 41,372 $ 36,593 $ 31,653 =========== =========== ========== SUPPLEMENTAL DISCLOSURE FOR CASH FLOW INFORMATION: Interest paid.............................................................. $ 24,189 $ 15,701 $ 14,294 Income taxes paid.......................................................... $ 1,763 $ 1,990 $ 1,623 SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES: Acquisition of other real estate owned and other repossessed assets through foreclosure............................................. $ 1,812 $ 1,148 $ 1,187 </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 53
55 NOTES TO FINANCIAL STATEMENTS Southside Bancshares, Inc. and Subsidiaries - -------------------------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES The significant accounting and reporting policies of Southside Bancshares, Inc. (the "Company"), and its wholly owned subsidiaries, Southside Delaware Financial Corporation, Southside Bank (the "Bank") and the nonbank subsidiary, are summarized below. Organization and Basis of Presentation. The consolidated financial statements include the accounts of the Company, Southside Delaware Financial Corporation, Southside Bank and the nonbank subsidiary, which did not conduct any business in 1998. Southside Bank offers a full range of financial services to commercial, industrial, financial and individual customers. All significant intercompany accounts and transactions are eliminated in consolidation. The preparation of these consolidated financial statements in conformity with generally accepted accounting principles requires the use of management's estimates. These estimates are subjective in nature and involve matters of judgment. Actual amounts could differ from these estimates. Cash Equivalents. Cash equivalents, for purposes of reporting cash flow, include cash and amounts due from banks. Loans. All loans are stated at principal outstanding net of unearned income. Interest income on installment loans is recognized primarily using the level yield method. Interest income on other loans is credited to income based primarily on the principal outstanding at contract rates of interest. Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. A loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Substantially all of the Company's impaired loans are collateral-dependent, and as such, are measured for impairment based on the fair value of the collateral. Loan Fees. The Company treats loan fees, net of direct costs, as an adjustment to the yield of the related loan over its term. Reserve for Loan Losses. A reserve for loan losses is provided through charges to income in the form of a provision for loan losses. Loans which management believes are uncollectible are charged against this account with subsequent recoveries, if any, credited to the account. The amount of the current allowance for loan losses is determined by management's evaluation of the quality and inherent risks in the loan portfolio, economic conditions and other factors which warrant current recognition. Nonaccrual Loans. A loan is placed on nonaccrual when principal or interest is contractually past due 90 days or more unless, in the determination of management, the principal and interest on the loan are well collateralized and in the process of collection. In addition, a loan is placed on nonaccrual when, in the opinion of management, the future collectibility of interest and principal is in serious doubt. When classified as nonaccrual, accrued interest receivable on the loan is reversed and the future accrual of interest is suspended. Payments of contractual interest are recognized as income only to the extent that full recovery of the principal balance of the loan is reasonably certain. 54
56 Other Real Estate Owned. Other Real Estate Owned includes real estate acquired in full or partial settlement of loan obligations. Other Real Estate Owned is carried at the lower of (1) the recorded amount of the loan for which the foreclosed property previously served as collateral or (2) the fair market value of the property. Prior to foreclosure, the recorded amount of the loan is written down, if necessary, to the appraised fair market value of the real estate to be acquired, less selling costs, by charging the allowance for loan losses. Any subsequent reduction in fair market value is charged to results of operations through the Allowance for Losses on Other Real Estate account. Costs of maintaining and operating foreclosed properties are expensed as incurred. Expenditures to complete or improve foreclosed properties are capitalized only if expected to be recovered; otherwise, they are expensed. Securities. The Company uses the specific identification method to determine the basis for computing realized gain or loss. The Company accounts for debt and equity securities as follows: Held to Maturity (HTM). Debt securities that management has the positive intent and ability to hold until maturity are classified as held to maturity and are carried at their remaining unpaid principal balance, net of unamortized premiums or unaccreted discounts. Premiums are amortized and discounts are accreted using the level interest yield method over the estimated remaining term of the underlying security. Available for Sale (AFS). Debt and equity securities that will be held for indefinite periods of time, including securities that may be sold in response to changes in market interest or prepayment rates, needs for liquidity and changes in the availability of and the yield of alternative investments are classified as available for sale. These assets are carried at market value. Market value is determined using published quotes as of the close of business. Unrealized gains and losses are excluded from earnings and reported net of tax as a separate component of shareholders' equity until realized. Premises and Equipment. Bank premises and equipment are stated at cost, net of accumulated depreciation. Depreciation is computed on a straight line basis over the estimated useful lives of the related assets. Useful lives are estimated to be twenty to forty years for premises and three to ten years for equipment. Maintenance and repairs are charged to income as incurred while major improvements and replacements are capitalized. Income Taxes. The Company files a consolidated Federal income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of changes in tax rates is recognized in income in the period the change occurs. Earnings Per Share. The Company adopted the provisions of Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (FAS128). This statement supersedes APB 15, "Earnings Per Share" and simplifies the computation of earnings per share (EPS) by replacing the "primary" EPS requirements of APB 15 with a "basic" EPS computation based upon weighted-average shares outstanding. The new standard requires a dual presentation of basic and diluted EPS. Diluted EPS is similar to fully diluted EPS required under APB 15 for entities with complex capital structures. The adoption of FAS128 did not have a material impact on the Company. All previous periods have been restated to reflect the adoption of FAS128. Earnings per share have been adjusted to give retroactive recognition to stock dividends. 55
57 Earnings per share on a basic and diluted basis as required by Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (FAS128), is calculated as follows (in thousands, except per share amounts): <TABLE> <CAPTION> Years Ended December 31, ---------------------------- 1998 1997 1996 ------ ------ ------ <S> <C> <C> <C> Basic net earnings per share Net income ........................................................... $5,351 $5,006 $4,205 Weighted average shares outstanding .................................. 3,529 3,564 3,580 ------ ------ ------ $ 1.52 $ 1.40 $ 1.17 ====== ====== ====== Diluted net earnings per share Net income ........................................................... $5,351 $5,006 $4,205 Weighted average shares outstanding plus assumed conversions ............................................... 3,664 3,673 3,672 ------ ------ ------ $ 1.46 $ 1.36 $ 1.15 ====== ====== ====== Calculation of weighted average shares outstanding plus assumed conversions Weighted average shares outstanding .................................. 3,529 3,564 3,580 Effect of dilutive securities options ................................ 135 109 92 ------ ------ ------ 3,664 3,673 3,672 ====== ====== ====== </TABLE> Comprehensive Income. In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (FAS130). This statement, which the Company adopted January 1, 1998, establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. The new standard requires that all items that are required to be recognized under generally accepted accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. Reclassification of financial statements for earlier periods provided for comparative purposes is required. The components of comprehensive income are as follows: <TABLE> <CAPTION> Year Ended December 31, 1998 ---------------------------------------------------- Before-Tax Tax (Expense) Net-of-Tax Amount or Benefit Amount ---------------- -------------- ---------------- <S> <C> <C> <C> Unrealized gains on securities: Unrealized holding gains arising during period....... $ 6,405 $ (2,177) $ 4,228 Less: reclassification adjustment for gains realized in net income........................... (1,260) 428 (832) --------------- -------------- --------------- Net unrealized gains................................ 5,145 (1,749) 3,396 Minimum pension liability adjustment.................... (76) 26 (50) --------------- -------------- --------------- Other comprehensive income.............................. $ 5,069 $ (1,723) $ 3,346 =============== ============== =============== </TABLE> 56
