UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934. For the quarterly period ended March 31, 2003 [ ] Transition Report pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934. For the transition period from ________________ to ________________ Commission file number 0-30533 TEXAS CAPITAL BANCSHARES, INC. (Exact Name of Registrant as Specified in Its Charter) <Table> <S> <C> DELAWARE 75-2679109 (State or other jurisdiction of incorporation or (I.R.S. Employer Identification Number) organization) 2100 MCKINNEY AVENUE, SUITE 900, DALLAS, TEXAS, U.S.A. 75201 (Address of principal executive officers) (Zip Code) </Table> 214/932-6600 (Registrant's telephone number, including area code) N/A (Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report) Indicate by checkmark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS: Indicate by check whether the issuer has filed all reports required to be filed by Section 12, 13 or 15(d) of the Securities and Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes [ ] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: On May 14, 2003, the number of shares set forth below was outstanding with respect to each of the issuer's classes of common stock: <Table> <S> <C> Common Stock 18,513,084 Series A-1 Non-voting Common Stock 694,672 </Table>
Texas Capital Bancshares, Inc. Form 10-Q Quarter Ended March 31, 2003 Index <Table> <S> <C> Part I. Financial Information Item 1. Financial Statements Consolidated Statements of Operations - Unaudited 3 Consolidated Balance Sheets - Unaudited 4 Consolidated Statements of Changes in Stockholders' Equity - Unaudited 5 Consolidated Statements of Cash Flows - Unaudited 6 Notes to Consolidated Financial Statements - Unaudited 7 Financial Summaries - Unaudited 11 Item 2. Management's Assessment of Operations and Financial Condition 12 Item 3. Quantitative and Qualitative Disclosures about Market Risk 19 Item 4. Controls and Procedures 21 Part II. Other Information Item 6. Exhibits and Reports on Form 8-K 22 </Table> 2
ITEM 1. FINANCIAL STATEMENTS TEXAS CAPITAL BANCSHARES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS - UNAUDITED (In thousands except per share data) <Table> <Caption> Three months ended March 31 2003 2002 ------------ ------------ <S> <C> <C> INTEREST INCOME Interest and fees on loans $ 14,696 $ 12,501 Securities 5,356 2,889 Federal funds sold 87 89 Deposits in other banks 1 1 ------------ ------------ Total interest income 20,140 15,480 INTEREST EXPENSE Deposits 5,382 4,907 Federal funds purchased 440 375 Other borrowings 2,445 804 Long-term debt 133 -- ------------ ------------ Total interest expense 8,400 6,086 ------------ ------------ NET INTEREST INCOME 11,740 9,394 PROVISION FOR LOAN LOSSES 1,250 1,171 ------------ ------------ NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 10,490 8,223 NON-INTEREST INCOME Service charges on deposit accounts 843 629 Trust fee income 281 247 Gain on sale of securities 341 -- Cash processing fees 900 993 Bank owned life insurance (BOLI) income 414 -- Other 550 327 ------------ ------------ Total non-interest income 3,329 2,196 NON-INTEREST EXPENSE Salaries and employee benefits 5,379 4,333 Net occupancy expense 1,187 1,277 Advertising 193 80 Legal and professional 579 684 Communications and data processing 720 722 Franchise taxes 37 14 Other 1,283 1,231 ------------ ------------ Total non-interest expense 9,378 8,341 ------------ ------------ INCOME BEFORE INCOME TAXES 4,441 2,078 Income tax expense 1,410 520 ------------ ------------ NET INCOME 3,031 1,558 Preferred stock dividends (274) (261) ------------ ------------ Income available to common stockholders $ 2,757 $ 1,297 ============ ============ EARNINGS PER SHARE: Basic $ .14 $ .07 Diluted $ .14 $ .07 </Table> See accompanying notes to consolidated financial statements. 3
TEXAS CAPITAL BANCSHARES, INC. CONSOLIDATED BALANCE SHEETS - UNAUDITED (In thousands except share data) <Table> <Caption> March 31, December 31, 2003 2002 ------------ ------------ <S> <C> <C> ASSETS Cash and due from banks $ 56,049 $ 88,744 Federal funds sold 62,210 -- Securities, available-for-sale 620,769 553,169 Loans, net 1,037,121 988,019 Loans held for sale 122,950 116,106 Premises and equipment, net 3,498 3,829 Accrued interest receivable and other assets 44,084 41,919 Goodwill, net 1,496 1,496 ------------ ------------ Total assets $ 1,948,177 $ 1,793,282 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Deposits: Non-interest bearing $ 272,789 $ 238,873 Interest bearing 1,023,357 957,662 ------------ ------------ Total deposits 1,296,146 1,196,535 Accrued interest payable 2,714 3,826 Other liabilities 7,413 8,485 Federal funds purchased 148,729 83,629 Repurchase agreements 352,628 302,083 Other borrowings 2,785 63,748 Long-term debt: Guaranteed preferred beneficial interests in the Company's subordinated debentures 10,000 10,000 ------------ ------------ Total liabilities 1,820,415 1,668,306 Stockholders' equity: Series A convertible preferred stock, $.01 par value, 6%: Authorized shares - 10,000,000 Issued shares - 1,057,142 at March 31, 2003 and December 31, 2002 11 11 Common stock, $.01 par value: Authorized shares - 100,000,000 Issued shares - 18,517,656 and 18,500,812 at March 31, 2003 and December 31, 2002, respectively 185 185 Series A-1 non-voting common stock, $.01 par value: Issued shares - 694,672 and 695,516 at March 31, 2003 and December 31, 2002, respectively 7 7 Additional paid-in capital 131,707 131,881 Accumulated deficit (10,316) (13,347) Treasury stock (shares at cost: 97,246 at March 31, 2003 and December 31, 2002) (668) (668) Deferred compensation 573 573 Accumulated other comprehensive income 6,263 6,334 ------------ ------------ Total stockholders' equity 127,762 124,976 ------------ ------------ Total liabilities and stockholders' equity $ 1,948,177 $ 1,793,282 ============ ============ </Table> See accompanying notes to consolidated financial statements. 4
TEXAS CAPITAL BANCSHARES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY - UNAUDITED (In thousands except share data) <Table> <Caption> Series A Series A-1 Convertible Non-voting Preferred Stock Common Stock Common Stock ------------------------- ------------------------- -------------------------- Additional Paid-in Shares Amount Shares Amount Shares Amount Capital ----------- ----------- ----------- ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> <C> <C> <C> Balance at December 31, 2001 753,301 $ 8 18,400,310 $ 184 741,392 $ 7 $ 127,378 Comprehensive income: Net income -- -- -- -- -- -- -- Change in unrealized gain (loss) on available-for-sale securities, net of tax of $3,683, net of reclassification amount of $1,375 -- -- -- -- -- -- -- Total comprehensive income Sale of Series A convertible preferred stock 303,841 3 -- -- -- -- 5,247 Sale of common stock -- -- 54,626 1 -- -- 350 Preferred dividends -- -- -- -- -- -- (1,097) Transfers -- -- 45,876 -- (45,876) -- -- Purchase of treasury stock -- -- -- -- -- -- -- Sale of treasury stock -- -- -- -- -- -- 3 ----------- ----------- ----------- ----------- ----------- ----------- ----------- Balance at December 31, 2002 1,057,142 11 18,500,812 185 695,516 7 131,881 Comprehensive income (loss): Net income -- -- -- -- -- -- -- Change in unrealized gain (loss) on available-for-sale securities, net of taxes of $38, net of reclassification amount