UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

ý 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

 

For the transition period from             to           

 

Commission file number  0-9439

 

INTERNATIONAL BANCSHARES CORPORATION

(Exact name of registrant as specified in its charter)

 

Texas		74-2157138
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
1200 San Bernardo Avenue, Laredo, Texas 78042-1359
(Address of principal executive offices)
(Zip Code)
(956) 722-7611
(Registrant’s telephone number, including area code)
None
(Former name, former address and former fiscal year, if changed since last report)

 

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.  Yesý     No     o

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class		Shares Issued and Outstanding
Common Stock, $1.00 par value		51,067,201 shares outstanding at April 29, 2005

 

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Condition (Unaudited)

(Dollars in Thousands)

 

		March 31, 2005			December 31, 2004
Assets
Cash and due from banks		$	188,806		$	174,770
Federal funds sold		89,000			21,000
Total cash and cash equivalents		277,806			195,770
Time deposits with banks		396			396
Investment securities:
Held-to-maturity (Market value of $2,385 on March 31, 2005 and December 31, 2004)		2,385			2,385
Available-for-sale (Amortized cost of $4,078,799 on March 31, 2005 and $3,851,741 on December 31, 2004)		4,052,300			3,874,833
Total investment securities		4,054,685			3,877,218
Loans, net of unearned discounts		4,964,339			4,888,974
Less allowance for possible loan losses		(86,849		)	(84,905		)
Net loans		4,877,490			4,804,069
Bank premises and equipment, net		309,238			302,230
Accrued interest receivable		43,873			41,140
Other investments		323,962			301,578
Identified intangible assets, net		43,102			44,400
Goodwill, net		289,262			289,262
Other assets		57,580			61,888
Total assets		$	10,277,394		$	9,917,951

 

2

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Consolidated Statements of Condition (Unaudited)

 

(Dollars in Thousands)

 

		March 31, 2005			December 31, 2004
Liabilities and Shareholders’ Equity
Deposits:
Demand – non-interest bearing		$	1,232,382		$	1,150,999
Savings and interest bearing demand		2,230,177			2,232,102
Time		3,136,051			3,188,003
Total deposits		6,598,610			6,571,104
Securities sold under repurchase agreements		806,014			619,806
Other borrowed funds		1,810,196			1,670,199
Junior subordinated deferrable interest debentures		235,651			235,395
Other liabilities		66,965			68,357
Total liabilities		9,517,436			9,164,861
Shareholders’ equity:
Common shares of $1.00 par value. Authorized 75,000,000 shares; issued 68,559,810 shares on March 31, 2005 and 68,431,225 shares on December 31, 2004		68,560			68,431
Surplus		132,015			130,597
Retained earnings		743,302			705,642
Accumulated other comprehensive (loss) income		(17,225		)	15,010
		926,652			919,680
Less cost of shares in treasury, 17,612,998 shares on March 31, 2005 and 17,610,126 shares on December 31, 2004		(166,694		)	(166,590		)
Total shareholders’ equity		759,958			753,090
Total liabilities and shareholders’ equity		$	10,277,394		$	9,917,951

 

See accompanying notes to consolidated financial statements.

 

3

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Income (Unaudited)

(Dollars in Thousands, except per share data)

 

		Three Months Ended March 31,
		2005			2004
Interest income:
Loans, including fees		$	79,825		$	43,426
Federal funds sold		567			469
Investment securities:
Taxable		36,513			25,623
Tax-exempt		1,217			1,284
Other interest income		197			168
Total interest income		118,319			70,970
Interest expense:
Savings deposits		5,474			2,217
Time deposits		14,480			9,051
Federal funds purchased and securities sold under repurchase agreements		5,448			4,757
Other borrowings		11,604			2,207
Junior subordinated deferrable interest debentures		4,200			2,487
Total interest expense		41,206			20,719
Net interest income		77,113			50,251
Provision for possible loan losses		2,610			1,342
Net interest income after provision for possible loan losses		74,503			48,909
Non-interest income:
Service charges on deposit accounts		20,045			14,409
Other service charges, commissions and fees
Banking		6,045			3,843
Non-banking		1,632			896
Investment securities transactions, net		(26		)	4,772
Other investments, net		4,417			2,512
Other income		10,310			1,881
Total non-interest income		42,423			28,313

