UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2004

OR

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

FOR THE TRANSITION PERIOD FROM                                       to                                      

Commission file number 0-12247

SOUTHSIDE BANCSHARES, INC.

903-531-7111

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes (x) . No ( ) .

The number of shares outstanding of each of the issuer’s classes of capital stock as of October 31, 2004 was 10,970,443 shares of Common Stock, par value $1.25.

Table of Contents

PART I. FINANCIAL INFORMATION

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

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

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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

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

2

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

(1)

Restated

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

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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

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

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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

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

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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES

1. Basis of Presentation

The consolidated balance sheet of Southside Bancshares, Inc. (the “Company”) as of September 30, 2004, and the related consolidated statements of income, shareholders’ equity, cash flow and notes to the financial statements for the quarter and nine-month periods ended September 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 Annual 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 nine month periods ended September 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, (in thousands):

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5. Employee Benefit Plans

Components of Net Periodic Benefit Cost, (in thousands)

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 would be allowed to contribute approximately $3.2 million to its defined benefit plan. This is down from $4.0 million the Company expected to be allowed to contribute. 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 September 30, 2004, $3.2 million of contributions have been made to the defined benefit plan. As of September 30, 2004, $56,000 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 September 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 30,325 incentive stock options granted in 2003. There were no incentive stock options granted in the nine 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 September 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 September 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 plan been determined consistent with the requirements of FAS 123, the Company’s net income and net income per common share for the quarter and nine month periods ending September 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 September 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 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 did not have a material impact on the Company’s consolidated financial statements.

In March 2004, the EITF reached a final consensus on Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 requires that when the fair value of an investment security is less than its carrying value, an impairment exists for which the determination must be made as to whether the impairment is other-than-temporary. The EITF 03-1 impairment model applies to all investment securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and to investment securities accounted for under the cost method to the extent an impairment indicator exists. Under the guidance, the determination of whether impairment is other than temporary and therefore would result in a recognized loss depends on market conditions and management’s intent and ability to hold the securities with unrealized losses. In September 2004, the FASB approved FSP EITF 03-1-1, which defers the effective date for recognition and measurement guidance contained in EITF 03-1 until certain issues are resolved. The Company will adopt the guidance in accordance with the required effective date. The Company previously implemented the disclosure requirements of EITF 03-1 in its December 31, 2003 Consolidated Financial Statements.

8. Commitments and Contingencies

In the normal course of business the Company buys and sells securities. There were no commitments to purchase securities at September 30, 2004. At December 31, 2003, the Company had recorded in its balance sheet commitments to purchase $1.7 million in securities.

The Company, or its subsidiaries, is involved with various litigation in the normal course of business. Management of the Company, after consulting with its legal counsel, believes that any liability resulting from current litigation will not have a material effect on the financial position and results of operations or 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 – Nine months ended September 30, 2004 compared to September 30, 2003.

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 globally, 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 acts of terrorism or 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 affecting 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.

Overview

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 Annual report on Form 10-K.

The Company reported an increase in net income for the quarter and nine months ended September 30, 2004 compared to the same period in 2003. Net income for the quarter and nine months ended September 30, 2004 was $4.2 million and $12.4 million, respectively, compared to $2.8 million and $9.5 million, respectively, for the same period in 2003.

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

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 GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. 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.

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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 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 September 30, 2004, the Company’s review of the loan portfolio indicates that a loan loss allowance of $6.82 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 Annual 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 Annual 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 September 30, 2004, the weighted-average actuarial assumptions of the defined benefit plan were: discount rate of 6.50%; long-term rate of return on plan assets of 8.5%; and assumed salary increases of 4.5%. At September 30, 2003, the weighted-average actuarial assumptions of the defined benefit plan were: discount rate of 6.75%; long-term rate of return on plan assets of 9.0%; and assumed salary increases of 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 defined benefit 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 $75.1 million and $53.6 million at September 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 September 30, 2004 and 2003 were $9.3 million and $8.6 million, respectively and are reflected in the due after one year category. The Company had outstanding standby letters of credit of $2.4 million and $1.1 million at September 30, 2004 and 2003, respectively. The scheduled maturities of unused commitments are presented below as of September 30, 2004 and 2003.