of $341 -- -- -- -- -- -- -- Total comprehensive income (loss) Sale of common stock -- -- 16,000 -- -- -- 100 Transfers -- -- 844 -- (844) -- -- Preferred dividend accrued -- -- -- -- -- -- (274) ----------- ----------- ----------- ----------- ----------- ----------- ----------- Balance at March 31, 2003 1,057,142 $ 11 18,517,656 $ 185 694,672 $ 7 $ 131,707 =========== =========== =========== =========== =========== =========== =========== <Caption> Accumulated Treasury Stock Other -------------------------- Compre- hensive Accumulated Deferred Income Deficit Shares Amount Compensation (Loss) Total ----------- ----------- ----------- ------------ ------------ ----------- <S> <C> <C> <C> <C> <C> <C> Balance at December 31, 2001 $ (20,690) (87,516) $ (594) $ 573 $ (507) $ 106,359 Comprehensive income: Net income 7,343 -- -- -- -- 7,343 Change in unrealized gain (loss) on available-for-sale securities, net of tax of $3,683, net of reclassification amount of $1,375 -- -- -- -- 6,841 6,841 ----------- Total comprehensive income 14,184 Sale of Series A convertible preferred stock -- -- -- -- -- 5,250 Sale of common stock -- -- -- -- -- 351 Preferred dividends -- -- -- -- -- (1,097) Transfers -- -- -- -- -- -- Purchase of treasury stock -- (14,144) (103) -- -- (103) Sale of treasury stock -- 4,414 29 -- -- 32 ----------- ----------- ----------- ----------- ----------- ----------- Balance at December 31, 2002 (13,347) (97,246) (668) 573 6,334 124,976 Comprehensive income (loss): Net income 3,031 -- -- -- -- 3,031 Change in unrealized gain (loss) on available-for-sale securities, net of taxes of $38, net of reclassification amount of $341 -- -- -- -- (71) (71) ----------- Total comprehensive income 2,960 (loss) Sale of common stock -- -- -- -- -- 100 Transfers -- -- -- -- -- -- Preferred dividend accrued -- -- -- -- -- (274) ----------- ----------- ----------- ----------- ----------- ----------- Balance at March 31, 2003 $ (10,316) (97,246) $ (668) $ 573 $ 6,263 $ 127,762 =========== =========== =========== =========== =========== =========== </Table> See accompanying notes to consolidated financial statements. 5
TEXAS CAPITAL BANCSHARES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS - UNAUDITED (In thousands) <Table> <Caption> Three months ended March 31 2003 2002 ------------ ------------ <S> <C> <C> OPERATING ACTIVITIES Net income $ 3,031 $ 1,558 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for loan losses 1,250 1,171 Depreciation and amortization 366 461 Gain on sale of securities (341) -- Amortization and accretion on securities 1,975 327 Bank owned life insurance (BOLI) income (414) -- Originations of loans held for sale (452,891) (230,012) Proceeds from sales of loans held for sale 446,047 249,776 Changes in operating assets and liabilities: Accrued interest receivable and other assets (1,735) (419) Accrued interest payable and other liabilities (1,867) (3,411) ------------ ------------ Net cash provided by (used in) operating activities (4,579) 19,451 INVESTING ACTIVITIES Purchases of available-for-sale securities (145,660) (80,534) Proceeds from sales of available-for-sale securities 10,694 -- Maturities and calls of available-for-sale securities 1,800 1,400 Principal payments received on securities 63,550 17,616 Net (increase) decrease in loans (50,408) 6,904 Purchase of premises and equipment, net 5 (123) ------------ ------------ Net cash used in investing activities (120,019) (54,737) FINANCING ACTIVITIES Net increase (decrease) in checking, money market and savings accounts 65,503 (25,573) Net increase in certificates of deposit 34,108 76,257 Sale of preferred stock -- 5,250 Sale of common stock 100 -- Net other borrowings (10,418) 5,805 Dividends paid (280) -- Net federal funds purchased 65,100 8,670 Sale of treasury stock, net -- 24 ------------ ------------ Net cash provided by financing activities 154,113 70,433 ------------ ------------ Net increase in cash and cash equivalents 29,515 35,147 Cash and cash equivalents at beginning of period 88,744 56,620 ------------ ------------ Cash and cash equivalents at end of period $ 118,259 $ 91,767 ============ ============ Supplemental disclosures of cash flow information: Cash paid during the period for interest $ 9,380 $ 6,644 Non-cash transactions: Transfers from loans/leases to other repossessed assets 16 -- Transfers from loans/leases to premises and equipment 40 -- </Table> See accompanying notes to consolidated financial statements. 6
TEXAS CAPITAL BANCSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - UNAUDITED (1) ACCOUNTING POLICIES Basis of Presentation The accounting and reporting policies of Texas Capital Bancshares, Inc. (the "Company") conform to accounting principles generally accepted in the United States and to generally accepted practices within the banking industry. The Consolidated Financial Statements of the Company include the accounts of the Company and its subsidiary, Texas Capital Bank, National Association (the "Bank"). The Company owns all of the outstanding common securities of Texas Capital Bancshares Statutory Trust I, which is a Connecticut business trust. Certain prior period balances have been reclassified to conform with the current period presentation. New Accounting Standards In December 2002, the Financial Accounting Standards Board issued FASB Statement No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure. Statement 148 amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition to Statement 123's fair value method of accounting for stock-based employee compensation. Statement 148 also amends the disclosure provisions of Statement 123 and APB Opinion No. 28, Interim Financial Reporting, to require disclosure in the summary of significant accounting policies of the effects of an entity's accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. While the Statement does not amend Statement 123 to require companies to account for employee stock options using the fair value method, the disclosure provisions of Statement 148 are applicable to all companies with stock-based employee compensation, regardless of whether they account for that compensation using the fair value method of Statement 123 or the intrinsic value method of Opinion 25. The Company adopted the disclosure provisions of Statement 148 effective December 31, 2002. At March 31, 2003, the Company had a stock-based employee compensation plan. The Company accounts for the plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123 to stock-based employee compensation. <Table> <Caption> Three months ended March 31 2003 2002 ------------ ------------ <S> <C> <C> Net income as reported $ 3,031 $ 1,558 Deduct: Total stock based employee compensation expense determined under fair value based method for all awards (188) (101) ------------ ------------ Pro forma net income $ 2,843 $ 1,457 ============ ============ Basic income per share: As reported $ .14 $ .07 Pro forma .13 .06 Diluted income per share: As reported $ .14 $ .07 Pro forma .13 .06 </Table> The fair value of these options was estimated at the date of grant using a Black-Scholes value option pricing model with the following weighted average assumptions used for 2003 and 2002, respectively: a risk free interest rate of 2.85% and 4.37%, a dividend yield of 0%, a volatility factor of .228 and .001, and an estimated life of five years. 7
