UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2004
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934
Commission file number 0-12247
SOUTHSIDE BANCSHARES, INC.
903-531-7111(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 ü . No .
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ü . No .
The number of shares outstanding of each of the issuer’s classes of capital stock as of July 31, 2004 was 10,435,628 shares of Common Stock, par value $1.25.
PART I. FINANCIAL INFORMATIONITEM 1. FINANCIAL STATEMENTS
SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(UNAUDITED)(in thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME(UNAUDITED)(in thousands, except per share data)
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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY(UNAUDITED)(in thousands, except per share amounts)
(1) Restated
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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOW(UNAUDITED)(in thousands)
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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOW (continued)(UNAUDITED)(in thousands)
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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIESNOTES TO FINANCIAL STATEMENTS
1. Basis of Presentation
The consolidated balance sheet as of June 30, 2004, and the related consolidated statements of income, shareholders’ equity, cash flow and notes to the financial statements for the quarter and six-month periods ended June 30, 2004 and 2003 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. 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 the Company’s latest report on Form 10-K. All share data has been adjusted to give retroactive recognition to stock splits and stock dividends.
2. Financial Statement Restatement for 2002
Certain financial statement components for the year ended December 31, 2002 were restated. It is important to note, the restatement entries described below completely reversed in the financial statements for the year ended December 31, 2003. It is also important to note, net income and earnings per share did not change for any of the periods presented.
During the preparation of the Form 10-K for December 31, 2003, the Company discovered, while reviewing retirement plan workpapers, that a minimum pension plan liability adjustment that should have been reflected on the balance sheet as of December 31, 2002 was inadvertently overlooked. The oversight occurred due in part to the fact that the Company, historically, had not had a minimum pension plan liability adjustment in its defined benefit plan. The entries required for 2002 completely reversed as the minimum pension plan liability adjustment reversed to zero as of December 31, 2003.
The net effect of the entries required, increased other liabilities; decreased deferred tax liability and decreased shareholders’ equity due to the minimum pension liability adjustment entry to accumulated other comprehensive income.
A summary of the adjustments made and their effect on the financial statements is presented below:
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3. 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 quarter and six month periods ended June 30, 2004 and 2003, there were no antidilutive shares.
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4. Comprehensive Income (Loss)
The components of other comprehensive income (loss) are as follows:
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5. Employee Benefit Plans
Components of Net Periodic Benefit Cost
Employer Contributions
The Company previously disclosed in its financial statements for the year ended December 31, 2003, that it expected to contribute $4.0 million to its defined benefit plan and $64,000 to its nonfunded supplemental retirement plan (“restoration plan”) in 2004. Based on actuarial reports received during the second quarter ended June 30, 2004, the Company presently anticipates contributing $3.2 million to its defined benefit plan. In addition, the Company presently anticipates contributing an additional $10,000 to fund its restoration plan in 2004 for a total of $74,000. As of June 30, 2004, $2.0 million of contributions have been made to the defined benefit plan. As of June 30, 2004, $37,000 of contributions were made to the restoration plan.
6. Incentive Stock Options
In April 1993, the Company adopted the Southside Bancshares, Inc. 1993 Incentive Stock Option Plan (“the Plan”), a stock-based incentive compensation plan. The plan expired March 31, 2003. The Company applied APB Opinion 25 and related Interpretations in accounting for the Plan and discloses the pro forma information required by FAS 123 and 148.
Under the Plan, the Company was 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 plan expired, awards were granted to selected employees and directors of the Company or any subsidiary. At June 30, 2004 and 2003, there were no stock options available for grant.
The 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. There were 28,875 incentive stock options granted in 2003. There were no incentive stock options granted in the first six months of 2004. The remaining outstanding stock options have contractual terms of 10 years. All options vest on a graded schedule, 20% per year for 5 years, beginning on the first anniversary date of the grant date. In accordance with APB Opinion 25, the Company has not recognized any compensation cost for these stock options.
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A summary of the status of the Company’s stock options as of June 30, 2004 and 2003 and the changes during the periods ended on those dates is presented below:
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%; the expected life of 6 years; the expected volatility is 28.90%.
The following table summarizes information about stock options outstanding at June 30, 2004:
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Pro Forma Net Income and Net Income Per Common Share
Had the compensation cost for the Company’s stock-based compensation plans been determined consistent with the requirements of FAS 123, the Company’s net income and net income per common share for the quarter and six month periods ending June 30 2004 and 2003 would approximate the pro forma amounts below (in thousands, except per share amounts, net of taxes):
The effects of applying FAS123 in this pro forma disclosure are not indicative of future amounts.
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7. Accounting Pronouncements
In November 2002, the Financial Accounting Standards Board (FASB) issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45), which covers guarantees such as standby letters of credit, performance guarantees, and direct or indirect guarantees of the indebtedness of others, but not guarantees of funding. FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability in an amount equal to the fair value of the obligation undertaken in issuing the guarantee, and requires disclosure about maximum potential payments that might be required, as well as the collateral or other recourse obtainable. The recognition and measurement provisions of FIN 45 were effective on a prospective basis after December 31, 2002. The adoption of FIN 45 did not have a material impact on the Company’s consolidated financial statements.
In January 2003, the FASB issued Interpretation No. 46 Consolidation of Variable Interest Entities (FIN 46), which establishes guidance for determining when an entity should consolidate another entity that meets the definition of a variable interest entity. FIN 46 requires a variable interest entity to be consolidated by a company if that company will absorb a majority of the expected losses, will receive a majority of the expected residual returns, or both. Transferors to qualified special-purpose entities (“QSPEs”) and certain other interests in a QSPE are not subject to the requirements of FIN 46. On December 17, 2003, the FASB revised FIN 46 (FIN 46R) and deferred the effective date of FIN 46 to no later than the end of the first reporting period that ends after March 15, 2004, however, for special-purpose entities the Company would be required to apply FIN 46 as of December 31, 2003.
The Company adopted FIN 46 in connection with its consolidated financial statements for the year ended December 31, 2003. FIN 46 required the Company to de-consolidate its investments in Southside Statutory Trust III in its financial statements. Effective December 31, 2003, the Company deconsolidated the wholly-owned issuing trust entity resulting in a recharacterization of the underlying consolidated debt obligation from the previous trust preferred securities obligation to the junior subordinated debenture obligation that exists between the Company and the issuing trust entity. As a result of adopting FIN 46 on December 31, 2003, the Company did not restate its prior period consolidated financial statements.
