UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

 

 

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 ý      No  o

 

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

 

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

 

 

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Consolidated Statements of Condition (Unaudited)

 

(Dollars in Thousands)

 

		June 30, 2004			December 31, 2003
Assets
Cash and due from banks		$	191,534		$	152,229
Federal funds sold		85,000			63,500
Total cash and cash equivalents		276,534			215,729
Time deposits with banks		23,996			100
Investment securities:
Held to maturity (Market value of $2,385 on June 30, 2004 and $2,160 on December 31, 2003)		2,385			2,160
Available for sale (Amortized cost of $3,013,817 on June 30, 2004 and $3,019,584 on December 31, 2003)		2,979,381			3,039,341
Total investment securities		2,981,766			3,041,501
Loans:
Commercial, financial and agricultural		3,068,162			1,400,173
Real estate – mortgage		949,546			495,481
Real estate – construction		623,379			492,208
Consumer		223,391			139,987
Foreign		221,501			222,797
Total loans		5,085,979			2,750,646
Less unearned discounts		(1,300		)	(1,646		)
Loans, net of unearned discounts		5,084,679			2,749,000
Less allowance for possible loan losses		(84,571		)	(48,646		)
Net loans		5,000,108			2,700,354
Bank premises and equipment, net		282,259			220,602
Accrued interest receivable		36,898			28,891
Other investments		290,869			244,113
Identified intangible assets		47,589			5,892
Goodwill		277,098			67,442
Other assets		84,088			53,686
Total assets		$	9,301,205		$	6,578,310

 

1

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Consolidated Statements of Condition (Unaudited)

 

(Dollars in Thousands)

 

		June 30, 2004			December 31, 2003
Liabilities
Deposits:
Demand – non-interest bearing		$	1,065,310		$	814,470
Savings and interest bearing demand		2,168,534			1,395,618
Time		3,227,671			2,225,611
Total deposits		6,461,515			4,435,699
Securities sold under repurchase agreements		552,182			501,296
Other borrowed funds		1,320,205			845,272
Junior subordinated deferrable interest debentures		234,882			172,254
Senior notes		21,295			—
Other liabilities		43,744			46,406
Total liabilities		8,633,823			6,000,927
Shareholders’ equity:
Common shares of $1.00 par value.  Authorized 75,000,000 shares; issued 68,288,065 shares on June 30, 2004 and 52,774,176 shares on December 31, 2003		68,288			52,774
Surplus		127,863			37,777
Retained earnings		659,614			639,606
Accumulated other comprehensive (loss) income		(22,383		)	12,842
		833,382			742,999
Less cost of shares in treasury, 17,594,464 shares on June 30, 2004 and 14,068,296 shares on December 31, 2003		(166,000		)	(165,616		)
Total shareholders’ equity		667,382			577,383
Total liabilities and shareholders’ equity		$	9,301,205		$	6,578,310

 

See accompanying notes to consolidated financial statements.

 

2

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Consolidated Statements of Income (Unaudited)

 

(Dollars in Thousands, except per share data)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2004			2003			2004			2003
Interest income:
Loans, including fees		$	45,596		$	43,346		$	89,022		$	88,690
Time deposits with banks		14			1			20			5
Federal funds sold		433			185			902			316
Investment securities:
Taxable		25,078			33,692			50,701			68,766
Tax-exempt		1,272			1,287			2,556			2,575
Other interest income		111			90			273			222
Total interest income		72,504			78,601			143,474			160,574
Interest expense:
Savings deposits		2,504			2,790			4,721			5,740
Time deposits		9,835			10,519			18,886			21,797
Securities sold under repurchase agreements		4,783			4,647			9,540			9,260
Other borrowings		2,437			3,551			4,644			6,570
Junior subordinated interest deferrable debentures		2,638			2,195			5,125			4,328
Senior notes		84			—			84			—
Total interest expense		22,281			23,702			43,000			47,695
Net interest income		50,223			54,899			100,474			112,879
Provision for possible loan losses		1,375			2,124			2,717			4,113
Net interest income after provision for possible loan losses		48,848			52,775			97,757			108,766
Non-interest income:
Service charges on deposit accounts		15,911			14,714			30,320			29,049
Other service charges, commissions and fees
Banking		4,443			3,855			8,286			7,316
Non-banking		1,652			2,247			2,548			6,281
Gain on investment securities transactions, net		3,689			5,542			8,461			8,305
Other investments, net		3,313			2,443			5,825			4,426
Other income		2,082			2,563			3,963			5,133
Total non-interest income		31,090			31,364			59,403			60,510

 

3

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2004			2003			2004			2003
Non-interest expense:
Employee compensation and benefits		$	17,123		$	17,629		$	33,564		$	36,093
Occupancy		3,626			3,519			6,899			6,479
Depreciation of bank premises and equipment		4,415			4,014			8,466			7,948
Professional fees		1,309			2,202			2,882			3,724
Stationery and supplies		910			991			1,889			1,877
Amortization of identified intangible assets		246			319			492			638
Advertising		2,237			2,029			4,093			3,772
Other		11,023			11,490			20,291			19,750
Total non-interest expense		40,889			42,193			78,576			80,281
Income before income taxes		39,049			41,946			78,584			88,995
Provision for income taxes		12,820			13,471			25,836			29,195
Net income		$	26,229		$	28,475		$	52,748		$	59,800
Basic earnings per common share:
Weighted average number of shares outstanding:		48,856,848			48,357,959			48,645,373			48,423,627
Net income		$	.54		$	.59		$	1.08		$	1.23
Fully diluted earnings per common share:
Weighted average number of shares outstanding:		49,978,541			49,402,854			49,643,608			49,263,468
Net income		$	.52		$	.58		$	1.06		$	1.21

 

See accompanying notes to consolidated financial statements.

 

4

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Consolidated Statements of Comprehensive (Loss) Income (Unaudited)

 

(Dollars in Thousands)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2004			2003			2004			2003
Net income		$	26,229		$	28,475		$	52,748		$	59,800
Other comprehensive loss, net of tax
Unrealized holding losses on securities arising during period, net of reclassification adjustment for gains included in net income		(40,794		)	(7,505		)	(35,226		)	(6,890		)
Change in fair value of equity method investee’s derivatives		—			—			—			616
Comprehensive (loss) income		$	(14,565	)	$	20,970		$	17,522		$	53,526

 

See accompanying notes to consolidated financial statements.

