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Sterling Bancshares 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2
Form 10-Q for quarterly period ended June 30, 2006
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

 

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

For the quarterly period ended June 30, 2006

OR

 

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

For the transition period from             to             

Commission file number: 0-20750

STERLING BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

 

Texas   74-2175590
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

2550 North Loop West, Suite 600

Houston, Texas

  77092
(Address of principal executive offices)   (Zip Code)

713-466-8300

(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.

Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act

Large accelerated filer  x                    Accelerated filer  ¨                    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨    No  x

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

 

Class

 

Outstanding at August 1, 2006

[Common Stock, $1.00 par value per share]   45,787,901 shares

 



Table of Contents

STERLING BANCSHARES, INC.

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2006

TABLE OF CONTENTS

 

PART I.

   FINANCIAL INFORMATION   

Item 1.

  

Financial Statements

   2
  

Consolidated Balance Sheets

   2
  

Consolidated Statements of Income

   3
  

Consolidated Statements of Shareholders’ Equity

   4
  

Consolidated Statements of Cash Flows

   5
  

Notes to Consolidated Financial Statements

   6

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    19

Item 3.

  

Quantitative and Qualitative Disclosures about Market Risk

   33

Item 4.

  

Controls and Procedures

   33

PART II.

   OTHER INFORMATION   

Item 1.

  

Legal Proceedings

   34

Item 1A.

  

Risk Factors

   34

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   34

Item 3.

  

Defaults Upon Senior Securities

   34

Item 4.

  

Submission of Matters to a Vote of Security Holders

   34

Item 5.

  

Other Information

   35

Item 6.

  

Exhibits

   35

SIGNATURES

   36

 

1


Table of Contents

PART I.    FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

STERLING BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

(In thousands, except per share amounts)

 

     June 30,
2006
    December 31,
2005
 

ASSETS

    

Cash and cash equivalents

   $ 106,531     $ 147,154  

Interest-bearing deposits in financial institutions

     99       99  

Trading assets

     —         28,515  

Available-for-sale securities, at fair value

     455,122       495,945  

Held-to-maturity securities, at amortized cost

     120,153       123,053  

Loans held for sale

     24,215       8,354  

Loans held for investment

     2,856,661       2,691,008  
                

Total loans

     2,880,876       2,699,362  

Allowance for loan losses

     (31,882 )     (31,230 )
                

Loans, net

     2,848,994       2,668,132  

Premises and equipment, net

     37,169       41,407  

Real estate acquired by foreclosure

     1,171       460  

Goodwill

     85,026       85,026  

Core deposit intangibles, net

     3,162       3,551  

Accrued interest receivable

     15,002       15,358  

Other assets

     117,491       118,159  
                

TOTAL ASSETS

   $ 3,789,920     $ 3,726,859  
                

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

LIABILITIES:

    

Deposits:

    

Noninterest-bearing demand

   $ 1,033,743     $ 1,045,937  

Interest-bearing demand

     1,032,465       1,017,832  

Certificates and other time deposits

     918,167       774,374  
                

Total deposits

     2,984,375       2,838,143  

Short-term borrowings

     330,700       392,850  

Subordinated debt

     44,358       46,238  

Junior subordinated debt

     52,836       82,475  

Accrued interest payable and other liabilities

     33,637       32,681  
                

Total liabilities

     3,445,906       3,392,387  

COMMITMENTS AND CONTINGENCIES

     —         —    

SHAREHOLDERS’ EQUITY:

    

Preferred stock, $1 par value, 1,000,000 shares authorized, no shares issued and outstanding at June 30, 2006 and December 31, 2005, respectively

     —         —    

Common stock, $1 par value, 100,000,000 shares authorized, 45,785,694 and 45,458,500 issued and 45,410,694 and 45,333,500 outstanding at June 30, 2006 and December 31, 2005, respectively

     45,786       45,458  

Capital surplus

     63,567       58,757  

Retained earnings

     254,125       239,171  

Treasury stock

     (6,111 )     (1,984 )

Accumulated other comprehensive loss, net of tax

     (13,353 )     (6,930 )
                

Total shareholders’ equity

     344,014       334,472  
                

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 3,789,920     $ 3,726,859  
                

See Notes to Consolidated Financial Statements.

 

2


Table of Contents

STERLING BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

(In thousands, except per share amounts)

 

    

Three Months

Ended June 30,

   

Six Months

Ended June 30,

     2006     2005     2006     2005

Interest income:

        

Loans, including fees

   $ 55,265     $ 41,933     $ 106,041     $ 79,924

Securities:

        

Taxable

     6,011       6,345       12,160       12,500

Non-taxable

     564       612       1,151       1,240

Trading assets

     270       322       570       634

Federal funds sold

     43       122       85       159

Deposits in financial institutions

     32       6       90       15
                              

Total interest income

     62,185       49,340       120,097       94,472
                              

Interest expense:

        

Demand and savings deposits

     3,883       1,853       6,960       3,627

Certificates and other time deposits

     8,542       4,669       15,676       8,041

Short-term borrowings

     4,413       3,669       8,575       6,359

Subordinated debt

     1,125       882       2,180       1,695

Junior subordinated debt

     1,409       1,722       3,201       3,412
                              

Total interest expense

     19,372       12,795       36,592       23,134
                              

Net interest income

     42,813       36,545       83,505       71,338

Provision for credit losses

     1,837       3,221       3,163       6,561
                              

Net interest income after provision for credit losses

     40,976       33,324       80,342       64,777
                              

Noninterest income:

        

Customer service fees

     3,061       2,888       5,638       5,880

Net gain (loss) on trading assets

     (167 )     (11 )     (302 )     98

Net gain (loss) on the sale of securities

     —         (31 )     —         54

Net gain on the sale of loans

     205       417       510       674

Other

     5,920       3,266       9,663       6,600
                              

Total noninterest income

     9,019       6,529       15,509       13,306
                              

Noninterest expense:

        

Salaries and employee benefits

     18,822       15,278       37,497       30,672

Occupancy expense

     4,061       3,909       7,904       7,551

Technology

     1,615       1,381       3,089       2,595

Professional fees

     1,473       1,630       2,898       2,926

Postage, delivery and supplies

     903       778       1,693       1,528

Marketing

     709       617       1,093       1,262

Core deposit intangibles amortization

     194       102       389       214

Other

     5,416       3,779       9,588       7,642
                              

Total noninterest expense

     33,193       27,474       64,151       54,390
                              

Income before income taxes

     16,802       12,379       31,700       23,693

Provision for income taxes

     5,533       3,863       10,399       7,419
                              

Net Income

   $ 11,269     $ 8,516     $ 21,301     $ 16,274
                              

Earnings per share:

        

Basic

   $ 0.25     $ 0.19     $ 0.47     $ 0.36
                              

Diluted

   $ 0.25     $ 0.19     $ 0.46     $ 0.36
                              

See Notes to Consolidated Financial Statements.

 

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Table of Contents

STERLING BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(UNAUDITED)

(In thousands)

 

    Preferred Stock   Common Stock   Capital
Surplus
  Retained
Earnings
    Treasury Stock     Accumulated
Other
Comprehensive
Loss
    Total  
    Shares   Amount   Shares   Amount       Shares   Amount      

BALANCE AT JANUARY 1, 2005

  —     $ —     45,068   $ 45,068   $ 54,522   $ 213,814     —     $ —       $ (232 )   $ 313,172  

Comprehensive income:

                   

Net income

              16,274             16,274  

Net change in unrealized gains and losses on available-for-sale securities, net of taxes of ($698)

                    (1,298 )     (1,298 )

Less: Reclassification adjustment for gains included in net income, net of taxes of ($19)

                    (35 )     (35 )
                         

Total comprehensive income

                      14,941  
                         

Issuance of common stock

      215     215     2,451             2,666  

Cash dividends paid

              (5,421 )           (5,421 )
                                                             

BALANCE AT JUNE 30, 2005

  —     $ —     45,283   $ 45,283   $ 56,973   $ 224,667     —     $ —       $ (1,565 )   $ 325,358  
                                                             

BALANCE AT JANUARY 1, 2006

  —     $ —     45,458   $ 45,458   $ 58,757   $ 239,171     125   $ (1,984 )   $ (6,930 )   $ 334,472  

Comprehensive income:

                   

Net income

              21,301             21,301  

Net change in unrealized gains and losses on available-for-sale securities, net of taxes of ($3,458)

                    (6,423 )     (6,423 )
                         

Total comprehensive income

                      14,878  
                         

Issuance of common stock

      328     328     4,810             5,138  

Repurchase of common stock

      —       —         250     (4,127 )       (4,127 )

Cash dividends paid

              (6,347 )           (6,347 )
                                                             

BALANCE AT JUNE 30, 2006

  —     $ —     45,786   $ 45,786   $ 63,567   $ 254,125     375   $ (6,111 )   $ (13,353 )   $ 344,014  
                                                             

See Notes to Consolidated Financial Statements.

 

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Table of Contents

STERLING BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(In thousands)

 

     Six Months Ended June 30,  
             2006                     2005          

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net income

   $ 21,301     $ 16,274  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Amortization and accretion of premiums and discounts on securities, net

     1,231       1,555  

Net gain on the sale of securities

     —         (54 )

Net gain on the sale of premises and equipment

     (1,122 )     (36 )

Net loss (gain) on trading assets

     302       (98 )

Net gain on sale of loans

     (510 )     (674 )

Provision for credit losses

     3,163       6,561  

Writedowns, less gains on sale, of real estate acquired by foreclosure

     (278 )     (29 )

Depreciation and amortization

     4,161       3,881  

Proceeds from sales of trading assets

     29,152       92,562  

Purchases of trading assets

     (1,375 )     (95,667 )

Proceeds from principal paydowns of trading securities

     203       20,801  

Stock-based compensation expense (net of tax benefit recognized)

     882       —    

Excess tax benefits from share-based payment arrangements

     (470 )     —    

Net increase in loans held for sale

     (3,296 )     (1,640 )

Net decrease (increase) in accrued interest receivable and other assets

     2,917       (3,324 )

Net increase (decrease) in accrued interest payable and other liabilities

     237       (1,935 )
                

Net cash provided by operating activities

     56,498       38,177  

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Proceeds from the maturities or calls and paydowns of held-to-maturity securities

     8,494       11,577  

Proceeds from the sale of available-for-sale securities

     —         44,257  

Proceeds from maturities or calls and paydowns of available-for-sale securities

     53,996       69,018  

Purchases of available-for-sale securities

     (23,976 )     (146,022 )

Purchases of held-to-maturity securities

     (5,671 )     (14,916 )

Net increase in loans held for investment

     (183,366 )     (241,083 )

Proceeds from sale of real estate acquired by foreclosure

     2,386       984  

Proceeds from sale of land held for sale

     1,570       —    

Net increase in interest-bearing deposits in financial institutions

     —         396  

Proceeds from sale of premises and equipment

     3,926       248  

Purchase of premises and equipment

     (2,339 )     (2,004 )
                

Net cash used in investing activities

     (144,980 )     (277,545 )

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Net increase in deposits

     146,232       161,213  

Net (decrease) increase in short-term borrowings

     (62,150 )     83,150  

Redemption of junior subordinated debt

     (29,639 )     —    

Proceeds from issuance of common stock

     3,420       2,666  

Repurchase of common stock

     (4,127 )     —    

Excess tax benefits from share-based payment arrangements

     470       —    

Dividends paid

     (6,347 )     (5,421 )
                

Net cash provided by financing activities

     47,859       241,608  

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS

     (40,623 )     2,240  

CASH AND CASH EQUIVALENTS:

    

Beginning of period

     147,154       88,439  
                

End of period

   $ 106,531     $ 90,679  
                

Supplemental information:

    

Income taxes paid

   $ 11,784     $ 7,600  

Interest paid

     34,737       21,595  

Noncash investing and financing activities—

    

Acquisitions of real estate through foreclosure of collateral

     2,819       891  

Transfer of loans from held for investment to loans held for sale

     12,100       —    

See Notes to Consolidated Financial Statements

 

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Table of Contents

STERLING BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1.    ACCOUNTING POLICIES

Basis of Presentation

The consolidated Financial Statements are unaudited and include the accounts of Sterling Bancshares and its subsidiaries (the “Company”) except for those subsidiaries where it has been determined that the Company is not the primary beneficiary. The Company’s accounting and financial reporting policies are in accordance with accounting principles generally accepted in the United States of America for interim financial information and in accordance with the instructions to Form 10-Q. The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such periods. Such adjustments are of a normal recurring nature unless otherwise disclosed in this Form 10-Q. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for the full year. The interim financial information should be read with the Company’s 2005 Annual Report on Form 10-K. Certain prior period amounts have been reclassified to conform to current period classifications. These reclassifications had no affect on net income or shareholders’ equity.