58 <TABLE> <CAPTION> Year Ended December 31, 1997 ---------------------------------------------------- Before-Tax Tax (Expense) Net-of-Tax Amount or Benefit Amount ---------------- -------------- ---------------- <S> <C> <C> <C> Unrealized gains on securities: Unrealized holding gains arising during period....... $ 907 $ (308) $ 599 Less: reclassification adjustment for gains realized in net income........................... (233) 79 (154) --------------- -------------- --------------- Net unrealized gains................................ 674 (229) 445 Minimum pension liability adjustment.................... (52) 17 (35) --------------- -------------- --------------- Other comprehensive income.............................. $ 622 $ (212) $ 410 =============== ============== =============== </TABLE> <TABLE> <CAPTION> Year Ended December 31, 1996 ---------------------------------------------------- Before-Tax Tax (Expense) Net-of-Tax Amount or Benefit Amount ---------------- -------------- ---------------- <S> <C> <C> <C> Unrealized gains on securities: Unrealized holding gains arising during period....... $ 600 $ (204) $ 396 Less: reclassification adjustment for gains realized in net income........................... (132) 45 (87) --------------- -------------- --------------- Net unrealized gains................................ 468 (159) 309 Minimum pension liability adjustment.................... 44 (15) 29 --------------- -------------- --------------- Other comprehensive income.............................. $ 512 $ (174) $ 338 =============== ============== =============== </TABLE> Stock Options. The Financial Accounting Standards Board published Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS123) on January 1, 1996 which encourages, but does not require, companies to recognize compensation expense for grants of stock, stock options and other equity instruments to employees based on new fair value accounting rules. Companies that choose not to adopt the new rules will continue to apply existing rules, but will be required to disclose pro forma net income and earnings per share under the new method. The Company elected to provide the pro forma disclosures for 1996, 1997 and 1998. Recent Accounting Pronouncements. On June 15, 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (FAS133). FAS133 is effective for all fiscal quarters of all fiscal years beginning after June 15, 1999 (January 1, 2000 for the Company). FAS133 requires that all derivative instruments be recorded on the balance at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. Management of the Company anticipates that the adoption of FAS133 will not have a significant effect on the Company's results of operations or its financial position. General. Certain prior period amounts have been reclassified to conform to current year presentation. 2. CASH AND DUE FROM BANKS The Company is required to maintain cash reserve balances with the Federal Reserve Bank. The reserve balances were $1,223,000 and $2,816,000 as of December 31, 1998 and 1997, respectively. 57
59 3. INVESTMENT, MORTGAGE-BACKED AND MARKETABLE EQUITY SECURITIES The amortized cost and estimated market value of investment, mortgage-backed and marketable equity securities as of December 31, 1998 and 1997 were (in thousands): <TABLE> <CAPTION> AVAILABLE FOR SALE ------------------------------------------------------------------------- Gross Gross Estimated December 31, Amortized Unrealized Unrealized Market 1998 Cost Gains Losses Value ---- ---------------- ----------------- ---------------- ---------------- <S> <C> <C> <C> <C> U.S. Treasury ........................ $ 19,137 $ 64 $ 3 $ 19,198 U.S. Government Agencies.............. 21,402 16 41 21,377 Mortgage-backed Securities: Direct Govt. Agency Issues.......... 227,804 2,342 439 229,707 Other Private Issues................ 102,577 1,261 351 103,487 State and Political Subdivisions...... 86,055 4,591 113 90,533 Other Stocks and Bonds................ 15,484 26 15,510 ---------------- ----------------- ---------------- ---------------- Total .............................. $ 472,459 $ 8,300 $ 947 $ 479,812 ================ ================= ================ ================ </TABLE> <TABLE> <CAPTION> HELD TO MATURITY ------------------------------------------------------------------------- Gross Gross Estimated December 31, Amortized Unrealized Unrealized Market 1998 Cost Gains Losses Value ---- ---------------- ----------------- ---------------- ---------------- <S> <C> <C> <C> <C> U.S. Government Agencies.............. $ 347 $ $ $ 347 Mortgage-backed Securities: Direct Govt. Agency Issues.......... 7,810 79 79 7,810 ---------------- ----------------- ---------------- ---------------- Total .............................. $ 8,157 $ 79 $ 79 $ 8,157 ================ ================= ================ ================ </TABLE> <TABLE> <CAPTION> AVAILABLE FOR SALE ------------------------------------------------------------------------- Gross Gross Estimated December 31, Amortized Unrealized Unrealized Market 1997 Cost Gains Losses Value ---- ---------------- ----------------- ---------------- ---------------- <S> <C> <C> <C> <C> U.S. Treasury ........................ $ 19,958 $ 6 $ 8 $ 19,956 U.S. Government Agencies.............. 629 2 631 Mortgage-backed Securities: Direct Govt. Agency Issues.......... 93,829 339 187 93,981 Other Private Issues................ 33,333 439 2 33,770 State and Political Subdivisions...... 45,938 1,728 8 47,658 Other Stocks and Bonds................ 6,041 3 6,044 ---------------- ----------------- ---------------- ---------------- Total .............................. $ 199,728 $ 2,517 $ 205 $ 202,040 ================ ================= ================ ================ </TABLE> <TABLE> <CAPTION> HELD TO MATURITY ------------------------------------------------------------------------- Gross Gross Estimated December 31, Amortized Unrealized Unrealized Market 1997 Cost Gains Losses Value ---- ---------------- ----------------- ---------------- ---------------- <S> <C> <C> <C> <C> U.S. Government Agencies.............. $ 804 $ $ 5 $ 799 Mortgage-backed Securities: Direct Govt. Agency Issues.......... 13,662 129 103 13,688 ---------------- ----------------- ---------------- ---------------- Total .............................. $ 14,466 $ 129 $ 108 $ 14,487 ================ ================= ================ ================ </TABLE> 58
60 Interest income recognized on securities for the years presented (in thousands): <TABLE> <CAPTION> Years Ended December 31, ------------------------------------------ 1998 1997 1996 ------------- ------------- ------------- <S> <C> <C> <C> U.S. Treasury.......................................................... $ 562 $ 461 $ 397 U.S. Government Agencies............................................... 614 578 858 Mortgage-backed Securities............................................. 12,116 7,729 6,756 State and Political Subdivisions....................................... 3,548 2,067 2,000 Other Stocks and Bonds................................................. 589 322 238 ------------- ------------- ------------- Total interest income on securities.................................... $ 17,429 $ 11,157 $ 10,249 ============= ============= ============= </TABLE> In October 1995, the Financial Accounting Standards Board issued an implementation guide to FAS115 which allowed entities to reclassify their securities among the three categories provided in FAS115. There were no securities transferred from AFS to HTM or sales from the HTM portfolio during the year ended December 31, 1998, 1997 or 1996. Of the $1,260,000 in net securities gains on sales from the AFS portfolio in 1998, there were $1,321,000 in realized gains and $61,000 in realized losses. Of the $233,000 in net securities gains on sales from the AFS portfolio in 1997, there were $376,000 in realized gains and $143,000 in realized losses. The $132,000 in net securities gains on sales from the AFS portfolio in 1996 were comprised of $199,000 in realized gains and $67,000 in realized losses. The scheduled maturities of AFS and HTM securities as of December 31, 1998 are presented below. Mortgage-backed securities are presented in total by category. <TABLE> <CAPTION> Amortized Aggregate Cost Fair Value --------------- --------------- (in thousands) <S> <C> <C> Held to maturity securities: Due in one year or less.......................................................... $ 347 $ 347 Mortgage-backed securities.......................................................... 7,810 7,810 --------------- --------------- Total......................................................................... $ 8,157 $ 8,157 =============== =============== Available for sale securities: Due in one year or less.......................................................... $ 34,441 $ 34,507 Due after one year through five years............................................ 11,522 11,676 Due after five years through ten years........................................... 22,736 23,464 Due after ten years.............................................................. 73,379 76,971 --------------- --------------- 142,078 146,618 Mortgage-backed securities.......................................................... 330,381 333,194 --------------- --------------- Total......................................................................... $ 472,459 $ 479,812 =============== =============== </TABLE> Investment securities with book values of $306,409,000 and $32,844,000 were pledged as of December 31, 1998 and 1997, respectively, to collateralize advances, public and trust deposits or for other purposes as required by law. 59