 

4

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Income (Unaudited)

(Dollars in Thousands, except per share data)

 

		Three Months Ended March 31,
		2005			2004
Non-interest expense:
Employee compensation and benefits		$	27,475		$	16,441
Occupancy		5,448			3,273
Depreciation of bank premises and equipment		5,710			4,051
Professional fees		3,208			1,574
Stationery and supplies		1,367			979
Amortization of identified intangible assets		1,298			246
Advertising		2,786			1,856
Other		12,732			9,268
Total non-interest expense		60,024			37,688
Income before income taxes		56,902			39,534
Provision for income taxes		19,242			13,015
Net income		$	37,660		$	26,519
Basic earnings per common share:
Weighted average number of shares outstanding:		50,882,971			48,433,898
Net income		$	.74		$	.55
Fully diluted earnings per common share:
Weighted average number of shares outstanding:		51,659,784			49,517,524
Net income		$	.73		$	.54

 

See accompanying notes to consolidated financial statements.

 

5

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Unaudited)

(Dollars in Thousands)

 

		Three Months Ended March 31,
		2005			2004
Net income		$	37,660		$	26,519
Other comprehensive income (loss), net of tax
Unrealized holding (losses) gains on securities arising during period, net of reclassification adjustment for (gains) losses included in net income		(32,235		)	5,569
Comprehensive income		$	5,425		$	32,088

 

See accompanying notes to consolidated financial statements.

 

6

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Unaudited)

(Dollars in Thousands)

 

		Three Months Ended March 31,
		2005			2004
Operating activities:
Net income		$	37,660		$	26,519
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for possible loan losses		2,610			1,342
Depreciation of bank premises and equipment		5,710			4,051
Gain on sale of bank premises and equipment		(73		)	(17		)
Depreciation and amortization of leased assets		422			422
Accretion of investment securities discounts		(176		)	(123		)
Amortization of investment securities premiums		7,474			7,973
Investment securities transactions, net		26			(4,772		)
Accretion of junior subordinated debenture discounts		256			256
Amortization of identified intangible assets		1,298			246
Earnings from affiliates and other investments		(3,374		)	(2,343		)
Deferred tax expense (benefit)		568			(203		)
(Increase) decrease in accrued interest receivable		(2,733		)	1,430
Net decrease in other assets		3,885			1,504
Net increase in other liabilities		15,396			12,878
Net cash provided by operating activities		68,949			49,163
Investing activities:
Proceeds from maturities of securities		500			2,293
Proceeds from sales of available-for-sale securities		75,960			279,535
Purchases of available for sale securities		(474,819		)	(268,930		)
Principal collected on mortgage-backed securities		163,977			145,883
Net increase in loans		(76,031		)	(44,999		)
(Purchases) distributions of other investments		(19,010		)	43,310
Purchases of bank premises and equipment		(13,052		)	(7,827		)
Proceeds from sale of bank premises and equipment		407			17
Net cash (used in) provided by investing activities		(342,068		)	149,282

 

7

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Unaudited)

(Dollars in Thousands)

 

		Three Months Ended March 31,
		2005			2004
Financing activities:
Net increase in non-interest bearing demand deposits		$	81,383		$	20,357
Net decrease in savings and interest bearing demand deposits		(1,925		)	(8,553		)
Net (decrease) increase in time deposits		(51,952		)	40,738
Net increase in securities sold under repurchase agreements		186,208			2,640
Proceeds from issuance of other borrowed funds		1,145,000			90,000
Principal payments on other borrowed funds		(1,005,003		)	(185,064		)
Purchase of treasury stock		(104		)	(332		)
Proceeds from stock transactions		1,548			1,458
Net provided by (used in) financing activities		355,155			(38,756		)
Increase in cash and cash equivalents		82,036			159,689
Cash and cash equivalents at beginning of period		195,770			215,729
Cash and cash equivalents at end of period		$	277,806		$	375,418
Supplemental cash flow information:
Interest paid		$	39,353		$	20,400
Income taxes paid		4,443			—

 

See accompanying notes to consolidated financial statements.

