UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2005

OR

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

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 þ. No o.

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

The number of shares outstanding of each of the issuer’s classes of capital stock as of April 27, 2005 was 11,397,026 shares of Common Stock, par value $1.25.

Table of Contents

PART I. FINANCIAL INFORMATION

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

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

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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)

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

2

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(UNAUDITED)

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

3

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
(UNAUDITED)

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

4

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW (continued)
(UNAUDITED)

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

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SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS

1. Basis of Presentation

The term “Company” is used throughout this report to refer to Southside Bancshares, Inc. and its subsidiaries. The term “Bank” is used to refer to Southside Bank wherever a distinction between Southside Bancshares, Inc. and Southside Bank aids in the understanding of this report.

The consolidated balance sheet as of March 31, 2005, and the related consolidated statements of income, shareholders’ equity and cash flow and notes to the financial statements for the three month periods ended March 31, 2005 and 2004 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. For a description of the Company’s significant accounting and reporting policies, refer to Note 1 of the Notes to Financial Statements in the 2004 Annual Report to Shareholders.

2. Earnings Per Share

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

For the quarters ended March 31, 2005 and 2004, there were no antidilutive shares.

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3. Comprehensive Income (Loss)

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

4. Employee Benefit Plans

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

Employer Contributions

The Company previously disclosed in its financial statements for the year ended December 31, 2004, that it expected to contribute $3.0 million to its defined benefit pension plan and $82,000 to its nonfunded supplemental retirement plan (“restoration plan”) in 2005. As of March 31, 2005, $1.0 million of contributions were made to the defined benefit pension plan, and $19,000 of contributions were made to the restoration plan.

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5. 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 FAS 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 March 31, 2005 and 2004, 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 no incentive stock options granted in the first quarter of 2005. The remaining 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 25, the Company has not recognized any compensation cost for these stock options.

The Company expects to adopt the provisions of SFAS No. 123, “Share-Based Payment (Revised 2004),” on January 1, 2006. Among other things, SFAS 123R eliminates the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the date of the grant. SFAS 123R is effective for the Company on January 1, 2006.

A summary of the status of the Company’s stock options as of March 31, 2005 and 2004 and the changes during the quarter ended on those dates is presented below:

The following table summarizes information about stock options outstanding at March 31, 2005:

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Pro Forma Net Income and Net Income Per Common Share

Had the compensation cost for the Company’s stock-based compensation plans been determined consistent with the requirements of SFAS 123, the Company’s net income and net income per common share for the three month periods ending March 31, 2005 and 2004 would approximate the pro forma amounts below (in thousands, except per share amounts, net of taxes):

The effects of applying SFAS 123 in this pro forma disclosure are not indicative of future amounts.

6. Accounting Pronouncements

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 previously implemented the disclosure requirements of EITF 03-1 in its December 31, 2003 Consolidated Financial Statements.

In December 2004, the FASB issued SFAS 123R (revised 2004), Share-Based Payment. SFAS 123R establishes standards for the accounting for transactions in which an entity (i) exchanges its equity instruments for goods or services, or (ii) incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of the equity instruments. SFAS 123R eliminates the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the date of the grant. On April 18, 2005, the Securities and Exchange Commission amended Regulation S-X to amend the date for compliance with SFAS 123R so that each registrant that is not a small business issuer will be required to prepare financial statements in accordance with SFAS 123R beginning with the first interim or annual period of the registrant’s first fiscal year beginning on or after June 15, 2005. The Company will transition to fair value based accounting for stock-based compensation using a modified version of prospective application (“modified prospective application”). Under modified prospective application, as it is applicable to the Company, SFAS 123R applies to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered (generally referring to non-vested awards) that are outstanding as of January 1, 2006 must be recognized as the remaining requisite service is rendered during the period of and/or the periods after the adoption of SFAS 123R. The attribution of compensation cost for those earlier awards will be based on the same method and on the same grant-date fair values previously determined for the pro forma disclosures required for companies that did not adopt the fair value accounting method for stock-based employee compensation. The Company anticipates the compensation cost associated with adopting SFAS 123R will be immaterial based on the current options outstanding.

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On March 29, 2005, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 107, Share Based Payment. SAB No. 107 expresses views of the staff regarding the interaction between SFAS 123R and certain Securities and Exchange Commission rules and regulations and provide the staff’s views regarding the valuation of share-based payment arrangements for public companies. The adoption of SAB No. 107 should not have a material impact on the Company’s consolidated financial statements.