(1) ACCOUNTING POLICIES (CONTINUED) The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. (2) EARNINGS PER SHARE The following table presents the computation of basic and diluted earnings per share (dollars in thousands except share data): <Table> <Caption> Three months ended March 31 2003 2002 -------------- -------------- <S> <C> <C> Numerator: Net income $ 3,031 $ 1,558 Preferred stock dividends (274) (261) -------------- -------------- Numerator for basic earnings per share-income available to common shareholders 2,757 1,297 Effect of dilutive securities: Preferred stock dividends(2) 274 -- -------------- -------------- Numerator for dilutive earnings per share-income available to common shareholders after assumed conversion $ 3,031 $ 1,297 ============== ============== Denominator: Denominator for basic earnings per share-weighted average shares 19,194,023 19,054,114 Effect of dilutive securities: Employee stock options(1) 207,804 203,298 Convertible preferred stock(2) 2,114,284 -- -------------- -------------- Dilutive potential common shares 2,322,088 203,298 -------------- -------------- Denominator for dilutive earnings per share-adjusted weighted average shares and assumed conversions 21,516,111 19,257,412 ============== ============== Basic earnings per share $ .14 $ .07 Diluted earnings per share $ .14 $ .07 </Table> (1) Excludes employee stock options with exercise price greater than current market price. (2) Effects of convertible preferred stock are anti-dilutive and are not included in March 2002. Effects of convertible preferred stock are dilutive and are included in March 2003. 8
(3) REPORTABLE SEGMENTS The Company operates two principal lines of business under the Bank: the traditional bank and BankDirect, an internet only bank. BankDirect has been a net provider of funds and the traditional bank has been a net user of funds. In order to provide a consistent measure of the net interest margin for BankDirect, a multiple pool funds transfer pricing method was used to calculate credit for funds provided. This method takes into consideration market conditions during the reporting period. TRADITIONAL BANKING (In thousands) <Table> <Caption> Three months ended March 31 2003 2002 ------------ ------------ <S> <C> <C> Net interest income $ 11,901 $ 9,019 Provision for loan losses 1,250 1,171 Non-interest income 3,286 2,154 Non-interest expense 8,448 7,689 ------------ ------------ Net income $ 5,489 $ 2,313 ============ ============ </Table> BANKDIRECT (In thousands) <Table> <Caption> Three months ended March 31 2003 2002 ------------ ------------ <S> <C> <C> Net interest income (loss) $ (28) $ 375 Provision for loan losses -- -- Non-interest income 43 42 Non-interest expense 476 518 ------------ ------------ Net loss $ (461) $ (101) ============ ============ </Table> Reportable segments reconciliations to the Consolidated Financial Statements for the three months ended March 31, 2003 are as follows (in thousands): <Table> <Caption> Net Interest Provision for Non-interest Non-interest Income Loan Losses Income Expense ------------ ------------- ------------ ------------ <S> <C> <C> <C> <C> Total reportable lines of business $ 11,873 $ 1,250 $ 3,329 $ 8,924 Unallocated items: Holding company (133) -- -- 454 ------------ ------------ ------------ ------------ The Company consolidated $ 11,740 $ 1,250 $ 3,329 $ 9,378 ============ ============ ============ ============ </Table> Reportable segments reconciliations to the Consolidated Financial Statements for the three months ended March 31, 2002 are as follows (in thousands): <Table> <Caption> Net Interest Provision for Non-interest Non-interest Income Loan Losses Income Expense ------------ ------------- ------------ ------------ <S> <C> <C> <C> <C> Total reportable lines of business $ 9,394 $ 1,171 $ 2,196 $ 8,207 Unallocated items: Holding company -- -- -- 134 ------------ ------------ ------------ ------------ The Company consolidated $ 9,394 $ 1,171 $ 2,196 $ 8,341 ============ ============ ============ ============ </Table> 9
(4) FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit which involve varying degrees of credit risk in excess of the amount recognized in the consolidated balance sheets. The Bank's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The amount of collateral obtained, if deemed necessary, is based on management's credit evaluation of the borrower. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's credit-worthiness on a case-by-case basis. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those 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 facilities to customers. <Table> <Caption> March 31, (In thousands) 2003 ------------ <S> <C> Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $ 344,098 Standby letters of credit 22,812 </Table> (5) SUBSEQUENT EVENTS Effective April 15, 2003, Raleigh Hortenstine resigned from his positions with the Company and the Bank. In accordance with the terms of his separation agreement, the Company incurred additional compensation expense. The amounts are not expected to materially affect the results of operations for the year 2003. 10
QUARTERLY FINANCIAL SUMMARY - UNAUDITED Consolidated Daily Average Balances, Average Yields and Rates (In thousands except per share data) <Table> <Caption> For the three months ended For the three months ended March 31, 2003 March 31, 2002 Average Revenue/ Yield/ Average Revenue/ Yield/ Balance(1) Expense Rate Balance(1) Expense Rate ----------- ----------- ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> <C> <C> ASSETS Taxable securities $ 546,120 $ 5,356 3.98% $ 214,281 $ 2,889 5.47% Federal funds sold 29,394 87 1.20% 21,291 89 1.70% Deposits in other banks 213 1 1.90% 171 1 2.37% Loans 1,119,684 14,696 5.32% 884,795 12,501 5.73% Less reserve for loan losses 14,944 -- -- 12,928 -- -- ----------- ----------- ----------- ----------- ----------- ----------- Loans, net of reserve 1,104,740 14,696 5.39% 871,867 12,501 5.81% ----------- ----------- ----------- ----------- ----------- ----------- Total earning assets 1,680,467 20,140 4.86% 1,107,610 15,480 5.67% Cash and other assets 144,661 87,044 ----------- ----------- Total assets $ 1,825,128 $ 1,194,654 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Transaction deposits $ 59,584 $ 112 0.76% $ 48,658 $ 125 1.04% Savings deposits 381,587 1,640 1.74% 342,460 1,519 1.80% Time deposits 524,622 3,630 2.81% 368,359 3,263 3.59% ----------- ----------- ----------- ----------- ----------- ----------- Total interest-bearing deposits 965,793 5,382 2.26% 759,477 4,907 2.62% Other borrowings 496,617 2,885 2.36% 185,263 1,179 2.58% Long-term debt 10,000 133 5.39% -- -- -- ----------- ----------- ----------- ----------- ----------- ----------- Total interest-bearing liabilities 1,472,410 8,400 2.31% 944,740 6,086 2.61% Demand deposits 213,991 130,552 Other liabilities 11,784 7,464 Stockholders' equity 126,943 111,898 ----------- ----------- Total liabilities and stockholders' equity $ 1,825,128 $ 1,194,654 =========== =========== Net interest income $ 11,740 $ 9,394 Net interest income to earning assets 2.83% 3.44% ----------- ----------- Provision for loan losses 1,250 1,171 Non-interest income 3,329 2,196 Non-interest expense 9,378 8,341 ----------- ----------- INCOME BEFORE TAXES 4,441 2,078 Federal income tax 1,410 520 ----------- ----------- NET INCOME $ 3,031 $ 1,558 =========== =========== EARNINGS PER SHARE: NET INCOME Basic $ .14 $ .07 Diluted $ .14 $ .07 Return on average equity 9.68% 5.65% Return on average assets .67% .53% Equity to assets 6.96% 9.37% </Table> (1) The loan averages include loans on which the accrual of interest has been discontinued and are stated net of unearned income. 11