 

8

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

 

Note 1 - Basis of Presentation

 

The accounting and reporting policies of International Bancshares Corporation (“Corporation”) and Subsidiaries (the Corporation and Subsidiaries collectively referred to herein as the “Company”) conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry.  The consolidated financial statements include the accounts of the Corporation and its wholly-owned subsidiaries, International Bank of Commerce, Laredo (“IBC”), Commerce Bank, International Bank of Commerce, Zapata, International Bank of Commerce, Brownsville and the Corporation’s wholly-owned non-bank subsidiaries, IBC Subsidiary Corporation, IBC Life Insurance Company, IBC Trading Company, and IBC Capital Corporation, as well as the GulfStar Group in which the Company owns a controlling interest.  All significant inter-company balances and transactions have been eliminated in consolidation.  The consolidated financial statements are unaudited, but include all adjustments, which, in the opinion of management, are necessary for a fair presentation of the results of the periods presented.  All such adjustments were of a normal and recurring nature.  It is suggested that these financial statements be read in conjunction with the financial statements and the notes thereto in the Company’s latest Annual Report on Form 10K.  The consolidated statement of condition at December 31, 2004 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  Certain reclassifications have been made to make prior periods comparable.

 

The Company operates as one segment.  The operating information used by the Company’s chief executive officer for purposes of assessing performance and making operating decisions about the Company is the consolidated statements presented in this report.  The Company has four active operating subsidiaries, namely, the bank subsidiaries, otherwise known as International Bank of Commerce, Laredo, Commerce Bank, International Bank of Commerce, Zapata and International Bank of Commerce, Brownsville.  The Company applies the provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” in determining its reportable segments and related disclosures.  None of the Company’s other subsidiaries meets the 10% threshold for disclosure under SFAS No. 131.

 

All per share data presented has been restated to reflect the stock splits effected through stock dividends, Note 8.

 

Note 2 – Loans

 

A summary of net loans, by loan type at March 31, 2005 and December 31, 2004 is as follows:

 

		March 31, 2005			December 31, 2004
		(Dollars in thousands)
Commercial, financial and agricultural		$	2,689,096		$	2,710,270
Real estate-mortgage		958,641			960,599
Real estate – construction		826,679			749,689
Consumer		240,701			229,302
Foreign		249,557			239,622
Total loans		4,964,674			4,889,482
Unearned discount		(335		)	(508		)
Loans, net of unearned discount		$	4,964,339		$	4,888,974

 

9

 

Note 3 – Stock Options

 

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 148 (“SFAS No. 148”), “Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123.”  SFAS No. 148 amends Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”), “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation.  In addition, SFAS No. 148 amends the disclosure requirement of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the fair value based method of accounting for stock-based employee compensation for those companies that have elected to continue to apply Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.”  In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”), “Share-Based Payment (Revised 2004).” SFAS 123R eliminates the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation expense in the consolidated statement of income based on their fair values on the date of the grant.  The Company will be required to adopt the provisions of SFAS No. 123R on January 1, 2006.

 

At March 31, 2005, the Company had one stock-based employee compensation plan and certain options granted outside the plan.  The Company accounts for options under the recognition and measurement principles of APB 25, and related interpretations.  No stock-based employee cost is reflected in net income, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant.  The following table, as prescribed by SFAS No. 148, illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock based employee compensation.

 

		Three Months Ended March 31,
		2005			2004
		(Dollars in Thousands, except per share data)
Net income, as reported		$	37,660		$	26,519
Deduct: Total stock-based compensation expense determined under the fair value based method for all awards, net of tax related tax effects		(91		)	(142		)
Pro forma net income		$	37,569		$	26,377
Earnings per share:
Basic earnings
As reported		$	.74		$	.55
Pro forma		.74			.54
Diluted earnings
As reported		$	.73		$	.54
Pro forma		.73			.53

 

Note 4 - Investment Securities

 

The Company classifies debt and equity securities into one of three categories:  held-to maturity, available-for-sale, or trading.  Such classifications are reassessed for appropriate classification at each reporting date.  Securities classified as “held-to-maturity” are carried at amortized cost for financial statement reporting, while securities classified as “available-for-sale” and “trading” are carried at their fair value.  Unrealized holding gains and losses are included in net income for those securities classified as “trading”, while unrealized holding gains and losses related to those securities classified as “available-for-sale” are excluded from net income and reported net of tax as other comprehensive income (loss) and accumulated other comprehensive income (loss) until realized.