7. Off-Balance Sheet Arrangements, Commitments and Contingencies

Financial Instruments with Off-Balance Sheet Risk. 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 $83.8 million and $56.4 million at March 31, 2005 and 2004, respectively. Each commitment has a maturity date and the commitment expires on that date with the exception of credit card and ready reserve lines of credit which have no stated maturity date. Unused lines of credit for credit card and ready reserve at March 31, 2005 and 2004 were $9.6 million and $8.7 million, respectively and are reflected in the due after one year category. The Company had outstanding standby letters of credit of $2.4 million and $998,000 at March 31, 2005 and 2004, respectively. The scheduled maturities of unused commitments are presented below as of March 31, 2005 and 2004.

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.

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

Securities. In the normal course of business the Company buys and sells securities. At March 31, 2005, the Company had recorded in its balance sheet commitments to purchase $16.6 million of securities. At December 31, 2004, there were no balance sheet commitments to purchase securities.

Litigation. The Company, or its subsidiaries, is involved with various litigation which resulted in the normal course of business. Management of the Company, after consulting with its legal counsel, believes that any liability resulting from litigation will not have a material effect on the financial position and results of operations and the liquidity of the Company or its subsidiaries.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Three months ended March 31, 2005 compared to March 31, 2004.

The following is a discussion of the consolidated financial condition, changes in financial condition, and results of operations of Southside Bancshares, Inc. (the “Company”), and should be read and reviewed in conjunction with the financial statements, and the notes thereto, in this presentation and in the Company’s latest report on Form 10-K.

The Company reported a decrease in net income for the three months ended March 31, 2005 compared to the same period in 2004. Net income for the three months ended March 31, 2005 was $3.6 million compared to $4.5 million for the same period in 2004.

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

Forward-Looking Information

Certain statements of other than historical fact that are contained in this document and in written material, press releases and oral statements issued by or on behalf of Southside Bancshares, Inc., (the “Company”) a bank holding company, may be considered to be “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements may include words such as “expect,” “estimate,” “project,” “anticipate,” “believe,” “could,” “should,” “may,” “intend,” “probability,” “risk,” “target,” “objective” and similar expressions. Forward-looking statements are subject to significant risks and uncertainties and the Company’s actual results may differ materially from the results discussed in the forward-looking statements. For example, certain market risk disclosures are dependent on choices about key model characteristics and assumptions and are subject to various limitations. See “Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations.” By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future. As a result, actual income gains and losses could materially differ from those that have been estimated. Other factors that could cause actual results to differ materially from forward-looking statements include, but are not limited to general economic conditions, either globally, nationally or in the State of Texas, legislation or regulatory changes which adversely affect the businesses in which the Company is engaged, adverse changes in Government Sponsored Enterprises (the “GSE”) status or financial condition impacting the GSE’s guarantees or ability to pay or issue debt, 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 effecting the leverage strategy, significant increases in competition in the banking and financial services industry, changes in consumer spending, borrowing and saving habits, technological changes, the Company’s ability to increase market share and control expenses, the effect of changes in federal or state tax laws, the effect of compliance with legislation or regulatory changes, the effect of changes in accounting policies and practices and the costs and effects of unanticipated litigation.

Critical Accounting Estimates

The accounting and reporting estimates of the Company conform with accounting principles generally accepted in the United States and general practices within the financial services industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The Company considers its critical accounting policies to include the following:

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

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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. The internal loan review department for the Company is responsible for an ongoing review of the Company’s loan portfolio with specific goals set for the loans to be reviewed on an annual basis.

At each review of a credit, a subjective analysis methodology is used to grade the respective loan. Categories of grading vary in severity to include loans which do not appear to have a significant probability of loss at the time of 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 department. This list is updated on a periodic basis in order to properly allocate necessary allowance and keep management informed on the status of attempts to correct the deficiencies noted in the credit.

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 March 31, 2005, the Company’s review of the loan portfolio indicated that a loan loss allowance of $6.9 million was adequate to cover probable losses in the portfolio.

Refer to Item 1 entitled Loan Loss Experience and Allowance for Loan Loss and Notes to Financial Statements No. 1, Summary of Significant Accounting and Reporting Policies in the Company’s latest report on Form 10-K for a detailed description of the Company’s estimation process and methodology related to the allowance for loan losses.

Estimation of Fair Value. The estimation of fair value is significant to a number of the Company’s assets, including available for sale (“AFS”) investment securities and other real estate owned. These are all recorded at either fair value or at the lower of cost or fair value. Furthermore, accounting principles generally accepted in the United States require disclosure of the fair value of financial instruments as a part of the notes to the consolidated financial statements. Fair values are volatile and may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates and the shape of yield curves.

Fair values for most AFS investment 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. The fair values of other real estate owned are typically determined based on appraisals by third parties, less estimated costs to sell.