Recent Accounting Standards

Statement of Accounting Standards No. 123R, Share-Based Payment (Revised 2004) (“SFAS 123R”) established standards for accounting for transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123R applies to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. The Company used the modified prospective application in implementing SFAS 123R. Beginning in 2006, the Company’s results of operations reflect compensation expense for all employee stock-based compensation, including the unvested portion of stock options granted prior to 2006. Prior to 2006, the Company accounted for stock-based employee compensation using the intrinsic value-based method of accounting, as permitted. Under the intrinsic value-based method of accounting, no compensation expense was recognized for the Company’s incentive stock options or for the Company’s employee stock purchase plan. The adoption of this accounting standard resulted in additional stock-based compensation expense of $97 thousand and $204 thousand for the three and six-month periods ended June 30, 2006, respectively, attributable to stock options and the Company’s employee stock purchase plan. There was no income tax benefit recorded for this additional stock-based compensation expense. The adoption of this accounting standard did not have a meaningful impact on earnings per share for the same time periods.

 

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The pro-forma net income and earnings per share information for the three and six-month periods ended June 30, 2005 presented below was determined as if we had accounted for our employee stock-based compensation under the fair value method (dollars in thousands except for per share amounts).

 

     Three months
ended June 30,
2005
    Six months
ended June 30,
2005
 

Net income, as reported

   $ 8,516     $ 16,274  

Add: Stock-based employee compensation expense included in reported net income, net of related tax effect

     241       241  

Less: Total stock-based employee compensation expense determined under the fair-value based method, net of related taxes

     (374 )     (514 )
                

Pro-forma net income

   $ 8,383     $ 16,001  
                

Earnings per share:

    

Basic—as reported

   $ 0.19     $ 0.36  
                

Basic—pro-forma

   $ 0.19     $ 0.35  
                

Diluted—as reported

   $ 0.19     $ 0.36  
                

Diluted—pro-forma

   $ 0.18     $ 0.35  
                

In February 2006, the Financial Accounting Standard Board (“FASB”) issued Statement of Accounting Standards No. 155 (“SFAS 155”) Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140. It establishes, among other things, the accounting for certain derivatives embedded in other financial instruments. The primary objective of this Statement with respect to FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, is to simplify accounting for any hybrid financial instrument that contains an embedded derivative that would otherwise require bifurcation. The primary objective of this Statement with respect to FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, is to eliminate a restriction on the passive derivative instruments that a qualifying special-purpose entity (QSPE) may hold. This statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of this accounting standard is not expected to have a material impact on the Company’s financial statements.

In March 2006, the FASB issued Statement of Accounting Standards No. 156 (“SFAS 156”) Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140. It establishes, among other things, the accounting for all separately recognized servicing assets and servicing liabilities. This Statement amends Statement 140 to require that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. This statement is effective for fiscal years beginning after September 15, 2006. The adoption of this accounting standard is not expected to have a material impact on the Company’s financial statements.

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”) Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109 (“FAS 109”), Accounting for Income Taxes. FIN 48 clarifies the application of FAS 109 by defining a criterion that an individual tax position must meet for any part of the benefit of that position to be recognized in an enterprise’s financial statements. Additionally, FIN 48 provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The adoption of this accounting standard is not expected to have a material impact on the Company’s financial statements.

 

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2.    SECURITIES

The amortized cost and fair value of securities are as follows (in thousands):

 

     June 30, 2006
     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair Value

Available-for-Sale

          

Obligations of the U.S. Treasury and other U.S. government agencies

   $ 9,011    $ —      $ (154 )   $ 8,857

Obligations of states of the U.S. and political subdivisions

     2,433      11      (4 )     2,440

Mortgage-backed securities and collateralized mortgage obligations

     447,843      119      (18,727 )     429,235

Other securities

     16,378      —        (1,788 )     14,590
                            

Total

   $ 475,665    $ 130    $ (20,673 )   $ 455,122
                            

Held-to-Maturity

          

Obligations of states of the U.S. and political subdivisions

   $ 55,410    $ 373    $ (855 )   $ 54,928

Mortgage-backed securities and collateralized mortgage obligations

     64,743      —        (2,173 )     62,570
                            

Total

   $ 120,153    $ 373    $ (3,028 )   $ 117,498
                            
     December 31, 2005
     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair Value

Available-for-Sale

          

Obligations of the U.S. Treasury and other U.S. government agencies

   $ 10,031    $ —      $ (107 )   $ 9,924

Obligations of states of the U.S. and political subdivisions

     3,303      27      (4 )     3,326

Mortgage-backed securities and collateralized mortgage obligations

     476,541      286      (10,099 )     466,728

Other securities

     16,732      —        (765 )     15,967
                            

Total

   $ 506,607    $ 313    $ (10,975 )   $ 495,945
                            

Held-to-Maturity

          

Obligations of states of the U.S. and political subdivisions

   $ 58,288    $ 649    $ (562 )   $ 58,375

Mortgage-backed securities and collateralized mortgage obligations

     64,765      9      (1,134 )     63,640
                            

Total

   $ 123,053    $ 658    $ (1,696 )   $ 122,015
                            

 

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The contractual maturities of securities at June 30, 2006 are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Dollar amounts are shown in thousands.

 

     Available-for-Sale    Held-to-Maturity
     Amortized
Cost
   Fair Value    Amortized
Cost
   Fair Value

Due in one year or less

   $ 3,797    $ 3,779    $ 5,655    $ 5,679

Due after one year through five years

     6,980      6,850      27,680      27,678

Due after five years through ten years

     667      668      22,075      21,571

Due after ten years

     —        —        —        —  

Mortgage-backed securities and collateralized mortgage obligations

     447,843      429,235      64,743      62,570

Other securities

     16,378      14,590      —        —  
                           

Total

   $ 475,665    $ 455,122    $ 120,153    $ 117,498
                           

The following table summarizes the proceeds received and gross realized gains and losses on the sales of the available-for-sale securities (dollars in thousands):

 

     Three months ended
June 30,
    Six months ended
June 30,
 
         2006            2005             2006            2005      

Proceeds from sales and calls

   $ —      $ 8,814     $ —      $ 44,257  

Gross realized gains

     —        5       —        143  

Gross realized losses

     —        (36 )     —        (89 )

Securities with unrealized losses segregated by length of impairment, were as follows (dollars in thousands):

 

     June 30, 2006
     Less than 12 Months    More than 12 Months
     Amortized
Cost
   Gross
Unrealized
Losses
    Fair Value    Amortized
Cost
   Gross
Unrealized
Losses
    Fair Value

Available-for-Sale

               

Obligations of the U.S. Treasury and other U.S. government agencies

   $ 1,504    $ (3 )   $ 1,501    $ 7,507    $ (151 )   $ 7,356

Obligations of states of the U.S. and political subdivisions

     848      (4 )     844      20      —         20

Mortgage-backed securities and collateralized mortgage obligations

     103,433      (2,705 )     100,728      339,863      (16,022 )     323,841

Other securities

     7,764      (1,192 )     6,572      8,439      (596 )     7,843
                                           

Total

   $ 113,549    $ (3,904 )   $ 109,645    $ 355,829    $ (16,769 )   $ 339,060
                                           

Held-to-Maturity

               

Obligations of states of the U.S. and political subdivisions

   $ 11,917    $ (164 )   $ 11,753    $ 18,939    $ (691 )   $ 18,248

Mortgage-backed securities and collateralized mortgage obligations

     23,852      (763 )     23,089      40,891      (1,410 )   $ 39,481
                                           

Total

   $ 35,769    $ (927 )   $ 34,842    $ 59,830    $ (2,101 )   $ 57,729
                                           

Declines in the fair value of individual securities below their cost that are other-than-temporary would result in writedowns, as a realized loss, of the individual securities to their fair value. In evaluating other-than-temporary

 

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impairment losses, management considers several factors including the severity and the duration that the fair value has been less than cost, the credit quality of the issuer, and the intent and ability of the Company to hold the security until recovery of the fair value. The average loss on securities in an unrealized loss position was 4.2% of the amortized cost basis at June 30, 2006. Other securities in an unrealized loss position of less than 12 months were in a loss position of approximately 15% of the Company’s amortized cost basis. These investments have declined in value over the last nine months due to increases in interest rates. There are no remaining securities in the Company’s securities portfolio in a loss position greater than 10% of the Company’s amortized cost basis at June 30, 2006. Management believes that the unrealized losses on the Company’s securities portfolio were caused primarily by interest rate increases. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold those investments until a recovery of fair value, which may be at maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2006.

The Company does not own any securities of any one issuer (other than U.S. government and its agencies) for which the aggregate adjusted cost exceeds 10% of the consolidated shareholders’ equity at June 30, 2006.

Securities with carrying values totaling $375.0 million and fair values totaling $361.6 million were pledged to secure public deposits at June 30, 2006.

3.    LOANS

The loan portfolio classified by major type was as follows (dollars in thousands):

 

     June 30, 2006     December 31, 2005  
     Amount    %     Amount    %  

Loans held for sale

   $ 24,215    0.8 %   $ 8,354    0.3 %

Loans held for investment

          

Domestic

          

Commercial and industrial

     784,856    27.2 %     738,061    27.3 %

Real estate:

          

Commercial

     1,281,615    44.5 %     1,221,610    45.3 %

Construction

     520,024    18.1 %     438,454    16.2 %

Residential mortgage

     171,581    6.0 %     190,701    7.1 %

Consumer/other

     71,867    2.5 %     72,937    2.7 %

Foreign

          

Commercial and industrial

     23,895    0.8 %     26,080    1.0 %

Other loans

     2,823    0.1 %     3,165    0.1 %
                          

Total loans held for investment

     2,856,661    99.2 %     2,691,008    99.7 %
                          

Total loans

   $ 2,880,876    100.0 %   $ 2,699,362    100.0 %
                          

Loan maturities and rate sensitivity of the loans held for investment excluding residential mortgage and consumer loans, at June 30, 2006 are as follows (in thousands):

 

     Due in One
Year or Less
   Due After
One Year
Through
Five Years
   Due After
Five Years
   Total

Commercial and industrial

   $ 607,769    $ 158,030    $ 19,057    $ 784,856

Real estate—commercial

     669,328      462,004      150,283      1,281,615

Real estate—construction

     402,977      84,690      32,357      520,024

Foreign loans

     25,285      1,433      —        26,718
                           

Total

   $ 1,705,359    $ 706,157    $ 201,697    $ 2,613,213
                           

Loans with a fixed interest rate

   $ 182,170    $ 600,455    $ 172,915    $ 955,540

Loans with a floating interest rate

     1,523,189      105,702      28,782      1,657,673
                           

Total

   $ 1,705,359    $ 706,157    $ 201,697    $ 2,613,213
                           

 

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The loan portfolio consists of various types of loans made principally to borrowers located in the Houston, Dallas and San Antonio metropolitan areas. As of June 30, 2006, there was no concentration of loans to any one type of industry exceeding 10% of total loans nor were there any loans classified as highly leveraged transactions.