In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This statement amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. This Statement is effective for contracts entered into or modified after June 30, 2003, except in certain circumstances, and for hedging relationships designated after June 30, 2003. The adoption of FAS 149 did not have a material impact on the Company’s consolidated financial statements.
In May 2003, FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This statement provides new rules on the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. Such financial instruments include mandatorily redeemable shares, instruments that require the issuer to buy back some of its shares in exchange for cash or other assets, or obligations that can be settled with shares, the monetary value of which is fixed. Most of the guidance in SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 30, 2003. The adoption of FAS 150 did not have a material impact on the Company’s consolidated financial statements.
In December 2003, the FASB issued SFAS No. 132 (revised 2003), Employers’ Disclosures about Pensions and Postretirement Benefits. This statement requires additional disclosures about the assets, obligations and cash flows of defined benefit pension and postretirement plans, as well as the expense recorded for such plans. As of June 30, 2004, the Company has disclosed the required elements related to its defined benefit pension plan in Note 5 of the consolidated financial statements.
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On March 9, 2004, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments. SAB No. 105 summarizes the view of the staff regarding the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments including recognition of the loan commitment and financial statement disclosures. The adoption of SAB 105 did not have a material impact on the Company’s consolidated financial statements.
On May 19, 2004, the Financial Accounting Standards Board (FASB) issued FASB Staff Position FAS 106-2, which provides guidance on accounting for the impact of the Medicare reform act. For most employers this guidance will apply for the first interim or annual accounting period beginning after June 15, 2004. The adoption of FAS 106-2 is not expected to have a material impact on the Company’s consolidated financial statements.
8. Commitments and Contingencies
In the normal course of business the Company buys and sells securities. At June 30, 2004 and December 31, 2003 the Company had recorded in its balance sheet commitments to purchase $9.2 million and $1.7 million in securities, respectively.
The Company, or its subsidiaries, is involved with various litigation which resulted in the normal course of business. Management of the Company, after consulting with its legal counsel, believes that any liability resulting from litigation will not have a material effect on the financial position and results of operations and the liquidity of the Company or its subsidiaries.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — Six months ended June 30, 2004 compared to June 30, 2003.
The following is a discussion of the consolidated financial condition, changes in financial condition, and results of operations of Southside Bancshares, Inc. (the “Company”), and should be read and reviewed in conjunction with the financial statements, and the notes thereto, in this presentation and in the Company’s latest report on Form 10-K.
The Company reported an increase in net income for the quarter and six months ended June 30, 2004 compared to the same period in 2003. Net income for the quarter and six months ended June 30, 2004 was $3.7 million and $8.2 million, respectively, compared to $3.4 million and $6.8 million, respectively, for the same period in 2003.
All share data has been adjusted to give retroactive recognition to stock splits and stock dividends.
Forward-Looking Information
Certain statements of other than historical fact that are contained in this document and in written material, press releases and oral statements issued by or on behalf of Southside Bancshares, Inc., (the “Company”) a bank holding company, may be considered to be “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements may include words such as “expect,” “estimate,” “project,” “anticipate,” “believe,” “could,” “should,” “may,” “intend,” “probability,” “risk,” “target,” “objective” and similar expressions. Forward-looking statements are subject to significant risks and uncertainties and the Company’s actual results may differ materially from the results discussed in the forward-looking statements. For example, certain market risk disclosures are dependent on choices about key model characteristics and assumptions and are subject to various limitations. See “Item 2- Management’s Discussion and Analysis of Financial Condition and Results of Operations.” By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future. As a result, actual income gains and losses could materially differ from those that have been estimated. Other factors that could cause actual results to differ materially from forward-looking statements include, but are not limited to general economic conditions, either nationally or in the State of Texas, legislation or regulatory changes which adversely affect the businesses in which the Company is engaged, economic or other disruptions caused by military actions in Iraq, Afghanistan or other areas, changes in the interest rate yield curve or interest rate environment which reduce interest margins and may impact prepayments on the mortgage-backed securities portfolio, changes effecting the leverage strategy, significant increases in competition in the banking and financial services industry, changes in consumer spending, borrowing and saving habits, technological changes, the Company’s ability to increase market share and control expenses, the effect of compliance with legislation or regulatory changes, the effect of changes in accounting policies and practices and the costs and effects of unanticipated litigation.
Critical Accounting Estimates
The accounting and reporting estimates of the Company 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 generally accepted accounting principles 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. The Company considers its critical accounting policies to include the following:
Allowance for Losses on Loans. The allowance for losses on loans represents management’s 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 management’s assessment of several factors: reviews and evaluations of specific loans, changes in the nature and volume of the loan portfolio, current and anticipated 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 at that time. 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. An internal loan review officer from the Company is responsible for an ongoing review of the Company’s entire loan portfolio with specific goals set for the volume of loans to be reviewed on an annual basis.
At each review of a credit, a subjective analysis methodology is used to grade the respective loan. Categories of grading vary in severity to include loans which do not appear to have a significant probability of loss at the time of
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review to grades which indicate a probability that the entire balance of the loan will be uncollectible. If full collection of the loan balance appears unlikely at the time of review, estimates or appraisals of the collateral securing the debt are used to allocate the necessary allowances. A list of loans or loan relationships of $50,000 or more, which are graded as having more than the normal degree of risk associated with them, is maintained by the internal loan review officer. This list is updated on a periodic basis, but no less than quarterly in order to properly allocate necessary allowance and keep management informed on the status of attempts to correct the deficiencies noted in the credit.
In addition to maintaining an ongoing review of the loan portfolio, the internal loan review officer maintains a history of the loans that have been charged-off without first being identified as problems. This history is used to assist in gauging the effectiveness of the specific reserve allocation process. The internal loan review officer also uses the loan portfolio data collected to determine the allocation of the allowance for loan loss appropriate for the risk in each of the Company’s major loan categories.
Loans are considered impaired if, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. 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, management uses assumptions (e.g., discount rates) and methodologies (e.g., comparison to the recent selling price of similar assets) consistent with those that would be utilized by unrelated third parties.
Changes in the financial condition of individual borrowers, in economic conditions, in historical loss experience and in 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, 2004, the Company’s review of the loan portfolio indicates that a loan loss allowance of $6.67 million is adequate to cover probable losses in the portfolio.