 

10

 

A summary of the investment securities held for investment and securities available-for-sale as reflected on the books of the Company is as follows:

 

		March 31, 2005			December 31, 2004
		(Dollars in Thousands)
U.S. Treasury and federal agencies
Available-for-sale		$	3,931,010		$	3,752,501
States and political subdivisions
Available-for-sale		103,839			104,317
Other
Held-to-maturity		2,385			2,385
Available-for-sale		17,451			18,015
Total investment securities		$	4,054,685		$	3,877,218

 

Note 5 - Allowance for Possible Loan Losses

 

A summary of the transactions in the allowance for possible loan losses is as follows:

 

		March 31, 2005			March 31, 2004
		(Dollars in Thousands)
Balance at December 31,		$	84,905		$	48,646
Losses charged to allowance		(1,231		)	(702		)
Recoveries credited to allowance		565			560
Net losses charged to allowance		(666		)	(142		)
Provisions charged to operations		2,610			1,342
Balance at March 31,		$	86,849		$	49,846

 

Impaired loans are those loans where it is probable that all amounts due according to contractual terms of the loan agreement will not be collected.  The Company has identified these loans through its normal loan review procedures.  Impaired loans are measured based on (1) the present value of expected future cash flows discounted at the loan’s effective interest rate; (2) the loan’s observable market price; or (3) the fair value of the collateral if the loan is collateral dependent.  Substantially all of the Company’s impaired loans are measured at the fair value of the collateral. In limited cases the Company may use other methods to determine the level of impairment of a loan if such loan is not collateral dependent.

 

The following table details key information regarding the Company’s impaired loans:

 

		March 31, 2005			December 31, 2004
		(Dollars in Thousands)
Balance of impaired loans where there is a related allowance for loan loss		$	33,811		$	37,037
Balance of impaired loans where there is no related allowance for loan loss		—			—
Total impaired loans		$	33,811		$	37,037
Allowance allocated to impaired loans		$	15,192		$	15,666

 

11

 

The impaired loans included in the table above were primarily comprised of collateral dependent commercial loans, which have not been fully charged off.  The average recorded investment in impaired loans was $37,653,000 and $34,226,000 for March 31, 2005 and December 31, 2004, respectively.  The increase in impaired loans can be attributed to the Local Financial Corporation (“LFIN”) acquisition.  The interest recognized on impaired loans was not significant.

 

Management of the Company recognizes the risks associated with these impaired loans.  However, management’s decision to place loans in this category does not necessarily mean that losses will occur.

 

The bank subsidiaries charge off that portion of any loan which management considers to represent a loss as well as that portion of any other loan which is classified as a “loss” by bank examiners.  Commercial and industrial or real estate loans are generally considered by management to represent a loss, in whole or part, when an exposure beyond any collateral coverage is apparent and when no further collection of the loss portion is anticipated based on the borrower’s financial condition and general economic conditions in the borrower’s industry. Generally, unsecured consumer loans are charged-off when 90 days past due.

 

While management of the Company considers that it is generally able to identify borrowers with financial problems reasonably early and to monitor credit extended to such borrowers carefully, there is no precise method of predicting loan losses.  The determination that a loan is likely to be un-collectible and that it should be wholly or partially charged-off as a loss is an exercise of judgment.  Similarly, the determination of the adequacy of the allowance for possible loan losses can be made only on a subjective basis.  It is the judgment of the Company’s management that the allowance for possible loan losses at March 31, 2005 was adequate to absorb probable losses from loans in the portfolio at that date.

 

Note 6 – Other Borrowed Funds

 

Other borrowed funds include Federal Home Loan Bank borrowings, which are short or long term, variable or fixed borrowings issued by the Federal Home Loan Bank of Dallas at the market price offered at the time of funding.  These borrowings are secured by mortgage-backed investment securities and a portion of the Company’s loan portfolio.  At March 31, 2005, other borrowed funds totaled $1,810,196,000, an increase of 8.4% from $1,670,199,000 at December 31, 2004.  The increase in other borrowed funds can be attributed to the additional funding requirements of the Company.

