Prosperity Bancshares Inc (PB) 2004 Q2 法說會逐字稿

Good day. (OPERATOR INSTRUCTIONS). And at this time, I would like to introduce your moderator, Mr. Dan Rollins. Please go ahead.

Thank you. Good morning, ladies and gentlemen. Welcome to Prosperity Bancshares' second-quarter 2004 earnings conference call. This call is also being broadcast live over the Internet at www.ProsperityBankTX.com, and will be available for reply at the same location for the next few weeks.

I'm Dan Rollins, Senior Vice President of Prosperity Bancshares, and here with me today is David Zalman, President and Chief Executive Officer, Tim Timanus, Executive Vice President and Chief Operating Officer, and David Hollaway, our Chief Financial Officer. This morning, David Zalman will lead off with a review of our financial results for the second quarter of 2004. He will be followed by David Hollaway, who will spend a few minutes reviewing some of our financial statistics. Tim Timanus will discuss our lending activity, including asset quality and I will provide an update on our recently announced acquisitions. Finally, we will open the call up for questions. During the call, interested parties may participate live by following the instructions that will be provided by our call moderator, Sara, or you may e-mail questions to InvestorRelations@ProsperityBankTX.com.

I assume you have all received a copy of the earnings announcement we released early this morning. If not, please call Kara Smart (ph) at 713-693-9308 and she will fax a copy to you.

Before we begin, let me make the usual disclaimers. Certain of the matters discussed in this presentation may constitute forward-looking statements for the purposes of the federal securities laws, and as such, may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of Prosperity Bancshares to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Additional information concerning factors that could cause actual results to be materially different from those in the forward-looking statements can be found in Prosperity Bancshares' filings with the Securities and Exchange Commission, including Forms 10-Q and 10-K. All forward-looking statements are expressly qualified in their entirety by these cautionary statements. Now let me turn our call over to David.

Thank you, Dan. We would like to welcome and thank everyone for participating in our second-quarter conference call. As we started putting together the information for this quarter's conference call, we look back on previous quarters, records and realize how successful our Company has been and felt we may have taken our past successes for granted. We recognize that we have been able to share very positive news with you, such as our ten-year average compounded annual growth rate and earnings per share in excess of 15 percent. We have always been able to meet or exceed analysts' earnings per share expectations since we became a public company in 1998. We have never had to make excuses about why we did not perform. We continue to believe that performance counts. We are proud of statistics like a 21.2 percent compounded annual average growth rate and earnings per share for the last five years. Our Company continues to perform and this quarter was no different.

We saw a 28.7 percent increase in second-quarter 2004 earnings, $8,362,000 compared to $6,497,000 in the same period last year. There was a 14.7 percent increase in diluted earnings per share, 39 cents in the second quarter of 2004 compared to 34 cents per diluted share for the same period last year. Our return on average common shareholders' equity for the three months ended June 30, 2004 was 14.63 percent. We are very proud of our performance and believe that our model will allow us to continue our historic success and earnings per share growth. Indeed, we believe our future is bright and our shareholders will continue to be rewarded.

Our performance could not be accomplished without the hard work and dedication of our directors, our officers and associates and to them we are grateful. We are very honored and proud to be recognized this quarter by Keefe, Bruyette & Woods, Inc. as a member of their 2004 Honor Roll for consistent earnings per share growth over the last ten years. Our team will strive hard to continue this honor going forward.

We are very pleased to announce that our bank achieved second-quarter 2004 annualized loan growth of 10.8 percent. We understand that in the past because of our M&A activity and the need to outsource some of the credits acquired in acquisition, it has been difficult for analysts to determine if the bank had internal loan growth. Going forward, we will continue to focus on increasing internal loan growth. This month alone, we hired four new lenders from competing banks in Houston. I should note, however, it could still be difficult for analysts to calculate our internal loan growth rate in periods where we have acquired (ph) institutions for the same reasons as stated above.

We are very pleased that we were able to sign definitive agreements with two banks in the Austin, Texas area -- Liberty Bank, with total assets of $178 million and Village Bank & Trust with assets of 111 million as of June 30, 2004. Both of these transactions are expected to be closed within 60 days. We are very proud and excited to have these banks joining us and welcome them aboard. Eddie Safady, who currently serves as president and CEO of Liberty Bank, will become chairman of the Austin area for Prosperity Bank. His knowledge of the community and civic awareness is apparent from all the organizations he is a member of and supporter of. This dedication to the growth and well-being of the Austin community has been invaluable to the growth of Liberty Bank and will continue to be invaluable to the growth of Prosperity. Chip Bray will become president of the Congress banking center. Michael Meyer, who is currently president of Village Bank, will become president of the Lakeway banking center. Other senior officers include Gary Green, Senior Vice President, Congress; Grover (ph) Jones, Senior Vice President, Congress; Dave Toggenbaugh (ph), Mike Reeves, Senior Vice President of Congress; Laurie Wakefield, Senior Vice President Lakeway; Denny Buchanan, Senior Vice President, Lakeway; Joe Gosland, Senior Vice President, Lakeway; Brent Weber (ph), Vice President banking center manager at Allendale; Charles Pierce, Vice President banking center manager at Oak Hill; and Kevin Rodriguez, Vice President, banking center manager at Riverside. There are many more outstanding individuals joining our team, and we welcome them all.

