Prosperity Bancshares Annual Report 2005

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FY2005 Annual Report · Prosperity Bancshares

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)
⌧ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES

EXCHANGE ACT OF 1934

For The Fiscal Year Ended December 31, 2005

(cid:133) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 0-25051

PROSPERITY BANCSHARES, INC.®

(Exact name of registrant as specified in its charter)

74-2331986
(I.R.S. Employer
Identification No.)

TEXAS
(State or other jurisdiction of
incorporation or organization)
PROSPERITY BANK PLAZA
4295 SAN FELIPE
HOUSTON, TEXAS
(Address of principal executive offices)

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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities

Act. Yes (cid:133) No ⌧

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the

Act. Yes (cid:133) No ⌧

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 ⌧ No (cid:133)

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. (cid:133)

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):

Large Accelerated Filer (cid:133)

Accelerated Filer ⌧

Non-accelerated Filer (cid:133)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the

Act). Yes (cid:133) No ⌧

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, 2005 was approximately $620.2 million.

As of March 1, 2006, the number of outstanding shares of Common Stock was 27,864,894.

Documents Incorporated by Reference:
Portions of the Company’s Proxy Statement relating to the 2006 Annual Meeting of Shareholders, which will be filed

within 120 days after December 31, 2005, are incorporated by reference into Part III, Items 10-14 of this Form 10-K.

PROSPERITY BANCSHARES, INC.®
2005 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

PART I

Item 1. Business............................................................................................................................
General.........................................................................................................................
2005 Acquisitions ........................................................................................................
Pending Acquisition.....................................................................................................
Recent Developments ..................................................................................................
Available Information..................................................................................................
Officers and Associates................................................................................................
Banking Activities .......................................................................................................
Business Strategies ......................................................................................................
Competition .................................................................................................................
Supervision and Regulation .........................................................................................

Risk Factors ......................................................................................................................

Item
1A.
Item
1B. Unresolved Staff Comments.............................................................................................
Item 2. Properties..........................................................................................................................
Item 3. Legal Proceedings.............................................................................................................
Item 4. Submission of Matters to a Vote of Security Holders ......................................................

PART II

Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of

Equity Securities ..........................................................................................................
Item 6. Selected Consolidated Financial Data ..............................................................................
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview......................................................................................................................
Critical Accounting Policies ........................................................................................
Results of Operations...................................................................................................
Financial Condition......................................................................................................

Item
7A. Quantitative and Qualitative Disclosures about Market Risk ...........................................
Item 8. Financial Statements and Supplementary Data.................................................................
Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
Item
9A.
Item
9B. Other Information .............................................................................................................

Controls and Procedures...................................................................................................

PART
III

PART
IV

Item
10.
Item
11.
Item
12.
Item
13.
Item
14.

Directors and Executive Officers of the Registrant ..........................................................

Executive Compensation ..................................................................................................
Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters

.....................................................................................................................................

Certain Relationships and Related Transactions...............................................................

Principal Accounting Fees and Services...........................................................................

Item
15.
Signatures

Exhibits, Financial Statement Schedules .........................................................................

3
3
4
4
5
5
5
5
6
7
7

19
20
21
21

21
23
25
26
27
28
35

53
54
55

PART I

ITEM 1. BUSINESS
General

Prosperity Bancshares, Inc.®, a Texas corporation (the “Company”), was formed in 1983 as a vehicle to acquire the
former Allied Bank in Edna, Texas which was chartered in 1949 as The First National Bank of Edna. The Company is a
registered financial holding company that derives substantially all of its revenues and income from the operation of its bank
subsidiary, Prosperity Bank® (“Prosperity Bank®” or the “Bank”). The Bank provides a broad line of financial products and
services to small and medium-sized businesses and consumers. As of December 31, 2005, the Bank operated eight-five
(85) full-service banking locations, with thirty-three (33) in the Greater Houston Consolidated Metropolitan Statistical Area
(“CMSA”), seventeen (17) in fifteen contiguous counties situated south and southwest of Houston and extending into South
Texas, six (6) in the Austin, Texas area, sixteen (16) in the Corpus Christi, Texas area, two (2) in the east Texas area and
eleven (11) in the Dallas, Texas area. The Greater Houston CMSA consists of Austin, Brazoria, Chambers, Fort Bend,
Galveston, Harris, Liberty, Montgomery, San Jacinto and Waller counties. The Company’s headquarters are located at
Prosperity Bank Plaza, 4295 San Felipe in Houston, Texas and its telephone number is (713) 693-9300. The Company’s
website address is www.prosperitybanktx.com.

The Company’s market consists of the communities served by its banking centers. US 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, Dallas, Corpus Christi and Austin 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
areas 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 (now
Wells Fargo), 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.

From December 31, 1998 through December 31, 2005, the Company grew through internal growth and the completion

of the following acquisitions:

Acquired Entity

South Texas Bancshares, Inc. ..................................
Compass Bank (5 branches) ....................................
Commercial Bancshares, Inc. ..................................
Texas Guaranty Bank, N.A......................................
The First State Bank of Needville(2) .........................
Paradigm Bancorporation, Inc. ................................
Southwest Bank Holding Company.........................
First National Bank of Bay City(2) ............................
Abrams Centre Bancshares, Inc...............................
Dallas Bancshares, Inc.............................................
MainBancorp, Inc. ...................................................
First State Bank of North Texas ..............................
Liberty Bancshares, Inc. ..........................................
Village Bank and Trust, s.s.b...................................
First Capital Bankers, Inc. .......................................
Grapeland Bancshares, Inc. .....................................

Acquired Bank
Commercial State Bank
N/A
Heritage Bank
Same
Same
Paradigm Bank Texas
Bank of the Southwest
Same
Abrams Centre National Bank
BankDallas
mainbank, n.a.
Same
Liberty Bank, S.S.B.
Same
FirstCapital Bank, s.s.b.
First State Bank of Grapeland

Completion
Date

Number of
Banking Centers
Added(1)

1999
2000
2001
2002
2002
2002
2002
2002
2003
2003
2003
2003
2004
2004
2005
2005

3
4
12
3
—
8
2
—
1
1
4
3
5
1
27
2

(1) The number of banking centers added does not include any locations of the acquired entity that were closed and

consolidated into existing banking centers of the Company.

(2) The only banking center of the acquired entity was closed and consolidated into an existing banking center of the

Company.

2005 Acquisitions

On December 1, 2005, the Company completed its acquisition of Grapeland Bancshares, Inc. (the “Grapeland
acquisition”), Grapeland, Texas. Under the terms of the agreement, Grapeland merged into the Company and subsequently,
Grapeland’s wholly owned subsidiary, First State Bank of Grapeland, merged into the Bank. The Company issued 232,888
shares of its common stock for all of the issued and outstanding capital stock of Grapeland. Grapeland was privately held and
operated two (2) banking offices in Grapeland and Crockett, Texas, both of which became full service banking centers of the
Company.

On March 1, 2005, the Company completed its acquisition of First Capital Bankers, Inc. (the “First Capital
acquisition”), Corpus Christi, Texas. Under the terms of the agreement, First Capital was merged into the Company and
subsequently, First Capital’s wholly owned subsidiary, FirstCapital Bank, s.s.b., was merged into the Bank. The Company
issued approximately 5.079 million shares of its common stock for all of the issued and outstanding capital stock of First
Capital and converted all outstanding options to acquire First Capital common stock into options to acquire approximately
234,000 shares of Company common stock. First Capital was privately held and operated thirty-two (32) banking offices in
and around Corpus Christi, Houston and Victoria, Texas, five of which were closed and consolidated with existing banking
centers of the Company.

Pending Acquisition

On November 16, 2005, the Company announced its proposed acquisition of SNB Bancshares, Inc. (“SNB”), Sugar

Land, Texas. Under the terms of the agreement, SNB will merge into the Company and subsequently, SNB’s wholly owned
subsidiary, Southern National Bank of Texas will merge into the Bank. The Company expects to issue approximately
4.448 million shares of its common stock and approximately $93.0 million in cash for all of the issued and outstanding
capital stock of SNB subject to adjustment as provided in the agreement. SNB is publicly traded and operates five
(5) banking offices in Fort Bend County, Houston and Katy, Texas and two (2) stand alone motor banks in Houston, Texas.
SNB has an additional banking office under construction in Katy, Texas. As of December 31, 2005, SNB had, on a
consolidated basis, total assets of $1.025 billion, loans (including loans held for sale) of $652.8 million, deposits of $892.0
million and shareholders’ equity of $82.5 million.

Recent Developments

On February 28, 2006, the Company redeemed in full the $6.2 million in junior subordinated debentures issued to
Paradigm Capital Trust II. Paradigm Capital Trust II in turn redeemed in full the trust preferred securities and common
securities it issued.

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. Information contained on the Company’s website is not incorporated by reference into this annual
report on Form 10-K and 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 civic and public service activities in the communities served by the
Company, including the Rotary Club, Lion’s Club, Pilot Club, United Way and Chamber of Commerce.

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 the Houston, Dallas, Austin and Corpus Christi 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. The Company’s local banking
centers have no 1-800 telephone numbers. Each banking center has its own listed local business telephone number, which
enables a customer to be served by a local banker with decision making authority.

As of December 31, 2005, the Company and the Bank had 859 full-time equivalent associates, 299 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, 2005, the Bank maintained approximately 185,000 separate deposit accounts
and 21,000 separate loan accounts and 23.1% of the Bank’s total deposits were noninterest-bearing demand deposits. For the
year ended December 31, 2005, the Company’s average cost of funds was 1.75% and the Company’s average cost of deposits
(excluding all borrowings) was 1.56%.

The Company has been an active mortgage lender, with commercial mortgage and 1-4 family residential loans
comprising 57.0% of the Company’s total loans as of December 31, 2005. The Company also offers loans for automobiles
and other consumer durables, home equity loans, debit cards, internet banking and other cash management services and
automated telephone banking. By offering certificates of deposit, checking with interest accounts, savings accounts and
overdraft protection at competitive rates, the Company gives its depositors a full range of traditional deposit products.

The businesses targeted by the Company in its lending efforts are primarily those that require loans in the $100,000 to
$8.0 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 internally, as well as 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. While maintaining its conservative approach to lending, the
Company has emphasized both new and existing loan products, focusing on growing its construction, commercial mortgage
and commercial loan portfolios. During the two-year period from December 31, 2003 to December 31, 2005, the Company’s
construction loans grew from $36.5 million to $206.7 million, or 466.6%. The Company’s commercial and industrial loans
grew from $94.0 million to $222.8 million, or 137.0%, and its commercial mortgages increased from $260.9 million to
$566.4 million, or 117.1% for the same period. In addition, the Company targets professional service firms including 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 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 among
its associates. 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.

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 has contributed to its low incidence of
nonperforming assets and its minimal charge-offs in relation to its size.

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
within 12 months after acquisition date and generally have supplied the Company with relatively low-cost deposits which
have been used to fund the Company’s lending and investing activities. However, the Company makes no guarantee that
future acquisitions, if any, will be accretive to earnings within any particular time period. 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 market presence.

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 believes it 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.

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 Bank are subject. References in

this annual report on Form 10-K 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

The Company is a financial holding company pursuant to 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 Permissible 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 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.

Notwithstanding the foregoing, 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 became a financial holding
company on April 18, 2000.

While the Federal Reserve Board is 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 ratio of total
capital to total tangible risk-weighted assets 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, 2005, the Company’s ratio of Tier 1 capital to total
tangible risk-weighted assets was 15.34% and its ratio of total capital to total tangible risk-weighted assets was 16.37%.
Tangible risk-weighted assets are calculated as total risk-weighted assets less intangible assets such as goodwill and core
deposit intangibles.

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 tangible 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, 2005,
the Company’s leverage ratio was 7.83%.

The federal banking agencies’ risk-based and leverage ratios are minimum supervisory ratios generally applicable to

banking organizations that meet certain specified criteria, assuming that they have the highest regulatory rating. Banking
organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The
federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the
minimum ratios when circumstances warrant. Federal Reserve Board guidelines also provide that banking organizations
experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above
the minimum supervisory levels, without significant reliance on intangible assets.

Imposition of Liability for Undercapitalized Subsidiaries. Bank regulators are required to take “prompt corrective
action” to resolve problems associated with insured depository institutions whose capital declines below certain levels. In the
event an institution becomes “undercapitalized,” it must submit a capital restoration plan. The capital restoration plan will not
be accepted by the regulators unless each company having control of the undercapitalized institution guarantees the
subsidiary’s compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a
depository institution’s holding company is entitled to a priority of payment in bankruptcy.

The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the
institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately
capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically”
undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an
institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to
consent to a consolidation or to divest the troubled institution or other affiliates.

Acquisitions by Bank Holding Companies. The BHCA requires every bank holding company to obtain the prior
approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or
control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly, more than
5% of the voting shares of such bank. In approving bank acquisitions by bank holding companies, the Federal Reserve Board
is required to consider the financial and managerial resources and future prospects of the bank holding company and the
banks concerned, the convenience and needs of the communities to be served, and various competitive factors.

Control Acquisitions. The Change in Bank Control Act prohibits a person or group of persons from acquiring “control”
of a bank holding company unless the Federal Reserve Board has been notified and has not objected to the transaction. Under
a rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock
of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Company,
would, under the circumstances set forth in the presumption, constitute acquisition of control of the Company.

In addition, any entity is required to obtain the approval of the Federal Reserve Board under the BHCA before
acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of the outstanding Common Stock of
the Company, or otherwise obtaining control or a “controlling influence” over the Company.

The Bank

The Bank is a Texas-chartered banking association, the deposits of which are insured by the Bank Insurance Fund
(“BIF”) of the FDIC. The Bank is not a member of the Federal Reserve System; therefore, the Bank is subject to supervision
and regulation by the FDIC and the Texas Banking Department. Such supervision and regulation subject the Bank to special
restrictions, requirements, potential enforcement actions and periodic examination by the FDIC and the Texas Banking
Department. Because the Federal Reserve Board regulates the bank holding company parent of the Bank, the Federal Reserve
Board also has supervisory authority which directly affects the Bank.

Equivalence to National Bank Powers. The Texas Constitution, as amended in 1986, provides that a Texas-chartered
bank has the same rights and privileges that are or may be granted to national banks domiciled in Texas. To the extent that
the Texas laws and regulations may have allowed state-chartered banks to engage in a broader range of activities than
national banks, the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) has operated to limit this
authority. FDICIA provides that no state bank or subsidiary thereof may engage as principal in any activity not permitted for
national banks, unless the institution complies with applicable capital requirements and the FDIC determines that the activity
poses no significant risk to the insurance fund. In general, statutory restrictions on the activities of banks are aimed at
protecting the safety and soundness of depository institutions.

Financial Modernization. Under the Gramm-Leach-Bliley Act, a national bank may establish a financial subsidiary and

engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting as
principal, insurance company portfolio investment, real estate development, real estate investment and annuity issuance. To
do so, a bank must be well capitalized, well managed and have a CRA rating of satisfactory or better. Subsidiary banks of a
financial holding company or national banks with financial subsidiaries must remain well capitalized and well managed in
order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could
include divestiture of the financial in nature subsidiary or subsidiaries. In addition, a financial holding company or a bank
may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the
financial holding company or the bank has a CRA rating of satisfactory of better.

Although the powers of state chartered banks are not specifically addressed in the Gramm-Leach-Bliley Act, Texas-
chartered banks such as the Bank, will have the same if not greater powers as national banks through the parity provision
contained in the Texas Constitution.

Branching. Texas law provides that a Texas-chartered bank can establish a branch anywhere in Texas provided that the

branch is approved in advance by the Texas Banking Department. The branch must also be approved by the FDIC, which
considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management,
needs of the community and consistency with corporate powers.

Restrictions on Transactions with Affiliates and Insiders. Transactions between the Bank and its nonbanking affiliates,
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 Federal Reserve
has also issued Regulation W which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and
interpretive guidance with respect to affiliate transactions.

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. In addition, the FDIC and Texas Banking Department may elect to conduct a joint examination.

Audit Reports. Insured institutions with total assets of $500 million or more must submit annual audit reports prepared

by independent auditors to federal and state regulators. In some instances, the audit report of the institution’s holding
company can be used to satisfy this requirement. Auditors must receive examination reports, supervisory agreements and
reports of enforcement actions. In addition, financial statements prepared in accordance with generally accepted accounting
principles, management’s certifications concerning responsibility for the financial statements, internal controls and
compliance with legal requirements designated by the FDIC, and an attestation by the auditor regarding the statements of
management relating to the internal controls must be submitted. For institutions with total assets of more than $3 billion,
independent auditors may be required to review quarterly financial statements. FDICIA requires that independent audit
committees be formed, consisting of outside directors only. The committees of such institutions must include members with
experience in banking or financial management, must have access to outside counsel, and must not include representatives of
large customers.

Capital Adequacy Requirements. The FDIC has adopted regulations establishing minimum requirements for the capital

adequacy of insured institutions. The FDIC may establish higher minimum requirements if, for example, a bank has
previously received special attention or has a high susceptibility to interest rate risk.

The FDIC’s risk-based capital guidelines generally require state banks to have a minimum ratio of Tier 1 capital to

total tangible risk-weighted assets of 4.0% and a ratio of total capital to total tangible risk-weighted assets of 8.0%. The
capital categories have the same definitions for the Bank as for the Company. As of December 31, 2005, the Bank’s ratio of
Tier 1 capital to total tangible risk-weighted assets was 15.04% and its ratio of total capital to total tangible risk-weighted
assets was 16.08%.

The FDIC’s leverage guidelines require state banks to maintain Tier 1 capital of no less than 4.0% of average total
tangible 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 5.0%. As of December 31, 2005, the Bank’s ratio of Tier 1 capital
to average total assets (leverage ratio) was 7.67%.

Corrective Measures for Capital Deficiencies. The federal banking regulators are required to take “prompt corrective
action” with respect to capital-deficient institutions. Agency regulations define, for each capital category, the levels at which
institutions are “well-capitalized,” “adequately capitalized,” “under capitalized,” “significantly under capitalized” and
“critically under capitalized.” A “well-capitalized” bank has a total risk-based capital ratio of 10.0% or higher; a Tier 1 risk-
based capital ratio of 6.0% or higher; a leverage ratio of 5.0% or higher; and is not subject to any written agreement, order or
directive requiring it to maintain a specific capital level for any capital measure. An “adequately capitalized” bank has a total
risk-based capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or higher; a leverage ratio of 4.0% or
higher (3.0% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing
significant growth); and does not meet the criteria for a well capitalized bank. A bank is “under capitalized” if it fails to meet
any one of the ratios required to be adequately capitalized. The Bank is classified as “well-capitalized” for purposes of the
FDIC’s prompt corrective action regulations.

In addition to requiring undercapitalized institutions to submit a capital restoration plan, agency regulations contain

broad restrictions on certain activities of undercapitalized institutions including asset growth, acquisitions, branch
establishment and expansion into new lines of business. With certain exceptions, an insured depository institution is
prohibited from making capital distributions, including dividends, and is prohibited from paying management fees to control
persons if the institution would be undercapitalized after any such distribution or payment.

As an institution’s capital decreases, the FDIC’s enforcement powers become more severe. A significantly

undercapitalized institution is subject to mandated capital raising activities, restrictions on interest rates paid and transactions
with affiliates, removal of management and other restrictions. The FDIC has only very limited discretion in dealing with a
critically undercapitalized institution and is virtually required to appoint a receiver or conservator.

Banks with risk-based capital and leverage ratios below the required minimums may also be subject to certain
administrative actions, including the termination of deposit insurance upon notice and hearing, or a temporary suspension of
insurance without a hearing in the event the institution has no tangible capital.

Deposit Insurance Assessments. The Bank must pay assessments to the FDIC for federal deposit insurance protection.
The FDIC has adopted a risk-based assessment system as required by FDICIA. Under this system, FDIC-insured depository
institutions pay insurance premiums at rates based on their risk classification. Institutions assigned to higher risk
classifications (that is, institutions that pose a greater risk of loss to their respective deposit insurance funds) pay assessments
at higher rates than institutions that pose a lower risk. An institution’s risk classification is assigned based on its capital levels
and the level of supervisory concern the institution poses to the regulators. In addition, the FDIC can impose special
assessments in certain instances. The current range of BIF assessments is between 0% and 0.27% of deposits.

The FDIC established a process for raising or lowering all rates for insured institutions semi-annually if conditions

warrant a change. Under this system, the FDIC has the flexibility to adjust the assessment rate schedule twice a year without
seeking prior public comment, but only within a range of five cents per $100 above or below the premium schedule adopted.
Changes in the rate schedule outside the five cent range above or below the current schedule can be made by the FDIC only
after a full rulemaking with opportunity for public comment.

In addition to BIF assessments, banks insured under the BIF are required to pay a portion of the interest due on bonds

that were issued by the Financing Corporation (“FICO”) to help shore up the ailing Federal Savings and Loan Insurance
Corporation in 1987. With regard to the assessment for the FICO obligation, for the fourth quarter 2005, the BIF rate was
.00134% of deposits.

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 Community Reinvestment Act (“CRA”) and the regulations issued thereunder are

intended to encourage banks to help meet the credit needs of their service area, including low and moderate income
neighborhoods, consistent with the safe and sound operations of the banks. These regulations also provide for regulatory
assessment of a bank’s record in meeting the needs of its service area when considering applications to establish branches,
merger applications and applications to acquire the assets and assume the liabilities of another bank. FIRREA requires federal
banking agencies to make public a rating of a bank’s performance under the CRA. In the case of a bank holding company, the
CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application

to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An
unsatisfactory record can substantially delay or block the transaction.

Consumer Laws and Regulations. In addition to the laws and regulations discussed herein, the Bank is also subject to

certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set
forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the
Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, and the Fair Housing
Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which
financial institutions must deal with customers when taking deposits or making loans to such customers. The Bank must
comply with the applicable provisions of these consumer protection laws and regulations as part of their ongoing customer
relations.

The USA PATRIOT Act of 2001. The Uniting and Strengthening America by Providing Appropriate Tools Required to

Intercept and Obstruct Terrorism Act of 2001 (“USA PATRIOT Act”) was enacted in October 2001. The USA PATRIOT
Act is intended to strengthen U.S. law enforcement’s and the intelligence communities’ ability to work cohesively to combat
terrorism on a variety of fronts. The potential impact of the USA PATRIOT Act on financial institutions of all kinds is
significant and wide ranging. The USA PATRIOT Act contains sweeping anti-money laundering and financial transparency
laws and requires various regulations, including: (i) due diligence requirements for financial institutions that administer,
maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons; (ii) standards for verifying
customer identification at account opening; (iii) rules to promote cooperation among financial institutions, regulators and law
enforcement entities in identifying parties that may be involved in terrorism or money laundering; (iv) reports by
nonfinancial trades and business filed with the Treasury Department’s Financial Crimes Enforcement Network for
transactions exceeding $10,000; and (v) filing of suspicious activities reports involving securities by brokers and dealers if
they believe a customer may be violating U.S. laws and regulations.

Privacy. In addition to expanding the activities in which banks and bank holding companies may engage, the Gramm-

Leach-Bliley Act also imposed new requirements on financial institutions with respect to customer privacy. The Gramm-
Leach-Bliley Act generally prohibits disclosure of customer information to non-affiliated third parties unless the customer
has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required to
disclose their privacy policies to customers annually. Financial institutions, however, will be required to comply with state
law if it is more protective of customer privacy than the Gramm-Leach-Bliley Act.

Legislative Initiatives

From time to time, various legislative and regulatory initiatives are introduced in Congress. Such initiatives 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 any potential legislation, if enacted, or
implementing regulations with respect thereto, would have, upon the financial condition or results of operations of the
Company or its subsidiaries. A change in statutes, regulations or regulatory policies applicable to the Company or any of its
subsidiaries could have a material effect on the financial condition, results of operations or business of the Company and its
subsidiaries.