Defined Benefit Retirement Plan. The plan obligations and related assets of the defined benefit pension plan are presented in Note 12 of the Notes to Consolidated Financial Statements in the Company’s latest report on Form 10-K. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using market quotations. Plan obligations and the annual pension expense are determined by independent actuaries and through the use of a number of assumptions. Key assumptions in measuring the plan obligations include the discount rate, the rate of salary increases and the estimated future return on plan assets. In determining the discount rate, the Company utilizes the yield on high-quality, fixed-income investments currently available with maturities corresponding to the anticipated timing of the benefit payments. Salary increase assumptions are based upon historical experience and anticipated future management actions. Asset returns are based upon the anticipated average rate of earnings expected on the invested funds of the plan. At March 31, 2005, the weighted-average actuarial assumptions of the Company’s plan were: discount rate 5.75%; long-term rate of return on plan assets 8.5%; and assumed salary increases 4.5%. At March 31, 2004, the weighted-average actuarial assumptions of the Company’s plan were: discount rate 6.25%; long-

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term rate of return on plan assets 8.5%; and assumed salary increases 4.5%. Material changes in pension benefit costs may occur in the future due to changes in these assumptions. Future annual amounts could be impacted by changes in the number of plan participants, changes in the level of benefits provided, changes in the discount rates, changes in the expected long-term rate of return, changes in the level of contributions to the plan and other factors.

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

Off-Balance Sheet Arrangements, Commitments and Contingencies

Details of the Company’s off-balance sheet arrangements, commitments and contingencies as of March 31, 2005 are included in Note 7 in the accompanying notes to the consolidated financial statements included in this report.

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 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 substantially higher prepayments experienced and reduces the overall yields of the premium mortgage-backed securities portfolio. 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, changes in the yield curve, and increased interest rate risk. During 2005, the yield curve has continued to flatten. During this flattening curve cycle which began during 2004, there has been a combination of increasing short-term interest rates combined with relatively flat to decreasing long-term (10 years and out) interest rates. Should this trend in the yield curve continue, the Company may not see prepayment speeds on its mortgage-backed securities slow and could see prepayment speeds increase. In addition, at the same time the Company could see its funding costs rise. Increased prepayment speeds and rising funding costs would most likely squeeze the Company’s net interest margin. The Company’s asset structure, spread and margin increases the need to monitor the Company’s interest rate risk. An additional risk is the change in market value of the AFS securities portfolio as a result of changes in interest rates. Significant increases in interest rates could impact the Company’s equity capital significantly.

The Company will attempt to adopt a balance sheet strategy going forward to manage the securities portfolio as a percentage of earning assets in combination with adequate quality loan growth available in the Company’s market area. If adequate quality loan growth is not available to achieve the Company’s goal of enhancing profitability by maximizing the use of the Company’s capital, as described above, then securities as a percentage of earning assets could increase through the purchase of additional securities if securities can be purchased at what the Company believes are acceptable margins. If acceptable securities are not available to purchase, the Company could reduce the level of securities through maturities of securities, principal payments and, or sales of securities. During the first quarter ended March 31, 2005, the Company’s loan growth was sufficient to allow the securities

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portfolio as a percentage of total assets to decrease slightly to 53.8% at March 31, 2005 from 54.4% at December 31, 2004. On the liability side, the Company will continue to utilize a combination of FHLB advances and deposits to achieve its strategy of minimizing cost while achieving overall interest rate risk objectives as well as ALCO objectives. During the first quarter ended March 31, 2005, long-term deposits necessary to balance ALCO objectives were not available in the Company’s market area at a market price the Company was willing to accept. As a result, additional long term FHLB borrowings were obtained, however, due to the overall increase in deposits, FHLB borrowings as a percentage of deposits decreased slightly to 55.6% at March 31, 2005 from 56.3% at December 31, 2004. The intended net result of the overall balance sheet strategy is to increase the Company’s net interest margin. The leverage strategy is dynamic and requires ongoing management. As interest rates, yield curves, funding costs and security spreads change, the Company’s determination of the proper securities, proper amount of 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. If the flattening yield curve cycle trend discussed above continues, the overall yield on the mortgage-backed securities may not increase and could decrease. If all interest rates were to 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.

