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 March 31, 2008

 

OR

 

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

 

For the transition period from       to       

 

Commission file number  0-9439

 

INTERNATIONAL BANCSHARES CORPORATION

(Exact name of registrant as specified in its charter)

 

 

1200 San Bernardo Avenue, Laredo, Texas 78042-1359

(Address of principal executive offices)

(Zip Code)

 

(956) 722-7611

(Registrant’s telephone number, including area code)

 

None

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o  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		Shares Issued and Outstanding
Common Stock, $1.00 par value		68,558,810 shares outstanding at May 5, 2008

 

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Consolidated Statements of Condition (Unaudited)

 

(Dollars in Thousands)

 

		March 31,			December 31,
		2008			2007
Assets
Cash and due from banks		$	272,745		$	329,052
Federal funds sold		86,000			17,000
Total cash and cash equivalents		358,745			346,052
Time deposits with banks		495			4,852
Investment securities:
Held-to-maturity (Market value of $2,300 on March 31, 2008 and $2,300 on December 31, 2007)		2,300			2,300
Available-for-sale (Amortized cost of $3,908,655 on March 31, 2008 and $4,167,624 on December 31, 2007)		3,941,721			4,167,888
Total investment securities		3,944,021			4,170,188
Loans, net of unearned discounts		5,601,432			5,536,628
Less allowance for possible loan losses		(62,109		)	(61,726		)
Net loans		5,539,323			5,474,902
Bank premises and equipment, net		443,592			435,654
Accrued interest receivable		50,767			54,301
Other investments		327,198			323,565
Identified intangible assets, net		30,208			31,507
Goodwill, net		282,357			283,198
Other assets		40,080			42,942
Total assets		$	11,016,786		$	11,167,161

 

2

 

		March 31,			December 31,
		2008			2007
Liabilities and Shareholders’ Equity
Liabilities:
Deposits:
Demand – non-interest bearing		$	1,516,350		$	1,512,627
Savings and interest bearing demand		2,328,333			2,292,589
Time		3,361,883			3,352,390
Total deposits		7,206,566			7,157,606
Securities sold under repurchase agreements		1,455,878			1,328,983
Other borrowed funds		1,049,779			1,456,936
Junior subordinated deferrable interest debentures		200,969			200,929
Other liabilities		136,231			86,802
Total liabilities		10,049,423			10,231,256
Commitments, Contingent Liabilities and Other Tax Matters (Note 10)
Shareholders’ equity:
Common shares of $1.00 par value. Authorized 275,000,000 shares; issued 95,446,857 shares on March 31, 2008 and 95,440,983 shares on December 31, 2007		95,447			95,441
Surplus		144,403			144,140
Retained earnings		940,002			929,145
Accumulated other comprehensive income		21,305			165
		1,201,157			1,168,891
Less cost of shares in treasury, 26,886,822 shares on March 31, 2008 and 26,848,880 shares on December 31, 2007		(233,794		)	(232,986		)
Total shareholders’ equity		967,363			935,905
Total liabilities and shareholders’ equity		$	11,016,786		$	11,167,161

 

See accompanying notes to consolidated financial statements.

 

3

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Consolidated Statements of Income (Unaudited)

 

(Dollars in Thousands, except per share data)

 

		Three Months Ended March 31,
		2008			2007
Interest income:
Loans, including fees		$	99,521		$	109,256
Federal funds sold		369			696
Investment securities:
Taxable		47,640			51,656
Tax-exempt		954			1,131
Other interest income		177			116
Total interest income		148,661			162,855
Interest expense:
Savings deposits		8,910			13,096
Time deposits		33,181			35,037
Securities sold under repurchase agreements		13,641			8,322
Other borrowings		11,600			27,205
Junior subordinated interest deferrable debentures		3,652			4,419
Other interest expense		46			—
Total interest expense		71,030			88,079
Net interest income		77,631			74,776
Provision for possible loan losses		1,552			1,361
Net interest income after provision for possible loan losses		76,079			73,415
Non-interest income:
Service charges on deposit accounts		23,754			20,225
Other service charges, commissions and fees
Banking		10,012			8,118
Non-banking		1,498			4,944
Investment securities transactions, net		146			(17,167		)
Other investments, net		4,425			5,783
Other income		6,459			4,337
Total non-interest income		46,294			26,240