We remain confident that our commitment to relationship banking with true customer service will continue to pay dividends, with our 3-point mission statement of, greet the customer with a smile, address the customer by name and try to say yes instead of no, we will continue to create long-term customer relationships and value for our shareholders.

Before turning over the program to David Hollaway, I would like to discuss our bond portfolio briefly because of the size and the current rising interest rate environment we are now in. Our portfolio, as of June 30th, has an effective duration of 3.29 years; 14 percent of the portfolio is classified as available for sale and 86 percent is classified as held to maturity. As most of you know, both securities classified as available for sale must be marked-to-market, thus affecting our capital account, but not the income statement. Our investments classified in available for sale as of June 30th had an unrealized after-tax loss of $2,914,000. Our model indicates that if interest rates increased 300 basis points immediately or tomorrow, the unrealized after-tax loss would increase to $9.7 million, causing our tangible equity to decline to approximately 4.2 percent from the current level of 4.5 percent. However, the tangible equity ratio would improve over the following 12 months to approximately 5.4 percent with all other things being equal due to accumulated earnings and an improvement in the after-tax loss provision of the available-for-sale portfolio to $8 million. It should be noted, however, that as we have had unrealized gains in the held-to-maturity-portfolio when rates decline, we will have losses as rates rise until the portfolio re-prices. These unrealized losses will not affect the capital account or the income statement. Our model reports that our income will increase next year if rates rise as much as 200 basis points.

Thanks, again, for your support of our company. Let me turn over our discussion to David Hollaway, our CFO, to discuss some of the specific financial results we achieved. David?

Thank you, David. As David Zalman has mentioned, diluted earnings per share for the second quarter was 39 cents, an increase of 14.7 percent over the same period last year and net income did increase 28.7 percent this quarter compared to second quarter of '03. Other second-quarter comparisons of '04 to '03 saw net interest income increase 24 percent to 19.4 million, non-interest income increase 36 percent to 5.5 million; operating expenses were up 22 percent. But I would note that if you're looking at the expenses second quarter to first quarter, they were actually down 3.1 percent. Return on average assets was 1.37 percent for the quarter, up from 1.33 percent in the first quarter, '04. Return on average equity was 14.63 percent for the quarter, up from 14.44 percent for the first quarter, '04. Loans were 791 million, up 13.1 percent year-over-year and up 2.7 percent from the first quarter, which as David mentioned, is on an annualized basis, 10.8 percent. Average deposits were up 24.7 percent, second quarter '04 to second quarter '03, with the average non-interest bearing deposits up 31.6 percent.

The tax equivalent net interest margin was 3.55 percent for the second quarter compared to 3.63 percent in the first quarter; and the main reason for the change was due to a 9 basis point drop in the yield on assets. The efficiency ratio was 48.7 percent for the quarter, down from 50.6 percent in the first quarter.

As a follow-up to David's comments on rising rates and the impact on the security portfolio, equity and the tangible capital ratio, we do look at different rate scenarios, and our asset liability model using June numbers shows that if there was a 300 basis point increase in rates immediately, the impact of the AFS portion of the bond portfolio on equity would be a net after-tax unrealized loss of $9.7 million versus the 2.9 million we had at 6/30/04. However, if we take a more moderate look at rate increases, our model using June numbers show that if rates go up 200 basis points over the next 12 months, the net after-tax unrealized loss impact on equity would be about 6 million, which is about a $3 million increase from our current 2.9 million number.

Looking forward, if we take the worst-case scenario of an immediate increase in rates of 300 basis points and then factor in the impact of the two announced acquisitions closing in the third quarter, one of which is a spot cash deal and the other one is an all-cash deal, and add in our earnings stream for the rest of the year, our tangible rate -- our tangible capital ratio, which is currently a 4.48 percent, projects out to about 4.25 percent by year-end. And I'd note that this is higher than the 4.16 percent tangible capital ratio we had at 12/31/03.

And with that, I'd like to turn over the presentation to Tim Timanus for some detail on asset quality.

