Southside Bancshares - 10-Q quarterly report FY

 UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

     (Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to ____________

Commission file number0-12247

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x .   No  o .

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a small reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes  o    No  x 

The number of shares of the issuer's common stock, par value $1.25, outstanding as of July 25, 2008 was 13,892,083 shares.

PART I.   FINANCIAL INFORMATION

ITEM 1.   FINANCIAL STATEMENTS

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

(in thousands, except share amounts)

The accompanying notes are an integral part of these consolidated financial statements.

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

(in thousands, except per share data)

The accompanying notes are an integral part of these consolidated financial statements.

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

(UNAUDITED)

(in thousands, except share amounts)

The accompanying notes are an integral part of these consolidated financial statements.

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(in thousands)

The accompanying notes are an integral part of these consolidated financial statements.

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

(UNAUDITED)

(in thousands)

The accompanying notes are an integral part of these consolidated financial statements

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS

1.         Basis of Presentation

In this report, the words “the Company,” “we,” “us,” and “our” refer to the combined entities of Southside Bancshares, Inc. and its subsidiaries.  The words “Southside” and “Southside Bancshares” refer to Southside Bancshares, Inc.  The words “Southside Bank” and “Fort Worth National Bank” refer to those entities, respectively, and the words “the Banks” refers to those entities collectively.  The word “SFG” refers to Southside Financial Group, LLC., of which Southside owns a 50% interest.

The consolidated balance sheet as of June 30, 2008, and the related consolidated statements of income, shareholders' equity and cash flows and notes to the financial statements for the three and six month periods ended June 30, 2008 and 2007 are unaudited; in the opinion of management, all adjustments necessary for a fair presentation of such financial statements have been included.  Such adjustments consisted only of normal recurring items.  All significant intercompany accounts and transactions are eliminated in consolidation.  The preparation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires the use of management’s estimates. These estimates are subjective in nature and involve matters of judgment.  Actual amounts could differ from these estimates.

Interim results are not necessarily indicative of results for a full year.  These financial statements should be read in conjunction with the financial statements and notes thereto in our Annual Report on Form 10-K for the year ended December 31, 2007.  All share data has been adjusted to give retroactive recognition to stock splits and stock dividends.  For a description of our significant accounting and reporting policies, refer to Note 1 of the Notes to Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2007.

2.         Earnings Per Share

Earnings per share on a basic and diluted basis has been adjusted to give retroactive recognition to stock splits and stock dividends and is calculated as follows (in thousands, except per share amounts):

For the three and six month periods ended June 30, 2008 and 2007, there were no antidilutive options.

3.  Comprehensive Income(Loss)

The components of other comprehensive income (loss) are as follows (in thousands):

4.         Securities

The amortized cost and estimated market value of investment and mortgage-backed securities as of June 30, 2008 and December 31, 2007, are reflected in the tables below (in thousands):

The Company concluded that, based on the creditworthiness of the issuer, the unrealized loss on each security in the above table represents a temporary impairment and does not require adjustment to the carrying amount of any of the individual securities.  Additionally, the Company has the ability and the intent to hold such securities through recovery of the unrealized losses.

Investment and mortgage-backed securities with book values of $620.4 million at June 30, 2008 and $496.8 million at December 31, 2007 were pledged to collateralize Federal Home Loan Bank (“FHLB”) advances, repurchase agreements, public funds and trust deposits or for other purposes as required by law.

5. Loans and Allowance for Probable Loan Losses

The following table sets forth loan totals by category for the periods presented (in thousands):

The summaries of the Allowance for Loan Losses and Reserve for Unfunded Loan Commitments are as follows (in thousands):

6.  Goodwill and Core Deposit Intangible Assets

Goodwill.  Goodwill totaled $22.0 million at June 30, 2008 and $21.6 million at December 31, 2007.  During the first quarter of 2008, we recorded goodwill totaling $395,000 in connection with the acquisition of Fort Worth National Bancshares, Inc.

Core Deposit Intangibles.  Core deposit intangible assets totaled $1.7 million at June 30, 2008 and $1.9 million at December 31, 2007.

During the fourth quarter of 2007, we recorded core deposit intangibles totaling $2.0 million in connection with the acquisition of Fort Worth National Bancshares, Inc.  Core deposit intangibles are amortized on an accelerated basis over their estimated lives, which range from 4 to 10 years.

For the three and six months ended June 30, 2008, amortization expense related to intangible assets totaled $114,000 and $231,000, respectively.  The estimated aggregate future amortization expense for intangible assets remaining as of June 30, 2008 is as follows (in thousands):

Long-term obligations are summarized as follows:

8.  Employee Benefit Plans

The components of net periodic benefit cost are as follows (in thousands):

Employer Contributions

We previously disclosed in our financial statements for the year ended December 31, 2007, that we expected to contribute $3.0 million to our defined benefit pension plan and $80,000 to our post retirement benefit plan in 2008.  As of June 30, 2008, we had contributed $1.5 million to the defined benefit pension plan, and contributions of $ 40,000 had been made to the post retirement benefit plan.

9.  Incentive Stock Options

In April 1993, we adopted the Southside Bancshares, Inc. 1993 Incentive Stock Option Plan ("the ISO Plan"), a stock-based incentive compensation plan.  The ISO Plan expired March 31, 2003.