 

4

 

		Three Months Ended March 31,
		2008				2007
Non-interest expense:
Employee compensation and benefits		$	31,040			$	31,193
Occupancy		8,076				7,040
Depreciation of bank premises and equipment		8,546				7,556
Professional fees		2,715				2,678
Stationery and supplies		1,328				1,481
Amortization of identified intangible assets		1,299				1,209
Advertising		3,183				3,251
Other		14,810				17,660
Total non-interest expense		70,997				72,068
Income before income taxes		51,376				27,587
Minority interest in consolidated subsidiaries		—				78
Provision for income taxes		17,896				8,865
Net income		$		33,480		$	18,644
Basic earnings per common share:
Weighted average number of shares outstanding:		68,583,274				69,315,455
Net income		$	.49			$	.27
Fully diluted earnings per common share:
Weighted average number of shares outstanding:		68,701,105				69,877,381
Net income		$	.49			$	.27

 

See accompanying notes to consolidated financial statements.

 

5

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Consolidated Statements of Comprehensive Income (Unaudited)

 

(Dollars in Thousands)

 

		Three Months Ended March 31,
		2008			2007
Net income		$	33,480		$	18,644
Other comprehensive income, net of tax:
Net unrealized holding gains on securities available for sale arising during period		20,994			37,592
Reclassification adjustment for gains (losses) on securities available for sale included in net income		146			(17,167		)
Comprehensive income		$	54,620		$	39,069

 

See accompanying notes to consolidated financial statements.

 

6

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Consolidated Statements of Cash Flows (Unaudited)

 

(Dollars in Thousands)

 

		Three Months Ended March 31,
		2008			2007
Operating activities:
Net income		$	33,480		$	18,644
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for possible loan losses		1,552			1,361
Amortization of loan premiums		67			175
Amortization of time deposits with banks		1			––
Accretion of time deposit discounts		(9		)	––
Depreciation of bank premises and equipment		8,546			7,556
Loss (gain) on sale of bank premises and equipment		19			(214		)
Depreciation and amortization of leased assets		358			542
Accretion of investment securities discounts		(117		)	(162		)
Amortization of investment securities premiums		1,619			1,068
Investment securities transactions, net		(146		)	153
Impairment on investment securities		––			17,014
Amortization of junior subordinated debenture discounts		40			108
Amortization of identified intangible assets		1,299			1,209
Stock based compensation expense		190			179
Earnings from affiliates and other investments		(3,142		)	(1,394		)
Deferred tax expense (benefit)		298			(6,297		)
Decrease (increase) in accrued interest receivable		3,534			(301		)
Net decrease (increase) in other assets		2,505			(38,446		)
Net increase in other liabilities		14,843			25,331
Net cash provided by operating activities		64,937			26,526
Investing activities:
Proceeds from maturities of securities		8,619			3,250
Proceeds from sales of available for sale securities		1,110			39,538
Purchases of available for sale securities		(109,924		)	(243,902		)
Principal collected on mortgage-backed securities		357,808			225,074
Maturities of time deposits with banks		4,358			3,465
Net increase in loans		(66,040		)	(129,609		)
Purchases of other investments		(3,918		)	(1,278		)
Distributions of other investments		4,268			6,688
Purchases of bank premises and equipment		(16,538		)	(13,723		)
Proceeds from sale of bank premises and equipment		35			820
Adjustment to goodwill related to prior acquisition		––			5,885
Cash paid in purchase transaction		––			(23,470		)
Cash acquired in purchase transaction		––			30,772
Net cash provided by (used in) investing activities		179,778			(96,490		)

 

7

 

		Three Months Ended March 31,
		2008			2007
Financing activities:
Net increase (decrease) in non-interest bearing demand deposits		$	3,723		$	(8,575	)
Net increase in savings and interest bearing demand deposits		35,744			114,045
Net increase (decrease) in time deposits		9,502			(632		)
Net increase in securities sold under repurchase agreements		126,895			191,747
Net change in other borrowed funds		(407,157		)	(168,461		)
Purchase of treasury stock		(808		)	(2,142		)
Proceeds from stock transactions		79			1,994
Net cash (used in) provided by financing activities		(232,022		)	127,976
Increase in cash and cash equivalents		12,693			58,012
Cash and cash equivalents at beginning of period		346,052			297,207
Cash and cash equivalents at end of period		$	358,745		$	355,219
Supplemental cash flow information:
Interest paid		$	74,016		$	85,580
Income taxes paid		4,363			506
Dividends declared, not yet paid		22,623			––
Adjustment to goodwill arising from acquisition		––			2,076

 

See accompanying notes to consolidated financial statements.