61 4. LOANS AND RESERVE FOR POSSIBLE LOAN LOSSES Loans in the accompanying consolidated balance sheets are classified as follows (in thousands): <TABLE> <CAPTION> December 31, December 31, 1998 1997 ----------------- ------------------ <S> <C> <C> Real Estate Loans: Construction........................................................ $ 10,509 $ 10,299 1-4 family residential.............................................. 93,215 76,243 Other............................................................... 68,140 55,802 Commercial loans........................................................ 68,117 62,161 Loans to individuals.................................................... 84,059 96,432 ----------------- ------------------ Total loans............................................................. 324,040 300,937 Less: Unearned income.............................................. 4,317 4,902 Reserve for loan losses.................................... 3,564 3,370 ----------------- ------------------ Net loans............................................................... $ 316,159 $ 292,665 ================= ================== </TABLE> The following is a summary of the Reserve for Loan Losses for the years ended December 31, 1998, 1997 and 1996 (in thousands): <TABLE> <CAPTION> Years Ended December 31, ----------------------------------------- 1998 1997 1996 ------------ ------------ ------------ <S> <C> <C> <C> Balance at beginning of year........................................... $ 3,370 $ 3,249 $ 3,317 Provision for loan losses.......................................... 1,215 1,005 500 Loans charged off............................................... (1,349) (1,229) (838) Recoveries of loans charged off................................. 328 345 270 ------------ ------------ ------------ Balance at end of year................................................. $ 3,564 $ 3,370 $ 3,249 ============ ============ ============ </TABLE> Nonaccrual loans at December 31, 1998 and 1997 were $432,000 and $1,344,000, respectively. Loans with terms modified in troubled debt restructuring at December 31, 1998 and 1997 were $473,000 and $435,000, respectively. The following is a summary of the Company's recorded investment in loans (primarily nonaccrual loans) for which impairment has been recognized in accordance with FAS114 (in thousands): <TABLE> <CAPTION> Valuation Carrying Total Allowance Value ------------ ------------ ------------ <S> <C> <C> <C> Real Estate Loans...................................................... $ 2 $ $ 2 Commercial Loans....................................................... 167 32 135 Loans to Individuals................................................... 263 49 214 ------------ ------------ ------------ Balance at December 31, 1998........................................... $ 432 $ 81 $ 351 ============ ============ ============ </TABLE> <TABLE> <CAPTION> Valuation Carrying Total Allowance Value ------------ ------------ ------------ <S> <C> <C> <C> Real Estate Loans...................................................... $ 108 $ 27 $ 81 Commercial Loans....................................................... 1,059 185 874 Loans to Individuals................................................... 177 12 165 ------------ ------------ ------------ Balance at December 31, 1997........................................... $ 1,344 $ 224 $ 1,120 ============ ============ ============ </TABLE> 60
62 For the years ended December 31, 1998 and 1997, the average recorded investment in impaired loans was approximately $665,000 and $1,450,000, respectively. During the year ended December 31, 1998, the amount of interest income reversed on impaired loans placed on nonaccrual and the amount of interest income subsequently recognized on the cash basis was not material. The amount of interest recognized on nonaccrual or restructured loans was $94,000, $110,000 and $97,000 for the years ended December 31, 1998, 1997 and 1996, respectively. If these loans had been accruing interest at their original contracted rates, related income would have been $113,000, $336,000 and $216,000 for the years ended December 31, 1998, 1997 and 1996, respectively. 5. BANK PREMISES AND EQUIPMENT <TABLE> <CAPTION> December 31, December 31, 1998 1997 ---------------- ----------------- (in thousands) <S> <C> <C> Bank premises............................................................. $ 20,675 $ 18,713 Furniture and equipment................................................... 10,435 9,559 ----------------- ----------------- 31,110 28,272 Less accumulated depreciation............................................. 11,944 10,645 ----------------- ----------------- Total............................................................ $ 19,166 $ 17,627 ================= ================= </TABLE> Depreciation expense was $1,397,000, $1,215,000 and $1,025,000 for the years ended December 31, 1998, 1997 and 1996, respectively. Rent expense was $198,000, $159,000 and $87,000 for the years ended December 31, 1998, 1997 and 1996, respectively. Future minimum rental commitments under noncancelable leases are (in thousands): <TABLE> <S> <C> 1999 $ 319 2000 257 2001 227 2002 137 2003 97 Thereafter 0 ---------------- $ 1,037 ================ </TABLE> 6. OTHER REAL ESTATE OWNED The following is a summary of the Allowance for Losses on Other Real Estate Owned for the periods presented (in thousands): <TABLE> <CAPTION> Years Ended December 31, ------------------------------------ 1998 1997 ----------------- ---------------- <S> <C> <C> Balance at beginning of year............................................... $ 672 $ 946 Disposition of OREO.................................................... (14) (274) ----------------- ---------------- Balance at end of year..................................................... $ 658 $ 672 ================= ================ </TABLE> For the years ended December 31, 1998, 1997 and 1996, income from OREO properties exceeded the provision and other expenses by $28,000, $23,000 and $35,000, respectively. 61
63 7. INTEREST BEARING DEPOSITS <TABLE> <CAPTION> December 31, December 31, 1998 1997 ------------------ ------------------ (in thousands) <S> <C> <C> Savings deposits......................................................... $ 17,649 $ 16,155 Money Market demand deposits............................................. 60,264 57,493 NOW demand deposits...................................................... 70,676 64,368 Certificates and other time deposits of $100,000 or more.................................................... 90,836 77,059 Certificates and other time deposits under $100,000................................................ 153,169 149,007 ------------------ ------------------ Total........................................................... $ 392,594 $ 364,082 ================== ================== </TABLE> For the years ended December 31, 1998, 1997 and 1996, interest expense on time certificates of deposit of $100,000 or more was $3,369,000, $2,922,000 and $2,518,000, respectively. At December 31, 1998, the scheduled maturities of CDs are as follows (in thousands): <TABLE> <S> <C> 1999 $ 200,821 2000 25,832 2001 5,291 2002 7,369 2003 and thereafter 4,692 ------------------- $ 244,005 =================== </TABLE> The aggregate amount of demand deposits that has been reclassified as loans was $.5 million for December 31, 1998 and 1997. 62