Net Interest Income

Net interest income for the three months ended March 31, 2005 was $10.4 million, an increase of $858,000, or 9.0%, when compared to the same period in 2004. Average interest earning assets increased $212.8 million, or 16.0%, while the net interest spread decreased from 2.75% at March 31, 2004 to 2.50% at March 31, 2005 and the net margin decreased from 3.17% at March 31, 2004 to 2.98% at March 31, 2005. Net interest income increased as a result of increases in the Company’s average interest earning assets during the first quarter of 2005 when compared to the same period in 2004, which more than offset the decrease in the Company’s net interest spread and margin during the same period. Future changes in interest rates could impact prepayment speeds on the Company’s mortgage-backed securities which could influence the Company’s net interest margin and spread during the coming quarters. Future changes in interest rates in which the yield curve continues to flatten could also influence the Company’s net interest margin and spread during the coming quarters.

During the three months ended March 31, 2005, average loans, funded by the growth in average deposits, increased $41.0 million, or 6.9%, compared to the same period in 2004. The average yield on loans decreased from 6.13% at March 31, 2004 to 6.09% at March 31, 2005 reflective of the repricing characteristics of the loans, interest rates at the time the loans repriced, and the competitive loan pricing environment. 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 increase in interest income on loans of $486,000, or 5.7%, was the result of the increase in average loans. During the first three months ended March 31, 2005, loans, net of unearned discount, increased $12.8 million, or 2.1%, when compared to the year ended December 31, 2004 primarily as a result of an increase in municipal loans, construction loans and 1-4 family residential loans.

Average investment and mortgage-backed securities increased $173.8 million, or 24.6%, for the three months ended March 31, 2005 when compared to the same period in 2004. This increase was funded by the increase in average deposits and average FHLB advances. The overall yield on average securities increased to 4.64% during the three months ended March 31, 2005, from 4.42% during the same period in 2004. This increase is primarily reflective of decreased prepayment speeds on mortgage-backed securities which led to decreased amortization expense. Interest income from investment and mortgage-backed securities increased $2.3 million, or 32.1%, compared to the same period in 2004 due to the increase in average balances and the increase in the overall yield.

Interest income from marketable equity securities, federal funds sold and other interest earning assets increased $97,000, or 75.8%, for the three months ended March 31, 2005, when compared to 2004 as a result of the increase in the average yield from 1.54% in 2004 to 3.17% at March 31, 2005, due to higher short-term interest rates which more than offset the decrease in the average balance.

Total interest expense increased $2.1 million, or 32.3%, to $8.5 million during the three months ended March 31,

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2005 as compared to $6.4 million during the same period in 2004. The increase was primarily attributable to increased funding costs associated with the Company’s deposits and FHLB advances due to an increase in these average interest bearing liabilities of $178.7 million, or 16.3% and an increase in the average yield on interest bearing liabilities from 2.36% at March 31, 2004 to 2.71% at March 31, 2005.

Average interest bearing deposits increased $41.2 million, or 6.4%, and the average rate paid increased from 1.48% at March 31, 2004 to 2.00% at March 31, 2005. Average short-term interest bearing liabilities, consisting primarily of FHLB advances and federal funds purchased, increased $75.1 million, or 45.3%, as compared to the same period in 2004 primarily as a result of the increase in securities during the first quarter of 2005 and the reclassification of FHLB advances from long-term to short-term. Interest expense associated with short-term interest bearing liabilities increased $395,000, or 25.6%, and the average rate paid decreased 48 basis points for the three month period ended March 31, 2005 when compared to the same period in 2004. The decrease in the average rate paid is due to higher interest rate FHLB advances paying off and lower interest rate long-term FHLB advances being reclassified to short-term. Average long-term interest bearing liabilities consisting of FHLB advances increased $62.4 million, or 24.0%, during the three months ended March 31, 2005 to $322.4 million as compared to $260.0 million at March 31, 2004. Interest expense associated with long-term FHLB advances increased $577,000, or 25.3%, and the average rate paid increased 7 basis points for the three months ended March 31, 2005 when compared to the same period in 2004. The long-term advances were obtained from the FHLB primarily to fund long-term securities and to a lesser extent long-term loans. FHLB advances are collateralized by FHLB stock, securities and nonspecific real estate loans.

Average long-term debt remained the same from March 31, 2004 to March 31, 2005. Interest expense increased $70,000, or 32.7% as a result of the increase in the three month LIBOR. The long-term debt adjusts quarterly at a rate equal to the three month LIBOR plus 294 basis points.