As of June 30, 2006 and December 31, 2005, loans from Sterling Bank outstanding to directors, officers and their affiliates were $6.9 million and $9.0 million, respectively. In the opinion of management, all transactions entered into between Sterling Bank and such related parties have been and are in the ordinary course of business, made on the same terms and conditions as similar transactions with unaffiliated persons. For the six months ended June 30, 2006, there were no principal additions while principal payments were $114.0 thousand. Insider loans were reduced by $2.0 million as two directors with insider loans were no longer serving on the board as of June 30, 2006 as compared to December 31, 2005.

The recorded investment in impaired loans was $12.4 million and $22.4 million at June 30, 2006 and December 31, 2005, respectively. Such impaired loans required an allowance for loan losses of $3.2 million and $4.2 million, respectively. The average recorded investment in impaired loans for the three and six months ended June 30, 2006 was $15.6 million and $19.2 million, respectively, and for the three and six months ended June 30, 2005 was $19.1 million and $21.1 million, respectively. Interest income on impaired loans of $39 thousand and $64 thousand was recognized for the three and six months ended June 30, 2005, respectively. No interest on impaired loans was received for the three and six months ended June 30, 2006.

Included in impaired loans are nonperforming loans of $12.4 million and $21.8 million at June 30, 2006 and December 31, 2005, respectively, which have been categorized by management as nonaccrual loans. Interest foregone on nonaccrual loans for the six months ended June 30, 2006 and 2005 was approximately $899 thousand and $880 thousand, respectively. The Company did not have any restructured loans as of June 30, 2006 or December 31, 2005.

When management doubts a borrower’s ability to meet payment obligations, which typically occurs when principal or interest payments are more than 90 days past due, the loans are placed on nonaccrual status. Loans 90 days or more past due, not on nonaccrual were $543 thousand and $162 thousand at June 30, 2006 and December 31, 2005, respectively.

4.    ALLOWANCE FOR CREDIT LOSSES

An analysis of activity in the allowance for credit losses was as follows (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2006     2005     2006     2005  

Allowance for loan losses at beginning of the period

   $ 31,116     $ 30,760     $ 31,230     $ 29,406  

Loans charged-off

     2,085       3,269       4,231       5,634  

Loan recoveries

     (929 )     (1,409 )     (1,437 )     (1,796 )
                                

Net loans charged-off

     1,156       1,860       2,794       3,838  

Provision for loan losses

     1,922       3,309       3,446       6,641  
                                

Allowance for loan losses at end of the period

     31,882       32,209       31,882       32,209  
                                

Reserve for losses on unfunded loan commitments at beginning of period

     975       834       1,173       826  

Provision for losses on unfunded loan commitments

     (85 )     (88 )     (283 )     (80 )
                                

Reserve for unfunded loan commitments at end of period

     890       746       890       746  
                                

Total allowance for credit losses

   $ 32,772     $ 32,955     $ 32,772     $ 32,955  
                                

 

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5.     GOODWILL AND OTHER INTANGIBLES

The changes in the carrying amount of goodwill by reporting unit for the year ended December 31, 2005, and the period ended June 30, 2006, were as follows (in thousands):

 

     Houston    San
Antonio
   Dallas    Total

Balance, January 1, 2005

   $ 29,613    $ 27,205    $ 5,662    $ 62,480

Prestonwood Bancshares acquisition

     —           22,546      22,546
                           

Balance, December 31, 2005

     29,613      27,205      28,208      85,026

Goodwill adjustment

     —        —        —        —  
                           

Balance, June 30, 2006

   $ 29,613    $ 27,205    $ 28,208    $ 85,026
                           

The changes in the carrying amounts of core deposit intangibles for the year ended December 31, 2005, and the period ended June 30, 2006, were as follows (in thousands):

 

     Core
Deposit
Intangibles
 

Balance, January 1, 2005

   $ 1,839  

Amortization expense

     (521 )

Prestonwood Bancshares acquisition

     2,233  
        

Balance, December 31, 2005

     3,551  

Amortization expense

     (389 )
        

Balance, June 30, 2006

   $ 3,162  
        

6.    JUNIOR SUBORDINATED DEBT/COMPANY MANDATORILY REDEEMABLE TRUST PREFERRED SECURITIES

As of June 30, 2006, the Company had the following issues of trust preferred securities outstanding and junior subordinated debt owed to trusts (dollars in thousands):

 

Description

 

Issuance Date

  Trust
Preferred
Securities
Outstanding
  Interest Rate   Junior
Subordinated
Debt Owed To
Trusts
 

Final Maturity Date

Statutory Trust One

  August 30, 2002   $ 20,000   3-month
LIBOR plus
3.45%
  $ 20,619   August 30, 2032

Capital Trust III

  September 26, 2002     31,250   8.30% Fixed     32,217   September 26, 2032
                 

Total

    $ 51,250     $ 52,836  
                 

Each of the trusts is a statutory business trust organized for the sole purpose of issuing trust securities and investing the proceeds thereof in junior subordinated debentures of Sterling Bancshares, the sole asset of each trust. The preferred trust securities of each trust represent preferred beneficial interests in the assets of the respective trusts and are subject to mandatory redemption upon payment of the junior subordinated debentures held by the trust. The common securities of each trust are wholly-owned by Sterling Bancshares. Each trust’s ability to pay amounts due on the trust preferred securities is solely dependent upon Sterling Bancshares making payment on the related junior subordinated debentures. Sterling Bancshares’ obligations under the junior subordinated debentures and other relevant trust agreements, in aggregate, constitute a full and unconditional guarantee by Sterling Bancshares of each respective trust’s obligations under the trust securities issued by each respective trust.

 

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Each issuance of trust preferred securities outstanding is mandatorily redeemable 30 years after issuance and is callable beginning five years after issuance if certain conditions are met (including the receipt of appropriate regulatory approvals). The trust preferred securities may be prepaid earlier upon the occurrence and continuation of certain events including a change in their tax status or regulatory capital treatment. In each case, the redemption price is equal to 100% of the face amount of the trust preferred securities, plus the accrued and unpaid distributions thereon through the redemption date.

The trust preferred securities issued under Statutory Trust One were privately placed. The interest on these securities is a floating rate that resets quarterly. Until August 30, 2007, there is a ceiling on the three-month LIBOR of 8.50% resulting in a ceiling on the floating rate of 11.95% during this period. As of June 30, 2006, the floating rate on these securities was 8.43% as compared to 7.47% at December 31, 2005.

During the second quarter of 2006, Sterling Bancshares Capital Trust II (the “Trust”), a subsidiary of the Company, redeemed all 1.2 million of its 9.20% Cumulative Trust Preferred Securities (Nasdaq: SBIBO) and all 35,567 of its 9.20% Common Securities at a redemption price equal to the $25.00 liquidation amount of each security, plus all accrued and unpaid distributions per security to the Redemption Date.

The Trust took such action in connection with the concurrent prepayment by the Company of all of its $29.6 million 9.20% Junior Subordinated Deferrable Interest Debentures (the “Debentures”) due March 21, 2031 which were held exclusively by the Trust. The Debentures were prepaid on the Redemption Date at a prepayment price equal to the principal outstanding amount of the Debentures plus accrued and unpaid interest to the Redemption Date. During the second quarter of 2006, the Company wrote off the remaining unamortized debt issuance costs associated with these Debentures totaling $1.3 million.

7.    STOCK-BASED COMPENSATION

The 2003 Stock Incentive and Compensation Plan (the “2003 Stock Plan”), which has been approved by the shareholders, permits the grant of unrestricted stock units, restricted stock unit awards, phantom stock awards, stock appreciation rights or stock options for up to 2,150,000 shares of common stock. Certain share awards granted under previous shareholder-approved plans are still outstanding and unvested at June 30, 2006.

Options are granted to officers and employees at exercise prices determined by the Human Resources Programs Committee (“Committee”) of the Board of Directors. These options generally have exercise prices equal to the fair market value of the common stock at the date of grant, vest ratably over a four-year period and must be exercised within ten years from the date of grant. Restricted stock unit awards generally vest over four years. Certain awards provide for accelerated vesting if there is a change in control (as defined in the 2003 Stock Plan).

Total stock-based compensation expense that was charged against income for the three and six-month periods ended June 30, 2006 was $643 thousand and $1.2 million, respectively. The total income tax benefit recognized in the income statement for share-based compensation arrangements was $191 thousand and $366 thousand for the three and six months ended June 30, 2006. There was no income tax benefit recognized in the income statement for the three month period ended June 30, 2005. Income tax benefit of $130 thousand was recognized for the six-month period ended June 30, 2005.

Cash received for exercises under all share-based payment arrangements during the three and six-month periods ended June 30, 2006 was $848 thousand and $3.4 million, respectively, and for the three and six-month periods ended June 30, 2005 was $386 thousand and $1.6 million, respectively. The actual tax benefit realized for the tax deductions under all share-based payment arrangements totaled $84 thousand and $470 thousand, respectively, for the three and six-month periods ended June 30, 2006 and $81 thousand and $354 thousand, respectively, for the three and six-month periods ended June 30, 2005.

The Company issues new shares upon the exercise of all share-based payment arrangements.

 

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Stock Options – The fair value of each option award is estimated on the date of grant using a Black-Scholes-Merton option valuation model that uses the assumptions noted in the following table. The Black-Scholes-Merton formula assumes that option exercises occur at the end of an option’s contractual term, and that expected volatility, expected dividends, and risk-free interest rates are constant over the option’s term. The Black-Scholes-Merton formula is adjusted to take into account certain characteristics of employee share options and similar instruments that are not consistent with the model’s assumptions. Because of the nature of the formula, those adjustments take the form of weighted-average assumptions about those characteristics. The expected term represents the period of time that options granted are expected to be outstanding. The risk-free interest rate of the option is based on the U.S. Treasury zero-coupon with a remaining term equal to the expected term used in the assumption model. The historical volatility is a measure of fluctuations in the Company’s share price.

 

     Six Months Ended
June 30,
 
         2006             2005      

Expected term (years)

   4.76     4.62  

Risk-free interest rate

   4.79 %   3.89 %

Historical volatility

   30.09 %   20.97 %

Dividend yield

   1.66 %   1.62 %

A summary of changes in outstanding stock options during the six months ended June 30, 2006 were as follows:

 

    

Shares

(In thousands)

    Weighted
Average
Exercise
Price
   Weighted
Average
Remaining
Contractual
Term
   Aggregate
Intrinsic
Value
(In thousands)

Shares under option, beginning of period

   1,314     $ 10.95      

Shares granted

   147       17.10      

Shares forfeited or expired

   (36 )     14.02      

Shares exercised

   (275 )     11.04      
                  

Shares under option, end of period

   1,150     $ 11.19    5.16    $ 8,697
                        

Shares exercisable, end of period

   900     $ 10.07    3.93    $ 7,807
                        

The weighted-average grant-date fair value of the options granted during the six-month period ended June 30, 2006 was $4.94, compared to $2.75 for the same time period in 2005. The total intrinsic value of options exercised during the six-month period ended June 30, 2006 was $1.7 million compared to $1.1 million for the comparable time period in 2005.

Share Awards – A summary of the status of the Company’s nonvested share awards is presented below (shares in thousands):

 

     Six months ended June 30,
     2006    2005
     Shares     Weighted
Average
Grant-Date
Fair Value
   Shares     Weighted
Average
Grant-Date
Fair Value

Nonvested share awards, beginning of period

   106     $ 14.33    41     $ 13.53

Shares granted

   83       16.95    40       13.99

Shares forfeited

   (9 )     14.42    (3 )     13.59

Shares vested

   (33 )     16.16    (10 )     16.29
                         

Nonvested share awards, end of period

   147     $ 15.39    68     $ 13.42
                         

 

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As of June 30, 2006, there was $1.7 million of total unrecognized compensation expense related to nonvested share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 2.51 years. The total fair value of shares vested during the six months ended June 30, 2006 was $537 thousand.