 

Note 7 – Junior Subordinated Deferrable Interest Debentures

 

The Company has formed eight statutory business trusts under the laws of the State of Delaware, for the purpose of issuing trust preferred securities.  As part of the LFIN acquisition, the Company acquired three additional statutory business trusts previously formed by LFIN for the purpose of issuing trust preferred securities.  The eight statutory business trusts formed by the Company and the three business trusts acquired in the LFIN transaction (the “Trusts”) have each issued Capital and Common Securities and invested the proceeds thereof in an equivalent amount of junior subordinated debentures (the “Debentures”) issued by the Company or LFIN, as appropriate.  The Company has succeeded to the obligations of LFIN under the LFIN Debentures, which have an outstanding principal balance of $62,115,000.  The Debentures will mature on various dates; however the Debentures may be redeemed at specified prepayment prices, in whole or in part after the optional redemption dates specified in the respective indentures or in whole upon the occurrence of any one of certain legal, regulatory or tax events specified in respective indentures.  As of March 31, 2005, the principal amount of debentures outstanding totaled $235,651,000.

 

In March 2005, the Federal Reserve Board issued a final rule that would continue to allow the inclusion of trust preferred securities in Tier 1 capital, but with stricter quantitative limits.  Under the final rule, after a five-year transition period ending March 31, 2009, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier 1 capital elements, net of goodwill, less any associated deferred tax liability.  The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions.  Bank holding companies with significant international operations will be expected to limit trust preferred securities to 15% of Tier 1 capital elements, net of goodwill; however, they may include qualifying mandatory convertible preferred securities up to the 25% limit.  The Company believes that substantially all of the $235,651,000 will be included in Tier 1 capital after the five-year transition period ending March 31, 2009.

 

12

 

The following table illustrates key information about each of the Capital and Common Securities and their interest rate at March 31, 2005:

 

		Junior Subordinated Deferrable Interest Debentures			Repricing Frequency		Interest Rate		Interest Rate Index		Maturity Date		Optional Redemption Date
		(in thousands)
Trust I		$	10,190		Fixed		10.18	%	Fixed		June 2031		June 2011
Trust II		$	25,641		Semi-Annually		6.71	%	LIBOR + 3.75		July 2031		July 2006
Trust III		$	33,855		Semi-Annually		6.44	%	LIBOR + 3.75		December 2031		December 2006
Trust IV		$	22,445		Semi-Annually		6.00	%	LIBOR + 3.70		April 2032		April 2007
Trust V		$	20,349		Quarterly		6.31	%	LIBOR + 3.65		July 2032		July 2007
Trust VI		$	25,399		Quarterly		6.24	%	LIBOR + 3.45		November 2032		November 2007
Trust VII		$	10,310		Quarterly		5.99	%	LIBOR + 3.25		April 2033		April 2008
Trust VIII		$	25,347		Quarterly		5.71	%	LIBOR + 3.05		October 2033		October 2008
LFIN Trust I		$	41,495		Fixed		9.00	%	Fixed		September 2031		September 2006
LFIN Trust II		$	10,310		Semi-Annually		6.57	%	LIBOR + 3.625		July 2032		July 2007
LFIN Trust III		$	10,310		Quarterly		6.24	%	LIBOR + 3.45		November 2032		November 2007
		$	235,651

 

Note 8 – Common Stock and Cash Dividends

 

All per share data presented has been restated to reflect the stock splits effected through stock dividends, which became effective May 3, 2004 and were paid on May 28, 2004.  Cash dividends of $.40 per share were paid on April 29, 2005 to all holders of record on April 15, 2005. A stock dividend of 25% will be paid on May 31, 2005 to all holders of record on May 2, 2005.