 

5

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Consolidated Statements of Cash Flows (Unaudited)

 

(Dollars in Thousands)

 

		Six Months Ended June 30,
		2004			2003
Operating activities:
Net income		$	52,748		$	59,800
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for possible loan losses		2,717			4,113
Depreciation of bank premises and equipment		8,466			7,948
Gain on sale of bank premises and equipment		(19		)	(89		)
Depreciation and amortization of leased assets		843			1,046
Accretion of investment securities discounts		(861		)	(624		)
Amortization of investment securities premiums		15,892			11,834
Gain on investment securities transactions, net		(8,461		)	(8,305		)
Accretion of junior subordinated debenture discounts		513			—
Amortization of identified intangible assets		492			638
Earnings from affiliates and other investments		(5,375		)	(3,463		)
Deferred tax benefit		(9,958		)	(246		)
Decrease in accrued interest receivable		237			1,998
Net decrease (increase) in other assets		26,597			(16,632		)
Net (decrease) increase in other liabilities		(18,153		)	1,513
Net cash provided by operating activities		65,678			59,531
Investing activities:
Proceeds from maturities of securities		27,062			2,800
Proceeds from sales of available for sale securities		647,828			237,147
Purchases of available for sale securities		(754,979		)	(1,440,050		)
Principal collected on mortgage-backed securities		410,717			891,616
Proceeds from matured time deposits with banks		63,800			—
Purchases of time deposits with banks		(296		)	—
Net (increase) decrease in loans		(149,558		)	26,959
Purchases of other investments		(223		)	(1,163		)
Distributions from other investments		50,684			2,094
(Purchases) disposals of bank premises and equipment		(19,979		)	1,094
Proceeds from sale of bank premises and equipment		30			645
Cash paid in purchase transaction (Note 2)		(276,555		)	—
Cash acquired in purchase transaction (Note 2)		66,009			—
Net cash provided by (used in) investing activities		64,540			(262,248		)

 

6

 

		Six Months Ended June 30,
		2004			2003
Financing activities:
Net increase in non-interest bearing demand deposits		$	17,858		$	79,930
Net increase in savings and interest bearing demand deposits		6,738			33,352
Net increase (decrease) in time deposits		64,029			(71,009		)
Net increase in federal funds purchased and securities sold under repurchase agreements		6,748			20,490
Proceeds from issuance of other borrowed funds		720,000			1,485,000
Principal payments on other borrowed funds		(869,449		)	(1,290,329		)
Purchase of treasury stock		(384		)	(22,622		)
Proceeds from stock transactions		4,504			3,442
Payment of cash dividends		(19,419		)	(13,298		)
Payment of cash dividends in lieu of fractional shares		(38		)	(26		)
Net cash (used in) provided by financing activities		(69,413		)	224,930
Increase in cash and cash equivalents		60,805			3,017
Cash and cash equivalents at beginning of period		215,729			154,104
Cash and cash equivalents at end of period		$	276,534		$	157,121
Supplemental cash flow information:
Interest paid		$	42,861		$	44,888
Income taxes paid		35,239			39,395

 

See accompanying notes to consolidated financial statements.

 

7

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

 

(Unaudited)

 

Note 1 - Basis of Presentation

 

The accounting and reporting policies of International Bancshares Corporation (“Corporation”) and Subsidiaries (the Corporation and Subsidiaries collectively referred to herein as the “Company”) conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry.  The consolidated financial statements include the accounts of the Corporation and its wholly-owned subsidiaries, International Bank of Commerce, Laredo (“IBC”), Commerce Bank, International Bank of Commerce, Zapata, International Bank of Commerce, Brownsville and the Corporation’s wholly-owned non-bank subsidiaries, IBC Subsidiary Corporation, IBC Life Insurance Company, IBC Trading Company, and IBC Capital Corporation, as well as the GulfStar Group in which the Company owns a controlling interest.  All significant inter-company balances and transactions have been eliminated in consolidation.  The consolidated financial statements are unaudited, but include all adjustments, which, in the opinion of management, are necessary for a fair presentation of the results of the periods presented.  All such adjustments were of a normal and recurring nature.  It is suggested that these financial statements be read in conjunction with the financial statements and the notes thereto in the Company’s latest Annual Report on Form 10K.  The consolidated statement of condition at December 31, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  Certain reclassifications have been made to make prior periods comparable.  Additionally, the June 2003 consolidated statement of income has been modified to reflect the effect of the deconsolidation under the provisions of FIN 46R, of eleven statutory business trusts, eight of which were formed by the Company to issue trust preferred securities and three that were acquired in the Company’s acquisition of Local Financial Corporation (“LFIN”). The Company early adopted the provisions of FIN 46R in December 2003.

 

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

 

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

 

Note 2 –Acquisition

 

On June 18, 2004, the Company acquired LFIN, an Oklahoma based bank holding company with approximately $2.8 billion in assets.  The acquisition was effected pursuant to the Agreement and Plan of Merger dated as of January 22, 2004 (the “Merger Agreement”).  The Company paid consideration totaling approximately $276.6 million in cash and 2.11 million shares of Company common stock. The aggregate purchase price was $367.4 million.  Under the terms of the Merger Agreement, LFIN shareholders were entitled to elect to receive either cash or Company shares in the merger, subject to the requirement that 75% of LFIN’s shares be exchanged for cash and 25% be exchanged for Company stock.  Based on the elections of LFIN shareholders and the terms of the Merger Agreement, LFIN shares held by LFIN shareholders who elected to receive shares of Company common stock in the Merger and LFIN shareholders who did not timely make a cash/stock election were exchanged entirely for shares of Company common stock.  As to those LFIN shares for which an election to receive cash was timely made, each such share was exchanged for approximately $20.59 in cash and 0.033 shares of Company common stock.  The exchange rate for those LFIN shareholders receiving Company shares in the Merger was 0.5170 shares of Company common stock for each share of LFIN.

 

The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of the acquisition, in thousands.  The Company is in the process of obtaining third party valuations of certain intangible assets; thus, the allocation of the purchase price is subject to adjustment.