The Company grants certain executives and other key employees restricted stock unit awards whose vesting is contingent upon meeting various office, departmental and company-wide annual performance goals. The fair value of each grant was estimated using the current public market price of the Company’s common stock on June 30, 2006 and assumes that performance goals will be achieved. If such goals are not met, no future compensation expense will be recognized and any previously recognized compensation expense will be reversed. There were 8,000 performance-based contingent grants outstanding at June 30, 2006. There was no unrecognized compensation expense for these grants at June 30, 2006.

Effective January 1, 2006, the Company entered into an employment agreement with its chief executive officer (“Executive”). This agreement establishes, among other things, certain incentive compensation terms which include equity incentives under the 2003 Stock Plan. The Executive was awarded 125,000 Performance Restricted Share Units (“PRSU”). The PRSUs will be earned subject to certain performance measures over a four year period. These performance measures include annual growth in earnings per share, average return on equity and an overall board evaluation. Based on these criteria, the Executive will earn a specific number of the eligible share units. In addition to the PRSUs, the Executive will earn up to 125,000 bonus shares subject to the same performance measures. The employment agreement also includes a severance and non-competition agreement. Under this agreement, upon termination of employment under the circumstances described in the agreement, the Executive would become vested in a specified number of bonus shares. The fair value of each PRSU and bonus share was estimated based on expected performance goals being attained and using the current public market price of the Company’s common stock at June 30, 2006. As of June 30, 2006, there was $2.4 million of total unrecognized compensation expense related to the PRSUs and bonus shares. This cost is expected to be recognized over a remaining period of 3.5 years. If performance measures are not met, no future compensation expense will be recognized and any previously recognized compensation expense will be reversed.

Stock purchase plan – The Company offers the 2004 Employee Stock Purchase Plan (the “Purchase Plan”) to eligible employees. An aggregate of 1.5 million shares of Company common stock may be issued under this plan subject to adjustment upon changes in capitalization. The Purchase Plan is a compensatory benefit plan to all employees who are employed for more than 20 hours per week and meet minimum length-of-service requirements of three months. The Purchase Plan is subscribed through payroll deduction which may not exceed 10% of the eligible employee’s compensation. The purchase price for shares available under the Purchase Plan is 90% of the lower of the fair market value on either the first or last day of each quarter. Compensation expense associated with the Purchase Plan was determined using a Black-Scholes-Merton option pricing formula. Assumptions used in this formula were the same as disclosed above for incentive stock options except that an expected term of three months was used. During the three and six months ended June 30, 2006, 5,948 shares and 11,953 shares, respectively, were subscribed for through payroll deductions under the Purchase Plan compared to 5,165 and 10,609 shares for the same periods in 2005.

 

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8.    EARNINGS PER COMMON SHARE

Earnings per common share was computed based on the following (in thousands, except per share amounts):

 

     Three months ended
June 30,
   Six months ended
June 30,
     2006    2005    2006    2005

Net income

   $ 11,269    $ 8,516    $ 21,301    $ 16,274

Basic:

           

Weighted average shares outstanding

     45,421      45,250      45,379      45,191

Diluted:

           

Add incremental shares for:

           

Assumed exercise of outstanding options

     447      463      447      473
                           

Total

   $ 45,868    $ 45,713    $ 45,826    $ 45,664
                           

Earnings per share:

           

Basic

   $ 0.25    $ 0.19    $ 0.47    $ 0.36
                           

Diluted

   $ 0.25    $ 0.19    $ 0.46    $ 0.36
                           

The incremental shares for the assumed exercise of the outstanding options were determined by application of the treasury stock method. The calculation of diluted earnings per share excludes 105,488 and 85,973 options outstanding for the three and six months ended June 30, 2006, and 175,816 for both the three and six month periods ended June 30, 2005, which were antidilutive.

9.    COMMITMENTS AND CONTINGENCIES

Leases – The Company leases certain office facilities and equipment under operating leases. Rent expense under all noncancelable operating lease obligations, net of income from noncancelable subleases aggregated, was approximately $1.2 million and $2.4 million for the three and six months ended June 30, 2006 and $1.1 million and $2.0 million for the three and six months ended June 30, 2005. There have been no significant changes in future minimum lease payments by the Company since December 31, 2005. Refer to the 2005 Form 10-K for information regarding these commitments.

Litigation – The Company has been named as a defendant in various legal actions arising in the normal course of business. In the opinion of management, after reviewing such claims with outside counsel, resolution of these matters will not have a material adverse impact on the consolidated financial statements.

Severance and non-competition agreements – The Company has entered into severance and non-competition agreements with its chief executive officer (discussed in Note 7) and certain other executive officers. Under the agreements with other executive officers, upon a termination of employment under the circumstances described in the agreements, each would receive: (i) two years’ base pay; (ii) an annual bonus for two years in an amount equal to the highest annual bonus paid to the respective executive officer during the three years preceding termination or change in control (as defined in the agreement); (iii) continued eligibility for Company perquisites, welfare and life insurance benefit plans, to the extent permitted, and in the event participation is not permitted, payment of the cost of such welfare benefits for a period of two years following termination of employment; (iv) payment of up to $20,000 in job placement fees; and (v) to the extent permitted by law or the applicable plan, accelerated vesting and termination of all forfeiture provisions under all benefit plans, options, restricted stock grants or other similar awards.

 

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10.    FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

The Company is a party to various financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of its customers. These financial 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 amounts recognized in the consolidated balance sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual or notional amount of these instruments. The Company uses the same credit policies in making these commitments and conditional obligations as it does for on-balance sheet instruments.

The following is a summary of the various financial instruments entered into by the Company (in thousands):

 

     June 30,
2006
   December 31,
2005

Commitments to extend credit

   $ 925,585    $ 832,866

Standby letters of credit

     77,215      53,252

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amounts disclosed above do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by the Company, upon extension of credit, is based on management’s credit evaluation of the customer.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk to the Company in issuing letters of credit is essentially the same as that involved in extending loan facilities to its customers.

Off-balance sheet arrangements also include an interest rate swap agreement and the Company’s Trust Preferred Securities. The interest rate swap agreement has a notional amount of $50.0 million in which the Company swapped the fixed rate to a floating rate. This swap is designated as a fair-value hedge that qualifies for the “short-cut” method of hedge accounting. The Company’s credit exposure on the interest rate swap is limited to its net favorable fair value, if any, and the interest payment receivable from the counterparty. Refer to the 2005 Form 10-K for information regarding the Trust Preferred Securities.

11.    REGULATORY MATTERS

Capital requirements – The Company is subject to various regulatory capital requirements administered by the state and federal banking agencies. Any institution that fails to meet its minimum capital requirements is subject to actions by regulators that could have a direct material effect on its financial statements. Under the capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines based on the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s capital amount and classification under the regulatory framework for prompt corrective action are also subject to qualitative judgments by the regulators.

To meet the capital adequacy requirements, Sterling Bancshares and the Bank must maintain minimum capital amounts and ratios as defined in the regulations. Management believes, as of June 30, 2006 and December 31, 2005, that Sterling Bancshares and the Bank met all capital adequacy requirements to which they are subject.

 

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The most recent notification from the regulatory banking agencies categorized Sterling Bank as “well capitalized” under the regulatory capital framework for prompt corrective action and there have been no events since that notification that management believes have changed the Bank’s category. The Company’s consolidated and the Bank’s capital ratios are presented in the following table:

 

     Actual     For Capital
Adequacy Purposes
    To Be Categorized as
Well Capitalized Under
Prompt Corrective
Action Provisions
 
     Amount    Ratio     Amount    Ratio     Amount    Ratio  
     (In thousands, except percentage amounts)  

CONSOLIDATED:

               

As of June 30, 2006:

               

Total capital (to risk weighted assets)

   $ 397,169    11.4 %   $ 278,486    8.0 %     N/A    N/A  

Tier 1 capital (to risk weighted assets)

     320,042    9.2 %     139,243    4.0 %     N/A    N/A  

Tier 1 capital (to average assets)

     320,042    8.6 %     148,067    4.0 %     N/A    N/A  

As of December 31, 2005:

               

Total capital (to risk weighted assets)

   $ 411,229    12.4 %   $ 266,220    8.0 %     N/A    N/A  

Tier 1 capital (to risk weighted assets)

     332,590    10.0 %     133,110    4.0 %     N/A    N/A  

Tier 1 capital (to average assets)

     332,590    9.1 %     145,980    4.0 %     N/A    N/A  

STERLING BANK:

               

As of June 30, 2006:

               

Total capital (to risk weighted assets)

   $ 392,484    11.3 %   $ 277,004    8.0 %   $ 346,255    10.0 %

Tier 1 capital (to risk weighted assets)

     315,356    9.1 %     138,502    4.0 %     207,753    6.0 %

Tier 1 capital (to average assets)

     315,356    8.5 %     147,874    4.0 %     184,842    5.0 %

As of December 31, 2005:

               

Total capital (to risk weighted assets)

   $ 406,444    12.2 %   $ 265,767    8.0 %   $ 332,209    10.0 %

Tier 1 capital (to risk weighted assets)

     327,804    9.9 %     132,884    4.0 %     199,326    6.0 %

Tier 1 capital (to average assets)

     327,804    9.0 %     145,709    4.0 %     182,137    5.0 %

On January 1, 2004 the Company deconsolidated the outstanding trust preferred securities from its Consolidated Financial Statements. However, trust preferred securities are still considered in calculating the Company’s Tier 1 capital ratios as permitted by the Federal Reserve rules. These rules, when fully transitioned and applicable on March 31, 2009, will limit the aggregate amount of trust preferred securities and certain other capital elements to 25% of Tier 1 capital, net of goodwill. At June 30, 2006 the entire amount of the $51.3 million of trust preferred securities outstanding would count as Tier 1 capital. Any excess amount of trust preferred securities not qualifying for Tier 1 capital may be included in Tier 2 capital. This amount is limited to 50% of Tier 1 capital. Additionally, the final rules provide that trust preferred securities no longer qualify for Tier 1 capital within 5 years of their maturity. Under the final transitioned rules, there would not be a material impact on the Company’s consolidated capital ratios at June 30, 2006.

Dividend restrictions – Dividends paid by Sterling Bank are subject to certain restrictions imposed by regulatory agencies. Under these restrictions there was an aggregate of approximately $115.5 million available for payment of dividends at June 30, 2006 by the Bank. At June 30, 2006, the aggregate amount of dividends, which legally could be paid without prior approval of various regulatory agencies, totaled approximately $46.2 million by the Bank.

12.    SUBSEQUENT EVENTS

On July 25, 2006, the Company entered into a definitive agreement to acquire through merger Kerrville, Texas-based BOTH, Inc. (“BOTH”), and its subsidiary bank, Bank of the Hills. BOTH operates five banking offices in

 

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San Antonio/Kerrville. As of June 30, 2006, BOTH had assets of approximately $320 million, loans of $145 million, and deposits of $294 million. The consideration for the merger will consist of a combination of stock and cash totaling approximately $72.5 million for all issued and outstanding shares of the common stock of BOTH, subject to certain prorations and adjustments. The merger agreement has been approved by the respective Boards of Directors of the Company and BOTH, and the transactions contemplated thereby are subject to the approval of BOTH stockholders. The merger is subject to customary closing conditions including receipt of regulatory approval, and is expected to occur during the third or fourth quarter of 2006. Additional information regarding this agreement is contained in a Form 8-K filed on July 26, 2006 with the SEC.

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This report, other periodic reports filed by us under the Exchange Act, and other written or oral statements made by or on behalf of the Company contain certain statements relating to future events and our future results which constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. These “forward-looking statements” are typically identified by words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” or words of similar meaning, or future or conditional verbs such as “should,” “could,” or “may.”