Thank you, David. Non-performing assets at quarter-end June 30, '04 totaled $1,609,000 or 0.20 percent of loans, repossessions and other real estate compared to $610,000 or 0.08 percent at March 31st, '04 and $2,242,000 or 0.29 percent a year ago at June 30th, '03. This represents an increase in non-performing assets from the end of the first quarter, 2004 and a 28 percent decrease from a year ago. The June 30th, '04 non-performing asset total was comprised of $1,561,000 in loans and $48,000 in other real estate. Net charge-offs for the three months ended June 30th, 2004 were $209,000 compared to $5,000 for the three months ended March 31st, '04 and $754,000 for the quarter ended June 30th, '03.

With regard to the generation of new loans, the average monthly production for the quarter ended June 30th, '04 was $36,711,000 compared to $26,914,000 for the first quarter ended March 31st, '04 for a 36 percent increase and compared to $25,665,000 for the quarter ended June 30th, '03, for a 43 percent increase. As has been mentioned, this month, we had added a team of commercial lenders to our staff. We hope that these additions, as well as other measures, will result in continued increases in loan production. I will now turn it over to Dan Rollins, who will give us a status report on our acquisitions and (inaudible) and provide more information on our lending staff additions and other efforts to improve the volume of new loans (ph).

I'm very pleased to report that we are on track to complete our two recently announced acquisitions in Austin within the next few months. Our new partners at Liberty Bank and Village Bank & Trust all share our desire to provide a level of banking service that is not often found in today's society. I would expect that prior to the end of the third quarter, we will have completed the re-branding and the computer conversions necessary to expand our presence across the great state of Texas. One year ago, our bank was predominantly a South Texas bank with 46 banking centers and over 56 percent of our deposit base in the Houston CMSA. Within the next few months, we will have 58 full-service banking centers spread across Texas with significant operations in the Dallas area and in Austin.

On the internal loan growth situation, as you have heard, we reported annualized loan growth of 10.8 percent for the quarter. As we have been expecting for some time, as rates began to stabilize and move upward, our loan machine began to get some traction. We saw good loan growth in the commercial real estate portfolio and in our ag portfolio for the quarter. The new lenders that David and Tim were talking about earlier are primarily commercial real estate lenders and commercial lenders, so we would expect this to continue. Our pipeline at quarter-end remains very strong and our team remains focused on producing results. At this time, I think we are ready to take some questions.

(OPERATOR INSTRUCTIONS). Jed Gore (ph), Sinova (ph) Capital.

I was just wondering if you wouldn't mind, going over the assumptions which gets you to a 4.25 percent tangible equity ratio by the end of the year?

Yes, it's taking -- the variables that go into that are threefold -- one, the re-pricing in our AFS, taking worst-case scenario of $9.8 million, up from the 3 million at 6/30, and then factoring in our earnings stream, our projected earnings stream for the remaining six months, and then overlaying that, we have two acquisitions that will actually close in the third quarter; one that's spot cash, will not have much impact on the tangible ratio; but the pure cash one, the village transaction, there's a premium of about 9 to $10 million; that would have a negative impact on that tangible ratio. If you put all that together and you run your model out, you should be in that neighborhood of 4.25.

That includes Liberty Village?

Absolutely.

Okay. Yes, great. And that's actually my only question. Thank you very much for addressing that up front.

Joe Stieven, Stifel Nicolaus.

First of all, good quarter. Can we talk a little bit about the net interest margin on a go-forward basis, and a little bit about both the deposit and loan pricing. Here is my question, when I look at your first-quarter margin and then to your second-quarter margin, it looked like your deposit rates already started going up in the second quarter prior to prime moving. And obviously prime just moved at the end of the quarter. And, can you give us a little color, let's just make the assumption Fed does not do anything. Let's just take this first 25 bips through the income statement. Can you talk about what you think you're going to have to do from a competitive perspective on deposit pricing? And then we could sort of figure out what we think is going to transfer through on the income side.

On the deposit pricing side, I think everybody kind of wants to jump in here, Joe; and I appreciate your question. This is Dan. On the deposit pricing side, you can see from quarter-end to quarter-end, from an interest-bearing deposit balance, we actually shrunk a little bit. We have not felt the desire or the need to chase high-priced money, so you're saying that our rates are up a little bit and I guess I'm flipping through pages to catch up with where your number is.

I was looking at the yields on interest-bearing demand deposits.

Dan, I can probably add a little bit of light. I actually, or we, raised rates probably in this last month, thinking that interest rates were going to go up and to get a little bit maybe of a competitive edge. We actually raised rates, like money market accounts and CD's and things like that, and I think that's what you're seeing right there. As far as the net interest margin, Dave, you have kind of a light, you can shed some light on that, what you think it is going forward.

A couple points there, staying on the liability side first, I think absolutely right what David is saying is just that we have been trying to stay a little more aggressive on the deposit side from (inaudible) perspective.