64 8. SHORT-TERM BORROWINGS (dollars in thousands) Information related to short-term borrowings for the three years ended December 31 is provided in the table below. <TABLE> <CAPTION> Years Ended December 31, --------------------------------------- 1998 1997 1996 ---------- ----------- ----------- <S> <C> <C> <C> Federal funds purchased Balance at end of period............................................ $ 4,168 $ 3,884 $ 4,800 Average amount outstanding during the period (1).................... 3,700 2,695 1,367 Maximum amount outstanding during the period........................ 25,364 12,384 7,700 Weighted average interest rate during the period (2)................ 5.7% 5.7% 5.1% Interest rate at end of period...................................... 5.1% 7.8% 6.9% Securities sold under agreements to repurchase Balance at end of period............................................ $ $ $ Average amount outstanding during the period (1).................... 59 3,649 191 Maximum amount outstanding during the period........................ 7,150 13,027 1,980 Weighted average interest rate during the period (2)................ 5.6% 5.2% 5.2% Interest rate at end of period...................................... Federal Home Loan Bank ("FHLB") Dallas Advances Balance at end of period............................................ $ 118,000 $ 29,000 $ Average amount outstanding during the period (1).................... 61,734 6,798 Maximum amount outstanding during the period........................ 135,000 29,000 Weighted average interest rate during the period (2)................ 5.3% 5.5% Interest rate at end of period...................................... 5.0% 4.9% Treasury tax and loan funds Balance at end of period............................................ $ 1,523 $ 1,647 $ 2,035 Average amount outstanding during the period (1).................... 1,293 1,080 1,113 Maximum amount outstanding during the period........................ 3,154 2,850 2,731 Weighted average interest rate during the period (2)................ 4.2% 5.2% 4.6% Interest rate at end of period...................................... 4.1% 5.3% 5.2% </TABLE> (1) The average amount outstanding during the period was computed by dividing the total month-end outstanding principal balances by the number of months in the period. (2) The weighted average interest rate during the period was computed by dividing the actual interest expense (annualized) by average balance outstanding during the period. The Company has two lines of credit for the purchase of federal funds. A $15.0 million and $10.0 million unsecured line of credit has been established with Nationsbank and Texas Independent Bank, respectively. 63
65 9. LONG TERM OBLIGATIONS (dollars in thousands) <TABLE> <CAPTION> Years Ended December 31, -------------------------------- 1998 1997 1996 --------- -------- -------- <S> <C> <C> <C> FHLB Dallas Advances Balance at end of period............................................ $ 156,027 $ 28,547 $ 9,096 Average amount outstanding during the period (1).................... 84,836 12,151 12,010 Maximum amount outstanding during the period........................ 156,238 28,547 13,686 Weighted average interest rate during the period (2)................ 5.5% 5.9% 5.6% Interest rate at end of period...................................... 5.3% 6.0% 5.8% </TABLE> (1) The average amount outstanding during the period was computed by dividing the total month-end outstanding principal balances by the number of months in the period. (2) The weighted average interest rate during the period was computed by dividing the actual interest expense (annualized) by average balance outstanding during the period. FHLB Dallas Long-term advances based on scheduled repayments at December 31 are: <TABLE> <CAPTION> Under Due Due Over 1998 1 Year 1-5 Years 6-10 Years 10 Years Total ------------- -------------- ------------- ------------- ------------ <S> <C> <C> <C> <C> <C> Fixed rate............................ $ 1,201 $ 96,636 $ 57,723 $ 467 $ 156,027 ------------- -------------- ------------- ------------- ------------- Total Long-term Obligations........ $ 1,201 $ 96,636 $ 57,723 $ 467 $ 156,027 ============= ============== ============= ============= ============= </TABLE> FHLB Dallas advances are collateralized by FHLB Dallas stock, nonspecified real estate loans and mortgage-backed securities. In April 1998, the Company formed a wholly-owned non-banking subsidiary Southside Capital Trust (the "Trust Issuer"). The Trust Issuer was created under the Business Trust Act of Delaware for the sole purpose of issuing and selling Preferred Securities and Common Securities and using proceeds from the sale of the Preferred Securities and Common Securities to acquire Junior Subordinated Debentures (the "Debentures") issued by the Company. Accordingly, the Debentures are the sole assets of the Trust Issuer and payments under the Debentures are the sole revenue of the Trust Issuer. All of the Common Securities are owned by the Company. The Company's obligations under the Debentures and related documents, taken together, constitute a full and unconditional guarantee by the Company of the Trust Issuer's obligations under the Preferred Securities. Although the Debentures are treated as debt of the Company, they currently qualify for tier 1 capital treatment subject to a limitation that the securities included as tier 1 capital not exceed 25% of total tier 1 capital. The Securities are callable by the Company on or about June 30, 2003, or earlier in the event the deduction of related interest for federal income taxes is prohibited, treatment as tier 1 capital is no longer permitted or certain other contingencies arise. The Preferred Securities must be redeemed upon maturity of the Debentures in year 2028. On May 18, 1998, the Company through the Trust Issuer sold 2,000,000 Preferred Securities at a liquidation amount of $10 per Preferred Security for an aggregate amount of $20,000,000. It has a distribution rate of 8.50% per annum payable at the end of each calendar quarter. 64
66 10. EMPLOYEE BENEFITS Southside Bank has a deferred compensation agreement with eight of its executive officers, which generally provides for payment of an aggregate amount of $3.4 million over a maximum period of fifteen years after retirement or death. Deferred compensation expense was $147,000, $43,000 and $96,000 for the years ended December 31, 1998, 1997 and 1996, respectively. The Company provides accident and health insurance for substantially all employees through an insurance program funded by the Company. Health insurance benefits are offered to retired employees who pay a premium based on cost as determined by a third party administrator. Substantially all of the Company's employees may become eligible for those benefits if they reach normal retirement age after fifteen years of employment with the Company. The cost of health care benefits was $802,000, $792,000 and $760,000 for the years ended December 31, 1998, 1997 and 1996, respectively. There were four retirees participating in the health insurance plan as of December 31, 1998. There was one retiree participating in the health insurance plan as of December 31, 1997. The Company has an Employee Stock Ownership Plan which covers substantially all employees. Contributions to the plan are at the sole discretion of the Board of Directors. There were no contributions to the plan for the year ended December 31, 1998 and 1997. Contributions to the plan for the year ended December 31, 1996 was $75,000. At December 31, 1997 and 1998, 93,286 and 98,544 shares of common stock were owned by the Employee Stock Ownership Plan, respectively. The number of shares have been adjusted as a result of stock dividends. These shares are treated as externally held shares for dividend and earnings per share calculations. The Company has an Officers Long-term Disability Income Plan, (the "Disability Plan"), which covers officers of the Company and Southside Bank in the event they become disabled as defined under its terms. Individuals are automatically covered under the plan if they (a) have been elected as an officer, (b) have been an employee of the Company and Southside Bank for three years and (c) receive earnings of $50,000 or more on an annual basis. The Disability Plan provides, among other things, under its terms that should a covered individual become totally disabled he would receive 66-2/3%, not to exceed $10,000 per month, of their current salary. The benefits paid out of this plan are limited by the benefits paid to the individual under the terms of other Company sponsored benefit plans. The Company and Southside Bank have a defined benefit pension plan pursuant to which participants are entitled to benefits based on final average monthly compensation and years of credited service determined in accordance with plan provisions. All employees of the Company and Southside Bank who have worked 1000 hours or more in their first twelve months of employment or during any plan year thereafter are eligible to participate. Employees are vested upon the earlier of five years credited service or the employee attaining 60 years of age. Benefits are payable monthly commencing on the later of age 65 or the participants date of retirement. Eligible participants may retire at reduced benefit levels after reaching age 55. The Company contributes amounts to the pension fund sufficient to satisfy funding requirements of the Employee Retirement Income Security Act. Plan assets included 62,992 shares of Southside Bancshares, Inc. stock purchased at fair market value as of December 31, 1998 and 1997. The number of shares have been adjusted as a result of stock dividends. 65