Forward-looking statements reflect our expectation or predictions of future conditions, events or results based on information currently available and involve risks and uncertainties that may cause actual results to differ materially from those in such statements. These risks and uncertainties include, but are not limited to, the following:

 

    general business and economic conditions in the markets we serve may be less favorable than anticipated which could decrease the demand for loan, deposit and other financial services and increase loan delinquencies and defaults;

 

    changes in market rates and prices may adversely impact the value of securities, loans, deposits and other financial instruments and the interest rate sensitivity of our balance sheet;

 

    our liquidity requirements could be adversely affected by changes in our assets and liabilities;

 

    the effect of legislative or regulatory developments including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial securities industry;

 

    competitive factors among financial services organizations, including product and pricing pressures and our ability to attract, develop and retain qualified banking professionals;

 

    the effect of changes in accounting policies and practices, as may be adopted by the Financial Accounting Standards Board, the Securities and Exchange Commission, the Public Company Accounting Oversight Board and other regulatory agencies; and

 

    the effect of fiscal and governmental policies of the United States federal government.

Forward-looking statements speak only as of the date of this report. We do not undertake to update forward-looking statements to reflect circumstances or events that occur after the date of this report or to reflect the occurrence of unanticipated events except as required by federal securities laws.

For additional discussion of such risks, uncertainties and assumptions, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission.

 

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OVERVIEW

For more than 31 years, Sterling Bancshares, Inc. and Sterling Bank have served the banking needs of small to mid-sized businesses. We provide a broad array of financial services to Texas businesses and consumers through 40 banking centers in the greater metropolitan areas of Houston, San Antonio and Dallas, Texas. These cities are the 4th, 7th and 9th largest, respectively, in the United States based on population according to the U.S. Census Bureau. On September 30, 2005, the Company completed its acquisition of Dallas, Texas-based Prestonwood Bancshares, Inc. and its subsidiary, The Oaks Bank & Trust Company (The Oaks Bank). The results of operations for this acquisition were included in the Company’s financial results beginning in the fourth quarter of 2005.

We reported net income of $11.3 million for the second quarter ended June 30, 2006, a 32.3% increase compared to $8.5 million reported for the second quarter of 2005. Second quarter earnings were $0.25 per diluted share, up from $0.19 per diluted share for the same quarter of 2005. Net income for the six months ended June 30, 2006 was $21.3 million, or $0.46 per diluted share, compared with $16.3 million, or $0.36 per diluted share earned for the same period in 2005.

Our second quarter 2006 earnings continue to reflect favorable trends in asset quality, loan growth and our net interest margin. We continue to see opportunities for growth in all three of the markets in which we operate. During 2006, we are introducing new products and services that will help us deepen relationships with our customers and capitalize on opportunities for future growth.

On July 26, 2006, we announced an agreement to acquire BOTH, a Texas Corporation, and its subsidiary, Bank of the Hills. This acquisition will enable us to expand our presence in the San Antonio/Kerrville area. Subject to satisfaction of customary closing conditions, including receipt of necessary regulatory approvals and approval of the BOTH stockholders, we expect to close this transaction in the fourth quarter of 2006. The consideration for the merger will consist of a mixture of stock and cash totaling approximately $72.5 million. The cash portion of the merger will be financed from available cash and short-term borrowings.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in our Consolidated Financial Statements and accompanying notes. We believe that the judgments, estimates and assumptions used in the preparation of our Consolidated Financial Statements are appropriate given the factual circumstances as of June 30, 2006.

Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. We have identified two accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, and the sensitivity of our Consolidated Financial Statements to those judgments, estimates and assumptions, are critical to an understanding of our Consolidated Financial Statements. These policies relate to the methodology that determines our allowance for credit losses and the assumptions used in determining stock-based compensation.

These policies and the judgments, estimates and assumptions are described in greater detail in the Company’s 2005 Annual Report on Form 10-K in the “Critical Accounting Policies” section of Management’s Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – “Organization and Summary of Significant Accounting and Reporting Policies.”

RECENT ACCOUNTING STANDARDS

Statement of Accounting Standards No. 123R, Share-Based Payment (Revised 2004) (“SFAS 123R”) established standards for accounting for transactions in which an enterprise receives employee services in exchange for

 

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(a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123R applies to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. The Company used the modified prospective application in implementing SFAS 123R. Beginning in 2006, the Company’s results of operations reflect compensation expense for all employee stock-based compensation, including the unvested portion of stock options granted prior to 2006. Prior to 2006, the Company accounted for stock-based employee compensation using the intrinsic value-based method of accounting, as permitted. Under the intrinsic value-based method of accounting, no compensation expense was recognized for the Company’s incentive stock options or for the Company’s employee stock purchase plan. The adoption of this accounting standard resulted in additional stock-based compensation expense of $97 thousand and $204 thousand for the three and six months period ended June 30, 2006, respectively, attributable to stock options and the Company’s employee stock purchase plan. There was no income tax benefit recorded for this additional stock-based compensation expense. The adoption of this accounting standard did not have a meaningful impact on earnings per share for the same time periods.

In February 2006, the Financial Accounting Standard Board (“FASB”) issued Statement of Accounting Standards No. 155 (“SFAS 155”) Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140. It establishes, among other things, the accounting for certain derivatives embedded in other financial instruments. The primary objective of this Statement with respect to FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, is to simplify accounting for any hybrid financial instrument that contains an embedded derivative that would otherwise require bifurcation. The primary objective of this Statement with respect to FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, is to eliminate a restriction on the passive derivative instruments that a qualifying special-purpose entity (QSPE) may hold. This statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of this accounting standard is not expected to have a material impact on the Company’s financial statements.

In March 2006, the FASB issued Statement of Accounting Standards No. 156 (“SFAS 156”) Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140. It establishes, among other things, the accounting for all separately recognized servicing assets and servicing liabilities. This Statement amends Statement 140 to require that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. This statement is effective for fiscal years beginning after September 15, 2006. The adoption of this accounting standard is not expected to have a material impact on the Company’s financial statements.

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”) Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109 (“FAS 109”), Accounting for Income Taxes. FIN 48 clarifies the application of FAS 109 by defining a criterion that an individual tax position must meet for any part of the benefit of that position to be recognized in an enterprise’s financial statements. Additionally, FIN 48 provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The adoption of this accounting standard is not expected to have a material impact on the Company’s financial statements.

 

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SELECTED FINANCIAL DATA

 

    

Three Months Ended

June 30,

   

Six Months Ended

June 30,

   

Year Ended

December 31,

 
     2006     2005     2006     2005     2005  
     (Dollars and shares in thousands, except for per share amounts)  

INCOME STATEMENT DATA:

          

Net interest income

   $ 42,813     $ 36,545     $ 83,505     $ 71,338     $ 150,230  

Provision for credit losses

     1,837       3,221       3,163       6,561       14,371  

Noninterest income

     9,019       6,529       15,509       13,306       26,959  

Noninterest expense

     33,193       27,474       64,151       54,390       110,646  

Income before income taxes

     16,802       12,379       31,700       23,693       52,172  

Net income

     11,269       8,516       21,301       16,274       36,222  

BALANCE SHEET DATA (at period-end):

          

Total assets

   $ 3,789,920     $ 3,591,433     $ 3,789,920     $ 3,591,433     $ 3,726,859  

Total loans

     2,880,876       2,583,645       2,880,876       2,583,645       2,699,362  

Allowance for loan losses

     31,882       32,209       31,882       32,209       31,230  

Total securities

     575,275       694,220       575,275       694,220       618,998  

Trading assets

     —         15,556       —         15,556       28,515  

Total deposits

     2,984,375       2,605,180       2,984,375       2,605,180       2,838,143  

Short-term borrowings

     330,700       503,725       330,700       503,725       392,850  

Subordinated debt

     44,358       47,956       44,358       47,956       46,238  

Junior subordinated debt

     52,836       82,475       52,836       82,475       82,475  

Shareholders’ equity

     344,014       325,358       344,014       325,358       334,472  

COMMON SHARE DATA:

          

Earnings per share (1)

          

Basic

   $ 0.25     $ 0.19     $ 0.47     $ 0.36     $ 0.80  

Diluted

     0.25       0.19       0.46       0.36       0.79  

Shares used in computing earnings per common share

          

Basic

     45,421       45,250       45,379       45,191       45,288  

Diluted

     45,868       45,713       45,826       45,664       45,761  

End of period common shares outstanding

     45,411       45,283       45,411       45,283       45,334  

Book value per common share at period-end

          

Total

   $ 7.58     $ 7.19     $ 7.58     $ 7.19     $ 7.38  

Tangible

     5.63       5.77       5.63       5.77       5.42  

Cash dividends paid per common share

     0.07       0.06       0.14       0.12       0.24  

Common stock dividend payout ratio

     28.24 %     31.88 %     29.81 %     33.32 %     30.00 %

SELECTED PERFORMANCE RATIOS AND OTHER DATA:

          

Return on average common equity (2)

     13.10 %     10.55 %     12.54 %     10.22 %     11.07 %

Return on average assets (2)

     1.19 %     0.97 %     1.14 %     0.95 %     1.02 %

Net interest margin

     4.98 %     4.54 %     4.93 %     4.56 %     4.63 %

Efficiency ratio

     64.04 %     63.78 %     64.79 %     64.26 %     62.44 %

Full-time equivalent employees

     1,015       951       1,015       951       1,014  

Number of banking offices

     40       35       40       35       40  

LIQUIDITY AND CAPITAL RATIOS:

          

Average loans to average deposits

     96.05 %     98.09 %     95.99 %     97.19 %     97.67 %

Period-end shareholders’ equity to total assets

     9.08 %     9.06 %     9.08 %     9.06 %     8.97 %

Average shareholders’ equity to average assets

     9.11 %     9.18 %     9.11 %     9.29 %     9.19 %

Period-end tangible capital to total tangible assets

     6.91 %     7.41 %     6.91 %     7.41 %     6.76 %

Tier 1 capital to risk-weighted assets

     9.19 %     11.05 %     9.19 %     11.05 %     9.99 %

Total capital to risk-weighted assets

     11.41 %     13.64 %     11.41 %     13.64 %     12.36 %

Tier 1 leverage ratio (Tier 1 capital to average assets)

     8.65 %     9.85 %     8.65 %     9.85 %     9.11 %

ASSET QUALITY RATIOS:

          

Period-end allowance for credit losses to period-end loans

     1.14 %     1.28 %     1.14 %     1.28 %     1.20 %

Period-end allowance for loan losses to period-end loans

     1.11 %     1.25 %     1.11 %     1.25 %     1.16 %

Period-end allowance for loan losses to nonperforming loans

     257.21 %     174.09 %     257.21 %     174.09 %     142.99 %

Nonperforming assets to period-end loans and foreclosed assets

     0.48 %     0.78 %     0.48 %     0.78 %     0.83 %

Nonperforming loans to period-end loans

     0.43 %     0.72 %     0.43 %     0.72 %     0.81 %

Nonperforming assets to period-end assets

     0.37 %     0.56 %     0.37 %     0.56 %     0.60 %

Net charge-offs to average loans (2)

     0.16 %     0.30 %     0.20 %     0.32 %     0.51 %

(1) The calculation of diluted EPS excludes 105,488 and 85,973 options for the three and six months ended June 30, 2006 and 175,816 options for both the three and six-month periods ended June 30, 2005, which were antidilutive.
(2) Interim periods annualized

 

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RESULTS OF OPERATIONS

Net Income – Net income was $11.3 million for the quarter ended June 30, 2006, a 32.3% increase compared to $8.5 million reported for the second quarter of 2005. Earnings were $0.25 per diluted share in 2006’s second quarter, up from $0.19 per diluted share for the second quarter of 2005.

Net income for the six months ended June 30, 2006 was $21.3 million, or $0.46 per diluted share, compared with $16.3 million, or $0.36 per diluted share, earned for the same period in 2005.

Details of the changes in the various components of net income are discussed below.

Net Interest Income – Net interest income represents the amount by which interest income on interest-earning assets, including loans and securities, exceeds interest paid on interest-bearing liabilities, including deposits and borrowings. Net interest income is our principal source of earnings. Interest rate fluctuations, as well as changes in the amount and type of earning assets and liabilities, combine to affect net interest income.