The Company applies the same credit policies in making commitments and issuing 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 which could increase the overall average yields of these 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 available for sale (“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 nine months ended September 30, 2004, the securities portfolio as a percentage of total assets increased slightly to 53.0% at September 30, 2004 from 52.2% at December 31, 2003. While loan growth has been solid, it has not been strong enough to maximize the use of the Company’s capital which resulted in the slight increase in the securities portfolio as a percentage of assets. 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 51.0% at December 31, 2003, to 54.7% at September 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 nine months ended September 30, 2004 was $29.1 million, an increase of $6.5 million, or 28.7%, when compared to the same period in 2003. Average interest earning assets increased $141.1 million, or 11.3%, while the net interest spread increased from 2.26% at September 30, 2003 to 2.65% at September 30, 2004 and the net margin increased from 2.74% at September 30, 2003 to 3.08% at September 30, 2004. Net interest income increased as a result of the increase in the Company’s average earning assets and increases in the Company’s net interest margin and spread during the nine 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, FHLB advances and decreased amortization expense on the Company’s mortgage-backed securities. For the quarter ended September 30, 2004 when compared to the same period in 2003, net interest income increased $2.9 million, or 39.2%, primarily as a result of increases in the Company’s average interest earning assets, net interest margin and spread. For the quarter ended September 30, 2004 when compared to the same period in 2003, average interest earning assets increased $149.1 million, or 11.7%, and the net interest margin and spread increased to 3.10% and 2.66%, respectively, from 2.57% and 2.11%, respectively. 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 nine months ended September 30, 2004, average loans, funded primarily by the growth in average deposits, increased $31.9 million, or 5.6%, compared to the same period in 2003. The average yield on loans decreased from 6.61% at September 30, 2003 to 6.10% at September 30, 2004 reflective of the overall interest rate environment. As interest rates have remained relatively low, 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 decrease in interest income on loans of $977,000, or 3.6%, was the result of the decrease in interest rates on loans partially offset by the increase in average loans for the nine months ended September 30, 2004 compared to the same period in 2003. During the nine months ended September 30, 2004, loans, net of unearned discount, increased $26.1 million, or 4.4%, when compared to the year ended December 31, 2003 primarily as a result of an increase in 1-4 family residential loans and loans to municipalities.

Average investment and mortgage-backed securities increased $112.0 million, or 17.6%, for the nine months ended September 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 increased to 4.31% during the nine months ended September 30, 2004 from 4.15% during the same period in 2003. This increase is reflective of the overall lower prepayments experienced on the Company’s mortgage-backed securities during this period which resulted in lower amortization expense. Interest income from investment and mortgage-backed securities increased $4.6 million, or 25.0%, compared to the same period in 2003 due to the increase in average balances and an increase in the overall yield.

On January 1, 2004, the Company transferred mortgage-backed securities totaling $44.4 million from AFS to held to maturity (“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. There were no securities transferred from AFS to HTM during the third quarter of 2004. 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 additional transfers in the future. There were no sales from the HTM portfolio during the nine months ended September 30, 2004, or the year ended December 31, 2003. There were $247.3 million and $6.4 million of securities classified as HTM for the periods ended September 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 $102,000, or 20.9%, for the nine months ended September 30, 2004 when compared to 2003 as a result of the decrease in the average yield from 2.02% in 2003 to 1.54% at September 30, 2004, due to lower average short-term interest rates, which were partially offset by an increase in the average balance.

Total interest expense decreased $3.0 million, or 12.9%, to $20.1 million during the nine months ended September 30, 2004 as compared to $23.1 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 $92.4 million, or 8.9%. The average yield on interest bearing liabilities decreased from 2.97% at September 30, 2003 to 2.37% at September 30, 2004.

Average interest bearing deposits increased $20.7 million, or 3.3%, while the average rate paid decreased from 1.92% at September 30, 2003 to 1.49% at September 30, 2004. Average short-term interest bearing liabilities, consisting primarily of FHLB Dallas advances and federal funds purchased, increased $24.3 million, or 16.0%, as compared to the same period in 2003 primarily as a result of the increase in securities during the nine months ended September 30, 2004. Interest expense associated with short-term interest bearing liabilities decreased $495,000, or 10.3%, and the average rate paid decreased 96 basis points for the nine month period ended September 30, 2004 when compared to the same period in 2003. Average long-term interest bearing liabilities consisting of FHLB Dallas advances increased $59.9 million, or 26.1%, during the nine months ended September 30, 2004 to $289.6 million as compared to $229.7 million at September 30, 2003. Interest expense associated with long-term FHLB Dallas advances increased $645,000 , or 8.9%, while the average rate paid decreased 58 basis points for the nine months ended September 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. 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 $13.1 million, or 100%, from September 30, 2003 to September 30, 2004. Interest expense decreased $823,000 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% Trust 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 September 30, 2003 to September 30, 2004. Interest expense decreased $1.2 million, or 100%, due to the redemption. 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 nine months ended September 30, 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 September 30, 2003 to September 30, 2004 to reflect the issuance of the trust preferred securities in the third quarter of 2003. Interest expense increased $664,000, 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.