 

8

 

		As of June 18, 2004
		(Unaudited)
		(Dollars in thousands)
Assets
Cash and cash equivalents		$	66,009
Time deposits with banks		87,400
Investment securities		331,656
Net loans		2,152,912
Bank premises and equipment		50,155
Accrued interest receivable		8,266
Other investments		91,820
Identified intangible asset		42,188
Goodwill		209,656
Other assets		31,948
Total assets acquired		3,072,010
Liabilities
Demand deposits		232,982
Savings deposits		766,178
Time deposits		938,031
Securities sold under repurchase agreements		44,138
Other borrowed funds		624,382
Senior notes		21,295
Other liabilities		77,606
Total liabilities assumed		2,704,612
Net assets acquired		$	367,398

 

The following table reflects the pro forma results of operations for the three months ended June 30, 2004 and 2003 and the six months ended June 30, 2004 and 2003, as though the acquisition had been completed as of January 1, 2003 (dollars in thousands, except per share data):

 

		Three Months Ended June 30, 2004			Three Months Ended June 30, 2003			Six Months Ended June 30, 2004			Six Months Ended June 30, 2003
		(Unaudited)						(Unaudited)
Interest income		$	102,800		$	115,914		$	209,041		$	237,581
Interest expense		35,282			40,370			71,284			81,716
Net interest income		67,518			75,544			137,757			155,865
Provision for possible loan losses		10,875			3,924			14,217			7,713
Non-interest income		38,104			40,182			75,504			77,153
Non-interest expense		98,330			60,348			153,517			117,395
(Loss) income before income taxes		(3,583		)	51,454			45,527			107,910
Income taxes		(1,006		)	16,684			15,148			35,541
Net (loss) income		$	(2,577	)	$	34,770		$	30,379		$	72,369
Per common share:
Basic		$	(.05	)	$	.72		$	.62		$	1.49
Diluted		$	(.05	)	$	.70		$	.61		$	1.47

 

Included in the non-interest expense of the combined operations are certain costs associated with contractual obligations related to the closing of the transaction.

 

9

 

Note 3 – Stock Options

 

At June 30, 2004, the Company had one stock-based employee compensation plan and certain options granted outside the plan.  The Company accounts for options under the recognition and measurement principles of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees,” and related interpretations.  No stock-based employee cost is reflected in net income, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant.  The following table, as prescribed by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123,” illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, (“SFAS No. 123”), “Accounting for Stock-Based Compensation,” to stock based employee compensation.

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2004			2003			2004			2003
		(Dollars in Thousands, except per share data)
Net income, as reported		$	26,229		$	28,475		$	52,748		$	59,800
Deduct:  Total stock-based compensation expense determined under the fair value based method for all awards, net of tax related tax effects		(143		)	(153		)	(286		)	(300		)
Pro forma net income		$	26,086		$	28,322		$	52,462		$	59,500
Earnings per share:
Basic earnings
As reported		$	.54		$	.59		$	1.08		$	1.23
Pro forma		.53			.59			1.08			1.23
Diluted earnings
As reported		$	.52		$	.58		$	1.06		$	1.21
Pro forma		.52			.57			1.05			1.21

 

Note 4 - Investment Securities

 

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

 

The unrealized losses on investments in mortgage-backed securities are caused by changes in market interest rates.  The contractual cash obligations of the securities are guaranteed by Freddie Mac, Fannie Mae, and Ginnie Mae.  Because the decrease in fair value is due to market interest rates and not other factors, and because the Company has the ability to hold these investments until a market price recovery, maturity of the securities, or a modification of the Company’s investment strategy, it is the conclusion of the Company that the investments are considered only temporarily impaired.

 

10

 

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

 

		June 30, 2004			December 31, 2003
		(Dollars in Thousands)
U.S. Treasury and federal agencies
Available for sale		$	2,851,343		$	2,890,304
States and political subdivisions
Available for sale		106,417			110,382
Other
Held to maturity		2,385			2,160
Available for sale		21,621			38,655
Total investment securities		$	2,981,766		$	3,041,501

 

Note 5 - Allowance for Possible Loan Losses

 

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

 

		June 30, 2004			June 30, 2003
		(Dollars in Thousands)
Balance at December 31,		$	48,646		$	44,213
Losses charged to allowance		(1,391		)	(1,956		)
Recoveries credited to allowance		715			738
Net losses charged to allowance		(676		)	(1,218		)
Provision charged to operations		2,717			4,113
Net allowance acquired in purchase transaction		33,884			—
Balance at June 30,		$	84,571		$	47,108

 

The Company classifies as impaired those loans where it is probable that all amounts due according to contractual terms of the loan agreement will not be collected. The Company has identified these loans through its normal loan review procedures.  Impaired loans include 1) all non-accrual loans, 2) loans which are 90 days or over past due unless they are well secured (the collateral value is sufficient to cover principal and accrued interest) and are in the process of collection, and 3) other loans which management believes are impaired.  Substantially all of the Company’s impaired loans are measured based on the fair value of the collateral. In limited cases the Company may use other methods to determine the level of impairment of a loan if such loan is not collateral dependent.  Amounts received on non-accruals are applied, for financial accounting purposes, first to principal and then to interest after all principal has been collected.  Impaired loans at June 30, 2004 were $44,102,000.  The income associated with these loans is not significant.

 

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

 

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

 

11

 

While management of the Company considers that it is generally able to identify borrowers with financial problems reasonably early and to monitor credit extended to such borrowers carefully, there is no precise method of predicting loan losses.  The determination that a loan is likely to be uncollectible and that it should be wholly or partially charged-off as a loss is an exercise of judgment.  Similarly, the determination of the adequacy of the allowance for possible loan losses can be made only on a subjective basis.  It is the judgment of the Company’s management that the allowance for possible loan losses at June 30, 2004, was adequate to absorb possible losses from loans in the portfolio at that date.

 

Note 6 – Other Borrowed Funds

 

Other borrowed funds include Federal Home Loan Bank borrowings, which are short term fixed borrowings issued by the Federal Home Loan Bank of Dallas at the market price offered at the time of funding.  These borrowings are secured by mortgage-backed investment securities and a portion of the Company’s loan portfolio.  At June 30, 2004, other borrowed funds totaled $1,320,205,000 an increase of 56.2% from $845,272,000 at December 31, 2003.  The increase in other borrowed funds can be attributed to the LFIN acquisition.

 

Note 7 – Junior Subordinated Interest Deferrable Debentures

 

The Company has formed eight statutory business trusts under the laws of the State of Delaware, (the “Trusts”) for the purpose of issuing trust preferred securities.  The Trusts have issued Capital and Common Securities and invested the proceeds in an equivalent amount thereof in Junior Subordinated Deferrable Interest Debentures (the “Debentures”) issued by the Company.  The Debentures will mature on various dates; however, the Debentures may be redeemed at specified prepayment prices, in whole or in part after the specified dates, or in whole within 90 days upon the occurrence of any one of certain legal, regulatory or tax events specified in the Indenture.

 

As part of the LFIN acquisition, the Company acquired three statutory business trusts, previously formed by LFIN for the purpose of issuing trust preferred securities.  The outstanding amount of debentures acquired totaled $62,115,000.