67 <TABLE> <CAPTION> December 31, December 31, Change in Benefit Obligation 1998 1997 -------------- -------------- (in thousands) <S> <C> <C> Benefit obligation at end of prior year $ 11,853 $ 10,086 Service cost ................................. 578 510 Interest cost ................................ 856 778 Actuarial loss ............................... 1,107 923 Benefits paid ................................ (468) (444) -------------- -------------- Benefit obligation at end of year ......... $ 13,926 $ 11,853 ============== ============== </TABLE> <TABLE> <CAPTION> December 31, December 31, 1998 1997 Change in Plan Assets -------------- -------------- (in thousands) <S> <C> <C> Fair value of plan assets at end of prior year $ 10,233 $ 9,049 Actual return ................................ 2,064 1,415 Employer contribution ........................ 284 213 Benefits paid ................................ (468) (444) -------------- -------------- Fair value of plan assets at end of year .. $ 12,113 $ 10,233 ============== ============== </TABLE> <TABLE> <CAPTION> December 31, December 31, Reconciliation of Funded Status 1998 1997 ------------- -------------- (in thousands) <S> <C> <C> Funded status ................... ............ $ (1,813) $ (1,620) Unrecognized net loss ........... ............ 1,076 1,143 Unrecognized net transition asset ............ (231) (278) -------------- -------------- Accrued benefit cost ......... ............ $ (968) $ (755) ============== ============== </TABLE> The weighted average discount rate and rate of increase in future compensation levels used in determining actuarial present value of the projected benefit obligation was 6.75% and 4.50% and 7.25% and 4.50% at December 31, 1998 and 1997, respectively. The assumed long-term rate of return on plan assets was 9.0% at December 31, 1998 and 1997. Net periodic pension cost for the years ended December 31, 1998, 1997 and 1996 included the following components (in thousands): <TABLE> <CAPTION> Years Ended December 31, ------------------------------------------------------ 1998 1997 1996 -------------- -------------- -------------- <S> <C> <C> <C> Service cost ................................. $ 578 $ 510 $ 547 Interest cost ................................ 856 778 691 Expected return on assets .................... (900) (806) (620) Transition asset recognition (46) (46) (46) Net loss recognition ......................... 9 -------------- -------------- -------------- Net periodic benefit cost..................... $ 497 $ 436 $ 572 ============== ============== ============== </TABLE> 66
68 The Company has a nonfunded supplemental retirement plan (restoration plan) for its employees whose benefits under the principal retirement plan are reduced because of compensation deferral elections or limitations under federal tax laws. The expense for this plan for the years ended December 31, 1998, 1997 and 1996 was $34,000, $45,000 and $52,000, respectively. <TABLE> <CAPTION> December 31, December 31, Change in Benefit Obligation 1998 1997 --------------- --------------- (in thousands) <S> <C> <C> Benefit obligation at end of prior year ............... $ 510 $ 584 Interest cost ......................................... 29 36 Actuarial gain ........................................ (77) (48) Benefits paid ......................................... (57) (62) --------------- --------------- Benefit obligation at end of year .................. $ 405 $ 510 =============== =============== </TABLE> <TABLE> <CAPTION> December 31, December 31, Change in Plan Assets 1998 1997 --------------- --------------- (in thousands) <S> <C> Fair value of plan assets at end of prior year ........ $ $ Employer contribution ................................. 57 62 Benefits paid ......................................... (57) (62) --------------- --------------- Fair value of plan assets at end of year ........... $ 0 $ 0 =============== =============== </TABLE> <TABLE> <CAPTION> December 31, December 31, Reconciliation of Funded Status 1998 1997 --------------- --------------- (in thousands) <S> <C> <C> Funded status ......................................... $ (405) $ (510) Unrecognized net loss ................................. 53 130 Unrecognized net transition obligation ................ 24 26 --------------- --------------- Accrued benefit cost .................................. (328) (354) Additional minimum liability .......................... (77) (156) --------------- --------------- Accrued benefit liability ............................. (405) (510) Intangible asset ...................................... 24 26 Accumulated other comprehensive income ................ 53 130 --------------- --------------- Net amount recognized ................................. $ (328) $ (354) =============== =============== </TABLE> The weighted average discount rate and rate of increase in future compensation levels used in determining actuarial present value of the projected benefit obligation was 6.75% and 4.50% and 7.25% and 4.50% at December 31, 1998 and 1997, respectively. The assumed long-term rate of return on plan assets was 9.0% at December 31, 1998 and 1997. Net periodic postretirement benefit cost for the years ended December 31, 1998, 1997 and 1996 includes the following components (in thousands): <TABLE> <CAPTION> Years Ended December 31, ------------------------------------------------------- 1998 1997 1996 --------------- --------------- --------------- <S> <C> <C> <C> Service cost .......................................... $ $ $ 1 Interest cost ......................................... 28 37 38 Transition obligation recognition ..................... 3 3 3 Net loss recognition .................................. 3 10 --------------- --------------- --------------- Net periodic benefit cost ............................. $ 31 $ 43 $ 52 =============== =============== =============== </TABLE> 67
69 Incentive Stock Options In April 1993, the Company adopted the Southside Bancshares, Inc. 1993 Incentive Stock Option Plan ("the Plan"), a stock-based incentive compensation plan. The Company applies APB Opinion 25 and related Interpretations in accounting for the Plan. In 1995, the FASB issued FASB Statement No. 123 "Accounting for Stock-Based Compensation" (FAS123), which, if fully adopted by the Company, would change the methods the Company applies in recognizing the cost of the Plan. Adoption of the cost recognition provisions of FAS123 is optional and the Company has decided not to elect these provisions of FAS123. However, pro forma disclosures as if the Company adopted the cost recognition provisions of FAS123 in 1995 are required by FAS123 and are presented below. Under the Plan, the Company is authorized to issue shares of Common Stock pursuant to "Awards" granted in the form of incentive stock options (intended to qualify under Section 422 of the Internal Revenue Code of 1986, as amended). Awards may be granted to selected employees and directors of the Company or any subsidiary. The Plan provides that the exercise price of any stock option may not be less than the fair market value of the Common Stock on the date of grant. The Company granted incentive stock options in 1996, 1997 and 1998. The stock options granted in 1996, 1997 and 1998 have contractual terms of 10 years. All options vest on a graded schedule, 20% per year for 5 years, beginning on the first anniversary date of the grant date. In accordance with APB 25, the Company has not recognized any compensation cost for these stock options granted in 1996, 1997 and 1998. A summary of the status of the Company's stock options as of December 31, 1998, 1997 and 1996 and the changes during the year ended on those dates is presented below: <TABLE> <CAPTION> INCENTIVE STOCK OPTIONS ------------------------------------------------------------------------------------- 1998 1997 1996 ------------------------- ------------------------- ------------------------- # SHARES OF WEIGHTED # SHARES OF WEIGHTED # SHARES OF WEIGHTED UNDERLYING AVERAGE UNDERLYING AVERAGE UNDERLYING AVERAGE OPTIONS EXERCISE OPTIONS EXERCISE OPTIONS EXERCISE PRICES PRICES PRICES ------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Outstanding at beginning of the year 244,967 $ 13.74 185,667 $ 11.85 129,750 $ 9.73 Granted 74,100 $ 18.25 72,000 $ 17.75 70,000 $ 15.00 Exercised 11,733 $ 8.00 11,700 $ 8.00 14,083 $ 8.00 Forfeited 1,000 $ 17.75 1,000 $ 17.75 0 N/A Expired 0 N/A 0 N/A 0 N/A Outstanding at end of year 306,334 $ 15.04 244,967 $ 13.74 185,667 $ 11.85 Exercisable at end of year 111,834 $ 12.17 69,617 $ 10.69 41,367 $ 9.08 Weighted-average FV of options granted during the year $ 5.45 $ 5.46 $ 4.05 </TABLE> The fair value of each stock option granted is estimated on the date of grant using the minimum value method of option pricing with the following weighted-average assumptions for grants in 1998, 1997 and 1996, respectively: dividend yield of 1.59%, 2.25%, and 2.67%; risk-free interest rates of 4.62%, 6.52%, and 5.41%; the expected lives of 6 years; the expected volatility is 27.13%. 68