ITEM 2. MANAGEMENT'S ASSESSMENT OF OPERATIONS AND FINANCIAL CONDITION FORWARD LOOKING STATEMENTS Statements and financial analysis contained in this document that are not historical facts are forward looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward looking statements describe our future plans, strategies and expectations and are based on certain assumptions. As a result, these forward looking statements involve substantial risks and uncertainties, many of which are beyond our control. The important factors that could cause actual results to differ materially from the forward looking statements include the following: (1) Changes in interest rates (2) Changes in the levels of loan prepayments, which could affect the value of our loans (3) Changes in general economic and business conditions in areas or markets where we compete (4) Competition from banks and other financial institutions for loans and customer deposits (5) The failure of assumptions underlying the establishment of and provisions made to the allowance for credit losses (6) The loss of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensation levels (7) Changes in government regulations We have no obligation to update or revise any forward looking statements as a result of new information or future events. In light of these assumptions, risks and uncertainties, the events discussed in any forward looking statements in this quarterly report might not occur. RESULTS OF OPERATIONS SUMMARY OF PERFORMANCE The Company recorded net income of $3.0 million or $.14 per diluted common share for the first quarter of 2003 compared to $1.6 million or $.07 per diluted common share for the first quarter of 2002. Return on average assets was .67% for the first quarter of 2003 compared to .53% for the first quarter of 2002. Return on average equity was 9.68% and 5.65%, for the first quarter of 2003 and 2002, respectively. The increase in net income for the quarter ended March 31, 2003 over the same period of 2002 was due to an increase in net interest income and an increase in non-interest income, offset by an increase in non-interest expenses. Net interest income for the first quarter of 2003 increased by $2.3 million or 25.0% from $9.4 million to $11.7 million over the first quarter of 2002. The increase in net interest income was due to an increase in average earning assets of $572.9 million or 51.7%, which offset a 61 basis point decrease in net interest margin. Non-interest income increased $1.1 million or 51.6% compared to the first quarter of 2002. This increase was due primarily to an increase in service charge income, BOLI income and an increase in mortgage warehouse fees. The first quarter of 2003 non-interest income also includes a $341,000 gain on sale of securities. Non-interest expense increased $1.0 million or 12.4% compared to the first quarter of 2002. This increase was primarily due to an increase in salaries and employee benefits of $1.0 million related to an increase in full-time employees. Total employees increased from 196 at March 31, 2002 to 224 at March 31, 2003. 12
NET INTEREST INCOME Net interest income was $11.7 million for the first quarter of 2003 compared to $9.4 million for the first quarter of 2002. The increase was primarily due to an increase in average earning assets of $572.9 million as compared to the first quarter of 2002. The increase in average earning assets from the first quarter of 2002 included a $232.9 million increase in average net loans which represented 65.7% of average earning assets for the quarter ended March 31, 2003 compared to 78.7% for the same period of 2002. Average securities in the first quarter of 2003 increased $331.8 million compared to the same quarter of 2002. Securities represented 32.5% of average earning assets for the quarter ended March 31, 2003 compared to 19.3% in the same quarter for 2002. Average interest bearing liabilities increased $527.7 million from the first quarter of 2002 which included a $206.3 million increase in interest bearing deposits and a $311.4 million increase in other borrowings. Average other borrowings were 27.2% of average total assets for the first quarter of 2003 compared to 15.5% in the same period in 2002. The increase in average other borrowings was primarily related to an increase in federal funds purchased and securities sold under repurchase agreements and was used to supplement deposits in funding loan growth and securities purchases. The average cost of interest bearing liabilities decreased from 2.61% for the quarter ended March 31, 2002 to 2.31% for the same period of 2003, reflecting the continuing decline in market interest rates. TABLE 1 - VOLUME/RATE ANALYSIS (In thousands) <Table> <Caption> Three months ended March 31, 2003/2002 ----------------------------------------------- Change Due To Change Volume Yield/Ratio ------------ ------------ ------------ <S> <C> <C> <C> Interest income Securities $ 2,467 $ 4,474 $ (2,007) Loans 2,195 3,319 (1,124) Federal funds sold (2) 34 (36) ------------ ------------ ------------ Total 4,660 7,827 (3,167) Interest expense: Transaction deposits (13) 28 (41) Savings deposits 121 174 (53) Time deposits 367 1,384 (1,017) Borrowed funds 1,706 1,981 (275) Long-term debt 133 133 -- ------------ ------------ ------------ Total 2,314 3,700 (1,386) ------------ ------------ ------------ Net interest income $ 2,346 $ 4,127 $ (1,781) ============ ============ ============ </Table> Net interest margin, the ratio of net interest income to average earning assets, was 2.83% for the first quarter of 2003 compared to 3.44% for the first quarter of 2002. The decrease in the net interest margin during the first quarter of 2003 was due to a continued overall decline in market interest rates. NON-INTEREST INCOME Non-interest income increased $1.1 million compared to the same quarter of 2002. Service charges on deposit accounts increased $214,000. This increase was due to the increase in deposits, which resulted in a higher volume of transactions. Trust fee income increased $34,000, due to continued growth of trust assets in 2003. Other non-interest income increased by $223,000 primarily due to an increase in mortgage warehouse fees. BOLI income was $414,000. The first quarter of 2003 non-interest income also includes a $341,000 gain on sale of securities. Consistent with the first quarter of 2002, non-interest income included cash processing fees that totaled $900,000. The fees are related to a special project that will not be recurring in future quarters in 2003. There will be some income recorded in the second quarter of 2003 as the project extended into the first few weeks of April. While management expects continued growth in non-interest income, the future rate of growth could be affected by increased competition from nationwide and regional financial institutions. In order to achieve continued growth in non-interest income, we may need to introduce new products or enter into new markets. Any new product introduction or new market entry would likely place additional demands on capital and managerial resources. 13