Enforcement Powers of Federal and State Banking Agencies

The 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 the Bank and their subsidiaries, as
well as officers, directors, and other institution-affiliated parties of these organizations, to administrative sanctions and
potentially substantial civil money penalties. In addition to the grounds discussed above under “—The Bank—Corrective
Measures for Capital Deficiencies,” 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 Department of Banking 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.

Effect on Economic Environment

The policies of regulatory authorities, including the monetary policy of the Federal Reserve Board, have a significant
effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the Federal
Reserve Board to affect the money supply are open market operations in U.S. government securities, changes in the discount
rate on member bank borrowings, and changes in reserve requirements against member bank deposits. These means are used
in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use
may affect interest rates charged on loans or paid for deposits.

Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past

and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on
the business and earnings of the Company and its subsidiaries cannot be predicted.

ITEM 1A. RISK FACTORS

An investment in the Company’s Common Stock involves risks. The following is a description of the material risks and

uncertainties that the Company believes affect its business and an investment in the Common Stock. Additional risks and
uncertainties that the Company is unaware of, or that it deems immaterial, also may become important factors that affect the
Company and its business. If any of the risks described in this annual report on Form 10-K were to occur, the Company’s
financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of
the Common Stock could decline significantly and you could lose all or part of your investment.

Risks Associated with the Company’s Business
If the Company is not able to continue its historical levels of growth, it may not be able to maintain its historical earnings
trends.

To achieve its past levels of growth, the Company has initiated internal growth programs and completed a number of
acquisitions. The Company may not be able to sustain its historical rate of growth or may not even be able to grow at all. In
addition, Prosperity may not be able to obtain the financing necessary to fund additional growth and may not be able to find
suitable candidates for acquisition. Various factors, such as economic conditions and competition, may impede or prohibit the
opening of new banking centers. Further, the Company may be unable to attract and retain experienced bankers, which could
adversely affect its internal growth. If the Company is not able to continue its historical levels of growth, it may not be able
to maintain its historical earnings trends.

If the Company is unable to manage its growth effectively, its operations could be negatively affected.

Companies that experience rapid growth face various risks and difficulties, including:
•

•

finding suitable markets for expansion;
finding suitable candidates for acquisition;
attracting funding to support additional growth;

•
• maintaining asset quality;
•
• maintaining adequate regulatory capital.

attracting and retaining qualified management; and

In addition, in order to manage its growth and maintain adequate information and reporting systems within its
organization, the Company must identify, hire and retain additional qualified employees, particularly in the accounting and
operational areas of its business.

If the Company does not manage its growth effectively, its business, financial condition, results of operations and

future prospects could be negatively affected, and the Company may not be able to continue to implement its business
strategy and successfully conduct its operations.

If the Company is unable to identify and acquire other financial institutions and successfully integrate its acquired
businesses, its business and earnings may be negatively affected.

The market for acquisitions remains highly competitive, and the Company may be unable to find acquisition candidates

in the future that fit its acquisition and growth strategy. To the extent that the Company is unable to find suitable acquisition
candidates, an important component of its growth strategy may be lost.

Acquisitions of financial institutions involve operational risks and uncertainties and acquired companies may have
unforeseen liabilities, exposure to asset quality problems, key employee and customer retention problems and other problems
that could negatively affect the Company’s organization. The Company may not be able to complete future acquisitions and,
if completed, the Company may not be able to successfully integrate the operations, management, products and services of
the entities that it acquires and eliminate redundancies. The integration process may also require significant time and
attention from the Company’s management that they would otherwise direct at servicing existing business and developing
new business. The Company’s failure to successfully integrate the entities it acquires into its existing operations may increase
its operating costs significantly and adversely affect its business and earnings.

The Company’s business is subject to interest rate risk and fluctuations in interest rates may adversely affect its earnings
and capital levels.

The majority of the Company’s assets are monetary in nature and, as a result, the Company is subject to significant risk

from changes in interest rates. Changes in interest rates can impact the Company’s net interest income as well as the
valuation of its assets and liabilities. The Company’s earnings are significantly dependent on its net interest income. Net
interest income is the difference between the interest income earned on loans, investments and other interest-earning assets
and the interest expense paid on deposits, borrowings and other interest-bearing liabilities. Therefore, any change in general
market interest rates, such as a change in the monetary policy of the Federal Reserve or otherwise, can have a significant
effect on the Company’s net interest income. The Company’s assets and liabilities may react differently to changes in overall
market rates or conditions because there may be mismatches between the repricing or maturity characteristics of the assets
and liabilities.

The Company’s profitability depends significantly on local economic conditions.

The Company’s success depends primarily on the general economic conditions of the geographic markets in which it

operates. Unlike larger banks that are more geographically diversified, the Company provides banking and financial services
to customers primarily in Houston, Dallas, Austin, Corpus Christi and surrounding areas and in the south and southeast areas
of Texas. The local economic conditions in these areas have a significant impact on the Company’s commercial, real estate
and construction loans, the ability of its borrowers to repay their loans and the value of the collateral securing these loans. A
significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or
other international or domestic calamities, unemployment or other factors could impact these local economic conditions and
negatively affect the Company’s financial results.

The Company’s allowance for credit losses may not be sufficient to cover actual credit losses, which could adversely affect
its earnings.

As a lender, the Company is exposed to the risk that its loan customers may not repay their loans according to the terms
of these loans and the collateral securing the payment of these loans may be insufficient to fully compensate the Company for
the outstanding balance of the loan plus the costs to dispose of the collateral. The Company may experience significant loan
losses which could have a material adverse effect on its operating results and financial condition. Management makes various
assumptions and judgments about the collectibility of the Company’s loan portfolio, including the diversification by industry
of its commercial loan portfolio, the amount of nonperforming loans and related collateral, the volume, growth and
composition of its loan portfolio, the effects on the loan portfolio of current economic indicators and their probable impact on
borrowers and the evaluation of its loan portfolio through its internal loan review process and other relevant factors.

The Company maintains an allowance for credit losses in an attempt to cover credit losses inherent in its loan portfolio.

Additional credit losses will likely occur in the future and may occur at a rate greater than the Company has experienced to
date. In determining the size of the allowance, the Company relies on an analysis of its loan portfolio, its experience and its
evaluation of general economic conditions. If the Company’s assumptions prove to be incorrect, its current allowance may
not be sufficient and adjustments may be necessary to allow for different economic conditions or adverse developments in its
loan portfolio. Material additions to the allowance would materially decrease net income.

In addition, federal and state regulators periodically review the Company’s allowance for credit losses and may require

the Company to increase its provision for credit losses or recognize further charge-offs, based on judgments different than
those of the Company’s management. Any increase in the Company’s allowance for credit losses or charge-offs as required
by these regulatory agencies could have a material adverse effect on the Company’s operating results and financial condition.

The Company’s small to medium-sized business target market may have fewer financial resources to weather a downturn
in the economy.

The Company targets its business development and marketing strategy primarily to serve the banking and financial

services needs of small to medium-sized businesses. These small to medium-sized businesses generally have fewer financial
resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact the
southeast Texas area or the other markets in which the Company operates, the Company’s results of operations and financial
condition may be negatively affected.

An interruption in or breach in security of the Company’s information systems may result in a loss of customer business.
The Company relies heavily on communications and information systems to conduct its business. Any failure or

interruption or breach in security of these systems could result in failures or disruptions in the Company’s customer
relationship management, general ledger, deposits, servicing or loan origination systems. Such interruptions may occur and
may not be adequately addressed by the Company. The occurrence of any failures or interruptions could result in a loss of
customer business and have a negative effect on the Company’s results of operations and financial condition.

The business of the Company is dependent on technology and its inability to invest in technological improvements may
adversely affect its results of operations and financial condition.

The financial services industry is undergoing rapid technological changes with frequent introductions of new
technology driven products and services. In addition to better serving customers, the effective use of technology increases
efficiency and enables financial institutions to reduce costs. The Company’s future success will depend in part upon its
ability to address the needs of its customers by using technology to provide products and services that will satisfy customer
demands for convenience as well as create additional efficiencies in our operations. Many of the Company’s competitors
have substantially greater resources to invest in technological improvements. The Company may not be able to effectively
implement new technology driven products and services or be successful in marketing these products and services to its
customers which may negatively affect the Company’s results of operations and financial condition.

The Company operates in a highly regulated environment and, as a result, is subject to extensive regulation and
supervision that could adversely affect its financial performance, and the Company may be adversely affected by changes
in federal and local laws and regulations.

The Company is subject to extensive regulation, supervision and examination by federal and state banking authorities.

Any change in applicable regulations or federal or state legislation could have a substantial impact on the Company, its
subsidiary bank, and their respective operations. Additional legislation and regulations may be enacted or adopted in the
future that could significantly affect the Company’s powers, authority and operations, or the powers, authority and operations
of the Bank, which could have a material adverse effect on the Company’s financial condition and results of operations.
Further, regulators have significant discretion and power to prevent or remedy unsafe or unsound practices or violations of
laws by banks and bank holding companies in the performance of their supervisory and enforcement duties. The exercise of
this regulatory discretion and power may have a negative impact on the Company.

Risks Associated with the Company’s Common Stock
The Company’s corporate organizational documents and the provisions of Texas law to which it is subject may delay or
prevent a change in control of the Company that you may favor.

The Company’s amended and restated articles of incorporation and amended and restated bylaws contain various

provisions which may delay, discourage or prevent an attempted acquisition or change of control of the Company. These
provisions include:

•

a board of directors classified into three classes of directors with the directors, of each class having staggered,
three year terms;
a provision that any special meeting of the Company’s shareholders may be called only by the chairman of the
board, the president and chief executive officer, a majority of the board of directors or the holders of at least 50%
of the Company’s shares entitled to vote at the meeting;

•

a provision establishing certain advance notice procedures for nomination of candidates for election as directors
and for shareholder proposals to be considered at an annual or special meeting of shareholders; and
a provision that denies shareholders the right to amend the Company’s bylaws.

The Company’s articles of incorporation provide for noncumulative voting for directors and authorize the board of
directors to issue shares of its preferred stock without shareholder approval and upon such terms as the board of directors
may determine. The issuance of the Company’s preferred stock could have the effect of making it more difficult for a third
party to acquire, or of discouraging a third party from acquiring, a controlling interest in the Company. In addition, certain
provisions of Texas law, including a provision which restricts certain business combinations between a Texas corporation
and certain affiliated shareholders, may delay, discourage or prevent an attempted acquisition or change in control of the
Company.

The holders of the Company’s junior subordinated debentures have rights that are senior to those of the Company’s
shareholders.

As of December 31, 2005, the Company had $75.8 million in junior subordinated debentures outstanding that were

issued to the Company’s subsidiary trusts. The subsidiary trusts purchased the junior subordinated debentures from the
Company using the proceeds from the sale of trust preferred securities to third party investors. Payments of the principal and
interest on the trust preferred securities are conditionally guaranteed by the Company to the extent not paid or made by each
trust, provided the trust has funds available for such obligations.

The junior subordinated debentures are senior to the Company’s shares of Common Stock. As a result, the Company
must make payments on the junior subordinated debentures (and the related trust preferred securities) before any dividends
can be paid on its Common Stock and, in the event of the Company’s bankruptcy, dissolution or liquidation, the holders of
the debentures must be satisfied before any distributions can be made to the holders of the Common Stock. The Company
had the right to defer distributions on the junior subordinated debentures (and the related trust preferred securities) for up to
five years, during which time no dividends may be paid to holders of the Company’s Common Stock.

Risks Related to the Company’s Acquisition of SNB Bancshares, Inc.
There may be undiscovered risks or losses associated with the SNB Bancshares acquisition.

As a result of the pending acquisition of SNB Bancshares, Inc., the Company will acquire all of the assets and
liabilities of SNB Bancshares, including, without limitation, its loan portfolio. The Company has not previously owned or
operated SNB Bancshares and it does not have any detailed working experience related to its business and operations. There
may be instances when the Company, under its normal operating procedures, may find after the acquisition, that there may be
additional losses or undisclosed liabilities with respect to the assets and liabilities of SNB Bancshares, and, with respect to its
loan portfolio, that the ability of a borrower to repay a loan may have become impaired, the quality of the value of the
collateral securing a loan may fall below the Company’s standards or the allowance for credit losses may not be adequate.
One or more of these factors might cause the Company to have additional losses or liabilities, additional loan charge-offs or
increases in allowances for credit losses, which could have a negative impact upon its future income.

The Company may not be able to successfully consummate the acquisition of SNB Bancshares. Even if the acquisition is
consummated, the Company may not be able to integrate SNB Bancshares’ operations with its business efficiently.

While the Company has entered into a definitive agreement to acquire all of the capital stock of SNB Bancshares, there
are a number of conditions to completing the acquisition, and there can be no assurance that those conditions will be satisfied.
Even if the acquisition is consummated, it will create risks associated with the integration of SNB Bancshares’ operations
with the Company’s, including, without limitation, the loss of key employees and customers, the disruption of ongoing
businesses and possible inconsistencies in standards, controls and procedures.

The Company may not realize the benefits from the SNB Bancshares acquisition that it anticipates, or it may not be

able to integrate SNB Bancshares’ operations successfully. If the Company fails to integrate the operations of SNB
Bancshares efficiently, it could have a material adverse effect on the Company’s business, financial condition, results of
operation and future prospects.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

As of December 31, 2005, the Company conducted business at 85 full-service banking centers. The Company’s
headquarters are located at Prosperity Bank Plaza, 4295 San Felipe, in the Galleria area in Houston, Texas. The Company
owns all of the buildings in which its banking centers are located other than those listed below. The expiration dates of the
leases for the banking centers listed below do not include optional renewal periods which may be available.

Banking Center
Houston CMSA:

Bellaire ....................................
City West.................................
Copperfield..............................
Downtown...............................
Fairfield...................................
Galveston ................................
Gladebrook..............................
Heights ....................................
Holcombe ................................
Medical Center ........................
Midtown ..................................
Post Oak ..................................
River Oaks...............................
Waugh Drive ...........................
Westheimer .............................

South Texas Area:

Gonzales..................................

Dallas, Texas Area:

Abrams Centre ........................
Preston Road ...........................

Corpus Christi, Texas Area:

Airline .....................................
Alameda ..................................
Aransas Pass............................
Carmel.....................................
Port Aransas ............................
Portland ...................................
Waterstreet ..............................
Woodlawn ...............................

Congress..................................
Congress Drive-thru ................
Oak Hill...................................
Riverside .................................

Austin, Texas Area:

East Texas Area:
None

Expiration Date of Lease

October 2007
January 2009
July 2006
October 2012
May 2008
November 2010
October 2010
January 2008
July 2009
March 2010
January 2007
June 2007
December 2009
February 2011
May 2011

November 2006

December 2008
September 2013

August 2008
March 2008
March 2011
January 2009
February 2007
December 2006
November 2015
April 2007

August 2014
April 2009
May 2007
July 2018

The following table sets forth specific information on each of the Company’s geographical market areas:

Geographical Area

Houston CMSA ..............................................
South Texas area.............................................
Dallas, Texas area...........................................
Corpus Christi, Texas area..............................
Austin, Texas area ..........................................
East Texas area ...............................................
Total................................................................

Number of Banking Centers

Deposits at December 31, 2005
(Dollars in thousands)

33 $
17
11
16
6
2

85 $

1,176,639
784,807
372,439
330,477
208,625
47,331

2,920,318

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 the Company’s security holders during the fourth quarter of 2005.

PART II.

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND

ISSUER PURCHASES OF EQUITY SECURITIES

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 March 1, 2006, there were 27,864,894 shares outstanding and 876 shareholders of record.
The number of beneficial owners is unknown to the Company at this time.

The following table presents the high and low intra-day sales prices for the Common Stock as reported on the Nasdaq

National Market during the two years ended December 31, 2005:

2005

Fourth Quarter ..........................................................................................
Third Quarter ............................................................................................
Second Quarter .........................................................................................
First Quarter..............................................................................................

2004

High
32.12 $
31.45
28.97
29.32

High
29.53 $
27.75
24.60
25.15

Low
27.97
28.14
25.05
25.50

Low
26.09
23.23
21.89
22.30

Dividends

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 $0.3475 per share in 2005 and $0.3075 per share in 2004, there is no
assurance that the Company will continue to pay dividends in the future. Future dividends on the Common Stock will depend
upon the Company’s earnings and financial condition, liquidity and capital requirements, the general economic and
regulatory climate, the Company’s ability to service any equity or debt obligations senior to the Common Stock and other
factors deemed relevant by the board of directors of the Company.

As a holding company, the Company is ultimately dependent upon its subsidiaries to provide funding for its operating
expenses, debt service and dividends. Various banking laws applicable to the Bank limit the payment of dividends and other
distributions by the Bank to the Company, and may therefore limit the Company’s ability to pay dividends on its Common
Stock. If required payments on the Company’s outstanding junior subordinated debentures held by its unconsolidated

subsidiary trusts are not made or suspended, the Company will be prohibited from paying dividends on its Common Stock.
Regulatory authorities could impose administratively stricter limitations on the ability of the Bank to pay dividends to the
Company if such limits were deemed appropriate to preserve certain capital adequacy requirements.

The cash dividends declared per share by quarter (and paid on the first business day of the subsequent quarter) for the

Company’s last two fiscal years were as follows:

Fourth quarter .......................................................................................
Third quarter .........................................................................................
Second quarter ......................................................................................
First quarter...........................................................................................

2005
0.1000 $
0.0825
0.0825
0.0825

2004
0.0825
0.0750
0.0750
0.0750

Recent Sales of Unregistered Securities

None.

Securities Authorized for Issuance under Equity Compensation Plans

As of December 31, 2005, the Company had outstanding stock options granted under three stock option plans, all of

which were approved by the Company’s shareholders. As of such date, the Company also had outstanding stock options
granted under stock option plans that it assumed in connection with various acquisition transactions. The following table
provides information as of December 31, 2005 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..............................................................
Total ............................................................

Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
(a)

Weighted-average
exercise price of
outstanding options
(b)

Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in
column (a))
(c)

1,168,667(1) $

—

1,168,667

21.58

—

21.58

1,236,083

—

1,236,083

(1)

Includes (a) 4,240 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 $11.50,
(b) 31,127 shares which may be issued upon exercise of options outstanding assumed by the Company in connection
with the acquisition of MainBancorp, Inc. at a weighted average exercise price of $16.26 and (c) 207,800 shares which
may be issued upon exercise of options outstanding assumed by the Company in connection with the acquisition of
First Capital Bankers, Inc. at a weighted average exercise price of $18.38.

Issuer Purchases of Equity Securities

None.

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, 2005 are derived from and should be read in conjunction with the Company’s consolidated financial
statements and the notes thereto. The historical consolidated 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 for
2002 and 2001 has been restated to give effect to 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(3):
Basic earnings per share............................... $
Diluted earnings per share............................
Book value per share ....................................
Cash dividends declared...............................
Dividend payout ratio...................................
Weighted average shares outstanding

(basic) (in thousands). .............................

Weighted average shares outstanding

(diluted) (in thousands)............................

Shares outstanding at end of period (in

thousands)................................................

2005(1)

As of and for the Years Ended December 31,
2004
2002
2003
(Dollars in thousands, except per share data)

162,123
51,226
110,897
480

$ 111,756
29,789
81,967
880

110,417
30,021
68,957
71,481
23,621
47,860

81,087
23,071
51,707
52,451
17,744
34,707

90,845
26,346
64,499
483

64,016
16,966
42,021
38,961
12,413
26,548

80,742
28,101
52,641
1,010

51,631
11,594
32,349
30,876
9,555
21,321

2001

76,520
37,410
39,110
700

38,410
8,635
28,715(2)

18,330(2)
5,372(2)

12,958(2)

1.79
1.77
16.69
0.35
20.11%

1.61
1.59
12.32
0.31
19.22%

1.38
1.36
10.49
0.25
18.29%

1.25
1.22
8.19
0.22
18.13%

26,706

27,024

27,821

21,534

21,804

22,381

19,225

19,536

20,930

17,122

17,442

18,896

0.80(4)
0.79(4)
5.47
0.195
24.39%

16,172

16,498

16,210

Balance Sheet Data (at period end):
Total assets ................................................... $ 3,585,982
1,572,602
Securities ......................................................
1,542,125
Loans............................................................
17,203
Allowance for credit losses ..........................
284,425
Total goodwill and intangibles .....................
2,920,318
Total deposits ...............................................
102,389
Borrowings and notes payable. ....................
464,717
Total shareholders’ equity............................
75,775(5)
Junior subordinated debentures ....................

Average Balance Sheet Data:
Total assets ................................................... $ 3,361,617
1,471,067
Securities ......................................................
1,435,376
Loans............................................................
16,334
Allowance for credit losses ..........................
253,703
Total goodwill and intangibles .....................
2,791,813
Total deposits ...............................................
413,864
Total shareholders’ equity............................
69,869(5)
Junior subordinated debentures ....................

$ 2,697,228
1,302,792
1,035,513
13,105
164,672
2,317,076
38,174
275,647
47,424

$ 2,400,487
1,376,880
770,053
10,345
124,755
2,083,748
30,936
219,588
59,804

$ 1,823,286
950,317
679,559
9,580
72,410
1,586,611
37,939
154,739
34,030

$ 1,263,169
752,322
424,400
5,985
22,641
1,123,397
18,080
88,725
27,844

$ 2,543,088
1,383,790
871,736
11,454
139,405
2,189,695
243,274
59,288

$ 2,006,869
1,108,153
697,235
9,525
81,485
1,749,045
170,167
39,400

$ 1,470,758
818,362
524,885
7,350
38,531
1,300,884
114,234
29,648

$ 1,191,783
666,241
419,553
5,586
22,807
1,061,195
85,319
19,468

(Table continued on next page)

Performance Ratios:
Return on average assets.............................................
Return on average equity ............................................
Net interest margin (not tax equivalent) .....................
Efficiency ratio(7).........................................................

Asset Quality Ratios(8):
Nonperforming assets to total loans and other real

estate. .....................................................................
Net charge-offs 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 ......................................

2005(1)

As of and for the Years Ended December 31,
2004
2003
(Dollars in thousands, except per share data)

2002

2001

1.42%
11.56
3.76
48.91

1.36%
14.27
3.56
49.23

1.32%
15.60
3.52
51.58

1.45%
18.66
3.86
50.36

1.09%(6)
15.19(6)
3.50
60.14(6)

0.09%
0.03
1.12
1,505.1

0.17%
0.06
1.27
949.6

0.13%
0.23
1. 34
1,519.1

0.38%
0.08
1.41
408.53

7.83%
12.31
15.34
16.37

6.30%
9.57
13.56
14.67

7.10%
8.48
15.82
16.90

6.56%
7.77
14.10
15.30

0.00%
0.06
1.41
n/m(10)

7.57%
7.16
18.34
19.52

(1) The Company completed the acquisition of First Capital Bankers, Inc. on March 1, 2005 and Grapeland Bancshares, Inc.

on December 1, 2005.

(2) Certain income statement data for the year ended December 31, 2001 includes merger-related expenses of $2.4 million,

net of tax, incurred in connection with the Commercial Bancshares merger.

(3) Adjusted for a two-for-one stock split effective May 31, 2002.
(4) Earnings per share amounts for the year ended December 31, 2001 include merger-related expenses of $2.4 million.
(5) Consists of $15.5 million of junior subordinated debentures of Prosperity Statutory Trust II due July 31, 2031, $6.2

million of junior subordinated debentures of Paradigm Capital Trust II due February 20, 2031 (assumed by the Company
on September 1, 2002), $12.9 million of junior subordinated debentures of Prosperity Statutory Trust III due
September 17, 2033, $12.9 million of junior subordinated debentures of Prosperity Statutory Trust IV due December 30,
2033, $20.6 million of junior subordinated debentures of First Capital Statutory Trust I due March 26, 2032 (assumed by
the Company on March 1, 2005) and $7.7 million of junior subordinated debentures of First Capital Statutory Trust II
due September 26, 2032 (assumed by the Company on March 1, 2005).