 

The following table illustrates key information about each of the Capital and Common Securities and their interest rate at June 30, 2004:

 

		Junior Subordinated Deferrable Interest Debentures							Repricing Frequency		Interest Rate		Interest Rate Index		Maturity Date		Optional Redemption Date
		(in thousands)
Trust I		$					10,164		Fixed		10.18	%	Fixed		June 2031		June 2011
Trust II		$					25,509		Semi-Annually		4.90	%	LIBOR + 3.75		July 2031		July 2006
Trust III		$				33,658			Semi-Annually		4.98	%	LIBOR + 3.75		December 2031		December 2006
Trust IV		$				22,327			Semi-Annually		4.92	%	LIBOR + 3.70		April 2032		April 2007
Trust V		$			20,259				Quarterly		4.80	%	LIBOR + 3.65		July 2032		July 2007
Trust VI		$			25,287				Quarterly		4.63	%	LIBOR + 3.45		November 2032		November 2007
Trust VII		$			10,310				Quarterly		4.41	%	LIBOR + 3.25		April 2033		April 2008
Trust VIII		$			25,253				Quarterly		4.19	%	LIBOR + 3.05		October 2033		October 2008
LFIN Trust I		$		41,495					Fixed		9.00	%	Fixed		September 2031		September 2006
LFIN Trust II		$		10,310					Semi-Annually		4.80	%	LIBOR + 3.625		July 2032		July 2007
LFIN Trust III		$	10,310						Quarterly		4.70	%	LIBOR + 3.45		November 2032		November 2007
		$	234,882

 

12

 

Note 8 – Common Stock and Cash Dividends

 

All per share data presented has been restated to reflect the stock splits effected through stock dividends, which became effective May 3, 2004 and May 19, 2003 and were paid on May 28, 2004 and June 16, 2003, respectively.  Cash dividends of $.50 per share were paid on April 30, 2004 to all holders of record on April 15, 2004.  The Company issued 2,114,558 shares of Company stock in connection with the LFIN acquisition on June 18, 2004.

 

The Company expanded its formal stock repurchase program on December 18, 2003.  Under the expanded stock repurchase program, the Company is authorized to repurchase up to $175,000,000 of its common stock through December 2004.  Stock repurchases may be made from time to time, on the open market or through private transactions.  Shares repurchased in this program will be held in treasury for reissue for various corporate purposes, including employee stock option plans.  As of August 3, 2004, a total of 3,647,408 shares had been repurchased under this program at a cost of $145,042,000, which shares are now reflected as 7,237,287 shares of treasury stock as adjusted for stock dividends.  Stock repurchases are reviewed quarterly at the Company’s Board of Directors meetings and the Board of Directors has stated that the aggregate investment in treasury stock should not exceed $195,973,000.  In the past, the Board of Directors has increased previous caps on treasury stock once they were met, but there are no assurances that an increase of the $195,973,000 cap will occur in the future.  As of August 3, 2004, the Company has approximately $166,016,000 invested in treasury shares, which amount has been accumulated since the inception of the Company.

 

Note 9 - Commitments and Contingent Liabilities

 

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

 

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

 

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

 

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

 

No reliable prediction can be made at this time as to the likely outcome of the lawsuits; however, if the lawsuits are decided adversely to the partnerships, all or a portion of the $12 million in tax benefits previously recognized by the Company in connection with the Partnerships’ lease-financing transactions would be in question and penalties and interest could be assessed by the IRS.  The Company has accrued approximately $12 million at June 30, 2004 in connection with the lawsuits.  Management intends to continue to evaluate the merits of each matter and make appropriate revisions to the accrued amount as deemed necessary.

 

13

 

Note 10 – Capital Ratios

 

The Company had a leverage ratio of 8.60% and 8.75%, risk-weighted Tier 1 capital ratio of 10.23% and 17.3% and risk-weighted total capital ratio of 11.56% and 19.33% at June 30, 2004 and December 31, 2003, respectively.  The change in the Company’s capital ratios can be attributed to the LFIN acquisition, which was completed on June 18, 2004.  The identified intangibles and goodwill of $324,687,000 as of June 30, 2004, recorded in connection with the acquisitions made by the Company, are deducted from the sum of core capital elements when determining the capital ratios of the Company.

 

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

 

Special Cautionary Notice Regarding Forward Looking Information

 

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

 

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

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

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

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

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

•                  The loss of senior management or operating personnel.

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

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

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

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

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

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

 

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

 

14

 

Overview

 

The Company, which is headquartered in Laredo, Texas, with more than 160 facilities and more than 250 ATMs, provides banking services for commercial, consumer and international customers of the South, Central and Southeast Texas regions and Oklahoma.  The Company is the second largest independent commercial bank holding company in Texas.  The Company, through its bank subsidiaries, is in the business of gathering funds from various sources and investing those funds in order to earn a return.  The Company owns an insurance agency, a broker/dealer and a majority interest in an investment banking unit.  The Company’s primary earnings come from the spread between the interest earned on interest bearing assets and the interest paid on interest-bearing liabilities.  In addition, the Company generates income from fees on products offered to commercial, consumer and international customers.  At June 30, 2004, the Company had total assets of $9,301,205, net loans of $5,000,108, and deposits of $6,461,515.  The substantial increase in total assets, net loans, and deposits can be attributed primarily to the acquisition of Local Financial Corporation (“LFIN”) on June 18, 2004.

 

The Company is very active in facilitating trade along the United States border with Mexico.  The Company does a significant amount of business with customers domiciled in Mexico.  Deposits from persons and entities domiciled in Mexico comprise a significant and stable portion of the deposit base of the Company’s bank subsidiaries.  Many of the Texas markets served by the Company have a large Hispanic population.

 

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

 

During the fourth quarter of 2003, the Company reduced its assets by approximately $1 billion dollars in anticipation of the LFIN acquisition.  The Company also increased its overnight liquidity in the form of fed funds sold to prepare for the cash payment required as part of the transaction.  On June 18, 2004, the Company completed its acquisition of LFIN.  The Company paid consideration totaling approximately $276.6 million in cash and 2.11 million shares of Company stock.  As a result of the reduction in assets, and the large increase in overnight liquidity in the form of fed funds sold, the Company’s first and second quarter earnings were negatively impacted.