TABLE 2 - NON-INTEREST INCOME (In thousands) <Table> <Caption> Three months ended March 31 2003 2002 ------------ ------------ <S> <C> <C> Service charges on deposit accounts $ 843 $ 629 Trust fee income 281 247 Gain on sale of securities 341 -- Cash processing fees 900 993 Bank owned life insurance (BOLI) income 414 -- Other 550 327 ------------ ------------ Total non-interest income $ 3,329 $ 2,196 ============ ============ </Table> NON-INTEREST EXPENSE Non-interest expense for the first quarter of 2003 increased $1.0 million or 12.4% compared to the first quarter of 2002. Salaries and employee benefits increased by $1.0 million or 24.1%. The increase in salaries and employee benefits was due to an increase in full time employees from 196 at March 31, 2002 to 224 at March 31, 2003. Advertising expense increased $113,000 or 141.3%. Advertising expense for the three months ended March 31, 2003 included $31,000 of direct marketing and branding, including print ads for the traditional bank, and $162,000 for the purchase of miles related to the American Airlines AAdvantage(R) program. We did not purchase any miles in the first quarter of 2002 because the miles that we were contractually required to purchase in 2000 were sufficient to cover our mileage rewards to customers for 2001 and the first part of 2002. In 2003, we are purchasing miles as we utilize them. Legal and professional expenses decreased $105,000 or 15.4%, mainly related to legal expenses incurred with our non-performing loans and leases that were experienced in 2002. Net occupancy expense for the three months ended March 31, 2003 decreased by $90,000, or 7.0% compared to the same quarter in 2002, because no additional facilities have been added, there were minimal capital expenditures and certain assets are becoming fully depreciated. TABLE 3 - NON-INTEREST EXPENSE (In thousands) <Table> <Caption> Three months ended March 31 2003 2002 ------------ ------------ <S> <C> <C> Salaries and employee benefits $ 5,379 $ 4,333 Net occupancy expense 1,187 1,277 Advertising 193 80 Legal and professional 579 684 Communications and data processing 720 722 Franchise taxes 37 14 Other 1,283 1,231 ------------ ------------ Total non-interest expense $ 9,378 $ 8,341 ============ ============ </Table> INCOME TAXES For the quarter ended March 31, 2003, the provision for income taxes was $1.4 million, which is based on the Company's estimated effective rate for the year ended December 31, 2003. 14
ANALYSIS OF FINANCIAL CONDITION The aggregate loan portfolio at March 31, 2003 increased $57.7 million from December 31, 2002 to $1.18 billion. Commercial loans increased $28.8 million and real estate loans increased $7.1 million. Construction loans increased $18.0 million and leases and consumer loans decreased $3.1 million. TABLE 4 - LOANS (In thousands) <Table> <Caption> March 31, December 31, 2003 2002 ------------ ------------ <S> <C> <C> Commercial $ 538,324 $ 509,505 Construction 190,491 172,451 Real estate 289,823 282,703 Consumer 22,714 24,195 Leases receivable 15,923 17,546 Loans held for sale 122,950 116,106 ------------ ------------ Total $ 1,180,225 $ 1,122,506 ============ ============ </Table> We continue to lend primarily in Texas. As of March 31, 2003, a substantial majority of the principal amount of the loans in our portfolio was to businesses and individuals in Texas. This geographic concentration subjects the loan portfolio to the general economic conditions within this area. We originate substantially all of the loans in our portfolio, except in certain instances we have purchased individual leases and lease pools (primarily commercial and industrial equipment and vehicles), as well as selected loan participations and USDA government guaranteed loans. SUMMARY OF LOAN LOSS EXPERIENCE The reserve for loans losses, which is available to absorb losses inherent in the loan portfolio, totaled $15.9 million at March 31, 2003, $14.5 million at December 31, 2002 and $12.8 million at March 31, 2002. This represents 1.35%, 1.30% and 1.46% of total loans at March 31, 2003, December 31, 2002 and March 31, 2002, respectively. The provision for loan losses is a charge to earnings to maintain the reserve for loan losses at a level consistent with management's assessment of the loan portfolio in light of current economic conditions and market trends. The Company recorded a provision of $1.3 million for the quarter ended March 2003 and $1.2 million for the same quarter in 2002. These provisions were made to reflect management's assessment of the risk of loan losses specifically including risk associated with the continued rapid growth in the loan portfolio and the unseasoned nature of the current portfolio. The reserve for loan losses is comprised of specific reserves assigned to classified loans and general reserves. We continuously evaluate our reserve for loan losses to maintain an adequate level to absorb estimated loan losses inherent in the loan portfolio. Factors contributing to the determination of specific reserves include the credit worthiness of the borrower, changes in the value of pledged collateral, and general economic conditions. All loan commitments rated substandard or worse and greater than $1,000,000 are specifically reviewed and a specific allocation is assigned based on the losses expected to be realized from those loans. For purposes of determining the general reserve, the portfolio is segregated by product types to recognize differing risk profiles among categories, and then further segregated by credit grades. Credit grades are assigned to all loans greater than $50,000. Each credit grade is assigned a risk factor, or reserve allocation percentage. These risk factors are multiplied by the outstanding principal balance and risk-weighted by product type to calculate the required reserve. A similar process is employed to calculate that portion of the required reserve assigned to unfunded loan commitments. The reserve allocation percentages assigned to each credit grade have been developed based on an analysis of historical loss rates at selected peer banks, adjusted for certain qualitative factors. Qualitative adjustments for such things as general economic conditions, changes in credit policies and lending standards, and changes in the trend and severity of problem loans, can cause the estimation of future losses to differ from past experience. The unallocated portion of the general reserve serves to compensate for additional areas of 15