(6) Selected performance ratios for the year ended December 31, 2001 include merger-related expenses of $2.4 million.
(7) Calculated by dividing total noninterest expense, excluding securities losses and credit loss provisions, by net interest
income plus noninterest income, excluding securities gains. Additionally, taxes are not part of this calculation.

(8) At period end, except for net 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.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF

OPERATIONS

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.

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements

of the Company’s balance sheets and statements of income. This section should be read in conjunction with the Company’s
consolidated financial statements and accompanying notes and other detailed information appearing elsewhere in this Annual
Report on Form 10-K. The Commercial merger was accounted for as a pooling of interests and therefore the historical
financial data of the Company has been restated to include the accounts and operations of Commercial for all periods prior to
February 23, 2001.

For the Years Ended December 31, 2005, 2004 and 2003

Overview

The Company generates the majority of its revenues from interest income on loans, service charges on customer
accounts and income from investment in securities. The revenues are partially offset by interest expense paid on deposits and
other borrowings and non-interest expenses such as administrative and occupancy expenses. Net interest income is the
difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as
deposits and borrowings which are used to fund those assets. Interest income is the Company’s largest source of revenue,
representing 57.7% of total revenue during 2005. The level of interest rates and the volume and mix of earning assets and
interest-bearing liabilities impact net interest income and margin. The Company has recognized increased net interest income
due primarily to an increase in the volume of interest-earning assets.

Three principal components of the Company’s growth strategy are internal growth, stringent cost control practices and

strategic merger transactions. The Company focuses on continual internal growth. Each banking center is operated as a
separate profit center, maintaining separate data with respect to its 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. The Company also focuses on maintaining 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 processing. Management believes that this centralized infrastructure can accommodate substantial
additional growth while enabling the Company to minimize operational costs through certain economies of scale. The
Company also intends to continue to seek expansion opportunities. During 2003, eleven banking centers were acquired in the
Dallas/Fort Worth area. The acquisitions of Abrams and Dallas Bancshares were completed in May and June 2003,
respectively, adding three banking centers in Dallas. The mergers with MainBancorp and FSBNT were completed in
November and December 2003, respectively, adding an additional eight banking centers in Dallas. As a part of these
acquisitions, two of the acquired banking centers were combined into existing banking centers nearby bringing the total to
nine banking centers added in 2003. During 2004, seven banking centers were acquired in the Austin, Texas area, one of
which was subsequently closed and consolidated into an existing banking center of the Company. The acquisitions of both
Liberty Bancshares, Inc. (the “Liberty acquisition”) and Village Bank and Trust s.s.b. (the “Village acquisition”) were
completed on August 1, 2004. During 2005, twenty seven (27) banking centers were acquired in the First Capital acquisition
on March 1, 2005 and two (2) additional banking centers were acquired in the Grapeland acquisition on December 1, 2005.

Net income was $47.9 million, $34.7 million and $26.5 million for the years ended December 31, 2005, 2004 and
2003, respectively, and diluted earnings per share were $1.77, $1.59 and $1.36, respectively, for these same periods. Earnings
growth during both 2005 and 2004 resulted principally from an increase in loan volume and acquisitions, including the
Liberty and Village acquisitions in August 2004 and the First Capital acquisition in March 2005. Earnings growth during
both 2004 and 2003 also resulted principally from an increase in loan volume and acquisitions, including the Abrams, Dallas
Bancshares, MainBancorp, FSBNT, Liberty and Village acquisitions. The Company posted returns on average assets of
1.42%, 1.36% and 1.32% and returns on average equity of 11.56%, 14.27% and 15.60% for the years ended December 31,
2005, 2004 and 2003, respectively. The Company’s efficiency ratio was 48.91% in 2005, 49.23% in 2004 and 51.58% in
2003.

Total assets at December 31, 2005 and 2004 were $3.586 billion and $2.697 billion, respectively. Total deposits at

December 31, 2005 and 2004 were $2.920 billion and $2.317 billion, respectively, with deposit growth in each period
resulting from acquisitions and internal growth. Total loans were $1.542 billion at December 31, 2005, an increase of $506.6
million or 48.9% compared with $1.036 billion at December 31, 2004. At December 31, 2005, the Company had $1.1 million
in nonperforming loans and its allowance for credit losses was $17.2 million. Shareholders’ equity was $464.7 million and
$275.6 million at December 31, 2005 and 2004, respectively.

Critical Accounting Policies

The Company’s significant accounting policies are integral to understanding the results reported. The Company’s
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. Portions of
the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in
management’s judgment, should be charged off. Charge-offs occur when loans are deemed to be uncollectible. The allowance
for credit losses includes allowance allocations calculated in accordance with Statement of Financial Accounting Standards
(SFAS) No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS 118, and allowance allocations
determined in accordance with SFAS No. 5, Accounting for Contingencies.

Goodwill—Goodwill and intangible assets that have indefinite useful lives are subject to at least an annual impairment

test and more frequently if circumstances indicate their value may not be recoverable. Goodwill is tested for impairment
using a two-step process that begins with an estimation of the fair value of each of the Company’s reporting units compared
with its carrying value. If the carrying amount exceeds the fair value of a reporting unit, a second step test is completed
comparing the implied fair value of the reporting unit’s goodwill to its carrying value to measure the amount of impairment.
Intangible assets that are not amortized will be tested for impairment at least annually by comparing the fair values of those
assets to their carrying values. Other identifiable intangible assets that are subject to amortization are amortized on an
accelerated basis over the years expected to be benefited, which the Company believes is 8 years. These amortizable
intangible assets are reviewed for impairment if circumstances indicate their value may not be recoverable based on a
comparison of fair value to carrying value. Based on the Company’s annual goodwill impairment test as of September 30,
2005, management does not believe any of its goodwill is impaired as of December 31, 2005. While the Company believes
no impairment existed at December 31, 2005 under accounting standards applicable at that date, different conditions or
assumptions, or changes in cash flows or profitability, if significantly negative or unfavorable, could have a material adverse
effect on the outcome of the Company’s impairment evaluation and financial condition or future results of operations.

Stock-based Compensation—The Company adopted the provisions of SFAS No. 123R “Share-Based Payment

(Revised 2004),” on January 1, 2006. The Company had previously adopted SFAS No. 123 on January 1, 2003. Among other
things, SFAS No. 123R eliminates the ability to account for stock-based compensation using the intrinsic value based method
of accounting and requires that such transactions be recognized as compensation expense in the income statement based on
their fair values on the date of the grant. SFAS No. 123R requires that management make assumptions including stock price
volatility and employee turnover that are utilized to measure compensation expense. The fair value of stock options granted is
estimated at the date of grant using the Black-Scholes option-pricing model. This model requires the input of highly
subjective assumptions.

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.”

The Company adopted FIN 46R, “Consolidation of Variable Interest Entities” on January 1, 2004. FIN 46R requires

that Prosperity Statutory Trust II, Prosperity Statutory Trust III, Prosperity Statutory Trust IV, Paradigm Capital Trust II
(fully redeemed on February 28, 2006), First Capital Statutory Trust I and First Capital Statutory Trust II be deconsolidated
from the consolidated financial statements. Accordingly, the trust preferred securities issued by each of the foregoing trusts
are no longer shown in the consolidated financial statements. Instead, the junior subordinated debentures issued by the
Company to each of these trusts are shown as liabilities in the consolidated balance sheets and interest expense associated
with such junior subordinated debentures is shown as interest expense in the consolidated statements of income. The dividend
expense associated with the trust preferred securities for the year ended December 31, 2003 was previously shown as
noninterest expense. Prior period data has been restated to reflect the adoption of FIN 46R.

2005 versus 2004. Net interest income before the provision for credit losses for the year ended December 31, 2005 was

$110.9 million compared with $82.0 million for the year ended December 31, 2004, an increase of $28.9 million or 35.3%.
The improvement in net interest income for 2005 was principally due to an increase in average interest-earning assets to
$2.949 billion at December 31, 2005 from $2.302 billion at December 31 2004, an increase of $647.7 million or 28.1%. The
increase in average interest-earning assets was primarily due to the First Capital acquisition. The improvement in net interest
income for 2005 was also partially due to an increase in the yield on interest-earning assets that was greater than the increase
in the rate paid on interest-bearing liabilities. Total cost of interest-bearing liabilities increased 57 basis points from 1.64%

for the year ended December 31, 2004 to 2.21% for the year ended December 31, 2005, while total yield on interest-earning
assets increased 64 basis points from 4.86% at December 31, 2004 to 5.50% at December 31, 2005. At December 31, 2005,
period end demand deposits represented an important component of funding sources and was 23.1% of total period end
deposits compared with 22.4% at December 31, 2004.

Net interest margin (not on a tax equivalent basis), defined as net interest income divided by average interest-earning

assets, for 2005 was 3.76%, up 20 basis points from 3.56% in 2004. The increase in the net interest margin was primarily
attributable to an increase in interest-earning assets.

2004 versus 2003. Net interest income before the provision for credit losses for the year ended December 31, 2004 was

$82.0 million compared with $64.5 million for the year ended December 31, 2003, an increase of $17.5 million or 27.1%.
The improvement in net interest income for 2004 was principally due to an increase in average interest-earning assets to
$2.302 billion at December 31, 2004 from $1.830 billion at December 31 2003, an increase of $471.3 million or 25.8%. The
improvement in net interest income for 2004 was also partially due to a decrease in the rate paid on interest-bearing liabilities
that was greater than the decrease in the yield on interest-earning assets. Total cost of interest-bearing liabilities decreased 15
basis points from 1.79% for the year ended December 31, 2003 to 1.64% for the year ended December 31, 2004 while total
yield on interest-earning assets decreased 10 basis points from 4.96% at December 31, 2003 to 4.86% at December 31, 2004.
At December 31, 2004, period end demand deposits averaged 22.4% of total period end deposits in 2004 compared with
22.4% in 2003.

Net interest margin (not on a tax equivalent basis) for 2004 was 3.56%, up four basis points from 3.52% in 2003. The

increase in the net interest margin was primarily attributable to an increase in interest-earning assets.

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
Outstanding
Balance

2005
Interest
Earned/
Paid

Average
Yield/
Rate

Years Ended December 31,
2004
Interest
Earned/
Paid

Average
Outstanding
Balance

Average
Yield/
Rate

Average
Outstanding
Balance

2003
Interest
Earned/
Paid

Average
Yield/
Rate

Assets
Interest-earning assets:

Loans held for investment. $ 1,435,376 $ 99,958
Securities(1) ........................
60,866
Federal funds sold and
other temporary
investments .................

1,471,067

42,859

1,299

(Dollars in thousands)

6.96% $
4.14

871,736
1,383,790

$ 55,779
55,241

6.40% $
3.99

697,235 $ 46,686
1,108,153 43,911

6.70%
3.96

3.03

46,121

736

1.60

24,976

248

0.99

Total interest-

earning assets.

2,949,302 162,123

5.50%

2,301,647

111,756

4.86%

1,830,364 90,845

4.96%

Less allowance for credit
losses...........................

(16,334)

Total interest-

earning assets,
net of
allowance. ......
Noninterest-earning assets

2,932,968
428,649
Total assets ........... $ 3,361,617

(11,454)

(9,525)

2,290,193
252,895

$ 2,543,088

1,820,839
186,030
$ 2,006,869

Liabilities and shareholders’

equity

Interest-bearing liabilities:
Interest-bearing demand

deposits ....................... $

Savings and money

market accounts. .........
Certificates of deposit. ......
Junior subordinated

debentures ...................

Securities sold under
repurchase
agreements ..................
Other borrowings ..............

Total interest-
bearing
liabilities.........

Noninterest-bearing liabilities:

Noninterest-bearing

demand deposits..........
Other liabilities..................

Total liabilities......

Shareholders’ equity ................

Total liabilities

Net interest rate spread ............

Net interest income and

margin(2) ............................

Net interest income and

margin (tax-equivalent
basis)(3) ..............................

4,666

0.98% $

485,557

5,027

1.04% $

477,199 $
696,237
1,009,147
69,869

10,683
28,294

4,895

29,850
40,794

768
1,920

1.53
2.80

7.00

2.57
4.71

495,330
735,095

4,002
15,557

59,288

4,046

19,522
20,597

232
925

0.81
2.12

6.82

1.19
4.49

371,801 $ 4,187
406,333
3,502
616,353 14,944
39,400

2,630

11,053
27,771

134
949

1.13%

0.86
2.42

6.68

1.21
3.42

2,323,096

609,230
15,427
2,947,753
413,864

51,226

2.21%

1,815,389

29,789

1.64%

1,472,711 26,346

1.79%

473,713
10,712

2,299,814

243,274

354,558
9,433
1, 836,702
170,167

$ 2,543,088

$ 2,006,869

3.29%

3.21%

3.17%

and
shareholders’
equity.............. $ 3,361,617

$ 110,897

3.76%

$ 81,967

3.56%

$ 64,499

3.52%

$ 112,262

3.81%

$ 83,631

3.63%

$ 66,612

3.64%

(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, 2005, 2004 and 2003 and other applicable effective tax
rates.

The following table presents information regarding 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 changes in interest rates. For purposes of this table,
changes attributable to both rate and volume which cannot be segregated have been allocated to rate.

2005 vs. 2004

Increase
(Decrease)
Due to Change in

Volume

Rate

Years Ended December 31,

2004 vs. 2003

Increase
(Decrease)
Due to Change in

Total
(Dollars in thousands)

Volume

Rate

Total

8,114 $ 44,179 $ 11,684 $
10,922
2,141

5,625

(2,591) $
408

9,093
11,330

investments..........................................

(52)

615

563

210

278

488

39,497

10,870

50,367

22,816

(1,905)

20,911

Interest-earning assets:

Loans held for investment ........................ $ 36,065 $
Securities ..................................................
Federal funds sold and other temporary

3,484

Total increase (decrease) in interest
income........................................

Interest-bearing liabilities:

Interest-bearing demand deposits.............
Savings and money market accounts........
Certificates of deposit...............................
Junior subordinated debentures ................
Securities sold under repurchase

agreements...........................................
Other borrowings. ....................................

Total increase (decrease) in interest
expense ......................................

(87)
1,623
5,800
722

123
907

9,088

Increase (decrease) in net interest income ......... $ 30,409 $

Provision for Credit Losses

(274)
5,058
6,937
127

413
88

(361)
6,681
12,737
849

536
995

1,281
767
2,879
1,328

103
(245)

(441)
(267)
(2,266)
88

(5)
221

840
500
613
1,416

98
(24)

6,112
12,349
(1,479) $ 28,930 $ 16,703 $

21,437

(2,669)

3,443

765 $ 17,468

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, 2005
was $17.2 million, representing 1.12% of outstanding loans. The provision for credit losses for the year ended December 31,
2005 was $480,000 compared with $880,000 for the year ended December 31, 2004. In 2004, an additional $400,000
provision for credit losses was made in anticipation of increased charge-offs related to loans acquired in merger transactions
that year. Net charge-offs for the year ended December 31, 2005 were $410,000 compared with $485,000 in net charge-offs
for the year ended December 31, 2004. The provision for credit losses for the year ended December 31, 2004 was $880,000
compared with $483,000 for the year ended December 31, 2003. Net charge-offs for the year ended December 31, 2003 were
$1.6 million.

Noninterest Income

The Company’s primary sources of recurring noninterest income are service charges on deposit accounts and other

banking service related fees. Noninterest income does not include loan origination fees which are recognized over the life of
the related loan as an adjustment to yield using the interest method. Banking related service fees include check cashing fees,
official check fees, safe deposit box rent and currency handling fees. For the year ended December 31, 2005, noninterest
income totaled $30.0 million, an increase of $7.0 million or 30.1% compared with $23.1 million in 2004. 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 Liberty and Village acquisitions in the third quarter of 2004 and the First Capital acquisition
completed in March 2005. As of December 31, 2005, the two acquisitions in 2004 and the two acquisitions in 2005 added
approximately 46,500 deposit accounts and over 11,500 debit cards. Noninterest income for 2004 was $23.1 million, an

increase of $6.1 million or 36.0% compared with $17.0 million in 2003, resulting largely from an increase in service charges
due to the additional deposit accounts from the MainBancorp and FSBNT acquisitions in the fourth quarter of 2003 and the
Liberty and Village acquisitions completed in August 2004.

Brokered mortgage income increased $312,000 to $695,000 for the year ended December 31, 2005 compared with
$383,000 for the year ended December 31, 2004. The increase was primarily due to additional mortgage loan originations
resulting from the mortgage division of each of Liberty and Village that was acquired in August 2004 and a third mortgage
division of First Capital that was acquired in March 2005.

Income from leased assets and bank owned life insurance increased $895,000 and $397,000 for the year ended
December 31, 2005 compared with the year ended December 31, 2004, respectively. Both leased assets and bank owned life
insurance were acquired in the First Capital acquisition. The expiration dates of the leased assets range from 2009 to 2011
and the related depreciation expense for the leased assets was $630,000 for the year ended December 31, 2005.

The following table presents, for the periods indicated, the major categories of noninterest income:

Service charges on deposit accounts..................................................
Banking related service fees ..............................................................
Brokered mortgage income................................................................
Trust and investment income .............................................................
Income from leased assets .................................................................
Bank Owned Life Insurance income (BOLI).....................................
Gains on sales of assets (net) .............................................................
Net (loss) gain on sale of securities ...................................................
Gain on held for sale loans ................................................................
Other noninterest income...................................................................
Total noninterest income..........................................................

Years Ended December 31,
2004
(Dollars in thousands)
$

2005

24,985
1,133
695
274
895
397
72
(79)
173
1,476

2003

14,236
780
—
502
—
—
379
—
—
1,069

20,215
1,002
383
214
—
—
315(1)
78
74
790
23,071

30,021

16,966

(1)

Includes gains on the sale of TIB-The Independent BankersBank stock acquired in various acquisitions and a gain on
the sale of real property acquired in the Paradigm acquisition.

Noninterest Expense

For the year ended December 31, 2005, noninterest expense totaled $69.0 million, an increase of $17.3 million or

33.4% compared with $51.7 million for the same period in 2004. This increase was principally due to increases in salaries
and employee benefits, net occupancy and depreciation costs and core deposit intangibles amortization primarily as a result
of the First Capital acquisition. For the year ended December 31, 2004, noninterest expense totaled $51.7 million, an increase
of $9.7 million or 23.1% compared with $42.0 million for the same period in 2003. The increase was primarily attributable to
the additional general operating costs associated with the acquisitions completed in 2004 and the full year effect of the
acquisitions completed in 2003. These items and other changes in the various components of noninterest expense are
discussed in more detail below.

The following table presents, for the periods indicated, the major categories of noninterest expense:

Salaries and employee benefits(1) .......................................................
Non-staff expenses:

Net occupancy expense ............................................................
Depreciation expense ...............................................................
Data processing ........................................................................
Regulatory assessments and FDIC insurance...........................
Ad valorem and franchise taxes. ..............................................
Core deposit intangibles amortization ......................................
Communications expense(2) ......................................................
Other.........................................................................................
Total noninterest expense. ..............................................

2005

Years Ended December 31,
2004
(Dollars in thousands)
27,860 $

36,672 $

6,663
4,462
2,837
548
1,594
3,912
3,782
8,487

68,957 $

4,814
2,843
2,036
524
1,154
1,781
2,929
7,766
51,707 $

2003

22,422

4,492
2,535
2,128
427
851
818
2,528
5,820

42,021

(1) Salaries and employee benefits expense includes $619,000, $141,000 and $25,000 in 2005, 2004 and 2003

respectively, in compensation expense related to the granting of stock options.

(2) Communications expense includes telephone, data circuits, postage and courier expenses.

Salaries and Employee Benefits. Salaries and employee benefits increased $8.8 million to $36.7 million at
December 31, 2005 compared with $27.9 million at December 31, 2004 primarily due to increased staff added with the
Liberty and Village acquisitions in August 2004 and the First Capital acquisition in March 2005. The number of associates
employed by the Company increased from 653 at December 31, 2004 to 859 at December 31, 2005. Salaries and employee
benefits increased $5.4 million from $22.4 million at December 31, 2003 to $27.9 million at December 31, 2004 primarily
due to increased staff added with the MainBancorp and FSBNT acquisitions in fourth quarter 2003 and the Village and
Liberty acquisitions in 2004 and also partially attributable to annual merit increases. The number of associates employed by
the Company increased from 629 at December 31, 2003 to 653 at December 31, 2004. In accordance with the Company’s
adoption of SFAS 123, salaries and employee benefits expense for the year ended December 31, 2005 includes $619,000 in
compensation expense related to the granting of stock options compared with $141,000 and $25,000 recorded for the years
ended December 31, 2004 and 2003, respectively.

Net Occupancy and Depreciation Expenses. Net occupancy expense increased $1.8 million or 38.4% to $6.7 million

for the year ended December 31, 2005 compared with $4.8 million for the year ended December 31, 2004. Depreciation
expense increased $1.6 million to $4.5 million compared with $2.8 million for the same periods. Both increases were
primarily attributable to the addition of thirty-five (35) banking centers acquired in 2004 and 2005. Net occupancy expense
increased $322,000 or 7.2% to $4.8 million for the year ended December 31, 2004 compared with $4.5 million for the year
ended December 31, 2003. Depreciation expense increased $308,000 to $2.8 million compared with $2.5 million for the same
periods. Both increases were primarily attributable to the addition of six banking centers associated with the acquisitions
made in 2004 and an additional seven banking centers associated with the FSBNT and MainBancorp acquisitions in fourth
quarter 2003.

Communications Expense. Communications expense includes telephone, data circuits, postage and courier expenses.

Communications expense increased $853,000 or 29.1% from $2.9 million for the year December 31, 2004 to $3.8 million for
the same period in 2005. The increase was primarily associated with the addition of thirty-five banking centers acquired in
2004 and 2005. Communications expense was $2.9 million for the year ended December 31, 2004 compared with $2.5
million for the same period in 2003, an increase of $401,000 or 15.9%. The increase was primarily attributable to the addition
of six banking centers in 2004 and an additional seven banking centers associated with the FSBNT and MainBancorp
acquisitions in fourth quarter 2003.

Core Deposit Intangibles Amortization. Core deposit intangibles amortization increased $2.1 million or 119.7% from
$1.8 million for the year December 31, 2004 to $3.9 million for the same period in 2005. The increase was associated with
the addition of $21.4 million in core deposit intangible assets related to the acquisitions made in 2004 and 2005. Core deposit
intangibles amortization was $1.8 million for the year ended December 31, 2004 compared with $818,000 for the same
period in 2003, an increase of $963,000 or 117.7%. The increase was attributable to the addition of $4.7 million in core
deposit intangible assets related to the Abrams, Dallas Bancshares, MainBancorp and FSBNT acquisitions in 2003 and the

Liberty and Village acquisitions completed in August 2004. Core deposit intangibles are being amortized on an accelerated
basis over an eight year life.

Other Noninterest Expense. Other operating expenses increased $721,000 or 9.3% from $7.8 million at December 31,
2004 to $8.5 million for the year ended December 31, 2005. The increase was primarily attributable to additional operating
expenses related to the First Capital acquisition made in 2005. Other operating expenses of $7.8 million for the year ended
December 31, 2004 represented an increase of $1.9 million or 33.4% compared with $5.8 million in 2003. The increase was
primarily attributable to increased advertising costs and the additional general operating costs associated with the acquisition
of seven banking centers in 2004 and the Abrams, Dallas Bancshares, MainBancorp and FSBNT acquisitions in 2003.