Refer to Item 1 entitled Loan Loss Experience and Allowance for Loan Loss and Notes to Financial Statements No. 1, Summary of Significant Accounting and Reporting Policies in the Company’s latest report on Form 10-K for a detailed description of the Company’s estimation process and methodology related to the allowance for loan losses.
Loans Held For Sale. Loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by aggregate outstanding commitments from investors or current investor yield requirements. Net unrealized losses are recognized through a valuation allowance by charges to income.
Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold.
Estimation of Fair Value. The Company is required to provide disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other estimation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Such techniques and assumptions, as they apply to individual categories of the Company’s financial instruments, are as follows:
The carrying amount of cash and due from banks and federal funds sold is a reasonable estimate of those assets' fair value.
Fair values for most available for sale and held to maturity 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.
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The fair values of other real estate owned are typically determined based on appraisals by third parties, less estimated costs to sell.
For adjustable rate loans that reprice frequently and with no significant change in credit risk, the carrying amounts are a reasonable estimate of those assets’ fair value. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Nonperforming loans are estimated using discounted cash flow analyses or underlying value of the collateral where applicable.
The carrying amount of deposit liabilities, federal funds purchased, commitments to extend credit and long-term debt is a reasonable estimate of those liabilities fair value.
Fair values for fixed rate certificates of deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered for deposits of similar remaining maturities.
The fair value of FHLB Dallas advances is estimated by discounting the future cash flows using rates at which advances would be made to borrowers with similar credit ratings and for the same remaining maturities.
Defined Benefit Retirement Plan. The plan obligations and related assets of the defined benefit retirement plan are presented in Note 12 of the Notes to Consolidated Financial Statements in the Company’s latest report on Form 10-K. 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, the Company utilizes the yield on high-quality, fixed-income investments currently available with maturities corresponding to the anticipated timing of the benefit payments. Salary increase assumptions are based upon historical experience and anticipated future management actions. Asset returns are based upon the anticipated average rate of earnings expected on the invested funds of the plan. At June 30, 2004, the weighted-average actuarial assumptions of the Company’s plan were: discount rate 6.50%; long-term rate of return on plan assets 8.5%; and assumed salary increases 4.5%. At June 30, 2003, the weighted-average actuarial assumptions of the Company’s plan were: discount rate 6.75%; long-term rate of return on plan assets 9.0%; and assumed salary increases 4.5%. 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 assumed salary increases, changes in the level of contributions to the plan and other factors.
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Off-Balance Sheet Arrangements
In the normal course of business, the Company is a party to certain financial instruments, with off-balance-sheet risk, to meet the financing needs of its customers. These off-balance-sheet instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount reflected in the financial statements. The contract or notional amounts of these instruments reflect the extent of involvement and exposure to credit loss the Company has in these particular classes of financial instruments.
Commitments to extend credit are agreements to lend to a customer provided that the terms established in the contract are met. Commitments generally have fixed expiration dates and may require payment of fees. Since some commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.
The Company had outstanding unused commitments to extend credit of $63.5 million and $56.0 million at June 30, 2004 and 2003, 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, 2004 and 2003 were $9.0 million and $8.7 million, respectively and are reflected in the due after one year category. The Company had outstanding standby letters of credit of $2.1 million and $1.1 million at June 30, 2004 and 2003, respectively. The scheduled maturities of unused commitments are presented below as of June 30, 2004 and 2003.
The Company applies the same credit policies in making commitments and standby letters of credit as it does for on-balance-sheet instruments. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, upon extension of credit is based on management’s credit evaluation of the borrower. Collateral held varies but may include cash or cash equivalents, negotiable instruments, real estate, accounts receivable, inventory, property, plant, and equipment.
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Leverage Strategy
In May 1998 the Company implemented a leverage strategy designed with the potential to enhance its profitability by maximizing the use of the Company’s capital with acceptable levels of credit, interest rate and liquidity risk. The leverage strategy consists of borrowing a combination of long and short-term funds from the Federal Home Loan Bank of Dallas (the “FHLB”) and investing the funds primarily in premium mortgage-backed securities, and to a lesser extent, long-term municipal securities. Although premium mortgage-backed securities often carry lower yields than traditional mortgage loans and other types of loans the Company makes, these securities generally increase the overall quality of the Company’s assets by virtue of the securities’ underlying insurance or guarantees, are more liquid than individual loans and may be used to collateralize the Company’s borrowings or other obligations. In addition, in low interest rate environments the amortization expense for premium mortgage-backed securities is associated with potentially substantial higher prepayments experienced that increases amortization expense based on the degree of increases in prepayments experienced, which reduces the overall yields of the premium mortgage-backed securities portfolio. In rising interest rate environments, prepayments can slow and extend the average life of the premium mortgage-backed securities. While the strategy of investing a substantial portion of the Company’s assets in premium mortgage-backed and municipal securities has resulted in lower interest rate spreads and margins, the Company believes that the lower operating expenses and reduced credit risk combined with the managed interest rate risk of this strategy have enhanced its overall profitability over the last several years. At this time, the Company maintains the leverage strategy for the purpose of enhancing overall profitability by maximizing the use of the Company’s capital. Risks associated with the asset structure the Company maintains are a lower net interest rate spread and margin when compared to its peers and increased interest rate risk. The Company’s asset structure, spread and margin increases the need to monitor the Company’s 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 could impact the Company’s equity capital significantly.
The Company will attempt to adopt a balance sheet strategy going forward to assess the proper mix of the securities portfolio as a percentage of earning assets by evaluating the quality loan growth available in the Company’s market area that the Company can profitably attract. If adequate quality loan growth is not available or the Company is not able to profitably attract these loans to achieve the Company’s goal of enhancing profitability by maximizing the use of the Company’s capital, as described above, then additional securities will be purchased. During the first six months ended June 30, 2004, the securities portfolio as a percentage of total assets increased slightly to 52.5% at June 30, 2004 from 52.2% at December 31, 2003. On the liability side, the Company will continue to utilize a combination of advances and deposits to achieve its strategy of minimizing cost while achieving overall interest rate risk objectives as well as Asset Liability Committee (“ALCO”) objectives. During the 2003 and 2004 low interest rate environment, long-term deposits necessary to balance ALCO objectives, as a result of long-term assets added to the balance sheet, have not been available in the Company’s market area at a market price the Company was willing to accept. As a result, FHLB borrowings as a percentage of deposits increased to 51.0% at December 31, 2003 from 47.2% at December 31, 2002. This percentage has increased from December 31, 2003, to 52.8% at June 30, 2004. The intended net result of the overall balance sheet strategy is to increase the Company’s net interest spread. The leverage strategy is dynamic and requires ongoing management. As interest rates, funding costs and security spreads change, the Company’s determination of the proper securities to own and funding to obtain must be re-evaluated. Management has attempted to design the leverage strategy so that in a rising interest rate environment the interest income earned on the premium mortgage-backed securities may increase to help offset the increase in funding costs. As interest rates decrease, the interest income on the premium mortgage-backed securities may decrease due to increased prepayments on these securities as funding costs decrease. 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 ALCO scenarios modeled.