Yes, and only because we do think interest rates are going to continue to go up instead of lagging behind. We kind of jumped out there, really.

A little ahead of the curve. And then as you are looking then when you jump over onto the income side, there was a little lag there because we lost about 9 basis points and that was just coming through the quarter. Obviously, a big bulk of it is in the security portfolio and reinvesting that thing at current rates and keeping it short versus what continues to pay off, there was a lot. I think on average, some of the cash flow coming in was probably 5.5 percent, somewhere in there. David, I don't know, just off the top of your head, reinvesting, we weren't reinvesting at 5.5?

No. Well, you're reinvesting probably at about a 4 percent rate, basically. Does that help?

No, that does. I'm just trying to figure out the benefit with the 25 bips how much we are going to see in the income statement.

Let me carry that thought forward also. We continue -- we didn't probably say this -- but we still continue to be just slightly asset gapped, really neutrally gapped. But in direct answer to your question, what happens going forward when we're looking out on the margin, how does that impact our earnings? And the (indiscernible) is, if rates stay where they are at, our margin will move a little bit.

That's what I was thinking. That's what I was sort of trying to imply; it's got to help a little bit in here.

Hopefully we did not imply that it was going to jump up significantly, because that would not be true. But yes, if rates will kind of stay where they are at today, that is good for us. We would not mind that.

Michael Pruner, SunTrust Robinson.

This is Jennifer Demba. Good morning. A question on the hiring efforts. You mentioned you hired four lenders from another institution recently. Do you have plans to hire more commercial lenders? And I think the last time we met, we discussed you guys kind of looking hard at your under-producing lenders and generating more production there. Can you kind of give us some color?

Sure. It's really two questions. The focus for the entire team has been consistent throughout. We have built in some production requirements or some production quotas, if you want to look at it from that; we are watching those numbers; we are talking about those. And I think that the team is welcoming that and is a part of that. On the new lender front, we have talked to many lenders over the past few months and we did bring in four new lenders here just recently. In fact, I think the fourth one is starting today or tomorrow. And we would continue to look for good lenders going forward. I think it is a matter of, you know, and if we are not going to hire 15 or 20 or 30 new people all at one time, we are going to be able to do it in an orderly fashion so that we can digest and get them acclimated and make sure that we can support their needs as we are growing. But I think absolutely, we think we can continue to lay lenders on across the system.

I would add, Jennifer, that we're really focused on this area, and I would even be stronger in saying that our underperforming lenders really have taken notice for the most part, some have not kicked in; but we have Tim Timanus has been doing a really good job talking with them and letting them know that they have to perform; if they don't, something has to be done. And we have seen, in several cases, significant changes in the performance of those under-performing lenders.

And the other question asked if hiring more lenders -- yes, we're going to continue to hire more lenders. We've hired more in the Houston area, and I think our next focus will continue to hire here, but also to focus on hiring in the Dallas market, new lenders. Probably in Austin right now, it will take us some time just to go through the stabilization period to see where we are at. They looked pretty well adequately staffed over there.

Great. Thank you very much.

Campbell Chaney, Sanders Morris Harris.

I have a couple questions. The first one on the loan portfolio, can you give us a breakdown in the major categories of your loan portfolio at June 30th? And then the second question relates back to the margin and the 9 basis point decrease in the yields. Can you give us some color on that? And then maybe more specifically, were there any prepayments of your securities that forced acceleration of the amortization of premiums, to cause some of that decline?

Your second question first, the question answer is yes to that, there was some impact when rates dipped, I think in the middle of the quarter. It did accelerate some of the premium amortization on the bond portfolio.

Can you give us kind of a basis point ballpark on that?

If you're comparing it to the first quarter because in my opinion, I don't know if it's 9 basis points, but I will put it in dollars for you.

That's fine.

It was probably, if you're comparing second quarter to the first quarter, a couple hundred thousand dollars at best, 200, 250. So in my opinion, not too significant, really.

Okay, not much. Then the loan portfolio, among the major categories, C&I, commercial real estate, residential?

I have those numbers for you, looking at a quarter-over-quarter number, March to June, on the commercial mortgage situation, we are up a percent almost. somewhere in the 34 percent range of the portfolio. One to 4 has stayed flat, a little over 30 percent. C&I is in the 12 percent range. We were sitting right on top -- almost 13 last time, so a little bit from a percentage standpoint. Construction is up almost a percent to 5. Where we are shrinking is on the consumer side, the consumer portfolio has continued to fall and the multi-family portfolio has dropped to under 2 percent of the portfolio. Ag is up to 4 percent. The big drivers in the portfolio are the commercial real estate, construction and 1 to 4's were flat.

And I think, Dan, you mentioned the commercial real estate and ag, you got traction in the second quarter, internally?