Efficiency Ratio. The efficiency ratio is a supplemental financial measure utilized in management’s internal evaluation

of the Company and is not defined under generally accepted accounting principles. The efficiency ratio is calculated by
dividing total noninterest expense, excluding securities losses and credit loss provisions, by net interest income plus
noninterest income, excluding securities gains. Taxes are not part of this calculation. An increase in the efficiency ratio
indicates that more resources are being utilized to generate the same volume of income, while a decrease would indicate a
more efficient allocation of resources. The Company’s efficiency ratio was 48.91% at December 31, 2005, a decrease from
49.23% at December 31, 2004. The decrease reflects the Company’s continued success in controlling operating expenses and
the cost savings achieved with the First Capital acquisition in 2005. The Company’s efficiency ratio was 51.58% at
December 31, 2003.

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, 2005, income tax expense was $23.6 million compared with $17.7 million for the year ended December 31,
2004 and $12.4 million for the year ended December 31, 2003. 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, 2005 compared with the
same period in 2004 and 2003. The effective tax rate for the years ended December 31, 2005, 2004 and 2003 was 33.0%,
33.8% and 31.9%, respectively. The effective income tax rates differed from the U.S. statutory rate of 35% during the
comparable periods primarily due to the effect of tax-exempt income from loans and securities.

Impact of Inflation

The Company’s consolidated financial statements and related notes included in this annual report on Form 10-K have

been prepared in accordance with generally accepted accounting principles. These require the measurement of financial
position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of
money over time due to inflation.

Unlike many industrial companies, substantially all of the Company’s assets and liabilities are monetary in nature. As a

result, interest rates have a more significant impact on the Company’s performance than the effects of general levels of
inflation. Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and
services. However, other expenses do reflect general levels of inflation.

Financial Condition
Loan Portfolio

At December 31, 2005, total loans were $1.542 billion, an increase of $506.6 million or 48.9% compared with $1.036
billion at December 31, 2004. The growth in loans was primarily attributable to the combined effect of internal growth and
the First Capital and Grapeland acquisitions. At December 31, 2005, total loans at the banking centers acquired in 2005
totaled $440.6 million. At December 31, 2005, total loans were 52.8% of deposits and 43.0% of total assets. At December 31,
2004, total loans were 44.7% of deposits and 38.4% of total assets. Loans increased 34.5% during 2004 from $770.1 million
at December 31, 2003 to $1.036 billion at December 31, 2004. The growth in loans was primarily attributable to internal
growth and the 2004 acquisitions.

The following table summarizes the Company’s loan portfolio by type of loan as of the dates indicated:

2005

2004

Amount

Percent

Amount

Percent

2002

2001

Amount

Percent

Amount

Percent

222,773

14.4% $

144,432

13.9% $

93,989

12.2% $

93,797

13.8% $

46,986

11.1%

December 31,

2003

Amount

Percent
(Dollars in thousands)

206,653
313,184
58,729
566,356
30,920
32,039
25,429

65,183
20,859

13.4
20.3
3.8
36.7
2.0
2.1
1.6
4.3
1.4

109,591
260,453
34,453
369,151
22,240
18,187
21,906

52,854
2,246

10.6
25.2
3.3
35.6
2.1
1.9
2.1

5.1
0.2

36,470
237,055
27,943
260,882
15,247
20,679
20,693

54,821
2,274

4.7
30.8
3.6
33.9
2.0
2.7
2.7

7.1
0.3

52,377
206,586
23,249
183,970
11,887
15,502
24,683

64,488
3,020

7.7
30.4
3.4
27.1
1.7
2.3
3.6
9.6
0.4

20,963
175,253
20,541
78,446
10,686
9,694
15,757

45,121
953

4.9
41.3
4.8
18.5
2.5
2.3
3.7

10.7
0.2

Commercial and industrial ........ $
Real estate:

Construction and land

development .................
1-4 family residential ..........
Home equity........................
Commercial mortgages .......
Farmland .............................
Multifamily residential .......
Agriculture.................................
Consumer (net of unearned

discount)..............................
Other ..........................................

Total loans. ................... $ 1,542,125

100.0% $ 1,035,513

100.0% $ 770,053

100.0% $ 679,559

100.0% $ 424,400

100.0%

The Company is focused on growing its construction and land development, commercial mortgage and commercial and

industrial loan portfolios. The Company’s construction and land development loans grew from $109.6 million at
December 31, 2004 to $206.7 million at December 31, 2005, an increase of $97.1 million or 88.6%. The Company’s
commercial mortgages grew from $369.2 million at December 31, 2004 to $566.4 million at December 31, 2005, an increase
of $197.2 million or 53.4%. The Company’s commercial and industrial loans grew from $144.4 million at December 31,
2004 to $222.8 million at December 31, 2005, an increase of $78.3 million or 54.2%. The Company offers a variety of
commercial lending products including term loans and lines of credit. The Company 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.

All loans over $500,000 and below $2.5 million are evaluated and acted upon on a daily basis by two of the Company’s

four loan concurrence officers. All loans above $2.5 million are evaluated and acted upon by an officers’ loan committee,
which meets weekly. In addition to the officers’ loan committee evaluation, loans from $5.0 million to $10.0 million are
evaluated and acted upon by the directors loan committee, which consists of three directors and meets as necessary. Loans
over $10.0 million are evaluated and acted upon by the Bank’s board of directors either at a regularly scheduled monthly
board meeting or by teleconference or written consent.

Commercial and Industrial Loans. In nearly all cases, the Company’s commercial loans are made in the Company’s

market areas and are underwritten on the basis of the borrower’s ability to service the 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 or principal. Working capital loans are primarily collateralized by short-term
assets whereas term loans are primarily collateralized by long-term assets. In general, commercial loans involve more credit
risk than residential mortgage loans and commercial mortgage loans and, therefore, usually yield a higher return. The
increased risk in commercial loans is due to the type of collateral securing these loans. The increased risk also derives from
the expectation that commercial loans generally will be serviced principally from the operations of the business, and those
operations may not be successful. Historical trends have shown these types of loans to have higher delinquencies than
mortgage loans. As a result of these additional complexities, variables and risks, commercial loans require more thorough
underwriting and servicing than other types of loans.

Commercial Mortgages. The Company makes commercial mortgage loans collateralized by real estate to finance the
purchase of real estate. The Company’s commercial mortgage loans are collateralized 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.

1-4 Family Residential Loans. 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.

Construction Loans. The Company makes loans to finance the construction of residential and, to a limited extent,
nonresidential properties. Construction loans generally are collateralized 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.

Agriculture 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.

Consumer Loans. 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 collateralized 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 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, 2005
are summarized in the following table:

December 31, 2005

Commercial and industrial...............................................................
Construction and land development.................................................
Total .......................................................................................
Loans with a predetermined interest rate. ........................................
Loans with a floating interest rate....................................................
Total .......................................................................................

One Year
or Less

After One
Through
Five Years

After Five
Years
(Dollars in thousands)

Total

57,522

39,292

98,823 $ 101,891 $ 22,059 $ 222,773
206,653
109,839
$ 208,662 $ 141,183 $ 79,581 $ 429,426
52,713 $ 24,154 $ 119,856
88,470
309,570
55,427
$ 208,662 $ 141,183 $ 79,581 $ 429,426

42,989 $

165,673

Nonperforming Assets

The Company has several procedures in place to assist it in maintaining the overall quality of its loan portfolio. The

Company has established underwriting guidelines to be followed by its officers and 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 collateralized 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 $1.4 million in

nonperforming assets at December 31, 2005 compared with $1.7 million at December 31, 2004 and $967,000 at
December 31, 2003. Interest foregone on nonaccrual loans for the years ended December 31, 2005, 2004 and 2003 was
$35,000, $54,000 and $38,000, respectively.

The following table presents information regarding past due loans and nonperforming assets at the dates indicated:

2005

2004

December 31,

2003

2002

2001

Nonaccrual loans. ........................................ $
Restructured loans. ......................................
Other nonperforming loans..........................
Accruing loans 90 or more days past due ....

Total nonperforming loans .................
Repossessed assets.......................................
Other real estate ...........................................

Total nonperforming assets ................ $

Nonperforming assets to total loans and

355
—
—
788
1,143
26
239
1,408

(Dollars in thousands)

297
—
—
1,083
1,380
—
341
1,721

2
—
—
679
681
40
246
967

1,125
—
1,100
120
2,345
46
219
2,610

1
—
—
—
1
—
—
1

other real estate .......................................

0.09%

0.17%

0.13%

0.38%

0.00%

Allowance for Credit Losses

The following table presents, for the periods indicated, an analysis of the allowance for credit losses and other related

data:

Average loans outstanding........................... $ 1,435,376
Gross loans outstanding at end of period. .... $ 1,542,125

871,736
$
$ 1,035,513

(Dollars in thousands)
$ 697,235
$ 770,053

$ 524,885
$ 679,559

$ 419,553
$ 424,400

2005

2004

2003

2002

2001

Years Ended December 31,

Allowance for credit losses at beginning of

period ...................................................... $

Balance acquired with the First Capital and
Grapeland acquisitions in 2005, Liberty
and Village acquisitions in 2004,
Abrams, Dallas Bancshares,
MainBancorp and FSBNT acquisitions
in 2003, and Texas Guaranty, First
State, Paradigm, FNB and Southwest
acquisitions in 2002 ................................
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 ............................................

Allowance for credit losses at end of

period. ..................................................... $

Ratio of allowance to end of period loans....
Ratio of net charge-offs to average loans.....
Ratio of allowance to end of period

nonperforming loans ...............................

13,105

10,345

9,580

5,985

5,523

4,028
480

(410)
(242)
(240)

188
184
110
(410)

2,365
880

(139)
(613)
(198)

239
65
161
(485)

1,900
483

(810)
(960)
(471)

159
198
266
(1,618)

2,981
1,010

(356)
(231)
(180)

111
175
85
(396)

—
700

(180)
(175)
(74)

15
121
55
(238)

17,203

13,105

10,345

9,580

5,985

1.12%
0.03

1.27%
0.06

1.34%
0.23

1.41%
0.08

1,505.1

949.6

1,519.1

408.5

1.41%
0.06

n/m(1)

(1) Amount not meaningful. Nonperforming loans totaled $1,000 at December 31, 2001.

The allowance for credit losses is a valuation 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 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 actively monitors the Company’s asset quality and 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.

Federal and state bank regulators also require that a bank maintain an allowance 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. 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 that one uncollectible loan would have a
more severe adverse impact.

At December 31, 2005, the allowance for credit losses totaled $17.2 million, or 1.12% of total loans. At December 31,

2004, the allowance aggregated $13.1 million or 1.27% of total loans and at December 31, 2003, the allowance was $10.3
million, or 1.34% of total loans.

The following tables describe the allocation of the allowance for credit losses among various categories of loans and

certain other information as of 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,

2005

Percent of
Loans to
Total Loans

2004

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 ............................................................................

636
923
28
53
15,563

Total allowance for credit losses. ................................. $ 17,203

(Dollars in thousands)

14.4% $
78.4
1.6
5.6
—

274
503
12
26
12,290
100.0% $ 13,105

13.9%
78.7
2.1
5.3
—
100.0%

2003

Percent of
Loans to
Total Loans

Amount

December 31,
2002

Percent of
Loans to
Total Loans

Amount

(Dollars in thousands)

2001

Percent of
Loans to
Total Loans

Balance of allowance for credit losses

applicable to:

Commercial and industrial ....................... $
Real estate ................................................
Agriculture ...............................................
Consumer and other. ................................
Unallocated ..............................................

253
957
35
34
9,066

12.2% $
77.7
2.7
7.4
—

559
397
42
71
8,781

13.8% $
72.6
3.6
10.0
—

357
553
11
10
5,054

Total allowance for credit losses. ... $ 10,345

100.0% $ 9,850

100.0% $ 5,985

11.1%
74.3
3.7
10.9
—
100.0%

The Company believes that the allowance for credit losses at December 31, 2005 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, 2005.

Securities

The Company uses its securities portfolio as a source of income, as a source of liquidity for cash requirements and to
manage interest rate risk. At December 31, 2005, investment securities totaled $1.573 billion, an increase of $269.8 million
or 20.7% compared with $1.303 million at December 31, 2004. The increase in securities was primarily due to the First
Capital acquisition. Securities decreased to $1.303 billion at December 31, 2004 from $1.377 billion at December 31, 2003, a
decrease of $74.1 million or 5.4%. At December 31, 2005, securities represented 43.9% of total assets compared with 48.3%
of total assets at December 31, 2004.

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 .....................................
Collateralized mortgage obligations ....................
Mortgage-backed securities .................................
Qualified Zone Academy Bond (QZAB).............
Other ....................................................................

2005

2004

December 31,

2003

(Dollars in thousands)

2002

2001

296,349 $
24,000
31,250
8,550
222,615
987,088
8,000
814

30,726 $
24,000
37,698
10,491
238,994
957,354
8,000
296

48,762 $
44,015
45,738
15,619
178,487
1,032,861
8,000
283

97,098 $ 143,397
24,058
44,029
43,503
50,994
22,712
25,338
17,378
168,282
492,940
552,515
8,000
8,000
—
—

Total ...........................................................

$ 1,578,666 $ 1,307,559 $ 1,373,765 $ 946,256 $ 751,988

The following table summarizes the contractual maturity of securities and their weighted average yields as of

December 31, 2005. Available-for-sale securities are shown at fair value and held-to-maturity securities are shown at
amortized cost. Other securities are included in the corporate debt securities category. For purposes of the table below, 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.

Within One
Year

After One Year
but
Within Five
Years

Amount

Yield

Amount

Yield

December 31, 2005
After Five Years
but
Within Ten
Years

Amount
Yield
(Dollars in thousands)

After Ten
Years

Total

Amount

Yield

Total

Yield

9,518

4.09% $

284,473

4.49% $

1,036

4.93% $

—

— % $

295,027

4.48%

—

5,723

4,826

—
5.01
5.46

—

—
7.37

—

18,666

8,748

3,038

913

59,236

5.64

6.20

3.67

4.38

8,174

1,500

18,728

544,631

7.05

7.38

4.63

4.29

9,610

—

202,984

382,782

2.76
7.73
—

4.25
4.92

18,666

32,255

9,364

222,626

986,664

—

8,000

2.00

—

8,000

2.76

6.51

6.01

4.28

4.54

2.00

4.51%

U.S. Treasury

securities and
obligations of U.S.
government
agencies.................. $

70% non-taxable

preferred stock .......

States and political

subdivisions. ..........

Corporate debt

securities ................

Collateralized
mortgage
obligations..............

Mortgage-backed

securities ................

Qualified Zone

Academy Bond
(QZAB) ..................

Total................. $

20,083

4.68% $

356,408

4.51% $

582,069

4.32% $

614,042

4.68% $

1,572,602

The 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. Mortgage-backed
securities monthly pay downs cause the average lives of the securities to be much different than their stated lives. The
weighted average life of the Company’s complete portfolio is 3.5 years with an effective duration of 2.9 years at
December 31, 2005. The 70% non-taxable preferred stock includes investments in Federal National Mortgage Association
(Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) preferred stock.

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, 2005 and December 31, 2004.

The average yield of the securities portfolio was 4.14% in 2005 compared with 3.99% in 2004 and 3.96% in 2003. The

15 basis point increase in 2005 was primarily due to the Company reinvesting funds at higher rates in 2005 compared to
2004. The overall growth in the securities portfolio over the comparable periods was primarily funded by deposit growth.

The following table summarizes the carrying value by classification of securities as of the dates shown:

Available-for-sale ...................... $
Held-to-maturity ........................
Total ................................. $

2005

2004

December 31,

2003

(Dollars in thousands)

410,361 $

177,683 $

263,648 $

1,162,241

1,125,109

1,113,232

1,572,602 $

1,302,792 $

1,376,880 $

2002

2001

309,219 $
641,098
950,317 $

482,233
270,089

752,322

The following tables present the amortized cost and fair value of securities classified as available-for-sale at

December 31, 2005, 2004 and 2003:

Amortized
Cost

December 31, 2005
Gross
Gross
Unrealized
Unrealized
Losses
Gains
(Dollars in thousands)

Fair
Value

Amortized
Cost

December 31, 2004
Gross
Gross
Unrealized
Unrealized
Losses
Gains
(Dollars in thousands)

Fair
Value

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..........
Qualified Zone Academy Bond

(QZAB) ..................................
Other .............................................

231,399 $
24,000
14,102

430
—
1,005

1,752 $ 230,077 $
5,334
—

18,666
15,107

10,579 $
24,000
14,382

2 $

—
1,366

69
6,150
—

10,512
17,850
15,748

8,096
130,014

8,000
814

45
277

—
—

34
701

—
—

8,107
129,590

8,000
814

13,143
112,050

8,000
296

76
545

—
—

35
502

—
—

13,184
112,093

8,000
296

Total................................. $

416,425 $

1,757

7,821 $ 410,361 $

182,450 $

1,989 $

6,756

$ 177,683

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.................
Qualified Zone Academy Bond (QZAB)
Other ....................................................
Total. .......................................

Amortized
Cost

December 31, 2003
Gross
Gross
Unrealized
Unrealized
Losses
Gains
(Dollars in thousands)

Fair
Value

15,824 $
44,015
15,141
17,745
159,525
8,000
283

247
—
1,798
510
1,179
—
—

— $
327
—
68
224
—
—

16,071
43,688
16,939
18,187
160,480
8,000
283

260,533 $

3,734

619 $ 263,648

The following tables present the amortized cost and fair value of securities classified as held-to-maturity at

December 31, 2005, 2004 and 2003:

Amortized
Cost

December 31, 2005
Gross
Gross
Unrealized
Unrealized
Gains
Losses
(Dollars in thousands)

Fair
Value

Amortized
Cost

December 31, 2004
Gross
Gross
Unrealized
Unrealized
Gains
Losses
(Dollars in thousands)

Fair
Value

U.S. Treasury securities

and obligations of U.S.
government agencies.... $

States and political

subdivisions..................
Corporate debt securities ....
Collateralized mortgage

17,148
8,550

obligations. ...................

214,519

Mortgage-backed

securities.......................

857,074

64,950 $

409 $

564 $

64,795 $

20,147 $

661 $

6 $

20,802

173
108

313

721

31
3

17,290
8,655

23,317
10,491

5,805

209,027

225,851

510
301

15
—

802

23,812
10,792

225,146

21,868

835,927

845,303

3,559

4,914

843,948

Total ....................... $ 1,162,241 $

1,724 $

28,271 $ 1,135,694 $ 1,125,109 $

5,128 $

5,737 $ 1,124,500

U.S. Treasury securities and obligations of U.S.

government agencies................
States and political subdivisions.....
Corporate debt securities ................
Collateralized mortgage obligations
Mortgage-backed securities............
Total ...................................

Amortized
Cost

December 31, 2003
Gross
Gross
Unrealized
Unrealized
Gains
Losses
(Dollars in thousands)

Fair
Value

32,938 $
30,597
15,619
160,742
873,336

1,591
1,121
743
1,338
7,806

14 $
—
—
191
3,175

34,515
31,718
16,362
161,889
877,967

$ 1,113,232 $

12,599

3,380 $ 1,122,451

Net unrealized losses on the available-for-sale securities were $6.1 million at December 31, 2005 compared with $4.8

million at December 31, 2004. Management believes that the unrealized losses in the Company’s securities portfolio at
December 31, 2005 were primarily due to interest rate increases. Because the decline in market value is attributable to
changes in interest rates and not credit quality, and because the Company has the ability and intent to hold such securities
until a recovery of fair value, which may be at maturity, the Company does not consider such securities to be other-than-
temporarily impaired at December 31, 2005.

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 Government National Mortgage Association (“Ginnie Mae”), 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.

Unlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, mortgage-
backed securities provide cash flows from regular principal and interest payments and principal prepayments throughout the
lives of the securities. Mortgage-backed securities which are purchased at a premium will generally suffer decreasing net
yields as interest rates drop because home owners tend to refinance their mortgages. Thus, the premium paid must be
amortized over a shorter period. Therefore, these securities purchased at a discount will obtain higher net yields in a
decreasing interest rate environment. As interest rates rise, the opposite will generally be true. During a period of increasing
interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal and
consequently, the average life of this security will not be shortened. If interest rates begin to fall, prepayments will increase.
At December 31, 2005, 38.8% of the mortgage-backed securities held by the Company had contractual final maturities of
more than ten years with a weighted average life of 3.73 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. 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’s lending and investment activities are primarily funded by deposits. The Company offers a variety of

deposit accounts having a wide range of interest rates and terms including 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, 2005 were $2.920 billion, an increase of $603.2 million or 26.0% compared with
$2.317 billion at December 31, 2004. The increase was primarily attributable to the First Capital and Grapeland acquisitions
in 2005. As of December 31, 2005, the banking centers acquired in 2005 had approximately $621.2 million in total deposits.
Noninterest-bearing deposits were $674.4 million at December 31, 2005, an increase of $156.0 million or 30.1% compared
with $518.4 million at December 31, 2004. Noninterest-bearing deposits at December 31, 2004 were $518.4 million
compared with $467.4 million at December 31, 2003. Interest-bearing deposits at December 31, 2005 were $2.25 billion, up
$447.2 million or 24.9% from $1.80 billion at December 31, 2004. Interest-bearing deposits at December 31, 2004 of $1.80
billion represented a $182.4 million or 11.3% increase compared with $1.62 billion at December 31, 2003. Total deposits at
December 31, 2003 were $2.08 billion. There were no major concentrations of deposits at December 31, 2005, 2004 or 2003.

The daily average balances and weighted average rates paid on deposits for each of the years ended December 31,

2005, 2004 and 2003 are presented below:

2005

Amount

Rate

Years Ended December 31,
2004

Amount
(Dollars in thousands)

Rate

2003

Amount

Rate

Interest-bearing checking........................... $
Regular savings..........................................
Money market savings ...............................
Time deposits.............................................

Total interest-bearing deposits .........
Noninterest-bearing deposits .....................

477,199
150,577
545,660
1,009,147

2,182,583
609,230

0.98% $
0.83
1.73
2.80
2.00
—

485,557
110,801
384,529
735,095

1,715,982
473,713

1.04% $
0.59
0.87
2.12
1.43
—

371,801
88,651
317,682
616,353

1,394,487
354,558

Total deposits ................................... $ 2,791,813

1.56% $ 2,189,695

1.12% $ 1,749,045

1.13%
0.66
0.92
2.42
1.62
—
1.29%

The Company’s ratio of average noninterest-bearing deposits to average total deposits for the years ended

December 31, 2005, 2004, and 2003 was 21.8%, 21.6%, and 20.3%, respectively.

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 ..............................................................................................

December 31, 2005
(Dollars in thousands)
188,658
80,731
103,911
116,245
489,545

Other Borrowings

The Company utilizes borrowings to supplement deposits to fund its lending and investment activities. Borrowings
consist of funds from the Federal Home Loan Bank (“FHLB”) and correspondent banks. FHLB advances are considered
short-term, overnight borrowings. At December 31, 2005, the Company had $55.4 million in FHLB borrowings which
consisted of $38.4 million in long-term FHLB notes payable and $17.0 million in FHLB advances compared with $13.1
million in FHLB borrowings at December 31, 2004, all of which were long-term FHLB notes payable. The $42.3 million
increase was primarily attributable to the acquisition of $2.6 million in FHLB long-term notes payable from the Village
acquisition, $30.6 million in FHLB long-term notes payable acquired from the First Capital acquisition and FHLB advances
of $17.0 million, partially offset by normal pay downs on the remaining notes. The weighted average interest rate paid on the
FHLB advances at period end was 4.4%. The maturity dates on the FHLB notes payable range from the years 2006 to 2028
and have interest rates ranging from 2.79% to 8.80%. The highest outstanding balance of FHLB advances during 2005 was
$39.0 million compared with $50.0 million during 2004. The Company had no federal funds purchased at December 31, 2005
or 2004.