 

15

 

Results of Operations

 

Summary

 

Consolidated Statements of Condition Information

 

		June 30, 2004			December 31, 2003			Percent Increase (Decrease)
					(Dollars in Thousands)
Assets		$	9,301,205		$	6,578,310		41.4	%
Net loans		5,000,108			2,700,354			85.2
Deposits		6,461,515			4,435,699			45.7
Other borrowed funds		1,320,205			845,272			56.2
Junior subordinated deferrable interest  debentures		234,882			172,254			36.4
Shareholders’ equity		667,382			577,383			15.6

 

		Three Months Ended June 30,						Percent		Six Months Ended June 30,						Percent
		(Dollars in Thousands)						Increase		(Dollars in Thousands)						Increase
		2004			2003			(Decrease)		2004			2003			(Decrease)
Interest income		$	72,504		$	78,601		(7.8	)%	$	143,474		$	160,574		(10.6	)%
Interest expense		22,281			23,702			(6.0	)	43,000			47,695			(9.8	)
Net interest income		50,223			54,899			(8.5	)	100,474			112,879			(11.0	)
Provision for possible loan losses		1,375			2,124			(35.3	)	2,717			4,113			(33.9	)
Non-interest income		31,090			31,364			(.9	)	59,403			60,510			(1.8	)
Non-interest expense		40,889			42,193			(3.1	)	78,576			80,281			(2.1	)
Net income		26,229			28,475			(7.9	)	52,748			59,800			(11.8	)
Per common share:
Basic		$	.54		$	.59		(8.5	)%	$	1.08		$	1.23		(12.2	)%
Diluted		.52			.58			(10.3	)	1.06			1.21			(12.4	)
Efficiency Ratio		50.3		%	48.9		%	2.8		49.1		%	46.3		%	6.0

 

Net Income

 

Net income decreased by 7.9% for the three months ended and 11.8% for the six months ended 2004 from the same periods in 2003.   Net income was positively affected in June by the LFIN acquisition, which was completed on June 18, 2004.  Net income was negatively impacted by the current low interest rate environment and the Company’s strategic management of earning assets in anticipation of its acquisition of LFIN, which was completed on June 18, 2004.

 

16

 

Net Interest Income

 

		Three Months Ended June 30,						Percent		Six Months Ended  June 30,						Percent
		(in Thousands)						Increase		(in Thousands)						Increase
		2004			2003			(Decrease)		2004			2003			(Decrease)
Interest income:
Loans, including fees		$	45,596		$	43,346		5.2	%	$	89,022		$	88,690		.4	%
Time deposits with banks		14			1			1,300.0		20			5			300.0
Federal funds sold		433			185			134.1		902			316			185.4
Investment securities:
Taxable		25,078			33,692			(25.6	)	50,701			68,766			(26.3	)
Tax-exempt		1,272			1,287			(1.2	)	2,556			2,575			(.7	)
Other interest income		111			90			23.3		273			222			23.0
Total interest income		72,504			78,601			(7.8	)	143,474			160,574			(10.6	)
Interest expense:
Savings deposits		2,504			2,790			(10.3	)	4,721			5,740			(17.8	)
Time deposits		9,835			10,519			(6.5	)	18,886			21,797			(13.4	)
Securities sold under repurchase agreements		4,783			4,647			2.9		9,540			9,260			3.0
Other borrowings		2,437			3,551			(31.4	)	4,644			6,570			(29.3	)
Junior subordinated interest deferrable debentures		2,638			2,195			20.2		5,125			4,328			18.4
Senior notes		84			—			100.0		84			—			100.0
Total interest expense		22,281			23,702			(6.0	)	43,000			47,695			(9.8	)
Net interest income		$	50,223		$	54,899		(8.5	)%	$	100,474		$	112,879		(11.0	)%

 

Net interest income is the spread between income on interest earning assets, such as loans and securities, and the interest expense on liabilities used to fund those assets, such as deposits, repurchase agreements and funds borrowed.  Net interest income is the Company’s largest source of revenue.  Net interest income is affected by both changes in the level of interest rates and changes in the amount and composition of interest earning assets and interest bearing liabilities.

 

Net interest income was negatively impacted due to the Company’s strategic management of earning assets in anticipation of its acquisition of LFIN and the low interest rate environment.

 

As part of its strategy to manage interest rate risk, the Company strives to manage both assets and liabilities so that interest sensitivities match. One method of calculating interest rate sensitivity is through gap analysis.  A gap is the difference between the amount of interest rate sensitive assets and interest rate sensitive liabilities that re-price or mature in a given time period.  Positive gaps occur when interest rate sensitive assets exceed interest rate sensitive liabilities, and negative gaps occur when interest rate sensitive liabilities exceed interest rate sensitive assets.  A positive gap position in a period of rising interest rates should have a positive effect on net interest income as assets will re-price faster than liabilities.  Conversely, net interest income should contract somewhat in a period of falling interest rates.  Management can quickly change the Company’s interest rate position at any given point in time as market conditions dictate.  Additionally, interest rate changes do not affect all categories of assets and liabilities equally or at the same time.  Analytical techniques employed by the Company to supplement gap analysis include simulation analysis to quantify interest rate risk exposure.  The gap analysis prepared by management is reviewed by the Investment Committee of the Company twice a year (see table on page 22 for the June 30, 2004 gap analysis).  Management currently believes that the Company is properly positioned for interest rate changes; however if management determines at any time that the Company is not properly positioned, it will strive to adjust the interest rate sensitive assets and liabilities in order to manage the effect of interest rate changes.

 

17

 

Non-Interest Income

 

		Three Months Ended June 30,						Percent		Six Months Ended June 30,						Percent
		(in Thousands)						Increase		(in Thousands)						Increase
		2004			2003			(Decrease)		2004			2003			(Decrease)
Service charges on deposit accounts		$	15,911		$	14,714		8.1	%	$	30,320		$	29,049		4.4	%
Other service charges, commissions and fees
Banking		4,443			3,855			15.3		8,286			7,316			13.3
Non-banking		1,652			2,247			(26.5	)	2,548			6,281			(59.4	)
Investment securities transactions, net		3,689			5,542			(33.4	)	8,461			8,305			1.9
Other investments, net		3,313			2,443			35.6		5,825			4,426			31.6
Other income		2,082			2,563			(18.8	)	3,963			5,133			(22.8	)
Total non-interest income		$	31,090		$	31,364		(0.9	)%	$	59,403		$	60,510		(1.8	)%

 

The decrease in non-banking service charges, commissions and fees can be attributed to a decrease in fees earned by the Company’s investment services unit in 2004.  The Company recorded investment securities gains of $3,689,000 for the quarter ended June 30, 2004 compared to gains of $5,542,000 for the same period of 2003.  The gains in 2004 and 2003 occurred due to an ongoing program to reposition a portion of the Company’s bond portfolio to realize the equity that was eroding in the portfolio due to rapid principal repayments, the result of which accelerated future earnings.