The Federal Reserve Board significantly influences market interest rates, including rates offered for loans and deposits by many financial institutions. Generally, when the Federal Reserve Board changes the target overnight interest rate charged by banks, the market responds with a similar change in the prime lending rate. Beginning in June 2004, the Federal Reserve Board increased overnight interest rates by 425 basis points to 5.25% at June 30, 2006. Our net interest margin has continued to benefit from these gradual increases in short-term interest rates. In contrast, long-term interest rates, which are impacted by various forces including national and world-wide economies and political and monetary policies, have not increased by the same amount. This has resulted in a general flattening of the interest rate yield curve. Since our balance sheet is asset sensitive, our interest-earning assets generally reprice more quickly than our interest-bearing liabilities. However, in the current interest rate environment, the benefit of the Company’s traditionally asset-sensitive position has been negatively impacted but not eliminated.

Net interest income was $42.8 million for the three month period ended June 30, 2006, an increase of $6.3 million or 17.2% compared to the same period in 2005. For the six-month period ended June 30, 2006, net interest income was $83.5 million, an increase of $12.2 million or 17.1% compared to the same period in 2005. Our net interest margin was 4.98% and 4.93% for the three and six-month periods ended June 30, 2006, respectively, compared to 4.54% and 4.56% for the three and six-month periods ended June 30, 2005, respectively. Overall, our net interest income and net interest margin were higher during the 2006 periods, as compared with 2005, due in large part to higher deposit balances that were used to fund interest-earning asset growth and reduce short-term borrowings. Additionally, during the second quarter of 2006, we repaid $29.6 million of junior subordinated debt with an interest rate of 9.20%. The expansion of the net interest margin has been partially offset by a flatter interest rate yield curve and higher rates paid on borrowings and deposits. Changes in the mix of interest-earning assets and liabilities influence our net interest income and net interest margin.

Average interest-earning assets for the three and six-month periods ended June 30, 2006 increased $219.8 million or 6.8% and $263.1 million or 8.3%, respectively, over the comparable periods in 2005. The average yield earned on interest-earning assets increased 110 basis points and 105 basis points, respectively, for the same periods. The increase in interest-earning assets was due primarily to an increase in average loans held for investment of $326.8 million or 13.1% and $343.1 million or 14.1% for the three and six months ended June 30, 2006, respectively, over the comparable periods in 2005. This increase in average loans held for investment and increases in short-term interest rates contributed to the $13.3 million and $26.1 million increase in interest income on loans held for investment for the three and six months ended June 30, 2006, respectively, over the comparable periods in 2005. The size of the loan portfolio during 2006 as a percentage of average interest-earning assets increased from 77.4% for the first six months of 2005 to 81.4% for the same period in 2006.

On average, the securities portfolio (including trading assets) was lower by $93.6 million or 13.2% and $73.8 million or 10.6% for the three and six-month periods ended June 30, 2006, respectively, compared to the same

 

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periods in 2005. We decreased the securities portfolio as a percentage of interest-earning assets through a combination of scheduled maturities, paydowns and sales of securities beginning in 2005. Given the current rate environment and shape of the yield curve, we plan for minimal near-term growth in the investment portfolio with a floor based on the need to maintain adequate liquidity and dependent on the short-term rate cycle. We believe we may have better investment opportunities later in 2006. On average, the available-for-sale and held-to-maturity portfolios represent 18% of average interest earning assets for the six-month period ended June 30, 2006, down from 21% for the same period in 2005. Interest income earned on the securities portfolio decreased $434 thousand and $493 thousand for the three and six-month periods ended June 30, 2006, respectively, compared to the same time periods in 2005. The average yield earned on the securities portfolio increased 34 basis points and 33 basis points, respectively, during the same time periods which offset the decrease in the average securities portfolio.

Average interest-bearing liabilities for the three and six-month periods ended June 30, 2006 increased $130.6 million or 5.8% and $162.1 million or 7.3%, respectively, compared to the same periods in 2005. The average rate paid on interest-bearing liabilities increased 98 basis points and 99 basis points for the same time frames. These increases in interest-bearing liabilities were primarily due to an increase in average interest-bearing deposits and certificates of deposit of $99.4 million and $190.4 million, respectively, for the three month period ended June 30, 2006 and $69.6 million and $202.9 million, respectively, for the six-month period ended June 30, 2006, compared to the same periods in 2005. The average rate paid on deposits increased 99 basis points and 96 basis points for the same time periods due primarily to increases in interest rates offered on deposit products. The increase in average deposit balances and interest rates paid resulted in additional interest expense of $5.9 million and $11.0, respectively, for the three and six-month periods ended June 30, 2006 compared to the same periods in 2005.

Average short-term borrowings for the three and six-month periods ended June 30, 2006 decreased $139.4 million or 28.2% and $100.0 million or 21.5%, respectively, compared to the same periods in 2005. These decreases in average short-term borrowings were due to increases in both average interest-bearing and noninterest-bearing deposits. The average rate paid on short-term borrowings increased 202 basis points and 198 basis points for the three and six-month periods ended June 30, 2006, respectively, compared to the same periods in 2005, resulting in an increase in interest expense of $744 thousand and $2.2 million during the same periods.

 

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Certain average balances, together with the total dollar amounts of interest income and expense and the average interest yields/rates are included below. No tax equivalent adjustments were made (dollars in thousands).

 

     Three Months Ended June 30,  
     (Dollars in thousands)  
     2006     2005  
     Average
Balance
    Interest    Average
Yield/Rate
    Average
Balance
    Interest    Average
Yield/Rate
 

Interest-Earning Assets:

              

Loans held for sale (1)

   $ 9,434     $ 191    8.10 %   $ 11,448     $ 200    7.02 %

Loans held for investment (1):

              

Taxable

     2,815,355       55,036    7.84 %     2,488,633       41,694    6.72 %

Non-taxable

     2,388       38    6.33 %     2,343       39    6.65 %

Securities:

              

Taxable

     538,584       6,011    4.48 %     616,753       6,345    4.13 %

Non-taxable

     58,533       564    3.87 %     62,945       612    3.90 %

Trading assets

     17,969       270    6.02 %     28,944       322    4.46 %

Federal funds sold

     3,590       43    4.87 %     16,880       122    2.89 %

Deposits in financial institutions

     2,678       32    4.88 %     770       6    3.18 %
                                          

Total interest-earning assets

     3,448,531       62,185    7.23 %     3,228,716       49,340    6.13 %

Noninterest-earning assets:

              

Cash and due from banks

     104,650            89,617       

Premises and equipment, net

     39,831            39,045       

Other assets

     224,804            199,954       

Allowance for loan losses

     (31,670 )          (31,097 )     
                          

Total noninterest-earning assets

     337,615            297,519       
                          

Total assets

   $ 3,786,146          $ 3,526,235       
                          

Interest bearing liabilities:

              

Deposits:

              

Demand and savings

   $ 1,059,200     $ 3,883    1.47 %   $ 959,832     $ 1,853    0.77 %

Certificates and other time

     871,336       8,542    3.93 %     680,948       4,669    2.75 %

Short-term borrowings

     354,102       4,413    5.00 %     493,464       3,669    2.98 %

Subordinated debt

     44,784       1,125    10.08 %     46,985       882    7.53 %

Junior subordinated debt

     64,887       1,409    8.71 %     82,475       1,722    8.37 %
                                          

Total interest-bearing liabilities

     2,394,309       19,372    3.25 %     2,263,704       12,795    2.27 %

Noninterest-bearing sources:

              

Demand deposits

     1,012,805            910,448       

Other liabilities

     34,155            28,322       
                          

Total noninterest-bearing liabilities

     1,046,960            938,770       

Shareholders’ equity

     344,877            323,761       
                          

Total liabilities and shareholders’ equity

   $ 3,786,146          $ 3,526,235       
                                          

Net interest income & margin

     $ 42,813    4.98 %     $ 36,545    4.54 %
                              

(1) For the purpose of calculating loan yields, average loan balances include nonaccrual loans with no related interest income.

 

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Table of Contents
     Six Months Ended June 30,  
     (Dollars in thousands)  
     2006     2005  
     Average
Balance
    Interest    Average
Yield/Rate
    Average
Balance
    Interest    Average
Yield/Rate
 

Interest-Earning Assets:

              

Loans held for sale (1)

   $ 8,493     $ 350    8.30 %   $ 9,808     $ 347    7.13 %

Loans held for investment (1):

              

Taxable

     2,771,636       105,614    7.68 %     2,428,303       79,473    6.60 %

Non-taxable

     2,454       77    6.35 %     2,713       104    7.73 %

Securities:

              

Taxable

     547,892       12,160    4.48 %     607,403       12,500    4.15 %

Non-taxable

     59,634       1,151    3.89 %     63,951       1,240    3.91 %

Trading assets

     18,368       570    6.26 %     28,368       634    4.51 %

Federal funds sold

     3,814       85    4.52 %     11,607       159    2.77 %

Deposits in financial institutions

     3,997       90    4.55 %     994       15    3.10 %
                                          

Total interest-earning assets

     3,416,288       120,097    7.09 %     3,153,147       94,472    6.04 %

Noninterest-earning assets:

              

Cash and due from banks

     108,822            95,930       

Premises and equipment, net

     40,352            39,472       

Other assets

     225,212            198,100       

Allowance for loan losses

     (31,438 )          (30,801 )     
                          

Total noninterest-earning assets

     342,948            302,701       
                          

Total assets

   $ 3,759,236          $ 3,455,848       
                          

Interest bearing liabilities:

              

Deposits:

              

Demand and savings

   $ 1,054,103     $ 6,960    1.33 %   $ 984,459     $ 3,627    0.74 %

Certificates and other time

     839,583       15,676    3.77 %     636,635       8,041    2.55 %

Short-term borrowings

     365,661       8,575    4.73 %     465,660       6,359    2.75 %

Subordinated debt

     45,399       2,180    9.69 %     47,020       1,695    7.27 %

Junior subordinated debt

     73,632       3,201    8.77 %     82,475       3,412    8.34 %
                                          

Total interest-bearing liabilities

     2,378,378       36,592    3.10 %     2,216,249       23,134    2.11 %

Noninterest-bearing sources:

              

Demand deposits

     1,005,064            890,365       

Other liabilities

     33,253            28,159       
                          

Total noninterest-bearing liabilities

     1,038,317            918,524       

Shareholders’ equity

     342,541            321,075       
                          

Total liabilities and shareholders’ equity

   $ 3,759,236          $ 3,455,848       
                                          

Net interest income & margin

     $ 83,505    4.93 %     $ 71,338    4.56 %
                              

(1) For the purpose of calculating loan yields, average loan balances include nonaccrual loans with no related interest income.

 

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Table of Contents

Noninterest IncomeNoninterest income for the three and six months ended June 30, 2006 and 2005, respectively, is summarized as follows (in thousands):

 

     For the Three Months Ended     For the Six Months Ended
     June 30,
    2006    
    June 30,
    2005    
    June 30,
    2006    
    June 30,
    2005    

Customer service fees

   $ 3,061     $ 2,888     $ 5,638     $ 5,880

Net gain (loss) on trading assets

     (167 )     (11 )     (302 )     98

Net gain (loss) on the sale of securities

     —         (31 )     —         54

Net gain on the sale of loans

     205       417       510       674

Bank owned life insurance

     713       770       1,444       1,534

Debit card income

     489       433       955       849

Other

     4,718       2,063       7,264       4,217
                              
   $ 9,019     $ 6,529     $ 15,509     $ 13,306
                              

Net losses on trading assets for the three and six months ended June 30, 2006 were attributable to the market conditions for these types of assets and our desire to reduce our holdings in these securities. During the second quarter of 2006, we sold our remaining trading assets but may potentially reinvest in these assets based on future market conditions. Trading assets are carried at fair market value in our consolidated balance sheets.

Net gains on the sale of loans decreased slightly for the three and six-month periods ended June 30, 2006 compared to the same periods in 2005. The decrease was due primarily to a decrease in the volume of loan sales.