70 The following table summarizes information about stock options outstanding at December 31, 1998: <TABLE> <CAPTION> Options Outstanding Options Exercisable ------------------------------------------------- ------------------------------ NUMBER WEIGHTED AVG. NUMBER RANGE OF OUTSTANDING REMAINING WEIGHTED AVG EXERCISABLE WEIGHTED AVG. EXERCISE PRICES AT 12/31/98 CONTR. LIFE EXERCISE PRICE AT 12/31/98 EXERCISE PRICE <S> <C> <C> <C> <C> <C> $ 8.00 to $12.00 92,234 5.70 $10.43 69,834 $ 9.92 $ 12.01 to $18.25 214,100 6.20 $17.02 42,000 $ 15.92 ---------------- ------- ---- ------ -------- ------- $ 8.00 to $18.25 306,334 6.00 $15.04 111,834 $ 12.17 </TABLE> Pro Forma Net Income and Net Income Per Common Share Had the compensation cost for the Company's stock-based compensation plans been determined consistent with FAS123, the Company's net income and net income per common share for 1996, 1997, and 1998 would approximate the pro forma amounts below (in thousands, net of taxes): <TABLE> <CAPTION> As Pro As Pro As Pro Reported Forma Reported Forma Reported Forma 12/31/98 12/31/98 12/31/97 12/31/97 12/31/96 12/31/96 --------- --------- --------- --------- --------- --------- <S> <C> <C> <C> <C> <C> <C> FAS123 Charge ........ $ $ 150 $ $ 101 $ $ 68 Net Income .......... $ 5,351 $ 5,201 $ 5,006 $ 4,905 $ 4,205 $ 4,137 Net Income per Common Share-Basic ....... $ 1.52 $ 1.47 $ 1.40 $ 1.38 $ 1.17 $ 1.16 Net Income per Common Share-Diluted ..... $ 1.46 $ 1.42 $ 1.36 $ 1.34 $ 1.15 $ 1.13 </TABLE> The effects of applying FAS123 in this pro forma disclosure are not indicative of future amounts. FAS123 does not apply to awards prior to 1995, and the Company anticipates making awards in the future under its stock-based compensation plan. 69
71 11. SHAREHOLDERS' EQUITY Cash dividends declared and paid were $.40 per share for the years ended December 31, 1998, 1997 and 1996. Future dividends will depend on the Company's earnings, financial condition and other factors which the Board of Directors of the Company considers to be relevant. The Company's dividend policy requires that any dividend payments made by the Company not exceed consolidated earnings for that year. Retained earnings not available for the payment of dividends at December 31, 1998 was $11,391,000. The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators regarding components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of Total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 1998, that the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 1998, the most recent notification from the Federal Deposit Insurance Corporation 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 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category. <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> As of December 31, 1998: Total Capital (to Risk Weighted Assets) ................ $63,962 14.86% >=$34,435 >=8.0% >=$43,044 >=10.0% Tier 1 Capital (to Risk Weighted Assets) ................ $54,280 12.61% >=$17,218 >=4.0% >=$25,827 >= 6.0% Tier 1 Capital (to Average Assets) (1) .................. $54,280 6.76% >=$32,108 >=4.0% >=$40,135 >= 5.0% As of December 31, 1997: Total Capital (to Risk Weighted Assets) ................ $41,965 12.89% >=$26,038 >=8.0% >=$32,547 >=10.0% Tier 1 Capital (to Risk Weighted Assets) ................ $38,595 11.86% >=$13,019 >=4.0% >=$19,528 >= 6.0% Tier 1 Capital (to Average Assets) (1) .................. $38,595 7.25% >=$21,283 >=4.0% >=$26,604 >= 5.0% </TABLE> (1) Refers to quarterly average assets as calculated by bank regulatory agencies. 70
72 Payment of dividends by the Bank is limited under regulation. The amount that can be paid in any calendar year without prior approval of the Bank's regulatory agencies cannot exceed the lesser of net profits (as defined) for that year plus the net profits for the preceding two calendar years, or retained earnings. The table below summarizes key equity ratios for the Company for the years ended December 31, 1998, 1997 and 1996. <TABLE> <CAPTION> Years Ended December 31, ---------------------------------- 1998 1997 1996 ----- ----- ----- <S> <C> <C> <C> Percentage of Net Income to: Average Total Assets............................................... .78% .99% .92% Average Shareholders' Equity....................................... 13.35% 13.57% 12.46% Percentage of Dividends Declared Per Common Share to Net Income Per Common Share-Basic......................... 26.32% 28.57% 34.19% Percentage of Dividends Declared Per Common Share to Net Income Per Common Share-Diluted....................... 27.40% 29.41% 34.78% Percentage of Average Shareholders' Equity to Average Total Assets..................................... 5.87% 7.31% 7.41% </TABLE> 12. DIVIDEND REINVESTMENT AND COMMON STOCK REPURCHASE PLAN The Company has a Dividend Reinvestment Plan funded by stock authorized, but not yet issued. Proceeds from the sale of the common stock will be used for general corporate purposes and could be directed to the Company's subsidiaries. For the year ended December 31, 1998, 15,427 shares were sold under this plan at an average price of $19.74 per share, reflective of other trades at the time of each sale. The Company instituted a Common Stock Repurchase Plan in late 1994. Under the repurchase plan, the Board of Directors establishes, on a quarterly basis, total dollar limitations and price per share for stock to be repurchased. The Board reviews this plan in conjunction with the capital needs of the Company and Southside Bank and may, at its discretion, modify or discontinue the plan. During 1998, 71,426 shares of treasury stock were purchased under this plan at a cost of $1,398,000. 13. INCOME TAXES The provisions for federal income taxes included in the accompanying statements consist of the following (in thousands): <TABLE> <CAPTION> Years Ended December 31, ----------------------------------------- 1998 1997 1996 ------------ ------------ ------------ <S> <C> <C> <C> Current tax provision.................................................. $ 1,496 $ 1,914 $ 1,648 Deferred tax benefit................................................... (272) (225) (211) ------------ ------------ ------------ Provision for tax expense charged to operations........................ $ 1,224 $ 1,689 $ 1,437 ============ ============ ============ </TABLE> 71
73 Deferred income taxes result from temporary differences in the recognition of revenues and expenses for tax and book purposes. These differences and the tax effect of each of the major categories are as follows (in thousands): <TABLE> <CAPTION> Years Ended December 31, ---------------------------- 1998 1997 1996 ----- ----- ----- <S> <C> <C> <C> Provision for loan losses ................... $(204) $(323) $(170) Provision for OREO losses ................... 83 Depreciation ................................ (6) 29 57 Retirement and other benefit plans .......... (211) (60) (123) FHLB Dallas Stock dividends ................. 149 40 37 Loan origination costs ...................... 11 2 Other ....................................... (5) (14) ----- ----- ----- Deferred tax benefit ........................ $(272) $(225) $(211) ===== ===== ===== </TABLE> The components of the net deferred tax asset (liability) as of December 31, 1998 and 1997 are summarized below (in thousands): <TABLE> <CAPTION> Assets Liabilities ------- ----------- <S> <C> <C> Allowance for Losses on OREO ............................ $ 308 $ Reserve for Loan Losses ................................. 729 Retirement and Other Benefit Plans ...................... 868 Unrealized gains on securities available for sale ....... (2,474) Loan Origination Costs .................................. (148) Premises and Equipment .................................. (187) FHLB Dallas Stock Dividends ............................. (294) Other ................................................... 14 ------- --------- Gross deferred tax assets (liabilities) .............. 1,905 (3,089) ------- --------- Net deferred tax liability at December 31, 1998 ... $ (1,184) ========= </TABLE> <TABLE> <CAPTION> Assets Liabilities ------- ----------- <S> <C> <C> Allowance for Losses on OREO............................. $ 318 $ Reserve for Loan Losses.................................. 737 Retirement and Other Benefit Plans....................... 684 Unrealized gains on securities available for sale........ (725) Loan Origination Costs................................... (154) Premises and Equipment................................... (209) FHLB Dallas Stock Dividends.............................. (145) Other.................................................... (2) ------- --------- Gross deferred tax assets (liabilities)............... 1,739 (1,235) ------- --------- Net deferred tax asset at December 31, 1997........ $ 504 ======= </TABLE> 72