 

Non-Interest Expense

 

		Three Months Ended June 30,						Percent		Six Months Ended June 30,						Percent
		(in Thousands)						Increase		(in Thousands)						Increase
		2004			2003			(Decrease)		2004			2003			(Decrease)
Employee compensation and benefits		$	17,123		$	17,629		(2.9	)%	$	33,564		$	36,093		(7.0	)%
Occupancy		3,626			3,519			3.0		6,899			6,479			6.5
Depreciation of bank premises and equipment		4,415			4,014			10.0		8,466			7,948			6.5
Professional fees		1,309			2,202			(40.6	)	2,882			3,724			(22.6	)
Stationery and supplies		910			991			(8.2	)	1,889			1,877			0.6
Amortization of identified intangible assets		246			319			(22.9	)	492			638			(22.9	)
Advertising		2,237			2,029			10.3		4,093			3,772			8.5
Other		11,023			11,490			(4.1	)	20,291			19,750			2.7
Total non-interest expense		$	40,889		$	42,193		(3.1	)%	$	78,576		$	80,281		(2.1	)%

 

The 7% decrease in employee compensation expense and benefits for the six months ended June 30, 2004 compared to the six months ended June 30, 2003 can be partially attributed to decreased salaries and commissions paid to the Company’s investment services unit.  The decrease correlates with the decrease in income produced by the investment services unit during the first six months of 2004 compared to the same period in 2003.

 

Expense control is an essential element in the Company’s profitability.  This is achieved through maintaining optimum staffing levels, an effective budgeting process, and internal consolidation of bank functions.

 

18

 

Financial Condition

 

Allowance for Possible Loan Losses

 

The allowance for possible loan losses increased 73.8% to $84,571,000 at June 30, 2004 from $48,646,000 at December 31, 2003.  The increase in the allowance can be attributed to the acquired allowance in the LFIN acquisition, totaling $33,884,000.  The provision for possible loan losses charged to expense decreased 33.9% to $2,717,000 for the six months ended June 30, 2004 from $4,113,000 for the same period in 2003.  The decrease in the provision for possible loan losses charged to expense can be attributed to the lack of substantial growth in the loan portfolio prior to the LFIN acquisition.  The allowance for possible loan losses was 1.7% and 1.8% of total loans, net of unearned income, at June 30, 2004 and December 31, 2003, respectively.

 

Investment Securities

 

Investment securities decreased 2.0% to $2,981,766,000 at June 30, 2004, from $3,041,501,000 at December 31, 2003.  The changes reflected during the first six months of 2004 were primarily from the results of the intentional contraction of the asset base of the Company, to position the Company’s liquidity in anticipation of the LFIN acquisition.

 

Foreign Operations

 

On June 30, 2004, the Company had $9,301,205,000 of consolidated assets, of which approximately $221,501,000, or 2.4%, was related to loans outstanding to borrowers domiciled in Mexico, compared to $222,797,000, or 3.4%, at December 31, 2003.  Of the $221,501,000, 76.8% is directly or indirectly secured by U.S. assets, certificates of deposits and real estate; 20.9% is secured by Mexican real estate; .9% is secured by Mexican real estate related to maquiladora plants and guaranteed under lease obligations primarily by U.S. companies, many of which are on the Fortune 500 list of companies; .8% is unsecured; and .6% represents accrued interest receivable on the portfolio.

 

Critical Accounting Policies

 

The Company has established various accounting policies which govern the application of accounting principles in the preparation of the Company’s consolidated financial statements.  The significant accounting policies are described in the Notes to the Consolidated Financial Statements in the Company’s latest Annual Report on Form 10K.  Certain accounting policies involve significant judgments and assumptions by management which have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies.

 

The Company considers its Allowance for Possible Loan Losses as a policy critical to the sound operations of the bank subsidiaries.  The allowance for possible loan losses consists of the aggregate loan loss allowances of the bank subsidiaries.  The allowances are established through charges to operations in the form of provisions for possible loan losses.  Loan losses or recoveries are charged or credited directly to the allowances.  The allowance for possible loan losses of each bank subsidiary is maintained at a level considered appropriate by management, based on estimated probable losses in the loan portfolio.  The allowance is derived from the following elements:  (i) allowances established on specific loans, and (ii) allowances based on historical loss experience on the Company’s remaining loan portfolio, which includes general economic conditions and other qualitative risk factors both internal and external to the Company.  See also discussion regarding the allowance for possible loan losses and provision for possible loan losses included in the results of operations and “Provision and Allowance for Possible Loan Losses” included in Notes 1 and 4 of the Notes to Consolidated Financial Statements in the Company’s latest Annual Report on Form 10K for further information regarding the Company’s provision and allowance for possible loan losses policy.

 

The specific loan loss provision is determined using the following methods.  On a weekly basis, loan past due reports are reviewed by the servicing loan officer to determine if a loan has a potential problem and if a loan should be placed on the Company’s internal classified report.  Additionally, the Company’s credit department reviews the majority of the loans regardless of whether they are past due and segregates any loans with potential problems for further review.  The credit department discusses the potential problem loans with the servicing loan officers to determine any relevant issues that were not discovered in the evaluation.  Also, any analysis on loans that is provided through examinations by regulatory authorities is considered in the review process.  After the above analysis is completed, the Company determines if a loan should be placed on an internal classified report because of issues related to the analysis of the credit, credit documents, collateral and/or payment history.

 

19

 

The Company’s internal classified report is segregated into the following categories:  (i) “Pass Credits,” (ii) “Special Review Credits,” (iii) “Watch List - Pass Credits,” or (iv) “Watch List – Substandard and Doubtful Credits.”  The loans placed in the “Pass Credits” category reflect the Company’s opinion that the loan conforms to the bank’s lending policies, which includes the borrower’s ability to repay, the value of the underlying collateral, if any, as it relates to the outstanding indebtedness of the loan, and the economic environment and industry in which the borrower operates.  The loans placed in the “Special Review Credits” category reflect the Company’s opinion that the loans reflect potential weaknesses which require monitoring on a more frequent basis; however, the “Special Review Credits” are not considered to need a specific reserve at the time, but are reviewed and discussed on a regular basis with the credit department and the lending staff to determine if a change in category is warranted.  The loans placed in the “Watch List – Pass Credits” category reflect the Company’s opinion that the loans contain pronounced credit weaknesses and/or inherent financial weaknesses of the borrower.  The loans placed in the “Watch List – Substandard and Doubtful Credits” category reflect the Company’s opinion that the loans contain clearly pronounced credit weaknesses and/or inherent weaknesses of the borrower.  Credits classified as “Watch List – Substandard and Doubtful Credits” are evaluated under Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan,” criteria and, if deemed necessary a specific reserve is allocated to the credit.  The specific reserve allocated under SFAS No. 114, is based on (1) the present value of expected future cash flows discounted at the loan’s effective interest rate; (2) the loan’s observable market price; or (3) the fair value of the collateral if the loan is collateral dependent.

 

The allowance, based on historical loss experience on the Company’s remaining loan portfolio, which includes the “Special Review Credits,” “Watch List - Pass Credits” and “Watch List – Substandard and Doubtful Credits,” is determined by segregating the remaining loan portfolio into certain categories such as commercial loans, installment loans, international loans, loan concentrations and overdrafts.  Installment loans are then further segregated by number of days past due.  A historical loss percentage, adjusted for (i) management’s evaluation of changes in lending policies and procedures, (ii) current economic conditions in the market area served by the Company, (iii) other risk factors, (iv) the effectiveness of the internal loan review function, (v) changes in loan portfolios, and (vi) the composition and concentration of credit volume is applied to each category.  Each category is then added together to determine the allowance allocated under Statement of Financial Accounting Standards No. 5.

