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Veritex(Mark One) UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ______________________ FORM 10-K [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Fiscal Year Ended December 31, 2002 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 0-25051 PROSPERITY BANCSHARES, INC. SM (Exact name of registrant as specified in its charter) TEXAS (State or other jurisdiction of incorporation or organization) 74-2331986 (I.R.S. Employer Identification No.) HOUSTON, TEXAS (Address of principal executive offices) 4295 SAN FELIPE 77027 (Zip Code) Registrant’s Telephone Number, Including Area Code: (713) 693-9300 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $1.00 per share Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment of this Form 10-K. [ ] The aggregate market value of the shares of Common Stock held by non-affiliates, based on the closing price of the Common Stock on the Nasdaq National Market System on June 30, 2002 was approximately $172,889,401. As of February 6, 2003, the number of outstanding shares of Common Stock was 18,903,483. Documents Incorporated by Reference: Portions of the Company’s Proxy Statement relating to the 2003 Annual Meeting of Shareholders, which will be filed within 120 days after December 31, 2002, are incorporated by reference into Part III, Items 10-13 of this Form 10-K. PROSPERITY BANCSHARES, INC. 2002 ANNUAL REPORT ON FORM 10-K SM TABLE OF CONTENTS PART I PART II Item 1. Business.............................................................................................................................................. General ........................................................................................................................................... Recent Mergers and Acquisitions................................................................................................. Recent Developments.................................................................................................................... Stock Split...................................................................................................................................... Available Information ................................................................................................................... Officers and Associates ................................................................................................................. Banking Activities ......................................................................................................................... Business Strategies ........................................................................................................................ Competition.................................................................................................................................... Supervision and Regulation .......................................................................................................... 2 2 3 3 4 4 4 4 5 6 6 Item 2. Properties ........................................................................................................................................... 13 Item 3. Legal Proceedings ............................................................................................................................. 16 Item 4. Submission of Matters to a Vote of Security Holders..................................................................... 16 Item 5. Market for Registrant’s Common Equity and Related Shareholder Matters................................. 16 Item 6. Selected Consolidated Financial Data.............................................................................................. 18 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations....... 20 Overview........................................................................................................................................ 20 Critical Accounting Policies ......................................................................................................... 20 Results of Operations..................................................................................................................... 21 Financial Condition ....................................................................................................................... 25 Item 7A. Quantitative and Qualitative Disclosures about Market Risk......................................................... 38 Item 8. Financial Statements and Supplementary Data ............................................................................... 38 Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure...... 40 PART III Item 10. Directors and Executive Officers of the Registrant......................................................................... 40 Item 11. Executive Compensation................................................................................................................... 40 Item 12. Security Ownership of Certain Beneficial Owners and Management ........................................... 40 Item 13. Certain Relationships and Related Transactions ............................................................................. 40 Item 14. Controls and Procedures ................................................................................................................... 40 PART IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8 -K ............................................. 41 Signatures PART I Special Cautionary Notice Regarding Forward-Looking Statements Statements and financial discussion and analysis contained in this annual report on Form 10-K that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on assumptions and involve a number of risks and uncertainties, many of which are beyond the Company’s control. Many possible events or factors could affect the future financial results and performance of the Company and could cause such results or performance to differ materially from those expressed in the forward-looking statements. These possible events or factors include, without limitation: • • • • • • • • • • • • • • changes in interest rates and market prices, which could reduce the Company’s net interest margins, asset valuations and expense expectations; changes in the levels of loan prepayments and the resulting effects on the value of the Company’s loan portfolio; changes in local economic and business conditions which adversely affect the Company’s customers and their ability to transact profitable business with the company, including the ability of the Company’s borrowers to repay their loans according to their terms or a change in the value of the related collateral; increased competition for deposits and loans adversely affecting rates and terms; the timing, impact and other uncertainties of future acquisitions, including the Company’s ability to identify suitable future acquisition candidates, the success or failure in the integration of their operations, and the ability to enter new markets successfully and capitalize on growth opportunities; increased credit risk in the Company’s assets and increased operating risk caused by a material change in commercial, consumer and/or real estate loans as a percentage of the total loan portfolio; the failure of assumptions underlying the establishment of and provisions made to the allowance for credit losses; changes in the availability of funds resulting in increased costs or reduced liquidity; increased asset levels and changes in the composition of assets and the resulting impact on the Company’s capital levels and regulatory capital ratios; the Company’s ability to acquire, operate and maintain cost effective and efficient systems without incurring unexpectedly difficult or expensive but necessary technological changes; the loss of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensation levels; changes in statutes and government regulations or their interpretations applicable to financial holding companies and the Company’s present and future banking and other subsidiaries, including changes in tax requirements and tax rates; acts of terrorism, an outbreak of hostilities or other international or domestic calamities, weather or other acts of God and other matters beyond the Company’s control; and other risks and uncertainties listed from time to time in the Company’s reports and documents filed with the Securities and Exchange Commission. A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these assumptions or bases in good faith and that they are reasonable. However, the Company cautions you that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material. The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless the securities laws require the Company to do so. 1 ITEM 1. BUSINESS General Prosperity Bancshares, Inc.SM (the “Company”) was formed in 1983 as a vehicle to acquire the former Allied Bank in Edna, Texas which was chartered in 1949. The Company is a registered financial holding company that derives substantially all of its revenues and income from the operation of its bank subsidiary, Prosperity BankSM (“Prosperity Bank” or the “Bank”). The Bank provides a broad line of financial products and services to small and medium-sized businesses and consumers. The Bank operates forty (40) full-service banking locations in the greater Houston metropolitan area and fifteen contiguous counties situated south and southwest of Houston and extending into South Texas and two (2) full service banking locations in Dallas, Texas. The Company's headquarters are located at 4295 San Felipe in Houston, Texas and its telephone number is (713) 693-9300. The Company's market consists of the communities served by its locations in the Greater Houston CMSA, additional locations in eight contiguous counties located to the south and southwest of Houston and its two banking locations in Dallas, Texas. The Greater Houston CMSA includes Brazoria, Chambers, Fort Bend, Galveston, Harris, Liberty, Montgomery and Walker counties. Texas Highway 59 (scheduled to become Interstate Highway 69), which serves as the primary “NAFTA Highway” linking the interior United States and Mexico, runs directly through the center of the Company’s market area. The increased traffic along this NAFTA Highway has enhanced economic activity in the Company’s market area and created opportunities for growth. The diverse nature of the economies in each local market served by the Company provides the Company with a varied customer base and allows the Company to spread its lending risk throughout a number of different industries including farming, ranching, petrochemicals, manufacturing, tourism, recreation and professional service firms and their principals. The Company's market areas outside of Houston are dominated by either small community banks or branches of large regional banks. Management believes that the Company, as one of the few mid-sized financial institutions that combines responsive community banking with the sophistication of a regional bank holding company, has a competitive advantage in its market area and excellent growth opportunities through acquisitions, new Banking Center locations and additional business development. Operating under a community banking philosophy, the Company seeks to develop broad customer relationships based on service and convenience while maintaining its conservative approach to lending and strong asset quality. The Company has grown through a combination of internal growth, the acquisition of community banks, branches of banks and the opening of new banking centers. Utilizing a low cost of funds and employing stringent cost controls, the Company has been profitable in every full year of its existence, including the period of adverse economic conditions in Texas in the late 1980s. From 1988 to 1992, as a sound and profitable institution, the Company took advantage of this economic downturn and acquired the deposits and certain assets of failed banks in West Columbia, El Campo and Cuero, Texas and two failed banks in Houston, which diversified the Company's franchise and increased its core deposits. The Company opened a full-service Banking Center in Victoria, Texas in 1993 and the following year established a Banking Center in Bay City, Texas. The Company expanded its Bay City presence in 1996 with the acquisition of an additional branch location from Norwest Bank Texas, and in 1997, the Company acquired the Angleton, Texas branch of Wells Fargo Bank. In 1998, the Company enhanced its West Columbia Banking Center with the purchase of a commercial bank branch located in West Columbia and acquired Union State Bank in East Bernard, Texas. In 1999, the Company acquired South Texas Bancshares, Inc. and its wholly owned subsidiary, The Commercial National Bank of Beeville, with locations in Beeville, Mathis and Goliad, Texas (the “South Texas Acquisition”). The Company acquired trust powers in connection with the South Texas Acquisition. Additionally, in September 2000, the Company purchased certain assets and assumed certain liabilities of five branches of Compass Bank located in El Campo, Hitchcock, Needville, Palacios and Sweeny, Texas. With the exception of the El Campo location, the former Compass branches are being operated as full-service Banking Centers. The El Campo location has been combined with the Company’s El Campo Banking Center. In February 2001, the Company completed a merger with Commercial Bancshares, Inc., (“Commercial”), whereby Commercial was merged with the Company and Heritage Bank, Commercial’s wholly owned subsidiary, was merged with the Bank. Heritage Bank had 12 full-service banking locations in the Houston metropolitan area and in three adjacent counties. The transaction was accounted for as a pooling of interests and therefore the historical financial data of the Company has been restated to include the accounts and operations of Commercial for all periods prior to the effective time of the Commercial merger. 2 Recent Mergers and Acquisitions On November 1, 2002, the Company acquired First National Bank of Bay City, Bay City, Texas (the "FNB Acquisition"), through the merger of FNB with and into Prosperity Bank for approximately $5.1 million in cash. FNB operated one (1) location in Bay City, Texas, which was closed and consolidated with Prosperity Bank's Bay City Banking Center. As of November 1, 2002, FNB had total assets of $27.1 million, total loans of $8.2 million and total deposits of $23.8 million. On October 1, 2002, the Company acquired Southwest Bank Holding Company, Dallas, Texas (the “Southwest Acquisition”) for approximately $19.6 million in cash. Southwest’s wholly owned subsidiary, Bank of the Southwest, Dallas, Texas, became a subsidiary of the Company but was merged into the Bank on January 2, 2003. Southwest was privately held and operated two (2) banking offices in Dallas, Texas. As of October 1, 2002, Southwest had total assets of $121.9 million, total loans of $58.7 million and total deposits of $108.9 million. On September 1, 2002, the Company acquired Paradigm Bancorporation, Inc. (the “Paradigm Acquisition”) in a stock transaction for approximately 2.58 million shares of Prosperity common stock for all outstanding shares of Paradigm. Paradigm operated a total of eleven (11) banking offices - six (6) in the greater metropolitan Houston area and five (5) in the nearby Southeast Texas cities of Dayton, Galveston, Mont Belvieu, and Winnie. The Company subsequently closed three banking offices and consolidated them into existing Banking Centers. As of September 1, 2002, Paradigm Bancorporation had total assets of $248.7 million, total loans of $175.7 million and total deposits of $218.3 million. In connection with the acquisition of Paradigm, 75,192 shares of Company Common Stock and cash in lieu of fractional share interests were placed into escrow to cover possible losses that may be incurred by the Company in the three year period following completion of the me rger with respect to certain specified loans made by Paradigm prior to execution of the merger agreement. At the end of the three year period, or sooner if all of these loans are paid in full or upgraded, the escrow agent will distribute a pro rata portion of the shares and cash to each of the Paradigm shareholders. While the shares are held in escrow, the Paradigm shareholders will not receive any dividends paid against the shares until such time, if any, that the shares are issued. In the event that during the three year escrow period a specified loan is either (i) not paid in full or (ii) deemed by the Company in its sole discretion to continue to be a specified loan based on the performance of the loan and the financial stability of the borrower, the shares of Common Stock will be used to compensate the Company for the losses associated with these loans. On July 12, 2002, the Company acquired The First State Bank, Needville, Texas (the “First State Acquisition”) for approximately $3.7 million in cash. Prosperity Bank’s existing Needville Banking Center has relocated into the former First State Bank location effective July 15, 2002. As of July 12, 2002, The First State Bank had total assets of $16.3 million, loans of $5.5 million and deposits of $14.1 million. On May 8, 2002, the Company acquired Texas Guaranty Bank, N.A. (the “Texas Guaranty Acquisition”) for approximately $11.8 million in cash. Texas Guaranty Bank operated three (3) offices in the western portion of Houston, Texas, all of which became full service banking centers of Prosperity Bank. As of May 8, 2002, Texas Guaranty Bank had total assets of $74.0 million, loans of $45.7 million and deposits of $61.8 million. Recent Developments On February 3, 2003, the Company announced the signing of a definitive agreement pursuant to which the Company will acquire Abrams Centre Bancshares, Dallas, Texas (“Abrams”) and its subsidiary, Abrams Centre National Bank, for approximately $16.3 million in cash. Abrams operates two (2) banking offices in Dallas, Texas. As of December 31, 2002, Abrams had total assets of $93.6 million, loans of $50.6 million, deposits of $69.0 million and shareholders’ equity of $13.9 million. The transaction is expected to close in the second quarter 2003 and is subject to approval by regulators and certain closing conditions. On March 4, 2003, the Company entered into a definitive agreement with Dallas Bancshares Corporation, Dallas, Texas. Pursuant to the agreement, Dallas Bancshares will merge into the Company and its wholly owned subsidiary, BankDallas will merge into the Bank. Under the terms of the agreement, the Company will pay approximately $7.0 million in cash. Dallas Bancshares is privately held and operates one (1) banking office in Dallas, Texas. As of December 31, 2002, BankDallas had total assets of $40.9 million, loans of $30.6 million, deposits of $36.5 million and shareholders’ equity of $4.3 million. The transaction is expected to close in the second quarter of 2003. The Company will not complete the acquisition unless customary closing conditions are satisfied or waived, including receipt of the necessary shareholder and regulatory approvals and consents from applicable regulatory agencies including the Federal Reserve Board, the Texas Banking Department and the Federal Deposit Insurance Corporation. 3 Stock Split On May 31, 2002, the Company effected a two -for-one stock split in the form of a 100 percent stock dividend to shareholders of record on May 20, 2002. The Company issued approximately 8.1 million shares in connection with the split. All per share and share information has been restated to reflect this split. Available Information The Company's website address is www.prosperitybanktx.com. The Company makes available free of charge on or through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. However, the information found on the Company's website is not part of this or any other report. Officers and Associates The Company's directors and officers are important to the Company's success and play a key role in the Company's business development efforts by actively participating in a number of civic and public service activities in the communities serve d by the Company, such as the Rotary Club, Lion's Club, Pilot Club, United Way and Chamber of Commerce. In addition, the Company's Banking Centers in Bay City, Clear Lake, Cleveland, Dayton, Galveston, Mathis, Medical Center, River Oaks, and Wharton maintain Community Development Boards, whose function is to solicit new business, develop customer relations and provide valuable community knowledge to their respective Banking Center Presidents or Managers. The Company has invested heavily in its officers and associates by recruiting talented officers in its market areas and providing them with economic incentive in the form of stock options and bonuses based on cross-selling performance. The senior management team has substantial experience in both the Hous ton and Dallas markets and the surrounding communities in which the Company has a presence. Each Banking Center location is administered by a local President or Manager with knowledge of the community and lending expertise in the specific industries found in the community. The Company entrusts its Banking Center Presidents and Managers with authority and flexibility within general parameters with respect to product pricing and decision making in order to avoid the bureaucratic structure of larger banks. The Company operates each Banking Center as a separate profit center, maintaining separate data with respect to each Banking Center's net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking Center Presidents and Managers are accountable for performance in these areas and compensated accordingly. Each Banking Center has its own local telephone number, which enables a customer to be served by a local banker. As of December 31, 2002, the Company and the Bank had 501 full-time equivalent associates, 187 of whom were officers of the Bank. The Company provides medical and hospitalization insurance to its full-time associates. The Company considers its relations with associates to be excellent. Neither the Company nor the Bank is a party to any collective bargaining agreement. Banking Activities The Company, through the Bank, offers a variety of traditional loan and deposit products to its customers, which consist primarily of consumers and small and medium-sized businesses. The Bank tailors its products to the specific needs of customers in a given market. At December 31, 2002, the Bank maintained approximately 111,000 separate deposit accounts and 16,500 separate loan accounts and approximately 20.7% of the Bank’s total deposits were noninterest-bearing demand deposits. For the year ended December 31, 2002, the Company's average cost of funds was 1.97%. The Company has been an active mortgage lender, with 1-4 family residential and commercial mortgage loans comprising 57.5% of the Company's total loans as of December 31, 2002. The Company also offers loans for automobiles and other consumer durables, home equity loans, debit cards, personal computer banking and other cash management services and telebanking. By offering certificates of deposit, NOW accounts, savings accounts and overdraft protection at competitive rates, the Company gives its depositors a full range of traditional deposit products. The Company has successfully introduced the Royal account, which for a monthly fee provides consumers with a package of benefits including unlimited free checking, free personalized checks, free travelers checks, free cashier's checks, free money orders, free ATM or debit card, imaged statements, free Advantage Overdraft protection up to $200 on qualifying accounts, free Internet Banking, discounted Internet Bill Pay pricing and certain travel discounts. 4 The businesses targeted by the Company in its lending efforts are primarily those that require loans in the $100,000 to $4.0 million range. The Company offers these businesses a broad array of loan products including term loans, lines of credit and loans for working capital, business expansion and the purchase of equipment and machinery, interim construction loans for builders and owner- occupied commercial real estate loans. For its business customers, the Company has developed a specialized checking product called Small Business Checking which provides fixed discounted fees for checking. Business Strategies The Company’s main objective is to increase deposits and loans through additional expansion opportunities while maintaining efficiency, individualized customer service and maximizing profitability. To achieve this objective, the Company has employed the following strategic goals: Continue Community Banking Emphasis. The Company intends to continue operating as a community banking organization focused on meeting the specific needs of consumers and small and medium-sized businesses in its market areas. The Company will continue to provide a high degree of responsiveness combined with a wide variety of banking products and services. The Company staffs its Banking Centers with experienced bankers with lending expertise in the specific industries found in the community, giving them authority to make certain pricing and credit decisions, thereby attempting to avoid the bureaucratic structure of larger banks. Increase Loan Volume and Diversify Loan Portfolio. Historically, the Company has elected to sacrifice some earnings for the historically lower credit losses associated with home mortgage loans. While maintaining its conservative approach to lending, the Company plans to emphasize both new and existing loan products, focusing on growing its home equity, commercial mortgage and commercial loan portfolios. The Company successfully introduced home equity lending in 1998. The balance of home equity loans was $23.2 million at December 31, 2002 and $20.5 million at December 31, 2001. During the two -year period from December 31, 2000 to December 31, 2002, the Company grew its commercial and industrial loans from $47.0 million to $83.8 million, or 106.0% and its commercial mortgages from $75.9 million to $184.0 million, or 142.4%. In addition, the Company targets professional service firms such as legal and medical practices for both loans secured by owner-occupied premises and personal loans to their principals. Continue Strict Focus on Efficiency. The Company plans to maintain its stringent cost control practices and policies. The Company has invested significantly in the infrastructure required to centralize many of its critical operations, such as data processing and loan application processing. For its Banking Centers, which the Company operates as independent profit centers, the Company supplies complete support in the areas of loan review, internal audit, compliance and training. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale. Enhance Cross-Selling. The Company recognizes that its customer base provides significant opportunities to cross-sell various products and it seeks to develop broader customer relationships by identifying cross-selling opportunities. The Company uses incentives and friendly competition to encourage cross-selling efforts and increase cross-selling results. Officers and associates have access to each customer’s existing and related account relationships and are better able to inform customers of additional products when customers visit or call the various Banking Centers or use their drive -in facilities. In addition, the Company includes product information in monthly statements and other mailings. Expand Market Share Through Internal Growth and a Disciplined Acquisition Strategy. The Company intends to continue seeking opportunities, both inside and outside its existing markets, to expand either by acquiring existing banks or branches of banks or by establishing new Banking Centers. All of the Company's acquisitions have been accretive to earnings immediately and have supplied the Company with relatively low-cost deposits which have been used to fund the Company's lending activities. Factors used by the Company to evaluate expansion opportunities include the similarity in management and operating philosophies, whether the acquisition will be accretive to earnings and enhance shareholder value, the ability to achieve economies of scale to improve the efficiency ratio and the opportunity to enhance the Company's image and market presence. Maintain Strong Asset Quality. The Company intends to maintain the strong asset quality that has been representative of its historical loan portfolio. As the Company diversifies and increases its lending activities, it may face higher risks of nonpayment and increased risks in the event of economic downturns. The Company intends, however, to continue to employ the strict underwriting guidelines and comprehensive loan review process that have contributed to its low incidence of nonperforming assets and its minimal charge-offs. 5 Competition The banking business is highly competitive, and the profitability of the Company depends principally on its ability to compete in its market areas. The Company competes with other commercial banks, savings banks, savings and loan associations, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking firms, asset-based nonbank lenders and certain other nonfinancial entities, including retail stores which may maintain their own credit programs and certain governmental organizations which may offer more favorable financing than the Company. The Company has been able to compete effectively with other financial institutions by emphasizing customer service, technology and responsive decision-making with respect to loans; by establishing long-term customer relationships and building customer loyalty; and by providing products and services designed to address the specific needs of its customers. Under the Gramm-Leach-Bliley Act, securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. The Gramm-Leach-Bliley Act may significantly change the competitive environment in which the Company and its subsidiaries conduct business. Supervision and Regulation The supervision and regulation of bank holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds of the Federal Deposit Insurance Corporation (“FDIC”) and the banking system as a whole, and not for the protection of the bank holding company shareholders or creditors. The banking agencies have broad enforcement power over bank holding companies and banks including the power to impose substantial fines and other penalties for violations of laws and regulations. The following description summarizes some of the laws to which the Company and the Banks are subject. References herein to applicable statutes and regulations are brief summaries thereof, do not purport to be complete, and are qualified in their entirety by reference to such statutes and regulations. The Company believes that it is in compliance in all material respects with these laws and regulations. The Company The Company is a financial holding company registered under the Gramm-Leach-Bliley Act and a bank holding company registered under the Bank Holding Company Act of 1956, as amended (“BHCA”). Accordingly, the Company is subject to supervision, regulation and examination by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”). The Gramm-Leach-Bliley Act, the BHCA and other federal laws subject financial and bank holding companies to particular restrictions on the types of activities in which they may engage, and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and regulations. Regulatory Restrictions on Dividends; Source of Strength. It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization's expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company's ability to serve as a source of strength to its banking subsidiaries. Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each of its banking subsidiaries and commit resources to their support. Such support may be required at times when, absent this Federal Reserve Board policy, a holding company may not be inclined to provide it. As discussed below, a bank holding company in certain circumstances could be required to guarantee the capital plan of an undercapitalized banking subsidiary. In the event of a bank holding company's bankruptcy under Chapter 11 of the U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is required to cure immediately any deficit under any commitment by the debtor holding company to any of the federal banking agencies to maintain the capital of an insured depository institution. Any claim for breach of such obligation will generally have priority over most other unsecured claims. Scope of Permissable Activities. Under the BHCA, bank holding companies generally may not acquire a direct or indirect interest in or control of more than 5% of the voting shares of any company that is not a bank or bank holding company or from engaging in activities other than those of banking, managing or controlling banks or furnishing services to or performing services for its subsidiaries, except that it may engage in, directly or indirectly, certain activities that the Federal Reserve Board determined to be 6 closely related to banking or managing and controlling banks as to be a proper incident thereto. In approving acquisitions or the addition of activities, the Federal Reserve considers whether the acquisition or the additional activities can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that outweigh such possible adverse effects as undue concentration of resources decreased or unfair competition, conflicts of interest or unsound banking practices. However, the Gramm-Leach-Bliley Act, effective March 11, 2000, eliminated the barriers to affiliations among banks, securities firms, insurance companies and other financial service providers and permits bank holding companies to become financial holding companies and thereby affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. The Gramm-Leach-Bliley Act defines “financial in nature” to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. Under the Gramm-Leach-Bliley Act, a bank holding company may become a financial holding company by filing a declaration with the Federal Reserve Board if each of its subsidiary banks is well capitalized under the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) prompt corrective action provisions, is well managed, and has at least a satisfactory rating under the Community Reinvestment Act of 1977 (“CRA”). The Company received approval to become a financial holding company on April 18, 2000. While the Federal Reserve Board will serve as the “umbrella” regulator for financial holding companies and has the power to examine banking organizations engaged in new activities, regulation and supervision of activities which are financial in nature or determined to be incidental to such financial activities will be handled along functional lines. Accordingly, activities of subsidiaries of a financial holding company will be regulated by the agency or authorities with the most experience regulating that activity as it is conducted in a financial holding company. Safe and Sound Banking Practices. Bank holding companies are not permitted to engage in unsafe and unsound banking practices. The Federal Reserve Board's Regulation Y, for example, generally requires a holding company to give the Federal Reserve Board prior notice of any redemption or repurchase of its own equity securities, if the consideration to be paid, together with the consideration paid for any repurchases or redemptions in the preceding year, is equal to 10% or more of the company's consolidated net worth. The Federal Reserve Board may oppose the transaction if it believes that the transaction would constitute an unsafe or unsound practice or would violate any law or regulation. Depending upon the circumstances, the Federal Reserve Board could take the position that paying a dividend would constitute an unsafe or unsound banking practice. The Federal Reserve Board has broad authority to prohibit activities of bank holding companies and their nonbanking subsidiaries which represent unsafe and unsound banking practices or which constitute violations of laws or regulations, and can assess civil money penalties for certain activities conducted on a knowing and reckless basis, if those activities caused a substantial loss to a depository institution. The penalties can be as high as $1.0 million for each day the activity continues. Anti-Tying Restrictions. Bank holding companies and their affiliates are prohibited from tying the provision of certain services, such as extensions of credit, to other services offered by a holding company or its affiliates. Capital Adequacy Requirements. The Federal Reserve Board has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies. Under the guidelines, specific categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a "risk-weighted'' asset base. The guidelines require a minimum total risk-based capital ratio of 8.0% (of which at least 4.0% is required to consist of Tier 1 capital elements). Total capital is the sum of Tier 1 and Tier 2 capital. As of December 31, 2002, the Company's ratio of Tier 1 capital to total risk-weighted assets was 14.10% and its ratio of total capital to total risk-weighted assets was 15.30%. See “Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Capital Resources.” In addition to the risk-based capital guidelines, the Federal Reserve Board uses a leverage ratio as an additional tool to evaluate the capital adequacy of bank holding companies. The leverage ratio is a company's Tier 1 capital divided by its average total consolidated assets. Certain highly rated bank holding companies may maintain a minimum leverage ratio of 3.0%, but other bank holding companies are required to maintain a leverage ratio of 4.0%. As of December 31, 2002, the Company's leverage ratio was 6.56%. 7 The federal banking agencies' risk-based and leverage ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria, assuming that they have the highest regulatory rating. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. Federal Reserve Board guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Imposition of Liability for Undercapitalized Subsidiaries. Bank regulators are required to take "prompt corrective action'' to resolve problems associated with insured depository institutions whose capital declines below certain levels. In the event an institution becomes “undercapitalized,” it must submit a capital restoration plan. The capital restoration plan will not be accepted by the regulators unless each company having control of the undercapitalized institution guarantees the subsidiary's compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution's holding company is entitled to a priority of payment in bankruptcy. The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution's assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company cont rolling such an institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates. Acquisitions by Bank Holding Companies. The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. In approving bank acquisitions by bank holding companies, the Federal Reserve Board is required to consider the financial and managerial resources and future prospects of the bank holding company and the banks concerned, the convenience and needs of the communities to be served, and various competitive factors. Control Acquisitions. The Change in Bank Control Act prohibits a person or group of persons from acquiring "control'' of a bank holding company unless the Federal Reserve Board has been notified and has not objected to the transaction. Under a rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Company, would, under the circumstances set forth in the presumption, constitute acquisition of control of the Company. In addition, any entity is required to obtain the approval of the Federal Reserve Board under the BHCA before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of the outstanding Common Stock of the Company, or otherwise obtaining control or a “controlling influence” over the Company. The Bank The Bank is a Texas-chartered banking association, the deposits of which are insured by the Bank Insurance Fund (“BIF”). The Bank is not a member of the Federal Reserve System; therefore, the Bank is subject to supervision and regulation by the FDIC and the Texas Banking Department. Such supervision and regulation subject the Bank to special restrictions, requirements, potential enforcement actions and periodic examination by the FDIC and the Texas Banking Department. Because the Federal Reserve Board regulates the bank holding company parent of the Bank, the Federal Reserve Board also has supervisory authority which directly affects the Bank. Equivalence to National Bank Powers. The Texas Constitution, as amended in 1986, provides that a Texas-chartered bank has the same rights and privileges that are or may be granted to national banks domiciled in Texas. To the extent that the Texas laws and regulations may have allowed state-chartered banks to engage in a broader range of activities than national banks, the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) has operated to limit this authority. FDICIA provides that no state bank or subsidiary thereof may engage as principal in any activity not permitted for national banks, unless the institution complies with applicable capital requirements and the FDIC determines that the activity poses no significant risk to the insurance fund. In general, statutory restrictions on the activities of banks are aimed at protecting the safety and soundness of depository institutions. 8 Financial Modernization. Under the Gramm-Leach-Bliley Act, a national bank may establish a financial subsidiary and engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting as principal, insurance company portfolio investment, real estate development, real estate investment and annuity issuance. To do so, a bank must be well capitalized, well managed and have a CRA rating of satisfactory or better. Subsidiary banks of a financial holding company or national banks with financial subsidiaries must remain well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of the financial in nature subsidiary or subsidiaries. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a CRA rating of satisfactory of better. Although the powers of state chartered banks are not specifically addressed in the Gramm-Leach-Bliley Act, Texas-chartered banks such as the Bank, will have the same if not greater powers as national banks through the parity provision contained in the Texas Constitution. Branching. Texas law provides that a Texas-chartered bank can establish a branch anywhere in Texas provided that the branch is approved in advance by the Texas Banking Department. The branch must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers. Restrictions on Transactions with Affiliates and Insiders. Transactions between the Bank and its nonbanking subsidiaries, including the Company, are subject to Section 23A of the Federal Reserve Act. In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties. It also limits the amount of advances to third parties which are collateralized by the securities or obligations of the Company or its subsidiaries. Affiliate transactions are also subject to Section 23B of the Federal Reserve Act which generally requires that certain transactions between the Bank and its affiliates be on terms substantially the same, or at least as favorable to the Bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons. The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to herein as "insiders'') contained in the Federal Reserve Act and Regulation O apply to all insured institutions and their subsidiaries and holding companies. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. These loans cannot exceed the institution's total unimpaired capital and surplus, and the FDIC may determine that a lesser amount is appropriate. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions. Restrictions on Distribution of Subsidiary Bank Dividends and Assets. Dividends paid by the Bank have provided a substantial part of the Company's operating funds and for the foreseeable future it is anticipated that dividends paid by the Bank to the Company will continue to be the Company's principal source of operating funds. Capital adequacy requirements serve to limit the amount of dividends that may be paid by the Bank. Under federal law, the Bank cannot pay a dividend if, after paying the dividend, the Bank will be “undercapitalized.” The FDIC may declare a dividend payment to be unsafe and unsound even though the Bank would continue to meet its capital requirements after the dividend. Because the Company is a legal entity separate and distinct from its subsidiaries, its right to participate in the distribution of assets of any subsidiary upon the subsidiary's liquidation or reorganization will be subject to the prior claims of the subsidiary's creditors. In the event of a liquidation or other resolution of an insured depository institution, the claims of depositors and other general or subordinated creditors are entitled to a priority of payment over the claims of holders of any obligation of the institution to its shareholders, including any depository institution holding company (such as the Company) or any shareholder or creditor thereof. Examinations. The FDIC periodically examines and evaluates insured banks. Based on such an evaluation, the FDIC may revalue the assets of the institution and require that it establish specific reserves to compensate for the difference between the FDIC- determined value and the book value of such assets. The Texas Banking Department also conducts examinations of state banks but may accept the results of a federal examination in lieu of conducting an independent examination. Audit Reports. Insured institutions with total assets of $500 million or more must submit annual audit reports prepared by independent auditors to federal and state regulators. In some instances, the audit report of the institution's holding company can be used to satisfy this requirement. Auditors must receive examination reports, supervisory agreements and reports of enforcement actions. In addition, financial statements prepared in accordance with generally accepted accounting principles, management's certifications concerning responsibility for the financial statements, internal controls and compliance with legal requirements 9 designated by the FDIC, and an attestation by the auditor regarding the statements of management relating to the internal controls must be submitted. For institutions with total assets of more than $3 billion, independent auditors may be required to review quarterly financial statements. FDICIA requires that independent audit committees be formed, consisting of outside directors only. The committees of such institutions must include members with experience in banking or financial management, must have access to outside counsel, and must not include representatives of large customers. Capital Adequacy Requirements. The FDIC has adopted regulations establishing minimum requirements for the capital adequacy of insured institutions. The FDIC may establish higher minimum requirements if, for example, a bank has previously received special attention or has a high susceptibility to interest rate risk. The FDIC's risk-based capital guidelines generally require state banks to have a minimum ratio of Tier 1 capital to total risk- weighted assets of 4.0% and a ratio of total capital to total risk-weighted assets of 8.0%. The capital categories have the same definitions for the Bank as for the Company. As of December 31, 2002, the Bank's ratio of Tier 1 capital to total risk-weighted assets was 13.71% and its ratio of total capital to total risk-weighted assets was 14.91%. See “Management's Discussion and Analysis of Financial Condition and Result of Operation of the Company - Financial Condition - Capital Resources.” The FDIC's leverage guidelines require state banks to maintain Tier 1 capital of no less than 4.0% of ave rage total assets, except in the case of certain highly rated banks for which the requirement is 3.0% of average total assets. The Texas Banking Department has issued a policy which generally requires state chartered banks to maintain a leverage ratio (defined in accordance with federal capital guidelines) of 6.0% . As of December 31, 2002, the Bank's ratio of Tier 1 capital to average total assets (leverage ratio) was 6.26%. Corrective Measures for Capital Deficiencies. The federal banking regulators are required to take "prompt corrective action'' with respect to capital-deficient institutions. Agency regulations define, for each capital category, the levels at which institutions are "well capitalized,” “adequately capitalized,” “under capitalized,” “s ignificantly under capitalized” and “critically under capitalized.” A “well capitalized” bank has a total risk-based capital ratio of 10.0% or higher; a Tier 1 risk-based capital ratio of 6.0% or higher; a leverage ratio of 5.0% or higher; and is not subject to any written agreement, order or directive requiring it to maintain a specific capital level for any capital measure. An “adequately capitalized” bank has a total risk-based capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing significant growth); and does not meet the criteria for a well capitalized bank. A bank is “under capitalized” if it fails to meet any one of the ratios required to be adequately capitalized. The Bank is classified as “well capitalized” for purposes of the FDIC’s prompt corrective action regulations. In addition to requiring undercapitalized institutions to submit a capital restoration plan, agency regulations contain broad restrictions on certain activities of undercapitalized institutions including asset growth, acquisitions, branch establishment and expansion into new lines of business. With certain exceptions, an insured depository institution is prohibited from making capital distributions, including dividends, and is prohibited from paying management fees to control persons if the institution would be undercapitalized after any such distribution or payment. As an institution's capital decreases, the FDIC's enforcement powers become more severe. A significantly undercapitalized institution is subject to mandated capital raising activities, restrictions on interest rates paid and transactions with affiliates, removal of management and other restrictions. The FDIC has only very limited discretion in dealing with a critically undercapitalized institution and is virtually required to appoint a receiver or conservator. Banks with risk-based capital and leverage ratios below the required minimums may also be subject to certain administrative actions, including the termination of deposit insurance upon notice and hearing, or a temporary suspension of insurance without a hearing in the event the institution has no tangible capital. Deposit Insurance Assessments. The Bank must pay assessments to the FDIC for federal deposit insurance protection. The FDIC has adopted a risk-based assessment system as required by FDICIA. Under this system, FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification. Institutions assigned to higher risk classifications (that is, institutions that pose a greater risk of loss to their respective deposit insurance funds) pay assessments at higher rates than institutions that pose a lower risk. An institution's risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. In addition, the FDIC can impose special assessments in certain instances. The current range of BIF assessments is between 0% and 0.27% of deposits. 10 The FDIC established a process for raising or lowering all rates for insured institutions semi-annually if conditions warrant a change. Under this system, the FDIC has the flexibility to adjust the assessment rate schedule twice a year without seeking prior public comment, but only within a range of five cents per $100 above or below the premium schedule adopted. Changes in the rate schedule outside the five cent range above or below the current schedule can be made by the FDIC only after a full rulemaking with opportunity for public comment. On September 30, 1996, President Clinton signed into law an act that contained a comprehensive approach to re-capitalizing the Savings Association Insurance Fund (“SAIF”) and to assure the payment of the Financing Corporation's (“FICO”) bond obligations. Under this new act, banks insured under the BIF are required to pay a portion of the interest due on bonds that were issued by FICO to help shore up the ailing Federal Savings and Loan Insurance Corporation in 1987. The BIF-rate was required to equal one-fifth of the SAIF rate through year-end 1999, or until the insurance funds merged, whichever occurred first. Thereafter, BIF and SAIF payers will be assessed pro rata for the FICO bond obligations. With regard to the assessment for the FICO obligation, for the fourth quarter 2002, both the BIF and SAIF rates were .00170% of deposits. Enforcement Powers. The FDIC and the other federal banking agencies have broad enforcement powers, including the power to terminate deposit insurance, impose substantial fines and other civil and criminal penalties and appoint a conservator or receiver. Failure to comply with applicable laws, regulations and supervisory agreements could subject the Company or its banking subsidiaries, as well as officers, directors and other institution-affiliated parties of these organizations, to administrative sanctions and potentially substantial civil money penalties. The appropriate federal banking agency may appoint the FDIC as conservator or receiver for a banking institution (or the FDIC may appoint itself, under certain circumstances) if any one or more of a number of circumstances exist, including, without limitation, the fact that the banking institution is undercapitalized and has no reasonable prospect of becoming adequately capitalized; fails to become adequately capitalized when required to do so; fails to submit a timely and acceptable capital restoration plan; or materially fails to implement an accepted capital restoration plan. The Texas Banking Department also has broad enforcement powers over the Bank, including the power to impose orders, remove officers and directors, impose fines and appoint supervisors and conservators. Brokered Deposit Restrictions. Adequately capitalized institutions cannot accept, renew or roll over brokered deposits except with a waiver from the FDIC, and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew, or roll over brokered deposits. Cross-Guarantee Provisions. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) contains a “cross-guarantee” provision which generally makes commonly controlled insured depository institutions liable to the FDIC for any losses incurred in connection with the failure of a commonly controlled depository institution. Community Reinvestment Act. The CRA and the regulations issued thereunder are intended to encourage banks to help meet the credit needs of their service area, including low and moderate income neighborhoods, consistent with the safe and sound operations of the banks. These regulations also provide for regulatory assessment of a bank's record in meeting the needs of its service area when considering applications to establish branches, merger applications and applications to acquire the assets and assume the liabilities of another bank. FIRREA requires federal banking agencies to make public a rating of a bank's performance under the CRA. In the case of a bank holding company, the CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction. Consumer Laws and Regulations. In addition to the laws and regulations discussed herein, the Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, and the Fair Housing Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part o f their ongoing customer relations. The USA Patriot Act of 2001. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 ("USA Patriot Act") was enacted in October 2001. The USA Patriot Act is intended to strengthen U.S. law enforcement's and the intelligence communities' ability to work cohesively to combat terrorism on a variety of fronts. The potential impact of the USA Patriot Act on financial institutions of all kinds is significant and wide ranging. The USA Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including: (i) due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non- 11 U.S. persons; (ii) standards for verifying customer identification at account opening; (iii) rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering; (iv) reports by nonfinancial trades and business filed with the Treasury Department's Financial Crimes Enforcement Network for transactions exceeding $10,000; and (v) filing of suspicious activities reports involving securities by brokers and dealers if they believe a customer may be violating U.S. laws and regulations. Privacy. In addition to expanding the activities in which banks and bank holding companies may engage, the Gramm-Leach- Bliley Act also imposed new requirements on financial institutions with respect to customer privacy. The Gramm-Leach-Bliley Act generally prohibits disclosure of customer information to non-affiliated third parties unless the customer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required to disclose their privacy policies to customers annually. Financial institutions, however, will be required to comply with state law if it is more protective of customer privacy than the Gramm-Leach-Bliley Act. Instability and Regulatory Structure Various legislation, such as the Gramm-Leach-Bliley Act which expanded the powers of banking institutions and bank holding companies, and proposals to ove rhaul the bank regulatory system and limit the investments that a depository institution may make with insured funds, is from time to time introduced in Congress. Such legislation may change banking statutes and the operating environment of the Company and its banking subsidiaries in substantial and unpredictable ways. The Company cannot determine the ultimate effect that the Gramm-Leach-Bliley Act will have, or the effect that any potential legislation, if enacted, or implemented regulations with respect thereto, would have, upon the financial condition or results of operations of the Company or its subsidiaries. Expanding Enforcement Authority One of the major additional burdens imposed on the banking industry by FDICIA is the increased ability of banking regulators to monitor the activities of banks and their holding companies. In addition, the Federal Reserve Board and FDIC are possessed of extensive authority to police unsafe or unsound practices and violations of applicable laws and regulations by depository institutions and their holding companies. For example, the FDIC may terminate the deposit insurance of any institution which it determines has engaged in an unsafe or unsound practice. The agencies can also assess civil money penalties, issue cease and desist or removal orders, seek injunctions, and publicly disclose such actions. FDICIA, FIRREA and other laws have expanded the agencies' authority in recent years, and the agencies have not yet fully tested the limits of their powers. Effect on Economic Environment The policies of regulatory authorities, including the monetary policy of the Federal Reserve Board, have a significant effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the Federal Reserve Board to affect the money supply are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid for deposits. Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on the business and earnings of the Company and its subsidiaries cannot be predicted. 12 ITEM 2. PROPERTIES The Company conducts business at 42 full-service banking locations. The Company’s headquarters are located at 4295 San Felipe, Houston, Texas. The Company owns all of the buildings in which its Banking Centers are located other than the following: Banking Center Expiration Date of Lease Bellaire....................................................... City West.................................................... Copperfield ................................................ Downtown .................................................. Fairfield...................................................... Galveston ................................................... Gladebrook................................................. Medical Center........................................... Post Oak ..................................................... River Oaks.................................................. Waugh ........................................................ October 2007 November 2003 April 2005 October 2012 May 2005 November 2005 October 2010 February 2005 June 2007 December 2004 February 2011 The expiration dates of the leases listed above do not include the renewal option periods which may be available. The following table sets forth specific information on each of the Company’s locations: Location Aldine Angleton Bay City (1) Beeville (2) Bellaire Camp Wisdom CityWest Clear Lake Cleveland Address Deposits at December 31, 2002 (Dollars in thousands) 1906 Aldine Bender Houston, TX 77032 116 South Velasco Angleton, TX 77516 1600 Seventh St. Bay City, TX 77404 100 South Washington Beeville, TX 78102 6800 West Loop South Suite 100 Bellaire, TX 77401 3515 W. Camp Wisdom Road Dallas, TX 75237 2500 CityWest Blvd. Houston, TX 77042 100 West Medical Center Blvd. Webster, TX 77598 104 West Crockett Cleveland, TX 77237 $ 17,923 43,830 72,068 68,983 29,168 35,173 15,694 44,128 62,099 13 Location Copperfield Cuero Cypress Dayton Downtown East Bernard Edna El Campo Fairfield Galveston Gladebrook Goliad Highway 6-West Hitchcock Liberty Magnolia Mathis Deposits at December 31, 2002 (Dollars in thousands) Address 8686 Highway 6 North Houston, TX 77095 106 North Esplanade Cuero, TX 77954 25820 U.S. 290 Cypress, TX 77429 106 North Main Dayton, TX 77535 777 Walker, Suite L140 Houston, TX 77002 700 Church St. East Bernard, TX 77435 102 North Wells Edna, TX 77962 1301 North Mechanic El Campo, TX 77437 15050 Fairfield Village Square Dr. Cypress, TX 77433 2424 Market St. Galveston, TX 77550 3934 FM 1960 West, Suite 100 Houston, TX 77068 145 North Jefferson Goliad, TX 77963 1070 Highway 6 South Houston, TX 77077 8300 Highway 6 Hitchcock, TX 77563 520 Main St. Liberty, TX 77575 18935 FM 1488 Magnolia, TX 77355 103 North Highway 359 Mathis, TX 78368 $ 2,171 26,616 35,158 63,769 9,904 56,455 62,133 99,468 6,666 4,225 35,853 12,455 7,858 11,121 55,081 28,710 27,526 25,515 Medical Center 7505 South Main St., Suite 100 Houston, TX 77030 14 Location Memorial Mont Belvieu Needville (3) Palacios Post Oak River Oaks Sweeny Tanglewood Victoria Waugh West Columbia Westmoreland Wharton Winnie Woodcreek __________________ Address Deposits at December 31, 2002 (Dollars in thousands) 12602 Memorial Drive Houston, TX 77024 10305 Eagle Drive Mont Belvieu, TX 77580 9022 Main St. Needville, TX 77461 600 Henderson Palacios, TX 77465 3040 Post Oak Blvd. Suite 150 Houston, TX 77056 4295 San Felipe Houston, TX 77027 206 North McKinney Sweeny, TX 77480 5707 Woodway Houston, TX 77057 2702 North Navarro Victoria, TX 77901 55 Waugh Drive Houston, TX 77007 510 East Brazos West Columbia, TX 77486 2415 S. Westmoreland Rd. Dallas, TX 75211 143 West Burleson Wharton, TX 77488 146 Spur 5 Winnie, TX 77665 2828 FM 1960 East Houston, TX 77073 $ 22,912 6,753 26,635 24,774 76,047 114,752 12,395 10,387 44,039 29,025 48,612 71,678 71,769 10,748 56,335 (1) The Bay City Banking Center consists of the main office located at 1600 Seventh Street and a drive-thru facility located approximately one- quarter mile from the main office. (2) The Beeville Banking Center consists of the main office located at 100 South Washington and a drive-thru facility located approximately one - half mile from the main office. (3) The Company is currently constructing a new facility for the Needville Banking Center located at 13325 Highway 36, Needville, Texas 77461. The building is expected to be completed by the end of 2003. 15 ITEM 3. LEGAL PROCEEDINGS Neither the Company nor the Bank is currently a party to any material legal proceeding. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 2002. PART II. ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The Company’s Common Stock began trading on November 12, 1998 and is listed on the Nasdaq National Market System under the symbol “PRSP”. Prior to that date, the Common Stock was privately held and not listed on any public exchange or actively traded. As of February 6, 2003, there were 18,903,483 shares outstanding and 536 shareholders of record. The number of beneficial owners is unknown to the Company at this time. The following table presents the high and low sales prices for the Common Stock reported on the Nasdaq National Market during the two years ended December 31, 2002: 2002 Fourth Quarter .......................................... Third Quarter............................................ Second Quarter......................................... First Quarter.............................................. 2001 Fourth Quarter .......................................... Third Quarter............................................ Second Quarter......................................... First Quarter.............................................. Dividends High $19.950 19.950 18.590 16.275 High $13.870 13.935 12.610 11.313 Low $15.280 15.000 15.550 13.475 Low $11.930 10.750 8.750 9.375 On May 31, 2002, the Company effected a two -for-one stock split in the form of a 100 percent stock dividend to shareholders of record on May 20, 2002. The Company issued approximately 8.1 million shares in connection with the split. All per share and share information has been restated to reflect this split. Holders of Common Stock are entitled to receive dividends when, as and if declared by the Company’s Board of Directors out of funds legally available therefor. While the Company has declared dividends on its Common Stock since 1994, and paid quarterly dividends aggregating $0.22 per share in 2002 and $0.195 per share in 2001, there is no assurance that the Company will continue to pay dividends in the future. The principal source of cash revenues to the Company is dividends paid by the Bank with respect to the Bank’s capital stock. There are certain restrictions on the payment of such dividends imposed by federal and state banking laws, regulations and authorities. Under federal law, the Bank cannot pay a dividend if it will cause the Bank to be "undercapitalized." The Bank is also subject to risk- based capital rules that restrict its ability to pay dividends. The risk-based capital rules set a specific schedule for achieving minimum capital levels in relation to risk-weighted assets. Regulatory authorities can impose stricter limitations on the ability of the Bank to pay dividends if they consider the payment to be an unsafe or unsound practice. 16 The cash dividends paid per share by quarter for the Company’s last two fiscal years were as follows: 2002 2001 Fourth quarter.................................................... $0.055 $0.050 Third quarter....................................................... 0.055 Second quarter................................................... 0.055 First quarter ....................................................... 0.055 0.050 0.050 0.045 Securities Authorized for Issuance under Equity Compensation Plans The Company currently has two stock option plans, both of which were approved by the Company's shareholders. The following table provides information as of December 31, 2002 regarding the Company's equity compensation plans under which the Company’s equity securities are authorized for issuance: Plan category Equity compensation plans approved by security holders.......... Equity compensation plans not approved by security holders.......... Number of securities to be issued upon exercise of outstanding options, warrants and rights Weighted-average exercise price of outstanding options 684,153(1) $ 7.88 -- -- Total .......................................... 684,153 $ 7.88 ______________________________ Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) 541,000 -- 541,000 (1) Includes (a) 29,673 shares which may be issued upon exercise of options outstanding assumed by the Company in connection with the acquisition of Paradigm Bancorporation, Inc. at a weighted average exercise price of $10.66 and (b) 2,480 shares which may be issued upon exercise of options outstanding assumed by the Company in connection with the merger with Commercial Bancshares, Inc. at a weighted-average exercise price of $5.16. 17 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The following selected consolidated financial data for, and as of the end of, each of the years in the five -year period ended December 31, 2002 are derived from and should be read in conjunction with the Company’s consolidated financial statements and the notes thereto and the information contained in “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.” The consolidated financial statements as of December 31, 2002 and 2001 and for each of the years in the three-year period ended December 31, 2002 and the report thereon of Deloitte & Touche LLP are included elsewhere in this document. The historical financial data of the Company has been restated to include the accounts and operations of Commercial Bancshares, Inc. for all periods prior to February 23, 2001. All per share data has been restated to include the two -for-one stock split effective May 31, 2002. Income Statement Data: Interest income ................................................... Interest expense.................................................. Net interest income ........................................ Provision for credit losses ................................... Net interest income after provision for credit losses ........................................... Noninterest income............................................. Noninterest expense............................................ Income before taxes ........................................ Provision for income taxes.................................. Net income......................................................... Per Share Data(2): Basic earnings per share...................................... Diluted earnings per share................................... Book value per share. ......................................... Cash dividends declared...................................... Dividend payout ratio ......................................... Weighted average shares outstanding (basic) 2002 As of and for the Years Ended December 31, 2000 2001 1999 1998 (Dollars in thousands, except per share data) $ 80,742 25,931 54,811 1,010 $ 76,520 35,785 40,735 700 $ 70,079 35,564 34,515 275 $ 56,458 26,189 30,269 420 $ 46,026 21,923 24,103 264 53,801 11,528 34,453 30,876 9,555 $ 21,321 40,035 8,590 30,295 (1) 18,330 (1) 5,372 (1) $ 12,958 (1) 34,240 7,760 26,767 15,233 4,532 $ 10,701 29,849 6,151 21,822 14,178 4,747 9,431 $ $ 1.25 1.22 8.19 0.22 18.13% $ $ 0.80 (3) $ 0.79 (3) 5.47 0.195 24.39% 0.67 0.65 4.98 0.18 25.75% 0.59 0.58 4.32 0.10 19.10% 23,839 4,808 17,989 10,658 3,577 7,081 0.51 0.50 3.88 0.10 33.82% $ $ (in thousands). ................................................ 17,122 16,172 16,064 15,972 13,832 Weighted average shares outstanding (diluted) (in thousands). ................................................ 17,442 16,498 16,454 16,408 14,230 Shares outstanding at end of period (in thousands). ................................................ 18,896 16,210 16,144 15,990 15,946 Balance Sheet Data (at period end): Total assets......................................................... Securities. .......................................................... Loans ................................................................. Allowance for credit losses ................................. Total deposits. .................................................... Borrowings and notes payable............................. Total shareholders' equity. .................................. Company-obligated mandatorily redeemable preferred securities of subsidiary $1,822,256 950,317 679,559 9,580 1,586,611 37,939 154,739 $1,262,325 752,322 424,400 5,985 1,123,397 18,080 88,725 $1,146,140 586,952 411,203 5,523 1,033,546 13,931 80,333 $1,027,631 514,983 366,803 5,031 878,589 53,119 69,025 $ 800,158 455,202 276,106 3,682 714,365 17,508 61,781 trusts (4) ......................................................... 33,000 27,000 12,000 12,000 -- Average Balance Sheet Data: Total assets......................................................... Securities. .......................................................... Loans ................................................................. Allowance for credit losses ................................. Total deposits. .................................................... Total shareholders' equity. .................................. Company-obligated mandatorily redeemable preferred securities of subsidiary trusts (4) ......................................................... $1,469,860 818,362 524,885 7,350 1,300,884 114,234 $1,191,190 666,241 419,553 5,586 1,061,195 85,319 $1,045,882 550,431 383,054 5,245 920,526 72,952 $ 875,781 465,788 319,178 4,272 767,879 64,911 $ 700,410 392,026 238,855 2,994 628,557 47,574 28,750 18,875 12,000 1,500 -- (Table continued on next page) 18 Performance Ratios: Return on average assets................................. Return on average equity ................................ Net interest margin (tax-equivalent) (6) ........... Efficiency ratio(7). ............................................. Asset Quality Ratios(8): Nonperforming assets to total loans and other real estate........................................... Net loan charge-offs (recoveries) to average loans ........................................... Allowance for credit losses to total loans........................................................... Allowance for credit losses to nonperforming loans(9) ............................... Capital Ratios(8): Leverage ratio ................................................ Average shareholders' equity to average total assets .................................................. Tier 1 risk-based capital ratio. ......................... Total risk-based capital ratio ........................... __________________ As of and for the Years Ended December 31, 2002 1.45% 18.66 4.16 50.36 2001 (Dollars in thousands, except per share data) 2000 1999 1998 1.09% (5) 1.02% 1.08 % 15.19 (5) 3.86 60.14 (5) 14.67 3.69 62.29 14.53 3.77 59.29 1.01% 14.88 3.75 61.72 0.38% 0.00% 0.32% 0.34% 0.14% 0.08 0.06 (0.04 ) (0.11 ) (0.08) 1.41 1.41 1.34 1.37 1.33 408.53 n/m(10) 700.89 657.65 941.69 6.56% 7.57% 6.17% 6.17% 6.59% 8.52 14.10 15.30 7.16 18.34 19.52 6.98 13.80 14.93 7.41 13.89 15.74 6.79 15.06 16.14 (1) Certain income statement data for the year ended December 31, 2001 includes the merger-related expenses of $2.4 million, net of tax. (2) Adjusted for a two-for one stock split effective May 31, 2002 and a four-for-one stock split effective September 10, 1998. (3) Earnings per share amounts for the year ended December 31, 2001 include the merger-related expenses of $2.4 million. (4) Consists of $12.0 million of trust preferred securities of Prosperity Capital Trust I due November 12, 2029, $15.0 million of trust preferred securities of Prosperity Statutory Trust II due July 31, 2031 and $6.0 million of trust preferred securities of Paradigm Capital Trust II due February 20, 2031. (5) Selected performance ratios for the year ended December 31, 2001 include the merger-related expenses of $2.4 million. (6) Calculated on a tax-equivalent basis using a 35% federal income tax rate for the years ended December 31, 2002 and 2001 and a 34% federal income tax rate for the years ended December 31, 1998, 1999 and 2000. (7) Calculated by dividing total noninterest expense, excluding securities losses and credit loss provisions, by net interest income plus noninterest income. The interest expense related to debentures issued by the Company in connection with the issuance by subsidiary trusts of trust preferred securities is treated as interest expense for this calculation. Additionally, taxes are not part of this calculation. (8) At period end, except for net loan charge-offs to average loans and average shareholders' equity to average total assets, which is for periods ended at such dates. (9) Nonperforming loans consist of nonaccrual loans, loans contractually past due 90 days or more, restructured loans and any other loan management deems to be nonperforming. (10) Amount not meaningful. Nonperforming assets totaled $1,000 at December 31, 2001. 19 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company's balance sheets and statements of income. This section should be read in conjunction with the Company's consolidated financial statements and accompanying notes and other detailed information appearing elsewhere in this Annual Report on Form 10- K. The Commercial Merger was accounted for as a pooling of interests and therefore the historical financial data of the Company has been restated to include the accounts and operations of Commercial for all periods prior to February 23, 2001. Overview For the Years Ended December 31, 2002, 2001 and 2000 Net income was $21.3 million, $13.0 million and $10.7 million for the years ended December 31, 2002, 2001 and 2000, respectively, and diluted earnings per share were $1.22, $0.79 and $0.65, respectively, for these same periods. Earnings growth during both 2002 and 2001 resulted principally from an increase in loan volume and acquisitions, including the Paradigm Acquisition and the Commercial Merger. The Company posted returns on average assets of 1.45%, 1.09% and 1.02% and returns on average equity of 18.66%, 15.19% and 14.67% for the years ended December 31, 2002, 2001 and 2000, respectively. The Company posted returns on average assets excluding amortization of goodwill and core deposit intangibles and related tax expense of 1.46%, 1.18% and 1.12% and returns on average equity excluding amortization of goodwill and core deposit intangibles and related tax expense of 18.82%, 16.55% and 16.08% for the years ended December 31, 2002, 2001 and 2000, respectively. The Company's efficiency ratio was 50.36% in 2002, 60.14% in 2001 and 62.29% in 2000. The Company's efficiency ratio excluding amortization of goodwill and core deposit intangibles was 50.06% in 2002, 57.29% in 2001 and 59.47% in 2000. Total assets at December 31, 2002, 2001 and 2000 were $1.822 billion, $1.262 billion and $1.146 billion, respectively. Total deposits at December 31, 2002, 2001 and 2000 were $1.587 billion, $1.123 billion, and $1.034 billion, respectively, with deposit growth in each period resulting from acquisitions and internal growth. Total loans were $679.6 million at December 31, 2002, an increase of $255.2 million or 60.1% from $424.4 million at the end of 2001. Total loans were $411.2 million at year-end 2000. At December 31, 2002, the Company had $2.3 million in nonperforming loans and its allowance for credit losses was $9.6 million. Shareholders' equity was $154.7 million, $88.7 million and $80.3 million at December 31, 2002, 2001 and 2000, respectively. On February 23, 2001, the Company completed its merger with Commercial Bancshares, Inc. As a result of the Commercial Merger, the Company issued an aggregate of 5,537,220 (after two for one stock split) shares of its Common Stock to the holders of Commercial common stock. In connection with the Commercial Merger, the Company incurred approximately $2.4 million in pretax merger-related expenses and other charges (the “Special Charge”). The transaction was accounted for as a pooling of interests and therefore the historical financial data of the Company has been restated to include the accounts and operations of Commercial for all periods prior to the effective time of the Commercial Merger. On May 31, 2002, the Company effected a two -for-one stock split in the form of a 100 percent stock dividend to shareholders of record on May 20, 2002. The Company issued approximately 8.1 million shares in connection with the split. All per share and share information has been restated to reflect this split. Critical Accounting Policies The Company’s accounting policies are integral to understanding the results reported. Accounting policies are described in detail in Note 1 to the consolidated financial statements. The Company believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity: Allowance for Credit Losses - The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company's loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank's Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company's commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company’s loan portfolio, current economic changes that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process and other relevant factors. Charge-offs occur when loans are deemed to be uncollectable. 20 Results of Operations Net Interest Income The Company’s operating results depend primarily on its net interest income, which is the difference between interest income on interest-earning assets, including securities and loans, and interest expense incurred on interest-bearing liabilities, including deposits and other borrowed funds. Interest rate fluctuations, as well as changes in the amount and type of earning assets and liabilities, combine to affect net interest income. The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “rate change.” 2002 versus 2001. Net interest income for the year ended December 31, 2002 was $54.8 million compared with $40.7 million for the year ended December 31, 2001, an increase of $14.1 million or 34.6%. The improvement in net interest income for 2002 was principally due to an increase in total average interest-earning assets and a decrease in the rate paid on interest-bearing liabilities that exceeded the decrease in the yield on interest-earning assets by 94 basis points. Average interest-earning assets increased $247.9 million from $1.116 billion at December 31 2001 to $1.364 billion at December 31, 2002. Total cost of interest-bearing liabilities decreased 160 basis points from 3.99% at December 31, 2001 to 2.39% at December 31, 2002. Total yield on interest-earning assets decreased 66 basis points from 6.58% at December 31, 2001 to 5.92% at December 31, 2002. The net interest margin on a tax- equivalent basis increased 30 basis points to 4.16% at December 31, 2002 from 3.86% at December 31, 2001. 2001 versus 2000. Net interest income for the year ended December 31, 2001 was $40.7 million compared with $34.5 million for the year ended December 31, 2000, an increase of $6.2 million or 18.0%. The improvement in net interest income for 2001 was principally due to an increase in total average interest-earning assets and a decrease in the rate paid on interest-bearing liabilities that exceeded the decrease in the yield on interest-earning assets by 22 basis points. Average interest-earning assets increased $144.9 million from $971.4 million at December 31 2000 to $1.116 billion at December 31, 2001. Total cost of interest-bearing liabilities decreased 58 basis points from 4.57% at December 31, 2000 to 3.99% at December 31, 2001. Total yield on interest-earning assets decreased 36 basis points from 7.21% at December 31, 2000 to 6.85% at December 31, 2001. The net interest margin on a tax- equivalent basis increased 17 basis points to 3.86% at December 31, 2001 from 3.69% at December 31, 2000. 21 The following table presents for the periods indicated the total dollar amount of average balances, interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield. Average 2002 Interest Outstanding Earned/ Balance Paid Years Ended December 31, 2001 Interest Earned/ Paid Average Yield/ Rate Average Average Yield/ Outstanding Rate Balance Average Interest Average 2000 Outstanding Earned/ Yield/ Rate Balance Paid Assets Interest-earning assets: Loans. ..................................................................... $ 524,885 $ 38,330 42,104 Securities(1)........................................................... Federal funds sold and other temporary 818,362 (Dollars in thousands) 7.30% 5.14 $ 419,553 666,241 $ 34,731 40,353 8.28% 6.06 $ 383,054 550,431 $ 33,599 33,978 8.77% 6.17 investments.......................................................... 20,956 308 1.47 30,478 1,436 4.71 37,929 2,502 6.60 Total interest-earning assets........................... 1,364,203 80,742 5.92% 1,116,272 76,520 6.58% 971,414 70,079 7.21% Less allowance for credit losses......................... (7,350 ) (5,586 ) (5,245 ) Total interest-earning assets, net of allowance. ................................................... 1,356,853 Noninterest-earning assets.................................. 113,007 Total assets........................................................ $1,469,860 Liabilities and shareholders' equity Interest-bearing liabilities: Interest-bearing demand deposits ...................... $ 249,045 $ Savings and money market accounts................ Certificates of deposit.......................................... Federal funds purchased and other 315,717 505,796 1,110,686 80,504 $1,191,190 966,169 79,713 $1,045,882 3,162 5,219 16,595 1.27% 1.65 3.28 $ 199,077 252,576 428,314 $ 4,529 7,978 22,273 2.27% 3.16 5.20 $ 185,486 $ 220,266 339,580 6,346 3.42% 3.92 5.47 8,628 18,577 borrowings........................................................... 16,435 955 5.81 17,219 1,005 5.84 32,333 2,013 6.23 Total interest-bearing liabilities .......................................................... 1,086,993 25,931 2.39% 897,186 35,785 3.99% 777,665 35,564 4.57% Noninterest-bearing liabilities: Noninterest-bearing demand deposits............... Company obligated mandatorily redeemable trust preferred securities of subsidiary trusts .................................................................... Other liabilities. .................................................... 230,326 28,750 9,557 Total liabilities.................................................. 1,355,626 Shareholders' equity ................................................. 114,234 Total liabilities and shareholders' equity................................................................ $ 1,469,860 181,228 18,875 8,582 1,105,871 85,319 175,194 12,000 8,071 972,930 72,952 $1,191,190 $1,045,882 Net interest rate spread............................................. 3.53 % 2.86% 2.64% Net interest income and margin(2). ....................... Net interest income and margin .............................. (tax-equivalent basis)(3)........................................ __________________________________________ $ 54,811 4.02% $ 40,735 3.65% $ 34,515 3.55% $ 56,734 4.16% $ 43,057 3.86% $ 35,890 3.69% (1) Yield is based on amortized cost and does not include any component of unrealized gains or losses. (2) The net interest margin is equal to net interest income divided by average interest-earning assets. (3) In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax- equivalent adjustment has been computed using a federal income tax rate of 35% for the years ended December 31, 2002 and December 31, 2001 and 34% for the period ended December 31, 2000 and other applicable effective tax rates. 22 The following table presents the dollar amount of changes in interest income and interest expense for the major components of interest-earning assets and interest-bearing liabilities and distinguishes between the increase (decrease) related to higher outstanding balances and the volatility of interest rates. For purposes of this table, changes attributable to both rate and volume which cannot be segregated have been allocated to rate. Years Ended December 31, 2002 vs. 2001 2001 vs. 2000 Increase (Decrease) Due to Volume Rate Increase (Decrease) Due to Total Volume (Dollars in thousands) Rate Total Interest-earning assets: Loans ........................................................................ $ Securities .................................................................. Federal funds sold and other temporary 8,719 9,214 $ (5,120 ) (7,463 ) $ 3,599 1,751 $ 3,201 7,149 $ (2,069) (774) $ 1,132 6,375 investments......................................................... Total increase (decrease) in interest income ......... (449 ) 17,484 (679 ) (13,262 ) (1,128 ) 4,222 (492) 9,858 (574) (3,417) (1,066) 6,441 Interest-bearing liabilities: Interest-bearing demand deposits ............................... Savings and money market accounts. ......................... Certificates of deposit. ............................................... Federal funds purchased and other borrowings............ 7,114 Total increase (decrease) in interest expense........ Increase in net interest income ....................................... $ 10,370 1,137 1,994 4,029 (46 ) (2,504 ) (4,753 ) (9,707 ) (4 ) (16,968 ) 3,706 $ (1,367 ) (2,759 ) (5,678 ) (50 ) (9,854 ) $ 14,076 $ 465 1,266 4,854 (941) 5,644 4,214 (2,282) (1,916) (1,158) (67) (5,423) 2,006 $ (1,817) (650) 3,696 (1,008 ) 221 6,220 $ Provision for Credit Losses The Company’s provision for credit losses is established through charges to income in the form of the provision in order to bring the Company’s allowance for credit losses to a level deemed appropriate by management based on the factors discussed under “Financial Condition - Allowance for Credit Losses”. The allowance for credit losses at December 31, 2002 was $9.6 million, representing 1.41% of outstanding loans. The provision for credit losses for the year ended December 31, 2002 was $1.0 million compared with $700,000 for the year ended December 31, 2001. The increase of $310,000 was primarily due to an increase in net loan charge-offs for the year ended December 31, 2002. At December 31, 2002, the Company had $396,000 in net loan charge-offs compared with $239,000 in net loan charge-offs during 2001. The provision for credit losses for the year ended December 31, 2001 was $700,000 compared with $275,000 in 2000. Net loan recoveries were $171,000 in 2000. Noninterest Income The Company’s primary sources of noninterest income are service charges on deposit accounts and other banking service related fees. Loan origination fees are recognized over the life of the related loan as an adjustment to yield using the interest method. In 2002, noninterest income totaled $11.5 million, an increase of $2.9 million or 34.2% compared with $8.6 million in 2001. The increase was primarily due to an increase in insufficient funds charges and customer service charges which resulted from an increase in the number of accounts due to the Texas Guaranty, First State, Paradigm, FNB and Southwest Acquisitions. Noninterest income for 2001 was $8.6 million, an $830,000 or 10.7% increase from $7.8 million in 2000, resulting largely from an increase in income due to the Commercial Merger. The following table presents for the periods indicated the major categories of noninterest income: 2002 Years Ended December 31, 2001 (Dollars in thousands) 2000 Service charges on deposit accounts.................................... Other noninterest income ...................................................... Total noninterest income................................................. $ 9,764 1,764 $11,528 $ 7,530 1,060 $ 8,590 $ 6,576 1,184 $ 7,760 23 Noninterest Expense For the years ended December 31, 2002, 2001 and 2000, noninterest expense totaled $34.5 million, $30.3 million and $26.8 million, respectively. The Company's efficiency ratio improved in 2002 as it was reduced from 60.14% at December 31, 2001 to 50.36% at December 31, 2002. This reduction reflects the Company's continued success in controlling operating expenses and the cost savings achieved following the integration of the Texas Guaranty Acquisition in the second quarter of 2002, the Paradigm and First State Acquisitions in the third quarter of 2002 and the FNB and Southwest Acquisitions in the fourth quarter of 2002. The Company’s efficiency ratio was 62.29% at December 31, 2000. The following table presents for the periods indicated the major categories of noninterest expense: Salaries and employe e benefits .................................................... Non-staff expenses: 2002 Years Ended December 31, 2001 (Dollars in thousands) 2000 $16,379 $12,955 $12,931 Net occupancy expense.................................................... Depreciation expense....................................................... Data processing ................................................................ Regulatory assessments and FDIC insurance................. Ad valorem and franchise taxes...................................... Goodwill and core deposit intangibles amortization..... Communications expense (1) .......................................... Minority expense-trust preferred securities.................... Merger-related expenses.................................................. Other ................................................................................. Total noninterest expense................................... 2,345 1,830 2,131 367 676 192 1,926 2,104 -- 6,503 $34,453 1,971 1,570 2,126 249 434 1,363 1,424 1,580 2,425 4,198 $30,295 1,761 1,553 1,956 284 473 1,160 750 1,151 -- 4,748 $26,767 ---------------------------------- (1) Communications expense includes telephone, data circuits, postage and courier expenses. For the year ended December 31, 2002, noninterest expense totaled $34.5 million, an increase of $4.2 million or 13.7% over $30.3 million for the same period in 2001. The amount of noninterest expense for 2001 included $2.4 million in merger related expenses. This increase is principally due to increases in salaries and employee benefits, building and equipment costs and general operating expenses associated with the Texas Guaranty, First State, Paradigm, FNB and Southwest Acquisitions. Salaries and employee benefits increased $3.4 million from $13.0 million at December 31, 2001 to $16.4 million at December 31, 2002 primarily due to increased staff associated with the acquisitions completed in 2002. Non-interest expense was also impacted by an increase in minority interest expense related to the trust preferred securities due to the issuance of $15.0 million in trust preferred securities in July 2001 and the acquisition of Paradigm Capital Trust II in September 2002 which has issued $6.0 million of trust preferred securities. This increase was partially offset by a decrease in goodwill amortization expense due to a recent accounting change. Minority expense-trust preferred securities increased $524,000 from $1.6 million at December 31, 2001 to $2.1 million at December 31, 2002. Other o perating expenses of $6.5 million at December 31, 2002 represented an increase of $2.3 million or 54.9% compared with $4.2 million in 2001. These increases were principally due to the Texas Guaranty, First State, Paradigm, FNB and Southwest Acquisitions. Total noninterest expenses in 2001 were $30.3 million, an increase of 13.2% from $26.8 million in 2000 primarily due to the Compass Acquisition in the fourth quarter of 2000. Income Taxes The amount of federal income tax expense is influenced by the amount of taxable income, the amount of tax-exempt income, the amount of nondeductible interest expense and the amount of other nondeductible expenses. For the year ended December 31, 2002, income tax expense was $9.6 million compared with $5.4 million for the year ended December 31, 2001 and $4.5 million for the year ended December 31, 2000. The increases were primarily attributable to higher pretax net earnings which resulted from an increase in net interest income for the year ended December 31, 2002 when compared to the same period in 2001 and 2000. In addition, the Company incurred $2.4 million in merger-related expenses during the year ended December 31, 2001 which had a tax benefit of approximately $849,000. The effective tax rate in the years ended December 31, 2002, 2001 and 2000 was 30.9%, 29.3% and 29.8%, respectively. 