That's right. Looking at the commercial mortgages, commercial mortgages were up 14 million, give or take, it looks like. Ag was up -- printing was too small on here -- ag was up 5 or 6 million for the quarter. Construction was up for 5 million for the quarter.

Do you think that going forward that the commercial real estate with the new hires in Houston, is that going to be where most of the attraction is going to be going forward on an internal basis?

If you look at what's coming through our loan committee, and Tim may want to jump in on this, but if you look at what's coming through our loan committee, it's primarily commercial real estate, some construction and some regular commercial type credits is the biggest items that are coming through. So not only are the new lenders focused on that, that's really what our entire team of lenders in the major metropolitan markets that we cover have been working towards.

So the answer to that is yes.

Kevin Reynolds, Morgan Keegan.

A couple of questions for you and I think this follows up on Joe's question from earlier. You raised rates ahead of the Fed in order to give you a competitive advantage. And I looked sequentially and interest-bearing deposits were actually down on a period-end basis. Are there some other factors that would affect the period-end balances on your interest-bearing deposits?

Second I guess part A or part B of that question, have you seen any or do you anticipate any competitive or increased intensity and competitive pressure on the deposit side now that you get say a Wachovia buying a SouthTrust expressly for the Texas footprint? That is question number one.

Let me jump in ahead of Dan on this; this is Dave Hollaway. On the non-interest bearing, just a quick point on that, when you are looking at period-end -- just sequential quarter, when you are looking at period-end to period-end, deposits move in and out on a daily basis, so sometimes it distorts what you look at. That's kind of why I hope that -- I mentioned the averages because that's important too. You're looking at 443 million average in the second quarter in non-interest money and 429 million in the first quarter. So on an average basis, it was actually up. Does that --?

That's fine.

Does that answer your question or does that make it muddier?

That actually helps out on the actual volumes. But could you speak about the potential for competitive pressure?

I would. (multiple speakers) I think from a competitive standpoint, I don't think that anybody is really jumping out there, you know at least some of the larger people paying extremely large rates or bigger rates than anybody else. I understand that one of our competitors had just bought out one of the bigger S&L's here in town, might be raising rates a little bit. But for the most part, I don't think that our competitors are raising rates that much. I think what we have seen -- and it's not only in our bank, and I think David Hollaway has mentioned this probably two years ago -- we had such increases in deposits that came into the banks because of the stock market and other factors being out there, I think you're starting to see some of that -- people taking some of that money back out -- and deploying it back into the stock market and things like that. Again, we will get a better feel for that when we look at some of the other banks' numbers also.

Does that answer your question, Kevin?

I think it does. And I guess question number two, even though I know it doesn't have an impact expressly on book value, could you tell us what the unrealized gain or loss is on the held to maturity portfolio and then maybe give me the number for last quarter, so I don't have to wait a few weeks for the Q?

I think the after-tax loss on the HTM is probably around -- again I don't have it right here, but I'm going to think around 15 million probably, Dave, after-tax.

He is shaking his head, you cannot see that!

I'm trying to think of what it was last quarter.

I don't know if I know what it was last quarter. I would say it was probably positive. You know, what we've seen is, we have only seen a quarter of a basis point's rise in the short-term rates in the Fed funds. But really if you go back and look, the part of the yield curve that we buy in, which is that 3 to 5-year yield curve, the five-year treasury has gone from 2.22 percent just two months ago or so; it got as high as 390. I think today it has kind of fallen back into the 360 range. And so, you know, you have seen about 150 basis points change already in the part of the yield curve where we're buying, not necessarily in the front part of the yield curve. And the tenure has gone up substantially like that also. So I think there has been a big shift from the two numbers that you're seeing, really where you have probably a pretty big gain to somewhat of an after-tax loss.

I think it's important to also talk about the way you manage that portfolio, David. We are not traders in the bond portfolio.

That's right. Dan is just mentioning that -- we really don't buy and trade. We really try to -- we buy and hold till the maturity. We really are not buyers and sellers. We structure the portfolio where there is about a $300 million a year rolloff in the actual principal, and we use that for liquidity purposes. But we are really not traders in the portfolio. In fact, we have never been able to call interest rates right. If I told you today where interest rates were going, you would probably do better going the other way and you'd win because we've never been right, so we just try to be consistent, (inaudible) three-year duration players, basically.

Does that answer your question, Kevin? I think they're still digging from the last quarter number.

We don't have the last quarter in front of us. We'll see if we can get that before we --

I can tell you. I've got -- if you'll give me just a minute, I've got this -- (inaudible) -- this is quota (indiscernible).

We will get it. We can get that number to you.

That's fine. In the analysis, you guys -- or the commentary, you guys were going through --

That's $15 million, basically, as an unrealized loss in the HTM portfolio.