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RESULTS OF OPERATIONS

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

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Noninterest Income

Noninterest income was $4.8 million for the three months ended March 31, 2005 compared to $6.5 million for the same period in 2004. During the three months ended March 31, 2005, the Company has a loss on the sale of AFS securities of $216,000 compared to gains of $1.8 million for the same period in 2004. The market value of the AFS securities portfolio at March 31, 2005 was $654.0 million with a net unrealized loss on that date of $1.8 million. The net unrealized loss is comprised of $7.5 million in unrealized losses and $5.7 million in unrealized gains. The market value of the HTM securities portfolio at March 31, 2005 was $238.2 million with a net unrealized loss on that date of $1.7 million. The net unrealized loss is comprised of $1.9 million in unrealized losses and $0.2 million in unrealized gains. The Company sold securities out of its AFS portfolio to accomplish ALCO and investment portfolio objectives aimed at repositioning a portion of the securities portfolio in an effort to maximize the total return of the securities portfolio and to reduce alternative minimum tax. Sales of AFS securities were the result of changes in economic conditions and a change in the desired mix of the securities portfolio. During the first quarter of 2005, the yield curve continued to flatten as short-term interest rates increased more than long-term interest rates. The Company used this interest-rate environment to reposition a portion of the securities portfolio. Lower yielding mortgage-backed securities and, or selected higher coupon premium mortgage-backed securities with high selling prices or with a potentially greater prepayment exposure were replaced with mortgage-backed securities that had characteristics which potentially might reduce the prepayment exposure and that had an overall higher average yield. Specific low selling yield and, or long duration municipal securities were sold and, in some circumstances, partially replaced with better call protected municipal securities. It is uncertain if economic conditions or ALCO and investment portfolio objectives that would precipitate sales of a significant amount of additional AFS securities, will exist during the remainder of 2005. Sales of AFS municipal securities will continue to be evaluated based on the Company’s ability to replace these municipal securities with more attractive municipal loans and the appropriate overall level of tax free income. Therefore, it is uncertain if the Company will have net gains on sales of securities during 2005.

Other changes to noninterest income included gain on sale of loans income which decreased $64,000, or 14.7%, to $370,000 for the three months ended March 31, 2005 from $434,000 for the same period in 2004 due to the decrease in mortgage loan refinancing the Company handled during the first three months of 2005 when compared to the same period in 2004. Trust income increased $52,000, or 18.8%, for the three months ended March 31, 2005 when compared to the same period in 2004 due to growth experienced in the Trust department. Other noninterest income increased $340,000, or 95.0%, for the three months ended March 31, 2005 primarily as a result of a special distribution received as a result of the merger of the Pulse EFT Association with Discover Financial Services of $244,000. Other increases in other income included increases in Southside Select fee income, gain on sale of automobiles, and Travelers Express income.

Noninterest Expense

Noninterest expense was $10.6 million for the three months ended March 31, 2005, compared to $10.1 million for the same period of 2004, representing an increase of $488,000 or 4.8%.

Salaries and employee benefits increased $360,000, or 5.5%, during the three months ended March 31, 2005 when compared to the same period in 2004. Direct salary expense and payroll taxes increased $576,000, or 11.7%, as a result of overall bank growth, new branches opened since first quarter 2004, and normal payroll increases for the three months ended March 31, 2005 when compared to the same period in 2004. Retirement expense increased $21,000, or 3.1%, for the three months ended March 31, 2005 when compared to the same period in 2004, primarily as a result of the increase in the number of participants, level of performance of retirement plan assets and actuarial assumptions. The Company’s actuarial assumptions used to determine net periodic pension costs were reduced for 2005 when compared to 2004 and the assumed long-term rate of return is 8.5% and the assumed discount rate is 5.75%. The Company will continue to evaluate the assumed long-term rate of return and the discount rate to determine if either should be changed in the future. If either of these assumptions were decreased, the cost and funding required for the retirement plan could increase. Health insurance expense decreased $237,000, or 26.7%, for the three months ended March 31, 2005 when compared to the same period in 2004 due to lower claims paid in the first quarter of 2005 compared to the same period in 2004. The Company has a self-insured health plan which is supplemented with stop loss insurance policies. Health insurance costs are rising nationwide and these costs may increase during the remainder of 2005.

Equipment expense increased $34,000, or 19.7%, for the three months ended March 31, 2005 compared to the same period in 2004 due to increases in various maintenance contracts.

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ATM expense decreased $32,000, or 18.6%, for the three months ended March 31, 2005 compared to the same period in 2004. The decrease occurred primarily due to renegotiated fees with the service provider.

Director fees increased $15,000, or 10.4%, for the three months ended March 31, 2005 compared to the same period in 2004, primarily as a result of increased fee amounts paid to holding company directors and a temporary increase in the number of directors that serve on the bank’s executive committee.

Professional fees decreased $46,000, or 18.9%, for the three months ended March 31, 2005 compared to the same period in 2004. The decrease occurred primarily due to a reduction in consulting fees associated with the Company’s internal and financial controls.

Other expense increased $81,000, or 7.8%, for the three months ended March 31, 2005 compared to the same period in 2004. The increase occurred primarily due to increases in bank exam fees, telephone expense and other losses, that were partially offset by decreases in legal fees.