At December 31, 2005, the Company had $47.0 million in securities sold under repurchase agreements compared with

$25.1 million at December 31, 2004, an increase of $21.9 million or 87.5%. The increase was primarily attributable to
customers maintaining higher balances.

At December 31, 2005, the Company had six issues of junior subordinated debentures outstanding totaling

$75.8 million compared with four issues totaling $47.4 million at December 31, 2004 as shown in the following table. The
Company assumed $28.4 million in junior subordinated debentures in connection with the First Capital acquisition in 2005.

Description

Paradigm Capital Trust II(1) ...........

Prosperity Statutory Trust II .........

First Capital Statutory Trust I(2).....

Trust
Preferred
Securities
Interest Rate(5)
Outstanding
Feb. 20, 2001$ 6,000,000 3-month LIBOR

Issuance Date

+ 4.50%

July 31, 2001 15,000,000 3-month LIBOR
+ 3.58%, not to
exceed 12.50%

Mar. 26, 2002 20,000,000 3-month LIBOR

+ 3.60%

Junior
Subordinated
Debt Owed
to Trusts
6,186,000

Maturity
Date(6)
Feb. 20, 2031

15,464,000

July 31, 2031

20,619,000

Mar. 26, 2032

First Capital Statutory Trust II(2)....

Sept. 26, 2002

7,500,000 3-month LIBOR

+ 3.40%

7,732,000

Sept. 26, 2032

Prosperity Statutory Trust III........

Aug. 15, 2003 12,500,000

Prosperity Statutory Trust IV........

Dec. 30, 2003 12,500,000

6.50%(3)

6.50%(4)

12,887,000

Sept. 17, 2033

12,887,000

Dec. 30, 2033

(1) Assumed in connection with the Paradigm acquisition on September 1, 2002 and fully redeemed on February 28, 2006.
(2) Assumed in connection with the First Capital acquisition on March 1, 2005.
(3) The debentures bear a fixed interest rate until September 17, 2008, when the rate begins to float on a quarterly basis

based on the three-month LIBOR plus 3.00%.

(4) The debentures bear a fixed interest rate until December 30, 2008, when the rate begins to float on a quarterly basis

based on the three-month LIBOR plus 2.85%.

(5) The 3-month LIBOR in effect as of December 31, 2005 was 4.53%.
(6) The debentures are callable five years from issuance date.

On December 31, 2004, the Company redeemed in full the $12.4 million in junior subordinated debentures issued to

Prosperity Capital Trust I. Prosperity Capital Trust I in turn redeemed in full the trust preferred securities and common
securities it issued.

Each of the trusts is a capital or statutory business trust organized for the sole purpose of issuing trust securities and

subordinate and junior in right of payment to all of the Company’s present and future senior indebtedness. The Company has
fully and unconditionally guaranteed each trust’s obligations under the trust securities issued by such trust to the extent not
paid or made by each trust, provided such trust has funds available for such obligations.

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 applicable trust preferred securities and common securities will also be
deferred.

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. 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.

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. Based upon the nature of the
Company’s operations, the Company is not subject to foreign exchange or commodity price risk. The Company does not own
any trading assets.

The Company’s exposure to 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:
(1) an analysis of relationships between interest-earning assets and interest-bearing liabilities; and (2) an interest rate shock
simulation model. The Company has traditionally managed its business to reduce its overall exposure to changes in interest
rates.

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 the Company’s interest rate sensitivity analysis at December 31, 2005:

0-30
days

Volumes Subject to Repricing Within
181-365
days

31-180
days

Greater than
one year

Total

Interest-earning assets:
Securities (excluding

unrealized loss of $6.1
million)................................. $

Loans.........................................
Federal funds sold and other

temporary investments .........

Total interest-earning

assets ...................... $

(Dollars in thousands)

52,517
592,317

176,732
133,398

172,967
124,484

$ 1,176,450
691,926

$ 1,578,666
1,542,125

5,846

200

—

6,143

650,680

310,330

297,548

$ 1,868,376

$ 3,126,934

Interest-bearing liabilities:

Demand, money market and

savings deposits.................... $ 1,203,557

—

$ 1,203,557

Certificates of deposit and

other time deposits. ..............
Junior subordinated debentures.
Securities sold under

repurchase agreements .........
Other borrowings ......................

136,203
30,125

46,985
17,000

384,595
6,000

—
616

244,169
15,000

—
11,301

277,387
24,650

—
26,487

1,042,354
75,775

46,985
55,404

Total interest-bearing

liabilities .......................... $ 1,433,870
(783,190)
(783,190)

Period GAP .......................... $
Cumulative GAP .................. $
Period GAP to total assets....
Cumulative GAP to total

$
$
(21.84)%

391,211
(80,881)
(864,071)

$
$
(2.26)%

270,470
27,078
(836,993)

328,524
$
$ 1,539,852
702,859
$
0.76%

42.94%

$ 2,424,075

702,859

assets................................

(21.84)%

(24.10)%

(23.34)%

19.60%

While the GAP position is a useful tool in measuring interest rate risk and contributes toward effective asset and
liability management, it is difficult to predict the effect of changing interest rates solely on that measure, without accounting
for alterations in the maturity or repricing characteristics of the balance sheet that occur during changes in market interest
rates. For example, the GAP position reflects only the prepayment assumptions pertaining to the current rate environment.
Assets tend to prepay more rapidly during periods of declining interest rates than during periods of rising interest rates.
Because of this and other risk factors not contemplated by the GAP position, an institution could have a matched GAP
position in the current rate environment and still have its net interest income exposed to increased rate risk. Additionally, the
Company had $674.4 million in noninterest-bearing deposits at December 31, 2005 which are not reflected in the table above
and are not directly impacted by interest rate changes.

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. The Company’s December 31, 2005 simulation analysis estimates a percentage of change in these metrics from the
stable rate base scenario versus alternative scenarios of rising and falling market interest rates by instantaneously shocking a
static balance sheet. The following table summarizes the simulated change in net interest income over a 12-month horizon in
the event of an immediate change in interest rates:

Change in Interest
Rates (Basis Points)

+200........................................................................................................
+100........................................................................................................
Base ........................................................................................................
-100.........................................................................................................
-200.........................................................................................................

Increase (Decrease)
in Net Interest Income

2.1%
1.7%
0.0%
0.8%
(2.6)%

The results are primarily due to behavior of demand, money market and savings deposits during such rate fluctuations.

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.

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, 2005, the Company’s liquidity needs have primarily been met by
growth in core deposits and the issuance of junior subordinated debentures, 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, 2005, the Company had cash and cash equivalents of $97.4 million compared with $137.9 million at
December 31, 2004. The decrease was mainly due to a decrease in federal funds sold of $73.3 million, partially offset by an
increase in cash and due from banks of $32.8 million. As of December 31, 2005, the Company had junior subordinated
debentures outstanding of $75.8 million compared with $47.4 million at December 31, 2004. The increase was due to the
assumption of $28.4 million in junior subordinated debentures from First Capital.

Contractual Obligations

The following table summarizes the Company’s contractual obligations and other commitments to make future
payments as of December 31, 2005 (other than deposit obligations). The Company’s future cash payments associated with its
contractual obligations pursuant to its junior subordinated debentures, FHLB notes payable and operating leases as of
December 31, 2005 are summarized below. Payments for FHLB notes payable include interest of $8.3 million that will be
paid over the future periods. Payments related to leases are based on actual payments specified in underlying contracts.

More than 1
year but less
than 3 years

Payments due in:

3 years or
more but less
than 5 years

1 year or less

5 years
or more

Total

Junior subordinated debentures(1) ...........................
Federal Home Loan Bank notes payable ...............
Operating leases.....................................................

— $

13,737
2,987

11,173
4,732

Total. ............................................................

16,724 $

15,905 $

— $ 75,775 $

75,775
12,017
46,707
9,780
2,979
13,664
2,966
14,996 $ 88,521 $ 136,146

(Dollars in thousands)

(1) On February 28, 2006 the Company redeemed in full the $6.2 million in junior subordinated debentures issued to

Paradigm Capital Trust II. Paradigm Capital Trust II in turn redeemed in full the trust preferred securities and common
securities it issued.

Off-Balance Sheet Items

In the normal course of business, the Company enters into various transactions, which, in accordance with accounting

principles generally accepted in the United States, are not included in its consolidated balance sheets. The Company enters
into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit
and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the
amounts recognized in the consolidated balance sheets.

The Company’s commitments associated with outstanding standby letters of credit and commitments to extend credit

as of December 31, 2005 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:

1 year or less

More than 1
year but less
than 3 years

3 years or
more but less
than 5 years

5 years
or more

Total

Standby letters of credit .........................................
Commitments to extend credit ...............................

6,514 $

902 $

213,824

23,619

Total. ............................................................

220,338 $

24,521 $

18 $ — $

7,434
4,338
335,291
93,510
4,356 $ 93,510 $ 342,725

(Dollars in thousands)

Standby Letters of Credit. Standby letters of credit are written conditional commitments issued by the Company to

guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the
terms of the agreement with the third party, the Company would be required to fund the commitment. The maximum
potential amount of future payments the Company could be required to make is represented by the contractual amount of the
commitment. If the commitment is funded, the Company would be entitled to seek recovery from the customer. The
Company’s policies generally require that standby letter of credit arrangements contain security and debt covenants similar to
those contained in loan agreements.

Commitments to Extend Credit. The Company enters into contractual commitments to extend credit, normally with

fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of the Company’s
commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan
funding. The Company minimizes its exposure to loss under these commitments by subjecting them to credit approval and
monitoring procedures. Management assesses the credit risk associated with certain commitments to extend credit in
determining the level of the allowance for credit losses.

Capital Resources

Capital management consists of providing equity to support the Company’s 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. 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-weighted tangible
assets. “Tier 1 capital” generally includes common shareholders’ equity and qualifying perpetual preferred stock together
with related surpluses and retained earnings, less deductions for goodwill and various other intangibles. “Tier 2 capital” may
consist of a limited amount of intermediate-term preferred stock, a limited amount of term subordinated debt, certain hybrid
capital instruments and other debt securities, perpetual preferred stock not qualifying as Tier 1 capital, and a limited amount
of the general valuation allowance for loan losses. The sum of Tier 1 capital and Tier 2 capital is “total risk-based capital.”

The Federal Reserve Board has also adopted guidelines which supplement the risk-based capital guidelines with a
minimum ratio of Tier 1 capital to average total consolidated tangible 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.

Total shareholders’ equity increased to $464.7 million at December 31, 2005 compared with $275.6 million at
December 31, 2004, an increase of $189.1 million or 68.6%. This increase was primarily the result of net income of $47.9
million and an increase in Common Stock issued of $149.6 million in connection with the First Capital and Grapeland
acquisitions, partially offset by dividends paid on the Common Stock of $9.6 million. During 2004, shareholders’ equity
increased by $56.1 million or 25.5% compared with $219.6 million at December 31, 2003 primarily due to net income of
$34.7 million and an increase in Common Stock issued of $32.0 million in connection with the Liberty acquisition, partially
offset by dividends paid on the Common Stock of $6.7 million.

The following table provides a comparison of the Company’s and the Bank’s leverage and risk-weighted capital ratios

as of December 31, 2005 to the minimum and well-capitalized regulatory standards:

Minimum Required
for Capital
Adequacy Purposes

To Be Categorized as
Well-Capitalized Under Prompt
Corrective Action
Provisions

Actual Ratio at
December 31, 2005

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

7.83%
15.34
16.37

7.67%
15.04
16.08

(1) The Federal Reserve Board may require the Company to maintain a leverage ratio above the required minimum.
(2) The FDIC may require the Bank to maintain a leverage ratio above the required minimum.

The trust preferred securities issued by the Company’s subsidiary trusts are currently included in the Company’s Tier 1
capital for regulatory purposes. On March 1, 2005, the Federal Reserve Board adopted final rules that continue to allow trust
preferred securities to be included in Tier 1 capital, subject to stricter quantitative and qualitative limits. Currently, trust
preferred securities and qualifying perpetual preferred stock are limited in the aggregate to no more than 25% of a bank
holding company’s core capital elements. The new rule amends the existing limit by providing that restricted core capital
elements (including trust preferred securities and qualifying perpetual preferred stock) can be no more than 25% of core
capital, net of goodwill and associated deferred tax liability. Because the 25% limit currently is calculated without deducting
goodwill, the final rule reduces the amount of trust preferred securities that the Company can include in Tier 1 capital. The
amount of such excess trust preferred securities are includable in Tier 2 capital. The new quantitative limits will be fully
effective March 31, 2009.

Assuming these final rules were effective at December 31, 2005, approximately $61.4 million of trust preferred
securities would count as Tier 1 capital. The excess amount of trust preferred securities may be included in Tier 2 capital.
Assuming these final rules were effective at December 31, 2005, the Company’s consolidated capital ratios would have been:

Pro forma Consolidated Risk Based Capital Ratios:
Total capital (to risk weighted assets)..........................................................
Tier I capital (to risk weighted assets) .........................................................
Tier I capital (to average assets) ..................................................................

16.37%
14.61%
7.46%

Each of the trusts issuing the trust preferred securities holds junior subordinated debentures the Company issued with a

30-year maturity. The final rules provide that in the last five years before the junior subordinated debentures mature, the
associated trust preferred securities will be excluded from Tier 1 capital and included in Tier 2 capital. In addition, the trust
preferred securities during this five-year period would be amortized out of Tier 2 capital by one-fifth each year and excluded
from Tier 2 capital completely during the year prior to maturity of the debentures.

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 report thereon, the notes thereto and supplementary data commence at page 63 of this

Annual Report on Form 10-K.

The following table presents certain unaudited quarterly financial information concerning the Company’s results of

operations for each of the two years indicated below. 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.

CONSOLIDATED QUARTERLY FINANCIAL DATA OF THE COMPANY

Quarter Ended 2005

December 31

September 30

June 30

March 31

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................................................................................

Earnings per share:

Basic...................................................................................
Diluted................................................................................

44,277 $
15,256

(Dollars in thousands, except per share data)
(unaudited)
42,707 $ 41,106 $ 34,033
13,787
9,556
12,627
28,920
120
28,800
8,092
18,070
18,822
18,428
15,056
6,351
4,502
6,220
12,471 $ 12,208 $ 10,554

28,359
7,881
17,812

24,357
6,533
15,834

28,479
120

24,477
120

29,021
120

28,901
7,515
17,241

19,175
6,548

12,627 $

0.46 $

0.45 $

0.45 $
0.45 $

0.44 $

0.44

0.43

Quarter Ended 2004

December 31

September 30

June 30

March 31

30,308 $
8,106

(Dollars in thousands, except per share data)
(unaudited)
28,763 $ 26,313 $ 26,372
7,696
7,025
6,962
21,067
420
20,647
6,111
13,194
13,564
4,618
8,946 $

19,231
5,455
12,067

19,227
5,272
12,459

12,619
4,257

12,040
3,977

19,351
120

19,347
120

8,362 $

8,063

22,202
220

21,982
6,233
13,987

14,228
4,892

9,336 $

0.42 $

0.41 $

0.41 $
0.40 $

0.40 $

0.39 $

0.39

0.38

Earnings per share are computed independently for each of the quarters presented and therefore may not total earnings

per share for the year.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL

DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, the Company

carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive
Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures.
In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures,
no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives,
and management was required to apply judgment in evaluating its 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-15(e) and 15d-15(e) 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 control over financial reporting. There were no changes in the Company’s internal control over
financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter
ended December 31, 2005, that have materially affected, or are reasonably likely to materially affect, the Company’s internal
control over financial reporting.

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of the Company is responsible for establishing and maintaining adequate internal control over
financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of
the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with
generally accepted accounting principles.

As of December 31, 2005, management assessed the effectiveness of the Company’s internal control over financial

reporting based on the criteria for effective internal control over financial reporting established in “Internal Control—
Integrated Framework,” issued by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission. This
assessment included controls over the preparation of the schedules equivalent to the basic financial statements in accordance
with the instructions for the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C) to meet the
reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act. Based on the
assessment, management determined that the Company maintained effective internal control over financial reporting as of
December 31, 2005, based on those criteria.

Deloitte & Touche, LLP, the independent registered public accounting firm that audited the consolidated financial
statements of the Company included in this Annual Report on Form 10-K, has issued an attestation report on management’s
assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. The
report is included in this Item under the heading “Report of Independent Registered Public Accounting Firm.”

Compliance with Designated Laws and Regulations

Management is also responsible for ensuring compliance with the federal laws and regulations concerning loans to

insiders and the federal and state laws and regulations concerning dividend restrictions, both of which are designated by the
Federal Deposit Insurance Corporation (FDIC) as safety and soundness laws and regulations.

Management assessed its compliance with the designated safety and soundness laws and regulations and has
maintained records of its determinations and assessments as required by the FDIC. Based on this assessment, management
believes that the Company has complied, in all material respects, with the designated safety and soundness laws and
regulations for the year ended December 31, 2005.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of
Prosperity Bancshares, Inc.
Houston, Texas

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control

over Financial Reporting, that Prosperity Bancshares, Inc. and subsidiaries (the “Company”) maintained effective internal
control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Because management’s
assessment and our audit were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance
Corporation Improvement Act (FDICIA), management’s assessment and our audit of the Company’s internal control over
financial reporting included controls over the preparation of the schedules equivalent to the basic financial statements in
accordance with the instructions for the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C).
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on
management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting
based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United

States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material respects. Our audit included obtaining an
understanding of internal control over financial reporting, evaluating management’s assessment, testing, and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in
the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the
company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the
company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted
accounting principles. A company’s internal control over financial reporting includes those policies and procedures that
(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with authorizations of management and directors of the
company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or
disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or
improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on
a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future
periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial
reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal
Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also,
in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of
December 31, 2005, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission.

We have not examined and, accordingly, we do not express an opinion or any other form of assurance on

management’s statement referring to compliance with laws and regulations.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United

States), the consolidated financial statements as of and for the year ended December 31, 2005 of the Company and our report
dated March 6, 2006, expressed an unqualified opinion on those financial statements.

Houston, Texas
March 6, 2006

ITEM 9B. OTHER INFORMATION

None.

PART III.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information under the captions “Election of Directors,” “Continuing Directors and Executive Officers,
Section 16(a) Beneficial Ownership Reporting Compliance, Corporate Governance and Nominating Procedures—
Committees of the Board of Directors—Audit Committee and Corporate Governance and Nominating Procedures—Code of
Ethics” in the Company’s definitive Proxy Statement for its 2006 Annual Meeting of Shareholders (the “2006 Proxy
Statement”) to be filed with the Commission pursuant to Regulation 14A under the Exchange Act within 120 days of the
Company’s fiscal year end, is incorporated herein by reference in response to this item.

ITEM 11. EXECUTIVE COMPENSATION

The information under the caption “Executive Compensation and Other Matters” and “Corporate Governance and

Nominating Procedures—Director Compensation” in the 2006 Proxy Statement is incorporated herein by reference in
response to this item.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND

RELATED SHAREHOLDER MATTERS

Certain information required by this Item 12 is included under “Securities Authorized for Issuance under Equity
Compensation Plans” in Part II, Item 5 of this annual report on Form 10-K. Additionally, the information under the caption
“Beneficial Ownership of Common Stock by Management of the Company and Principal Shareholders” in the 2006 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 2006 Proxy

Statement is incorporated herein by reference in response to this item.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

The information under the caption “Fees and Services of Independent Registered Public Accounting Firm” in the 2006

Proxy Statement is incorporated herein by reference in response to this item.

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Consolidated Financial Statements and Schedules

PART IV.

Reference is made to the Consolidated Financial Statements, the report thereon, the notes thereto and supplementary
data commencing at page 63 of this Annual Report on Form 10-K. Set forth below is a list of such Consolidated Financial
Statements:

Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2005 and 2004
Consolidated Statements of Income for the Years Ended December 31, 2005, 2004 and 2003
Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2005, 2004 and 2003
Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003
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(1)

Description

2.1 —Agreement and Plan of Reorganization dated as of November 16, 2005 by and between the Company and

SNB Bancshares, Inc. (incorporated herein by reference to Exhibit 2.1 to the Company’s Current Report on
Form 8-K filed November 17, 2005)

2.2 —Agreement and Plan of Reorganization, dated as of October 25, 2004, by and between the Company and First
Capital Bankers, Inc. (incorporated herein by reference to Exhibit 2.1 to the Company’s Registration
Statement on Form S-4 (Registration No. 333-121767))

2.3 —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))

2.4 —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)

2.5 —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)

2.6 —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))

2.7 —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)

Exhibit
Number(1)

Description

2.8 —Agreement and Plan of Reorganization dated June 5, 1998 by and among Prosperity, 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 Registration Statement on Form S-1 (Registration No. 333-63267))

3.2 —Amended and Restated Bylaws of Prosperity (incorporated herein by reference to Exhibit 3.1 to the

Company’s Current Report on Form 8-K filed March 10, 2006)

4.1 —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))

4.2 —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)

4.3 —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)

4.4 —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)

10.1† —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))

10.2† —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))

10.3† —Prosperity Bancshares, Inc. 2004 Stock Incentive Plan (incorporated herein by reference to Exhibit 10.3 to the

Company’s Registration Statement on Form S-4 (Registration No. 333-121767))

10.4† —Amended and Restated Employment Agreement by and between Prosperity Bank and David Zalman

(incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed January
24, 2005)

10.5† —Amended and Restated Employment Agreement by and between Prosperity Bank and

H. E. Timanus, Jr. (incorporated herein by reference to Exhibit 10.2 to the Company’s Current Report on
Form 8-K filed January 24, 2005)

10.6† —Termination Agreement dated as of December 8, 2005 by and among Prosperity Bancshares, Inc., Prosperity

Bank and D. Michael Hunter (incorporated herein by reference to Exhibit 10.1 to the Company’s Current
Report on Form 8-K filed December 9, 2005)

10.7† —Non-Competition Agreement dated as of December 8, 2005 by and among Prosperity Bancshares, Inc.,

Prosperity Bank and D. Michael Hunter (incorporated herein by reference to Exhibit 10.2 to the Company’s
Current Report on Form 8-K filed December 9, 2005)

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))

10.9† —MainBancorp, Inc. 1996 Employee Stock Option Plan (incorporated herein by reference to Exhibit 4.2 to the

Company’s Registration Statement on Form S-8 (Registration No. 333-110755))

Exhibit
Number(1)
10.10† —Form of MainBancorp, Inc. Non-Qualified Stock Option Agreement (incorporated herein by reference to

Description

Exhibit 4.3 to the Company’s Registration Statement on Form S-8 (Registration No. 333-110755))

10.11† —First Capital Bankers, Inc. 1996 Executive Stock Option Plan (incorporated herein by reference to Exhibit
10.11 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004)

10.12† —First Capital Bankers, Inc. Amended and Restated 1998 Stock Option Plan (incorporated herein by reference

to Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004)

21.1* —Subsidiaries of Prosperity Bancshares, Inc.

23.1* —Consent of Deloitte & Touche LLP

31.1* —Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of

1934, as amended.

31.2* —Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of

1934, as amended.

32.1** —Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section

906 of the Sarbanes-Oxley Act of 2002.

32.2** —Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section

906 of the Sarbanes-Oxley Act of 2002.

† Management contract or compensatory plan or arrangement.
*
**
(1) The Company has other long-term debt agreements that meet the exclusion set forth in Section 601(b)(4)(iii)(A) of

Filed with this Annual Report on Form 10-K.
Furnished with this Annual Report on Form 10-K.

Regulation S-K. The Company hereby agrees to furnish a copy of such agreements to the Commission upon request.

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 15, 2006.

SIGNATURES

PROSPERITY BANCSHARES, INC.®

By:

/s/ DAVID ZALMAN

David Zalman
President and Chief Executive Officer

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 15, 2006.

Signature

/s/ DAVID ZALMAN
David Zalman

/s/ NED S. HOLMES
Ned S. Holmes

/s/ DAVID HOLLAWAY
David Hollaway

/s/ H.E. TIMANUS, JR.
H.E. Timanus, Jr.