That's for this third quarter. He also wanted last quarter.

I think you probably have a gain last quarter.

That's fine, I can go find that. When you were talking about margin mechanics and you said sort of, the unrealistic scenario of up 300 tomorrow --

Right.

-- versus a gradual rise, what happens -- let me ask this question, does that assume that when you run those through any sort of parallel shift, or are you talking about just the short end rising and long end staying where it is, so you're really getting a flattening, potentially significant flattening in the yield curve?

Probably it's not a direct parallel shift. What we do is without being real technical, we use some regression analysis, and we take the last 25 or 30 years and we plot it out and say, okay, if the short-term went up 100 basis points, how much does this 3 to 5 year go? So it may only be going up 70 or 80 basis points and not necessarily, because it's never been a strictly parallel shift and I don't think that you can use that. So our model does take into consideration the last 25 years and the spreads in the shifts.

Using kind of beta factors.

Yes, that's right.

Charlie Ernst, Sandler O'Neill.

A couple quick questions for you. It looked to me like the effective tax rate was up a little bit in the quarter. If my model is right, could you explain why that is and kind of what our expectations should be going forward?

How much did it move up when you're looking at it?

I've got it at 33.7 percent and I think it was about 33 percent last quarter and even lower than that in prior quarters.

And I think that's right. And that's just a direct reflection of just the increase in earnings. Not the effective rate but our run rate is about 35 percent, but to get that effective rate at 33 percent is a reflection of tax-free loans we have on the books, municipals; we've got a cusai (ph) bond, all these things that affect the tax rate. And it's just a factor of growing. More earnings that are not tax-free are -- (multiple speakers.)

Because the incremental rate is 35.

But (indiscernible) when you calculate out, I think it is 33.5, roughly.

I've got your fully taxable equivalent at like 35.7, which was flat with last quarter. But the effective tax rate seemed like it went up a little bit in the quarter.

Again, yes, I think that is true.

I am like you, Dave, I think that is directly related to increased earnings and more of the earnings that are taxable compared to nontaxable, that we just haven't put on as many nontaxable assets, basically.

Also, could you mention how much of your loans are variable today?

I don't have that number in front of me. But to answer your question, I think when you look at our portfolio as a whole, that's not significantly moved from quarter-to-quarter. So when you look at the different categories of loans that we are in, what's coming through the pipeline today, loans are being booked at a variable rate. The C&I portfolio is going to be variable rate; the commercial mortgages that we are putting on the books, while they may have a rate that's locked in on the front end of the loan for one or two or three years or so, it has a variable feature on the back end of it. The home mortgages that we are doing, the construction loans we're doing, they are variable. I don't have a number to quote to you, though, as to what percent is floating to prime today.

Do you have any guess on what that number might be, Dan?

I would hesitate to put a guess on that because I just have not seen that number, Charlie.

We can get it for you. That is a number we can get for you.

Bain Slack, KBW.

I just want to know a couple things. One, what is the current cash flow coming off this (indiscernible) portfolio, I guess either on a monthly or quarterly basis? And then also, the second thing is if you can provide a little color on just the $1 million increase in the non-performing assets? And then third, on the non-interest -- both the income and expense side, I just want to know if there's any I guess nonrecurring items in there that we need to be paying attention to or (indiscernible) rights for both of those?

I will address the first one. The cash flow, on an annualized basis, I have that in front of me, is one year, it's just about $300 million a year, on the annual cash flow for the securities. Regarding the non-performing assets, on the very last day of the month, we put -- Tim, did you want to address that?

It's about $900,000.

I think I can answer that. As we said earlier, in the non-performing total at quarter end, was $1,561,000 in loans and roughly 1.5 million, in other words, almost all of that total, is made up of three different relationships, two that are in our Dallas banks, one here in Houston. They are all residential real estate property-secured. If they go into foreclosure and they certainly could, we would not anticipate a significant loss, really, on any of them, based on the book values now. Does that answer for you, Bain?

Staying with what David was going to say, Dave, was I think, you know, 900,000 of that is one relationship give or take, just got distressed here late in the quarter and we added it on the non-accrual.

I would say this, that that relationship was analyzed when we purchased the bank. And again, all of the loans that are non-performing are from banks that we acquired.

All acquired loans, that's right.

So it's nothing that we were not aware of. And again, it may or may not -- just to be careful, we make sure we put it on non-performing. But I'm like Tim, I don't think there's going to be much if any loss in it if we do have to foreclose.

Does that answer your question?

So it sounds like it's still performing, it's just stressed?

When we put it on non-accrual, it's got some sort of sickness.

Okay.

And yes, the non-interest income, non-interest expense, those are good numbers to use.