Other noninterest income increased $2.7 million and $3.0 million, respectively, for the three and six months ended June 30, 2006 compared to the same periods in 2005. These increases are primarily due to a gain of $1.1 million on the sale of a multi-tenant office building during the second quarter of 2006. The Company will continue to occupy the banking center located in this building. In addition, commission income and other lending fees increased $935 thousand and $1.3 million for the three and six months ended June 30, 2006, respectively, compared to the same periods in 2005.

Noninterest Expense – Noninterest expense for the three and six months ended June 30, 2006 and 2005, respectively, is summarized as follows (in thousands):

 

     For the Three Months Ended    For the Six Months Ended
     June 30,
    2006    
    June 30,
    2005    
   June 30,
    2006    
    June 30,
    2005    

Salaries and employee benefits

   $ 18,822     $ 15,278    $ 37,497     $ 30,672

Occupancy expense

     4,061       3,909      7,904       7,551

Technology

     1,615       1,381      3,089       2,595

Professional fees

     1,473       1,630      2,898       2,926

Postage, delivery and supplies

     903       778      1,693       1,528

Marketing

     709       617      1,093       1,262

Core deposit intangibles amortization

     194       102      389       214

Net losses (gains) and carrying costs of other real estate and foreclosed property

     (238 )     41      (219 )     97

Other

     5,654       3,738      9,807       7,545
                             
   $ 33,193     $ 27,474    $ 64,151     $ 54,390
                             

Salaries and employee benefits for the three and six-month periods ended June 30, 2006 increased $3.5 million and $6.8 million, respectively, compared to the same periods in 2005. The Company added 64 full-time equivalent employees since June 30, 2005, principally related to new office additions and to support growth.

 

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Table of Contents

During the first quarter of 2006, the Company added experienced key officers to further implement its growth strategy. During the second quarter of 2006, the Company experienced higher incentive compensation expense as we crossed higher thresholds of production and profitability. As a result, incentive compensation expense increased $929 thousand or 52% and $1.8 million or 65% for the three and six-month periods ended June 30, 2006, respectively, compared to the same periods in 2005. In addition, profit sharing expense, which we began accruing during 2006 as the 12% ROE target stated in the plan was attained, increased $564 thousand and $996 thousand for the three and six-month periods ended June 30, 2006, respectively, compared to the same periods in 2005.

Occupancy expense increased $152 thousand or 3.9% and $353 thousand or 4.7%, respectively, for the three and six-month periods ended June 30, 2006 compared to the same periods in 2005. These increases were due primarily to the addition of five banking centers from the acquisition of The Oaks Bank on September 30, 2005.

Technology expense increased $234 thousand or 16.9% and $494 thousand or 19.0%, respectively, for the three and six-month periods ended June 30, 2006 compared to the same periods in 2005. These increases were due to additional hardware and customer products including an upgrade in the Bank’s deposit system.

Professional fees decreased $157 thousand or 9.6% and $28 thousand or 1.0% for the three and six-month periods ended June 30, 2006, respectively, compared to the same periods in 2005 due in part to a decrease in legal fees primarily related to a decrease in nonperforming assets.

Other noninterest expense was $5.7 million and $9.8 million for the three and six months ended June 30, 2006, respectively, up $1.9 million or 51.3% and $2.3 million or 30.0% compared with the same periods in 2005. During the second quarter of 2006, the Company prepaid $29.6 million of junior subordinated debt that carried a 9.20% interest rate. As the result of calling these securities, the Company wrote off the remaining associated unamortized debt issuance costs totaling $1.3 million.

Income Taxes – We provided $5.5 million and $10.4 million for federal and state income taxes during the three and six-month periods ended June 30, 2006, respectively, and $3.9 million and $7.4 million, respectively, for the same periods of 2005. The effective tax rate for the three and six-month periods in 2006 was approximately 33% compared to 31% for the same periods in 2005.

FINANCIAL CONDITION

Loans Held for Investment – The following table summarizes our loan portfolio by type, excluding loans held for sale (dollars in thousands):

 

     June 30, 2006     December 31, 2005  
     Amount    %     Amount    %  

Commercial and industrial

   $ 784,856    27.5 %   $ 738,061    27.4 %

Real estate:

          

Commercial

     1,281,615    44.9 %     1,221,610    45.4 %

Construction

     520,024    18.2 %     438,454    16.3 %

Residential mortgage

     171,581    6.0 %     190,701    7.1 %

Consumer/other

     71,867    2.5 %     72,937    2.7 %

Foreign loans

     26,718    0.9 %     29,245    1.1 %
                          

Total loans held for investment

   $ 2,856,661    100.0 %   $ 2,691,008    100.0 %
                          

At June 30, 2006, loans held for investment were $2.9 billion, an increase of $165.7 million or 6.2% over loans held for investment at December 31, 2005. This increase was due to internal loan growth. We have experienced good growth in the commercial and industrial, commercial real estate and construction lending portfolios during 2006.

 

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Table of Contents

Our primary lending focus is commercial loans and owner-occupied real estate loans to businesses with annual sales ranging from $300 thousand to $30 million. At June 30, 2006, commercial real estate loans and commercial and industrial loans were 44.9% and 27.5%, respectively, of loans held for investment.

At June 30, 2006, loans held for investment were 95.7% of deposits and 75.4% of total assets. As of June 30, 2006, we had no material concentrations of loans.

Loans Held for Sale – Loans held for sale totaled were $24.2 million at June 30, 2006, as compared with $8.4 million at December 31, 2005. Loans held for sale includes the guaranteed portion of SBA loans originated by the Bank and loans originated as part of the Bank’s wholesale lending operations. During the second quarter of 2006, $12.1 million of wholesale real estate loans were reclassified from loans held for investment to loans held for sale. Due to the timing of the sales of SBA and other loans to investors, the balance of loans in the held for sale category at any given time may vary.

Trading Assets – During 2006, we sold our remaining holdings of trading assets in response to current market conditions and our desire to reduce our holdings in these securities. We may potentially reinvest in these assets based on future market conditions.

Securities – The Company’s securities portfolio at June 30, 2006 totaled $575.3 million, as compared to $619.0 million at December 31, 2005, a decrease of $43.7 million or 7.1%. We have decreased the securities portfolio as a percentage of interest earning assets through a combination of scheduled maturities, paydowns and sales of securities.

Net unrealized losses on the available-for-sale securities were $20.5 million at June 30, 2006 as compared to $10.7 million at December 31, 2005. Management believes that the unrealized losses on the Company’s securities portfolio were caused primarily by interest rate increases. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold those investments until a recovery of fair value, which may be at maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2006.

Deposits – The following table summarizes the Company’s deposit portfolio by type (dollars in thousands):

 

     June 30, 2006     December 31, 2005  
     Amount    %     Amount    %  

Noninterest-bearing demand

   $ 1,033,743    34.6 %   $ 1,045,937    36.8 %

Interest-bearing demand

     1,032,465    34.6 %     1,017,832    35.9 %

Certificates and other time deposits

          

Jumbo

     564,365    18.9 %     467,672    16.5 %

Regular

     231,329    7.8 %     216,585    7.6 %

Brokered

     122,473    4.1 %     90,117    3.2 %
                          

Total deposits

   $ 2,984,375    100.0 %   $ 2,838,143    100.0 %
                          

Total deposits as of June 30, 2006 increased $146.2 million to $3.0 billion, up 5.2% compared to $2.8 billion at December 31, 2005. The deposit growth we experienced during the first six months of 2006 was driven primarily by interest-bearing and time deposits. The percentage of noninterest-bearing deposits to total deposits as of June 30, 2006 was 34.6%, and our loan to deposit ratio remained at 97%.

Short-term borrowings – As of June 30, 2006, we had $330.7 million in short-term borrowings compared to $392.9 million at December 31, 2005, a decrease of $62.2 million or 15.8%. The Company’s primary source of short-term borrowings is the Federal Home Loan Bank. At June 30, 2006, borrowings under FHLB advances totaled $300 million and had maturities less than 30 days. The average interest rate on these borrowings was 5.19% at June 30, 2006. The Company utilizes these borrowings to meet liquidity needs. Maturing advances are replaced by drawing on available cash, making additional borrowings or through increased customer deposits.

 

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Table of Contents

ASSET QUALITY

Risk Elements – Our nonperforming and past-due loans are substantially collateralized by assets, with any excess of loan balances over collateral values specifically allocated in the allowance for loan losses. On an ongoing basis we receive updated appraisals on loans secured by real estate, particularly those categorized as nonperforming loans and potential problem loans. In those instances where updated appraisals reflect reduced collateral values, an evaluation of the borrower’s overall financial condition is made to determine the need, if any, for possible write-downs or appropriate additions to the allowance for loan losses.

Nonperforming assets and potential problem loans consisted of the following (dollars in thousands):

 

    

June 30,

2006

   

December 31,

2005

 

Nonperforming and nonaccrual loans

   $ 12,395     $ 21,841  

Real estate acquired by foreclosure

     1,171       460  

Other repossessed assets

     412       137  
                

Total nonperforming assets

   $ 13,978     $ 22,438  
                

Potential problem loans

   $ 43,846     $ 58,011  
                

Accruing loans past due 90 days or more

   $ 543     $ 162  
                

Period-end allowance for loan losses to nonperforming loans

     257.21 %     142.99 %

Nonperforming loans to period-end loans

     0.43 %     0.81 %

Nonperforming assets to period-end assets

     0.37 %     0.60 %

Nonperforming assets to period-end loans and foreclosed assets

     0.48 %     0.83 %

Nonperforming assets were $14.0 million at June 30, 2006, an $8.5 million decrease from December 31, 2005. Accruing loans past due 90 days or more at June 30, 2006 totaled $543 million.

Allowance for Credit Losses – The allowance for credit losses and the related provision for credit losses are determined based on the historical credit loss experience, changes in the loan portfolio, including size, mix and risk of the individual loans, and current economic conditions. We monitor economic conditions in our local market areas and the probable impact on borrowers, on past-due amounts, on related collateral values, on the number and size of the non-performing loans and on the resulting amount of charges-offs for the period.

The provision for credit losses for the three and six months ended June 30, 2006 was $1.8 million and $3.2 million, respectively, as compared to $3.2 million and $6.6 million for the same periods in 2005. The lower provision for credit losses during the three and six months ended June 30, 2006 was due to a favorable improvement in net charge-offs for this same time period and is reflective of the general improvement in asset quality in the Company that has been a function of both a healthy Texas economy and a strengthening in our credit culture.

Net charge-offs were $1.2 million or 0.16% (annualized) and $2.8 million or 0.20% (annualized) of average loans for the three and six months ended June 30, 2006, respectively. Net charge-offs decreased $704 thousand and $1.0 million for the three and six months ended June 30, 2006, respectively, compared to the same periods in 2005. These improvements in asset quality are primarily attributable to several internal changes during the past year. Some of these changes include: implementing a consumer and micro-business loan credit scoring system, updating and revising our loan policy, standardizing our loan funding process, improving our loan approval process and enhancing our credit culture to take a more value-added risk management approach.

The allowance for loan losses at June 30, 2006 was $31.9 million and represented 1.11% of total loans. The allowance for loan losses at June 30, 2006 was 257.21% of nonperforming loans, up from 142.99% at December 31, 2005, principally because of improvements in asset quality. The reserve for unfunded lending commitments was $890 thousand at June 30, 2006 as compared with $1.2 million at December 31, 2005.