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Net Interest Income
Net interest income for the six months ended June 30, 2004 was $19.0 million, an increase of $3.6 million, or 23.7%, when compared to the same period in 2003. Average interest earning assets increased $137.2 million, or 11.2%, while the net interest spread increased from 2.34% at June 30, 2003 to 2.64% at June 30, 2004 and the net margin increased from 2.84% at June 30, 2003 to 3.07% at June 30, 2004. Net interest income increased as a result of the Company’s average earning assets and increases in the Company’s net interest margin and spread during the first six months of 2004 when compared to the same period in 2003. The increases in the net interest margin and spread were primarily a result of lower interest expense on the Company’s long-term debt and decreased funding costs associated with the Company’s deposits and FHLB advances and decreased amortization expense on the Company’s mortgage-backed securities. For the quarter ended June 30, 2004 when compared to the period in 2003, net interest income increased $1.6 million, or 19.9%, primarily as a result of increases in the Company’s average interest earning assets, net interest margin and spread. For the quarter ended June 30, 2004 when compared to the same period in 2003, average interest earning assets increased $151.6 million, or 12.2%, and the net interest margin and spread increased to 2.98% and 2.54% from 2.87% and 2.37%, respectively. While the net interest margin and spread for the quarter ended June 30, 2004 increased compared to the same period in the previous year, the net interest margin and spread decreased when compared to the first quarter ended March 31, 2004 which were 3.17% and 2.75%, respectively. This was due primarily to additional long-term advances obtained by the Company during the quarter ended June 30, 2004 to partially pre-fund a portion of the short-term FHLB advances maturing during the remainder of 2004 and slightly faster prepayment speeds on the Company’s mortgage-backed securities during the second quarter when compared to the first quarter. Future changes in interest rates could impact prepayment speeds on the Company’s mortgage-backed securities and the Company’s funding decisions which could influence the Company’s net interest margin and spread during the coming quarters.
During the six months ended June 30, 2004, average loans, funded primarily by the growth in average deposits, increased $25.0 million, or 4.39%, compared to the same period in 2003. The average yield on loans decreased from 6.74% at June 30, 2003 to 6.15% at June 30, 2004 reflective of the overall interest rate environment. As interest rates declined, especially short-term interest rates, loan customers increasingly requested floating rate loans, which lowered the overall yield on loans. In addition, the Company experienced a number of loan customers requesting loan repricing due to lower interest rates offered by competing financial institutions. If interest rates remain at current levels or move lower, the Company anticipates it may be required to continue to meet lower interest rate offers from competing financial institutions in order to retain quality loan relationships, which could impact the overall loan yield and, therefore profitability. The recent increase in interest rates during the second quarter of 2004 may reduce some of those requests. The decrease in interest income on loans of $1.0 million, or 5.5%, was the result of the decrease in interest rates partially offset by the increase in average loans for the six months ended June 30, 2004 compared to the same period in 2003. During the first six months ended June 30, 2004, loans, net of unearned discount, increased $17.9 million, or 3.0%, when compared to the year ended December 31, 2003 primarily as a result of an increase in 1-4 family residential loans.
Average investment and mortgage-backed securities increased $111.4 million, or 18.0%, for the six months ended June 30, 2004 when compared to the same period in 2003. This increase was funded by the increase in average deposits and average FHLB Dallas advances. The overall yield on average securities decreased to 4.25% during the six months ended June 30, 2004 from 4.39% during the same period in 2003. This decrease is reflective of the overall lower interest rate environment and a restructuring of a portion of the securities portfolio in an effort to reposition some of the mortgage-backed securities coupons in an attempt to reduce prepayments. Interest income from investment and mortgage-backed securities increased $2.0 million, or 16.2%, compared to the same period in 2003 due to the increase in average balances which was partially offset by the decrease in the overall yield.
On January 1, 2004, the Company transferred mortgage-backed securities totaling $44.4 million from AFS to HTM due to overall balance sheet strategies and potential changes in market conditions. The unrealized loss on the securities transferred from AFS to HTM was $319,000, net of tax, at the date of transfer based on the fair value of the securities on the transfer date. During the second quarter of 2004, the Company transferred mortgage-backed securities totaling $197.1 million from AFS to HTM. The unrealized loss on the securities transferred from AFS to HTM was $2.6 million, net of tax, during the second quarter based on the fair value of the securities on the transfer dates. The Company has a significant amount of long-term Federal Home Loan Bank fixed rate liabilities and determined it was appropriate that a portion of the Company’s securities portfolio should be designated HTM. At present the Company does not have any current plans to transfer additional AFS securities to HTM. Should conditions change, ALCO may consider transfers in the future. There were no sales from the HTM portfolio during the six months ended June 30, 2004, and the year ended December 31, 2003. There were $253.0 million and $6.4 million of securities classified as HTM for the periods ended June 30, 2004 and December 31, 2003, respectively.
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Interest income from marketable equity securities, federal funds sold and other interest earning assets decreased $95,000, or 27.1%, for the six months ended June 30, 2004 when compared to 2003 as a result of the decrease in the average yield from 2.16% in 2003 to 1.40% at June 30, 2004, due to lower interest rates, which were offset by an increase in the average balance.
Total interest expense decreased $2.7 million, or 17.0%, to $13.1 million during the six months ended June 30, 2004 as compared to $15.8 million during the same period in 2003. The decrease was attributable to lower interest expense on the Company’s long-term debt and decreased funding costs associated with the Company’s deposits and FHLB Dallas advances, partially offset by an increase in average interest bearing liabilities of $87.8 million, or 8.5%. The average yield on interest bearing liabilities decreased from 3.09% at June 30, 2003 to 2.36% at June 30, 2004.