Okay. And with the expenses, specifically, are those cost saves pretty much all in from the two fourth-quarter deals, the MainBancorp and the First State --?

Yes.

Okay great.

Dan and I disagree a little bit.

David's trying to figure out which deal you're talking about. The answer is, I think that if there are some more cost saves, they are going to be insignificant and not noticeable going forward. I think we have worked hard to try and get all of the Dallas stuff and the team up there is doing a great job. That allows us now to focus on the two newest deals we have got moving into Austin.

Great, thanks.

Nick Adams, Wellington Management.

A quick question, again, on the capital ratio. If you take into account the change in held-to-maturity and again I know that isn't normally factored in, but if you do, you get your tangible common down to about 3.5. And we've noticed of late that the regulators seem to be leaning towards looking at and including held-to-maturity in the way they look at how well a company is capitalized. Again, are we getting close to the edge of what will be considered capital adequacy in your mind? I mean 3.5 is -- for a premium community regional bank like yourselves, seems awful levered relative to your peers.

I think you are miscalculating somewhere, because I think -- we are at a tangible equity ratio right now, of about 4.5 percent. And if even with (technical difficulty) any other banks (technical difficulty) and had (technical difficulty) points increase in interest rates, we are still going to be at 4.2 percent at year-end. So I don't know really where you are getting your number from.

He is adding in the held-to-maturity.

I am adding in the held-to-maturity. And again, recent regulatory pronouncements that we have seen have said that they are going to start looking at the held-to-maturity in the mark there with respect to where they see capital ratios.

You know, my question would be, Nick, that under GAAP accounting, it doesn't impact your capital. And I wished if they were going to do that, then they didn't give us the 20 or $30 million gain that we had probably six months ago. So I don't know if you can do it both ways with all do respect, Nick.

Remember, GAAP doesn't run -- doesn't make the rules for capital adequacy. The regulators do.

That's right, and plus, too, you have to factor in if as you say, if they start looking at the held-to-maturity and what's going on there, they have got to look at the rest of the balance sheet too because you are only looking at one part of it being mark-to-market. I mean you have to look at the loans, you have to look at the deposits and then factor that all in.

No question about that. But again, just looking at you relative to other premium community banks, the mark-to-market capital ratio looks, on a tangible basis, awful low.

I would say, Nick, the bottom line is, the ratio that we are at, we have been like that since I started with the bank when it was $40 million in size. And we have always taken our accumulated earnings and redeployed them and purchased more banks and it's helped give us the earnings per share increases that we continually have. I hear what you are saying. But, again, I have extremely good contacts. We deal with the regulatory agencies on a daily basis. And from what you are saying and what they are saying, they have not seen any issues with what you're talking -- as you are applying taking in and adding back the HTM gain or loss to the portfolio. I have not seen anything like that or any regulatory guidelines suggesting that.

We have just come through both a bank exam with bank examiners and the holding company examiners (multiple speakers) --

And we were rated the highest ratings you could have.

None of that was out there. I think while I can appreciate the mathematical formula that you are running there, Nick, I think it is important to look at the history of the way the Company has been run. And if you want to factor in that you're going to close it out and we are going to take that loss, I think it is what it is. But the facts are, we are not trading in that bond portfolio. We have never traded in that bond portfolio. So I don't think that is an issue that -- we are not going to focus on what the loss in the HTM portfolio is.

And again, that's not our -- where we have kept a short duration, and again, I don't think you can call rates or I can call rates. That's not our job. And again, I think going forward, it is what it is, as Dan says.

And again, I would not be worried if you kind of had the tangible ratio that most of the competition has, the 6, 7, 8 percent tangible. But when you start at 4.5, at least that's what I get when I do the division. And you start getting hits on the HTM portfolio, it seems low to me.

I think you've got to factor in asset quality in that picture as a piece of where the risk model is. I think our risk model is very low compared to our peers.

Yes, I mean when you look at our total classified assets to total assets, what is it, like 7 or 0.07, 7 basis points. So I mean it's extremely low.

And it is for most of your peers, too. And one of the other things I worry about is as rates rise, that maybe this commercial real estate portfolio that everybody has built up quite rapidly over the last several years does not behave quite as benignly. But again, my prejudice, I'm probably overly concerned about nothing.

I think you are, Nick. The other option is to have a secondary issue and there has been many firms that have wanted us to do a secondary issue and doing 50 or $100 million secondary issue and beefing up our capital position. On the other hand, as a shareholder and a larger shareholder myself, I don't know if I am as willing to give away, from a shareholder standpoint, the dilution or not.

There just comes a point where leverage can hurt from unforeseen circumstances that may come anybody's way. But again, that's my prejudice. It should not be yours. Thank you, guys.

Steve Griesdo, Satellite Assets.