uncertainty and considers industry comparable reserve ratios. In addition, the reserve considers the results of reviews performed by independent third party reviewers as reflected in their confirmations of assigned credit grades within the portfolio. The methodology used in the periodic review of reserve adequacy, which is performed at least quarterly, is designed to be dynamic and responsive to changes in actual credit losses. The changes are reflected in the general reserve and in specific reserves as the collectibility of larger classified loans is continuously recalculated with new information. As our portfolio matures, historical loss ratios are being closely monitored. Eventually our reserve adequacy analysis will rely more on our loss history and less on the experience of peer banks. Currently, the review of reserve adequacy is performed by executive management and presented to the Board of Directors for their review, consideration and ratification on a quarterly basis. TABLE 5 - SUMMARY OF LOAN LOSS EXPERIENCE (In thousands) <Table> <Caption> Three months Three months Year ended ended March 31, ended March 31, December 31, 2003 2002 2002 --------------- --------------- ------------ <S> <C> <C> <C> Beginning balance $ 14,538 $ 12,598 $ 12,598 Loans charged-off: Commercial -- 1,000 2,096 Consumer -- -- 11 Leases 13 -- 1,740 ------------ ------------ ------------ Total 13 1,000 3,847 Recoveries: Commercial 78 -- 116 Consumer -- 1 -- Leases 40 -- 42 ------------ ------------ ------------ Total recoveries 118 1 158 ------------ ------------ ------------ Net charge-offs (recoveries) (105) 999 3,689 Provision for loan losses 1,250 1,171 5,629 ------------ ------------ ------------ Ending balance $ 15,893 $ 12,770 $ 14,538 ============ ============ ============ Reserve for loan losses to loans outstanding at end of period 1.35% 1.46% 1.30% Net charge-offs to average loans(1) -- .46% .38% Provision for loan losses to average loans(1) .45% .54% .58% Recoveries to gross charge-offs 907.69% .10% 4.11% Reserve as a multiple of net charge-offs -- 12.8x 3.9x Non-performing and renegotiated loans: Loans past due (90 days) $ 38 $ 5,312 $ 135 Non-accrual 3,769 4,750 2,776 ------------ ------------ ------------ Total $ 3,807 $ 10,062 $ 2,911 ============ ============ ============ Reserve as a percent of non-performing and renegotiated loans 417.47% 126.91% 499.42% </Table> (1) Interim period ratios are annualized. NON-PERFORMING ASSETS Non-performing assets include non-accrual loans and leases, accruing loans 90 or more days past due, restructured loans, and other repossessed assets. We had non-accrual loans and leases of $3,769,000, $2,776,000 and $4,750,000 at March 31, 2003, December 31, 2002 and March 31, 2002, respectively. At March 31, 2003, our non-accrual loans and leases consisted of $815,000 in commercial loans, $1,355,000 in 16
real estate loans, $13,000 in consumer loans and $1,586,000 in leases. At December 31, 2002, our non-accrual loans and leases consisted of $641,000 in commercial loans, $1,367,000 in real estate, $26,000 in consumer loans and $742,000 in leases. At March 31, 2003, we had $38,000 in loans past due 90 days and still accruing interest. At March 31, 2003, we had $66,000 in other repossessed assets. Generally, we place loans on non-accrual when there is a clear indication that the borrower's cash flow may not be sufficient to meet payments as they become due, which is generally when a loan is 90 days past due. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due (both principal and interest) according to the terms of the loan agreement. Reserves on impaired loans are measured based on the present value of the expected future cash flows discounted at the loan's effective interest rate or the fair value of the underlying collateral. LIQUIDITY AND CAPITAL RESOURCES In general terms, liquidity is a measurement of our ability to meet our cash needs. Our objective in managing our liquidity is to maintain our ability to meet loan commitments, purchase securities or repay deposits and other liabilities in accordance with their terms, without an adverse impact on our current or future earnings. Our liquidity strategy is guided by policies, which are formulated and monitored by our senior management and our bank's Balance Sheet Management Committee (BSMC), and which take into account the marketability of assets, the sources and stability of funding and the level of unfunded commitments. We regularly evaluate all of our various funding sources with an emphasis on accessibility, stability, reliability and cost-effectiveness. For the year ended December 31, 2002 and for the three months ended March 31, 2003, our principal source of funding has been our customer deposits, supplemented by our short-term and long-term borrowings, primarily from securities sold under repurchase agreements and federal funds purchased from our downstream correspondent bank relationships (which consist of banks that are considered to be smaller than our bank). Since early 2002, our liquidity needs have primarily been fulfilled through growth in our traditional bank customer and stockholder deposits. Our goal is to obtain as much of our funding as possible from deposits of these customers and stockholders, which as of March 31, 2003, comprised $893.2 million, or 69%, of total deposits, compared to $605.2 million, or 65%, of total deposits, at March 31, 2002. These traditional deposits are generated principally through development of long-term relationships with customers and stockholders. In addition to deposits from our traditional bank customers and stockholders, we also have access to incremental consumer deposits through BankDirect and through brokered retail certificates of deposit, or CDs. As of March 31, 2003, BankDirect deposits comprised $252.9 million, or 20%, of total deposits, and brokered retail CDs comprised $150.0 million, or 12%, of total deposits. Our dependence on internet deposits and retail brokered CDs is limited by our internal funding guidelines, which as of March 31, 2003, limited borrowing from these sources to 15-20% and 10-20%, respectively, of total deposits. Additionally, we have borrowing sources available to supplement deposits and meet our funding needs. These borrowing sources include federal funds purchased from our downstream correspondent bank relationships and from our upstream correspondent bank relationships (which consist of banks that are larger than our bank), securities sold under repurchase agreements, treasury, tax and loan notes, and advances from the Federal Home Loan Bank, or FHLB. As of March 31, 2003, our borrowings consisted of a total of $346.3 million of securities sold under repurchase agreements, $148.7 million of downstream federal funds purchased, $6.4 million from customer repurchase agreements and $2.8 million of treasury, tax and loan notes. Credit availability from the FHLB is based on our bank's financial and operating condition and borrowing collateral we hold with the FHLB. At March 31, 2003, there were no borrowings from the FHLB. Our unused FHLB borrowing capacity at March 31, 2003 was approximately $290 million. As of March 31, 2003, we had unused upstream federal fund lines available from commercial banks of approximately $43 million. During the three months ended March 31, 2003, our average borrowings from these sources were 27% of average assets, which is well within our internal funding guidelines, which limit our dependence on borrowing sources to 25-30% of total assets. In prior periods, our internal funding guidelines limited our dependence on borrowing sources to 20-25% of total assets. In the current quarter, management's strategy of increasing the investment securities portfolio funded by term repurchase agreements to lock in a return required us to increase this internal guideline. Average borrowed funds were $496.6 million during the three month period ended March 31, 2003. The maximum amount of borrowed funds outstanding at any month-end during the first three months of 2003 was $516.2 million, or 27%, of total assets. 17