 

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The following table presents an analysis of the allowance for credit losses and other related data (dollars in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2006     2005     2006     2005  

Allowance for loan losses at beginning of period

   $ 31,116     $ 30,760     $ 31,230     $ 29,406  

Charge-offs:

        

Commercial, financial, and industrial

     1,393       1,881       2,421       3,220  

Real estate, mortgage and construction

     439       1,065       1,444       1,576  

Consumer

     253       323       366       838  
                                

Total charge-offs

     2,085       3,269       4,231       5,634  
                                

Recoveries

        

Commercial, financial, and industrial

     782       721       1,167       1,034  

Real estate, mortgage and construction

     2       605       5       610  

Consumer

     145       83       265       152  
                                

Total recoveries

     929       1,409       1,437       1,796  
                                

Net charge-offs

     1,156       1,860       2,794       3,838  

Provision for loan losses

     1,922       3,309       3,446       6,641  
                                

Allowance for loan losses at end of period

     31,882       32,209       31,882       32,209  
                                

Reserve for losses on unfunded loan commitments at beginning of period

     975       834       1,173       826  

Provision for losses on unfunded loan commitments

     (85 )     (88 )     (283 )     (80 )
                                

Reserve for losses on unfunded loan commitments at end of period

     890       746       890       746  
                                

Total allowance for credit losses

   $ 32,772     $ 32,955     $ 32,772     $ 32,955  
                                

Period-end allowance for credit losses to period-end loans

     1.14 %     1.28 %     1.14 %     1.28 %

Period-end allowance for loan losses to period-end loans

     1.11 %     1.25 %     1.11 %     1.25 %

Period-end allowance for loan losses to nonperforming loans

     257.21 %     174.09 %     257.21 %     174.09 %

Nonperforming assets to period-end loans and foreclosed assets

     0.48 %     0.78 %     0.48 %     0.78 %

Nonperforming loans to period-end loans

     0.43 %     0.72 %     0.43 %     0.72 %

Nonperforming assets to period-end assets

     0.37 %     0.56 %     0.37 %     0.56 %

Net charge-offs to average loans (annualized)

     0.16 %     0.30 %     0.20 %     0.32 %

INTEREST RATE SENSITIVITY

Interest rate risk is the risk to interest income attributed to the repricing characteristics of interest sensitive assets and liabilities. An interest sensitive asset or liability is one that experiences changes in cashflows as a direct result of changes in market interest rates.

We manage interest rate risk by positioning the balance sheet to maximize net interest income while maintaining an acceptable level of risk, remaining mindful of the relationship between profitability, liquidity and interest rate risk. The overall interest rate risk position and strategies for the management of interest rate risk are reviewed by senior management, the Asset/Liability Management Committee and our Board of Directors on an ongoing basis.

We measure interest rate risk using a variety of methodologies including, but not limited to, dynamic simulation analysis, gap analysis and static balance sheet rate shocks. Dynamic simulation analysis is the primary tool used to measure interest rate risk and allow us to model the effects of non-parallel movements in multiple yield curves, changes in borrower and depositor behaviors, changes in loan and deposit pricing, and changes in loan and deposit portfolio compositions and growth rates over a 24-month horizon.

 

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We utilize static balance sheet rate shocks to estimate the potential impact on net interest income of changes in interest rates under various rate scenarios. This analysis estimates a percentage of change in these metrics from the stable rate base scenario versus alternative scenarios of rising and falling market interest rates by instantaneously shocking a static balance sheet. The following table summarizes the simulated change over a 12-month horizon as of June 30, 2006 and December 31, 2005:

 

   

   Changes in

 Interest Rates

 (Basis Points)

   Increase
(Decrease)
in Net
Interest
Income
 

June 30, 2006

  
 

+200

   5.39 %
 

+100

   2.74 %
 

Base

   0.00 %
 

-100

   -2.92 %
 

-200

   -8.62 %

December 31, 2005

  
 

+200

   6.59 %
 

+100

   3.45 %
 

Base

   0.00 %
 

-100

   -3.43 %
 

-200

   -10.68 %

Each rate scenario reflects unique prepayment and repricing assumptions. Because of uncertainties related to customer behaviors, loan and deposit pricing levels, competitor behaviors, and socio-economic factors that could effect the shape of the yield curves, this analysis is not intended to and does not provide a precise forecast of the affect actual changes in market rates will have on the Company. The interest rate sensitivity analysis includes assumptions that (i) the composition of our interest sensitive assets and liabilities existing at period-end will remain constant over the measurement period; and (ii) changes in market rates are parallel and instantaneous across the yield curve regardless of duration or repricing characteristics of specific assets or liabilities. Further, this analysis does not contemplate any actions that we might undertake in response to changes in market factors. Accordingly, this analysis is not intended to and does not provide a precise forecast of the affect actual changes in market rates will have on the Company.

During July of 2006, the Company executed a hedging strategy utilizing interest rate derivatives designed as a means to mitigate some of the Company’s asset sensitivity. The Company purchased an interest rate floor contract with a notional amount of $113 million and a strike rate of 8.00% and an interest rate collar contract with a notional amount of $250 million with an 8.42% interest rate cap and an 8.0% interest rate floor. These contracts were designated as cash flow hedges of the monthly interest receipts from the Company’s portfolio of variable-rate loans. The interest rate floor and interest rate collar contracts have termination dates of August 1, 2009 and August 1, 2010, respectively.

CAPITAL AND LIQUIDITY

Capital – At June 30, 2006, shareholders’ equity totaled $344.0 million or 9.08% of total assets, as compared to $334.5 million or 8.97% of total assets at December 31, 2005. Our risk-based capital ratios together with the minimum capital amounts and ratios at June 30, 2006 were as follows (dollars in thousands):

 

     Actual     For Minimum
Capital Adequacy
Purposes
 
     Amount    Ratio     Amount    Ratio  

Total capital (to risk weighted assets)

   $ 397,169    11.4 %   $ 278,486    8.0 %

Tier 1 capital (to risk weighted assets)

     320,042    9.2 %     139,243    4.0 %

Tier 1 capital (to average assets)

     320,042    8.6 %     148,067    4.0 %

See Note 11 to our Consolidated Financial Statements for further discussion of regulatory capital requirements.

 

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Liquidity – The objectives of our liquidity management is to maintain our ability to meet day-to-day deposit withdrawals and other payment obligations, to raise funds to support asset growth, to maintain reserve requirements and otherwise operate on an ongoing basis. We strive to manage a liquidity position sufficient to meet operating requirements while maintaining an appropriate balance between assets and liabilities to meet the expectations of our shareholders. In recent years, our liquidity needs have primarily been met by growth in deposits including brokered certificates of deposit. In addition to deposits, we have access to funds from correspondent banks and from the Federal Home Loan Bank, supplemented by cash flows from amortizing securities and loan portfolios. For more information regarding liquidity, please refer to our 2005 Annual Report on Form 10-K.

Sterling Bancshares must provide for its own liquidity and fund its own obligations. The primary source of Sterling Bancshares’ revenues is from dividends declared by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to Sterling Bancshares. Under these provisions, there was an aggregate of approximately $115.5 million available for payment of dividends at June 30, 2006, by the Bank. At June 30, 2006, the aggregate amount of dividends, which legally could be paid without prior approval of various regulatory agencies, totaled $46.2 million. It is not anticipated that such restrictions will have an impact on the ability of Sterling Bancshares to meet its ongoing cash obligations. As of June 30, 2006, we did not have any material commitments for capital expenditures.

On May 8, 2006, Sterling Bancshares prepaid all of its $29.6 million 9.20% Junior Subordinated Deferrable Interest Debentures. The payment of these Debentures was funded by a dividend from the Bank. Our planned acquisition of BOTH, Inc. is expected to close in the fourth quarter of 2006. The cash portion of the total purchase price will be financed from available cash and short-term borrowings.

On April 25, 2005, the Company’s Board of Directors authorized the repurchase of up to 2,500,000 shares of common stock, not to exceed 500,000 shares in any calendar year. The Company may repurchase shares of its common stock from time to time in the open market or through privately negotiated transactions. The table below lists the Company’s purchases of its equity securities registered pursuant to Section 12 of the Exchange Act during the quarter ended June 30 2006:

 

Period

  

Total Number

of Shares

Purchased

  

Weighted Average

Price Paid per

Share

   Total Number of Shares
Purchased as Part of Publicly
Announced Plans
   Shares That May Yet
Be Purchased Under the
Plans

April 1, 2006 to
April 30, 2006

   48,000    $ 17.71    298,000    2,202,000

May 1, 2006 to
May 31, 2006

   66,000    $ 16.66    364,000    2,136,000

June 1, 2006 to
June 30, 2006

   11,000    $ 17.01    375,000    2,125,000

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

There have been no material changes in market risk we face since December 31, 2005. For information regarding the market risk of our financial instruments, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Interest Rate Sensitivity.” Our principal market risk exposure is to interest rates.

 

ITEM 4. CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures – As of the end of the period covered by this report, an evaluation was made by the Company’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities and Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period.

There were no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) during the most recent fiscal quarter that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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Table of Contents

PART II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS.

Not applicable.

 

ITEM 1A. RISK FACTORS

Information regarding risk factors appears in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Forward-Looking Statements,” in Part I – Item 2 of this Form 10-Q and in Part I – Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2005. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K.

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

Not applicable.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

Not applicable.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

The Company’s Annual Meeting of Stockholders was held on April 24, 2006, to consider and vote on the following proposals:

Proposal 1: The Election of Directors

The following individual was nominated and elected as a Class I director to hold office until the 2008 annual meeting of the stockholders of the Company or until his successor has been duly elected and qualified.

 

     For    Withheld

J. Downey Bridgwater

   36,998,427    3,740,669

The following individuals were nominated and elected as Class II directors to hold office until the 2009 annual meeting of the stockholders of the Company or until their successors have been duly elected and qualified.

 

     For    Withheld

David L. Hatcher

   39,139,689    1,594,407

G. Edward Powell

   38,922,886    1,816,210

Raimundo Riojas E.  

   37,985,811    2,758,285

Dan C. Tutcher

   39,158,383    1,580,713

Max W. Wells

   37,864,954    2,869,143

The following directors continued in office after the annual meeting:

 

George Beatty, Jr.  

   Glenn H. Johnson

Anat Bird

   R. Bruce LaBoon

James D. Calaway

   Thomas A. Reiser

Bruce J. Harper

  

 

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Table of Contents

Proposal 2: Ratification of the appointment of Deloitte & Touche LLP as the Company’s independent registered public accounting firm for its fiscal year ending December 31, 2006.

 

            For            

 

        Against        

 

    Abstain    

37,912,200

  2,789,193   34,302

 

ITEM 5. OTHER INFORMATION.

Not applicable.

 

ITEM 6. EXHIBITS.

 

    11    —   Statement Regarding Computation of Earnings Per Share (included as Note (8) to Consolidated Financial Statements on page 16 of this Quarterly Report on Form 10-Q).
  *31.1 —   Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of J. Downey Bridgwater, Chairman, President and Chief Executive Officer.
  *31.2 —   Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Stephen C. Raffaele, Executive Vice President and Chief Financial Officer.
**32.1 —   Section 1350 Certification of the Chief Executive Officer.
**32.2 —   Section 1350 Certification of the Chief Financial Officer.

* As filed herewith.
** As furnished herewith.

 

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Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused the report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    STERLING BANCSHARES, INC.
Date: August 7, 2006     By:   /S/    J. DOWNEY BRIDGWATER        
        J. Downey Bridgwater
        Chairman, President and
        Chief Executive Officer
        (Principal executive officer)
Date: August 7, 2006     By:   /S/    STEPHEN C. RAFFAELE        
        Stephen C. Raffaele
        Executive Vice President
        and Chief Financial Officer
        (Principal financial and accounting officer)

 

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Table of Contents

EXHIBIT INDEX

 

Exhibit  

Description

    11    —   Statement Regarding Computation of Earnings Per Share (included as Note (8) to Consolidated Financial Statements on page 16 of this Quarterly Report on Form 10-Q).
  *31.1 —   Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of J. Downey Bridgwater, Chairman, President and Chief Executive Officer.
  *31.2 —   Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Stephen C. Raffaele, Executive Vice President and Chief Financial Officer.
**32.1 —   Section 1350 Certification of the Chief Executive Officer.
**32.2 —   Section 1350 Certification of the Chief Financial Officer.

* As filed herewith.
** As furnished herewith.

 

37

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