24 Goodwill Amortization In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142). SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121 and subsequently, SFAS No. 144 after its adoption. The Company adopted the provisions of SFAS No. 142 as of January 1, 2002. Goodwill and intangible assets determined to have an indefinite useful life acquired in a purchase business combination completed after June 30, 2001 are no longer amortized. Impact of Inflation The effects of inflation on the local economy and on the Company's operating results have been relatively modest for the past several years. Since substantially all of the Company's assets and liabilities are monetary in nature, such as cash, securities, loans and deposits, their values are less sensitive to the effects of inflation than to changing interest rates, which do not necessarily change in accordance with inflation rates. The Company tries to control the impact of interest rate fluctuations by managing the relationship between its interest rate sensitive assets and liabilities. See “Financial Condition - Interest Rate Sensitivity and Market Risk.” Financial Condition Loan Portfolio At December 31, 2002, total loans were $679.6 million, an increase of $255.2 million or 60.1% from $424.4 million at December 31, 2001. The growth in loans in partially attributable to internal growth and the Texas Guaranty, First State, Paradigm, FNB and Southwest Acquisitions. At December 31, 2002, total loans were 42.8% of deposits and 37.3% of total assets. At December 31, 2001, total loans were 37.8% of deposits and 33.6% of total assets. Loans increased 3.2% during 2001 from $411.2 million at December 31, 2000 to $424.4 million at December 31, 2001. The following table summarizes the Company’s loan portfolio by type of loan as of the dates indicated: Commercial and industrial ................................ Real estate: Construction and land development................................................... 1-4 family residential ........................................ Home equity........................................................ Commercial mortgages..................................... Farmland.............................................................. Multifamily residential...................................... Agriculture ............................................................ Other....................................................................... Consumer. ............................................................ Total loans.............................................. 2002 Amount Percent 2001 Amount Percent Amount December 31, 2000 Percent Amount Percent 1999 1998 Amount Percent $ 93,797 13.8% $ 46,986 11.1% $ 45,529 11.3% $ 42,003 11.5% $ 33,242 12.0% (Dollars in thousands) 52,377 206,586 23,249 183,970 11,887 15,502 24,683 3,020 64,488 $ 679,559 100.0% 7.7 30.4 3.4 27.1 1.7 2.3 3.6 0.4 9.6 20,963 175,253 20,541 78,446 10,686 9,694 15,757 953 45,121 $424,400 4.9 41.3 4.8 18.5 2.5 2.3 3.7 0.2 10.7 100.0 % 20,128 175,525 16,762 75,896 12,218 2,961 13,251 2,563 45,370 $411,203 4.9 42.7 4.1 18.5 3.0 0.7 3.2 0.6 11.0 21,333 165,238 11,343 64,738 8,552 3,071 13,592 2,671 5.8 45.1 3.1 17.7 2.3 0.8 3.7 0.7 9.3 12,477 123,581 8,077 41,436 6,455 2,074 15,138 2,511 4.5 44.8 2.9 15.0 2.3 0.8 5.5 0.9 11.3 34,262 100.0% $ 366,803 100.0% 31,115 $276,106 100.0% The lending focus of the Company is on growing its commercial mortgage and commercial loan portfolios. The Company offers a variety of commercial lending products including term loans and lines of credit. The Company also offers a broad range of short to medium-term commercial loans, primarily collateralized, to businesses for working capital (including inventory and receivables), business expansion (including acquisitions of real estate and improvements) and the purchase of equipment and machinery. Historically, the Company has originated loans for its own account and has not securitized its loans. The purpose of a particular loan generally determines its structure. All loans in the 1-4 family residential category were originated by the Company. Loans from $750,000 to $2.0 million are evaluated and acted upon by an officers' loan committee, which meets weekly. Loans from $2.0 million to $7.5 million are evaluated and acted upon by the Directors Loan Committee, which consists of three directors and meets as necessary. Loans over $7.5 million must be evaluated and acted upon by the full board of directors which meets monthly. 25 In nearly all cases, the Company's commercial loans are made in the Company's primary market area and are underwritten on the basis of the borrower's ability to service such debt from income. As a general practice, the Company takes as collateral a lien on any available real estate, equipment or other assets owned by the borrower and obtains a personal guaranty of the borrower. Working capital loans are primarily collateralized by short-term assets whereas term loans are primarily collateralized by long-term assets. As a result, commercial loans involve additional complexities, variables and risks and require more thorough underwriting and servicing than other types of loans. In addition to commercial loans, the Company makes commercial mortgage loans to finance the purchase of real estate. The Company's commercial mortgage loans are secured by first liens on real estate, typically have variable interest rates and amortize over a ten to 15 year period. Payments on loans secured by such properties are often dependent on the successful operation or management of the properties. Accordingly, repayment of these loans may be subject to adverse conditions in the real estate market or the economy to a greater extent than other types of loans. The Company seeks to minimize these risks in a variety of ways, including giving careful consideration to the property's operating history, future operating projections, current and projected occupancy, location and physical condition in connection with underwriting these loans. The underwriting analysis also includes credit verification, appraisals and a review of the financial condition of the borrower. Additionally, a significant portion of the Company's lending activity has consisted of the origination of 1-4 family residential mortgage loans collateralized by owner-occupied properties located in the Company's market areas. The Company offers a variety of mortgage loan products which generally are amortized over five to 25 years. Loans collateralized by 1-4 family residential real estate generally have been originated in amounts of no more than 90% of appraised value or have mortgage insurance. The Company requires mortgage title insurance and hazard insurance. The Company has elected to keep all 1-4 family residential loans for its own account rather than selling such loans into the secondary market. By doing so, the Company is able to realize a higher yield on these loans; however, the Company also incurs interest rate risk as well as the risks associated with nonpayments on such loans. The Company makes loans to finance the construction of residential and, to a limited extent, nonresidential properties. Construction loans generally are secured by first liens on real estate and have floating interest rates. The Company conducts periodic inspections, either directly or through an agent, prior to approval of periodic draws on these loans. Underwriting guidelines similar to those described above are also used in the Company's construction lending activities. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of a project under construction, and the project is of uncertain value prior to its completion. Because of uncertainties inherent in estimating construction costs, the market value of the completed project and the effects of governmental regulation on real property, it can be difficult to accurately evaluate the total funds required to complete a project and the related loan to value ratio. As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If the Company is forced to foreclose on a project prior to completion, there is no assurance that the Company will be able to recover all of the unpaid portion of the loan. In addition, the Company may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time. While the Company has underwriting procedures designed to identify what it believes to be acceptable levels of risks in construction lending, no assurance can be given that these procedures will prevent losses from the risks described above. Consumer loans made by the Company include direct “A”-credit automobile loans, recreational vehicle loans, boat loans, home improvement loans, home equity loans, personal loans (collateralized and uncollateralized) and deposit account collateralized loans. The terms of these loans typically range from 12 to 120 months and vary based upon the nature of collateral and size of loan. Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws may limit the amount which can be recovered on such loans. The Company provides agricultural loans for short-term crop production, including rice, cotton, milo and corn, farm equipment financing and agricultural real estate financing. The Company evaluates agricultural borrowers primarily based on their historical profitability, level of experience in their particular agricultural industry, overall financial capacity and the availability of secondary collateral to withstand economic and natural variations common to the industry. Because agricultural loans present a higher level of risk associated with events caused by nature, the Company routinely makes on-site visits and inspections in order to monitor and identify such risks. 26 The contractual maturity ranges of the commercial and industrial and construction and land development portfolios and the amount of such loans with predetermined interest rates and floating rates in each maturity range as of December 31, 2002 are summarized in the following table: December 31, 2002 One Year or Less After One Through Five Years After Five Years (Dollars in thousands) Commercial and industrial............................................ Construction and land development............................... Total............................................................. Loans with a predetermined interest rate........................ Loans with a floating interest rate.................................. Total............................................................. $44,597 38,469 $83,066 $ 17,895 65,171 $83,066 $35,896 10,084 $45,980 $ 23,370 22,610 $45,980 $ 13,304 3,824 $17,128 $ 6,020 11,108 $17,128 Nonperforming Assets Total $ 93,797 52,377 $146,174 $ 47,285 98,889 $146,174 The Company has several procedures in place to assist it in maintaining the overall quality of its loan portfolio. The Company has established underwriting guidelines to be followed by its officers. The Company also monitors its delinquency levels for any negative or adverse trends. There can be no assurance, however, that the Company's loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions. The Company requires appraisals on loans secured by real estate. With respect to potential problem loans, an evaluation of the borrower's overall financial condition is made to determine the need, if any, for possible write-downs or appropriate additions to the allowance for credit losses. The Company generally places a loan on nonaccrual status and ceases accruing interest when the payment of principal or interest is delinquent for 90 days, or earlier in some cases, unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan. The Company generally charges off such loans before attaining nonaccrual status. The Company's conservative lending approach has resulted in strong asset quality. The Company had $2.6 million in nonperforming assets as of December 31, 2002 compared with $1,000 at December 31, 2001 and $1.3 million at December 31, 2000. Interest foregone on nonaccrual loans for the year ended December 31, 2002 was $25,000.00. The following table presents information regarding nonperforming assets at the dates indicated: Nonaccrual loans. ........................................................ Restructured loans. ....................................................... Other non-performing loans .......................................... Accruing loans 90 or more days past due ....................... Other real estate........................................................... Total nonperforming assets............................... Nonperforming assets to total loans 2002 2001 December 31, 2000 (Dollars in thousands) 1999 1998 $ 1,125 -- 1,100 120 219 $ 2,564 $ $ 1 -- -- -- -- 1 $ 10 -- -- 778 $ 756 5 -- 4 545 1,333 $ 500 1,265 $ $ $ 108 150 -- 133 -- 391 and other real estate................................................. 0.38% 0.00% 0.32% 0.34% 0.14% 27 Allowance for Credit Losses The following table presents for the periods indicated an analysis of the allowance for credit losses and other related data: Years Ended December 31, 2002 2001 2000 (Dollars in thousands) 1999 1998 Average loans outstanding ......................................... $524,885 $419,553 $ 383,054 $319,178 $238,855 Gross loans outstanding at end of period. .................... $679,559 $424,400 $ 411,203 $366,803 $276,106 Allowance for credit losses at beginning of period ............................................... Balance acquired with the Texas Guaranty, First State, Paradigm, FNB, Southwest, Compass, South Texas and Union Acquisitions, respectively ........... Provision for credit losses .......................................... Charge-offs: Commercial and industrial..................................... Real estate and agriculture..................................... Consumer. ............................................................ Recoveries: Commercial and industrial..................................... Real estate and agriculture..................................... Consumer. ............................................................ Net (charge-offs) recoveries....................................... Allowance for credit losses at end of period. ............... Ratio of allowance to end of period loans ..................................................................... Ratio of net charge-offs (recoveries) to average loans ........................................................ 1.41% 0.08 Ratio of allowance to end of period nonperforming loans ............................................. ----------------------------------- (1) Amount not meaningful. Nonperforming loans totaled $1,000 at December 31, 2001. 408.5 $ 5,985 $ 5,523 $ 5,031 $ 3,682 $ 2,567 2,981 1,010 (356 ) (231 ) (180 ) 111 175 85 (396 ) $ 9,580 $ -- 700 (180 ) (175 ) (74 ) 15 121 55 (238) 5,985 1.41% 0.06 46 275 (116 ) (38 ) (63 ) 43 263 82 171 $ 5,523 $ 566 420 (30 ) (43 ) (64 ) 236 218 46 363 5,031 661 264 ( 67 ) (14 ) ( 83 ) 276 52 26 190 3,682 $ 1.34 % 1.37 % 1.33 % (0.04 ) (0.11 ) (0.08) n/m(1) 700.89 657.65 941.69 The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company's loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank's Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company's commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company’s loan portfolio, current economic changes that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process and other relevant factors. Charge-offs occur when loans are deemed to be uncollectible. The Company considers risk elements attributable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements include: for 1-4 family residential mortgage loans, the borrower's ability to repay the loan, including a consideration of the debt to • income ratio and employment and income stability, the loan to value ratio, and the age, condition and marketability of collateral; for commercial mortgage loans and multifamily residential loans, the debt service coverage ratio (income from the • property in excess of operating expenses compared to loan payment requirements), operating results of the owner in the case of owner-occupied properties, the loan to value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type; • for agricultural real estate loans, the experience and financial capability of the borrower, projected debt service coverage of 28 the operations of the borrower and loan to value ratio; • for construction and land development loans, the perceived feasibility of the project including the ability to sell developed lots or improvements constructed for resale or ability to lease property constructed for lease, the quality and nature of contracts for presale or preleasing, if any, experience and ability of the developer and loan to value ratio; • for commercial and industrial loans, the operating results of the commercial, industrial or professional enterprise, the borrower's business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral; and for non-real estate agricultural loans, the operating results, experience and financial capability of the borrower, historical • and expected market conditions and the value, nature and marketability of collateral. In addition, for each category, the Company considers secondary sources of income and the financial strength and credit history of the borrower and any guarantors. The Company follows a loan review program to evaluate the credit risk in the loan portfolio. Through the loan review process, the Company maintains an internally classified loan list which, along with the delinquency list of loans, helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for credit losses. Loans classified as “substandard” are those loans with clear and defined weaknesses such as a highly-leveraged position, unfavorable financial ratios, uncertain repayment sources or poor financial condition, which may jeopardize recoverability of the debt. Loans classified as “doubtful” are those loans which have characteristics similar to substandard accounts but with an increased risk that a loss may occur, or at least a portion of the loan may require a charge-off if liquidated at present. Loans classified as "loss'' are those loans which are in the process of being charged off. For each classified loan, the Company generally allocates a specific loan loss reserve equal to a predetermined percentage of the loan amount, depending on the classification. In addition to the internally classified loan list and delinquency list of loans, the Company maintains a separate “watch list” which further aids the Company in monitoring loan portfolios. Watch list loans have one or more deficiencies that require attention in the short term or pertinent ratios of the loan account that have weakened to a point where more frequent monitoring is warranted. These loans do not have all of the characteristics of a classified loan (substandard or doubtful) but do show weakened elements compared with those of a satisfactory credit. The Company reviews these loans to assist in assessing the adequacy of the allowance for credit losses. In order to determine the adequacy of the allowance for credit losses, management considers the risk classification or delinquency status of loans and other factors, such as collateral value, portfolio composition, trends in economic conditions and the financial strength of borrowers. Management establishes specific allowances for loans which management believes require reserves greater than those allocated according to their classification or delinquent status. An unallocated allowance is also established based on the Company's historical charge-off experience and existing general economic and business conditions affecting the key lending areas of the Company, credit quality trends, collateral values, loan volume and concentrations and seasoning of the loan portfolio. The Company then charges to operations a provision for credit losses to maintain the allowance for credit losses at an adequate level determined by the foregoing methodology. For the year ended December 31, 2002, net charge-offs totaled $396,000 or 0.08% of average loans outstanding for the period, compared with net charge-offs of $238,000 or 0.06% of average loans during 2001. The Company's net recoveries totaled $171,000 or (0.04)% of average loans outstanding in 2000. During 2002, the Company recorded a provision for credit losses of $1.0 million compared with $700,000 for 2001. At December 31, 2002, the allowance for credit losses totaled $9.6 million, or 1.41% of total loans. The Company made a provision for credit losses of $700,000 during 2001 compared with a provision of $275,000 for 2000. At December 31, 2001, the allowance aggregated $6.0 million, or 1.41% of total loans. At December 31, 2000, the allowance was $5.5 million, or 1.34% of total loans. 29 The following tables describe the allocation of the allowance for credit losses among various categories of loans and certain other information for the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which future losses may occur. The total allowance is available to absorb losses from any segment of loans. December 31, 2002 2001 Percent of Loans to Total Loans Amount (Dollars in thousands) Percent of Loans to Total Loans Amount Balance of allowance for credit losses applicable to: Commercial and industrial.......................................... Real estate .................................................................. Agriculture ................................................................. Consumer and other. ................................................... Unallocated ................................................................ Total allowance for credit losses..................... $ 559 397 42 71 8,781 $ 9,850 11.1% 74.4 3.7 10.8 -- 100.0% $ 357 553 11 10 5,054 $ 5,985 11.1% 74.4 3.7 10.8 -- 100.0% December 31, 2000 1999 Percent of Loans to Total Loans Amount Amount Percent of Loans to Total Loans (Dollars in thousands) 1998 Percent of Loans to Amount Total Loans Balance of allowance for credit losses applicable to: Commercial and industrial.............................. $ 625 116 17 28 4,737 Real estate..................................................... Agriculture.................................................... Consumer and other....................................... Unallocated................................................... Total allowance for credit 11.3% 73.9 3.2 11.6 -- $ 620 74 22 25 4,290 11.5% 74.8 3.7 10.0 -- $ 520 79 40 14 3,029 12.0% 70.3 5.5 12.2 -- losses. ............................................ $ 5,523 100.0% $ 5,031 100.0% $ 3,682 100.0% Where management is able to identify specific loans or categories of loans where specific amounts of reserve are required, allocations are assigned to those categories. Federal and state bank regulators also require that a bank maintain a reserve that is sufficient to absorb an estimated amount of unidentified potential losses based on management's perception of economic conditions, loan portfolio growth, historical charge-off experience and exposure concentrations. Management, along with a number of economists, has perceived during the past year an increasing instability in the national and Southeast Texas economies and a worldwide economic slowdown that could contribute to job losses and otherwise adversely affect a broad variety of business sectors. In addition, as the Company has grown, its aggregate loan portfolio has increased and since the Company has made a decision to diversify its loan portfolio into areas other than 1-4 family residential mortgage loans, the risk profile of the Company's loans has increased. By virtue of its increased capital levels, the Company is able to make larger loans, thereby increasing the possibility of one bad loan having a larger adverse impact than before. The Company believes that the allowance for credit losses at December 31, 2002 is adequate to cover losses inherent in the portfolio as of such date. There can be no assurance, however, that the Company will not sustain losses in future periods, which could be substantial in relation to the size of the allowance at December 31, 2002. Securities The Company uses its securities portfolio both as a source of income and as a source of liquidity. At December 31, 2002, investment securities totaled $950.3 million, an increase of $198.0 million or 26.3% from $752.3 million at December 31, 2001, primarily due to the Company investing excess deposits. At December 31, 2002, securities represented 52.2% of total assets compared with 59.6% of total assets at December 31, 2001. 30 Securities increased $165.4 million or 28.2% from $587.0 million at December 31, 2000 to $752.3 million at December 31, 2001, primarily due to the investment of excess deposits. The following table summarizes the amortized cost of securities as of the dates shown (available-for-sale securities are not adjusted for unrealized gains or losses): U.S. Treasury securities and obligations of U.S. government agencies........................................ 70% non-taxable preferred stock............................................ States and political subdivisions............................................ Corporate debt securities ......................................................... Equity securities ........................................................................ Collateralized mortgage obligations...................................... Mortgage-backed securities .................................................... Other............................................................................................ Total .................................................................................. December 31, 2002 2001 2000 1999 1998 (Dollars in thousands) $ $ 97,098 $ 44,029 58,994 25,338 -- 168,282 552,515 -- 946,256 $ 143,397 $ 24,058 51,503 22,712 -- 17,378 492,940 -- 751,988 $ 334,562 19,085 46,819 24,879 2 18,307 142,354 25 586,033 $ $ 316,859 4,049 40,369 28,038 2 12,267 117,436 25 519,045 $ $ 305,592 -- 30,250 27,610 -- 12,914 78,283 25 454,674 The following table summarizes the contractual maturity of securities and their weighted average yields: Within One Year After One Year but Within Five Years December 31, 2002 After Five Years but Within Ten After Ten Years Years Total Amo unt Yield Amount Yield Amount Yield Amount Yield Total Yield (Dollars in thousands) U.S. Treasury securities and obligations of U.S. government agencies ............. $ 24,296 5.43% $ 51,658 5.48% $ 20,710 5.67 % $ 499 6.49% $ 97,163 5.51% 70% non-taxable preferred stock............... -- -- -- -- 19,145 3.78 States and political subdivisions................. 5,361 6.44 19,079 6.37 10,553 6.50 24,000 17,809 5.43 7.44 43,145 52,802 Corporate debt securities .............................. 9,541 5.89 15,797 5.86 -- -- -- -- 25,338 4.70 6.76 5.87 Collateralized mortgage obligations........... -- -- 199 4.11 7,429 2.96 161,236 4.75 168,864 4.67 Mortgage-backed securities ......................... 1,403 5.67 12,344 5.42 117,494 5.06 423,764 4.83 555,005 4.89 Qualified Zone Academy Bond (QZAB)... -- -- -- -- 8,000 2.00 -- -- 8,000 2.00 Total ................................................................. $ 40,601 5.68% $ 99,077 5.70% $ 183,331 4.86 % $627,308 4.91% $ 950,317 5.01 % Contractual maturity of mortgage-backed securities and collateralized mortgage obligations is not a reliable indicator of their expected life because borrowers have the right to prepay their obligations at any time. The tax-exempt states and political subdivisions are calculated on a tax equivalent basis. The QZAB bond is not calculated on a tax-equivalent basis and it generates a tax credit of 7.18%, which is included in gross income. The 70% non-taxable preferred stock includes investments in Government National Mortgage Association (Ginnie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) preferred stock. 31 The following table summarizes the carrying value by classification of securities as of the dates shown: 2002 2001 December 31, 2000 (Dollars in thousands) 1999 1998 Available-for-sale ........................................................... $ 309,219 $ 482,233 $ 334,773 $ 224,790 Held-to-maturity.............................................................. 641,098 270,089 252,179 290,193 $ 113,828 341,374 Total ........................................................................ $ 950,317 $ 752,322 $ 586,952 $ 514,983 $ 455,202 The following tables present the amortized cost and fair value of securities classified as available-for-sale at December 31, 2002, 2001 and 2000: Amortized Cost December 31, 2002 Gross Unrealized Gains Gross Unrealized Losses (Dollars in thousands) Fair Value Amortized Cost December 31, 2001 Gross Unrealized Gains Gross Unrealized Losses (Dollars in thousands) Fair Value U.S. Treasury securities and obligations of U.S. government agencies............................. $ 18,511 $ 70% non-taxable preferred stock........................... 44,029 States and political subdivisions........................... 27,115 Collateralized mortgage obligations..................... 18,616 Mortgage-backed securities ................................... 196,887 Total................................................................... $305,158 65 -- 1,808 596 2,600 $ 5,069 $ -- $18,576 $ 2,248 $ 884 43,145 -- 14 28,923 19,198 24,058 28,165 17,356 201 107 483 314 110 199,377 410,072 1,646 $ 1,008 $ 309,219 $481,899 $ 2,751 $ -- $ 2,449 -- 73 22 24,165 28,575 17,648 2,322 409,396 $ 2,417 $ 482,233 Amortized Cost December 31, 2000 Gross Unrealized Gains Gross Unrealized Losses (Dollars in thousands) Fair Value U.S. Treasury securities and obligations of U.S. government agencies............................. $ 186,832 $ 70% non-taxable preferred stock........................... States and political subdivisions............................ Corporate debt securities ........................................ Equity securities ....................................................... Collateralized mortgage obligations..................... Mortgage-backed securities................................... Total.................................................................. 19,085 20,240 1,021 2 17,979 88,695 $333,854 905 145 216 -- 5 292 652 $ 742 $ 186,995 -- 2 5 -- 54 493 19,230 20,454 1,016 7 18,217 88,854 $334,773 $ 2,215 $ 1,296 The following tables present the amortized cost and fair value of securities classified as held-to-maturity at December 31, 2002, 2001 and 2000: December 31, 2002 Amortized Unrealized Cost Gains Gross Gross Unrealized Losses (Dollars in thousands) Fair Value Amortized Cost December 31, 2001 Gross Unrealized Gains Gross Unrealized Losses (Dollars in thousands) Fair Value U.S. Treasury securities and obligations of U.S. government agencies............................ $ 78,587 $ 3,131 $ Corporate debt securities ....................................... 25,338 942 States and political subdivisions........................... 31,879 1,241 Collateralized mortgage obligations.................... 149,666 1,662 Mortgage-backed securities .................................. 355,628 12,297 -- 87 6 12 5 $ 81,718 $ 141,149 $ 3,180 $ 204 $ 144,125 26,193 22,712 33,114 151,316 23,338 22 367,920 82,868 609 605 -- 535 167 12 -- 408 23,154 23,931 22 82,995 Total.................................................................. $ 641,098 $ 19,273 $ 110 $ 660,261 $ 270,089 $ 4,929 $ 791 $ 274,227 32 U.S. Treasury securities and obligations of U.S. government agencies............................ Corporate debt securities ....................................... States and political subdivisions........................... Collateralized mortgage obligations.................... Mortgage-backed securities.................................. Other.......................................................................... December 31, 2000 Gross Gross Unrealized Unrealized Losses Gains (Dollars in thousands) Fair Value $ 460 67 137 -- 148 -- $ 1,309 $ 146,881 760 23,165 205 26,511 2 542 -- 326 53,265 25 Amortized Cost $ 147,730 23,858 26,579 328 53,659 25 Total .......................................................................... $ 252,179 $ 812 $ 2,818 $ 250,173 Mortgage-backed securities are securities that have been developed by pooling a number of real estate mortgages and which are principally issued by federal agencies such as Ginnie Mae, Federal National Mortgage Association (Fannie Mae) and Freddie Mac. These securities are deemed to have high credit ratings, and minimum regular monthly cash flows of principal and interest are guaranteed by the issuing agencies. However, unlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, mortgage-backed securities provide cash flows from regular principal and interest payments and principal prepayments throughout the lives of the securities. Mortgage-backed securities which are purchased at a premium will generally suffer decreasing net yields as interest rates drop because home owners tend to refinance their mortgages. Thus, the premium paid must be amortized over a shorter period. Therefore, these securities purchased at a discount will obtain higher net yields in a decreasing interest rate envi ronment. As interest rates rise, the opposite will generally be true. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal and consequently, the average life of this security will not be unduly shortened. If interest rates begin to fall, prepayments will increase. At December 31, 2002, 76.4% of the mortgage-backed securities held by the Company had contractual final maturities of more than ten years with a weighted ave rage life of 2.06 years. Collateralized mortgage obligations (CMOs) are bonds that are backed by pools of mortgages. The pools can be Ginnie Mae, Fannie Mae or Freddie Mac pools or they can be private-label pools. The CMOs are designed so that the mortgage collateral will generate a cash flow sufficient to provide for the timely repayment of the bonds. The mortgage collateral pool can be structured to accommodate various desired bond repayment schedules, provided that the collateral cash flow is adequate to meet scheduled bond payments. This is accomplished by dividing the bonds into classes to which payments on the underlying mortgage pools are allocated in different order. The bond’s cash flow, for example can be dedicated to one class of bondholders at a time, thereby increasing call protection to bondholders. In private-label CMOs, losses on underlying mortgages are directed to the most junior of all classes and then to the classes above in order of increasing seniority, which means that the senior classes have enough credit protection to be given the highest credit rating by the rating agencies. At the date of purchase, the Company is required to classify debt and equity securities into one of three categories: held-to- maturity, trading or available-for-sale. At each reporting date, the appropriateness of the classification is reassessed. Investments in debt securities are classified as held-to-maturity and measured at amortized cost in the financial statements only if management has the positive intent and ability to hold those securities to maturity. Securities that are bought and held principally for the purpose of selling them in the near term are classified as trading and measured at fair value in the financial statements with unrealized gains and losses included in earnings. Investments not classified as either held-to-maturity or trading are classified as available-for-sale and measured at fair value in the financial statements with unrealized gains and losses reported, net of tax, in a separate component of shareholders' equity until realized. Deposits The Company offers a variety of deposit accounts having a wide range of interest rates and terms. The Company's deposits consist of demand, savings, money market and time accounts. The Company relies primarily on competitive pricing policies and customer service to attract and retain these deposits. The Company does not have or accept any brokered deposits. Total deposits at December 31, 2002 were $1.587 billion, an increase of $463.2 million or 41.2% from $1.123 billion at December 31, 2001. The increase is primarily attributable to internal growth and the Texas Guaranty, First State, Paradigm, FNB and Southwest acquisitions in 2002. Noninterest-bearing deposits of $327.7 million at December 31, 2002 increased $138.9 million or 33 73.5% from $189.0 million at December 31, 2001. Noninterest-bearing deposits at December 31, 2001 were $189.0 million compared with $188.0 million at December 31, 2000. Interest-bearing deposits at December 31, 2002 were $1.259 billion, up $324.3 million or 34.7% from $934.6 million at December 31, 2001. Interest-bearing deposits at December 31, 2001 of $934.6 million represented a $89.0 million or 10.5% increase from $845.6 million at December 31, 2000. Total deposits at December 31, 2000 were $1.033 billion. The daily average balances and weighted average rates paid on deposits for each of the years ended December 31, 2002, 2001 and 2000 are presented below: Years Ended December 31, 2002 2001 2000 Amount Rate Rate Amount (Dollars in thousands) Amount Rate Interest-bearing checking. .......................................... Regular savings. ......................................................... Money market savings ............................................... Time deposits. ........................................................... Total interest-bearing deposits ......................... Noninterest-bearing deposits ...................................... Total deposits.................................................. $ 249,045 58,218 257,499 505,796 1,070,558 230,326 $1,300,884 1.27% 1.41 1.71 3.28 2.33 -- 1.92% $ 199,077 41,472 211,104 428,314 879,967 181,228 $1,061,195 2.27% 2.36 3.31 5.20 3.95 -- 3.28% $ 185,486 39,085 181,181 339,580 745,332 175,194 $ 920,526 3.42 % 2.76 4.17 5.47 4.50 -- 3.64 % The following table sets forth the amount of the Company's certificates of deposit that are $100,000 or greater by time remaining until maturity: Three months or less........................................................... Over three through six months. ........................................... Over six through 12 months ................................................ Over 12 months .................................................................. Total ........................................................................... Other Borrowings December 31, 2002 (Dollars in thousands) $ 104,001 52,754 50,527 40,708 $ 247,990 Deposits are the primary source of funds for the Company's lending and investment activities. As needed, the Company obtains additional funds from the Federal Home Loan Bank (“FHLB”) and correspondent banks. At December 31, 2002, the Company had $37.9 million in FHLB borrowings of which $12.6 million consisted of long-term FHLB notes payable and $25.3 million consisted of FHLB advances compared with $18.1 million in FHLB borrowings at December 31, 2001 of which $13.3 million consisted of long-term FHLB notes payable and $4.8 million consisted of FHLB advances. The highest outstanding balance of FHLB advances during 2002 was $31.4 million compared with $30.2 million during 2001. The maturity dates on the FHLB notes payable range from 2004 to 2018 and the interest rates range from 5.95% to 6.48%. FHLB advances are considered short-term, overnight borrowings. At December 31, 2001, the Company had $13.3 million in FHLB notes payable compared with $13.9 million at December 31, 2000. The Company had no federal funds purchased at December 31, 2002, December 31, 2001 or December 31, 2000. At December 31, 2002, 2001, and 2000, the Company had no outstanding borrowings under a revolving line of credit extended by a commercial bank. In November 1999, the Company formed a wholly-owned statutory business trust, Prosperity Capital Trust I ("Trust I"), which issued $12.0 million in trust preferred securities, and in July 2001, the Company formed a second wholly-owned statutory business trust, Prosperity Statutory Trust II ("Trust II”), which issued $15.0 million in trust preferred securities on July 31, 2001. Trust I and Trust II invested the proceeds in an equivalent amount of the Company’s junior subordinated debentures bearing an interest rate equal to the distribution rate on the respective issue of trust preferred securities. The debentures issued to Trust I will mature on November 17, 2029, which date may be shortened to a date not earlier than November 17, 2004 if certain conditions are met, including prior approval of the Federal Reserve Board. The debentures issued to Trust II will mature on July 31, 2031, which date may be shortened to a date not earlier than July 31, 2006, if certain conditions are met, including prior approval of the Federal 34 Reserve Board. These debentures, which are the only assets of each trust, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the respective Indentures) of the Company. The Company has fully and unconditionally guaranteed each trust's obligations under the trust preferred securities. The debentures issued to Trust I accrue interest at an annual rate of 9.60% of the aggregate liquidation amount, payable quarterly. The debentures issued to Trust II accrue interest at a floating rate equal to 3-month LIBOR plus 3.58% of the aggregate liquidation amount, not to exceed 12.50%, payable quarterly. The quarterly interest rate on the debentures issued to Trust II for the period from October 31, 2002 through December 31, 2002 was equal to 5.34%. The quarterly distributions on each issuance of trust preferred securities are paid at the same rate that interest is paid on the corresponding debentures. Under the provisions of each issue of the debentures, the Company has the right to defer payment of interest on the debentures at any time, or from time to time, for periods not exceeding five years. If interest payments on either issue of the debentures are deferred, the distributions on the respective trust preferred securities will also be deferred. In connection with the Paradigm acquisition, on September 1, 2002 the Company acquired Paradigm Capital Trust II (“Paradigm Trust”), which has $6.0 million of floating rate preferred securities outstanding. The Company also assumed the obligations under the floating rate debentures held by Paradigm Trust. The floating rate debentures will mature on February 20, 2031, which date may be shortened to a date not earlier than February 20, 2006 if certain conditions are met. These debentures, which are the only assets of Paradigm Trust, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture) of Paradigm, and now the Company as Paradigm’s successor. The Company has fully and unconditionally guaranteed Paradigm Trust's obligations under the preferred securities. The debentures issued to Paradigm Trust accrue interest at a floating rate that adjusts quarterly based on the 3 -month LIBOR plus 4.50%. The quarterly distributions on the preferred securities are paid at the same rate that interest is paid on the debentures. For the quarter ended December 31, 2002, the rate on the debentures was 6.33%. For financial reporting purposes, Trust I, Trust II and Paradigm Trust are treated as subsidiaries of the Company and consolidated in the corporate financial statements. The trust preferred securities are presented as a separate category of long-term debt on the balance sheet. Although the trust preferred securities are not included as a component of shareholders' equity on the balance sheet, for regulatory purposes, the trust preferred securities are treated as Tier 1 capital by the Federal Reserve. The treatment of the trust preferred securities as Tier 1 capital, in addition to the ability to deduct the expense of the debentures for federal income tax purposes, provided the Company with a cost-effective method of raising capital. Interest Rate Sensitivity and Market Risk The Company's asset liability and funds management policy provides management with the necessary guidelines for effective funds management, and the Company has established a measurement system for monitoring its net interest rate sensitivity position. The Company manages its sensitivity position within established guidelines. As a financial institution, the Company's primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of the Company's assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which have a short term to maturity. Based upon the nature of the Company's operations, the Company is not subject to foreign exchange or commodity price risk. The Company does not own any trading assets. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent, and that the goal is to identify and accept the risks. The Company's exposure to interest rate risk is managed by the Asset Liability Committee (“ALCO”), which is composed of senior officers of the Company, in accordance with policies approved by the Company's Board of Directors. The ALCO formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, the ALCO considers the impact on earnings and capital of the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. The ALCO meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, the ALCO reviews liquidity, cash flow flexibility, maturities of deposits and consumer and commercial deposit activity. Management uses two methodologies to manage interest rate risk: (i) an analysis of relationships between interest-earning assets and interest-bearing 35 liabilities; and (ii) an interest rate shock simulation model. The Company has traditionally managed its business to reduce its overall exposure to changes in interest rates. The Company manages its exposure to interest rates by structuring its balance sheet in the ordinary course of business. The Company does not enter into instruments such as leveraged derivatives, interest rate swaps, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk. An interest rate sensitive asset or liability is one that, within a defined time period, either matures or experiences an interest rate change in line with general market interest rates. The management of interest rate risk is performed by analyzing the maturity and repricing relationships between interest-earning assets and interest-bearing liabilities at specific points in time (“GAP”) and by analyzing the effects of interest rate changes on net interest income over specific periods of time by projecting the performance of the mix of assets and liabilities in varied interest rate environments. Interest rate sensitivity reflects the potential effect on net interest income of a movement in interest rates. A company is considered to be asset sensitive, or having a positive GAP, when the amount of its interest-earning assets maturing or repricing within a given period exceeds the amount of its interest-bearing liabilities also maturing or repricing within that time period. Conversely, a company is considered to be liability sensitive, or having a negative GAP, when the amount of its interest-bearing liabilities maturing or repricing within a given period exceeds the amount of its interest- earning assets also maturing or repricing within that time period. During a period of rising interest rates, a negative GAP would tend to affect net interest income adversely, while a positive GAP would tend to result in an increase in net interest income. During a period of falling interest rates, a negative GAP would tend to result in an increase in net interest income, while a positive GAP would tend to affect net interest income adversely. The following table sets forth an interest rate sensitivity analysis for the Company at December 31, 2002: Volumes Subject to Repricing Within 0-30 days 31-180 days 181-365 days Greater than one year Total (Dollars in thousands) Interest-earning assets: Securities (net of unrealized gain of $4.1 million) Loans................................................................. Federal funds sold and other earning assets ......... Total interest-earning assets. .................... $ 83,151 235,043 14,092 $ 332,286 $ 142,128 58,487 100 $ 200,715 $ 221,670 56,608 199 $ 278,477 $ 499,307 329,421 100 $ 828,828 $ 946,256 679,559 14,491 $ 1,640,306 Interest-bearing liabilities: Demand, money market and savings deposits ......................................................... $ 676,397 $ -- $ -- $ -- $ 676,397 Certificates of deposit and other time deposits.................................................. FHLB Advances and FHLB notes payable .......... Total interest-bearing liabilities ...................... 77,106 25,352 778,855 $ 245,343 262 $ 245,605 150,479 323 $ 150,802 109,587 12,002 $ 121,589 Period GAP................................................... Cumulative GAP........................................... Period GAP to total assets.............................. Cumulative GAP to total assets...................... $ $ (446,569 ) (446,569 ) (24.51 ) % (24.51 ) % $ (44,890 ) $ (491,459 ) $ 127,675 $(363,784 ) $ 707,239 $ 343,455 (2.46 ) % (26.97 ) % 7.01% (19.96) % 38.81 % 18.85 % 582,515 37,939 $ 1,296,851 $ 343,455 Shortcomings are inherent in any GAP analysis since certain assets and liabilities may not move proportionally as interest rates change. In addition to GAP analysis, the Company uses an interest rate risk simulation model and shock analysis to test the interest rate sensitivity of net interest income and the balance sheet, respectively. Contractual maturities and repricing opportunities of loans are incorporated in the model as are prepayment assumptions, maturity data and call options within the investment portfolio. Assumptions based on past experience are incorporated into the model for nonmaturity deposit accounts. Based on the Company's December 31, 2002 simulation analysis, the Company estimates that its current net interest income structure would decrease by approximately 3.52% over the next twelve months assuming an immediate 100 basis point decline in rates and increase by approximately 3.62% over the next twelve months assuming an immediate 100 basis point increase in rates. The Company estimates that its current net interest income structure would decrease by approximately 5.65% over the next twelve months assuming an immediate 200 basis point decline in rates and increase by approximately 3.73% over the next twelve months assuming an immediate 200 basis point increase in rates. The results are primarily from the behavior of demand, money market and savings deposits. The Company has found that historically, interest rates on these deposits change more slowly than changes in the discount and federal funds rates. This assumption is incorporated into the simulation model and is generally not fully reflected in a GAP analysis. 36 Liquidity Liquidity involves the Company's ability to raise funds to support asset growth or reduce assets to meet deposit withdrawals and other payment obligations, to maintain reserve requirements and otherwise to operate the Company on an ongoing basis. During the three years ended December 31, 2002, the Company's liquidity needs have primarily been met by growth in core deposits, as previously discussed. Although access to purchased funds from correspondent banks is available and has been utilized on occasion to take advantage of investment opportunities, the Company does not generally rely on these external funding sources. The cash and federal funds sold position, supplemented by amortizing investment and loan portfolios, have generally created an adequate liquidity position. Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. As of December 31, 2002, the Company had cash and cash equivalents of $80.8 million, up from $41.7 million, at December 31, 2001. The increase was mainly due to an increase in federal funds sold of $13.3 million and increases in total deposits and the number of deposit accounts. The Company’s future cash payments associated with its contractual obligations pursuant to its long-term debt and operating leases as of December 31, 2002 are summarized below: Fiscal 2003 Fiscal 2004-2005 Payments due in: Fiscal 2006-2007 Thereafter Total (Dollars in thousands) Company-obligated manditorily redeemable trust preferred securities of subsidiary trusts............................................................. Long-term debt .................................................. Operating leases................................................. Total........................................................ $ $ -- 704 1,322 2,026 $ $ -- 2,122 1,702 3,824 $ $ -- 3,306 1,017 4,323 $ $ 33,000 6,507 933 40,440 $ $ 33,000 12,639 4,974 50,613 The Company’s commitments associated with outstanding letters of credit and commitments to extend credit as of December 31, 2002 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements: Fiscal Fiscal 2003 Fiscal 2004-2005 Fiscal 2006-2007 Thereafter Total (Dollars in thousands) Standby letters of credit....................................... Commitments to extend credit ............................. Total........................................................ $ $ 1,322 43,795 45,117 $ $ 353 4,308 4,661 $ -- 16,874 $ 16,874 $ $ 6 13,382 13,388 $ $ 1,681 78,359 80,040 Capital Resources Capital management consists of providing equity to support both current and future operations. The Company is subject to capital adequacy requirements imposed by the Federal Reserve Board and the Bank is subject to capital adequacy requirements imposed by the FDIC and the Texas Banking Department. Both the Federal Reserve Board and the FDIC have adopted risk-based capital requirements for assessing bank holding company and bank capital adequacy. These standards define capital and establish minimum capital requirements in relation to assets and off-balance sheet exposure, adjusted for credit risk. The risk-based capital standards currently in effect are designed to make regulatory capital requirements more sensitive to differences in risk profiles among bank holding companies and banks, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate relative risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items. The risk-based capital standards issued by the Federal Reserve Board require all bank holding companies to have “Tier 1 capital” of at least 4.0% and “total risk-based” capital (Tier 1 and Tier 2) of at least 8.0% of total risk-adjusted assets. “Tier 1 capital” generally includes common shareholders' equity and qualifying perpetual preferred stock together with related surpluses and retained earnings, less deductions for goodwill and various other intangibles. “Tier 2 capital” may consist of a limited amount of intermediate- term preferred stock, a limited amount of term subordinated debt, certain hybrid capital instruments and other debt securities, perpetual preferred stock not qualifying as Tier 1 capital, and a limited amount of the general valuation allowance for loan losses. The sum of Tier 1 capital and Tier 2 capital is “total risk-based capital.” 37 The Federal Reserve Board has also adopted guidelines which supplement the risk-based capital guidelines with a minimum ratio of Tier 1 capital to average total consolidated assets, or “leverage ratio,” of 3.0% for institutions with well diversified risk, including no undue interest rate exposure; excellent asset quality; high liquidity; good earnings; and that are generally considered to be strong banking organizations, rated composite 1 under applicable federal guidelines, and that are not experiencing or anticipating significant growth. Other banking organizations are required to maintain a leverage ratio of at least 4.0%. These rules further provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels and comparable to peer group averages, without significant reliance on intangible assets. Pursuant to FDICIA, each federal banking agency revised its risk-based capital standards to ensure that those standards take adequate account of interest rate risk, concentration of credit risk and the risks of nontraditional activities, as well as reflect the actual performance and expected risk of loss on multifamily mortgages. The Bank is subject to capital adequacy guidelines of the FDIC that are substantially similar to the Federal Reserve Board's guidelines. Also pursuant to FDICIA, the FDIC has promulgated regulations setting the levels at which an insured institution such as the Bank would be considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” Under the FDIC's regulations, the Bank is classified “well capitalized” for purposes of prompt corrective action. See “Business - Supervision and Regulation - The Company” and “ - The Bank.” Total shareholders' equity increased to $154.7 million at December 31, 2002 from $88.7 million at December 31, 2001, an increase of $66.0 million or 74.4%. This increase was primarily the result of net income of $21.3 million partially offset by dividends paid on the Common Stock of $3.9 million and an increase in Common Stock issued of $45.9 million in connection with the Paradigm Acquisition. During 2001, shareholders' equity increased by $8.4 million or 10.1% from $80.3 million at December 31, 2000 due primarily to net income of $13.0 million partially offset by dividends paid on the Common Stock of $3.2 million and trust preferred issuance costs of $476,000. The following table provides a comparison of the Company's and the Bank's leverage and risk-weighted capital ratios as of December 31, 2002 to the minimum and well capitalized regulatory standards: Minimum Required for Capital Adequacy Purposes To Be Well Capitalized Under Prompt Corrective Action Provisions Actual Ratio at December 31, 2002 The Company Leverage ratio. ........................................... Tier 1 risk-based capital ratio ..................... Total risk-based capital ratio. ...................... The Bank Leverage ratio. ........................................... Tier 1 risk-based capital ratio ..................... Total risk-based capital ratio. ...................... ____________________ 3.00% (1) 4.00 8.00 3.00% (2) 4.00 8.00 N/A N/A N/A 5.00 % 6.00 10.00 6.56% 14.10 15.30 6.26 % 13.71 14.91 (1) (2) The Federal Reserve Board may require the Company to maintain a leverage ratio above the required minimum. The FDIC may require the Bank to maintain a leverage ratio above the required minimum. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For information regarding the market risk of the Company’s financial instruments, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation – Financial Condition - Interest Rate Sensitivity and Market Risk”. The Company’s principal market risk exposure is to changes in interest rates. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements, the reports thereon, the notes thereto and supplementary data commence at page F-1 of this Annual Report on Form 10-K. 38 The following table presents certain unaudited quarterly financial information concerning the Company’s results of operations for each of the two years ended December 31, 2002. The information should be read in conjunction with the historical consolidated financial statements of the Company and the notes thereto appearing elsewhere in this Annual Report on Form 10-K. The historical financial data of the Company has been restated to include the accounts and operations of Commercial Bancshares, Inc. for all periods prior to February 23, 2001. CONSOLIDATED QUARTERLY FINANCIAL DATA OF THE COMPANY Quarter Ended 2002 (unaudited) December 31 September 30 June 30 March 31 (Dollars in thousands, except per share data) Interest income .............................................. Interest expense............................................. Net interest income .................................. Provision for credit losses............................. Net interest income after provision......... Noninterest income ....................................... Noninterest expense...................................... Income before income taxes.................... Provision for income taxes ........................... Net income ..................................................... Earnings per share: Basic......................................................... Diluted...................................................... $ 22,837 6,828 16,009 650 15,359 4,148 10,160 9,347 2,965 $ 6,382 $ $ 0.34 0.33 $ 20,419 6,464 13,955 120 13,835 2,893 8,506 8,222 2,569 $ 5,653 $ $ 0.33 0.32 $ 19,106 6,283 12,823 120 12,703 2,326 8,125 6,904 2,109 $ 4,795 $ 18,380 6,356 12,024 120 11,904 2,161 7,662 6,403 1,912 $ 4,491 $ $ 0.30 0.29 $ $ 0.28 0.27 Quarter Ended 2001 (unaudited) December 31 September 30 June 30 March 31 (Dollars in thousands, except per share data) Interest income .............................................. Interest expense............................................. Net interest income .................................. Provision for credit losses............................. Net interest income after provision......... Noninterest income ....................................... Noninterest expense...................................... Income before income taxes.................... Provision for income taxes ........................... Net income................................................ $ 18,956 7,518 11,438 650 10,788 2,310 7,361 5,737 1,747 3,990 $ 19,101 8,841 10,260 50 10,210 2,187 7,068 5,329 1,598 $ 3,731 $ 19,143 9,407 9,736 -- 9,736 2,058 6,737 5,057 1,487 $ 3,570 Earnings per share: Basic.......................................................... Diluted ...................................................... ----------------------- (1) The financial data for the quarter ended March 31, 2001 includes the merger-related expenses of $2.4 million. 0.25 0.24 0.23 0.23 0.22 0.22 $ $ $ $ $ $ $ 19,320 10,019 9,301 -- 9,301 2,035 9,129 (1) 2,207 (1) 540 (1) $ 1,667 (1) $ $ 0.11 (1) 0.10 (1) 39 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no disagreements with accountants on any matter of accounting principles or practices or financial statement disclosures during the two year period ended December 31, 2002. PART III. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information under the captions “Election of Directors,” “Continuing Directors and Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s definitive Proxy Statement for its 2003 Annual Meeting of Shareholders (the “2003 Proxy Statement”) to be filed with the Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, is incorporated herein by reference in response to this item. ITEM 11. EXECUTIVE COMPENSATION The information under the caption “Executive Compensation and Other Matters” in the 2003 Proxy Statement is incorporated herein by reference in response to this item. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the caption “Beneficial Ownership of Common Stock by Management of the Company and Principal Shareholders” in the 2003 Proxy Statement is incorporated herein by reference in response to this item. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the caption “Interests of Management and Others in Certain Transactions” in the 2003 Proxy Statement is incorporated herein by reference in response to this item. ITEM 14. CONTROLS AND PROCEDURES Evaluation of disclosure controls and procedures. Within 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934 (the "Exchange Act")) are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported to the Company's management within the time periods specified in the Securities and Exchange Commission's rules and forms. Changes in internal controls. Subsequent to the date of their evaluation, there were no significant changes in the Company's internal controls or in other factors that could significantly affect the Company's disclosure controls and procedures, and there were no corrective actions with regard to significant deficiencies and material weaknesses based on such evaluation. 40 PART IV. ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Consolidated Financial Statements and Schedules Reference is made to the Consolidated Financial Statements, the reports thereon, the notes thereto and supplementary data commencing at page F-1 of this Annual Report on Form 10-K. Set forth below is a list of such Consolidated Financial Statements: Independent Auditors’ Report Consolidated Balance Sheets as of December 31, 2002 and 2001 Consolidated Statements of Income for the Years Ended December 31, 2002, 2001 and 2000 Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2002, 2001 and 2000 Consolidated Statements of Cash Flows for the Years Ended December 31, 2002, 2001 and 2000 Notes to Consolidated Financial Statements Financial Statement Schedules All supplemental schedules are omitted as inapplicable or because the required information is included in the Consolidated Financial Statements or notes thereto. Exhibits Each exhibit marked with an asterisk is filed with this Annual Report on Form 10-K. Exhibit Number Description 2.1 - Agreement and Plan of Reorganization dated as of May 1, 2002 by and between Prosperity Bancshares, Inc. and Paradigm Bancorporation, Inc. (incorporated herein by reference to Exhibit 2.1 to the Company's Registration Statement on Form S-4 (Registration No. 333-91248)) 2.2 - Stock Purchase Agreement dated as of February 22, 2002 by and between Prosperity Bancshares, Inc. and American Bancorp of Oklahoma, Inc. (incorporated herein by reference to Exhibit 2.