A summary of the status of our nonvested shares as of June 30, 2008 is as follows:

For the six months ended June 30, 2008 and 2007, we recorded approximately $7,000 and $14,000, respectively, of stock-based compensation expense.  As of June 30, 2008, there was no unrecognized compensation cost related to the ISO Plan for nonvested options granted in March 2003.  At June 30, 2007, there was $20,000 of total unrecognized cost.

The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes method of option pricing with the following weighted-average assumptions for grants in 2003: dividend yield of 1.93%; risk-free interest rate of 4.93%; expected life of six years; and expected volatility of 28.90%.

Under the ISO Plan, we were authorized to issue shares of common stock pursuant to "Awards" granted in the form of incentive stock options (intended to qualify under Section 422 of the Internal Revenue Code of 1986, as amended).  Before the ISO Plan expired, awards were granted to selected employees and directors.  No stock options have been available for grant under the ISO Plan since its expiration in March 2003.  Currently, we do not offer stock-based payment programs to our employees.

The ISO Plan provided that the exercise price of any stock option not be less than the fair market value of the common stock on the date of grant.  The outstanding stock options have contractual terms of 10 years.  All options vest on a graded schedule, 20% per year for five years, beginning on the first anniversary date of the grant date.

A summary of the status of our stock options as of June 30, 2008 and the changes during the six months ended on those dates is presented below:

The total intrinsic value (i.e., the amount by which the fair value of the underlying common stock exceeds the exercise price of a stock option on exercise date) of stock options exercised during the six months ended June 30, 2008 and 2007 were $1.2 million and $1.5 million, respectively.

Cash received from stock option exercises for the six months ended June 30, 2008 and 2007 was $342,000 and $360,000, respectively.  The tax benefit realized for the deductions related to the stock option exercises were $145,000 and $21,000 for the six months ended June 30, 2008 and 2007, respectively.

10.  Fair Value Measurement

11.  Accounting Pronouncements

Statements of Financial Accounting Standards

SFAS No. 141, “Business Combinations (Revised 2007).”  SFAS 141R replaces SFAS 141, “Business Combinations,” and applies to all transactions and other events in which one entity obtains control over one or more other businesses.  SFAS 141R requires an acquirer, upon initially obtaining control of another entity, to recognize the assets, liabilities and any non-controlling interest in the acquiree at fair value as of the acquisition date.  Contingent consideration is required to be recognized and measured at fair value on the date of acquisition rather than at a later date when the amount of that consideration may be determinable beyond a reasonable doubt.  This fair value approach replaces the cost-allocation process required under SFAS 141 whereby the cost of an acquisition was allocated to the individual assets acquired and liabilities assumed.  Under SFAS 141R, the requirements of SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” would have to be met in order to accrue for a restructuring plan in purchase accounting.  Pre-acquisition contingencies are to be recognized at fair value, unless it is a non-contractual contingency that is not likely to materialize, in which case, nothing should be recognized in purchase accounting and, instead, that contingency would be subject to the probable and estimable recognition criteria of SFAS 5, “Accounting for Contingencies.”  SFAS 141R is expected to have a significant impact on our accounting for business combinations closing on or after January 1, 2009.

 

SFAS No. 160, “Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB Statement No. 51.”  SFAS 160 amends Accounting Research Bulletin (ARB) No. 51, “Consolidated Financial Statements,” to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for deconsolidation of a subsidiary.  SFAS 160 clarifies that a non-controlling interest in a subsidiary, which is sometimes referred to as minority interest, is an ownership interest in the consolidated entity that should be reported as a component of equity in the consolidated financial statements.  Among other requirements, SFAS 160 requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the non-controlling interest.  It also requires disclosure, on the face of the consolidated income statement, of the amounts of consolidated net income attributable to the parent and to the non-controlling interest.  SFAS 160 is effective for us on January 1, 2009 and is not expected to have a significant impact on our financial statements.

SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115.”  SFAS 159, issued by the Financial Accounting Standards Board (“FASB”) in February 2007, allows entities to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities that are not otherwise required to be measured at fair value, with changes in fair value recognized in earnings as they occur.  We adopted SFAS 159 on January 1, 2008.  We did not identify any financial assets or liabilities for which we elected the fair value option.  In future periods, we will consider if, or to what extent, we will elect to use the fair value option to value our financial assets and liabilities.

SFAS No. 157, “Fair Value Measurements.”  SFAS 157 defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. We adopted SFAS 157 on January 1, 2008 and it did not have a material impact on our consolidated financial statements.

Emerging Issues Task Force Consensuses

In September 2006, the Emerging Issues Task Force (“EITF”) reached a final consensus on Issue 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.”  EITF 06-4 requires that for a split-dollar life insurance arrangement, an employer should recognize a liability for future benefits in accordance with SFAS 106, “Employers' Accounting for Postretirement Benefits Other Than Pensions.”  Under the guidance, the purchase of an endorsement type policy does not constitute a settlement since the policy does not qualify as nonparticipating because the policyholders are subject to the favorable and unfavorable experience of the insurance company.  EITF 06-4 is effective for fiscal years beginning after December 15, 2007.  We adopted EITF 06-4 as of January 1, 2008 as a change in accounting principle through a cumulative-effect adjustment to retained earnings.  The amount of the adjustment was $351,000.