Average interest bearing deposits increased $20.2 million, or 3.2%, while the average rate paid decreased from 2.06% at June 30, 2003 to 1.46% at June 30, 2004. Average short-term interest bearing liabilities, consisting primarily of FHLB Dallas advances and federal funds purchased, increased $21.6 million, or 15.0%, as compared to the same period in 2003 primarily as a result of the increase in securities during the first six months of 2004. Interest expense associated with short-term interest bearing liabilities decreased $317,000, or 10.3%, and the average rate paid decreased 96 basis points for the six month period ended June 30, 2004 when compared to the same period in 2003. Average long-term interest bearing liabilities consisting of FHLB Dallas advances increased $59.2 million, or 26.4%, during the six months ended June 30, 2004 to $283.5 million as compared to $224.3 million at June 30, 2003. Interest expense associated with long-term FHLB Dallas advances increased $344,000, or 7.1%, and the average rate paid decreased 68 basis points for the six months ended June 30, 2004 when compared to the same period in 2003. The long-term advances were obtained from the FHLB Dallas primarily to fund long-term securities and to a lesser extent long-term loans. During the second quarter ended June 30, 2004, the Company obtained additional long-term advances to partially pre-fund a portion of the short-term FHLB advances maturing during the remainder of 2004. FHLB Dallas advances are collateralized by FHLB Dallas stock, securities and nonspecific real estate loans.
Average long-term junior subordinated convertible debentures (the “Cumulative Convertible Trust Preferred Securities”) decreased $13.8 million, or 100%, from June 30, 2003 to June 30, 2004. Interest expense decreased $577,000 or 100% as a result of the decrease in the average balance. On December 31, 2003, Southside Capital Trust II, a subsidiary of the Company, redeemed 6,571 shares of its 8.75% Cumulative Convertible Trust Preferred Securities and all of its 8.75% Common Securities which totaled $678,000. Prior to the redemption date, December 31, 2003, all other cumulative Convertible Trust Preferred securities were converted into shares of the Company’s common stock.
Average long-term junior subordinated debentures (the “Cumulative Trust Preferred Securities”) decreased $20.0 million, or 100%, from June 30, 2003 to June 30, 2004. Interest expense decreased $850,000, or 100%, due to the decrease in average balance. On October 6, 2003, Southside Capital Trust, a subsidiary of Southside Bancshares, Inc., redeemed all of its 8.50% Cumulative Trust Preferred Securities and 8.50% Trust Common Securities which totaled $20,618,560. Southside Bancshares funded the redemption through the issuance of $20,000,000 of trust preferred securities and $619,000 of trust common securities that adjust quarterly at a rate equal to the three month LIBOR plus 294 basis points. The lower interest rate provided interest savings during the first six months of 2004 and should provide a better match for the overall interest rate sensitivity position of the Company.
Average long-term debt increased $20.6 million, or 100%, from June 30, 2003 to June 30, 2004 to reflect the issuance of the trust preferred securities in the third quarter of 2003. Interest expense increased $425,000, or 100%. The Company adopted FIN 46 in connection with its consolidated financial statements for the year ended December 31, 2003. FIN 46 required the Company to de-consolidate its investments in Southside Statutory Trust III in its financial statements. Effective December 31, 2003, the Company deconsolidated the wholly-owned issuing trust entity resulting in a recharacterization of the underlying consolidated debt obligation from the previous trust preferred securities obligation to the junior subordinated debenture obligation that exists between the Company and the issuing trust entity.
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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.
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Noninterest Income
Noninterest income was $11.7 million for the six months ended June 30, 2004 compared to $12.7 million for the same period in 2003. Deposit services income increased $877,000, or 14.4%, for the six months ended June 30, 2004 compared to June 30, 2003. Deposit services income increased primarily as a direct result of increases in overdraft income, increased numbers of deposit accounts, increased deposit activity and an increase in the pricing of deposit service charges during the third quarter ended September 30, 2003. Gain on sale of loans income decreased $574,000, or 39.3%, to $887,000 for the six months ended June 30, 2004 from $1.5 million for the same period in 2003 due to a higher interest rate environment and the decrease in mortgage loan refinancing the Company handled during the first six months of 2004 when compared to the same period in 2003. Trust income increased $99,000, or 20.8%, for the six months ended June 30, 2004 when compared to the same period in 2003 due to growth in managed assets experienced in the Trust department. Other noninterest income increased $121,000, or 18.1%, for the six months ended June 30, 2004 primarily as a result of increases in other fee income, credit life income, exchange fee income, income from subsidiaries, and MasterCard income. During the six months ended June 30, 2004, the Company had gains on the sale of securities of $2.1 million compared to $3.6 million for the same period in 2003. The Company sold securities out of its AFS portfolio to accomplish ALCO and investment portfolio objectives aimed at repositioning the securities portfolio in an effort to maximize the total return of the securities portfolio. During the first six months, selected long duration municipal securities were sold to reduce the overall municipal securities portfolio to provide for municipal loan growth and to reduce the overall level of tax free income derived from the securities portfolio. Selected premium mortgage-backed securities were also sold in an effort to reposition a portion of the securities portfolio in an attempt to reduce prepayment exposure.
The market value of the AFS securities portfolio at June 30, 2004 was $542.8 million with a net unrealized gain on that date of $2.6 million. The net unrealized gain is comprised of $6.9 million in unrealized gains and $4.3 million in unrealized losses. The market value of the HTM securities portfolio at June 30, 2004 was $253.5 million with a net unrealized gain on that date of $488,000. The net unrealized gain is comprised of $941,000 in unrealized gains and $453,000 in unrealized losses.
Noninterest Expense
Noninterest expense was $19.9 million for the six months ended June 30, 2004, compared to $19.0 million for the same period of 2003, representing an increase of $980,000, or 5.2%.