My questions have all been answered. Thank you.

Jon Arfstrom, RBC.

I've got to be hitting ninth, maybe tenth here.

You are tenth.

I'm tenth. A question for Dave Zalman. It looks like good organic loan growth for the quarter. And I'm just curious; I know in the past, you preferred purchasing investment securities when you compare it to a fully loaded loan. And I am just curious if the attractiveness of commercial lending has changed in your mind? And just kind of walk through the metrics you would walk through on evaluating a loan versus purchasing a security?

Well, there's two sides of the story. I mean it's true. One of the issue I've had with commercial lending, not even that long ago, is that it's so competitive in the interest rates that people were charging on loans, the risks that you're taking and by the time you loaded the lender's salary in it and the potential loss, you'd almost come out the same on a bond to short-term security. On the other hand, we realize going forward and growing that we need to make loans, and so we are going to make an all-out effort to go forward and focus on growing the loan portfolio. And that's through internal growth and recruiting new people too.

Again, I don't think we have changed the focus. I think that what you have seen over the last two years has been a lot of pollution in the numbers. The lenders that are out there, we are in the banking business. We are in the customer relationship business. We have good customers that we have relationships with that have lending needs. We have got people that are out calling on customers daily. I think we're winning business on a daily basis. So I do not think that the idea has changed, it's just been you've been seeing some polluted numbers over the last couple of years with nine acquisitions.

Again, I think I made that point earlier, Dan, is that it's hard for an analyst, for you and all the analysts, I can't see how you could show what we're doing either. But when we buy banks and there is a $30 million rolloff or we try to outsource $30 million in loans, there's no way that you have those numbers and there's no way that you can see those numbers. So our internal growth rate has always shown, with the exception of what last year, Dave, to have an 8 percent internal growth rate. But again, I understand how you guys can't see that. I understand that.

From your side, this was really the first quarter in ten quarters that we have not had computer conversions, acquisition-related pollution into the numbers.

I hear you. I just remembered David saying a couple of times why put on loans when it seems like a fully-loaded loan is less profitable than buying securities, and it seems like maybe that approach is changing when you look at the numbers on a stand-alone basis?

I don't know if I said that exactly,. What I said is, look at our competitors. Our competitors, even our local competitors, may have 80 and 90 percent loan-to-deposit ratios; and yet when you compare their return on equity and their earnings per share growth and you compare that to ours, we were doing just as good, and I brought the question up, you know, everybody was focused. Let's get a 70 or 80 percent loan-to-deposit ratio. But again when you look at their ratios and look at our ratios, all I made the point was that our loan-to-deposit ratio was not nearly that and yet our numbers were as good or better. So what reward were we going to get from the street by jumping in there and putting 30 to 40 percent increase in loans on immediately like that.

The next question, on your reserve ratio, reserve-to-loan ratio, it's down by 5 basis points, and certainly when you look at the charge-offs and the NPA's, you have more than adequate reserves, so I am not making a statement there. But maybe it adds a penny to EPS if you would have held it flat at 135. And I am just curious what is an adequate reserve level for you, given your asset quality history and where might we see that percentage go?

Well, you know, the 1.3 in my opinion was -- it's very adequate compared to our previous charge-offs. And so, you know, I --

A year ago, we were at 132; today we are at 131. So again, I think you're seeing some pollution in the numbers. You've got some acquisitions that have played in there in the last two quarters, where the loan loss reserves that come in in an acquisition are there so that we can walk through some of the problem assets that you've seen us flush through during that time frame. So I think when you look back over a longer period than just one quarter, I think we are fairly consistent.

You also should point out though that the monthly accrual that we're doing has been the same.

Been the same, that's right.

It has not changed.

That's right. The expense hit in the first quarter and the second quarter was identical. We did not lower an accrual. But what you're seeing again is the using of some of that as we kind of wash through some of the assets that have been acquired.

And I think there's going to be some recoveries probably too; historically, there really has. We're just taking a real strong approach on some of these loans.

So 130 is probably a floor, just a guess.

I don't even know if you have to have that much for our portfolio. But we don't have any intentions of reducing it, no.

I guess that's the question, is what is adequate, and that's what I am getting at, is there's leverage from that coming down over time?

I would not want to make this statement right now. But the reason I would not want to say we would reduce it to 1 is because if we do grow our loan portfolio, I think you are going to need to be adequately reserved, basically.

Jed Gore, Sinova Capital.

Thanks. My follow-up was actually addressed by Nick. Thank you, very much.

(OPERATOR INSTRUCTIONS). It appears we have no further questions at this time.

Thanks. It appears we've batted around. We will look forward to talking to you all again. Thank you, very much, for participating in our call. We appreciate your support of our Company. Thank you, very much.