In September 2006, the EITF reached a final consensus on Issue 06-5, “Accounting for Purchases of Life Insurance.”  EITF 06-5 provides guidance on FASB Technical Bulletin No. 85-4, “Accounting for Purchases of Life Insurance.”  Under the guidance, the policyholder should consider any additional amounts included in the contractual terms of the policy in determining the amount that could be realized under the insurance contract.  In addition, the policyholder should also determine the amount that could be realized under the life insurance contract assuming the surrender of an individual-life by individual-life policy.  EITF 06-5 was effective for fiscal years beginning after December 15, 2006.  The adoption of EITF 06-5 did not have a material impact on our consolidated financial statements.

SEC Staff Accounting Bulletins

SAB No. 109, “Written Loan Commitments Recorded at Fair Value Through Earnings.”  SAB No. 109 supersedes SAB 105, “Application of Accounting Principles to Loan Commitments,” and indicates that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings.  The guidance in SAB 109 became effective on January 1, 2008 and did not have a material impact on our financial statements.

12.  Off-Balance-Sheet Arrangements, Commitments and Contingencies

Financial Instruments with Off-Balance-Sheet-Risk. In the normal course of business, we are a party to certain financial instruments, with off-balance-sheet risk, to meet the financing needs of our customers. These off-balance-sheet instruments include commitments to extend credit and standby letters of credit.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount reflected in the financial statements.  The contract or notional amounts of these instruments reflect the extent of involvement and exposure to credit loss we have in these particular classes of financial instruments.

Commitments to extend credit are agreements to lend to a customer provided that the terms established in the contract are met.  Commitments generally have fixed expiration dates and may require payment of fees.  Since some commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  These guarantees are primarily issued to support public and private

borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.

We had outstanding unused commitments to extend credit of $145.7 million and $118.0 million at June 30, 2008 and 2007, respectively.  Each commitment has a maturity date and the commitment expires on that date with the exception of credit card and ready reserve commitments, which have no stated maturity date.  Unused commitments for credit card and ready reserve at June 30, 2008 and 2007 were $8.7 million and $9.3 million, respectively, and are reflected in the due after one year category.  We had outstanding standby letters of credit of $4.9 million and $3.9 million at June 30, 2008 and 2007, respectively.

The scheduled maturities of unused commitments as of June 30, 2008 and 2007 were as follows (in thousands):

We apply the same credit policies in making commitments and standby letters of credit as we do for on-balance-sheet instruments.  We evaluate each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary, upon extension of credit is based on management's credit evaluation of the borrower.  Collateral held varies but may include cash or cash equivalents, negotiable instruments, real estate, accounts receivable, oil, gas and mineral interests, inventory and property, plant, and equipment.

Lease Commitments. We lease certain branch facilities and office equipment under operating leases.  It is expected that certain leases will be renewed or equipment replaced with new leased equipment as these leases expire.

Securities. In the normal course of business we buy and sell securities.  There were $17.9 million of unsettled trades to purchase and $725,000 of unsettled trades to sell securities at June 30, 2008.  At December 31, 2007, there were $6.1 million unsettled trades to purchase securities.  There were no unsettled trades to sell securities at December 31, 2007.

Litigation. We are subject to litigation in the normal course of business.  Management, after consulting with our legal counsel, believes that any liability resulting from litigation will not have a material effect on our financial position and results of operations or our liquidity.

13.  Variable Interest Entities

Effective December 31, 2003, we adopted FASB Interpretation No. 46 (R) (“FIN 46 (R)”), Consolidation of Variable Interest Entities in connection with our consolidated financial statements.  FIN 46 (R) requires companies to consolidate “variable interest entities” (“VIEs”) if those companies are the primary beneficiaries of those VIEs.

Southside Bank, our wholly-owned subsidiary, is the sole owner of Southside Venue I, LLC (“Venue”).  On August 21, 2007, SFG was formed and is considered a VIE in accordance with FIN 46 (R).  Venue has 50% ownership rights and 51% voting rights of SFG based on their investment of $500,000 in the entity.  The remaining 50% ownership rights are held by an unrelated third party.  Southside Bank currently has extended credit to finance SFG’s activities.  Based on the credit facility and investment, Southside Bank and Venue are obligated to absorb the majority of SFG’s expected losses and receive a majority of SFG’s expected residual returns, and therefore Southside Bank is considered the primary beneficiary of SFG.  SFG is accordingly consolidated by Southside Bank in accordance with FIN 46 (R).

SFG is a limited liability company that buys consumer loans secured by automobiles, primarily through the purchase of existing automobile loan portfolios from lenders throughout the United States.  As of June 30, 2008, SFG had purchased approximately $63.0 million in automobile loan portfolios.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is a discussion of the consolidated financial condition, changes in financial condition, and results of our operations, and should be read and reviewed in conjunction with the financial statements, and the notes thereto, in this presentation and in our Annual Report on Form 10-K for the year ended December 31, 2007.

We reported an increase in net income for the three and six months ended June 30, 2008 compared to the same period in 2007.  Net income for the three and six months ended June 30, 2008 was $8.5 million and $14.1 million, respectively, compared to $4.6 million and $8.4 million, respectively, for the same periods in 2007.

All share data has been adjusted to give retroactive recognition to stock splits and stock dividends.