 

The Company’s management continually reviews the loan loss allowance of the bank subsidiaries using the amounts determined from the allowances established on specific loans, the allowance established based on historical percentages and the loans charged off and recoveries to establish an appropriate amount to maintain in the Company’s loan loss allowance.  If the basis of the Company’s assumptions change, the loan loss allowance would either decrease or increase and the Company would increase or decrease the provision for loan loss charged to operations accordingly.

 

Liquidity and Capital Resources

 

The maintenance of adequate liquidity provides the Company’s bank subsidiaries with the ability to meet potential depositor withdrawals, provide for customer credit needs, maintain adequate statutory reserve levels and take full advantage of high-yield investment opportunities as they arise.  Liquidity is afforded by access to financial markets and by holding appropriate amounts of liquid assets.  The Company’s bank subsidiaries derive their liquidity largely from deposits of individuals and business entities.  Deposits from persons and entities domiciled in Mexico comprise a significant and stable portion of the deposit base of the Company’s bank subsidiaries. Other important funding sources for the Company’s bank subsidiaries during 2004 and 2003 have been borrowings from FHLB, securities sold under repurchase agreements and large certificates of deposit, requiring management to closely monitor its asset/liability mix in terms of both rate sensitivity and maturity distribution.  Primary liquidity of the Company and its subsidiaries has been maintained by means of increased investment in shorter-term securities, certificates of deposit and loans.  The Company has also increased it overnight liquidity by a sufficient amount, in the form of fed funds sold, to prepare for the cash payment required by the LFIN acquisition.  As in the past, the Company will continue to monitor the volatility and cost of funds in an attempt to match maturities of rate-sensitive assets and liabilities and respond accordingly to anticipated fluctuations in interest rates over reasonable periods of time.

 

The Company maintains an adequate level of capital as a margin of safety for its depositors and shareholders.  At June 30, 2004, shareholders’ equity was $667,382,000 compared to $577,383,000 at December 31, 2003, an increase of $89,999,000, or 15.6%.  The change in shareholders’ equity can be attributed to the retention of earnings and the issuance of 2,114,558 million shares of common stock as part of the LFIN acquisition.

 

20

 

The Company had a leverage ratio of 8.60% and 8.75%, risk-weighted Tier 1 capital ratio of 10.23% and 17.3% and risk-weighted total capital ratio of 11.56% and 19.33% at June 30, 2004 and December 31, 2003, respectively.  The change in the Company’s capital ratios can be attributed to the LFIN acquisition, which was completed on June 18, 2004.  The identified intangibles and goodwill of $324,687,000 as of June 30, 2004, recorded in connection with the acquisitions made by the Company, are deducted from the sum of core capital elements when determining the capital ratios of the Company.

 

As in the past, the Company will continue to monitor the volatility and cost of funds in an attempt to match maturities of rate-sensitive assets and liabilities, and respond accordingly to anticipate fluctuations in interest rates by adjusting the balance between sources and uses of funds as deemed appropriate.  The net-interest rate sensitivity as of June 30, 2004 is illustrated in the table on page 22.  This information reflects the balances of assets and liabilities for which rates are subject to change.  A mix of assets and liabilities that are roughly equal in volume and re-pricing characteristics represents a matched interest rate sensitivity position.  Any excess of assets or liabilities results in an interest rate sensitivity gap.

 

The Company undertakes an interest rate sensitivity analysis to monitor the potential risk on future earnings resulting from the impact of possible future changes in interest rates on currently existing net asset or net liability positions.  However, this type of analysis is as of a point-in-time position, when in fact that position can quickly change as market conditions, customer needs, and management strategies change. Thus, interest rate changes do not affect all categories of asset and liabilities equally or at the same time.  As indicated in the table, the Company is liability sensitive during the early time periods and asset sensitive in the longer periods.  The Company’s Asset and Liability Committee semi-annually reviews the consolidated position along with simulation and duration models, and makes adjustments as needed to control the Company’s interest rate risk position.  The Company uses modeling of future events as a primary tool for monitoring interest rate risk.

 

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Interest Rate Sensitivity

(Dollars in Thousands)

 

		Rate/Maturity
June 30, 2004		3 Months or Less			Over 3 Months to 1 Year			Over 1 Year to 5 Years			Over 5 Years			Total
Rate sensitive assets
Federal funds sold		$	85,000		$	—		$	—		$	—		$	85,000
Time deposits with banks		23,996			—			—			—			23,996
Investment securities		46,087			283,281			535,806			2,116,592			2,981,766
Loans, net of non-accruals		3,141,043			370,453			885,110			660,357			5,056,963
Total earning assets		$	3,296,126		$	653,734		$	1,420,916		$	2,776,949		$	8,147,725
Cumulative earning assets		$	3,296,126		$	3,949,860		$	5,370,776		$	8,147,725
Rate sensitive liabilities
Time deposits		$	1,376,849		$	1,274,499		$	566,414		$	1,219		$	3,218,981
Other interest bearing deposits		2,168,535			—			—			—			2,168,535
Securities sold under repurchase  agreements		178,309			69,538			4,335			300,000			552,182
Other borrowed funds		1,320,000			124			—			81			1,320,205
Junior subordinated deferrable  interest debentures		127,237			55,985			—			51,660			234,882
Senior notes		21,295			—			—			—			21,295
Total interest bearing liabilities		$	5,192,225		$	1,400,146		$	570,749		$	352,960		$	7,516,080
Cumulative sensitive liabilities		$	5,192,225		$	6,592,371		$	7,163,120		$	7,516,080
Repricing gap		$	(1,896,099	)	$	(746,412	)	$	850,167		$	2,423,989		$	631,645
Cumulative repricing gap		(1,896,099		)	(2,642,511		)	(1,792,344		)	631,645
Ratio of interest-sensitive assets  to liabilities		.64			.47			2.49			7.87			1.08
Ratio of cumulative, interest-  sensitive assets to liabilities		.64			.60			.75			1.08

 

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

 

During the first six months of 2004, there were no material changes in market risk exposures that affected the quantitative and qualitative disclosures regarding market risk presented under the caption “Liquidity & Capital Resources” located on pages 17 through 22 of the Company’s 2003 Annual Report as filed as an exhibit to the Company’s Form 10-K for the year ended December 31, 2003.