 

The pro forma effect of the May 31, 2005 stock dividend is as follows:

 

		Three Months Ended March 31,
		2005			2004
Basic earnings per common share:
Weighted average number of shares outstanding:		63,603,714			60,542,373
Net income		$	.59		$	.44
Fully diluted earnings per common share:
Weighted average number of shares outstanding:		64,574,730			61,896,905
Net income		$	.58		$	.43

 

13

 

The Company expanded its formal stock repurchase program on December 16, 2004.  Under the expanded stock repurchase program, the Company is authorized to repurchase up to $175,000,000 of its common stock through December 2005.  Stock repurchases may be made from time to time, on the open market or through private transactions.  Shares repurchased in this program will be held in treasury for reissue for various corporate purposes, including employee stock option plans.  As of April 29, 2005, a total of 3,672,964 shares had been repurchased under this program at a cost of $145,978,000, which shares are now reflected as 7,262,843 shares of treasury stock as adjusted for stock dividends.  Stock repurchases are reviewed quarterly at the Company’s Board of Directors meetings and the Board of Directors has stated that the aggregate investment in treasury stock should not exceed $195,973,000.  In the past, the Board of Directors has increased previous caps on treasury stock once they were met, but there are no assurances that an increase of the $195,973,000 cap will occur in the future.  As of April 29, 2005, the Company has approximately $166,951,000 invested in treasury shares, which amount has been accumulated since the inception of the Company.

 

Note 9 - Commitments, Contingent Liabilities and Other Tax Matters

 

The Company is involved in various legal proceedings that are in various stages of litigation.  Some of these actions allege “lender liability” claims on a variety of theories and claim actual and punitive damages.  The Company has determined, based on discussions with its counsel that any material loss in such actions, individually or in the aggregate, is remote or the damages sought, even if fully recovered, would not be considered material to the consolidated financial position or results of operations of the Company.  However, many of these matters are in various stages of proceedings and further developments could cause management to revise its assessment of these matters.

 

The Company’s lead bank subsidiary has invested in partnerships, which have entered into several lease-financing transactions.  The lease-financing transactions in two of the partnerships have been examined by the Internal Revenue Service (“IRS”).  In both partnerships, the lead bank subsidiary was the owner of a ninety-nine percent (99%) limited partnership interest.  The IRS has issued separate Notice of Final Partnership Administrative Adjustments (“FPAA”) to the partnerships and on September 25, 2001, and January 10, 2003, the Company filed lawsuits contesting the adjustments asserted in the FPAAs.

 

Prior to filing the lawsuits the Company was required to deposit the estimated tax due of approximately $4,083,000 with respect to the first FPAA, and $7,710,606 with respect to the second FPAA, with the IRS pursuant to the Internal Revenue Code.  If it is determined that the amount of tax due, if any, related to the lease-financing transactions is less than the amount of the deposits, the remaining amount of the deposits would be returned to the Company.

 

In order to curtail the accrual of additional interest related to the disputed tax benefits and because interest rates were unfavorable, on March 7, 2003, the Company submitted to the IRS a total of $13,640,797, which constitutes the interest that would have accrued based on the adjustments proposed in the FPAAs related to both of the lease-financing transactions.  If it is determined that the amount of interest due, if any, related to the lease-financing transactions is less than the $13,640,797, the remaining amount of the prepaid interest will be refunded to the Company, plus interest thereon.

 

No reliable prediction can be made at this time as to the likely outcome of the lawsuits; however, if the lawsuits are decided adversely to the partnerships, all or a portion of the $12 million in tax benefits previously recognized by the Company in connection with the Partnerships’ lease-financing transactions would be in question and penalties and interest could be assessed by the IRS.  The Company has accrued approximately $12 million at March 31, 2005 in connection with the lawsuits.  Management intends to continue to evaluate the merits of each matter and make appropriate revisions to the accrued amount as deemed necessary.

 

As part of the LFIN acquisition, the Company acquired two tax matters. The first relates to deductions taken on amended returns filed by LFIN during 2003 for the tax years ended June 30, 1999 through December 31, 2001. The refunds requested on the amended returns amounted to approximately $7,000,000. At December 31, 2003, LFIN had received approximately $2,000,000 of the total refund requested. Because all the refunds are under review by the IRS, LFIN had established a reserve equal to the $2,000,000 received and did not recognize any benefit for the remaining $5,000,000. The second tax contingency, which is also approximately $7,000,000, relates to permanent differences applicable to prior periods taken as deductions in 2002 and was received by LFIN during 2003. LFIN had recorded a reserve equal to the amounts received pending final resolution with the IRS. Both reserves are included in the current income taxes payable of the Company.  The Company will continue to monitor the IRS reviews.