Salaries and employee benefits increased $853,000, or 7.1%, during the six months ended June 30, 2004 when compared to the same period in 2003. Normal payroll increases and higher benefit costs were the primary reasons for the increase. Direct salary expense and payroll taxes increased $270,000, or 2.8%, as a result of bank growth and pay increases for the six months ended June 30, 2004 when compared to the same period in 2003. Retirement expense decreased $21,000, or 1.7%, for the six months ended June 30, 2004 when compared to the same period in 2003, primarily as a result of the level of performance of retirement plan assets and actuarial assumptions. The Company’s assumed long-term rate of return is 8.5% and the assumed discount rate is 6.5%. Due to the decline in major stock market indexes for three straight years combined with low interest rates the Company’s rate of return on plan assets did not achieve an 8.5% return for the years ended December 31, 2002, 2001 and 2000. During 2003, the Company achieved a return above the 8.5% assumed long-term rate of return. The Company will continue to evaluate the assumed long-term rate of return of 8.5% to determine if it should be changed in the future. If this assumption were decreased the cost and funding required for the retirement plan could increase. Health insurance expense increased $603,000, or 53.3%, for the six months ended June 30, 2004 when compared to the same period in 2003. The Company has a self-insured health plan which is supplemented with stop loss insurance policies. Health insurance costs are rising nationwide and these costs may continue to increase during 2004.
ATM and bank analysis fees increased $90,000, or 20.4%, for the six months ended June 30, 2004 compared to the same period in 2003. The increase occurred primarily due to a decrease in the earning credit rate and overall deposit and activity growth.
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Professional fees increased $76,000, or 20.9%, for the six months ended June 30, 2004 compared to the same period in 2003. The increase occurred primarily due to consulting fees associated with the Company’s internal and financial controls.
Other expense decreased $77,000, or 3.2%, for the six months ended June 30, 2004 compared to the same period in 2003. The decrease occurred primarily due to decreases in losses in other real estate owned, computer fees, amortization expense and other losses that were partially offset by increases in director fees, bank exam fees, accounting fees and telephone expenses.
Income Taxes
Income tax expense was $2.1 million for the six months ended June 30, 2004 compared to $1.3 million for the six months ended June 30, 2003. The effective tax rate as a percentage of pre-tax income was 20.1% for the six months ended June 30, 2004 compared to 15.9% for the six months ended June 30, 2003. The increase in the effective tax rate and income tax expense for 2004 was due to the increase in taxable income as a percentage of total income for the six months ended June 30, 2004 when compared to June 30, 2003. The Company decreased its municipal securities portfolio the first six months of 2004 to reduce the overall level of tax free income from the securities portfolio and to allow the Company the opportunity to grow its municipal loan portfolio. During 2002 and 2003 the Company was in an alternative minimum tax position due to unusually high retirement contributions, the $1.0 million amortization expense during 2003 associated with the redemption of the trust preferred securities and the level of tax free income. During 2004, the Company will not have the amortization expense referenced above and has the ability to and is addressing the appropriate level of tax free income to potentially avoid an alternative minimum tax position for 2004. Based on this information, management believes this is reversible in the future and no valuation allowance on the deferred tax asset is deemed necessary at this time.
Capital Resources
Total shareholders’ equity for the Company at June 30, 2004, was $99.4 million representing a decrease of $966,000 from December 31, 2003, and represented 6.6% of total assets at June 30, 2004 compared to 6.9% of total assets at December 31, 2003. Decreases to shareholders’ equity consisted of $2.1 million in dividends paid along with the decrease of $7.4 million in the accumulated other comprehensive income and the purchase of $675,000 in common stock (36,700 shares). Net income of $8.2 million offset the decrease in shareholders’ equity at June 30, 2004 in addition to the issuance of $827,000 in common stock (96,462 shares) through the Company’s incentive stock option and dividend reinvestment plans. The Company purchased common stock pursuant to a common stock repurchase plan instituted in late 1994. Under the repurchase plan, the Board of Directors establishes, on a quarterly basis, total dollar limitations. The Board reviews this plan in conjunction with the capital needs of the Company and Southside Bank and may, at its discretion, modify or discontinue the plan. The Company’s dividend policy requires that any cash dividend payments made by the Company not exceed consolidated earnings for that year. Shareholders should not anticipate a continuation of the cash dividend simply because of the implementation of a dividend reinvestment program. The payment of dividends will depend upon future earnings, the financial condition of the Company, and other related factors including the discretion of the Board of Directors.
Under the Federal Reserve Board’s risk-based capital guidelines for bank holding companies, the minimum ratio of total capital to risk-adjusted assets (including certain off-balance sheet items, such as standby letters of credit) is currently eight percent. The minimum Tier 1 capital to risk-adjusted assets is four percent. The Company’s $20 million of trust preferred securities is considered Tier 1 capital by the Federal Reserve Board. The Federal Reserve Board also requires bank holding companies to comply with the minimum leverage ratio guidelines. The leverage ratio is a ratio of bank holding company’s Tier 1 capital to its total consolidated quarterly average assets, less goodwill and certain other intangible assets. The guidelines require a minimum average of four percent for bank holding companies that meet certain specified criteria. Failure to meet minimum capital regulations can initiate certain mandatory and possibly additional discretionary actions by regulation, that if undertaken, could have a direct material effect on the Company’s financial statements. At June 30, 2004, the Company and the Bank exceeded all regulatory minimum capital requirements.
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The Federal Reserve Deposit Insurance Act requires bank regulatory agencies to take “prompt corrective action” with respect to FDIC-insured depository institutions that do not meet minimum capital requirements. A depository institution’s treatment for purposes of the prompt corrective action provisions will depend on how its capital levels compare to various capital measures and certain other factors, as established by regulation.
It is management’s intention to maintain the Company’s capital at a level acceptable to all regulatory authorities and future dividend payments will be determined accordingly. Regulatory authorities require that any dividend payments made by either the Company or Southside Bank not exceed earnings for that year.
Liquidity and Interest Rate Sensitivity
Liquidity management involves the ability to convert assets to cash with a minimum of loss. The Company must be capable of meeting its obligations to its customers at any time. This means addressing (1) the immediate cash withdrawal requirements of depositors and other funds providers; (2) the funding requirements of all lines and letters of credit; and (3) the short-term credit needs of customers. Liquidity is provided by short-term investments that can be readily liquidated with a minimum risk of loss. Cash, Interest Earning Deposits, Federal Funds Sold and short-term investments with maturities or repricing characteristics of one year or less continue to be a substantial percentage of total assets. At June 30, 2004, these investments were 20.5% of total assets. Liquidity is further provided through the matching, by time period, of rate sensitive interest earning assets with rate sensitive interest bearing liabilities. The Company has three lines of credit for the purchase of overnight federal funds at prevailing rates. Two $15.0 million and one $10.0 million unsecured lines of credit have been established with Bank of America, Frost Bank and Texas Independent Bank, respectively. The Company has obtained a $12.3 million letter of credit from FHLB Dallas as collateral for a portion of the Company’s public funds deposits.