 

8

 

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

 

(Unaudited)

 

Note 1 – Basis of Presentation

 

The accounting and reporting policies of International Bancshares Corporation (“Corporation”) and Subsidiaries (the Corporation and Subsidiaries collectively referred to herein as the “Company”) conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry.  The consolidated financial statements include the accounts of the Corporation and its wholly-owned subsidiaries, International Bank of Commerce, Laredo (“IBC”), Commerce Bank, International Bank of Commerce, Zapata, International Bank of Commerce, Brownsville and the Corporation’s wholly-owned non-bank subsidiaries, IBC Subsidiary Corporation, IBC Life Insurance Company, IBC Trading Company, and IBC Capital Corporation.  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 10-K.  The consolidated statement of condition at December 31, 2007 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  Certain reclassifications have been made to make prior periods comparable.

 

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

 

Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards No. 157 (“SFAS No. 157”), “Fair Value Measurements” for financial assets and financial liabilities.  In accordance with Financial Accounting Standards Board Staff Position No. 157-2, (“FSP No. 157-2”), “Effective date of FASB Statement No. 157,” the Company will delay application of SFAS No. 157 for non-financial assets and non-financial liabilities until January 1, 2009, except  for those that are recognized or disclosed at fair value on a recurring basis.  SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements.  SFAS No. 157 applies to all financial instruments that are being measured and reported on a fair value basis.  SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  SFAS No. 157 also establishes a fair value hierarchy that prioritizes the inputs used in valuation methodologies into the following three levels:

 

·      Level 1 Inputs – Unadjusted quoted prices in active markets for identical assets or liabilities.

·      Level 2 Inputs – Observable inputs other than Level I prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

·      Level 3 Inputs – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.  Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or other valuation techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

 

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy is set forth below.

 

9

 

The following table represents assets and liabilities reported on the consolidated balance sheets at their fair value as of March 31, 2008 by level within the SFAS No. 157 fair value measurement hierarchy:

 

					Fair Value Measurements at Reporting Date Using
								(in thousands)
		Assets/Liabilities Measured at Fair Value			Quoted Prices in Active Markets for Identical Assets			Significant Other Observable Inputs			Significant Unobservable Inputs
		March 31, 2008			(Level 1)			(Level 2)			(Level 3)
Measured on a recurring basis:
Assets:
Investment securities available-for-sale		$	3,941,721		$	647		$	3,941 074		$	—
Measured on a non-recurring basis:
Assets:
Impaired Loans		44,184			—			44,184			—

 

Investment securities available-for-sale are classified within level 2 of the valuation hierarchy, with the exception of certain equity investments that are classified within level 1.  The Company obtains fair value measurements for investment securities from an independent pricing service.  The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

 

Impaired loans are classified within level 2 of the valuation hierarchy.  The fair value of impaired loans is derived in accordance with Statement of Financial Accounting Standards No. 114 (“SFAS No. 114”), “Accounting by Creditors for Impairment of a Loan.”  The fair value of impaired loans is based on the fair value of the collateral, as determined through an external appraisal process.  Impaired loans are primarily comprised of collateral-dependent commercial loans.

 

Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis.  The instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).

 

Note 2 –Acquisition

 

On March 16, 2007, the Company completed its acquisition of Southwest First Community, Inc. (“Southwest Community”), a bank holding company with approximately $133 million in assets that owned State Bank & Trust in Beeville, Texas and Commercial State Bank in Sinton, Texas.  The transaction was pursuant to the Agreement and Plan of Merger dated December 1, 2006 (the “Merger Agreement”).  The Company paid consideration totaling $23.5 million in cash.