 

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Note 10 – Capital Ratios

 

The Company had a leverage ratio of 6.80% and 6.91%, risk-weighted Tier 1 capital ratio of 11.34% and 10.74% and risk-weighted total capital ratio of 12.60% and 11.99% at March 31, 2005 and December 31, 2004, respectively.  The identified intangibles and goodwill of $332,364,000 as of March 31, 2005, recorded in connection with the acquisitions made by the Company, are deducted from the sum of core capital elements when determining the capital ratios of the Company.  The Company actively monitors the regulatory capital ratios to ensure that the Company’s bank subsidiaries are well capitalized under the regulatory framework.

 

In March 2005, the Federal Reserve Board issued a final rule that would continue to allow the inclusion of trust preferred securities in Tier 1 capital, but with stricter quantitative limits.  Under the final rule, after a five-year transition period ending March 31, 2009, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier 1 capital elements, net of goodwill, less any associated deferred tax liability.  The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions.  Bank holding companies with significant international operations will be expected to limit trust preferred securities to 15% of Tier 1 capital elements, net of goodwill; however, they may include qualifying mandatory convertible preferred securities up to the 25% limit.

 

Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Special Cautionary Notice Regarding Forward Looking Information

 

Certain matters discussed in this report, excluding historical information, include forward-looking statements, within the meaning of Section 27A of the Securities Exchange Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the safe harbor created by these sections.  Although the Company believes such forward-looking statements are based on reasonable assumptions, no assurance can be given that every objective will be reached.  The words “estimate,” “expect,” “intend,” “believe” and “project,” as well as other words or expressions of a similar meaning are intended to identify forward-looking statements.  Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this report.  Such statements are based on current expectations, are inherently uncertain, are subject to risks and should be viewed with caution.  Actual results and experience may differ materially from the forward-looking statements as a result of many factors.

 

Factors that could cause actual results to differ materially from any results that are projected, forecasted, estimated or budgeted by the Company in forward-looking statements include, among others, the following possibilities:

•                  Changes in interest rates and market prices, which could reduce the Company’s net interest margins, asset valuations and expense expectations.

•                  Changes in the capital markets utilized by the Company and its subsidiaries, including changes in the interest rate environment that may reduce margins.

•                  Changes in state and/or federal laws and regulations to which the Company and its subsidiaries, as well as their customers, competitors and potential competitors, are subject, including, without limitation, changes in the accounting, tax and regulatory treatment of trust preferred securities, as well as changes in banking, tax, securities, insurance and employment laws and regulations.

•                  Changes in U.S. – Mexico trade, including, without limitation, reductions in border crossings and commerce resulting from the Homeland Security Programs called “US-VISIT,” which is derived from Section 110 of the Illegal Immigration Reform and Immigrant Responsibility Act of 1996.

•                  The loss of senior management or operating personnel.

•                  Increased competition from both within and outside the banking industry.

•                  Changes in local, national and international economic business conditions that adversely affect the Company’s customers and their ability to transact profitable business with the Company, including the ability of its borrowers to repay their loans according to their terms or a change in the value of the related collateral.

•                  The timing, impact and other uncertainties of the Company’s potential future acquisitions including the Company’s ability to identify suitable potential future acquisition candidates, the success or failure in the integration of their operations and the Company’s ability to maintain its current branch network and to enter new markets successfully and capitalize on growth opportunities.

•                  Changes in the Company’s ability to pay dividends on its Common Stock.

•                  The effects of the litigation and proceedings pending with the Internal Revenue Service regarding the Company’s lease financing transactions.

 

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•                  Additions to the Company’s loan loss allowance as a result of changes in local, national or international conditions which adversely affect the Company’s customers.

•                  Political instability.

•                  Technological changes.

•                  Acts of war or terrorism.

•                  The effect of changes in accounting policies and practices as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standards setters.

 

It is not possible to foresee or identify all such factors.  The Company makes no commitment to update any forward-looking statement, or to disclose any facts, events or circumstances after the date hereof that may affect the accuracy of any forward-looking statement, unless required by law.