Certain statements of other than historical fact that are contained in this document and in written material, press releases and oral statements issued by or on behalf of Southside Bancshares, Inc., a bank holding company, may be considered to be “forward-looking statements” within the meaning of and subject to the protections of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date.  These statements may include words such as "expect," "estimate," "project," "anticipate," “appear,” "believe," "could," "should," "may," "intend," "probability," "risk," "target," "objective," “plans,” “potential,” and similar expressions.  Forward-looking statements are statements with respect to our beliefs, plans, expectations, objectives, goals, anticipations, assumptions, estimates, intentions and future performance, and are subject to significant known and unknown risks and uncertainties, which could cause our actual results to differ materially from the results discussed in the forward-looking statements.  For example, discussions of the effect of our expansion, trends in asset quality and earnings from growth, and certain market risk disclosures are based upon information presently available to management and are dependent on choices about key model characteristics and assumptions and are subject to various limitations.  By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future.  As a result, actual income gains and losses could materially differ from those that have been estimated.  Other factors that could cause actual results to differ materially from forward-looking statements include, but are not limited to, the following:

in which we operate, including, without limitation, the recent deterioration of the subprime, mortgage, credit and liquidity markets, which could cause compression of the Company’s net interest margin, or a decline in the value of the Company’s assets, which could result in realized losses;

Additional information concerning us and our business, including additional factors that could materially affect our financial results, is included in our filings with the Securities and Exchange Commission.  All written or oral forward-looking statements made by us or attributable to us are expressly qualified by this cautionary notice.  We disclaim any obligation to update any factors or to announce publicly the result of revisions to any of the forward-looking statements included herein to reflect future events or developments.

Our accounting and reporting estimates conform with accounting principles generally accepted in the United States (“GAAP”) and general practices within the financial services industry.  The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  Actual results could differ from those estimates.  We consider our critical accounting policies to include the following:

Allowance for Losses on Loans.  The allowance for losses on loans represents our best estimate of probable losses inherent in the existing loan portfolio.  The allowance for losses on loans is increased by the provision for losses on loans charged to expense and reduced by loans charged-off, net of recoveries.  The provision for losses on loans is determined based on our assessment of several factors:  reviews and evaluations of specific loans, changes in the nature and volume of the loan portfolio, and current economic conditions and the related impact on specific borrowers and industry groups, historical loan loss experience, the level of classified and nonperforming loans and the results of regulatory examinations.

The loan loss allowance is based on the most current review of the loan portfolio.  The servicing officer has the primary responsibility for updating significant changes in a customer's financial position.  Each officer prepares status updates on any credit deemed to be experiencing repayment difficulties which, in the officer's opinion, would place the collection of principal or interest in doubt.  Our internal loan review department is responsible for an ongoing review of our loan portfolio with specific goals set for the loans to be reviewed on an annual basis.

At each review, a subjective analysis methodology is used to grade the respective loan.  Categories of grading vary in severity from loans that do not appear to have a significant probability of loss at the time of review to loans that indicate a probability that the entire balance of the loan will be uncollectible.  If full collection of the loan balance appears unlikely at the time of review, estimates or appraisals of the collateral securing the debt are used to allocate the necessary allowances.  The internal loan review department maintains a list of all loans or loan relationships that are graded as having more than the normal degree of risk associated with them.  In addition, a list of loans or loan relationships of $50,000 or more is updated on a periodic basis in order to properly allocate necessary allowance and keep management informed on the status of attempts to correct the deficiencies noted with respect to the loan.

Loans are considered impaired if, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on fair value of the collateral.  In measuring the fair value of the collateral, we use assumptions, such as discount rates, and methodologies, such as comparison to the recent selling price of similar assets, consistent with those that would be utilized by unrelated third parties performing a valuation.

Changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the conditions of the various markets in which collateral may be sold may all affect the required level of the allowance for losses on loans and the associated provision for loan losses.

As of June 30, 2008, our review of the loan portfolio indicated that a loan loss allowance of $11.5 million was adequate to cover probable losses in the portfolio.

Refer to “Part II - Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Loan Loss Experience and Allowance for Loan Losses” and “Note 1 – Summary of Significant Accounting and Reporting Policies” of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2007 for a detailed description of our estimation process and methodology related to the allowance for loan losses.

Estimation of Fair Value. On January 1, 2008, we adopted SFAS 157, “Fair Value Measurements”, as presented in “Note 10 – Fair Value Measurement” in the accompanying Notes to Financial Statements included in this report.  The estimation of fair value is significant to a number of our assets and liabilities.  GAAP requires disclosure of the fair value of financial instruments as a part of the notes to the consolidated financial statements.  Fair values are volatile and may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates and the shape of yield curves. Fair values for most investment and mortgage-backed securities are based on quoted market prices, where available.  If quoted market prices are not available, fair values are based on the quoted prices of similar instruments.  

Impairment of Investment Securities and Mortgage-backed Securities.  Investment and mortgage-backed securities classified as available for sale (“AFS”) are carried at fair value and the impact of changes in fair value are recorded on our consolidated balance sheet as an unrealized gain or loss in “Accumulated other comprehensive income (loss),” a separate component of shareholders’ equity.  Securities classified as AFS or held to maturity (“HTM”) are subject to our review to identify when a decline in value is other than temporary.  Factors considered in determining whether a decline in value is other than temporary include: whether the decline is substantial; the duration of the decline; the reasons for the decline in value; whether the decline is related to a credit event or to a change in interest rate; our ability and intent to hold the investment for a period of time that will allow for a recovery of value; and the financial condition and near-term prospects of the issuer.  When it is determined that a decline in value is other than temporary, the carrying value of the security is reduced to its estimated fair value, with a corresponding charge to earnings.