 

Note 3– Loans

 

A summary of net loans, by loan type at March 31, 2008 and December 31, 2007 is as follows:

 

		March 31,			December 31,
		2008			2007
		(Dollars in thousands)
Commercial, financial and agricultural		$	2,425,903		$	2,426,064
Real estate – mortgage		816,517			798,708
Real estate – construction		1,883,011			1,835,950
Consumer		194,790			190,899
Foreign		281,212			285,008
Total loans		5,601,433			5,536,629
Unearned discount		(1		)	(1		)
Loans, net of unearned discount		$	5,601,432		$	5,536,628

 

10

 

Note 4 - Allowance for Possible Loan Losses

 

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

 

		2008			2007
		(Dollars in Thousands)
Balance at December 31,		$	61,726		$	64,537
Losses charged to allowance		(1,347		)	(1,249		)
Recoveries credited to allowance		178			238
Net losses charged to allowance		(1,169		)	(1,011		)
Provision charged to operations		1,552			1,361
Allowance acquired in acquisition (Note 2)		—			1,054
Balance at March 31,		$	62,109		$	65,941

 

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

 

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

 

		March 31,			December 31,
		2008			2007
		(Dollars in Thousands)
Balance of impaired loans where there is a related allowance for loan loss		$	48,897		$	39,618
Balance of impaired loans where there is no related allowance for loan loss		—			—
Total impaired loans		$	48,897		$	39,618
Allowance allocated to impaired loans		$	4,713		$	4,903

 

The impaired loans included in the table above were primarily comprised of collateral dependent commercial loans, which have not been fully charged off.  The average recorded investment in impaired loans was $44,257,000 and $22,590,000 for the three months and year ended March 31, 2008 and December 31, 2007, respectively.  The interest recognized on impaired loans was not significant.

 

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

 

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

 

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 March 31, 2008 was adequate to absorb probable losses from loans in the portfolio at that date.

 

Note 5 – Stock Options

 

On April 1, 2005, the Board of Directors adopted the 2005 International Bancshares Corporation Stock Option Plan (the “2005 Plan”).  The 2005 Plan replaced the 1996 International Bancshares Corporation Key Contributor Stock Option Plan (the “1996 Plan”).  Under the 2005 Plan, both qualified incentive stock options (“ISOs”) and non-qualified stock options (“NQSOs”) may be granted.  Options granted may be exercisable for a period of up to 10 years from the date of grant, excluding ISOs granted to 10% shareholders, which may be exercisable for a period of up to only five years.  As of March 31, 2008, 51,622 shares were available for future grants under the 2005 Plan.

 

                A summary of option activity under the stock option plans for the three months ended March 31, 2008 is as follows:

 

		Number of options		Weighted average exercise price			Weighted average remaining contractual term (years)		Aggregate intrinsic value ($)
Options outstanding at December 31, 2007		924,486		$	21.00
Plus: Options granted		—		—
Less:
Options exercised		5,877		13.51
Options expired		—		—
Options forfeited		10,881		25.02
Options outstanding at March 31, 2008		907,728		$	21.00		4.26		$	3,173,000
Options fully vested and exercisable at March 31, 2008		431,293		$	15.96		2.35		$	3,085,000

 

Stock-based compensation expense included in the consolidated statement of income for the three months ended March 31, 2008 was approximately $190,000.  As of March 31, 2008, there was approximately $1,580,000 of total unrecognized stock-based compensation cost related to non-vested options granted under the Company plans that will be recognized over a weighted average period of 1.9 years.

 

Note 6 - Investment Securities

 

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

 

12

 

In the first quarter 2007, the Company wrote down approximately $732.0 million of investment securities to fair value, which resulted in an impairment charge of approximately $17.0 million.  The write down was a result of the Company’s strategic identification of certain investment securities that were sold in the second quarter of 2007 with the proceeds used to reduce Federal Home Loan Bank (“FHLB”) borrowings.  The investments sold were certain hybrid mortgage backed securities with a coupon re-set date that exceeded 30 months and a weighted average yield to coupon re-set that was approximately 100 basis points less than the FHLB certificate of indebtedness short term-rate.  The sale of the securities facilitated a repositioning of the balance sheet to a more neutral position in terms of interest rate risk and improved the Company’s operating ratios.