As of March 31, 2003, our contractual obligations and commercial commitments, other than deposit liabilities, were as follows: <Table> <Caption> After One After Three Within but Within but Within After One Year Three Years Five Years Five Years Total ----------- ----------- ----------- ----------- ----------- (In Thousands) <S> <C> <C> <C> <C> <C> Federal funds purchased $ 148,729 $ -- $ -- $ -- $ 148,729 Securities sold under repurchase agreements 82,318 263,937 -- -- 346,255 Customer repurchase agreements 6,373 -- -- -- 6,373 Treasury, tax and loan notes 2,785 -- -- -- 2,785 Operating lease obligations 2,544 4,991 4,924 5,398 17,857 Long-term debt -- -- -- 10,000 10,000 ----------- ----------- ----------- ----------- ----------- Total contractual obligations $ 242,749 $ 268,928 $ 4,924 $ 15,398 $ 531,999 =========== =========== =========== =========== =========== </Table> The contractual amount of our financial instruments with off-balance sheet risk expiring by period at March 31, 2003 is presented below: <Table> <Caption> After One After Three Within but Within but Within After One Year Three Years Five Years Five Years Total ----------- ----------- ----------- ----------- ----------- (In Thousands) <S> <C> <C> <C> <C> <C> Commitments to extend credit $ 226,554 $ 97,216 $ 14,653 $ 5,675 $ 344,098 Standby letters of credit 16,129 6,683 -- -- 22,812 ----------- ----------- ----------- ----------- ----------- Total financial instruments with off-balance sheet risk $ 242,683 $ 103,899 $ 14,653 $ 5,675 $ 366,910 =========== =========== =========== =========== =========== </Table> Due to the nature of our unfunded loan commitments, including unfunded lines of credit, the amounts presented in the table above do not necessarily represent amounts that we anticipate funding in the periods presented above. Our equity capital averaged $126.9 million for the three months ended March 31, 2003 as compared to $111.9 million for the same period in 2002. This increase reflects our retention of net earnings during this period. We have not paid any cash dividends on our common stock since we commenced operations and have no plans to do so in the near future. TABLE 6 - CAPITAL RATIOS <Table> <Caption> March 31, March 31, 2003 2002 ------------ ------------ <S> <C> <C> Risk-based capital: Tier 1 capital 9.69% 11.13% Total capital 10.88 12.38 Leverage 7.15 9.38 </Table> CRITICAL ACCOUNTING POLICIES The Securities and Exchange Commission ("SEC") recently issued guidance for the disclosure of "critical accounting policies." The SEC defines "critical accounting policies" as those that are most important to the presentation of a company's financial condition and results, and require management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We follow financial accounting and reporting policies that are in accordance with generally accepted accounting principles. Not all these significant accounting policies require management to make difficult, subjective, or complex judgments. However, the policies noted below could be deemed to meet the SEC's definition of critical accounting policies. 18
Management considers the policies related to the allowance for loan losses as the most critical to the financial statement presentation. The total allowance for loan losses includes activity related to allowances calculated in accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan" and SFAS No. 5, "Accounting for Contingencies." The allowance for loan losses is established through a provision for loan losses charged to current earnings. The amount maintained in the allowance reflects management's continuing evaluation of the loan losses inherent in the loan portfolio. The allowance for loan losses is comprised of specific reserves assigned to certain classified loans and general reserves. Factors contributing to the determination of specific reserves include the creditworthiness of the borrower, and more specifically, changes in the expected future receipt of principal and interest payments and/or in the value of pledged collateral. A reserve is recorded when the carrying amount of the loan exceeds the discounted estimated cash flows using the loan's initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. For purposes of determining the general reserve, the portfolio is segregated by product types in order to recognize differing risk profiles among categories, and then further segregated by credit grades. See "Summary of Loan Loss Experience" for further discussion of the risk factors considered by management in establishing the allowance for loan losses. Management considers the policies related to income taxes to be critical to the financial statement presentation. The Company utilizes the liability method in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based upon the difference between the values of the assets and liabilities as reflected in the financial statements and their related tax basis using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. As changes in tax law or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. A valuation reserve is provided against deferred tax assets unless it is more likely than not that such deferred tax assets will be realized. The Company has a gross deferred tax asset and the asset is realizable to the extent it offsets deferred tax liabilities in a given year, creates a loss that can be carried back and offset against 2002 taxes paid or reduces future taxable income. The Company has not assumed future income in assessing the recoverability of the deferred tax assets due to the uncertainty surrounding current economic conditions and the fact that the Company has a limited operating history and is in an accumulated deficit position for the most recent three calendar years. As a result, the Company has provided a valuation allowance related to deferred taxes unless such assets are certain to turn around during a period in which losses could be carried back to 2002 or in the same period as an offsetting deferred tax liability is certain to turn around. The largest component of the valuation allowance relates to the allowance for loan losses, as it is not practical to determine the exact period in which a charge-off would be recorded and sustained as a tax deduction. At such time as the Company concludes it is appropriate to consider future taxable income in assessing the recoverability of the deferred tax asset, all or a portion of the allowance would be reversed resulting in a reduction of tax expense. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is a broad term for the risk of economic loss due to adverse changes in the fair value of a financial instrument. These changes may be the result of various factors, including interest rates, foreign exchange rates, commodity prices, or equity prices. Additionally, the financial instruments subject to market risk can be classified either as held for trading purposes or held for other than trading. The Company is subject to market risk primarily through the effect of changes in interest rates on its portfolio of assets held for purposes other than trading. The effect of other changes, such as foreign exchange rates, commodity prices, and/or equity prices do not pose significant market risk to the Company. The responsibility for managing market risk rests with the BSMC, which operates under policy guidelines established by the Board of Directors. The negative acceptable variation in net interest revenue due to a 200 basis point increase or decrease in interest rates is generally limited by these guidelines to +/- 10%. These guidelines also establish maximum levels for short-term borrowings, short-term assets, and public and brokered deposits. They also establish minimum levels for unpledged assets, among other things. Compliance with these guidelines is the ongoing responsibility of the BSMC, with exceptions reported to the full Board of Directors on a quarterly basis. 19