74 A reconciliation of tax at statutory rates and total tax expense is as follows (dollars in thousands): <TABLE> <CAPTION> Years Ended December 31, --------------------------------------------------------------------- 1998 1997 1996 ------------------- -------------------- ---------------------- Percent Percent Percent of of of Pre-tax Pre-tax Pre-tax Amount Income Amount Income Amount Income ------- ------- ------- ------- ------- ------- <S> <C> <C> <C> <C> <C> <C> Calculated Tax Expense .................. $ 2,236 34.0% $ 2,276 34.0% $ 1,918 34.0% Increase (Decrease) in Taxes from: Tax Exempt Interest ..................... (1,210) (18.4%) (706) (10.5%) (650) (11.5%) Other Net ............................... 198 3.0% 119 1.7% 169 3.0% ------- ------- ------- ------- ------- ------- Provision for Tax Expense Charged to Operations ........................... $ 1,224 18.6% $ 1,689 25.2% $ 1,437 25.5% ======= ======= ======= ======= ======= ======= </TABLE> 14. COMMITMENTS AND CONTINGENCIES In the normal course of business the Company buys and sells securities. At December 31, 1998 and 1997, the Company had commitments to purchase $8,294,000 and $624,000 in securities, respectively. The Company, or its subsidiaries, is involved with various litigation which resulted in the normal course of business. Management of the Company, after consulting with its legal counsel, believes that any liability resulting from litigation will not have a material effect on the financial position and results of operations and the liquidity of the Company or its subsidiaries. 15. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK In the normal course of business the Company is a party to certain financial instruments, with off-balance-sheet risk, to meet the financing needs of its customers. These off-balance-sheet 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 amount reflected in the financial statements. The contract or notional amounts of these instruments reflect the extent of involvement and exposure to credit loss the Company has in these particular classes of financial instruments. Commitments to extend credit are agreements to lend to a customer provided that the terms established in the contract are met. Commitments generally have fixed expiration dates and may require payment of fees. Since some commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers. 73
75 The Company had outstanding unused commitments to extend credit and outstanding credit card arrangements of $29,810,000 and $28,313,000 at December 31, 1998 and 1997, respectively. The Company had outstanding standby letters of credit of $246,000 and $277,000 at December 31, 1998 and 1997, respectively. The Company applies the same credit policies in making commitments and standby letters of credit as it does for on-balance-sheet instruments. The Company evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, upon extension of credit is based on management's credit evaluation of the borrower. Collateral held varies but may include real estate, accounts receivable, inventory, property, plant, and equipment. 16. SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK The economy of the Company's market area, East Texas, is directly tied to the oil and gas industry. Oil prices have had an indirect effect on the Company's business. Although the Company has a diversified loan portfolio, a significant portion of its loans are collateralized by real estate. Repayment of these loans is in part dependent upon the economic conditions in the market area. Part of the risk associated with real estate loans has been mitigated since 54.2% of this group represents loans collateralized by residential dwellings that are primarily owner occupied. Losses on this type of loan have historically been less than those on speculative properties. Many of the remaining real estate loans are collateralized primarily with owner occupied commercial real estate. The Mortgage-backed Securities held by the Company consist solely of Government agency pass-through securities which are either directly or indirectly backed by the full faith and credit of the United States Government. 17. RELATED PARTY TRANSACTIONS Loan activity of executive officers, directors, and their affiliates for the years ended December 31, 1998 and 1997 were (in thousands): <TABLE> <CAPTION> 1998 1997 --------- --------- <S> <C> <C> Beginning Balance of Loans........... $ 6,160 $ 6,999 Additional Loans................... 3,917 2,507 Payments........................... (3,649) (3,346) --------- --------- Ending Balance of Loans.............. $ 6,428 $ 6,160 ========= ========= </TABLE> Other indebtedness of officers and employees as of December 31, 1998 and 1997 was $2,656,000 and $2,478,000, respectively. The Company incurred legal costs of $176,000, $148,000 and $141,000 during the years ended December 31, 1998, 1997 and 1996, respectively, from a law firm of which an outside director of the Company is a partner. The Company paid approximately $49,000, $55,000 and $57,000 in insurance premiums during the years ended December 31, 1998, 1997 and 1996, respectively, to companies of which two outside directors are officers. The Company paid approximately $5,000, $50,000 and $106,000 in architectural fees during the years ended December 31, 1998, 1997 and 1996, respectively, to a company of which an outside director is an officer. 74
76 18. DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (FAS107), requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other estimation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Such techniques and assumptions, as they apply to individual categories of the Company's financial instruments, are as follows: Cash and due from banks: The carrying amounts for cash and due from banks is a reasonable estimate of those assets' fair value. Investment, mortgage-backed and marketable equity securities: Fair values for these securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices for similar securities. Loans receivable: For adjustable rate loans that reprice frequently and with no significant change in credit risk, the carrying amounts are a reasonable estimate of those assets' fair value. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Nonperforming loans are estimated using discounted cash flow analyses or underlying value of the collateral where applicable. Accrued interest receivable: The carrying amount of accrued interest approximates its fair value. Deposit liabilities: The fair value of demand deposits, savings accounts, and certain money market deposits is the amount on demand at the reporting date, that is, the carrying value. Fair values for fixed rate certificates of deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered for deposits of similar remaining maturities. Federal funds purchased and securities sold under agreement to repurchase: Federal funds purchased and securities sold under agreement to repurchase generally have an original term to maturity of one day and thus are considered short-term borrowings. Consequently, their carrying value is a reasonable estimate of fair value. Commitments to extend credit: The carrying amounts of commitments to extend credit and standby letters of credit are a reasonable estimate of those assets' fair value. FHLB Dallas Advances: The fair value of these advances is estimated by discounting the future cash flows using rates at which advances would be made to borrowers with similar credit ratings and for the same remaining maturities. 75
77 The following table presents the Company's assets, liabilities, and unrecognized financial instruments at both their respective carrying amounts and fair value. The Company's nonfinancial assets and liabilities are presented in both columns at their carrying amount (in thousands). <TABLE> <CAPTION> At December 31, 1998 At December 31, 1997 ---------------------- ---------------------- Carrying Carrying Amount Fair Value Amount Fair Value -------- ---------- -------- ---------- <S> <C> <C> <C> <C> Financial assets: Cash and due from banks ................. $ 41,372 $ 41,372 $ 36,593 $ 36,593 Investment securities: Available for sale .................... 132,447 132,447 71,031 71,031 Held to maturity ...................... 347 347 804 799 Mortgage-backed and related securities: Available for sale .................... 333,194 333,194 127,751 127,751 Held to maturity ...................... 7,810 7,810 13,662 13,688 Marketable equity securities: Available for sale .................... 14,171 14,171 3,258 3,258 Loans, net ................................. 316,159 321,238 292,665 295,097 Interest receivable ........................ 6,065 6,065 3,918 3,918 Financial liabilities: Retail deposits ......................... $515,034 $515,968 $462,674 $463,157 Federal funds purchased ................. 4,168 4,168 3,884 3,884 FHLB Dallas advances .................... 274,027 261,240 57,547 54,753 Junior subordinated debentures .......... 20,000 20,000 Off-balance sheet liabilities: Commitments to extend credit ............ 24,643 24,643 24,036 24,036 Standby letters of credit ............... 246 246 277 277 Credit card arrangements ................ 5,167 5,167 4,277 4,277 </TABLE> As discussed earlier, the fair value estimate of financial instruments for which quoted market prices are unavailable is dependent upon the assumptions used. Consequently, those estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Accordingly, the aggregate fair value amounts presented in the above fair value table do not necessarily represent the underlying value of the Company. 76