/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/ D. MICHAEL HUNTER
D. Michael Hunter

/s/ S. REED MORIAN
S. Reed Morian

Positions

President and Chief Executive Officer

(principal executive officer); Director

Chairman of the Board; Director

Chief Financial Officer (principal financial officer and

principal accounting officer)

Executive Vice President and

Chief Operating Officer; Director

Director

/s/ PERRY MUELLER, JR., D.D.S.
Perry Mueller, Jr., D.D.S.

/s/ TRACY T. RUDOLPH
Tracy T. Rudolph

/s/ HARRISON STAFFORD II
Harrison Stafford II

/s/ ROBERT STEELHAMMER
Robert Steelhammer

Director

TABLE OF CONTENTS TO CONSOLIDATED FINANCIAL STATEMENTS

Prosperity Bancshares, Inc.®

Report of Independent Registered Public Accounting Firm...................................................................

Consolidated Balance Sheets as of December 31, 2005 and 2004 .........................................................

Consolidated Statements of Income for the Years Ended December 31, 2005, 2004 and 2003 ............

Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2005, 2004

and 2003 ............................................................................................................................................

Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003......

Notes to Consolidated Financial Statements ..........................................................................................

Page

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of
Prosperity Bancshares, Inc.
Houston, Texas

We have audited the accompanying consolidated balance sheets of Prosperity Bancshares Inc. and subsidiaries (the

“Company”) as of December 31, 2005 and 2004, and the related statements of income, shareholders’ equity, and cash flows
for each of the three years in the period ended December 31, 2005. 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 the standards of the Public Company Accounting Oversight Board (United
States). 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 financial statements present fairly, in all material respects, the financial position of Prosperity

Bancshares, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows
for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally
accepted in the United State of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United
States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on the
criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission and our report dated March 6, 2006, expressed an unqualified opinion on management’s assessment
of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the
effectiveness of the Company’s internal control over financial reporting.

Houston, Texas
March 6, 2006

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

ASSETS

Cash and due from banks................................................................................................
Federal funds sold...........................................................................................................
Total cash and cash equivalents ............................................................................
Interest bearing deposits in financial institutions............................................................
Available for sale securities, at fair value .......................................................................
Held to maturity securities, at cost..................................................................................
Loans held for investment...............................................................................................
Less allowance for credit losses......................................................................................
Loans, net ...........................................................................................
Accrued interest receivable.............................................................................................
Goodwill .........................................................................................................................
Core deposit intangibles, net of accumulated amortization of $6.7 million and $2.8 million,
respectively ................................................................................................................
Bank premises and equipment, net .................................................................................
Other real estate owned...................................................................................................
Bank Owned Life Insurance (BOLI), net........................................................................
Leased assets...................................................................................................................
Other assets.....................................................................................................................
TOTAL ASSETS............................................................................................................

LIABILITIES AND SHAREHOLDERS’ EQUITY

LIABILITIES:
Deposits:

Noninterest-bearing .....................................................................................
Interest-bearing............................................................................................
Total deposits .....................................................................................
Other borrowings ..................................................................................................
Securities sold under repurchase agreements ........................................................
Accrued interest payable .......................................................................................
Other liabilities......................................................................................................
Junior subordinated debentures .............................................................................
Total liabilities ...................................................................................

SHAREHOLDERS EQUITY:

Preferred stock, $1 par value; 20,000,000 shares authorized; none issued or

outstanding .......................................................................................................

Common stock, $1 par value; 50,000,000 shares authorized; 27,857,887 and

22,418,128 shares issued at December 31, 2005 and 2004, respectively; 27,820,799
and 22,381,040 shares outstanding at December 31, 2005 and 2004, respectively

Capital surplus.......................................................................................................
Retained earnings ..................................................................................................
Accumulated other comprehensive loss—net unrealized loss on available for sale
securities, net of tax benefit of $1,669 and $1,090, respectively......................
Less treasury stock, at cost, 37,088 shares ............................................................
Total shareholders’ equity..................................................................
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY ........................................

See notes to consolidated financial statements.

December 31,

2005
(Dollars in thousands)

2004

91,518 $
5,846
97,364
297
410,361
1,162,241
1,542,125
(17,203)
1,524,922
16,105
261,964

58,760
79,150

137,910
200
177,683
1,125,109
1,035,513
(13,105)

1,022,408
10,171
153,180

22,461
49,244
239
13,676
4,464
22,644

11,492
35,793
341
—
—
22,941
$ 3,585,982 $ 2,697,228

674,407 $
2,245,911
2,920,318
55,404
46,985
6,546
16,237
75,775
3,121,265

518,358
1,798,718

2,317,076
13,116
25,058
3,102
15,805
47,424

2,421,581

—

27,858
280,525
160,883

(3,942)
(607)
464,717

22,418
134,288
122,647

(3,099)
(607)

275,647
$ 3,585,982 $ 2,697,228

PROSPERITY BANCSHARES, INC.® 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.............................................................................................
Junior subordinated debentures .........................................................
Securities sold under repurchase agreements ....................................
Note payable and other borrowings...................................................
Total interest expense.....................................................
NET INTEREST INCOME ........................................................................
PROVISION FOR CREDIT LOSSES........................................................
NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES
...............................................................................................................

NONINTEREST INCOME:

Service charges on deposit accounts .................................................
(Loss) gain on sale of securities, net .................................................
Other..................................................................................................
Total noninterest income................................................

NONINTEREST EXPENSE:

Salaries and employee benefits .........................................................
Net occupancy expense .....................................................................
Data processing .................................................................................
Core deposit intangibles amortization ...............................................
Depreciation expense ........................................................................
Other..................................................................................................
Total noninterest expense...............................................
INCOME BEFORE INCOME TAXES......................................................
PROVISION FOR INCOME TAXES........................................................
NET INCOME............................................................................................
EARNINGS PER SHARE:

Basic..................................................................................................
Diluted...............................................................................................

2005

For the Years Ended
December 31,
2004
(Dollars in thousands, except
per share data)

2003

99,958 $

55,779 $

46,686

59,066
1,286
514
1,292
7
162,123

43,643
4,895
768
1,920
51,226
110,897
480

52,771
1,461
1,009
556
180

111,756

24,586
4,046
232
925

29,789

81,967
880

40,507
1,625
1,779
232
16

90,845

22,633
2,630
134
949

26,346

64,499
483

110,417

81,087

64,016

24,985
(79)
5,115
30,021

36,672
6,663
2,837
3,912
4,462
14,411
68,957
71,481
23,621
47,860 $

20,215
78
2,778

23,071

27,861
4,814
2,036
1,781
2,843
12,372

51,707

52,451
17,744

14,236
—
2,730

16,966

22,422
4,492
2,128
818
2,535
9,626

42,021

38,961
12,413

34,707 $

26,548

1.79 $
1.77 $

1.61 $

1.59 $

1.38

1.36

See notes to consolidated financial statements.

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Common Stock

Amount

Capital
Surplus

Retained
Earnings

Accumulated
Other
Comprehensive
Income (loss)

Treasury
Stock

Total
Shareholders’
Equity

BALANCE AT JANUARY 1, 2003 .....................................................................................................................

Comprehensive income:

18,903,028 $ 18,903 $

Total comprehensive income ..........................................................................................

(Dollars in thousands, except share data)
2,644
60,312

72,917

26,548

(620)

Sale of common stock in connection with the exercise of stock options.................................................
Refund of escrow shares in connection with the Paradigm acquisition...................................................
Common stock issued in connection with the Mainbancorp acquisition.................................................
Common stock issued in connection with the FSBNT acquisition..........................................................
Stock option compensation expense.........................................................................................................
Junior subordinated debentures issuance costs ........................................................................................
Cash dividends declared, $0.25 per share ................................................................................................

170,638

171

824

1,499,966
393,074

1,500
393

33,149
8,538
25
(254)

BALANCE AT DECEMBER 31, 2003 ................................................................................................................

Comprehensive income:

20,966,706

20,967

102,594

Total comprehensive income ..........................................................................................

Sale of common stock in connection with the exercise of stock options.................................................
Common stock issued in connection with the Liberty acquisition ..........................................................
Stock option compensation expense.........................................................................................................
Cash dividends declared, $0.31 per share ................................................................................................

206,231
1,245,191

206
1,245

840
30,713
141

(4,855)

94,610

34,707

(6,670)

(37) $

(570)

2,024

(607)

(5,123)

22,418,128

22,418

134,288

122,647

(3,099)

(607)

BALANCE AT DECEMBER 31, 2004 ................................................................................................................

Comprehensive Income:

Net income ...................................................................................................................................
Net change in unrealized loss on available for sale securities ....................................................
Add: Reclassification adjustment for net losses included in net income, net of tax benefit of
$28 .........................................................................................................................................

Total comprehensive income ..........................................................................................

Sale of common stock in connection with the exercise of stock options.................................................
Common stock issued in connection with restricted stock awards ..........................................................
Common stock issued in connection with the First Capital acquisition ..................................................
Common stock issued in connection with the Grapeland acquisition......................................................
Stock option compensation expense.........................................................................................................
Cash dividends declared, $0.35 per share ................................................................................................
Other .........................................................................................................................................................

123,098
4,917
5,078,856
232,888

123
5
5,079
233

962
127
137,439
6,894
619

196

(894)

47,860

(9,624)

BALANCE AT DECEMBER 31, 2005 ................................................................................................................

27,857,887 $ 27,858 $ 280,525

$ 160,883

(3,942) $

(607) $

See notes to consolidated financial statements.

154,739
26,548
(620)
25,928
995
(570)
34,649
8,931
25
(254)
(4,855)
219,588
34,707
(5,123)
29,584
1,046
31,958
141
(6,670)
275,647
47,860
(894)

51
47,017
1,085
132
142,518
7,127
619
(9,624)
196
464,717

PROSPERITY BANCSHARES, INC.® 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 of premium on investments ...............................................................................
Gain on sale of premises, equipment and other real estate ...........................................................
Gain on held for sale loans ............................................................................................................
Loss on sale of securities ...............................................................................................................
Funding of held for sale loans .......................................................................................................
Proceeds from sale of held for sale loans ......................................................................................
Stock option compensation expense..............................................................................................
Restricted stock award ...................................................................................................................
Decrease (increase) in accrued interest receivable and other assets .............................................
(Decrease) increase in accrued interest payable and other liabilities............................................
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 ...................................
Proceeds from the sales 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 .....................................................
Purchase of First Capital Bankers, Inc .......................................................................................................
Cash and cash equivalents acquired in the purchase of First Capital Bankers, Inc. ..................................
Purchase of Grapeland Bancshares, Inc. ....................................................................................................
Cash and cash equivalents acquired in the purchase of Grapeland Bancshares, Inc. ................................
Purchase of Liberty Bancshares, Inc. and Village Bank & Trust, ssb .......................................................
Cash and cash equivalents acquired in the purchase of Liberty Bancshares, Inc. and Village Bank & Trust,
ssb .........................................................................................................................................................
Purchase of Abrams Centre Bancshares, Dallas Bancshares, MainBancorp and FSBNT ........................
Cash and cash equivalents acquired in the purchase of Abrams Centre Bancshares, Dallas Bancshares,
MainBancorp and FSBNT....................................................................................................................
Net (increase) decrease in interest-bearing deposits in financial institutions ............................................
Net cash (used in) provided by investing activities..........................................................

CASH FLOWS FROM FINANCING ACTIVITIES:

Net increase (decrease) in noninterest-bearing deposits ............................................................................
Net (decrease) increase in interest-bearing deposits ..................................................................................
Proceeds (repayments) of other borrowings and securities sold under repurchase agreements (net) .......
Proceeds from issuance of junior subordinated debentures .......................................................................
Junior subordinated debentures issuance costs ..........................................................................................
Redemption of junior subordinated debentures issued to Prosperity Capital Trust I (net)........................
Proceeds from stock option exercises.........................................................................................................
Payments of cash dividends........................................................................................................................
Net cash (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 ....................................................................................
NONCASH ACTIVITIES:
Stock issued in connection with the First Capital Bankers, Inc. acquisition ..........................................................
Stock issued in connection with the Grapeland Bancshares, Inc. acquisition ........................................................
Stock issued in connection with the Liberty Bancshares, Inc. acquisition .............................................................
Stock issued in connection with the MainBancorp and FSBNT acquisitions ........................................................
SUPPLEMENTAL INFORMATION:
Income taxes paid ....................................................................................................................................................
Interest paid .............................................................................................................................................................

See notes to consolidated financial statements.

2005

For the Years Ended
December 31,
2004
(Dollars in thousands)

2003

47,860 $
8,374
480
2,781
(72)
(173)

79
(14,540)
14,717
619
132
5,891
(446)
65,702

(224,203)

263,966
(254,476)
81,916
—
2,279
(1,745)
2,428
(2,182)
58,972
(163)
4,525
—
—
—
—
(1)

34,707

26,548

5,122
880
4,869
(389)
—
—
—
—
141
—
(4,056)
7,649

3,353
483
9,707
(378)
—
—
—
—
25
—
4,871
(3,995)

48,923

40,614

257,501
(270,855)
67,201
20,000
(299)
(68,254)
(895)
3,297
—
—
—
—
(28,282)

62,719
—

—
762

505,733
(973,480)
144,821
—
(11,951)
38,001
(3,485)
3,243
—
—
—
—
—

—
(45,665)

158,902
399

(68,684)

42,895

(183,482)

(122,734)

60,252 $
33,457
—
—
—
1,085
(9,624)

(9,892) $
(14,727)
4,622
—
—
(12,000)
1,046
(6,670)

(37,564)

(37,621)

23,579
125,657
(24,340)
25,000
(254)
—
995
(4,855)

145,782

2,914
80,799

(40,546) $
137,910
97,364 $

54,197
83,713

137,910

83,713

142,518
7,127
—
—

—
—
31,958
—

—
—
—
43,580

21,350 $
47,782 $

19,464

29,368

14,397

26,215

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING

POLICIES

Nature of Operations—Prosperity Bancshares, Inc.® (“Bancshares”) and its subsidiaries, Prosperity Holdings of

Delaware, LLC (“Holdings”) and Prosperity Bank® (the “Bank”, and together with Bancshares and Holdings, collectively
referred to as the “Company”) provide retail and commercial banking services.

The Bank operates eighty-five (85) full-service banking locations in the state of Texas; with thirty-three (33) in the

Greater Houston Consolidated Metropolitan Statistical Area (“CMSA”), seventeen (17) in fifteen contiguous counties
situated south and southwest of Houston and extending into South Texas, eleven (11) in the Dallas area, six (6) in the Austin
area, sixteen (16) in the Corpus Christi area and two (2) in the East Texas area with locations in:

Austin Area-
Allandale
Congress
Lakeway
Oak Hill
Research Blvd.
Riverside

Dallas Area-
Abrams Centre
Blooming Grove
Camp Wisdom
Cedar Hill
Corsicana
Ennis
Kiest
Preston Road
Red Oak
Turtle Creek
Westmoreland

Corpus Christi
Area-
Airline
Alameda
Alice
Aransas Pass
Carmel
Everhart
Kingsville
Mathis
Northwest
Port Aransas
Portland
Rockport
Saratoga
Sinton
Waterstreet
Woodlawn

East Texas Area-
Crockett
Grapeland

Houston Area-
Aldine
Angleton
Bellaire
City West
Clear Lake
Cleveland
Copperfield
Cypress
Dayton
Downtown
Fairfield
Galveston
Gladebrook
Heights
Highway 6
Hitchcock
Holcombe
Liberty
Magnolia
Medical Center
Memorial
Midtown
Mont Belvieu
Needville
Post Oak
River Oaks
Sweeny

Tanglewood
Waugh Drive
West Columbia
Westheimer
Winnie
Woodcreek

South Texas Area-
Bay City
Beeville
Cuero
East Bernard
Edna
El Campo
Goliad
Gonzales
Hallettsville
Palacios
Port Lavaca
Seguin
Victoria
Victoria-North
Wharton
Yoakum
Yorktown

Principles of Consolidation—The consolidated financial statements include the accounts of Bancshares and its wholly

owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation. The accounting and
reporting policies of the Company conform to accounting principles generally accepted in the United States of America
(“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 shareholders’ equity until realized. Securities within the available for sale

portfolio may be used as part of the Company’s asset/liability strategy and may be sold in response to changes in interest risk,
prepayment risk or other similar economic factors.

Declines in the fair value of individual held to maturity and available for sale securities below their cost that are other
than temporary would result in write-downs of the individual securities to their fair value. The related write-downs would be
included in earnings as realized losses.

Premiums and discounts are amortized and accreted to operations using the level-yield method of accounting, adjusted

for prepayments as applicable. The specific identification method of accounting is used to compute gains or losses on the
sales of these assets. Interest earned on these assets is included in interest income.

Loans Held for Investment—Loans are stated at the principal amount outstanding, net of unearned discount and fees.

Unearned discount relates principally to consumer installment loans. The related interest income for multipayment loans is
recognized principally by the “sum of the digits” method which records interest in proportion to the declining outstanding
balances of the loans; for single payment loans, such income is recognized using the straight-line method.

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 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 inherent in the loan 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.

In making its evaluation of the adequacy of the allowance for credit losses, 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.

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.

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 loan’s observable market price or the fair value of the collateral if the
loan is collateral dependent. At December 31, 2005, the Company had $355,000 in nonaccrual loans, $788,000 in 90 days or
more past due loans and no restructured loans. At December 31, 2004, the Company had $297,000 in nonaccrual loans, $1.1
million in 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.

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. Leasehold improvements are amortized using the straight-line method over the periods of the leases or the
estimated useful lives, whichever is shorter.

Goodwill—Goodwill is annually assessed for impairment or 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—Core deposit intangibles are amortized using an accelerated amortization

method over an 8 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—As of December 31, 2005, the Company had three stock-based employee compensation
plans. Prior to 2003, the Company accounted for awards granted under stock-based compensation plans under the recognition
and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations.
No stock-based employee compensation cost was reflected in previously reported results, as all options granted under those
plans had an exercise price equal to the market value of the underlying common stock on the date of grant. In December
2002, the FASB issued Statement No. 148 (SFAS 148). Accounting for Stock-Based Compensation—Transition and
Disclosure, an amendment to FASB Statement No. 123. SFAS 148 provides alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee compensation. SFAS 148 was effective for
financial statements for fiscal years ending after December 15, 2002. Effective January 1, 2003, the Company adopted the
fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, as provided by
SFAS No. 148 for stock-based employee compensation (see Note 14).

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 prior year amounts to conform to current year

presentation. All reclassifications have been applied consistently for the periods presented. During 2005, the Company
elected to reclassify brokered mortgage income from other noninterest income to a separate category and reclassify net gains
on held for sale loans from net gains on sales of assets to a separate category. These reclassifications had no impact on
financial condition, net income or equity in any of the reported periods.

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:

2005

December 31,
2004

Amount

Per
Share
Amount

Amount

Per
Share
Amount

Net income..................................... $
Basic:

47,860

Weighted average shares

(In thousands, except per share data)
$

34,707

2003

Amount

26,548

Per
Share
Amount

outstanding ......................

26,706 $

1.79

21,534 $

1.61

19,225 $

1.38

Diluted:

Weighted average shares

outstanding ......................

26,706

Effect of dilutive

securities— options .........

318

21,534

270

19,225

311

Total .....................................

27,024 $

1.77

21,804 $

1.59

19,536 $

1.36

The incremental shares for the assumed exercise of the outstanding options were determined by application of the

treasury stock method. There were no stock options exercisable at December 31, 2005, 2004 and 2003 that would have had
an anti-dilutive effect on the above computation.

New Accounting Standards—

Statements of Financial Accounting Standards

SFAS No. 154, Accounting Changes and Error Corrections, a Replacement of APB Opinion No. 20 and FASB

Statement No. 3. SFAS 154 establishes, unless impracticable, retrospective application as the required method for reporting a
change in accounting principle in the absence of explicit transition requirements specific to a newly adopted accounting
principle. Previously, most changes in accounting principle were recognized by including the cumulative effect of changing
to the new accounting principle in net income of the period of the change. Under SFAS 154, retrospective application
requires (i) the cumulative effect of the change to the new accounting principle on periods prior to those presented to be
reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented, (ii) an offsetting
adjustment, if any, to be made to the opening balance of retained earnings (or other appropriate components of equity) for
that period, and (iii) financial statements for each individual prior period presented to be adjusted to reflect the direct period-
specific effects of applying the new accounting principle. Special retroactive application rules apply in situations where it is
impracticable to determine either the period-specific effects or the cumulative effect of the change. Indirect effects of a
change in accounting principle are required to be reported in the period in which the accounting change is made. SFAS 154
carries forward the guidance in APB Opinion 20, Accounting Changes, requiring justification of a change in accounting
principle on the basis of preferability. SFAS 154 also carries forward without change the guidance contained in APB
Opinion 20, for reporting the correction of an error in previously issued financial statements and for a change in an
accounting estimate. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning
after December 15, 2005. The Company does not expect SFAS 154 will significantly impact its financial statements upon its
adoption on January 1, 2006.

SFAS No. 123, Share-Based Payment (Revised 2004). SFAS 123R establishes standards for the accounting for
transactions in which an entity (i) exchanges its equity instruments for goods or services, or (ii) incurs liabilities in exchange
for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance
of the equity instruments. SFAS 123R eliminates the ability to account for stock-based compensation using APB 25 and
requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the
date of the grant. SFAS 123R is mandatory for all entities on January 1, 2006. The Company does not expect SFAS 123R
will significantly impact its financial statements upon its adoption on January 1, 2006.

Financial Accounting Standards Board Staff Positions

FASB Staff Position (FSP) No. 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments. FSP 115-1 provides guidance for determining when an investment is considered impaired, whether
impairment is other-than-temporary, and measurement of an impairment loss. An investment is considered impaired if the
fair value of the investment is less than its cost. If, after consideration of all available evidence to evaluate the realizable
value of its investment, impairment is determined to be other-than-temporary, then an impairment loss should be recognized
equal to the difference between the investment’s cost and its fair value. FSP 115-1 nullifies certain provisions of Emerging
Issues Task Force (EITF) Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments, while retaining the disclosure requirements of EITF 03-1 which were adopted in 2003. FSP 115-1 is effective
for reporting periods beginning after December 15, 2005. The Company does not expect FSP 115-1 will significantly impact
its financial statements upon its adoption on January 1, 2006.

American Institute of Certified Public Accounting Statements of Position

SOP No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 addresses

accounting for differences between the contractual cash flows of certain loans and debt securities and the cash flows expected
to be collected when loans or debt securities are acquired in a transfer and those cash flow differences are attributable, at least
in part, to credit quality. As such, SOP 03-3 applies to loans and debt securities acquired individually, in pools or as part of a
business combination and does not apply to originated loans. The application of SOP 03-3 limits the interest income,
including accretion of purchase price discounts, that may be recognized for certain loans and debt securities. Additionally,
SOP 03-3 does not allow the excess of contractual cash flows over cash flows expected to be collected to be recognized as an
adjustment of yield, loss accrual or valuation allowance, such as the allowance for possible loan losses. SOP 03-3 requires
that increases in expected cash flows subsequent to the initial investment be recognized prospectively through adjustment of
the yield on the loan or debt security over its remaining life. Decreases in expected cash flows should be recognized as
impairment. In the case of loans acquired in a business combination where the loans show signs of credit deterioration,
SOP 03-3 represents a significant change from current purchase accounting practice whereby the acquiree’s allowance for
loan losses is typically added to the acquirer’s allowance for loan losses. SOP 03-3 is effective for loans and debt securities
acquired by the Company beginning January 1, 2005. The Company evaluates the impact of SOP 03-03 on all of its
acquisitions. The adoption of SOP 03-03 on January 1, 2005 did not have a material impact on the Company’s financial
statements.