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2002) 2.3 - Agreement and Plan of Reorganization dated as of April 26, 2002 by and among Prosperity Bancshares, Inc., Prosperity Bank and The First State Bank (incorporated herein by reference to Exhibit 2.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2002) 2.4 2.5 2.6 - Agreement and Plan of Reorganization by and between the Prosperity Bancshares, Inc and Commercial Bancshares, Inc. dated November 8, 2000 (incorporated herein by reference to Exhibit 2.1 to the Company’s Registration Statement on Form S-4 (Registration No. 333-52342)) - Agreement and Plan of Reorganization by and between Prosperity Bancshares, Inc. and South Texas Bancshares, Inc. dated June 17, 1999 (incorporated herein by reference to Exhibit 2.1 to the Company’s Form 10-Q for the quarter ended June 30, 1999) - Agreement and Plan of Reorganization dated June 5, 1998 by and among Prosperity, First Prosperity Bank and Union State Bank (incorporated herein by reference to Exhibit 10.4 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267)) 3.1 - Amended and Restated Articles of Incorporation of Prosperity (incorporated herein by reference to Exhibit 3.1 to the Company’s Form 10-Q for the quarter ended March 31, 2001) 3.2 - Amended and Restated Bylaws of Prosperity (incorporated herein by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267)) 41 4.1 4.2 4.3 4.4 4.5 4.6 4.7 10.1+ 10.2+ 10.3+ 10.4 - - - - - Form of certificate representing shares of Prosperity common stock (incorporated herein by reference to Exhibit 4 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267)) Form of Indenture by and between Prosperity Bancshares, Inc. and First Union Trust Company, N.A. with respect to the Junior Subordinated Debentures of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-89481)) Form of Amended and Restated Trust Agreement of Prosperity Capital Trust I (incorporated herein by reference to Exhibit 4.5 to the Company’s Registration Statement on Form S-1 (Registration No. 333-89481)) Form of Trust Preferred Securities Guarantee Agreement by and between Prosperity and First Union Trust Company, N.A. (incorporated herein by reference to Exhibit 4.7 to the Company’s Registration Statement on Form S-1 (Registration No. 333-89481)) Indenture dated as of July 31, 2001 by and between Prosperity Bancshares, Inc., as Issuer, and State Street Bank and Trust Company of Connecticut, National Association, with respect to the Floating Rate Junior Subordinated Deferrable Interest Debentures of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001) - Amended and Restated Declaration of Trust of Prosperity Statutory Trust II dated as of July 31, 2001 (incorporated herein by reference to Exhibit 4.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001) - Guarantee Agreement dated as of July 31, 2001 by and between Prosperity Bancshares, Inc. and State Street Bank and Trust Company of Connecticut, National Association (incorporated herein by reference to Exhibit 4.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001) - - - Prosperity Bancshares, Inc. 1995 Stock Option Plan (incorporated herein by reference to Exhibit 10.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267)) Prosperity Bancshares, Inc. 1998 Stock Incentive Plan (incorporated herein by reference to Exhibit 10.2 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267)) Form of Employment Agreements (incorporated herein by reference to Exhibit 10.3 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267)) - Loan Agreement dated December 27, 1997 between Prosperity and Norwest Bank Minnesota, National Association (incorporated herein by reference to Exhibit 10.5 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267)) 10.5+ - Form of Employment Agreement by and between First Prosperity Bank and H.E. Timanus, Jr. (incorporated herein by reference to Exhibit 10.5 to the Company’s Registration Statement on Form S-4 (Registration No. 333-52342)) 10.6+ - Commercial Bancshares, Inc. Incentive Stock Option Plan for Key Employees (incorporated herein by reference to Exhibit 4.5 to the Company's Registration Statement on Form S-8 (Registration No. 333-57238)) 10.7+ - Form of Stock Option Agreement under the Commercial Bancshares, Inc. Incentive Stock Option Plan for Key Employees (incorporated herein by reference to Exhibit 4.6 to the Company's Registration Statement on Form S-8 (Registration No. 333-57238)) 42 10.8+ - Paradigm Bancorporation, Inc. 1999 Stock Incentive Plan (incorporated herein by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8 (Registration No. 333-100815)) 21.1* - Subsidiaries of Prosperity 23.1* - Consent of Deloitte & Touche LLP 99.1* - Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002 99.2* - Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002 ----------------------------------------- + Management contract or compensatory plan or arrangement. Reports on Form 8-K The following reports on Form 8-K were filed during the fourth quarter 2002: (i) The Company filed a Current Report on Form 8-K under Item 5 on November 5, 2002 to announce the completion of the acquisition of The First National Bank of Bay City, in Bay City, Texas. (ii) The Company filed a Current Report on Form 8-K under Item 5 on October 22, 2002 to announce the release of the Company’s earnings for the third quarter 2002. (iii) The Company filed a Current Report on Form 8-K under Item 5 on October 2, 2002 to announce the completion of the merger of Southwest Bank Holding Company, Dallas, Texas, into the Company. 43 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Prosperity Bancshares, Inc., has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Houston and State of Texas on March 7 , 2003. PROSPERITY BANCSHARES, INC. sm Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons on behalf of the registrant in the indicated capacities on March 7, 2003. By: /s/DAVID ZALMAN David Zalman President and Chief Executive Officer Signature /s/DAVID ZALMAN David Zalman /s/NED S. HOLMES Ned S. Holmes /s/DAVID HOLLAWAY David Hollaway /s/HARRY BAYNE Harry Bayne /s/JAMES A. BOULIGNY James A. Bouligny /s/CHARLES A. DAVIS, JR. Charles A. Davis, Jr. /s/WILLIAM H. FAGAN, M.D. William Fagan, M.D. /s/CHARLES J. HOWARD, M.D. Charles Howard, M.D. /s/PERRY MUELLER, JR., D.D.S. Perry Mueller, Jr., D.D.S. /s/A. VIRGIL PACE, JR. A. Virgil Pace, Jr. /s/TRACY T. RUDOLPH Tracy T. Rudolph /s/HARRISON STAFFORD II Harrison Stafford II /s/ROBERT STEELHAMMER Robert Steelhammer /s/H.E. TIMANUS, JR. H. E. Timanus, Jr. Positions President and Chief Executive Officer (principal executive officer) Chairman of the Board; Director Chief Financial Officer (principal financial officer and principal accounting officer) Director Director Director Director Director Director Director Director Director Director Director 44 Certifications I, David Zalman, President and Chief Executive Officer of the registrant, certify that: 1. I have reviewed this annual report on Form 10-K of Prosperity Bancshares, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect the internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 7, 2003 /s/David Zalman David Zalman President and Chief Executive Officer 45 I, David Hollaway, Chief Financial Officer of the registrant, certify that: 1. I have reviewed this annual report on Form 10-K of Prosperity Bancshares, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect the internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 7, 2003 /s/David Hollaway David Hollaway Chief Financial Officer 46 TABLE OF CONTENTS TO FINANCIAL STATEMENTS Prosperity Bancshares, Inc. sm Independent Auditors' Report ................................................................................. Consolidated Balance Sheets as of December 31, 2002 and 2001...................... Page F-2 F-3 Consolidated Statements of Income for the Years Ended December 31, 2002, 2001 and 2000........................................................................................ F-4 Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 2002, 2001 and 2000......................................... F-5 Consolidated Statements of Cash Flows for the Years Ended December 31, 2002, 2001 and 2000 ............................................................... Notes to Consolidated Financial Statements ......................................................... F-6 F-8 F-1 INDEPENDENT AUDITORS’ REPORT To the Shareholders and Board of Directors of Prosperity Bancshares, Inc. and Subsidiaries: We have audited the accompanying consolidated balance sheets of Prosperity Bancshares, Inc. and subsidiaries (collectively, the “Company”) as of December 31, 2002 and 2001 and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Prosperity Bancshares, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 1 to the consolidated financial statements, in 2002 the Company adopted the provisions of Statement of Accounting Standards No. 141 “Business Combinations” and Statement of Accounting Standards No. 142 “Goodwill and Other Intangible Assets.” Deloitte & Touche LLP Houston, Texas February 14, 2003 F-2 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2002 2001 (Dollars in thousands) ASSETS Cash and due from banks (Note 4) ...................................... Federal funds sold .............................................................. Total cash and cash equivalents ..................................... Interest bearing deposits in financial institutions .................. Available for sale securities, at fair value (Note 5) .............. Held to maturity securities, at cost (Note 5) ........................ Loans (Notes 6 and 10). ...................................................... Less allowance for credit losses (Note 7) ............................. Loans, net.................................................... Accrued interest receivable ................................................. Goodwill ........................................................................... Core deposit intangibles, net of accumulated amortization of $192,000................................................................... Bank premises and equipment, net (Note 8) Other real estate owned...................................................... Other assets........................................................................ TOTAL ASSETS ............................................................... LIABILITIES AND SHAREHOLDERS' EQUITY LIABILITIES: Deposits (Note 9): Noninterest-bearing................................................. Interest-bearing....................................................... Total deposits .............................................. Other borrowings (Note 10) ........................................... Accrued interest payable ................................................ Other liabilities .............................................................. Total liabilities............................................. COMMITMENTS AND CONTINGENCIES (Notes 12 and 16) COMPANY-OBLIGATED MANDITORILY REDEEMABLE TRUST PREFERRED SECURITIES OF SUBSIDIARY TRUSTS (Note 19) ....................................................... SHAREHOLDERS' EQUITY (Notes 14 and 17): Common stock, $1 par value; 50,000,000 shares authorized; 18,903,028 and 16,218,022 shares issued at December 31, 2002 and 2001, respectively; 18,895,876 and 16,210,870 shares outstanding at December 31, 2002 and 2001, respectively .............. Capital surplus ............................................................... Retained earnings ........................................................... Accumulated other comprehensive income -- net unrealized gains on available for sale securities, net of tax of $1,424 and of $117, $ 66,806 13,993 80,799 498 309,219 641,098 679,559 (9,580 ) 669,979 10,348 68,290 4,120 27,010 219 10,676 $1,822,256 $ 327,699 1,258,912 1,586,611 37,939 2,550 7,417 1,634,517 $ 41,005 715 41,720 198 482,233 270,089 424,400 (5,985 ) 418,415 8,466 22,641 -- 15,077 -- 3,486 $1,262,325 $ 188,832 934,565 1,123,397 18,080 2,869 2,254 1,146,600 33,000 27,000 18,903 60,312 72,917 16,218 16,865 55,462 respectively ............................................................ Less treasury stock, at cost, 7,152 shares........................ Total shareholders' equity............................. 2,644 (37 ) 154,739 217 (37 ) 88,725 TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY................................................................. $1,822,256 $1,262,325 See notes to consolidated financial statements. F-3 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME INTEREST INCOME: Loans, including fees ...................................... Securities: Taxable..................................................... Nontaxable ............................................... 70% nontaxable preferred dividends .......... Federal funds sold. .......................................... Deposits in financial institutions ...................... Total interest income. ............................ INTEREST EXPENSE: Deposits. ........................................................ Note payable and other borrowings ................. Total interest expense ............................ NET INTEREST INCOME ................................ PROVISION FOR CREDIT LOSSES (Note 7) ... NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES .................................. NONINTEREST INCOME: Customer service fees ..................................... Other.............................................................. Total noninterest income ....................... NONINTEREST EXPENSE: Salaries and employee benefits (Note 15). ................................................. Net occupancy expense ................................... Data processing .............................................. Goodwill amortization ................................... Core deposit intangible amortization................ Depreciation expense. ..................................... Minority interest trust preferred securities........ Merger related expenses.................................. Other.............................................................. Total noninterest expense. ..................... INCOME BEFORE INCOME TAXES. .............. PROVISION FOR INCOME TAXES (Note 13) .. For the Years Ended December 31, 2002 2001 (Dollars in thousands, except per share data) 2000 $ 38,330 $ 34,731 $ 33,599 39,289 1,599 1,216 285 23 80,742 37,413 1,597 1,343 1,401 35 76,520 24,976 955 25,931 54,811 1,010 53,801 9,764 1,764 11,528 16,379 2,345 2,131 -- 192 1,830 2,104 -- 9,472 34,453 30,876 9,555 34,780 1,005 35,785 40,735 700 40,035 7,530 1,060 8,590 12,955 1,971 2,126 1,363 -- 1,570 1,580 2,425 6,305 30,295 18,330 5,372 31,845 1,477 656 2,414 88 70,079 33,551 2,013 35,564 34,515 275 34,240 6,576 1,184 7,760 12,931 1,761 1,956 1,160 -- 1,553 1,151 -- 6,255 26,767 15,233 4,532 NET INCOME. .................................................. $ 21,321 $ 12,958 $ 10,701 EARNINGS PER SHARE (Note 1): Basic .............................................................. Diluted ........................................................... $ $ 1.25 1.22 $ $ 0.80 0.79 $ $ 0.67 0.65 See notes to consolidated financial statements. F-4 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Common Stock Shares Amount Capital Surplus Other Retained Comprehensive Treasury Income Earnings Stock Total Shareholders’ Equity (Amounts in thousands, except share data) Accumulated BALANCE AT JANUARY 1, 2000 ................. Net income . ........................................... Net change in unrealized gain (loss) on available for sale securities. ............. Total comprehensive income ................... Sale of common stock ............................. Trust preferred issuance costs................... Cash paid in lieu of fractional shares in connection with issuance of common stock in exchange for stock of Heritage Bank .................................................... Cash paid to dissenting shareholder in connection with the issuance of common stock in exchange for common stock of Heritage Bank ...................................... Cash dividends declared, $0.18 per share............................................. BALANCE AT DECEMBER 31, 2000 ............ Net income. ............................................ Net change in unrealized gain (loss) on available for sale securities. ............. Total comprehensive income. ................... Sale of common stock. ............................ Trust preferred issuance costs.................. Cash paid to dissenting shareholders in connection with the issuance of common stock in exchange for common stock of Commercial........................................ Cash dividends declared, $0.195 per share............................................. BALANCE AT DECEMBER 31, 2001 ........... Net income . ........................................... Net change in unrealized gain (loss) on available for sale secur ities. ............. Total comprehensive income ................... Sale of common stock ............................. Common stock issued in connection with 15,998,596 $15,999 $18,024 $37,719 10,701 $(2,681 ) $(37 ) 3,286 152,400 152 183 (90 ) (24 ) (15 ) (153 ) 16,150,972 16,151 17,949 130,600 131 175 (476 ) (63,550 ) (64 ) (783 ) (2,755 ) 45,665 12,958 (3,161 ) 605 (37 ) (388 ) 16,218,022 $ 16,218 $ 16,865 $ 55,462 $ 217 $ (37 ) $ 21,321 2,427 104,504 105 155 Paradigm Acquisition ........................... 2,580,502 2,580 43,295 Cash paid in lieu of fractional shares in connection with the Paradigm Acquisition .......................................... Cash dividends declared, $0.22 (3) per share............................................. (3,866 ) BALANCE AT DECEMBER 31, 2002 ........... $18,903,028 $ 18,903 $ 60,312 $ 72,917 $ 2,644 $ (37 ) $ See notes to consolidated financial statements. $69,024 10,701 3,286 13,987 335 (90 ) (24 ) (153 ) (2,755 ) 80,333 12,958 (388 ) 12,570 306 (476 ) (847 ) (3,161 ) 88,725 21,321 2,427 23,748 260 45,875 (3 ) (3,866 ) 154,739 F-5 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS CASH FLOWS FROM OPERATING ACTIVITIES: Net income. .................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization ..................... Provision for credit losses............................ Net amortization (accretion) of premium/ discount on investments.......................... Loss (gain) on sale of premises, equipment and other real estate ................ Decrease (increase)in accrued interest receivable and other assets....................... (Decrease) increase in accrued interest payable and other liabilities .................... Total adjustments .................................... Net cash provided by operating activities . CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturities and principal paydowns of held to maturity securities....................................... Purchase of held to maturity securities............. Proceeds from maturities and principal paydowns of available for sale securities......................................... Purchase of available for sale securities ........... Net decrease (increase) in loans ....................... Purchase of bank premises and equipment ....... Proceeds from sale of bank premises, equipment and other real estate.................................... Premium paid for Texas Guaranty Bank .......... Net liabilities acquired in purchase of Texas Guaranty Bank (net of acquired cash of $12,723) ................................................. Premium paid for The First State Bank ............ Net liabilities acquired in purchase of The First State Bank (net of acquired cash of $4,938) ................................................... Premium paid for Paradigm Bancorporation .... Net liabilities acquired in purchase of Paradigm Bancorporation (net of acquired cash of $14,447) ................................................. Premium paid for First National Bank of Bay City ........................................................... Net liabilities acquired in purchase of First National Bank of Bay City (net of acquired cash of $5,816) ........................................... Premium paid for Southwest Bank Holding Company ........................................................ Net liabilities acquired in purchase of Southwest Bank Holding Company (net of acquired cash of $14,282) ............................ Net decrease in interest-bearing deposits in financial institutions ................................ Net liabilities acquired in purchase of Compass branches....................................... Net cash (used in) investing activities.................. 2002 For the Years Ended December 31, 2001 (Dollars in thousands) 2000 $ 21,321 $ 12,958 $ 10,701 2,022 1,010 4,317 (39) 7 (2,520 ) 4,797 26,118 2,933 700 982 87 2,661 275 (16) -- 3,358 (1,340) (1,177) 6,883 19,841 383 1,963 12,664 211,467 (300,816 ) 212,615 (75,671 ) 79,347 (65,703 ) 128,906 (119,527 ) 37,291 (2,171 ) 1,229 (3,649) 3,815 (1,721 ) 2,859 (36,489) 49,223 (2,217) 2,425 (5,693) 836 397 -- (33,835) 92,386 (396,280 ) (13,197 ) (3,073 ) 1,312 -- -- -- -- -- -- -- -- -- -- 887 -- (181,021) 25,765 (101,572 ) (39,294 ) (1,308 ) 75 -- -- -- -- -- -- -- -- -- -- -- 77,473 (25,217) (Table continued on following page) F-6 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in noninterest-bearing deposits. ..................................................... Net increase in interest-bearing deposits .......... Proceeds (repayments ) of other borrowings (net)......................................... Proceeds from issuance of junior subordinated debentures .............................. Trust preferred issuance costs......................... Cash paid in lieu of fractional shares ............... Cash paid to dissenting shareholder in connection with the issuance of common stock in exchange for common stock of Heritage Bank........................................................... Proceeds from the issuance of common stock. ............................................ Payments of cash dividends............................. Net cash provided by For the Years Ended December 31, 2002 2001 2000 (Dollars in thousands) $ 10,118 26,228 $ 873 88,978 $ 54,429 13,037 14,059 4,149 (49,188) -- -- (3 ) 15,000 (476 ) -- -- ( 90 ) (15) -- (847 ) (153) 260 (3,866 ) 306 (3,161 ) 335 (2,755 ) financing activities............................. 46,796 104,822 15,600 NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS. ................................ CASH AND CASH EQUIVALENTS, BEGINNING, OF PERIOD................................................... CASH AND CASH EQUIVALENTS, END OF PERIOD......................................................... INCOME TAXES PAID..................................... INTEREST PAID............................................... TRANSFER OF AVAILABLE FOR SALE SECURITIES TO HELD TO MATURITY SECURITIES ................................................. $ 39,079 $ (56,358) $ 3,047 41,720 98,078 95,031 $ $ $ 80,799 9,182 26,250 $ $ $ 41,720 6,410 36,396 $ 241,756 $ 170,601 $ $ $ $ 98,078 4,259 32,484 -- See notes to consolidated financial statements. F-7 PROSPERITY BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS sm 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES Nature of Operations -- Prosperity Bancshares, Inc. (“Bancshares”) and its subsidiaries, Prosperity Holdings, Inc. (“Holdings”), Prosperity Banksm and Bank of the Southwest (the “Banks”), (collectively referred to as the “Company”) provide retail and commercial banking services. As of December 31, 2002, the Company had two bank subsidiaries, Prosperity Banksm and Bank of the Southwest. Effective January 2, 2003, Bank of the Southwest was merged into Prosperity Bank (the “Bank”). The historical financial data of the Company has been restated to include the accounts and operations of Commercial Bancshares, Inc. which was merged into the Company effective February 23, 2001 and was accounted for as a pooling of interests. The Banks operate forty (40) banking centers in fifteen contiguous counties located in Southeast Texas and two (2) banking centers in Dallas, Texas, with locations in Angleton, Bay City, Beeville, Houston-Bellaire, Dallas-Camp Wisdom, Houston-City West, Houston-Clear Lake, Cleveland, Houston-Copperfield, Cuero, Cypress, Dayton, Houston-Downtown, East Bernard, Edna, El Campo, Fairfield, Galveston, Houston-Gladebrook, Goliad, Houston-Highway 6, Hitchcock, Liberty, Magnolia, Mathis, Houston-Medical Center, Houston-Memorial, Mont Belvieu, Needville, Palacios, Houston-Post Oak, Houston-River Oaks, Sweeny, Houston- Tanglewood, Victoria, Houston-Waugh Drive, West Columbia, Dallas-Westmoreland, Wharton, Winnie and Houston-Woodcreek. . Principles of Consolidation -- The consolidated financial stateme nts include the accounts of Bancshares and its wholly owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation. The accounting and reporting policies of the Company conform to generally accepted accounting principles (“GAAP”) and the prevailing practices within the banking industry. A summary of significant accounting and reporting policies is as follows: Use of Estimates -- The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. Securities -- Securities held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts. Management has the positive intent and the Company has the ability to hold these assets as long-term securities until their estimated maturities. Securities available for sale are carried at fair value. Unrealized gains and losses are excluded from earnings and reported, net of tax, as a separate component of shareho lders' equity until realized. Securities within the available for sale portfolio may be used as part of the Company's asset/liability strategy and may be sold in response to changes in interest risk, prepayment risk or other similar economic factors. Declines in the fair value of individual held to maturity and available for sale securities below their cost that are other than temporary would result in write-downs of the individual securities to their fair value. The related write-downs would be included in earnings as realized losses. Premiums and discounts are amortized and accreted to operations using the level-yield method of accounting, adjusted for prepayments as applicable. The specific identification method of accounting is used to compute gains or losses on the sales of these assets. Interest earned on these assets is included in interest income. Loans -- Loans are stated at the principal amount outstanding, net of unearned discount and fees. Unearned discount relates principally to consumer i nstallment loans. The related interest income for multipayment loans is recognized principally by the “sum of the digits” method which records interest in proportion to the declining outstanding balances of the loans; for single payment loans, such income is recognized using the straight-line method. Statement of Financial Accounting Standards (“SFAS”) No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure applies to all impaired loans, with the exception of groups of smaller-balance homogeneous loans that are collectively evaluated for impairment. A loan is defined as impaired by SFAS No. 114 if, based on current information and events, it is probable that a creditor will be unable to collect all amounts due, both interest and principal, according to the contractual terms of the loan agreement. Specifically, SFAS No. 114 requires that the allowance for credit losses related to impaired loans be determined based on the difference of carrying value of loans and the present value of expected cash flows discounted at the loan's effective interest rate or, as a practical expedient, the F-8 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) loan's observable market price or the fair value of the collateral if the loan is collateral dependent. At December 31, 2002, the Company had $1.1 million in nonaccrual loans, $120,000 in 90 days or more past due loans, $1.1 million in other nonperforming loans and no restructured loans. At December 31, 2001, the Company had $1,000 in nonaccrual loans, no 90 days or more past due loans and no restructured loans. Interest revenue received on impaired loans is either applied against principal or realized as interest revenue, according to management's judgment as to the collectibility of principal. Nonrefundable Fees and Costs Associated with Lending Activities - Loan origination fees in excess of the associated costs are recognized over the life of the related loan as an adjustment to yield using the interest method. Generally, loan commitment fees are deferred, except for certain retrospectively determined fees, and recognized as an adjustment of yield by the interest method over the related loan life or, if the commitment expires unexercised, recognized in income upon expiration of the commitment. Nonperforming Loans and Past Due Loans -- Included in the nonperforming loan category are loans which have been categorized by management as nonaccrual because collection of interest is doubtful and loans which have been restructured to provide a reduction in the interest rate or a deferral of interest or principal payments. When the payment of principal or interest on a loan is delinquent for 90 days, or earlier in some cases, the loan is placed on nonaccrual status unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan. If the decision is made to continue accruing interest on the loan, periodic reviews are made to confirm the accruing status of the loan. When a loan is placed on nonaccrual status, interest accrued during the current year prior to the judgment of uncollectibility is charged to operations. Interest accrued during prior periods is charged to allowance for credit losses. Generally, any payments received on nonaccrual loans are applied first to outstanding loan amounts and next to the recovery of charged-off loan amounts. Any excess is treated as recovery of lost interest. Restructured loans are those loans on which concessions in terms have been granted because of a borrower's financial difficulty. Interest is generally accrued on such loans in accordance with the new terms. Allowance for Credit Losses -- The allowance for credit losses is a valuation allowance available for losses incurred on loans. All losses are charged to the allowance when the loss actually occurs or when a determination is made that such a loss is probable. Recoveries are credited to the allowance at the time of recovery. Throughout the year, management estimates the probable level of losses to determine whether the allowance for credit losses is adequate to absorb losses in the existing portfolio. Based on these estimates, an amount is charged to the provision for credit losses and credited to the allowance for credit losses in order to adjust the allowance to a level determined to be adequate to absorb losses. Management's judgment as to the level of losses on existing loans involves the consideration of current and anticipated economic conditions and their potential effects on specific borrowers; an evaluation of the existing relationships among loans, probable credit losses and the present level of the allowance; results of examinations of the loan portfolio by regulatory agencies; and management's internal review of the loan portfolio. In determining the collectibility of certain loans, management also considers the fair value of any underlying collateral. The amounts ultimately realized may differ from the carrying value of these assets because of economic, operating or other conditions beyond the Company's control. Estimates of credit losses involve an exercise of judgment. While it is possible that in the short term the Company may sustain losses which are substantial in relation to the allowance for credit losses, it is the judgment of management that the allowance for credit losses reflected in the consolidated balance sheets is adequate to absorb probable losses that exist in the current loan portfolio. Premises and Equipment -- Premises and equipment are carried at cost less accumulated depreciation. Depreciation expense is computed principally using the straight-line method over the estimated useful lives of the assets which range from three to 30 years. . F-9 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Amortization of Goodwill -- Goodwill was amortized using the straight-line method through December 31, 2001 (See Note 1-New Accounting Standards). Goodwill is periodically assessed for impairment when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. The Company bases its evaluation on such impairment factors as the nature of the assets, the future economic benefit of the assets, any historical or future profitability measurements, as well as other external market conditions or factors that may be present. Amortization of Core Deposit Intangibles (CDI) – CDI is amortized using an accelerated amortization method over an eight year period. Income Taxes -- Bancshares files a consolidated federal income tax return. The Bank computes federal income taxes as if it filed a separate return and remits to, or is reimbursed by, Bancshares based on the portion of taxes currently due or refundable. Deferred tax assets and liabilities are recognized for the estimated tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Stock-Based Compensation -- The Company accounts for its employee stock options using the intrinsic value-based method and makes pro forma disclosures of net income and earnings per share using the fair value-based method (see Note 13). Cash and Cash Equivalents -- For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks as well as federal funds sold that mature in three days or less. Reclassifications -- Certain reclassifications have been made to 2001 and 2000 balances to conform to the current year presentation. All reclassifications have been applied consistently for the periods presented. Earnings Per Share -- SFAS No. 128, Earnings Per Share, requires presentation of basic and diluted earnings per share. Basic earnings per share has been computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding for the reporting period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Net income per common share for all periods presented has been calculated in accordance with SFAS No. 128. Outstanding stock options issued by the Company represent the only dilutive effect reflected in diluted weighted average shares. The following table illustrates the computation of basic and diluted earnings per share: 2002 December 31, 2001 Per Share Amount Amount Per Share Amount Amount Amount Amount 2000 Per Share Net income. ............................................. Basic: Weighted average shares outstanding.................................. Diluted: Weighted average shares outstanding Effect of dilutive securities -- options............................................ (Dollars in thousands, except per share data) $ 21,321 $ 12,958 $ 10,701 17,122 $ 1.25 16,172 $ 0.80 16,064 $ 0.67 17,122 320 16,172 326 16,064 390 Total .................................................... 17,442 $ 1.22 16,498 $ 0.79 16,454 $ 0.65 There were no stock options exercisable at December 31, 2002, 2001 and 2000 that would have had an anti-dilutive effect on the above computation. F-10 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) New Accounting Standards – In June 2001, the Financial Accounting Standards Board (“FASB”), issued Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations. SFAS No. 141 establishes accounting and reporting standards for business combinations. This Statement eliminates the use of the pooling-of-interest method of accounting for business combinations, requiring future business combinations to be accounted for using the purchase method of accounting. Additionally, SFAS No. 141 enhances the disclosures related to business combinations, and requires that all intangible assets acquired in a business combination be reported separately from goodwill. These intangible assets must then be assigned to a specifically identified reporting unit and assigned a useful life. The provisions of this statement apply to all business combinations initiated after June 30, 2001. The adoption of this statement did not have a material impact on the Company’s financial position or results of operations. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets, which addresses the accounting for goodwill and other intangible assets. SFAS 142 specifies that, among other things, intangible assets with an indefinite useful life and goodwill will no longer be amortized. The standard requires goodwill to be periodically tested for impairment and written down to fair value if considered impaired. The provisions of SFAS 142 were effective for fiscal years beginning after December 15, 2001. The adoption of this statement did not have a material impact on the Company’s financial position or results o f operations. In July 2001, FASB issued SFAS 143, Accounting for Asset Retirement Obligations. The statement requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When the liability is initially recorded, the entity capitalizes a cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement. The standard is effective for fiscal years beginning after September 15, 2002, with earlier application encouraged. The adoption of this statement did not have a material impact on the Company’s financial position or results of operations. In August 2001, the FASB issued SFAS 144, Accounting for Impairment or Disposal of Long-lived Assets. SFAS 144 addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of. It supersedes, with exceptions, SFAS 121, Accounting for the Impairment of Long-lived Assets and Long-lived Assets to be Disposed Of, and was effective for fiscal years beginning after December 15, 2001. The adoption of this statement did not have a material impact on the Company’s financial position or results of operations. In May of 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No.4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections as of April 2002. This Statement rescinds SFAS No. 4 and 64, Reporting Gains and Losses from Extinguishment of Debt and Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements, respectively, and restricts the classification of early extinguishment of debt as an extraordinary item to the provisions of APB Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. The Statement also rescinds SFAS No. 44, Accounting for Intangible Assets of Motor Carriers, which is no longer necessary because the transition to the provision s of the Motor Carrier Act of 1980 is complete. The statement also amends SFAS No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. Finally, the Statement makes various technical corrections to existing pronouncements which are not considered substantive. The provisions of this Statement are effective for fiscal years beginning after May 15, 2002. The adoption of this statement did not have a material impact on the Company’s financial position or results of operations. In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 provides guidance on the recognition and measurement of liabilities for cost associated with exit or disposal activities. SFAS no. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not believe that the implementation of this statement will have a material impact on the Company’s financial position or results of operations. In October 2002, the FASB issued SFAS 147, Acquisitions of Certain Financial Institutions (“SFAS 147”). SFAS 147 provides guidance on the accounting for the acquisition of a financial institution, except transactions between two or more mutual enterprises. The implementation of this standard did not have a material impact on the Company’s financial position or results of operations. F-11 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) In December 2002, the FASB issued SFAS 148, Accounting for Stock-Based Compensation (“SFAS 148”). SFAS 148 provides guidance on the accounting for stock based compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company adopted SFAS 148 as of December 31, 2002 and has elected to continue to account for its employee stock options using the intrinsic value-based method. Stock Split -- On May 31, 2002, the Company effected a two -for-one stock split in the form of a 100 percent stock dividend to shareholders of record on May 20, 2002. The Company issued approximately 8.1 million shares in connection with the split. All per share and share information has been restated to reflect this stock split. 2. ACQUISITIONS On November 1, 2002, the Company completed the acquisition of First National Bank of Bay City, Bay City, Texas (the "FNB Acquisition"), through the merger of FNB with and into Prosperity Bank. Under the terms of the Agreement and Plan of Reorganization dated as of August 15, 2002, as amended, the Company paid approximately $5.1 million in cash for all of the issued and outstanding common stock of FNB. FNB operated one (1) location in Bay City, Texas, which was closed and consolidated with Prosperity Bank's Bay City Banking Center. As of November 1, 2002, FNB had total assets of $27.1 million, total loans of $8.2 million and total deposits of $23.8 million. In connection with the purchase, the Company paid a cash premium of $2.2 million of which $168,000 was identified as core deposit intangibles. This premium was recorded as goodwill and the core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life. The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date. On October 1, 2002, the Company completed the acquisition of Southwest Bank Holding Company, Dallas, Texas (the “Southwest Acquisition”). Southwest’s wholly owned subsidiary, Bank of the Southwest, Dallas, Texas, became a subsidiary of the Company. Under the terms of the Agreement and Plan of Merger dated as of July 14, 2002, the Company paid approximately $19.6 million in cash. Southwest was privately held and operated two (2) banking offices in Dallas, Texas. As of October 1, 2002, Southwest had total assets of $121.9 million, total loans of $58.7 million and total deposits of $108.9 million. In connection with the purchase, the Company paid a cash premium of $5.7 million of which $640,000 was identified as core deposit intangibles. This premium was recorded as goodwill and the core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life. The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date. On September 1, 2002, the Company completed the acquisition of Paradigm Bancorporation, Inc. (the “Paradigm Acquisition”) in a stock transaction. Under the terms of the Agreement and Plan of Reorganization dated as of May 2, 2002, Prosperity issued approximately 2.58 million shares of its common stock for all outstanding shares of Paradigm (giving effect to the two for one stock split). Paradigm operated a total of eleven (11) banking offices - six (6) in the greater metropolitan Houston area and five (5) in the nearby Southeast Texas cities of Dayton, Galveston, Mont Belvieu, and Winnie, three (3) of which were closed following completion of the transaction. As of September 1, 2002, Paradigm Bancorporation had total assets of $248.7 million, total loans of $175.7 million and total deposits of $218.3 million. In connection with the purchase, the Company paid a cash premium of $36.6 million of which $2.8 million was identified as core deposit intangibles. This premium was recorded as goodwill and the core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life. F-12 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date. On July 12, 2002, the Company completed the acquisition of The First State Bank, Needville, Texas (the “First State Acquisition”) for approximately $3.7 million in cash. Prosperity Bank’s existing Needville Banking Center has relocated into the former First State Bank location effective July 15, 2002. As of July 12, 2002, The First State Bank had total assets of $16.3 million, loans of $5.5 million and deposits of $14.1 million. In connection with the purchase, the Company paid a cash premium of $1.7 million of which $293,000 was identified as core deposit intangibles. This premium was recorded as goodwill and the core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life. The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date. On May 8, 2002, the Company completed the acquisition of Texas Guaranty Bank, N.A. (the “Texas Guaranty Acquisition”) for approximately $11.8 million in cash. Texas Guaranty Bank operated three (3) offices in Houston, Texas, all of which became full service banking centers of Prosperity Bank. As of May 8, 2002, Texas Guaranty Bank had total assets of $74.0 million, loans of $45.7 million and deposits of $61.8 million. In connection with the purchase, the Company paid a cash premium of $3.7 million of which $431,000 was identified as core deposit intangibles. This premium was recorded as goodwill and the core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life. The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date. On February 23, 2001, the Company completed a merger with Commercial Bancshares, Inc., a Texas corporation (“Commercial”), whereby Commercial was merged with and into the Company (the “Commercial Merger”). The Company issued 2,768,610 shares of its Common Stock for all of the outstanding shares of Commercial. In connection with the Commercial Merger, Heritage Bank, Commercial’s wholly owned subsidiary, was merged with and into the Bank. Heritage Bank had 12 full-service banking locations in the Houston metropolitan area and in three adjacent counties, including Houston-Bellaire, Cleveland, Cypress, Fairfield, Houston-Downtown, Houston-Medical Center, Houston-River Oaks, Houston-Tanglewood, Houston-Waugh Drive, Liberty, Magnolia and Wharton. In connection with this Commercial Merger, the Company incurred approximately $2.4 million in pretax merger-related expenses and other charges. The transaction was accounted for as a pooling of interests and therefore the historical financial data of the Company has been restated to include the accounts and operations of Commercial for all periods prior to the Effective Time of the Commercial Merger. Effective September 15, 2000, the Company consummated a transaction with Compass Bank (“Compass”) whereby the Company purchased certain assets and assumed certain liabilities of five Compass branches (the “Compass Acquisition”). The branches are located in El Campo, Hitchcock, Needville, Palacios and Sweeny, Texas. With the exception of the El Campo location, the former Compass branches are being operated as full-service Banking Centers. The El Campo location has been combined with the Company’s El Campo Banking Center. The Company purchased $5.0 million in loans and assumed $87.3 million in deposits in connection with the transaction. In connection with the purchase, the Company paid a cash premium of $5.4 million. This premium was recorded as goodwill and was amortized until December 31, 2001 on a straight-line basis (See Note 1 -New Accounting Standards). The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date. F-13 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 3. GOODWILL In June 2001, the FASB issued SFAS no. 142, which no longer permits the amortization of goodwill and indefinite-lived intangible assets. Instead, these assets must be reviewed annually (or more frequently under certain conditions) for impairment. Intangible assets that do not have indefinite lives will continue to be amortized over their useful lives and reviewed for impairment. The Company adopted the provisions of SFAS No. 142 and therefore discontinued the amortization of goodwill effective January 1, 2002. During fiscal 2002, the Company completed the initial transitional goodwill impairment test, which did not indicate any goodwill impairment and therefore did not have an effect on the Company’s consolidated financial condition of results of operations. The following table presents a reconciliation of reported net income and earnings per share to the amounts adjusted for the exclusion of goodwill amortization, net of the related income tax effect: Fiscal 2002 Fiscal 2001 (Dollars in thousands, except per share data) Fiscal 2000 Net income ..................................................................................... Add: Goodwill amortization, net of tax...................................... Adjusted.................................................................................. Basic earnings per common share................................................ Add: Goodwill amortization, net of tax ...................................... Adjusted.................................................................................. Diluted earnings per common share............................................. Add: Goodwill amortization, net of tax ...................................... Adjusted.................................................................................. $21,321 -- $21,321 $ 1.25 -- $ 1.25 $ 1.22 -- $ 1.22 $12,958 1,158 $14,116 $ 0.80 0.07 $ 0.87 $ 0.79 0.07 $ 0.86 $10,701 1,033 $ 11,734 $ 0.67 0.06 $ 0.73 $ 0.65 0.06 $ 0.71 Changes in the carrying amount of the Company’s goodwill for fiscal 2002 were as follows: Balance as of December 31, 2001............................................. Less: Amortization........................................................................... Add:............................................................................................. Acquisition of Texas Guaranty Bank .................................... Acquisition of First State Bank of Needville........................ Acquisition of Paradigm Bancorporation............................. Acquisition of First National Bank of Bay City................... Acquisition of Southwest Bank Holding Company ............. Balance as of December 31, 2002................................... Goodwill Core Deposit Intangibles $ 22,641 $ -- -- 3,254 1,448 33,846 2,048 5,053 68,290 $ (192 ) 431 293 2,781 168 640 4,121 $ 4. CASH AND DUE FROM BANKS The Bank is required by the Federal Reserve Bank to maintain average reserve balances. “Cash and due from banks” in the consolidated balance sheets includes amounts so restricted of $15.0 million and $12.1 million at December 31, 2002 and 2001, respectively. F-14 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 5. SECURITIES The amortized cost and fair value of debt securities are as follows: Available for Sale U.S. Treasury securities and obligations of U.S. government agencies.................................................. 70% non-taxable preferred stock ................. States and political subdivisions .................. Collateralized mortgage obligations ............ Mortgage-backed securities......................... Amortized Cost Gross Unrealized Gains December 31, 2002 Gross Unrealized Losses (Dollars in thousands) Fair Value Carrying Value $ 18,511 44,029 27,115 18,616 196,887 $ 65 -- 1,808 596 2,600 $ -- 884 -- 14 110 $ 18,576 43,145 28,923 19,198 199,377 $ 18,576 43,145 28,923 19,198 199,377 Total...................................................... $ 305,158 $ 5,069 $ 1,008 $ 309,219 $ 309,219 Held to Maturity U.S. Treasury securities and obligations of U.S. government agencies.................................................. Corporate debt securities............................. States and political subdivisions .................. Collateralized mortgage obligations ............ Mortgage-backed securities......................... $ 78,587 25,338 31,879 149,666 355,628 $ 3,131 942 1,241 1,662 12,297 $ -- 87 6 12 5 $ 81,718 26,193 33,114 151,316 367,920 Total....................................................... $641,098 $ 19,273 $ 110 $ 660,261 $ 78,587 25,338 31,879 149,666 355,628 $ 641,098 Available for Sale U.S. Treasury securities and obligations of U.S. government agencies.................................................. 70% non-taxable preferred stock ................. States and political subdivisions .................. Collateralized mortgage obligations ............ Mortgage-backed securities......................... Amortized Cost Gross Unrealized Gains December 31, 2001 Gross Unrealized Losses (Dollars in thousands) Fair Value Carrying Value $ 2,248 24,058 28,165 17,356 410,072 $ 201 107 483 314 1,646 $ -- -- 73 22 2,322 $ 2,449 24,165 28,575 17,648 409,396 $ 2,449 24,165 28,575 17,648 409,396 Total...................................................... $ 481,899 $ 2,751 $ 2,417 $ 482,233 $ 482,233 Held to Maturity U.S. Treasury securities and obligations of U.S. government agencies.................................................. Corporate debt securities............................. States and political subdivisions .................. Collateralized mortgage obligations ............ Mortgage-backed securities......................... $ 141,149 22,712 23,338 22 82,868 $ 3,180 609 605 -- 535 $ 204 167 12 -- 408 $ 144,125 23,154 23,931 22 82,995 $ 141,149 22,712 23,338 22 82,868 Total...................................................... $ 270,089 $ 4,929 $ 791 $ 274,227 $ 270,089 F-15 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) The amortized cost and fair value of debt securities at December 31, 2002, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Due in one year or less............................................ Due after one year through five years.................................................................. Due after five years through ten years.................................................................. Due after ten years.................................................. Subtotal. ................................................................. Mortgage-backed securities and collateralized mortgage obligations ......................................................... December 31, 2002 Held to Maturity Amortized Cost Fair Value Available for Sale Fair Value Amortized Cost (Dollars in thousands) $ 36,045 $ 36,822 $ 3,034 $ 3,050 71,528 75,136 27,731 500 135,804 28,556 512 141,026 15,060 31,437 40,124 89,655 15,141 30,644 41,809 90,644 505,294 519,235 215,503 218,575 Total.................................................................. $ 641,098 $ 660,261 $ 305,158 $ 309,219 Gross proceeds from the sale of held to maturity securities was approximately $17,400 and gross proceeds from the sale of available for sale securities was approximately $48,800 for the year ended December 31, 2002. There was one sale of a held to maturity security with gross proceeds of $1.0 million and no sales of available for sale securities during 2001. The sale of the held to maturity security during 2001 occurred due to a de -valuation of the security to a junk bond status. No material gains were recognized related to any sale. The Company does not own securities of any one issuer (other than the U.S. government and its agencies) for which aggregate adjusted cost exceeds 10% of the consolidated shareholders' equity at December 31, 2002 and December 31, 2001. Securities with amortized costs of $403.5 million and $350.9 million and a fair value of $416.8 million and $353.9 million at December 31, 2002 and 2001, respectively, were pledged to secure public deposits and for other purposes required or permitted by law. F-16 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 6. LOANS The loan portfolio consists of various types of loans made principally to borrowers located in Southeast Texas and Dallas and is classified by major type as follows: Commercial and industrial............................................ Real estate: Construction and land development....................................................... 1-4 family residential. .............................................. Home equity.............................................................. Commercial mortgages............................................ Farmland. .................................................................. Multi-family residential........................................... Agriculture..................................................................... Other............................................................................... Consumer....................................................................... Total ............................................................................... Less unearned discount................................................. December 31, 2002 2001 (Dollars in thousands) $ 93,797 $ 46,986 52,377 206,586 23,249 183,970 11,887 15,502 24,683 3,020 64,919 679,990 431 20,963 175,253 20,541 78,446 10,686 9,694 15,757 953 45,230 424,509 109 Total.......................................................................... $ 679,559 $ 424,400 The contractual maturity ranges of the commercial and industrial and construction and land development portfolios and the amount of such loans with predetermined interest rates and floating rates in each maturity range are summarized in the following table: Commercial and industrial........................................ Construction and land development......................... Total...................................................................... Loans with a predetermined interest rate................. Loans with a floating interest rate............................ Total...................................................................... December 31, 2002 After One Through Five Years After Five Years (Dollars in thousands) $35,896 10,084 $45,980 $23,370 22,610 $45,980 $13,304 3,824 $17,128 $ 6,020 11,108 $17,128 One Year or Less $44,597 38,469 $83,066 $17,895 65,171 $83,066 Total $ 93,797 52,377 $146,174 $ 47,285 98,889 $146,174 F-17 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) As of December 31, 2002 and 2001, loans outstanding to directors, officers and their affiliates totaled $9.8 million and $7.1 million, respectively. In the opinion of management, all transactions entered into between the Company and such related parties have been, and are, in the ordinary course of business, made on the same terms and conditions as similar transactions with unaffiliated persons. An analysis of activity with respect to these related-party loans is as follows: Year Ended December 31, 2002 2001 (Dollars in thousands) Beginning balance...................................................... New loans and reclassified related loans .................. Repayments. ............................................................... $ 7,144 8,336 (5,676 ) Ending balance. .......................................................... $ 9,804 $ 6,850 4,448 (4,154 ) $ 7,144 7. ALLOWANCE FOR CREDIT LOSSES An analysis of activity in the allowance for credit losses is as follows: Balance at beginning of year. ................................................. Balance acquired with the Texas Guaranty, First State, Paradigm, FNB, Southwest and Compass, Acquisitions, respectively ....................................... Addition -- provision charged to 2,981 operations ............................................................... 1,010 Net (charge-offs) and recoveries: Loans charged off ............................................. Loan recoveries................................................. (767 ) 371 Year Ended December 31, 2002 2001 2000 (Dollars in thousands) $ 5,985 $ 5,523 $ 5,031 -- 700 (429 ) 191 46 275 (217 ) 388 171 Total net (charge-offs) recoveries........................................... (396 ) (238) Balance at end of year............................................................ $ 9,580 $ 5,985 $ 5,523 8. PREMISES AND EQUIPMENT Premises and equipment are summarized as follows: Year Ended December 31, 2002 2001 (Dollars in thousands) Land........................................................................................ Buildings ................................................................................ Furniture, fixtures and equipment ........................................ Construction in progress....................................................... Total................................................................................ Less accumulated depreciation............................................. Premises and equipment, net......................................... $ 6,953 19,966 9,595 763 37,277 (10,267 ) $27,010 $ 3,161 12,645 6,754 912 23,472 (8,395 ) $15,077 F-18 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 9. DEPOSITS Included in interest-bearing deposits are certificates of deposit in amounts of $100,000 or more. These certificates and their remaining maturities at December 31, 2002 were as follows: Three months or less.............................................................. Greater than three through six months.................................. Greater than six through twelve months ............................... Thereafter................................................................................ December 31,2002 (Dollars in thousands) $104,001 52,754 50,527 40,708 Total................................................................................. $247,990 Interest expense for certificates of deposit in excess of $100,000 was $6.9 million, $8.7 million and $6.0 million, for the years ended December 31, 2002, 2001 and 2000, respectively. The Company has no brokered deposits and there are no major concentrations of deposits. 10. OTHER BORROWINGS Note Payable -- During December 1997, Bancshares entered into an agreement with a bank to borrow up to $8.0 million under a reducing, revolving line of credit (the “Line”). The purpose of the Line is to provide funding for potential acquisitions in the future. The maximum amount available under the Line is reduced by $1.1 million each year beginning December 1998 with all amounts due and payable on December 31, 2004. The Line bears interest, payable quarterly, at the Federal Funds Rate plus 2.75%. The Line is collateralized by 100% of the issued and outstanding common shares of Holdings and the Bank. At December 31, 2002 and 2001, Bancshares had no outstanding borrowings under the Line. Other Borrowings – At December 31, 2002, the Company had $37.9 million in FHLB borrowings of which $12.6 million consisted of long-term FHLB notes payable and $25.3 million consisted of FHLB advances compared with $18.1 million in FHLB borrowings at December 31, 2001 of which $13.3 million consisted of long-term FHLB notes payable and $4.8 million consisted of FHLB advances. The highest outstanding balance of FHLB advances during 2002 was $31.4 million compared with $30.2 million during 2001. The maturity dates on the FHLB notes payable range from 2004 to 2018 and the interest rates range from 5.95% to 6.48%. FHLB advances consist of short-term, over-night borrowings. The advances under the FHLB line of credit are secured by a blanket pledge of the Bank's 1-4 family residential mortgages. The Company had no federal funds purchased at December 31, 2002 or 2001. 11. INTEREST RATE RISK The Company is principally engaged in providing real estate, consumer and commercial loans, with interest rates that are both fixed and variable. These loans are primarily funded through short-term demand deposits and longer-term certificates of deposit with variable and fixed rates. The fixed real estate loans are more sensitive to interest rate risk because of their fixed rates and longer maturities. F-19 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 12. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK In the normal course of business, the Company is a party to various financial instruments with off-balance-sheet risk to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of these instruments reflect the extent of the Company's involvement in particular classes of financial instruments. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making these commitments and conditional obligations as it does for on-balance-sheet instruments. The following is a summary of the various financial instruments entered into by the Company: December 31, 2002 2001 (Dollars in thousands) Commitments to extend credit ............................ Standby letters of credit....................................... $ 78,359 1,681 $ 46,789 1,481 At December 31, 2002, $21.0 million of commitments to extend credit have fixed rates ranging from 3.60% to 12.00%. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amounts disclosed above do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company evaluates customer creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by the Company upon extension of credit, is based on management's credit evaluation of the customer. 13. INCOME TAXES The components of the provision for federal income taxes are as follows: Year Ended December 31, 2002 2001 2000 (Dollars in thousands) Current .................................................................................... Deferred. ................................................................................. $ 8,963 592 $ 5,894 (522) Total ........................................................................................ $ 9,555 $ 5,372 $ 4,501 31 $ 4,532 F-20 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) The provision for federal income taxes differs from the amount computed by applying the federal income tax statutory rate on income as follows: Taxes calculated at statutory rate... ..................................... Increase (decrease) resulting from: Tax-exempt interest................................................. Qualified Zone Academy Bond credit.................... Dividends received deduction................................. Amortization of goodwill ........................................ Other, net.................................................................. Year Ended December 31, 2002 2001 2000 (Dollars in thousands) $ 10,807 $ 6,415 $ 5,179 (690 ) (373 ) (298 ) 61 48 (702 ) (373 ) (329 ) 262 99 (550 ) (379) (156) 200 238 Total ....................................................................................... $ 9,555 $ 5,372 $ 4,532 Deferred tax assets and liabilities are as follows: December 31, 2002 (Dollars in thousands) 2001 Deferred tax assets: Allowance for credit losses ...................................... Nonaccrual loan interest........................................... Accrued liabilities..................................................... Transfers from acquired banks ................................. Other .......................................................................... Total deferred tax assets......................................................... $ 1,088 104 318 579 56 2,145 $ 994 104 105 -- 31 1,234 Deferred tax liabilities: Accretion on investments ......................................... Bank premises and equipment.................................. Unrealized gain on available for sale securities............................................................... FHLB dividends ................................................... Transfer from Heritage Bank .............................. Total deferred tax liabilities................................................... $ (437 ) (926 ) $ (545 ) (1,046 ) (1,417 ) (125 ) (-- ) (2,905 ) (117 ) (125) (32 ) (1,865 ) Net deferred tax liabilities. .................................................... $ (760 ) $ ( 631 ) F-21 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 14. STOCK INCENTIVE PROGRAM During 1995, the Company's Board of Directors approved a stock option plan (the "1995 Plan") for executive officers and key associates to purchase common stock of Bancshares. A total of 660,000 options have been granted under the 1995 plan as of December 31, 2002. Compensation expense was not recognized for the stock options granted under the 1995 Plan because the options had an exercise price approximating the fair value of Bancshares' common stock at the date of grant. The maximum number of shares reserved for issuance pursuant to options granted under the 1995 Plan is 680,000 (after two-for-one and four-for-one stock splits). During 1998, the Company's Board of Directors and shareholders approved a second stock option plan (the "1998 Plan") which authorizes the issuance of up to 920,000 (after two-for-one stock split) shares of the common stock of Bancshares under both "non-qualified" and "incentive" stock options to employees and "non-qualified" stock options to directors who are not employees. The 1998 Plan also provides for the granting of restricted stock awards, stock appreciation rights, phantom stock awards and performance awards on substantially similar terms. Compensation expense was not recognized for the stock options granted under the 1998 Plan because the options had an exercise price approximating the fair value of Bancshares common stock at the date of grant. Options to purchase 399,000 (after two -for-one stock split) shares of Bancshares common stock have been granted under the 1998 Plan. On February 23, 2001, the Company consummated its merger with Commercial. The options to purchase shares of Commercial common stock which were outstanding at the effective time of the merger were converted into options to purchase a total of 26,660 (after two -for-one stock split) shares of Bancshares common stock at exercise prices ranging from $0.725 to $5.16 per share. The converted options are governed by the original plans under which they were issued. During 2000, Commercial granted 8,680 options at an exercise price of $5.16 per share. On September 1, 2002, the Company acquired Paradigm Bancorporation. The options to purchase shares of Paradigm common stock outstanding at the effective time of the transaction were converted (at a rate of 1 to 1.08658) into options to purchase a total of 33,804 shares of Bancshares Common Stock at exercise prices ranging from $8.28 to $11.50 per share. The converted options are governed by the original plans under which they were issued. 2002 2001 2000 Year Ended December 31, Number of Options Weighted- Average Exercise Price Number of Options Weighted- Average Exercise Price Number of Options Weighted- Average Exercise Price Options outstanding, beginning of period. 530,180 Options granted ....................................... 287,804 (1) Options forfeited ..................................... (29,327 ) Options exercised .................................... (104,504 ) $ 4.47 16.92 15.55 2.48 486,780 $ 2.53 184,000 (2) 10.01 10.01 (10,000 ) 2.34 (130,600 ) 650,000 8,680 (19,500 ) (152,400 ) 2.40 $ 5.16 1.89 2.20 Options outstanding, end of period... ........ 684,153 --------------------------------------------- $ 8.65 530,180 $ 4.47 486,780 $ 2.53 (1) Includes options to acquire 33,804 shares of Bancshares Common Stock assumed in connection with the Paradigm Acquisition. (2) Includes options to acquire 26,660 shares of Bancshares Common Stock assumed in connection with the Commercial Merger. At December 31, 2002, there were 54,153 options exercisable under all plans. During 2002, 104,504 options were exercised. At December 31, 2001, there were 94,380 options exercisable under all plans and 130,600 options were exercised. At December 31, 2000, there were 144,200 options exercisable under all plans and 152,400 options we re exercised. During 2002, the Company granted 254,000 options under the 1998 Plan. The options were granted at exercise prices ranging from $16.55 per share to $19.01 per share. Compensation expense was not recorded for the stock options because the exercise price approximated the fair value of common stock at the date of grant. On April 18, 2001, the Company granted 184,000 options under the 1998 Plan. The options were granted at an exercise price of $10.01 per share. Compensation expense was not recorded for the stock options because the exercise price approximated the fair value of common stock at the date of grant. F-22 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) The weighted-average fair value of the stock options on the grant dates ranged from $3.86 to $4.10 in 2002 and was $2.415 in 2001 respectively. The weighted-average remaining contractual life of options outstanding as of December 31, 2002 ranged from 9.91 years to 9.33 years for the options granted in 2002 and 8.33 years for the options granted in 2001, respectively. The fair value of each stock options was estimated using an option-pricing model with the following assumptions (1) for the options granted in 2002, risk-free interest rates ranging from 5.735% to 5.490%; dividend yields ranging from 1.18% to 1.33%; and expected lives of 4.5 years (2) for the options granted in 2001, risk-free interest rate of 5.383%; dividend yield of 1.95%; and an expected life of 4.5 years (3) for the options granted in 2000, risk free interest rates ranging from 4.575% to 5.313%; dividend yields ranging from 3.78% to 26.90%; and expected lives ranging from 1.3 years to 3.0 years. If compensation expense had been recorded based on the fair value at the grant date for awards consistent with SFAS No. 123, the Company’s net income and earnings per share would have been as follows: Year Ended December 31, Net Income as reported........................................................ Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax effects .................. 2002 2001 2000 (Dollars in thousands, except per share data) $ 10,701 $ 12,958 $ 21,321 (180) (51) (10) Proforma net income......................................................... $ 21,141 $ 12,907 $ 10,691 Earnings per share: Basic-as reported...................................................... Basic-proforma......................................................... Diluted-as reported................................................... Diluted-proforma ..................................................... $ $ $ $ 1.25 1.24 1.22 1.21 $ $ $ $ 0.80 0.79 0.79 0.78 $ $ $ $ 0.67 0.67 0.65 0.65 15. PROFIT SHARING PLAN The Company has adopted a profit sharing plan pursuant to Section 401(k) of the Internal Revenue Code whereby the participants may contribute a percentage of their compensation as permitted under the Code. Matching contributions are made at the discretion of the Company. Presently, The Company matches 50 % of an employee's contributions, up to 15 % of compensation, not to exceed the maximum allowable pursuant to the Internal Revenue Code and excluding catch-up contributions. Such matching contributions were approximately $439,000, $351,000 and $327,000, for the years ended December 31, 2002, 2001 and 2000, respectively. F-23 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 16. COMMITMENTS AND CONTINGENCIES Leases -- A summary of noncancelable future operating lease commitments as of December 31, 2002 follows (dollars in thousands): 2003.............................................................. 2004.............................................................. 2005.............................................................. 2006.............................................................. 2007.............................................................. Total ............................................................. $ 1,322 1,063 639 561 456 $ 4,041 It is expected that in the normal course of business, expiring leases will be renewed or replaced by leases on other property or equipment. Rent expense under all noncancelable operating lease obligations aggregated approximately $1.3 million for the year ended December 31, 2002, $957,000 for the year ended December 31, 2001 and $834,000 for the year ended December 31, 2000. Litigation -- The Company has been named as a defendant in various legal actions arising in the normal course of business. In the opinion of management, after reviewing such claims with outside counsel, resolution of such matters will not have a materially adverse impact on the consolidated financial statements. 17. REGULATORY MATTERS The Company and the Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Any institution that fails to meet its minimum capital requirements is subject to actions by regulators that could have a direct material effect on the Company's and the Banks’ financial statements. Under the capital adequacy guidelines and the regulatory framework for prompt corrective action, the Banks must meet specific capital guidelines based on the Banks’ assets, liabilities and certain off- balance-sheet items as calculated under regulatory accounting practices. The Company's and the Banks’ capital amounts and the Banks’ classification under the regulatory framework for prompt corrective action are also subject to qualitative judgements by the regulators about the components, risk weightings and other factors. To meet the capital adequacy requirements, the Company and the Banks must maintain minimum capital amounts and ratios as defined in the regulations. Management believes, as of December 31, 2002 that the Company and the Banks met all capital adequacy requirements to which they are subject. Management believes, as of December 31, 2001 that the Company and Prosperity Bank met all capital adequacy requirements to which they are subject. At December 31, 2002, the most recent notification from the FDIC categorized the Banks as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Banks must maintain minimum total risk- based, Tier I risk-based and Tier I leverage ratios as set forth in the table. There have been no conditions or events since that notification which management believes have changed the Banks’ category. F-24 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) The following is a summary of the Company's and the Banks’ capital ratios at December 31, 2002 and 2001. Bank of the Southwest data is reflected for 2002 only (dollars in thousands): Actual For Capital Adequacy Purposes To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Ratio Amount Ratio Amount Ratio CONSOLIDATED: As of December 31, 2002: Total Capital (to Risk Weighted Assets) ................... $122,265 15.30% $63,914 8.0% N/A N/A Tier I Capital (to Risk Weighted Assets) ................... $112,685 14.10% $31,957 4.0% N/A N/A Tier I Capital (to Average Assets)............................. $112,685 6.56% $51,553 3.0% N/A N/A As of December 31, 2001: Total Capital (to Risk Weighted Assets) ................... $98,852 19.52% $40,509 8.0% N/A N/A Tier I Capital (to Risk Weighted Assets) ................... $92,867 18.34% $ 20,254 4.0% N/A N/A Tier I Capital (to Average Assets)............................. $92,867 7.57% $36,781 3.0% N/A N/A Actual For Capital Adequacy Purposes To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Ratio Amount Ratio Amount Ratio PROSPERITY BANK ONLY: As of December 31, 2002: Total Capital (to Risk Weighted Assets) ................... $110,587 14.91% $59,337 8.0% $74,171 10.0% Tier I Capital (to Risk Weighted Assets) ................... $101,677 13.71% $ 29,668 4.0% $44,503 Tier I Capital (to Average Assets)............................. $101,677 6.26% $48,730 3.0% $81,217 6.0% 5.0% As of December 31, 2001: Total Capital (to Risk Weighted Assets) ................... $85,584 16.90% $40,502 8.0% $50,628 10.0% Tier I Capital (to Risk Weighted Assets) ................... $79,599 15.72% $ 20,251 4.0% $30,377 Tier I Capital (to Average Assets) $79,599 6.50% $ 36,751 3.0% $61,251 6.0% 5.0% F-25 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Actual For Capital Adequacy Purposes To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Ratio Amount Ratio Amount Ratio BANK OF THE SOUTHWEST ONLY: As of December 31, 2002: Total Capital (to Risk Weighted Assets) ................... $ 9,533 15.15% $ 5,035 8.0% $ 6,294 10.0% Tier I Capital (to Risk Weighted Assets) ................... $ 8,863 14.08% $ 2,518 4.0% $ 3,777 Tier I Capital (to Average Assets)............................. $ 8,863 7.62% $ 3,488 3.0% $ 5,814 6.0% 5.0% Dividends paid by Bancshares and the Banks are subject to restrictions by certain regulatory agencies. There was an aggregate of $35.2 million and $27.6 million available for payment of dividends by Bancshares and by the Banks to Bancshares, respectively, at December 31, 2002 under these restrictions. Dividends paid by Bancshares during the years ended December 31, 2002 and 2001 were $3.9 million and $3.2 million, respectively. There were $18.4 million of dividends paid by the Banks to Bancshares during the year ended 2002 and $2.3 paid by the Banks to Bancshares during the year ended 2001. 18. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS Disclosures of the estimated fair value amounts of financial instruments have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a material effect on the estimated fair value amounts. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and Cash Equivalents -- For these short-term instruments, the carrying amount is a reasonable estimate of f air value. Securities -- For securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Loan Receivables -- For certain homogeneous categories of loans (such as some residential mortgages and other consumer loans), fair value is estimated by discounting the future cash flows using the risk-free Treasury rate for the applicable maturity, adjusted for servicing and credit risk. The carrying value of variable rate loans approximates fair value because the loans reprice frequently to current market rates. Company-Obligated Mandatorily Redeemable Trust Preferred Securities of Subsidiary Trusts – The fair value of the Company-Obligated Mandatorily Redeemable Trust Preferred Securities of Subsidiary Trusts was calculated using the quoted market price. F-26 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Deposit Liabilities -- The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. Long-Term Debt and Other Borrowings -- Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt using a discounted cash flows methodology. Off-Balance Sheet Financial Instruments -- The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the present creditworthiness of the counterparties. The estimated fair values of the Company's interest-earning financial instruments are as follows (dollars in thousands): Financial assets: Cash and due from banks....................................... Federal funds sold ................................................. Held to maturity securities. .................................... Available for sale securities... ................................ Loans.................................................................... Less allowance for credit losses ............................. Total................................................................................. Financial liabilities: Deposits................................................................ Company-obligated mandatorily redeemable trust preferred securities of subsidiary trusts ................................................................ Federal Home Loan Bank Advances ...................... Federal Home Loan Bank notes payable ................. Total................................................................................. December 31, 2002 2001 Carrying Amount Fair Value Carrying Amount Fair Value $ 66,806 13,993 641,098 309,219 679,559 (9,580 ) $ 66,806 13,993 660,261 309,219 698,496 (9,580 ) $ 41,005 715 270,089 482,233 424,400 (5,985 ) $ 41,005 715 274,227 482,233 434,441 (5,985 ) $ 1,701,095 $ 1,739,195 $ 1,212,457 $ 1,226,636 $ 1,586,611 $ 1,594,728 $ 1,123,397 $ 1,128,732 33,000 25,300 12,639 $ 1,657,550 33,900 25,300 13,914 $ 1,667,842 27,000 4,775 13,305 $ 1,168,477 28,741 4,775 17,743 $ 1,179,991 The differences in fair value and carrying value of commitments to extend credit and standby letters of credit were not material at December 31, 2002 and 2001. The fair value estimates presented herein are based on pertinent information available to management as of the dates indicated. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amounts presented herein. 19. TRUST PREFERRED SECURITIES In July 2001, the Company formed Prosperity Statutory Trust II ("Trust II”) and on July 31, 2001, Trust II issued 15,000 Floating Rate Capital Securities (the "Capital Securities") with an aggregate liquidation value of $15,000,000 to a third party. Concurrent with the issuance of the Capital Securities, Trust II issued trust common securities to the Company in the aggregate liquidation value of $464,000. The proceeds of the issuance of the Capital Securities and trust common securities were invested in the Company's Floating Rate Junior Subordinated Deferrable Interest Debentures (the "Floating Rate Debentures"). The Floating Rate Debentures will mature on July 31, 2031, which date may be shortened to a date not earlier than July 31, 2006, if certain conditions are met (including the Company having received prior approval of the Federal Reserve and any other required regulatory approvals). These Floating Rate Debentures, which are the only assets of Trust II, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture dated July 31, 2001) of the Company. The Floating Rate Debentures accrue interest at a floating rate equal to 3-month LIBOR plus 3.58%, not to exceed 12.50%, payable quarterly. The quarterly interest rate on F-27 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) the Debentures for the period from October 31, 2002 through Decembe r 31, 2002 was equal to 5.34%. The quarterly distributions on the Capital Securities will be paid at the same rate that interest is paid on the Floating Rate Debentures. The Company has fully and unconditionally guaranteed the Trust II’s obligations under the Capital Securities. Trust II must redeem the Capital Securities when the Floating Rate Debentures are paid at maturity or upon any earlier prepayment of the Floating Rate Debentures. The Floating Rate Debentures may be prepaid if certain events occur, including a change in the tax status or regulatory capital treatment of the Capital Securities or a change in existing laws that requires Trust II to register as an investment company. The Company received net proceeds of $14.5 million, which will be used for the general corporate purposes of the Company and the Bank, including supporting continued expansion activities in the Houston metropolitan area and surrounding counties through the establishment and/or acquisition of additional Banking Centers and possible acquisitions. In November 1999, the Company formed Prosperity Capital Trust I, a business trust formed under the laws of the State of Delaware (“Trust I”). Trust I issued $12.0 million of 9.60% Trust Preferred Securities and invested the proceeds thereof in the 9.60% Junior Subordinated Deferrable Interest Debentures (the “Fixed Rate Debentures”) issued by the Company. The Fixed Rate Debentures will mature on November 17, 2029, which date may be shortened to a date not earlier than November 17, 2004, if certain conditions are met (including the Company having received prior approval of the Federal Reserve and any other required regulatory approvals). The Trust Preferred Securities will be subject to mandatory redemption if the Fixed Rate Debentures are repaid by the Company. The Fixed Rate Debentures may be prepaid if certain events occur, including a change in the tax status or regulatory capital treatment of the Trust Preferred Securities. In each case, redemption will be made at par, plus the accrued and unpaid distributions thereon through the redemption date. In connection with the Paradigm acquisition, on September 1, 2002 the Company acquired Paradigm Capital Trust II (“Paradigm Trust”), which issued $6.0 million of floating rate preferred securities on February 20, 2001. The Company also assumed the obligations under the floating rate debentures held by Paradigm Trust. The floating rate debentures will mature on February 20, 2031, which date may be shortened to a date not earlier than February 20, 2006 if certain conditions are met. These debentures, which are the only assets of the trust, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture) of Paradigm. The Company has fully and unconditionally guaranteed Paradigm Trust’s obligations under the preferred securities. The Floating Rate Debentures held by Paradigm Trust accrue interest at a floating rate equal to 3-month LIBOR plus 4.5%, payable quarterly. The quarterly distributions on the preferred securities are paid at the same rate that interest is paid on the debentures. For the quarter ended December 31, 2002, the rate on the debentures was 6.33%. For financial reporting purposes, Trust I, Trust II and Paradigm Trust are treated as subsidiaries of the Company and consolidated in the corporate financial statements. The trust preferred securities are presented as a separate category of long-term debt on the balance sheet. Although the trust preferred securities are not included as a component of shareholders' equity on the balance sheet, for regulatory purposes, the trust preferred securities are treated as Tier 1 capital by the Federal Reserve. The treatment of the trust preferred securities as Tier 1 capital, in addition to the ability to deduct the expense of the debentures for federal income tax purposes, provided the Company with a cost-effective method of raising capital. F-28 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 20. PARENT COMPANY ONLY FINANCIAL STATEMENTS PROSPERITY BANCSHARES, INC. (Parent Company Only) BALANCE SHEETS December 31, 2002 2001 (Dollars in thousands) ASSETS Cash. ....................................................................... Investment in subsidiaries..................................... Investment in Prosperity Capital Trust I .............. Investment in Prosperity Statutory Trust II.......... Investment in Paradigm Capital Trust II .............. Goodwill, net.......................................................... Other assets............................................................ TOTAL .......................................................................... LIABILITIES AND SHAREHOLDERS' EQUITY LIABILITIES: Accrued interest payable and other liabilities...... Junior subordinated debentures............................. Total liabilities ............................................ SHAREHOLDERS' EQUITY: Common stock....................................................... Capital surplus. ...................................................... Retained earnings................................................... Unrealized losses on available $ 2,027 181,615 380 464 186 3,983 587 $189,242 $ 473 34,030 34,503 18,903 60,312 72,917 for sale securities, net of tax............................... 2,644 Less treasury stock, at cost (7,152 shares at December 31, 2002 and 2001, respectively) ..... Total shareholders' equity.......................... (37 ) 154,739 $ 13,331 98,485 380 464 -- 3,983 83 $116,726 $ 157 27,844 28,001 16,218 16,865 55,462 217 (37 ) 88,725 TOTAL .......................................................................... $189,242 $116,726 F-29 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) PROSPERITY BANCSHARES, INC. (Parent Company Only) STATEMENTS OF INCOME For the Years Ended December 31, 2001 2000 2002 (Dollars in thousands) OPERATING INCOME: Dividends from subsidiaries. ................... Other income .......................................... Total income ................................. OPERATING EXPENSE: Amortization of goodwill ........................ Minority expense trust preferred securities............................................. Other expenses ....................................... Total operating expense ................ INCOME BEFORE INCOME TAX BENEFIT AND EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES........................................... FEDERAL INCOME TAX BENEFIT............... INCOME BEFORE EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES. ................ EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES......................................... $ $ 13,100 -- 13,100 -- 2,104 174 2,278 10,822 797 11,619 9,702 2,272 -- 2,272 466 1,580 158 2,204 $ -- 2 2 466 1,151 81 1,698 68 716 (1,696) 535 784 (1,161) 12,174 11,862 NET INCOME. ................................................ $ 21,321 $ 12,958 $ 10,701 F-30 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) PROSPERITY BANCSHARES, INC. (Parent Company Only) STATEMENTS OF CASH FLOWS 2002 For the Years Ended December 31, 2001 (Dollars in thousands) 2000 CASH FLOWS FROM OPERATING ACTIVITIES: Net income.................................................. Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed earnings of subsidiaries...................................... Amortization of goodwill. ........................ Decrease (increase) in other assets............ (Decrease) increase in accrued interest payable and other liabilities ................. Cash paid in lieu of fractional shares......... Increase in other liabilities........................ $ 21,321 $ 12,958 $ 10,701 (9,702 ) -- 268 (43) -- -- (12,175 ) 466 708 ( 61 ) -- -- (10,962 ) 466 (190 ) (142) (15) 15 Total adjustments. ............................ (9,477 ) (11,062 ) (10,828 ) Net cash flows provided by (used in) operating activities .................... CASH FLOWS FROM INVESTING ACTIVITIES: Capital contribution to subsidiary................. Net cash flows used in investing activities ................... CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of common stock. .......................... Trust preferred securities issuance cost......... Payments of cash dividends. ........................ Cash paid to dissenting shareholders ............ Cash paid for acquisitions ............................ Dividends received from subsidiaries ........... Proceeds from issuance of junior subordinated debentures ....................... Net cash flows (used in) provided by financing activities…………. NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS. .................... CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD................................................ CASH AND CASH EQUIVALENTS, END OF PERIOD...................................................... 11,844 1,896 (127) -- -- 260 -- (3,866 ) (3 ) (24,789 ) 5,250 -- (23,148) -- -- 306 (476) (3,161 ) (667) -- -- 15,000 11,002 -- -- 335 (90 ) (2,755 ) -- -- -- -- (2,510 ) (11,304) 12,898 (2,637 ) 13,331 433 3,070 $ 2,027 $ 13,331 $ 433 F-31 PROSPERITY BANCSHARES, INC. sm AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 21. SUBSEQUENT EVENT (Unaudited) On February 3, 2003, the Company announced the signing of a definitive agreement pursuant to which the Company will acquire Abrams Centre Bancshares, Dallas, Texas (“Abrams”) and its subsidiary, Abram’s Centre National Bank, will merge into the Bank. Under the terms of the agreement, the Company will pay approximately $16.3 million in cash. Abrams operates two (2) banking offices in Dallas, Texas. As of December 31, 2002, Abrams had total assets of $93.6 million, loans of $50.6 million, deposits of $69.0 million and shareholders’ equity of $13.9 million. The transaction is expected to close in the second quarter of 2003. The Company will not complete the acquisition unless customary closing conditions are satisfied or waived, including receipt of the necessary regulatory approvals and consents from applicable regulatory agencies including the Federal Reserve Board, the Texas Banking Department and the Federal Deposit Insurance Corporation. On March 4, 2003, the Company entered into a definitive agreement with Dallas Bancshares Corporation, Dallas, Texas (“Dallas”). Pursuant to the agreement, Dallas Bancshares will merge into the Company and it’s wholly owned subsidiary, BankDallas will merge into the Bank. Under the terms of the agreement, the Company will pay approximately $7.0 million in cash. Dallas Bancshares is privately held and operates one (1) banking office in Dallas, Texas. As of December 31, 2002, BankDallas had total assets of $40.9 million, loans of $30.6 million, deposits of $36.5 million and shareholders’ equity of $4.3 million. The transaction is expected to close in the second quarter of 2003. The Company will not complete the acquisition unless customary closing conditions are satisfied or waived, including receipt of the necessary regulatory and shareholder approvals and consents from applicable regulatory agencies including the Federal Reserve Board, the Texas Banking Department and the Federal Deposit Insurance Corporation. F-32
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