 

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

 

		March 31,			December 31,
		2008			2007
		(Dollars in Thousands)
U.S. Treasury securities
Available-for-sale		$	1,323		$	1,308
Mortgage-backed securities
Available-for-sale		3,850,207			4,066,829
States and political subdivisions
Available-for-sale		75,042			84,633
Other
Held-to-maturity		2,300			2,300
Available-for-sale		15,149			15,118
Total investment securities		$	3,944,021		$	4,170,188

 

Included in mortgage-backed securities in the table above are $2,157,753 of mortgage-backed securities issued by either the Federal Home Loan Mortgage Corporation (“Freddie Mac”) or the Federal National Mortgage Corporation (“Fannie Mae”), and $1,692,454 of mortgage-backed securities issued by the Government National Mortgage Corporation (“Ginnie Mae”).  Investments in mortgage-backed securities issued by Ginnie Mae are fully guaranteed by the U.S. Government.  Investments in mortgage-backed securities issued by Freddie Mac and Fannie Mae are not fully guaranteed by the U.S. Government, but are rated AAA.

 

Note 7 – Other Borrowed Funds

 

Other borrowed funds include Federal Home Loan Bank borrowings, which are short-term, variable-rate borrowings issued by the Federal Home Loan Bank of Dallas at the market price offered at the time of funding.  These borrowings are secured by mortgage-backed investment securities and a portion of the Company’s loan portfolio.  At March 31, 2008, other borrowed funds totaled $1,049,779,000, a decrease of 27.9% from $1,456,936,000 at December 31, 2007.

 

Note 8 – Junior Subordinated Interest Deferrable Debentures

 

The Company has formed twelve statutory business trusts under the laws of the State of Delaware, for the purpose of issuing trust preferred securities.  As part of the Local Financial Corporation (“LFIN”) acquisition, the Company acquired three additional statutory business trusts previously formed by LFIN for the purpose of issuing trust preferred securities.  The twelve statutory business trusts formed by the Company and the three business trusts acquired in the LFIN transaction (the “Trusts”) have each issued Capital and Common Securities and invested the proceeds thereof in an equivalent amount of junior subordinated debentures (the “Debentures”) issued by the Company or LFIN, as appropriate.  As of March 31, 2008, the Debentures issued by four of the trusts formed by the Company and the Debentures issued by all three of the trusts formed by LFIN have been redeemed by the Company.  As of March 31, 2008, the principal amount of debentures outstanding totaled $200,969,000.

 

13

 

The Debentures are subordinated and junior in right of payment to all present and future senior indebtedness (as defined in the respective indentures) of the Company, and are pari passu with one another.  The interest rate payable on, and the payment terms of the Debentures are the same as the distribution rate and payment terms of the respective issues of Capital and Common Securities issued by the Trusts.  The Company has fully and unconditionally guaranteed the obligations of each of the Trusts with respect to the Capital and Common Securities.  The Company has the right, unless an Event of Default (as defined in the Indentures) has occurred and is continuing, to defer payment of interest on the Debentures for up to ten consecutive semi-annual periods on Trust I and for up to twenty consecutive quarterly periods on Trusts VI, VII, VIII, IX, X, XI and XII.  If interest payments on any of the Debentures are deferred, distributions on both the Capital and Common Securities related to that Debenture would also be deferred.  The redemption prior to maturity of any of the Debentures may require the prior approval of the Federal Reserve and/or other regulatory bodies.

 

For financial reporting purposes, the Trusts are treated as investments of the Company and not consolidated in the consolidated financial statements.  Although the Capital Securities issued by each of the Trusts are not included as a component of shareholders’ equity on the consolidated statement of condition, the Capital Securities are treated as capital for regulatory purposes.  Specifically, under applicable regulatory guidelines, the Capital Securities issued by the Trusts qualify as Tier 1 capital up to a maximum of 25% of Tier 1 capital on an aggregate basis.  Any amount that exceeds the 25% threshold would qualify as Tier 2 capital.  For March 31, 2008, the total $200,969,000, of the Capital Securities outstanding qualified as Tier 1 capital.