Defined Benefit Pension Plan. The plan obligations and related assets of the defined benefit pension plan (the “Plan”) are presented in “Note 14 – Employee Benefits” of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2007.  Plan assets, which consist primarily of marketable equity and debt instruments, are valued using market quotations.  Plan obligations and the annual pension expense are determined by independent actuaries and through the use of a number of assumptions.  Key assumptions in measuring the plan obligations include the discount rate, the rate of salary increases and the estimated future return on plan assets.  In determining the discount rate, we utilized a cash flow matching analysis to determine a range of appropriate discount rates for our defined benefit pension and restoration plans.  In developing the cash flow matching analysis, we constructed a portfolio of high quality non-callable bonds (rated AA- or better) to match as closely as possible the timing of future benefit payments of the Plan at December 31, 2007.  Based on this cash flow matching analysis, we were able to determine an appropriate discount rate.

Salary increase assumptions are based upon historical experience and our anticipated future actions.  The expected long-term rate of return assumption reflects the average return expected based on the investment strategies and asset allocation on the assets invested to provide for the Plan’s liabilities.  We considered broad equity and bond indices, long-term return projections, and actual long-term historical Plan performance when evaluating the expected long-term rate of return assumption.  At June 30, 2008, the weighted-average actuarial assumptions of the Plan were: a discount rate of 6.25%; a long-term rate of return on plan assets of 7.50%; and assumed salary increases of 4.50%.  Material changes in pension benefit costs may occur in the future due to changes in these assumptions.  Future annual amounts could be impacted by changes in the number of Plan participants, changes in the level of benefits provided, changes in the discount rates, changes in the expected long-term rate of return, changes in the level of contributions to the Plan and other factors.

Details of our off-balance-sheet arrangements, commitments and contingencies as of June 30, 2008 and 2007, are included in “Note 12 – Off-Balance-Sheet Arrangements, Commitments and Contingencies” in the accompanying Notes to Financial Statements included in this report.

We utilize wholesale funding and securities to enhance our profitability and balance sheet composition by determining acceptable levels of credit, interest rate and liquidity risk consistent with prudent capital management.  The leverage strategy consists of borrowing a combination of long and short-term funds from the FHLB and, when determined appropriate, issuing brokered certificates of deposit (“CDs”). These funds are invested primarily in U. S. Agency mortgage-backed securities, and to a lesser extent, long-term municipal securities.  Although U. S. Agency mortgage-backed securities often carry lower yields than traditional mortgage loans and other types of loans we make, these securities generally increase the overall quality of our assets because of underlying insurance or guarantees, are more liquid than individual loans and may be used to collateralize our borrowings or other obligations.  While the strategy of investing a substantial portion of our assets in U. S. Agency mortgage-backed securities and to a lesser extent municipal securities has resulted in lower interest rate spreads and margins, we believe that the lower operating expenses and reduced credit risk combined with the managed interest rate risk of this strategy have enhanced our overall profitability over the last several years.  At this time, we utilize the leverage strategy with the goal of enhancing overall profitability by maximizing the use of our capital.

Risks associated with the asset structure we maintain include a lower net interest rate spread and margin when compared to our peers, changes in the slope of the yield curve, which can reduce our net interest rate spread and margin, increased interest rate risk, the length of interest rate cycles, and the unpredictable nature of mortgage-backed securities prepayments.  See “Part I - Item 1A.  Risk Factors – Risks Related to Our Business.” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 for a discussion of risks related to interest rates.  During the first half of 2007, the interest rate yield curve was relatively flat to only slightly positively sloped.  During the second half of 2007 and the first half of 2008, the Federal Reserve decreased the overnight federal funds rate by 325 basis points while at the same time short-term U. S. Treasury interest rates decreased more than long-term U. S. Treasury interest rates.  These changes during 2007 and the first half of 2008 resulted in a positively sloped U. S. Treasury yield curve at June 30, 2008.  Our asset structure, net interest spread and net interest margin require us to closely monitor our interest rate risk.  An additional risk is the change in market value of the AFS securities portfolio as a result of changes in interest rates.  Significant increases in interest rates, especially long-term interest rates, could adversely impact the market value of the AFS securities portfolio, which could also significantly impact our equity capital.  Due to the unpredictable nature of mortgage-backed securities prepayments, the length of interest rate cycles, and the slope of the interest rate yield curve, net interest income could fluctuate more than simulated under the scenarios modeled by our Asset/Liability Committee (“ALCO”) and described under “Item 3.  Quantitative and Qualitative Disclosures about Market Risk” in this report.