 

Overview

 

The Company, which is headquartered in Laredo, Texas, with more than 180 facilities and more than 290 ATMs, provides banking services for commercial, consumer and international customers of South, Central and Southeast Texas and the State of Oklahoma.  The Company is the one of the largest independent commercial bank holding companys headquartered in Texas.  The Company, through its bank subsidiaries, is in the business of gathering funds from various sources and investing those funds in order to earn a return.  The Company either directly or through a bank subsidiary owns two insurance agencies, a broker/dealer and a majority interest in an investment banking unit that owns a broker/dealer.  The Company’s primary earnings come from the spread between the interest earned on interest-bearing assets and the interest paid on interest-bearing liabilities.  In addition, the Company generates income from fees on products offered to commercial, consumer and international customers.

 

The Company is very active in facilitating trade along the United States border with Mexico.  The Company does a significant amount of business with customers domiciled in Mexico.  Deposits from persons and entities domiciled in Mexico comprise a significant and stable portion of the deposit base of the Company’s bank subsidiaries.  The Company also serves the growing Hispanic population through the Company’s facilities located throughout South, Central and Southeast Texas and the State of Oklahoma.

 

Expense control is an essential element in the Company’s long-term profitability.  As a result, one of the key ratios the Company monitors is the efficiency ratio, which is a measure of non-interest expense to net-interest income plus non-interest income.  The Company’s efficiency ratio has been under 53% for each of the last five years, which the Company believes is better than average compared to its national peer group.  One of the benefits derived from such operating efficiencies is that the Company is not subject to undue pressure to generate interest income from high-risk loans.

 

Results of Operations

 

Summary

 

Consolidated Statements of Condition Information

 

		March 31, 2005			December 31, 2004			Percent Increase (Decrease)
		(Dollars in Thousands)
Assets		$	10,277,394		$	9,917,951		3.6	%
Net loans		4,877,490			4,804,069			1.5
Deposits		6,598,610			6,571,104			.4
Other borrowed funds		1,810,196			1,670,199			8.4
Junior subordinated deferrable interest debentures		235,651			235,395			.1
Shareholders’ equity		759,958			753,090			.9

 

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		Quarter Ended March 31, 2005			Quarter Ended March 31, 2004			Percent Increase (Decrease)
		(in Thousands)
Interest income		$	118,319		$	70,970		66.7	%
Interest expense		41,206			20,719			98.9
Net interest income		77,113			50,251			53.5
Provision for possible loan losses		2,610			1,342			94.5
Non-interest income		42,423			28,313			49.8
Non-interest expense		60,024			37,688			59.3
Net income		37,660			26,519			42.0
Per common share:
Basic		$	.74		$	.55		34.5	%
Diluted		.73			.54			35.2
Efficiency Ratio		50.2		%	48.0		%	4.6	%

 

Net Income

 

Net income increased by 42.0% for the first quarter of 2005 from the same period in 2004.  Net income was positively impacted by the acquisition of Local Financial Corporation (“LFIN”) in June 2004 and was positively impacted by a $4,786,000 distribution, net of tax, from the January 2005 merger of the PULSE EFT Association with Discover Financial Services, a business unit of Morgan Stanley.  Members of the PULSE EFT Association received these distributions based in part upon their volume of transactions through the PULSE network.

 

Net Interest Income

 

		Quarter Ended March 31, 2005			Quarter Ended March 31, 2004			Percent Increase (Decrease)
		(in Thousands)
Interest income:
Loans, including fees		$	79,825		$	43,426		83.8	%
Federal funds sold		567			469			20.9
Investment securities:
Taxable		36,513			25,623			42.5
Tax-exempt		1,217			1,284			(5.2	)
Other interest income		197			168			17.3
Total interest income		118,319			70,970			66.7
Interest expense:
Savings deposits		5,474			2,217			146.9
Time deposits		14,480			9,051			60.0
Securities sold under repurchase agreements		5,448			4,757			14.5
Other borrowings		11,604			2,207			425.8
Junior subordinated interest deferrable debentures		4,200			2,487			68.9
Total interest expense		41,206			20,719			98.9
Net interest income		$	77,113		$	50,251		53.5	%

 

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