78 19. CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (in thousands, except per share data) <TABLE> <CAPTION> 1998 ------------------------------------------- Fourth Third Second First Quarter Quarter Quarter Quarter ------- ------- ------- ------- <S> <C> <C> <C> <C> Interest income ............................. $12,661 $11,325 $10,138 $ 9,553 Net interest income ......................... 5,152 4,396 4,533 4,849 Income before provision for income taxes .... 2,031 1,653 1,330 1,561 Provision for income taxes .................. 425 248 176 375 Net income .................................. 1,606 1,405 1,154 1,186 Net income per share Basic ................................... .46 .40 .32 .34 Diluted ................................. .44 .38 .31 .33 </TABLE> <TABLE> <CAPTION> 1997 ------------------------------------------- Fourth Third Second First Quarter Quarter Quarter Quarter ------- ------- ------- ------- <S> <C> <C> <C> <C> Interest income ............................. $ 9,278 $ 8,898 $ 8,724 $ 8,267 Net interest income ......................... 4,912 4,759 4,755 4,536 Income before provision for income taxes .... 1,889 1,827 1,504 1,475 Provision for income taxes .................. 465 478 375 371 Net income .................................. 1,424 1,349 1,129 1,104 Net income per share Basic ................................... .40 .37 .32 .31 Diluted ................................. .39 .36 .31 .30 </TABLE> 77
79 20. PARENT COMPANY FINANCIAL INFORMATION Condensed financial information for Southside Bancshares, Inc. (parent company only) was as follows (dollars in thousands): CONDENSED BALANCE SHEETS <TABLE> <CAPTION> December 31, December 31, ASSETS 1998 1997 ------------ ------------ <S> <C> <C> Cash and due from banks....................................... $ 6,329 $ 222 Investment in bank subsidiaries at equity in underlying net assets...................................... 58,829 39,804 Investment in nonbank subsidiary at equity in underlying net assets...................................... 15 15 Other assets.................................................. 1,285 2 --------- --------- TOTAL ASSETS.......................................... $ 66,458 $ 40,043 ========= ========= LIABILITIES Junior subordinated debentures................................ $ 20,000 $ Other liabilities............................................. 10 12 --------- --------- TOTAL LIABILITIES..................................... 20,010 12 --------- --------- SHAREHOLDERS' EQUITY Common stock ($2.50 par, 6,000,000 shares authorized: 3,685,775 and 3,496,269 and shares issued)................ 9,214 8,740 Paid-in capital............................................... 24,198 21,290 Retained earnings............................................. 11,391 10,414 Treasury stock (182,176 and 116,750 shares)................... (3,158) (1,820) Net unrealized gains on securities available for sale ........ 4,803 1,407 --------- --------- TOTAL SHAREHOLDERS' EQUITY............................ 46,448 40,031 --------- --------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY............ $ 66,458 $ 40,043 ======== ========= </TABLE> 78
80 <TABLE> <CAPTION> CONDENSED STATEMENTS OF INCOME Years Ended December 31, ------------------------------- 1998 1997 1996 ------- ------- ------- <S> <C> <C> <C> INCOME Dividends from subsidiary ....................................... $ 586 $ 2,066 $ 1,458 ------- ------- ------- TOTAL INCOME ............................................... 586 2,066 1,458 ------- ------- ------- EXPENSE Interest expense ................................................ 1,048 Salaries and employee benefits .................................. 75 Taxes other than income ......................................... 27 41 40 Other ........................................................... 171 70 43 ------- ------- ------- TOTAL EXPENSE .............................................. 1,246 111 158 ------- ------- ------- (Loss) income before federal income tax expense ................. (660) 1,955 1,300 Benefit for federal income tax expense .......................... 424 37 54 ------- ------- ------- (Loss) income before equity in undistributed earnings of subsidiaries ..................................... (236) 1,992 1,354 Equity in undistributed earnings of subsidiaries ................ 5,587 3,014 2,851 ------- ------- ------- NET INCOME ................................................. $ 5,351 $ 5,006 $ 4,205 ======= ======= ======= </TABLE> <TABLE> <CAPTION> CONDENSED STATEMENTS OF CASH FLOW Years Ended December 31, ------------------------------- 1998 1997 1996 ------- ------- ------- <S> <C> <C> <C> OPERATING ACTIVITIES: Net Income..................................................... $ 5,351 $ 5,006 $ 4,205 Adjustments to reconcile net income to cash provided by operations: Equity in undistributed earnings of subsidiaries............ (5,587) (3,014) (2,851) (Increase) decrease in other assets......................... (1,283) 7 Decrease in other liabilities............................... (2) (40) (3) ------- ------- ------- Net cash (used in) provided by operating activities.... (1,521) 1,952 1,358 INVESTING ACTIVITIES: Investments in subsidiaries................................... (10,000) (10) ------- ------- ------- Net cash used in investing activities.................. (10,000) (10) FINANCING ACTIVITIES: Purchase of treasury stock.................................... (1,398) (1,154) (425) Proceeds from sale of treasury stock.......................... 38 77 97 Proceeds from issuance of Common Stock........................ 347 326 308 Dividends paid................................................ (1,359) (1,316) (1,258) Proceeds from the issuance of junior subordinated debentures..................................... 20,000 ------- ------- ------- Net cash provided by (used in) financing activities.... 17,628 (2,067) (1,278) Net increase (decrease) in cash and cash equivalents.......... 6,107 (125) 80 Cash and cash equivalents at beginning of year................ 222 347 267 ------- ------- ------- Cash and cash equivalents at end of year...................... $ 6,329 $ 222 $ 347 ======= ======= ======= </TABLE> 79
81 INDEX TO EXHIBITS <TABLE> <CAPTION> Exhibit No. -------- <S> <C> 3 (a)(i) - Articles of Incorporation as amended and in effect on December 31, 1992, of SoBank, Inc. (now named Southside Bancshares, Inc.)(filed as Exhibit 3 to the Registrant's Form 10-K for the year ended December 31, 1992, and incorporated herein). 3 (a)(ii) - Articles of Amendment effective May 9, 1994 to Articles of Incorporation of SoBank, Inc. (now named Southside Bancshares, Inc.) (filed as Exhibit 3(a)(ii) to the Registrant's Form 10-K for the year ended December 31, 1994, and incorporated herein). 3 (b) - Bylaws as amended and in effect on March 23, 1995 of Southside Bancshares, Inc. (filed as Exhibit 3(b) to the Registrant's Form 10-K for the year ended December 31, 1994, and incorporated herein). ** 10 (a)(i) - Deferred Compensation Plan for B. G. Hartley effective February 13, 1984, as amended June 28, 1990 and December 15, 1994 (filed as Exhibit 10(a)(i) to the Registrant's Form 10-K for the year ended December 31, 1994, and incorporated herein). ** 10 (a)(ii) - Deferred Compensation Plan for Robbie N. Edmonson effective February 13, 1984, as amended June 28, 1990 and March 16, 1995 (filed as Exhibit 10(a)(ii) to the Registrant's Form 10-K for the year ended December 31, 1995, and incorporated herein). ** 10 (b) - Officers Long-term Disability Income Plan effective June 25, 1990 (filed as Exhibit 10(b) to the Registrant's Form 10-K for the year ended June 30, 1990, and incorporated herein). ** 10 (c) - Retirement Plan Restoration Plan for the subsidiaries of SoBank, Inc. (now named Southside Bancshares, Inc.)(filed as Exhibit 10(c) to the Registrant's Form 10-K for the year ended December 31, 1992, and incorporated herein). ** 10 (d) - Incentive Stock Option Plan effective April 1, 1993 of SoBank, Inc. (now named Southside Bancshares, Inc.) (filed as Exhibit 10(d) to the Registrant's Form 10-K for the year ended December 31, 1994, and incorporated herein). ** 10 (e) - Form of Deferred Compensation Agreements dated June 30, 1994 with each of Titus Jones and Andy Wall as </TABLE>
82 <TABLE> <S> <C> amended November 13, 1995. (filed as Exhibit 10(e) to the Registrant's Form 10-K for the year ended December 31, 1995, and incorporated herein). ** 10 (f) - Form of Deferred Compensation Agreements dated June 30, 1994 with each of Sam Dawson, Lee Gibson and Jeryl Story as amended October 15, 1997 and Form of Deferred Compensation Agreement dated October 15, 1997 with Lonny Uzzell. * 21 - Subsidiaries of the Registrant. * 23 - Consent of Independent Accountants. * 27 - Financial Data Schedule for the year ended December 31, 1998. </TABLE> * Filed herewith. ** Compensation plan, benefit plan or employment contract or arrangement.