Income Taxes

Income tax expense was $771,000 for the three months ended March 31, 2005 compared to $1.2 million for the three months ended March 31, 2004. The effective tax rate as a percentage of pre-tax income was 17.7% for the three months ended March 31, 2005 compared to 21.2% for the three months ended March 31, 2004. The decrease in the effective tax rate and income tax expense for 2005 was due to the decrease in taxable income as a percentage of total income for the three months ended March 31, 2005 when compared to March 31, 2004. The decrease in taxable income as a percentage of total income is a result of the decrease in pre-tax income primarily due to the decrease in income on sales of securities in the first quarter of 2005 compared to the same period in 2004.

The Company decreased its municipal securities portfolio during the first quarter of 2005 and plans to decrease it further during the second quarter of 2005 to reduce the overall level of tax free income from the securities portfolio and to allow the Company the opportunity to grow its municipal loan portfolio. During 2003 the Company was in an alternative minimum tax position due to unusually high retirement expenses, the one time $1.0 million amortization expense during 2003 and the level of tax free income. The Company has the ability to and is addressing the appropriate level of tax free income so as to not be in an alternative minimum tax position during 2005. Based on this information, management believes this is reversible in the future and no valuation allowance is deemed necessary at this time.

On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004 (the “Act”), which includes numerous provisions that may affect business practices and accounting for income taxes. The Company does not expect the Act to have a material impact on its income tax expense. The Company will continue to monitor any possible impact in future periods.

Capital Resources

Total shareholders’ equity for the Company at March 31, 2005, was $98.2 million representing a decrease of $6.5 million from December 31, 2004, and represented 5.9% of total assets at March 31, 2005 compared to 6.5% of total assets at December 31, 2004. The decrease of $4.6 million in accumulated other comprehensive income (loss), $1.2 million in dividends paid and the purchase of $5.0 million in common stock (233,550 shares) were the major contributors to the decrease in shareholders’ equity at March 31, 2005. Increases to shareholders’ equity consisted of net income of $3.6 million and the issuance of $517,000 in common stock (76,637 shares) through the Company’s incentive stock option and dividend reinvestment plans. The Company has a common stock repurchase plan that was instituted in late 1994. Under the repurchase plan, the Board of Directors establishes, on a quarterly basis, total dollar limitations. The Board reviews this plan in conjunction with the capital needs of the Company and the Bank and may, at its discretion, modify or discontinue the plan. The Company’s dividend policy requires that any cash dividend payments made by the Company not exceed consolidated earnings for that year. Shareholders should not anticipate a continuation of the cash dividend simply because of the existence of a dividend reinvestment program. The payment of dividends will depend upon future earnings, the financial condition of the Company, and other related factors including the discretion of the Board of Directors.

Under the Federal Reserve Board’s risk-based capital guidelines for bank holding companies, the minimum ratio of total capital to risk-adjusted assets (including certain off-balance sheet items, such as standby letters of credit) is currently eight percent. The minimum Tier 1 capital to risk-adjusted assets is four percent. The Company’s $20 million of trust preferred securities is considered Tier 1 capital by the Federal Reserve Board. The Federal Reserve Board also requires bank holding companies to comply with the minimum leverage ratio guidelines. The leverage ratio is a ratio of bank holding company’s Tier 1 capital to its total consolidated quarterly average assets, less goodwill and certain other intangible assets. The guidelines require a minimum average of four percent for bank holding companies that meet certain specified criteria. Failure to meet minimum capital regulations can initiate certain mandatory and possibly additional discretionary actions by regulation, that if undertaken, could have a direct material effect on the Company’s financial statements. At March 31, 2005, the Company and the Bank exceeded all regulatory minimum

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capital requirements.

The Federal Reserve Deposit Insurance Act requires bank regulatory agencies to take “prompt corrective action” with respect to FDIC-insured depository institutions that do not meet minimum capital requirements. A depository institution’s treatment for purposes of the prompt corrective action provisions will depend on how its capital levels compare to various capital measures and certain other factors, as established by regulation.

It is management’s intention to maintain the Company’s capital at a level acceptable to all regulatory authorities and future dividend payments will be determined accordingly. Regulatory authorities require that any dividend payments made by either the Company or the Bank not exceed earnings for that year.