INTEREST RATE RISK MANAGEMENT We perform a sensitivity analysis to identify interest rate risk exposure on net interest income. We quantify and measure interest rate risk exposure using a model to dynamically simulate the effect of changes in net interest income relative to changes in interest rates over the next twelve months based on three interest rate scenarios. These are a "most likely" rate scenario and two "shock test" scenarios. The "most likely" rate scenario is based on the consensus forecast of future interest rates published by independent sources. These forecasts incorporate future spot rates and relevant spreads of instruments that are actively traded in the open market. The Federal Reserve's Federal Funds target affects short-term borrowing; the prime lending rate and the London Interbank Offering Rate are the basis for most of our variable-rate loan pricing. The 30-year mortgage rate is also monitored because of its effect on prepayment speeds for mortgage-backed securities. These are our primary interest rate exposures. We are currently not using derivatives to manage our interest rate exposure. The two "shock test" scenarios assume an instantaneous sustained parallel 200 basis point increase or decrease, respectively, in interest rates. As short-term rates fell below 2.0% by the end of 2002, we could not assume interest rate changes of 200 basis points as the results in the decreasing rates scenario would be negative rates. Therefore, we are using 100 basis point variance for our "shock test" decreasing scenario until short-term rates rise above 2.0%. Our interest rate risk exposure model incorporates assumptions regarding the level of interest rate or balance changes on indeterminable maturity deposits (demand deposits, interest bearing transaction accounts and savings accounts) for a given level of market rate changes. These assumptions have been developed through a combination of historical analysis and future expected pricing behavior. Changes in prepayment behavior of mortgage-backed securities, residential, and commercial mortgage loans in each rate environment are captured using industry estimates of prepayment speeds for various coupon segments of the portfolio. The impact of planned growth and new business activities is factored into the simulation model. This modeling indicated interest rate sensitivity is as follows: TABLE 7 - INTEREST RATE SENSITIVITY (In thousands) <Table> <Caption> Anticipated Impact Over the Next Twelve Months as Compared to Most Likely Scenario ---------------------------------------------- 200 bp Increase 100 bp Decrease March 2003 March 2003 --------------- --------------- <S> <C> <C> Change in net interest income $ 10,330 $ (6,461) </Table> With the record number of interest rate declines in the past two years, we have positioned our balance sheet to take advantage of a rising rate environment. The estimated changes in interest rates on net interest income are not within guidelines established by our Board of Directors for all interest rate scenarios. These exceptions are not excessive in the current rate environment and are being monitored closely. In the declining scenario, the larger sensitivity is due in large part to the artificial floor created for the liabilities, due to the overall low market interest rates. In the upward rate shock, the guideline is exceeded due to the asset sensitive nature of the balance sheet. The simulations used to manage market risk are based on numerous assumptions regarding the effect of changes in interest rates on the timing and extent of repricing characteristics, future cash flows, and customer behavior. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies, among other factors. We expect our balance sheet will continue to be asset sensitive over the next twelve months, which means that we will have more loans repricing than deposits over this period. This is largely due to the concentration of our 20
assets in variable rate (rather than fixed rate) loans. In the current rate environment, management may choose to fund investment securities purchased with term liabilities/deposits to lock in a return. Investment securities are generally held in the "available for sale" category so that gains and losses can be realized as appropriate. At certain times, we use the "held to maturity" category if we are not planning to sell these securities before maturity. As of March 31, 2003, the Bank sources approximately 20% of its total deposits from retail consumer internet deposit customers through BankDirect. These retail consumer deposits may be more interest rate sensitive than our other deposits as a result of the extremely competitive internet banking market. ITEM 4. CONTROLS AND PROCEDURES The Company's chief executive officer and chief financial officer have evaluated the Company's disclosure controls and procedures as of March 31, 2003 and concluded that those disclosure controls and procedures are effective. There have been no changes in the Company's internal controls or in other factors known to the Company that could significantly affect these controls subsequent to their evaluation, nor any corrective actions with regard to significant deficiencies and material weaknesses. While the Company believes that its existing disclosure controls and procedures have been effective to accomplish these objectives, the Company intends to continue to examine, refine and formalize its disclosure controls and procedures and to monitor ongoing developments in this area. 21
PART II - OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 99.1 Certification of Chief Executive Officer 99.2 Certification of Chief Financial Officer (b) Report on Form 8-K Current report filed on Form 8-K regarding Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits) and Item 9 (Other Events) dated March 21, 2003. 22
SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. TEXAS CAPITAL BANCSHARES, INC. Date: May 14, 2003 /s/ Gregory B. Hultgren -------------------------------------------- Gregory B. Hultgren Chief Financial Officer (Duly authorized officer and principal financial officer) 23
CERTIFICATIONS I, Joseph M. Grant, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Texas Capital Bancshares, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /S/ Joseph M. Grant - ------------------------------------ Joseph M. Grant Chief Executive Officer 24
I, Gregory B. Hultgren, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Texas Capital Bancshares, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /S/ Gregory B. Hultgren - ------------------------------------ Gregory B. Hultgren Chief Financial Officer 25
EXHIBIT INDEX Exhibit Number 99.1 Certification of Chief Executive Officer 99.2 Certification of Chief Financial Officer 26