Determining the appropriate size of the balance sheet is one of the critical decisions any bank makes.  Our balance sheet is not merely the result of a series of micro-decisions, but rather the size is controlled based on the economics of assets compared to the economics of funding.  The management of our securities portfolio as a percentage of earning assets is guided by changes in our overall loan and deposit levels combined with changes in our wholesale funding levels.  If adequate quality loan growth is not available to achieve our goal of enhancing profitability by maximizing the use of capital, as described above, then we could purchase additional securities, if appropriate, which could cause securities as a percentage of earning assets to increase.  Should we determine that increasing the securities portfolio or replacing the current securities maturities and principal payments is not an efficient use of capital, we could decrease the level of securities through proceeds from maturities, principal payments on mortgage-backed securities or sales.  During the quarter ended June 30, 2008, credit and volatility spreads remained wide which, combined with the steeper yield curve, led to buying opportunities primarily in U. S. Agency mortgage-backed securities.  While we experienced modest loan growth during the first half of 2008, we took advantage of buying opportunities for securities which resulted in an increase in securities as a percentage of assets.  At June 30, 2008, the securities portfolio as a percentage of total assets increased to 50.2% from 47.8% at December 31, 2007 as the increase in investment securities exceeded the growth in loans during the first six months of 2008.  The current interest rate yield curve and spreads remain investment friendly and changes to the securities portfolio as a percentage of earning assets will be guided by the availability of attractive investment opportunities and funding options as well as changes in our loan and deposit levels during the third quarter of 2008.  During the six months ended June 30, 2008, we increased our investment and U. S. Agency mortgage-backed securities approximately $107.9 million as investment and U. S. Agency mortgage-backed securities increased from $1.028 billion at December 31, 2007 to $1.136 billion at June 30, 2008.  During the first six months of 2008, the Company restructured a portion of the securities portfolio by selling lower coupon fixed rate mortgage-backed securities and replacing them with higher coupon fixed rate mortgage-backed securities.  As a result, the coupon of the Company’s fixed rate mortgage-backed securities has increased approximately 30 basis points from December 31, 2007 to approximately 6.00% at June 30, 2008.  Our balance sheet management strategy is dynamic and requires ongoing management and will be reevaluated as market conditions warrant.  As interest rates, yield curves, mortgage-backed securities prepayments, funding costs, security spreads and loan and deposit portfolios change, our determination of the proper types and maturities of securities to own, proper amount of securities to own and funding needs and funding sources will continue to be reevaluated.

With respect to liabilities, we will continue to utilize a combination of FHLB advances and deposits to achieve our strategy of minimizing cost while achieving overall interest rate risk objectives as well as the liability management objectives of the ALCO.  The FHLB funding and the brokered CDs represent wholesale funding sources we currently have available to utilize.  Our FHLB borrowings at June 30, 2008 increased 30.8%, or $135.5 million, to $575.5 million from $440.0 million at December 31, 2007 primarily as a result of a $127.9 million decrease in brokered CDs and an increase in securities.  At December 31, 2007, our callable brokered CDs totaled $123.4 million and our other brokered CDs, all of which were acquired through Fort Worth National Bank, were $9.5 million, for total brokered CDs of $132.9 million.  Due to the significant decrease in interest rates, including brokered CD rates during the first six months of 2008, we called $123.4 million of the callable brokered CDs.  During the first six months, another $4.5 million of brokered CDs issued by Fort Worth National Bank matured.  As we integrate our funds management processes, the Banks will likely issue similar structures of brokered CDs when needed.  We utilized long-term brokered CDs because the brokered CDs better matched overall ALCO objectives at the time of issuance by protecting us with fixed rates should interest rates increase, while providing us options to call the funding should interest rates decrease.  Our wholesale funding policy currently allows maximum brokered CDs of $150 million; however, this amount could be increased to match changes in ALCO objectives.  The potential higher interest expense and lack of customer loyalty are risks associated with the use of brokered CDs.   We replaced the long-term callable brokered CDs with long-term FHLB advances.  For the six months ended June 30, 2008, the increase in FHLB borrowings was almost completely offset by the decrease in brokered CDs while overall deposits, net of brokered deposits, increased which resulted in a decrease in our total wholesale funding as a percentage of deposits, not including brokered CDs, from 41.0% at December 31, 2007, to 38.9% at June 30, 2008.

Net interest income is the difference between interest income earned on assets (loans and investments) and interest expense due on our funding sources (deposits and borrowings) during a particular period.

Net interest income for the six months ended June 30, 2008 was $33.3 million, an increase of $13.2 million, or 65.6%, when compared to the same period in 2007.  Average interest earning assets increased $338.8 million, or 19.6%, to $2.1 billion, the net interest spread increased from 1.68% for the six months ended June 30, 2007 to 2.80% for the same period in 2008, and the net interest margin increased from 2.52% for the six months ended June 30, 2007 to 3.44% for the same period in 2008.  Net interest income increased as a result of increases in our average earning assets, net interest spread and net interest margin during the six months of 2008 when compared to the same period in 2007.

Net interest income increased $7.8 million, or 77.9%, to $17.9 million for the three months ended June 30, 2008, when compared to $10.1 million for the same period in 2007.  This is a result of an increase in the average yield on our interest earning assets combined with a decrease in the average yield on the average interest bearing liabilities. The increase in the yield on interest earning assets is reflective of the purchase of $63.0 million of high yield auto loans by SFG, the addition of approximately $90.5 million of loans associated with the acquisition of Fort Worth National Bank, an 11 basis point increase in the yield on our securities portfolio and an increase in average interest earning assets of $392.1 million, or 23.2%.  The decrease in the average yield on interest bearing liabilities is a result of an overall decrease in interest rates and calling $123.4 million of high yield brokered deposits during 2008.  For the three months ended June 30, 2008, our net interest spread increased to 3.06% from 1.71% and our net interest margin increased to 3.65% from 2.57% when compared to the same period in 2007.  The net interest margin and net interest spread for the three months ended June 30, 2008, increased to 3.65% and 3.06%, respectively, from 3.22% and 2.55% for the three months ended March 31, 2008.