Liquidity and Interest Rate Sensitivity

Liquidity management involves the ability to convert assets to cash with a minimum of loss. The Company must be capable of meeting its obligations to its customers at any time. This means addressing (1) the immediate cash withdrawal requirements of depositors and other funds providers; (2) the funding requirements of all lines and letters of credit; and (3) the short-term credit needs of customers. Liquidity is provided by short-term investments that can be readily liquidated with a minimum risk of loss. Cash, Interest Earning Deposits, Federal Funds Sold and short-term investments with maturities or repricing characteristics of one year or less continue to be a substantial percentage of total assets. At March 31, 2005, these investments were 16.9% of total assets. Liquidity is further provided through the matching, by time period, of rate sensitive interest earning assets with rate sensitive interest bearing liabilities. The Company has three lines of credit for the purchase of overnight federal funds at prevailing rates. Two $15.0 million and one $10.0 million unsecured lines of credit have been established with Bank of America, Frost Bank and TIB — The Independent BankersBank, respectively. The Company has obtained a $12.0 million letter of credit from FHLB as collateral for a portion of the Company’s public fund deposits.

Interest rate sensitivity management seeks to avoid fluctuating net interest margins and to enhance consistent growth of new interest income through periods of changing interest rates. The ALCO closely monitors various liquidity ratios, interest rate spreads and margins, interest rate shock reports and market value of portfolio equity (MVPE) with rates shocked plus and minus 200 basis points to ensure a satisfactory liquidity position for the Company. In addition, ALCO utilizes a simulation model to determine the impact of net interest income under several different interest rate scenarios. By utilizing this technology, the Company can determine changes that need to be made to the asset and liability mixes to minimize the change in net interest income under these various interest rate scenarios.

Composition of Loans

One of the Company’s main objectives is to seek attractive lending opportunities in East Texas, primarily in the counties in which it operates. Substantially all of the Company’s loans are made to borrowers who live in and conduct business in East Texas, with the exception of municipal loans. Municipal loans are made to municipalities and school districts throughout the state of Texas. The majority of the increase from December 31, 2004 to March 31, 2005, was in loans to municipalities, construction loans and 1-4 family residential loans. The increase in these loan categories is due to the Company’s continued strong commitment in these areas.

Loan Loss Experience and Allowance for Loan Losses

The loan loss allowance is based on the most current review of the loan portfolio at that time. Several methods are used to maintain the review in the most current manner. First, the servicing officer has the primary responsibility for updating significant changes in a customer’s financial position. Accordingly, each officer prepares status updates on any credit deemed to be experiencing repayment difficulties which, in the officer’s opinion, would place the collection of principal or interest in doubt. Second, the internal loan review department for the Company is responsible for an ongoing review of the Company’s loan portfolio with specific goals set for the loans to be reviewed on an annual basis.

At each review of a credit, a subjective analysis methodology is used to grade the respective loan. Categories of grading vary in severity to include loans which do not appear to have a significant probability of loss at the time of 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

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as having more than the normal degree of risk associated with them, is maintained by the internal loan review department. This list is updated on a periodic basis in order to properly allocate necessary allowances and keep management informed on the status of attempts to correct the deficiencies noted in the credit.

Industry experience shows that a portion of the Company’s loans will become delinquent and a portion of the loans will require partial or entire charge-off. Regardless of the underwriting criteria utilized, losses may be experienced as a result of various factors beyond the Company’s control, including, among other things, changes in market conditions affecting the value of properties and problems affecting the credit of the borrower. Management’s determination of the adequacy of allowance for loan losses is based on various considerations, including an analysis of the risk characteristics of various classifications of loans, previous loan loss experience, specific loans which would have loan loss potential, delinquency trends, estimated fair value of the underlying collateral, current economic conditions, the views of the regulators (who have the authority to require additional allowances), and geographic and industry loan concentration.

As of March 31, 2005, the Company’s review of the loan portfolio indicated that a loan loss allowance of $6.9 million was adequate to cover probable losses in the portfolio.

For the three months ended March 31, 2005, loan charge-offs were $642,000 and recoveries were $349,000, resulting in net charge-offs of $293,000. For the three months ended March 31, 2004, loan charge-offs were $266,000 and recoveries were $65,000, resulting in net charge-offs of $201,000. The necessary provision expense was estimated at $235,000 for the three months ended March 31, 2005.

Nonperforming Assets

Nonperforming assets consist of delinquent loans 90 days or more past due, nonaccrual loans, other real estate owned, repossessed assets and restructured loans. Nonaccrual loans are those loans which are 90 days or more delinquent and collection in full of both the principal and interest is in doubt. Additionally, some loans that are not delinquent may be placed on nonaccrual status due to doubts about full collection of principal or interest. When a loan is categorized as nonaccrual, the accrual of interest is discontinued and the accrued balance is reversed for financial statement purposes. Restructured loans represent loans which have been renegotiated to provide a reduction or deferral of interest or principal because of deterioration in the financial position of the borrowers. Categorization of a loan as nonperforming is not in itself a reliable indicator of potential loan loss. Other factors, such as the value of collateral securing the loan and the financial condition of the borrower must be considered in judgments as to potential loan loss. Other Real Estate Owned (OREO) represents real estate taken in full or partial satisfaction of debts previously contracted. The dollar amount of OREO is based on a current evaluation of the OREO at the time it is recorded on the Company’s books, net of estimated selling costs. Updated valuations are obtained as needed and any additional impairments are recognized.