 

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Item 4.  Controls and Procedures

 

The Company has evaluated the effectiveness of its disclosure controls and procedures pursuant to Securities Exchange Act Rule 13a-15.  The evaluation was performed under the supervision and with the participation of the Company’s Disclosure Committee and Management, including the principal executive officer and the principal financial officer, as of the end of the period covered by this report.  Based on this evaluation, the principal executive officer and principal financial officer have concluded that the disclosure controls and procedures are effective in ensuring that all material information required to be disclosed in this quarterly report has been accumulated and communicated to them in a manner appropriate to allow timely decisions regarding disclosure.

 

During the most recent fiscal quarter, there were no significant changes in the internal controls or in other factors that have materially affected or are reasonably likely to materially affect the internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

PART II - OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

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

 

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

 

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

 

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

 

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Item 2.  Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

 

The Company expanded its formal stock repurchase program on December 18, 2003. Under the expanded stock repurchase program, the Company is authorized to repurchase up to $175,000,000 of its common stock through December 2004.  Stock repurchases may be made from time to time, on the open market or through private transactions.  Shares repurchased in this program will be held in treasury for reissue for various corporate purposes, including employee stock option plans.  As of August 3, 2004, a total of 3,647,408 shares had been repurchased under this program at a cost of $145,042,000, which shares are now reflected as 7,237,287 shares of treasury stock as adjusted for stock dividends.  Stock repurchases are reviewed quarterly at the Company’s Board of Directors meetings and the Board of Directors has stated that the aggregate investment in treasury stock should not exceed $195,973,000.  In the past, the Board of Directors has increased previous caps on treasury stock once they were met, but there are no assurances that an increase of the $195,973,000 cap will occur in the future.  As of August 3, 2004, the Company has approximately $166,016,000 invested in treasury shares, which amount has been accumulated since the inception of the Company.

 

Share repurchases are only conducted under publicly announced repurchase programs approved by the Board of Directors.  The following table includes information about share repurchases for the quarter ended June 30, 2004 and reflects the 25% stock dividend that was paid in May 2004.

 

		Total Shares Purchased		Average Price Per Share			Shares Purchased as Part of a Publicly- Announced Program		Maximum Shares Still Available for Repurchase (1)
April 1 – April 30, 2004		—		$	—		—		560,461
May 1 – May 31, 2004		—		—			—		565,738
June 1 – June 30, 2004		1,237		43.25			—		722,390
		1,237		$	43.25		—

 

(1)          The formal stock repurchase program was initiated in 1999 and has been expanded periodically through 2004.  The current program allows for the repurchase of up to $175,000,000 of treasury stock through December 2004 of which $29,994,000 is remaining.

 

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Item 4.  Submission of Matters to a Vote of Security Holders

 

The Annual Meeting of Shareholders of the Company was held May 17, 2004 for the consideration of the following items which were approved by the number of votes set forth:

 

				Votes For		Votes Withheld
1.		To elect eleven (11) directors of the Company until the next Annual Meeting of Shareholders and until their successors are elected and qualified; The following directors, constituting the entire board of directors, were elected:
		Lester Avigael		32,902,714		95,297
		Irving Greenblum		32,791,874		206,137
		R. David Guerra		31,543,575		1,454,436
		Daniel B. Hastings, Jr.		32,915,430		82,581
		Richard E. Haynes		32,898,539		99,472
		Imelda Navarro		31,556,636		1,441,375
		Sioma Neiman		31,380,479		1,617,532
		Peggy J. Newman		32,996,686		1,325
		Dennis E. Nixon		31,338,141		1,659,870
		Leonardo Salinas		31,536,303		1,461,708
		A.R. Sanchez, Jr.		31,518,587		1,479,424

 

				Votes For		Votes Withheld
2.		To approve the appointment of independent auditors for the 2004 fiscal year		32,928,939		79,986

 

Abstentions:                          5,718,841

 

Item 6.  Exhibits and Reports on Form 8-K

 

(a)           Exhibits

 

The following exhibits are filed as a part of this Report:

 

31(a) –Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

31(b) –Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

32(a) –Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

32(b) –Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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(b)           Reports on Form 8-K

 

Registrant filed a current report on Form 8-K on May 21, 2004 covering Item 5 – Other Events and Regulation FD Disclosure and Item 9 - Regulation FD Disclosure, in connection with the announcement that the shareholders of Local Financial Corporation (“LFIN”) approved the merger agreement between the Registrant and LFIN at the annual meeting of shareholders on May 19, 2004.

 

Registrant filed a current report on Form 8-K on May 28, 2004 covering Item 5 – Other Events and Regulation FD Disclosure and Item 9 – Regulation FD Disclosure in connection with the announcement of a correction to the telephone number for the American Stock Transfer & Trust Company included in the Election Form and Letter of Transmittal previously mailed to LFIN stockholders in connection with the pending merger between the Registrant and Local Financial Corporation.

 

Registrant filed a current report on Form 8-K on June 9, 2004 covering Item 5 – Other Events and Regulation FD Disclosure and Item 9 – Regulation FD Disclosure in connection with the announcement of an extension of the deadline for election of consideration of cash or common shares (or a combination of both) in connection with the acquisition of Local Financial Corporation by the Registrant.

 

Registrant filed a current report on Form 8-K on June 21, 2004 covering Item 2 – Acquisition or Disposition of Assets and Item 5 – Other Events and Regulation FD Disclosure in connection with consummation of the acquisition of Local Financial Corporation by the Registrant, pursuant to the Agreement and Plan of Merger dated January 22, 2004.

 

Registrant filed a current report on Form 8-K on July 16, 2004 covering Item 5 – Other Events and Regulation FD Disclosure and Item 9 – Regulation FD Disclosure in connection with the offer to purchase for cash any and all of the outstanding 11.0% Senior Notes due 2004, originally issued by Local Financial Corporation.

 

Registrant filed an amended report on Form 8-K on August 3, 2004 to the current report on Form 8K originally filed on June 21, 2004, covering Item 2 – Acquisition or Disposition of Assets and Item 5 – Other Events and Regulation FD Disclosure in connection with the consummation of the acquisition of Local Financial Corporation by the Registrant, pursuant to the Agreement and Plan of Merger dated January 22, 2004.

 

Registrant filed a current report on Form 8-K on August 5, 2004 covering Item 12 - Results of Operations and Financial Condition and Item 9 - Regulation FD Disclosure in connection with the announcement of second quarter 2004 earnings.

 

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SIGNATURES

 

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

 

	INTERNATIONAL BANCSHARES CORPORATION
Date:  August 9, 2004	/s/ Dennis E. Nixon
	Dennis E. Nixon
	President
Date:  August 9, 2004	/s/ Imelda Navarro
	Imelda Navarro
	Treasurer

 

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