During the six months ended June 30, 2008, average loans increased $209.9 million, or 27.4%, to $977.1 million, compared to $767.2 million for the same period in 2007.  Approximately half of this increase is the result of the Fort Worth National Bank loans acquired on October 10, 2007.  Automobile loans purchased through SFG represent the next largest part of this increase.  The average yield on loans increased from 6.90% for the six months ended June 30, 2007 to 7.65% for the six months ended June 30, 2008.  The increase in interest income on loans of $10.8 million, or 42.8%, to $36.1 million for the six months ended June 30, 2008, when compared to $25.2 million for the same period in 2007, and the increase in interest income on loans of $5.0 million, or 39.5%, to $17.8 million for the three months ended June 30, 2008, when compared to $12.7 million for the same period in 2007 was the result of an increase in average loans and the average yield.  For the three months ended June 30, 2008, average loans increased $209.4 million, or 27.2%, to $978.1 million, compared to $768.7 million for the same period in 2007.  The average yield on loans increased from 6.91% for the three months ended June 30, 2007 to 7.54% for the three months ended June 30, 2008.  The increase in the yield on loans was due to the increase in credit spreads, the repricing characteristics of Southside Bank’s loan portfolio and the addition of higher yielding subprime automobile loan portfolios purchased during the second half of 2007 and first six months of 2008.  Due to the competitive loan pricing environment, we anticipate that we may be required to continue to offer lower interest rate loans that compete with those offered by other financial institutions in order to retain quality loan relationships.  Offering lower interest rate loans could impact the overall loan yield and, therefore, profitability.

Average investment and mortgage-backed securities increased $120.6 million, or 12.9%, to $1.1 billion, for the six months ended June 30, 2008, when compared to $933.4 million for the same period in 2007.  The increase was the result of securities purchased due to buying opportunities available during the last half of 2007 and the first six months and quarter ended June 30, 2008.  The overall yield on average investment and mortgage-backed securities increased to 5.32% during the six months ended June 30, 2008, from 5.18% during the same period in 2007.  Interest income on investment and mortgage-backed securities for the six months ended June 30, 2008 increased $3.5 million, or 14.8%, to $27.0 million compared to $23.6 million for the same period in 2007.  For the three months ended June 30, 2008, average investment and mortgage-backed securities increased $171.2 million, or 19.1%, to $1.1 billion, when compared to $895.4 million for the same period in 2007.  The overall yield on average investment and mortgage-backed securities increased to 5.26% during the three months ended June 30, 2008, from 5.15% during the same period in 2007.  Interest income from investment and mortgage-backed securities increased $2.3 million, or 20.3%, to $13.6 million for the three months ended June 30, 2008, compared to $11.3 million for the same period in 2007.  The increase in interest income for the three and six month periods ending June 30, 2008 was due to the increase in the average balance and the increase in the average yield.  The increase in the average yield primarily reflects purchases of higher-yielding securities combined with reinvestment of proceeds from lower-yielding matured securities into higher-yielding securities.  This was due primarily to increased credit and volatility spreads.  A return to lower long-term interest rate and prepayment levels similar to that experienced in May and June of 2003 could negatively impact our net interest margin in the future due to increased prepayments and repricing.

Average FHLB stock and other investments increased $5.2 million, or 24.2%, to $26.7 million, for the six months ended June 30, 2008 when compared to $21.5 million for the same period in 2007.  The average yield on FHLB stock and other investments decreased to 3.58% for the six months ended June 30, 2008, when compared to 6.56% for the same period in 2007 due to the lower average short-term interest rates.  Interest income from our FHLB stock and other investments decreased $224,000, or 32.0%, to $476,000 for the six months ended June 30, 2008, when compared to $700,000 for the same period in 2007 due to a decrease in the average yield.  For the three months ended June 30, 2008, average FHLB stock and other investments increased $10.7 million, or 60.2%, to $28.5 million, when compared to $17.8 million for the same period in 2007.  We are required as a member of FHLB to own a specific amount of stock that changes as the level of our FHLB advances change.  For the three months ended June 30, 2008, interest income from FHLB stock and other investments decreased $116,000, or 35.2%, to $214,000, when compared to $330,000 for the same period in 2007 as a result of the decrease in the average yield from 7.45% in 2007 to 3.02% in 2008.  

Average federal funds sold and other interest earning assets increased $3.9 million, or 143.1%, to $6.5 million, for the six months ended June 30, 2008, when compared to $2.7 million for the same period in 2007.  Interest income from federal funds sold and other interest earning assets increased $22,000, or 31.9%, for the six months ended June 30, 2008, when compared to the same period in 2007, as a result of the increase in the average balance, which more than offset the decrease in the average yield from 5.17% in 2007 to 2.80% in 2008.  Average federal funds sold and other interest earning assets increased $2.1 million, or 82.9%, to $4.6 million, for the three months ended June 30, 2008, when compared to $2.5 million for the same period in 2007.  Interest income from federal funds sold and other interest earning assets decreased $9,000, or 27.3%, for the three months ended June 30, 2008, when compared to the same period in 2007, as a result of the decrease in the average yield from 5.31% in 2007 to 2.12% in 2008.

Total interest expense increased $ 916,000, or 3.1%, to $30.4 million during the six months ended June 30, 2008 as compared to $29.5 million during the same period in 2007.    The increase in interest expense was attributable to an increase in the average balance which more than offset a decrease in the yield on interest bearing liabilities from 4.28% for the six months ended June 30, 2007 to 3.59% for the six months ended June 30, 2008.  Average interest bearing liabilities increased $315.3 million, or 22.7%, for the six months ended June 30, 2008 as compared to the same period in 2007.  For the three months ended June 30, 2008, total interest expense decreased $639,000, or 4.5%, to $13.7 million, compared to $14.3 million for the same period in 2007 as a result of a decrease in the average yield on interest bearing liabilities which more than offset the increase in average interest bearing liabilities.  Average interest bearing liabilities increased $361.2 million, or 26.9%, while the average yield decreased from 4.27% for the three months ended June 30, 2007 as compared to 3.23% for the three months ended June 30, 2008.