Total nonperforming assets at March 31, 2005 were $2.9 million, a decrease of $656,000, or 18.6%, from $3.5 million at December 31, 2004. From December 31, 2004 to March 31, 2005, nonaccrual loans decreased $413,000, or 18.4%, to $1.8 million. Of the total at March 31, 2005, 30.7% are residential real estate loans, 6.6% are commercial real estate loans, 49.0% are commercial loans and 13.7% are loans to individuals. Other real estate owned decreased $153,000, or 71.5%, to $61,000 at March 31, 2005 from $214,000 at December 31, 2004. Of the total at March 31, 2005, 73.9% consist of residential dwellings, and 26.1% consist of commercial real estate. The Company is actively marketing all properties and none are being held for investment purposes. Loans 90 days or more past due decreased $521,000, or 63.0%, to $306,000. Repossessed assets increased $384,000, or 936.6%, to $425,000. Approximately $330,000 of the repossessed assets at March 31, 2005 represented a loan with an SBA guarantee of approximately $306,000. Restructured loans increased $47,000, or 24.4%, to $240,000.

Expansion

The Company opened a mortgage lending center in Gresham, Texas in Smith County during January 2005, with plans to ultimately expand it to a full service branch.

The Company plans to open a full service grocery store branch in Seven Points, Texas in Henderson County during the second quarter of 2005.

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Accounting Pronouncements

See “Accounting Pronouncements” in Note 6 to the Company’s financial statements in this Form 10-Q.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In the banking industry, a major risk exposure is changing interest rates. The primary objective of monitoring the Company’s interest rate sensitivity, or risk, is to provide management the tools necessary to manage the balance sheet to minimize adverse changes in net interest income as a result of changes in the direction and level of interest rates. Federal Reserve Board monetary control efforts, the effects of deregulation and legislative changes have been significant factors affecting the task of managing interest rate sensitivity positions in recent years.

In an attempt to manage its exposure to changes in interest rates, management closely monitors the Company’s exposure to interest rate risk. Management maintains an asset/liability committee which meets regularly and reviews the Company’s interest rate risk position and makes recommendations for adjusting this position. In addition, the Board reviews on a monthly basis the Company’s asset/liability position. The Company primarily uses two methods for measuring and analyzing interest rate risk: Net income simulation analysis and market value of portfolio equity modeling. Through these simulations the Company attempts to estimate the impact on net interest income of a 200 basis point parallel shift in the yield curve. Policy guidelines limit the estimated change in net interest income to 10 percent of forecasted net income over the succeeding 12 months and 200 basis point parallel rate shock. Policy guidelines limit the change in market value of equity in a 200 basis point parallel rate shock to 20 percent of the base case. The results of the valuation analysis as of March 31, 2005, were within policy guidelines. Due to the level of interest at March 31, 2005, many of the interest rates cannot move down 200 basis points. As part of the overall assumptions, certain assets and liabilities have been given reasonable floors. In the present interest rate environment, management is primarily focusing on the shock down 100 basis points and the shock up 100 and 200 basis points. This type of simulation analysis requires numerous assumptions including but not limited to changes in balance sheet mix, prepayment rates on mortgage-related assets and fixed rate loans, cash flows and repricings of all financial instruments, changes in volumes and pricing, future shapes of the yield curve, relationship of market interest rates to each other (basis risk), credit spread and deposit sensitivity. Assumptions are based on management’s best estimates but may not accurately reflect actual results under certain changes in interest rates.

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The following table provides information about the Company’s financial instruments that are sensitive to changes in interest rates. Except for the effects of prepayments and scheduled principal amortization, the table presents principal cash flows and related weighted average interest rates by the contractual term to maturity. Callable FHLB Advances are presented based on contractual maturity. Loans held for sale totaling $4,633,000 are classified in the one-year category. Adjustable rate student loans totaling $7.7 million are classified in the one year category. These loans reprice annually and are not retained by the Company when they enter repayment status. Nonaccrual loans, totaling $1,835,000, are not included in the loan totals. All instruments are classified as other than trading.

EXPECTED MATURITY DATE
(dollars in thousands)