2. ACQUISITIONS

Acquisitions are an integral part of the Company’s growth strategy. All acquisitions were accounted for using the
purchase method of accounting. Accordingly, the assets and liabilities of the acquired entities were recorded at their fair
values at the acquisition date. The excess of the purchase price over the estimated fair value of the net assets for each
acquisition was recorded as goodwill, none of which was deductible for tax purposes. The results of operations for each
acquisition have been included in the Company’s consolidated financial results beginning on the respective acquisition date.
The following acquisitions were completed on the dates indicated:

On December 1, 2005, the Company completed its acquisition of Grapeland Bancshares, Inc. (“Grapeland”),
Grapeland, Texas. Under the terms of the agreement, Grapeland merged into the Company and subsequently, Grapeland’s
wholly owned subsidiary, First State Bank of Grapeland, merged into the Bank. The Company issued 232,888 shares of its
Common Stock for all of the issued and outstanding capital stock of Grapeland. Grapeland was privately held and operated
two (2) banking offices in Grapeland and Crockett, Texas, both of which became full service banking centers of the
Company. As of September 30, 2005, Grapeland had, on a consolidated basis, total assets of $72.2 million, loans of $43.7
million, deposits of $46.6 million and shareholders’ equity of $3.8 million.

In connection with the purchase, the Company recorded a premium of $5.4 million, of which $1.5 million was

identified as core deposit intangibles. The remaining $3.9 million of the premium was recorded as goodwill. The core deposit
intangibles are being amortized using an accelerated amortization method over an 8 year life.

On March 1, 2005, the Company completed its acquisition of First Capital Bankers, Inc. (“First Capital”), Corpus

Christi, Texas. Under the terms of the agreement, First Capital was merged into the Company and subsequently, First
Capital’s wholly owned subsidiary, FirstCapital Bank, s.s.b., was merged into the Bank. The Company issued approximately
5.079 million shares of its Common Stock for all of the issued and outstanding capital stock of First Capital and converted all
outstanding options to acquire First Capital common stock into options to acquire approximately 234,000 shares of Company
common stock. First Capital was privately held and operated thirty-two (32) banking offices in and around Corpus Christi,
Houston and Victoria, Texas, five of which were closed and consolidated with existing banking centers of the Company. As

of December 31, 2004, First Capital had, on a consolidated basis, total assets of $761.6 million, loans of $499.0 million,
deposits of $629.6 million and shareholders’ equity of $61.7 million.

In connection with the purchase, the Company recorded a premium of $116.6 million, of which $13.4 million was
identified as core deposit intangibles. The remaining $103.2 million of the premium was recorded as goodwill. The core
deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

The table below summarizes select pro forma data for the combined company for the periods indicated assuming the

First Capital merger was effective on January 1st of the indicated periods. The information in the table below also gives
effect to the Company’s acquisition of Grapeland as of December 1, 2005.

Net interest income ......................................................
Net income...................................................................
Earnings per share (diluted).........................................
Weighted average diluted shares .................................

$
$
$

For the twelve months ended December 31,

2005

2004

(Dollars in thousands)
(unaudited)
$
$
$

114,694
49,166
1.77
27,854

106,468
41,765
1.57
26,613

The pro forma results are not necessarily indicative of what actually would have occurred if the merger had occurred

on January 1 of each indicated period, or of any future consolidated results.

On August 1, 2004, the Company completed its acquisition of Village Bank and Trust, s.s.b. (“Village”), Austin,
Texas. Under the terms of the agreement, the Company paid approximately $19.1 million in cash for all of the outstanding
shares of capital stock of Village. Village was privately held and operated one (1) banking office in the Lakeway area of
Austin, Texas. As of June 30, 2004, Village had total assets of $110.9 million, loans of $79.7 million, deposits of $97.3
million and shareholders’ equity of $10.4 million.

In connection with the purchase, the Company recorded a premium of $12.2 million, of which $331,000 was identified

as core deposit intangibles. The remaining $11.9 million of the premium was recorded as goodwill. The core deposit
intangibles are being amortized using an accelerated amortization method over an 8 year life.

On August 1, 2004, the Company completed its acquisition of Liberty Bancshares, Inc. (“Liberty”), Austin, Texas,

pursuant to which Liberty merged into the Company and subsequently, its wholly owned subsidiary, Liberty Bank, S.S.B.,
merged into the Bank. Under the terms of the agreement, the Company paid approximately $8.9 million in cash and issued
approximately 1.3 million shares of its Common Stock for all outstanding shares of capital stock of Liberty and Liberty Bank
and all outstanding stock options of Liberty Bank. Liberty was privately held and operated six (6) banking offices in Austin,
Texas, one of which was closed and consolidated with an existing banking center of the Company in September 2005. As of
June 30, 2004, Liberty had, on a consolidated basis, total assets of $178.7 million, loans of $120.3 million, deposits of $158.9
million and shareholders’ equity of $16.5 million.

In connection with the purchase, the Company recorded a premium of $28.8 million of which $3.8 million was

identified as core deposit intangibles. The remaining $25.0 million of the premium was recorded as goodwill. The core
deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

On December 9, 2003, the Company completed the merger of First State Bank of North Texas, Dallas, Texas
(“FSBNT”) into the Bank. Under the terms of the agreement, the Company paid approximately $12.6 million in cash and
issued approximately 393,074 shares of its Common Stock for all outstanding shares of capital stock of FSBNT. FSBNT was
privately held and operated four (4) banking offices in Dallas, Texas. One banking center was closed and consolidated with
an existing banking center located nearby. As of September 30, 2003, First State had total assets of $100.7 million, loans of
$20.1 million, deposits of $91.4 million and shareholders’ equity of $8.8 million.

In connection with the purchase, the Company recorded a premium of $14.0 million of which $1.9 million was

identified as core deposit intangibles. The remaining $12.1 million of the premium was recorded as goodwill. The core
deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

On November 1, 2003, the Company completed the merger of MainBancorp, Inc., Dallas Texas (“MainBancorp”), into
the Company. In connection with the transaction, MainBancorp’s wholly owned subsidiary, mainbank, n.a., was merged into
the Bank. Under the terms of the agreement, the Company issued approximately 1.5 million shares of its Common Stock and
paid approximately $9.1 million in cash for all outstanding shares of capital stock of MainBancorp. In addition, the Company
assumed options to acquire 100,851 shares of its Common Stock. MainBancorp was privately held and operated four

(4) banking offices in Dallas, Texas. As of September 30, 2003, MainBancorp had, on a consolidated basis, total assets of
$177.1 million, loans of $90.8 million, deposits of $153.7 million and shareholders’ equity of $22.6 million.

In connection with the purchase, the Company recorded a premium of $30.7 million of which $3.0 million was

identified as core deposit intangibles. The remaining $27.7 million of the premium was recorded as goodwill. The core
deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

On June 1, 2003, the Company completed the merger of Dallas Bancshares, Inc., Dallas, Texas (“Dallas Bancshares”),
into the Company. In connection with the transaction, Dallas Bancshares’ wholly owned subsidiary, BankDallas, was merged
into the Bank. Under the terms of the agreement, the Company paid approximately $7.0 million in cash for all outstanding
shares of capital stock of Dallas Bancshares. Dallas Bancshares operated one (1) banking office in Dallas, Texas. As of
March 31, 2003, Dallas Bancshares had on a consolidated basis, total assets of $42.0 million, loans of 28.3 million, deposits
of $37.6 million and shareholders’ equity of $4.3 million.

In connection with the purchase, the Company recorded a premium of $3.0 million of which $45,000 was identified as
core deposit intangibles. The remaining $3.0 million of the premium was recorded as goodwill. The core deposit intangibles
are being amortized using an accelerated amortization method over an 8 year life.

On May 6, 2003, the Company completed the merger of Abrams Centre Bancshares, Inc., Dallas, Texas (“Abrams”),

into the Company. In connection with the acquisition, Abrams’ wholly owned subsidiary, Abrams Centre National Bank, was
merged into the Bank. Under the terms of the agreement, the Company paid approximately $16.3 million in cash for all
outstanding shares of capital stock of Abrams. Abrams operated two (2) banking offices in Dallas, Texas. One banking center
was closed and consolidated with an existing banking center located nearby. As of March 31, 2003, Abrams, on a
consolidated basis, had total assets of $96.5 million, loans of $31.7 million, deposits of $70.8 million and shareholders’
equity of $14.0 million.

In connection with the purchase, the Company recorded premium of $7.3 million of which $430,000 was identified as
core deposit intangibles. The remaining $6.9 million of the premium was recorded as goodwill. The core deposit intangibles
are being amortized using an accelerated amortization method over an 8 year life.

3. GOODWILL AND OTHER INTANGIBLE ASSETS

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles for fiscal 2005 and 2004 were

as follows:

Goodwill

Core Deposit
Intangibles

(Dollars in thousands)

118,012 $

Balance as of December 31, 2003.................................................................
Less:

Amortization .......................................................................................

Add:

Acquisition of Liberty Bancshares ......................................................
Acquisition of Village Bank & Trust, ssb ...........................................
Acquisition of MainBancorp ...............................................................
Acquisition of FSBNT ........................................................................

Purchase accounting adjustments to prior year acquisitions (deferred tax

adjustments):

Acquisition of FSBNT ........................................................................
Acquisition of MainBancorp ...............................................................
Acquisition of Texas Guaranty Bank ..................................................
Acquisition of First State Bank of Needville ......................................
Acquisition of Paradigm Bancorporation............................................
Acquisition of Abrams Centre.............................................................
Acquisition of Dallas Bancshares........................................................
Acquisition of Southwest Bank Holding Company ............................
Balance as of December 31, 2004..............................................

—

23,803
11,851
(203)
(2,266)

404
748
(9)
(6)
(127)
153
24
796
153,180 $

6,743

(1,781)

3,797
331
300
2,102

—
—
—
—
—
—
—
—

11,492

Less:

Add:

Amortization .......................................................................................

Acquisition of Grapeland Bancshares .................................................
Acquisition of First Capital Bankers, Inc. ...........................................
Acquisition of Liberty Bancshares ......................................................
Acquisition of Village Bank & Trust, ssb ...........................................

Purchase accounting adjustments to prior year acquisitions (deferred tax

adjustments) .............................................................................................
Balance as of December 31, 2005..............................................

—

(3,912)

3,923
103,184
1,160
9

508
261,964 $

1,488
13,393
—
—

—

22,461

Gross core deposit intangibles outstanding were $29.2 million at December 31, 2005 and $14.3 million at

December 31, 2004. Purchase accounting adjustments to prior year acquisitions were made to adjust deferred tax asset and
liability balances. Goodwill is recorded on the acquisition date of each entity. The Company may record subsequent
adjustments to goodwill for amounts undeterminable at acquisition date, such as deferred taxes, and therefore the goodwill
amounts reflected in the table above may change accordingly.

Core deposit intangibles are amortized on an accelerated basis over their estimated lives which is 8 years. Amortization

expense related to intangible assets totaled $3.9 million in 2005, $1.8 million in 2004 and $818,000 in 2003. The estimated
aggregate future amortization expense for intangible assets remaining as of December 31, 2005 is as follows (dollars in
thousands):

2006 .........................................................................................
2007 .........................................................................................
2008 .........................................................................................
2009 .........................................................................................
2010 .........................................................................................
Thereafter.................................................................................
Total ...............................................................................

4,231
3,940
3,648
3,357
2,964
4,321
22,461

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 $34.5 million and $20.9 million at December 31, 2005 and
2004, respectively.

5. SECURITIES

The amortized cost and fair value of investment 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. ................................
Qualified Zone Academy Bond ...........................
Other securities ....................................................

Amortized
Cost

Gross
Unrealized
Gains

December 31, 2005

Gross
Unrealized
Losses
(Dollars in thousands)

Fair
Value

Carrying
Value

231,399 $
24,000
14,102
8,096
130,014
8,000
814

430 $
—
1,005
45
277
—
—

1,752 $
5,334
—
34
701
—
—

230,077 $
18,666
15,107
8,107
129,590
8,000
814

230,077
18,666
15,107
8,107
129,590
8,000
814

Total ...........................................................

416,425 $

1,757 $

7,821 $

410,361 $

410,361

Held to Maturity
U.S. Treasury securities and obligations of U.S.
government agencies.......................................
States and political subdivisions ..........................
Corporate debt securities .....................................
Collateralized mortgage obligations ....................
Mortgage-backed securities .................................

64,950 $
17,148
8,550
214,519
857,074

409 $
173
108
313
721

564 $
31
3
5,805
21,868

64,795 $
17,290
8,655
209,027
835,927

64,950
17,148
8,550
214,519
857,074

Total ...........................................................

$ 1,162,241 $

1,724 $

28,271 $ 1,135,694 $ 1,162,241

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. ................................
Qualified Zone Academy Bond ...........................
Equity securities...................................................

Amortized
Cost

Gross
Unrealized
Gains

December 31, 2004

Gross
Unrealized
Losses
(Dollars in thousands)

Fair
Value

Carrying
Value

10,579 $
24,000
14,382
13,143
112,050
8,000
296

2 $

69 $

—
1,366
76
545
—
—

6,150
—
35
502
—
—

10,512 $
17,850
15,748
13,184
112,093
8,000
296

10,512
17,850
15,748
13,184
112,093
8,000
296

Total ...........................................................

182,450 $

1,989 $

6,756 $

177,683 $

177,683

20,147 $
23,317
10,491
225,851
845,303

661 $
510
301
97
3,559

6 $

15
—
802
4,914

20,802 $
23,812
10,792
225,146
843,948

20,147
23,317
10,491
225,851
845,303

Total ...........................................................

$ 1,125,109 $

5,128 $

5,737 $ 1,124,500 $ 1,125,109

In estimating other-than-temporary impairment losses, management considers, among other things, (i) the length of

time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the
issuer and (iii) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to
allow for any anticipated recovery in fair value.

Management has the ability and intent to hold its securities until they mature, at which time the Company will receive

full value for the securities. The unrealized losses are largely due to increases in market interest rates over the yields available
at the time the underlying securities were purchased. The fair value is expected to recover as the investments approach their
maturity date or repricing date or if market yields for such investments decline. Management does not believe any of the
securities in an unrealized loss position at December 31, 2005 are impaired due to reasons of credit quality. Accordingly, as
of December 31, 2005, management believes the impairments detailed in the table above are temporary and no impairment
loss has been realized in the Company’s consolidated statements of income.

Securities with unrealized losses segregated by length of time such securities have been in a continuous loss position at

December 31, 2005 were as follows:

Less than 12 Months

Estimated
Fair Value

Unrealized
Losses

More than 12 Months

Estimated
Fair Value

Unrealized
Losses
(Dollars in thousands)

Total

Estimated
Fair Value

Unrealized
Losses

Available for Sale
U.S. Treasury securities and obligations

of U.S. government agencies ............... $ 177,152 $

70% non-taxable preferred stock ..............
Collateralized mortgage obligations .........
Mortgage-backed securities ......................

—
—
60,284

1,691 $
—
—
460

5,515 $

61 $ 182,667 $

18,666
2,592
32,746

5,334
34
241

18,666
2,592
93,030

Total ................................................ $ 237,436 $

2,151 $

59,519 $

5,670 $ 296,955 $

1,752
5,334
34
701

7,821

Held to Maturity
U.S. Treasury securities and obligations

of U.S. government agencies ............... $

States and political subdivisions ...............
Corporate debt securities ..........................
Collateralized mortgage obligations .........
Mortgage-backed securities ......................

24,933 $
4,298
—
53,384
343,533

564 $
18
—
1,167
6,767

— $

1,530
1,503
134,739
414,563

— $
13
3
4,638
15,101

24,933 $
5,828
1,503
188,123
758,096

564
31
3
5,805
21,868

Total ................................................ $ 426,418 $

8,516 $ 552,335 $

19,755 $ 978,483 $

28,271

At December 31, 2005, there were approximately 185 securities in an unrealized loss position for more than 12 months.

The amortized cost and fair value of investment securities at December 31, 2005, by contractual maturity, are shown

below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay
obligations at any time with or without call or prepayment penalties.

December 31, 2005

Held to Maturity

Amortized
Cost

14,242 $
71,027
5,379
—

Fair
Value
(Dollars in thousands)
14,275 $
70,964
5,501
—

Available for Sale
Fair
Value

Amortized
Cost

5,876 $
226,503
13,026
32,910

5,825
225,232
13,331
28,276

90,648

90,740

278,315

272,664

1,071,593

1,044,954

138,110

137,697

$ 1,162,241 $ 1,135,694 $ 416,425 $ 410,361

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.............................................................................
Total .................................................................................

Gross proceeds from the sale of securities classified as available for sale was approximately $3.2 million for the year
ended December 31, 2005 and resulted in a loss of $79,000 for the same period. Gross proceeds from the sale of securities
classified as available for sale was approximately $20.1 million for the year ended December 31, 2004 and resulted in a gain
of $78,000 for the same period.

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, 2005 and 2004.

Securities with an amortized cost of $842.3 million and $790.2 million and a fair value of $823.3 million and $789.6
million at December 31, 2005 and 2004, respectively, were pledged to collateralize public deposits and for other purposes
required or permitted by law.

6. LOANS

The loan portfolio consists of various types of loans made principally to borrowers located in South and Southeast

Texas, the Houston CMSA, Austin, Corpus Christi and Dallas and is classified by major type as follows:

December 31,

2005

2004

Commercial and industrial...........................................................
Real estate:

Construction and land development ...................................
1-4 family residential .........................................................
Home equity .......................................................................
Commercial mortgages ......................................................
Farmland ............................................................................
Multi-family residential......................................................
Agriculture...................................................................................
Consumer.....................................................................................
Other ............................................................................................
Total ...................................................................................
Less unearned discount................................................................
Total ...................................................................................

(Dollars in thousands)

222,773 $

206,653
313,184
58,729
566,356
30,920
32,039
25,429
65,185
20,859
1,542,127
2

1,542,125 $

144,432

109,591
260,453
34,453
369,151
22,240
18,187
21,906
52,887
2,246

1,035,546
33

1,035,513

The Company had $1.4 million in nonperforming assets at December 31, 2005 compared with $1.7 million at

December 31, 2004. Interest foregone on nonaccrual loans for the years ended December 31, 2005, 2004 and 2003 was
$35,000, $54,000 and $38,000, respectively.

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:

December 31, 2005

One Year
or Less

After One
Through
Five Years

After Five
Years
(Dollars in thousands)

Total

57,522

39,292

98,823 $ 101,891 $ 22,059 $ 222,773
206,653
109,839
$ 208,662 $ 141,183 $ 79,581 $ 429,426
52,713 $ 24,154 $ 119,856
88,470
309,570
55,427
$ 208,662 $ 141,183 $ 79,581 $ 429,426

42,989 $

165,673

As of December 31, 2005 and 2004, loans outstanding to directors, officers and their affiliates totaled $7.6 million and
$7.3 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,

2005

2004

Beginning balance ..........................................................................................
New loans and reclassified related loans ........................................................
Repayments ....................................................................................................
Ending balance................................................................................................

7. ALLOWANCE FOR CREDIT LOSSES

An analysis of activity in the allowance for credit losses is as follows:

(Dollars in thousands)
7,346 $
4,045
(3,771)
7,620 $

5,589
4,217
(2,460)

7,346

Balance at beginning of year. ............................................................

Balance acquired in the First Capital and Grapeland acquisitions
Balance acquired in the Liberty and Village acquisitions ........
Balance acquired in the Abrams, Dallas Bancshares, MainBancorp
and FSBNT acquisitions......................................................
Addition—provision charged to operations .............................
(Charge-offs) and recoveries:

Loans charged off ...........................................................
Loan recoveries...............................................................
Net charge-offs.........................................................................
Balance at end of year........................................................................

8. PREMISES AND EQUIPMENT

Premises and equipment are summarized as follows:

2005

Year Ended December 31,
2004
(Dollars in thousands)
10,345 $
—
2,365

13,105 $
4,028
—

2003

9,580
—
—

1,900
483

—
480

(892)
482

(410)

17,203 $

—
880

(950)
465
(485)
13,105 $

(2,241)
623

(1,618)

10,345

Land ....................................................................................................
Buildings.............................................................................................
Furniture, fixtures and equipment.......................................................
Construction in progress .....................................................................
Total ..........................................................................................
Less accumulated depreciation ...........................................................
Premises and equipment, net.....................................................

Year Ended
December 31,

2004

2005
(Dollars in thousands)
12,969 $
39,110
13,993
740
66,812
(17,568)
49,244 $

8,636
30,236
10,739
74

49,685
(13,892)

35,793

Depreciation expense was $4.5 million, $2.8 million and $2.5 million for the years ended December 31, 2005, 2004

and 2003 respectively.

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, 2005 were as follows:

Three months or less...............................................................................
Greater than three through six months....................................................
Greater than six through twelve months .................................................
Thereafter................................................................................................
Total ..............................................................................................

December 31, 2005
(Dollars in thousands)
188,658
80,731
103,911
116,245
489,545

Interest expense for certificates of deposit in excess of $100,000 was $14.2 million, $8.5 million and $7.4 million, for

the years ended December 31, 2005, 2004 and 2003, respectively.

The Company has no brokered deposits and there are no major concentrations of deposits with any one depositor.

10. BORROWINGS

Other borrowings—The Company utilizes borrowings to supplement deposits to fund its lending and investment

activities. Borrowings consist of funds from the Federal Home Loan Bank (“FHLB”) and correspondent banks. FHLB
advances are considered short-term, overnight borrowings. At December 31, 2005, the Company had $55.4 million in FHLB
borrowings which consisted of $38.4 million in long-term FHLB notes payable and $17.0 million in FHLB advances
compared with $13.1 million in FHLB borrowings at December 31, 2004, all of which were long-term FHLB notes payable.
The $42.3 million increase was primarily attributable to the $2.6 million in FHLB long-term notes payable acquired in the
Village acquisition, $30.6 million in FHLB long-term notes payable acquired in the First Capital acquisition and FHLB
advances of $17.0 million, partially offset by normal pay downs on the remaining notes. The weighted average interest rate
paid on the FHLB advances at period end was 4.4%. The maturity dates on the FHLB notes payable range from the years
2006 to 2028 and have interest rates ranging from 2.79% to 8.80%. The highest outstanding balance of FHLB advances
during 2005 was $39.0 million compared with $50.0 million during 2004. The Company had no federal funds purchased at
December 31, 2005 or 2004.

Securities sold under repurchase agreements—At December 31, 2005, the Company had $47.0 million in securities

sold under repurchase agreements compared with $25.1 million at December 31, 2004, an increase of $21.9 million or 87.5%.

11. INTEREST RATE RISK

The Company is principally engaged in providing real estate, consumer and commercial loans, with interest rates that

are both fixed and variable. These loans are primarily funded through short-term demand deposits and longer-term
certificates of deposit with variable and fixed rates. The fixed real estate loans are more sensitive to interest rate risk because
of their fixed rates and longer maturities.

12. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK

In the normal course of business, the Company is a party to various financial instruments with off-balance-sheet risk to

meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby
letters of credit, which 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 contract or notional amount of the various financial instruments entered into by the

Company:

December 31,

Commitments to extend credit ..........................................................
Standby letters of credit ....................................................................

335,291 $
7,434

190,845
5,863

2005
(Dollars in thousands)

2004

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 funding requirements. At December 31, 2005,
$30.4 million of commitments to extend credit have fixed rates ranging from 3.15% to 18.00%.

Standby letters of credit are written conditional commitments issued by the Company to guarantee the performance of a

customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the
third party, the Company would be required to fund the commitment. The maximum potential amount of future payments the
Company could be required to make is represented by the contractual amount of the commitment. If the commitment is
funded, the Company would be entitled to seek recovery from the customer. The Company’s policies generally require that
standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.

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:

Current ...............................................................................................
Deferred. ............................................................................................
Total...................................................................................................