Interest rate sensitivity management seeks to avoid fluctuating net interest margins and to enhance consistent growth of new interest income through periods of changing interest rates. The ALCO closely monitors various liquidity ratios, interest rate spreads and margins, interest rate shock reports and market value of portfolio equity (MVPE) with rates shocked plus and minus 200 basis points to ensure a satisfactory liquidity position for the Company. In addition, ALCO utilizes a simulation model to determine the impact of net interest income under several different interest rate scenarios. By utilizing this technology, the Company can determine changes that need to be made to the asset and liability mixes to minimize the change in net interest income under these various interest rate scenarios.
Composition of Loans
One of the Company’s main objectives is to seek attractive lending opportunities in East Texas, primarily in Smith and Gregg counties. Substantially all of the Bank’s loans are made to borrowers who live in and conduct business in East Texas, with the exception of municipal loans. Municipal loans are made to municipalities and school districts throughout the state of Texas. Total average loans increased $25.0 million, or 4.4%, from the six months ended June 30, 2003 to June 30, 2004. The majority of the increase was in 1-4 family residential loans and loans to municipalities. The increase in 1-4 family residential loans is primarily due to the Bank’s continued strong commitment in this area, the solid housing market in the Company’s area, and the decrease in prepayments of these loans due to the increase in interest rates. The increase in municipal loans is due to the Bank’s continued strong commitment in this area.
Loan Loss Experience and Allowance for Loan Losses
The loan loss allowance is based on the most current review of the loan portfolio at that time. Several methods are used to maintain the review in the most current manner. First, the servicing officer has the primary responsibility for updating significant changes in a customer’s financial position. Accordingly, each officer prepares status updates on any credit deemed to be experiencing repayment difficulties which, in the officer’s opinion, would place the collection of principal or interest in doubt. Second, an internal loan review officer from the Company is responsible for an ongoing review of the Company’s entire loan portfolio with specific goals set for the volume of loans to be reviewed on an annual basis. Independent Bank Services, L.C., a partially owned subsidiary of the Bank, supplements the internal loan review officer’s process by performing additional loan reviews designed to achieve overall goals of penetration.
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At each review of a credit, a subjective analysis methodology is used to grade the respective loan. Categories of grading vary in severity to include loans which do not appear to have a significant probability of loss at the time of review to grades which indicate a probability that the entire balance of the loan will be uncollectible. If full collection of the loan balance appears unlikely at the time of review, estimates or appraisals of the collateral securing the debt are used to allocate the necessary allowances. A list of loans or loan relationships of $50,000 or more, which are graded as having more than the normal degree of risk associated with them, is maintained by the internal loan review officer. This list is updated on a periodic basis, but no less than quarterly in order to properly allocate necessary allowances and keep management informed on the status of attempts to correct the deficiencies noted in the credit.
Industry experience shows that a portion of the Company’s loans will become delinquent and a portion of the loans will require partial or entire charge-off. Regardless of the underwriting criteria utilized, losses may be experienced as a result of various factors beyond the Company’s control, including, among other things, changes in market conditions affecting the value of properties and problems affecting the credit of the borrower. Management’s determination of the adequacy of allowance for loan losses is based on various considerations, including an analysis of the risk characteristics of various classifications of loans, previous loan loss experience, specific loans which would have loan loss potential, delinquency trends, estimated fair value of the underlying collateral, current economic conditions, the views of the regulators (who have the authority to require additional allowances), and geographic and industry loan concentration.
For the second quarter and six months ended June 30, 2004, loan charge-offs were $166,000 and $432,000 and recoveries were $101,000 and $166,000, respectively, resulting in net charge-offs of $65,000 and $266,000. For the second quarter and six months ended June 30, 2003, loan charge-offs were $580,000 and $915,000 and recoveries were $161,000 and $271,000, resulting in net charge-offs of $419,000 and $644,000 respectively. The necessary provision expense was estimated at $525,000 for the six months ended June 30, 2004.
Nonperforming Assets
Nonperforming assets consist of delinquent loans over 90 days past due, nonaccrual loans, other real estate owned, repossessed assets and restructured loans. Nonaccrual loans are those loans which are more than 90 days delinquent and collection in full of both the principal and interest is in doubt. Additionally, some loans that are not delinquent may be placed on nonaccrual status due to doubts about full collection of principal or interest. When a loan is categorized as nonaccrual, the accrual of interest is discontinued and the accrued balance is reversed for financial statement purposes. Restructured loans represent loans which have been renegotiated to provide a reduction or deferral of interest or principal because of deterioration in the financial position of the borrowers. Categorization of a loan as nonperforming is not in itself a reliable indicator of potential loan loss. Other factors, such as the value of collateral securing the loan and the financial condition of the borrower must be considered in judgments as to potential loan loss. Other Real Estate Owned (OREO) represents real estate taken in full or partial satisfaction of debts previously contracted. The dollar amount of OREO is based on a current evaluation of the OREO at the time it is recorded on the Company’s books, net of estimated selling costs. Updated valuations are obtained as needed and any additional impairments are recognized.
Total nonperforming assets at June 30, 2004 were $2.1 million, a decrease of $139,000, or 6.1%, from $2.3 million at December 31, 2003. From December 31, 2003 to June 30, 2004, nonaccrual loans decreased $169,000, or 10.9%, to $1.4 million. Of the total at June 30, 2004, 33.0% are residential real estate loans, 17.7% are commercial real estate loans, 24.1% are commercial loans and 25.2% are loans to individuals. Other real estate owned increased $70,000, or 35.9%, to $265,000 at June 30, 2004 from $195,000 at December 31, 2003. Of the total at June 30, 2004, 21.9% consist of residential dwellings, and 78.1% consist of commercial real estate. The Company is actively marketing all properties and none are being held for investment purposes. Loans 90 days past due or more increased $28,000, or 10.3%, to $300,000. Of this $28,000 increase, $33,000 related to commercial loans and $29,000 related to loans to individuals with a decrease of $34,000 in residential real estate loans. Repossessed assets decreased $44,000, or 91.7%, to $4,000. Restructured loans decreased $24,000, or 11.0%, to $195,000.