Average interest bearing deposits increased $111.2 million, or 11.3%, to $1.1 billion during the six months ended June 30, 2008, when compared to $985.1 million for the same period in 2007, while the average rate paid decreased from 4.01% for the six month period ended June 30, 2007 to 3.42% for the same period in 2008.  For the three months ended June 30, 2008, average interest bearing deposits increased $67.3 million, or 6.8%, to $1.1 billion, when compared to $997.1 million for the same period in 2007 while the average rate paid decreased from 4.03% for the three month period ended June 30, 2007 to 2.97% for the three month period ended June 30, 2008.   The increase in our average total deposits is the result of overall bank growth, branch expansion and the acquisition of Fort Worth National Bank which more than offset the brokered CDs called during 2008.  Interest expense for interest bearing deposits for the three and six months ended June 30, 2008 decreased $2.2 million, or 21.5%, and $967,000, or 4.9%, when compared to the same periods in 2007 due to the decrease in the average rate paid which more than offset the increase in the average balance.

Average short-term interest bearing liabilities, consisting primarily of FHLB advances, federal funds purchased and repurchase agreements, increased $28.4 million, or 10.1%, to $309.0 million for the six months ended June 30, 2008, when compared to $280.7 million for the same period in 2007.  Interest expense associated with short-term interest bearing liabilities decreased $1.6 million, or 23.5%, and the average rate paid decreased 149 basis points to 3.34% for the six month period ended June 30, 2008 when compared to 4.83% for the same period in 2007.  For the three months ended June 30, 2008, average short-term interest bearing liabilities increased $26.3 million, or 11.3%, when compared to the same period in 2007.  Interest expense associated with short-term interest bearing liabilities decreased $937,000, or 33.8%, and the average rate paid decreased 193 basis points to 2.87% for the three month period ended June 30, 2008 when compared to 4.80% for the same period in 2007.  The decrease in the interest expense for the three month period ended June 30, 2008 when compared to 2007 was due to the decrease in the average rate paid, which more than offset the increase in the average balance.

Average long-term interest bearing liabilities consisting of FHLB advances increased $136.0 million, or 131.4%, during the six months ended June 30, 2008 to $239.5 million as compared to $103.5 million for the six months ended June 30, 2007.  The increase in the average long-term FHLB advances occurred primarily as a result of our decision to call outstanding brokered CDs and replace them with long-term FHLB borrowings.  Interest expense associated with long-term FHLB advances increased $2.3 million, or 98.3%, while the average rate paid decreased 66 basis points to 3.86% for the six months ended June 30, 2008 when compared to 4.52% for the same period in 2007.  For the three months ended June 30, 2008, long-term interest bearing liabilities increased $227.9 million, or 242.2%, when compared to the same period in 2007.  Interest expense associated with long-term FHLB advances increased $1.9 million, or 177.3%, while the average rate paid decreased 87 basis points to 3.76% for the three months ended June 30, 2008 when compared to 4.63% for the same period in 2007.  The increase in interest expense was due to the increase in the average balance of long-term interest bearing liabilities which more than offset the decrease in the average rate paid.  FHLB advances are collateralized by FHLB stock, securities and nonspecific real estate loans.

Average long-term debt, consisting of our junior subordinated debentures issued in 2003 and August 2007 and junior subordinated debentures acquired in the purchase of Fort Worth Bancshares, Inc., was $60.3 million for the six months ended June 30, 2008 compared to $20.6 million for the same period in 2007.  During the third quarter ended September 30, 2007, we issued $36.1 million of junior subordinated debentures in connection with the issuance of trust preferred securities by our subsidiaries Southside Statutory Trusts IV and V.  The $36.1 million in debentures were issued to fund the purchase of Fort Worth Bancshares, Inc., which occurred on October 10, 2007.  Interest expense increased $530,000, or 122.7%, to $962,000 and $1.2 million, or 138.0%, to $2.0 million for the three and six months ended June 30, 2008, respectively, when compared to $432,000 and $860,000 for the same periods in 2007, respectively, primarily as a result of the increase in the average balance during the three and six months ended June 30, 2008 when compared to the same periods in 2007.  The interest rate on the $20.6 million of long-term debentures issued to Southside Statutory Trust III adjusts quarterly at a rate equal to three-month LIBOR plus 294 basis points.  The $23.2 million of long-term debentures issued to Southside Statutory Trusts IV and the $12.9 million of long-term debentures issued to Southside Trust V have fixed rates of 6.518% through October 30, 2012 and 7.48% through December 15, 2012, respectively, and thereafter, adjusts quarterly.  The interest rate on the $3.6 million of long-term debentures issued to Magnolia Trust Company I, assumed in the purchase of Fort Worth Bancshares, Inc., adjusts quarterly at a rate equal to three-month LIBOR plus 180 basis points.

RESULTS OF OPERATIONS

The analysis below shows average interest earning assets and interest bearing liabilities together with the average yield on the interest earning assets and the average cost of the interest bearing liabilities.