2005

Year Ended December 31,
2004
(Dollars in thousands)
16,211 $
1,533
17,744 $

17,566 $
6,055

23,621 $

2003

12,203
210

12,413

The provision for federal income taxes differs from the amount computed by applying the federal income tax statutory

rate on income as follows:

2005

Year Ended December 31,
2004
(Dollars in thousands)
18,358 $

25,018

(538)
(373)
(126)
(139)
—
(221)

23,621

(612)
(373)
(286)
—
623
34
17,744 $

2003

13,636

(702)
(373)
(436)
—
—
288

12,413

Taxes calculated at statutory rate.......................................................
Increase (decrease) resulting from:

Tax-exempt interest..................................................................
Qualified Zone Academy Bond credit......................................
Dividends received deduction ..................................................
BOLI income............................................................................
Amortization of CDI and goodwill ..........................................
Other, net..................................................................................
Total...................................................................................................

Deferred tax assets and liabilities are as follows:

Deferred tax assets:

Allowance for credit losses ........................................................
Nonaccrual loan interest.............................................................
Accrued liabilities ......................................................................
Bank premises and equipment....................................................
Basis difference in loans ............................................................
Unrealized loss on available for sale securities ..........................
Loss carry forwards (expire 2022) .............................................
Credit carry forwards (expire 2021)...........................................
Other...........................................................................................
Total deferred tax assets ......................................................................
Deferred tax liabilities:

Accretion on investments ...........................................................
Goodwill and core deposit intangibles .......................................
Bank premises and equipment....................................................
Basis difference in loans ............................................................
Securities premium amortization................................................
Investments in partnerships........................................................
Prepaid expenses ........................................................................
FHLB dividends .........................................................................
Other...........................................................................................
Total deferred tax liabilities..............................................
Net deferred tax (liabilities) assets.......................................................

December 31,

2005
(Dollars in thousands)

2004

5,917 $
—
659
—
—
2,165
553
1,402
128
10,824

(1,134) $
(8,550)
(1,792)
(219)
—
(2,033)
(389)
(580)
—
(14,697)
(3,873) $

4,193
104
349
1,080
199
1,669
1,280
2,077
282

11,233

(1,196)
(4,879)
—
—
(205)
(1,259)
(260)
(98)
—

(7,897)

3,336

The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the

periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred
tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of
historical taxable income and estimates of future taxable income over the periods for which the deferred tax assets are
deductible, management believes it is more likely than not the Company will realize the benefits of these deductible
differences at December 31, 2005. The change in the Company’s deferred tax assets and liabilities include purchase
accounting adjustments.

14. STOCK INCENTIVE PROGRAMS

The Company had three stock-based employee compensation plans at December 31, 2005. Prior to 2003, the Company

accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock
Issued to Employees, and related Interpretations. No stock-based employee compensation cost was reflected in previously
reported results, as all options granted under those plans had an exercise price equal to the market value of the underlying
common stock on the date of grant. In December 2002, the FASB issued Statement No. 148 (SFAS 148). Accounting for
Stock-Based Compensation—Transition and Disclosure, an amendment to FASB Statement No. 123. SFAS 148 provides
alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based
employee compensation. SFAS 148 is effective for financial statements for fiscal years ending after December 15, 2002.
Effective January 1, 2003, the Company adopted the fair value recognition provisions of FASB Statement No. 123,
Accounting for Stock-Based Compensation, as provided by SFAS 148 for stock-based employee compensation.

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 675,000 options have been granted under the 1995
plan as of December 31, 2005. 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). Options to acquire a total of 53,000 shares of common
stock of Bancshares were outstanding at December 31, 2005, of which 2,000 shares were exercisable. The 1995 Plan expired
on July 31, 2005 and therefore no additional options may be issued from the Plan.

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. A total of 886,500 options have been
granted under the 1998 plan as of December 31, 2005. Options to purchase a total of 830,000 shares of common stock of
Bancshares were outstanding at December 31, 2005, of which 74,350 shares were exercisable.

In December 2004, the Company’s Board of Directors established the Prosperity Bancshares, Inc. 2004 Stock Incentive
Plan (the “2004 Plan”), which was approved by the Company’s shareholders on February 23, 2005. The 2004 Plan authorizes
the issuance of up to 1,250,000 shares of Common Stock upon the exercise of options granted under the 2004 Plan or upon
the grant or exercise, as the case may be, of other awards granted under the 2004 Plan. The 2004 Plan provides for the
granting of incentive and nonqualified stock options to employees and nonqualified stock options to directors who are not
employees. The 2004 Plan also provides for the granting of shares of restricted stock, stock appreciation rights, phantom
stock awards and performance awards on substantially similar terms. A total of 42,500 options and 4,917 shares of restricted
stock have been granted under the 2004 Plan as of December 31, 2005. Options to purchase a total of 42,500 shares of
common stock of Bancshares were outstanding at December 31, 2005, of which none were exercisable. At December 31,
2005, 4,917 shares of restricted stock were outstanding and subject to forfeiture restrictions.

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 into options to purchase a total of 34,673
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 plan under which they were issued. A total of 4,240 options were outstanding at December 31, 2005.

On November 1, 2003, the Company acquired MainBancorp, Inc. A portion of the options to purchase shares of
MainBancorp common stock outstanding at the effective time of the transaction were converted at the option of the holder
into options to purchase a total of 100,851 shares of Bancshares Common Stock at exercise prices ranging from $8.03 to
$16.26 per share. The converted options are governed by the original plan under which they were issued. A total of 31,127
options were outstanding at December 31, 2005.

On August 1, 2004, the Company acquired Liberty Bancshares, Inc. A portion of the options to purchase shares of

Liberty Bank common stock outstanding at the effective time of the transaction, at the option of the holder, were converted
into options to purchase a total of 107,948 shares of Bancshares Common Stock at exercise prices ranging from $3.66 to
$7.79 per share. The converted options were governed by the original plan under which they were issued. No options were
outstanding at December 31, 2005.

On March 1, 2005, the Company acquired First Capital Bankers, Inc. The options to purchase shares of First Capital
Bankers, Inc. common stock outstanding at the effective time of the transaction were converted into options to purchase a
total of 233,779 shares of Bancshares Common Stock at exercise prices ranging from $8.60 to $20.26 per share. The
converted options are governed by the original plans under which they were issued. A total of 207,800 options were
outstanding at December 31, 2005.

A summary of changes in outstanding options is set forth below:

2005

Year Ended December 31,
2004

2003

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 .................................................
Options granted.......................................
Options forfeited.....................................
Options exercised....................................

918,409
410,279(1)
(36,923)
(123,098)

19.64 599,692
22.35 576,948(2)
24.43
(52,000)
8.81 (206,231)

11.69
22.69
19.65
4.60

684,153
164,851(3)
(78,674)
(170,638)

Options outstanding, end of period.........

1,168,667

21.58 918,409

19.64

599,692

8.65
14.58
15.91
5.83

11.69

(1)

Includes options to acquire 233,779 shares of Bancshares Common Stock assumed in connection with the First Capital
acquisition.

(2)

(3)

Includes options to acquire 107,948 shares of Bancshares Common Stock assumed in connection with the Liberty
acquisition.
Includes options to acquire 100,851 shares of Bancshares Common Stock assumed in connection with the
MainBancorp acquisition.

At December 31, 2005, there were 319,517 options exercisable under all plans at a weighted average price of $17.27

and 123,098 options were exercised. At December 31, 2004, there were 85,209 options exercisable under all plans at a
weighted average exercise price of $14.00. During 2004, 206,231 options were exercised. At December 31, 2003, there were
79,192 options exercisable under all plans at a weighted average exercise price of $9.68 and 170,638 options were exercised.

During 2005, the Company granted 15,000 options under the 1995 Plan, 119,000 options under the 1998 Plan and
42,500 options under the 2004 Plan. The options were granted at exercise prices ranging from $25.57 per share to $30.99 per
share. Compensation expense in the amount of $619,000 was recorded.

During 2004, the Company granted 469,000 options under the 1998 Plan. The options were granted at exercise prices

ranging from $23.60 per share to $27.02 per share. Compensation expense in the amount of $141,000 was recorded.

During 2003, the Company granted 64,000 options under the 1998 Plan. The options were granted at exercise prices

ranging from $19.30 per share to $23.10 per share. Compensation expense in the amount of $25,000 was recorded.

The weighted-average fair value of the stock options granted on the respective grant dates ranged from $5.05 to $6.40

in 2005 and ranged from $5.09 to $6.94 in 2004 respectively. The weighted-average remaining contractual life of options
outstanding as of December 31, 2005 ranged from 9.16 years to 9.92 years for the options granted in 2005 and ranged from
8.05 years to 8.80 years for the options granted in 2004, respectively. The weighted-average fair value of the stock options on
the grant dates ranged from $5.09 to $6.94 in 2004 and ranged from $3.89 to $5.13 in 2003 respectively. The weighted-
average remaining contractual life of options outstanding as of December 31, 2005 ranged from 8.05 years to 8.80 years for
the options granted in 2004 and ranged from 7.35 years to 7.84 years for the options granted in 2003, respectively.

The fair value of options was estimated using an option-pricing model with the following weighted average

assumptions:

Expected life .......................................................................................
Risk free interest rate ..........................................................................
Volatility.............................................................................................
Dividend yield ....................................................................................

Year Ended December 31,
2004
5.82
3.56%
22.00%
1.13%

2005
4.50
3.93%
19.00%
1.19%

2003
4.50
2.58%
23.00%
1.25%

The following table presents information relating to the Company’s stock options outstanding at December 31, 2005:

Options Outstanding 2005

Options Exercisable

Range of Exercise Prices

$ 0.00 - $ 5.00 ...................................
$ 5.01 - $10.00 ...................................
$10.01 - $15.00 ...................................
$15.00 - $20.00 ...................................
$20.01 - $25.00 ...................................
$25.01 - $31.00 ...................................

15. PROFIT SHARING PLAN

Number
Outstanding

36,000 $
9,329
113,671
268,017
187,150
554,500

Weighted
Average
Exercise Price
3.125
8.12
10.19
17.62
21.49
27.28

Weighted
Average Remaining
Life (years)

Number
Outstanding

Weighted
Average
Exercise Price
—
8.12
10.48
17.44
20.26
—

2.17 $
3.10
5.63
5.39
5.96
8.94

— $

9,329
42,671
150,367
117,150
—

1,168,667 $

21.58

7.07 $

319,517 $

17.27

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 such employee’s compensation, not to exceed the maximum allowable pursuant to the Internal Revenue Code and
excluding catch-up contributions. Such matching contributions were approximately $866,000, $681,000 and $593,000, for
the years ended December 31, 2005, 2004 and 2003, respectively.

16. COMMITMENTS AND CONTINGENCIES

Leases—The following table presents a summary of non-cancelable future operating lease commitments as of

December 31, 2005 (dollars in thousands):

2006. ........................................................................................
2007. ........................................................................................
2008 .........................................................................................
2009 .........................................................................................
2010 .........................................................................................
Thereafter.................................................................................
Total ...............................................................................

2,987
2,601
2,131
1,679
1,300
2,966
13,664

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 $3.0 million for the year

ended December 31, 2005, $1.8 million for the year ended December 31, 2004 and $1.3 million for the year ended
December 31, 2003.

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 Bank are subject to various regulatory capital requirements administered by the federal banking

agencies. Any institution that fails to meet its minimum capital requirements is subject to actions by regulators that could
have a direct material effect on the Company’s and the Bank’s financial statements. Under the capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines based on the
Bank’s assets, liabilities and certain off- balance-sheet items as calculated under regulatory accounting practices. The
Company’s and the Bank’s capital amounts and the Bank’s classification under the regulatory framework for prompt
corrective action are also subject to qualitative judgements by the regulators about the components, risk weightings and other
factors.

To meet the capital adequacy requirements, the Company and the Bank must maintain minimum capital amounts and
ratios as defined in the regulations. Management believes, as of December 31, 2005 that the Company and the Bank met all
capital adequacy requirements to which they are subject.

At December 31, 2005, the most recent notification from the FDIC categorized the Bank as “well capitalized” under

the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain
minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table. There have been no conditions
or events since that notification which management believes have changed the Bank’s category.

The following is a summary of the Company’s and the Bank’s capital ratios at December 31, 2005 and 2004:

Actual

Amount

Ratio

For Capital
Adequacy Purposes
Amount
Ratio
(Dollars in thousands)

CONSOLIDATED:
As of December 31, 2005:
Total Capital

(to Risk Weighted Assets) ............. $ 271,470

16.37% $ 132,636

8.0%

Tier I Capital

(to Risk Weighted Assets) .............

254,267

Tier I Capital

(to Average Tangible Assets) ........

254,267

As of December 31, 2004:
Total Capital

15.34

7.83

66,318

97,366

4.0

3.0

(to Risk Weighted Assets) ............. $ 173,179

14.67% $

94,411

8.0%

Tier I Capital

(to Risk Weighted Assets) .............

160,074

Tier I Capital

(to Average Tangible Assets) ........

160,074

13.56

6.30

47,205

76,218

4.0

3.0

Actual

Amount

Ratio

For Capital
Adequacy Purposes
Amount
Ratio
(Dollars in thousands)

PROSPERITY BANK® ONLY:
As of December 31, 2005:
Total Capital

To Be Categorized As
Well Capitalized Under
Prompt Corrective
Action Provisions

Amount

Ratio

N/A

To Be Categorized As
Well Capitalized Under
Prompt Corrective
Action Provisions

Amount

Ratio

(to Risk Weighted Assets) ............. $ 265,486

16.08% $ 132,105

8.0% $

165,131

10.0%

Tier I Capital

(to Risk Weighted Assets) .............

248,283

Tier I Capital

(to Average Tangible Assets) ........

248,283

As of December 31, 2004:
Total Capital

15.04

7.67

66,052

97,165

4.0

3.0

99,079

161,941

6.0

5.0

(to Risk Weighted Assets) ............. $ 167,157

14.20% $

94,156

8.0% $

117,695

10.0%

Tier I Capital

(to Risk Weighted Assets) .............

154,052

Tier I Capital

(to Average Tangible Assets) ........

154,052

13.09

6.07

47,078

76,120

4.0

3.0

70,617

126,867

6.0

5.0

Dividends paid by Bancshares and the Bank are subject to restrictions by certain regulatory agencies. Dividends paid
by Bancshares during the years ended December 31, 2005, 2004 and 2003 were $9.6 million, $6.7 million and $4.9 million,
respectively. Dividends paid by the Bank to Bancshares during the years ended December 31, 2005, 2004 and 2003 were
$6.0 million, $40.0 million and $37.0 million, respectively.

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 fair

value.

Interest-Bearing Deposits in Financial Institutions—The carrying amount is a reasonable estimate of fair value.

Federal Funds Sold—The carrying amount is a reasonable estimate of fair value.

Securities—For securities held as investments, fair value equals quoted market price, if available. If a quoted market

price is not available, fair value is estimated using quoted market prices for similar securities.

Loans Held for Investment—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.

Deposits—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.

Junior Subordinated Debentures—The fair value of the junior subordinated debentures was calculated using the
quoted market prices, if available. If a quoted market prices are not available, fair value is estimated using quoted market
prices for similar subordinated debentures.

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.

Securities Sold Under Repurchase Agreements—The fair value of securities sold under repurchase agreements is the

amount payable on demand at the reporting date.

Federal Home Loan Bank Notes Payable—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:

Financial assets:

Cash and due from banks ...........................................
Interest bearing deposits in financial institutions .......
Federal funds sold ......................................................
Held to maturity securities .........................................
Available for sale securities .......................................
Loans held for investment ..........................................
Less allowance for credit losses .................................

Total.....................................................................................
Financial liabilities:

Deposits......................................................................
Junior subordinated debentures ..................................
Other borrowings .......................................................
Securities sold under repurchase agreements .............
Federal Home Loan Bank notes payable....................

Total.....................................................................................

December 31,

2005

2004

Carrying
Amount

Estimated
Fair
Value

Carrying
Amount

Estimated
Fair
Value

(Dollars in thousands)

91,518 $
297
5,846
1,162,241
410,361
1,542,125
(17,203)

58,760
200
79,150
1,124,500
177,683
1,046,218
(13,105)
$ 3,195,185 $ 3,152,932 $ 2,463,310 $ 2,473,406

91,518 $
297
5,846
1,135,694
410,361
1,526,419
(17,203)

58,760 $
200
79,150
1,125,109
177,683
1,035,513

(13,105)

$ 2,920,318 $ 2,917,559 $ 2,317,076 $ 2,322,213
42,795
—
25,058
14,021
$ 3,098,482 $ 3,094,446 $ 2,402,674 $ 2,404,087

47,424
—
25,058
13,116

74,110
17,000
46,985
38,792

75,775
17,000
46,985
38,404

The differences in fair value and carrying value of commitments to extend credit and standby letters of credit were not

material at December 31, 2005 and 2004.

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. JUNIOR SUBORDINATED DEBENTURES

At December 31, 2005, the Company had six issues of junior subordinated debentures outstanding totaling

Description

Paradigm Capital Trust II(1) ...............

Trust
Preferred
Securities
Interest Rate(5)
Outstanding
Feb. 20, 2001 $ 6,000,000 3-month LIBOR

Issuance Date

+ 4.50%

Prosperity Statutory Trust II .............

July 31, 2001

First Capital Statutory Trust I(2).........

Mar. 26, 2002

First Capital Statutory Trust II(2)........

Sept. 26, 2002

15,000,000 3-month LIBOR
+ 3.58%, not to
exceed 12.50%
20,000,000 3-month LIBOR

+ 3.60%

7,500,000 3-month LIBOR

Prosperity Statutory Trust III............
Prosperity Statutory Trust IV............

Aug. 15, 2003
Dec. 30, 2003

12,500,000
12,500,000

+ 3.40%
6.50%(3)
6.50%(4)

Junior
Subordinated
Debt Owed
to Trusts
$ 6,186,000

Maturity
Date(6)
Feb. 20, 2031

15,464,000

July 31, 2031

20,619,000

Mar. 26, 2032

7,732,000

Sept. 26, 2032

12,887,000
12,887,000

Sept. 17, 2033
Dec. 30, 2033

based on the three-month LIBOR plus 3.00%.

(4) The debentures bear a fixed interest rate until December 30, 2008, when the rate begins to float on a quarterly basis

based on the three-month LIBOR plus 2.85%.

(5) The 3-month LIBOR in effect as of December 31, 2005 was 4.53%.
(6) The debentures are callable five years after issuance date.

On December 31, 2004, the Company redeemed in full the $12.4 million in junior subordinated debentures issued to

Prosperity Capital Trust I. Prosperity Capital Trust I in turn redeemed in full the trust preferred securities and common
securities it issued.

Each of the trusts is a capital or statutory business trust organized for the sole purpose of issuing trust securities and

investing the proceeds in the Company’s junior subordinated debentures. The preferred trust securities of each trust represent
preferred beneficial interests in the assets of the respective trusts and are subject to mandatory redemption upon payment of
the junior subordinated debentures held by the trust. The common securities of each trust are wholly-owned by the Company.
Each trust’s ability to pay amounts due on the trust preferred securities is solely dependent upon the Company making
payment on the related junior subordinated debentures. The debentures, which are the only assets of each trust, are
subordinate and junior in right of payment to all of the Company’s present and future senior indebtedness. The Company has
fully and unconditionally guaranteed each trust’s obligations under the trust securities issued by each respective trust to the
extent not paid or made by each trust, provided such trust has funds available for such obligations.

Under the provisions of each issue of the debentures, the Company has the right to defer payment of interest on the

In late 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46R (FIN 46R),

Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51 (Revised December
2003). FIN 46R requires that trust preferred securities be deconsolidated from the Company’s consolidated financial
statements. The Company adopted FIN 46R on January 1, 2004 and as a result, no longer reflects the trust preferred securities
in its consolidated financial statements. Instead, the junior subordinated debentures are shown as liabilities in the Company’s
consolidated balance sheets and interest expense associated with the junior subordinated debentures is shown as interest
expense in the Company’s consolidated statements of income.

December 31,

2005
(Dollars in thousands)

2004

2,166 $

528,262
464
387
387
186
619
232
3,983
4,355
541,041 $

4,614
311,656
464
387
387
186
—
—
3,983
1,753

323,430

549 $

75,775
76,324

359
47,424

47,783

27,858
280,525
160,883
(3,942)
(607)
464,717
541,041 $

22,418
134,288
122,647
(3,099)
(607)

275,647

323,430

20. PARENT COMPANY ONLY FINANCIAL STATEMENTS

PROSPERITY BANCSHARES, INC.
(Parent Company Only)
CONDENSED BALANCE SHEETS

ASSETS

Cash.........................................................................................................
Investment in subsidiary..........................................................................
Investment in Prosperity Statutory Trust II .............................................
Investment in Prosperity Statutory Trust III............................................
Investment in Prosperity Statutory Trust IV ...........................................
Investment in Paradigm Capital Trust II .................................................
Investment in First Capital Statutory Trust I...........................................
Investment in First Capital Statutory 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 loss on available for sale securities, net of tax benefit ..........
Less treasury stock, at cost, 37,088 shares ..............................................
Total shareholders’ equity .............................................................
TOTAL .............................................................................................................

PROSPERITY BANCSHARES, INC.
(Parent Company Only)
CONDENSED STATEMENTS OF INCOME

OPERATING INCOME:

Dividends from subsidiaries...........................................................................
Other income..................................................................................................
Total income .........................................................................................

OPERATING EXPENSE:

Junior subordinated debentures interest expense............................................
Stock option compensation expense...............................................................
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 (DISTRIBUTIONS IN EXCESS OF EARNINGS) IN UNDISTRIBUTED
EARNINGS OF SUBSIDIARIES ......................................................................
NET INCOME.........................................................................................................

For the Years Ended December 31,
2003
2004
2005
(Dollars in thousands)

6,000 $ 40,000 $ 37,900
79
112

142

6,142

40,112

37,979

4,895
619
484

5,998

143
1,833

4,046
141
228

4,415

2,630
26
252

2,908

35,697
1,498

35,071
990

1,976

37,195

36,061

45,884

(2,488)

(9,513)

$ 47,860 $ 34,707 $ 26,548

PROSPERITY BANCSHARES, INC.
(Parent Company Only)
CONDENSED STATEMENTS OF CASH FLOWS

2005

For the Years Ended December 31,
2004
(Dollars in thousands)

2003

47,860 $

34,707 $

26,548

(45,883)

619
132
(277)
(117)
2,334

2,488
141
—
(1,508)
37

9,513
25
—
369
(189)

35,865

36,266

—
3,757
—
3,757

1,085
—

(9,624)

—

(8,539)

(2,448)
4,614
2,166 $

(28,016)
—
(10)

(28,026)

1,047
(12,000)
(6,670)
—

(17,623)

(9,784)
14,398

(44,805)
—
—

(44,805)

995
—
(4,855)
24,770

20,910

12,371
2,027

4,614 $

14,398

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 ...............................
Stock option compensation expense .................................................
Restricted stock award......................................................................
(Increase) decrease in other assets ....................................................
(Decrease) increase in accrued interest payable and other liabilities
Net cash provided by operating activities ...............................

CASH FLOWS FROM INVESTING ACTIVITIES:

Cash paid for acquisitions ..........................................................................
Cash acquired from acquisitions ................................................................
Capital contribution to subsidiary ..............................................................
Net cash provided by (used in) investing activities.................

CASH FLOWS FROM FINANCING ACTIVITIES:

Issuance of common stock .........................................................................
Redemption of junior subordinated debentures (net) .................................
Payments of cash dividends .......................................................................
Proceeds from issuance of junior subordinated debentures (net) ...............
Net cash (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 .................................

21. SUBSEQUENT EVENT

Exhibit index:

Each exhibit marked with an asterisk is filed or furnished, as indicated, with this Annual Report on Form 10-K.