Expansion
The Company opened a full service branch in Jacksonville, Texas in Cherokee County early in the second quarter of 2004.
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Accounting Pronouncements
See “Accounting Pronouncements” in Note 7 to the Company’s financial statements in this Form 10-Q.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In the banking industry, a major risk exposure is changing interest rates. The primary objective of monitoring the Company’s interest rate sensitivity, or risk, is to provide management the tools necessary to manage the balance sheet to minimize adverse changes in net interest income as a result of changes in the direction and level of interest rates. Federal Reserve Board monetary control efforts, the effects of deregulation and legislative changes have been significant factors affecting the task of managing interest rate sensitivity positions in recent years.
In an attempt to manage its exposure to changes in interest rates, management closely monitors the Company’s exposure to interest rate risk. The Company’s ALCO meets regularly and reviews the Company’s interest rate risk position and makes recommendations for adjusting this position. In addition, the Board reviews on a monthly basis the Company’s asset/liability position. The Company primarily uses two methods for measuring and analyzing interest rate risk: Net income simulation analysis and market value of portfolio equity modeling. Through these simulations the Company attempts to estimate the impact on net interest income of a 200 basis point parallel shift in the yield curve. Policy guidelines limit the estimated change in net interest income to 10 percent of forecasted net income over the succeeding 12 months and 200 basis point parallel rate shock. Policy guidelines limit the change in market value of equity in a 200 basis point parallel rate shock to 20 percent of the base case. The results of the valuation analysis as of June 30, 2004, were within policy guidelines. Due to the level of interest rates at June 30, 2004, many interest rates cannot move down 200 basis points. As part of the overall assumptions, certain assets and liabilities have been given reasonable floors. In the present interest rate environment, management is primarily focusing on the shock down 100 basis and the shock up 100 and 200 basis points. This type of simulation analysis requires numerous assumptions including but not limited to changes in balance sheet mix, prepayment rates on mortgage-related assets and fixed rate loans, cash flows and repricing of all financial instruments, changes in volumes and pricing, future shapes of the yield curve, relationship of market interest rates to each other (basis risk), credit spread and deposit sensitivity. Assumptions are based on ALCO’s best estimates but may not accurately reflect actual results under certain changes in interest rates.
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The following table provides information about the Company’s financial instruments that are sensitive to changes in interest rates. Except for the effects of prepayments and scheduled principal amortization, the table presents principal cash flows and related weighted average interest rates by the contractual term to maturity. Callable FHLB Dallas Advances are presented based on contractual maturity. Adjustable rate student loans totaling $5.4 million are classified in the one year category. These loans reprice annually and are not retained by the Company when they enter repayment status. Nonaccrual loans, totaling $1,378,000, are not included in the loan totals. All instruments are classified as other than trading.
EXPECTED MATURITY DATE(dollars in thousands)
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Residential fixed rate loans are assumed to have annual prepayment rates between 7% and 35% of the portfolio. Commercial and multi-family real estate loans are assumed to prepay at an annualized rate between 8% and 40%. Consumer loans are assumed to prepay at an annualized rate between 8% and 30%. Commercial loans are assumed to prepay at an annualized rate between 8% and 45%. Municipal loans are assumed to prepay at an annualized rate between 6% and 15%. Fixed and adjustable rate mortgage-backed securities, including Collateralized Mortgage Obligations (“CMOs”) and Real Estate Mortgage Investment Conduits (“REMICs”), have annual payment assumptions ranging from 6% to 50%. At June 30, 2004, the contractual maturity of substantially all of the Company’s mortgage-backed or related securities was in excess of ten years. The actual maturity of a mortgage-backed or related security is less than its stated maturity due to regular principal payments and prepayments of the underlying mortgages. Prepayments that are faster than anticipated may shorten the life of the security and affect its yield to maturity. The yield to maturity is based upon the interest income and the amortization of any premium or discount related to the security. In accordance with GAAP, premiums and discounts are amortized over the estimated lives of the mortgage-backed securities, which decrease and increase interest income, respectively. The prepayment assumptions used to determine the amortization period for premiums and discounts can significantly affect the yield of the mortgage-backed or related security, and these assumptions are reviewed periodically to reflect actual prepayments. Although prepayments of underlying mortgages depend on many factors, including the type of mortgages, the coupon rate, the age of mortgages, the geographical location of the underlying real estate collateralizing the mortgages and general levels of market interest rates, the difference between the interest rates on the underlying mortgages and the prevailing mortgage interest rates generally is the most significant determinant of the rate of prepayments. During periods of falling mortgage interest rates, if the coupon rate of the underlying mortgages exceeds the prevailing market interest rates offered for mortgage loans, refinancing may increase and accelerate the prepayment of the underlying mortgages and the related security. At June 30, 2004, $660.2 million of mortgage-backed and related securities held by the Company were collateralized by fixed-rate mortgage loans.
The Company assumes 70% of savings accounts and approximately 60% of transaction accounts at June 30, 2004, are core deposits and are, therefore, expected to roll-off after five years. The Company assumes 30% of Money Market accounts at June 30, 2004 are core deposits and are, therefore, expected to roll-off after five years. The Company does not consider any of its Platinum Money Markets accounts as core deposits. No roll-off rate is applied to certificates of deposit. Fixed maturity deposits reprice at maturity.
In evaluating the Company’s exposure to interest rate risk, certain limitations inherent in the method of analysis presented in the foregoing table must be considered. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable rate mortgages, have features which restrict changes in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table. Finally, the ability of many borrowers to service their debt may decrease in the event of an interest rate increase. The Company considers all of these factors in monitoring its exposure to interest rate risk.
ITEM 4. CONTROLS AND PROCEDURES
The Company’s Chief Executive Officer and its Chief Financial Officer undertook an evaluation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) as of the end of the period covered by this report and concluded that the Company’s controls and procedures are effective in ensuring that all material information required to be filed in this quarterly report has been made known to them in a timely fashion. There have been no significant changes in the Company’s internal controls over financial reporting that occurred during the Company’s last fiscal quarter that materially affected, or is reasonably likely to materially affect the Company’s internal controls over financial reporting.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not Applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
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ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits -
(b) Reports on Form 8-K -
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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Exhibit Index
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