 

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

 

The following table illustrates key information about each of the debentures and their interest rate at March 31, 2008:

 

		Junior Subordinated Deferrable Interest Debentures			Repricing Frequency		Interest Rate		Interest Rate Index		Maturity Date		Optional Redemption Date
		(in thousands)
Trust I		$	10,295		Fixed		10.18	%	Fixed		June 2031		June 2011
Trust VI		$	25,774		Quarterly		6.52	%	LIBOR + 3.45		November 2032		May 2008
Trust VII		$	10,310		Quarterly		6.49	%	LIBOR + 3.25		April 2033		July 2008
Trust VIII		$	25,722		Quarterly		7.31	%	LIBOR + 3.05		October 2033		October 2008
Trust IX		$	41,238		Fixed		7.10	%	Fixed		October 2036		October 2011
Trust X		$	34,021		Fixed		6.66	%	Fixed		February 2037		February 2012
Trust XI		$	32,990		Fixed		6.82	%	Fixed		July 2037		July 2012
Trust XII		$	20,619		Fixed		6.85	%	Fixed		September 2037		September 2012
		$	200,969

 

(1) Trust IX, X, XI and XII accrue interest at a fixed rate for the first five years, then floating at LIBOR + 1.62%, 1.65%, 1.62% and 1.45% thereafter, respectively.

 

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Note 9 – Common Stock and Dividends

 

All per share data presented has been restated to reflect the stock split effected through a stock dividend, which became effective May 21, 2007 and was paid on June 8, 2007.  Cash dividends of $.33 were paid on April 18, 2008 to all holders of record on March 31, 2008.

 

The Company expanded its formal stock repurchase program on May 3, 2007.  Under the expanded stock repurchase program, the Company is authorized to repurchase up to $225,000,000 of its common stock through December 2008.  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 May 5, 2008, a total of 6,195,133 shares had been repurchased under this program at a cost of $212,872,000.  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 $245,973,000.  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 $245,973,000 cap will occur in the future.  As of May 5, 2008, the Company has approximately $233,845,000 invested in treasury shares, which amount has been accumulated since the inception of the Company.

 

Note 10 - Commitments and Contingent Liabilities and Other Tax Matters

 

The Company is involved in various legal proceedings that are in various stages of litigation.  Some of these actions allege “lender liability” claims on a variety of theories and claim actual and punitive damages.  The Company has determined, based on discussions with its counsel that any 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 approximately $13.7 million, 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 approximate $13.7 million, the remaining amount of the prepaid interest would be refunded to the Company, plus interest thereon.

 

Beginning August 29, 2005, IBC proceeded to litigate one of the partnership tax cases in the Federal District Court in San Antonio, Texas.  The case was tried over nine days beginning August 29, 2005.  On March 31, 2006, the trial court rendered a judgment against the Company on the first FPAA.  IBC timely filed its notice of appeal to the Fifth Circuit Court of Appeals.  The appeal was argued on August 8, 2007 and the Trial Court decision was affirmed on August 23, 2007.  The judgment became non-appealable on November 21, 2007.  The other partnership case was stayed by the same Trial Court pending the appeal.  Following the resolution of the first case, the trial court reopened the second case and set it for trial on September 2, 2008.  Subsequently, the Company has engaged in settlement negotiations with the Department of Justice, and has agreed to settle the second case.  Under the terms of the settlement, the Company has conceded the entire amount in dispute based upon the similarity of the facts of that case to the first case and the likelihood of an unfavorable outcome if litigated based upon the Court rulings in the first case.

 

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The Company, through December 31, 2005, had previously expensed approximately $12.0 million in connection with the lawsuits.  Because of the above-referenced trial court judgment against the Company on the first FPAA, the uncertainty of the outcome at the appellate level, and the similarity between the two FPAAs, the Company additionally expensed an approximate $13.7 million in the first quarter of 2006.  The resultant approximately $25.7 million expensed is the total of the tax adjustments due and the interest due on such adjustments for both FPAAs.  Management will continue to evaluate the correspondence with the IRS on the FPAAs and make any appropriate revisions to the amounts as deemed necessary.

 

Note 11 – Capital Ratios

 

The Company had a leverage ratio of 7.74% and 7.76%, risk-weighted Tier 1 capital ratio of 12.01% and 11.98% and risk-weighted total capital ratio of 13.01% and 12.99% at March 31, 2008 and December 31, 2007, respectively.  The identified intangibles and goodwill of $312,565,000 as of March 31, 2008, recorded in connection with the acquisitions made by the Company, are deducted from the sum of core capital elements when determining the capital ratios of the Company.  The Company actively monitors the regulatory capital ratios to ensure that the Company’s bank subsidiaries are well capitalized under the regulatory framework.

 

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

 

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

 

Special Cautionary Notice Regarding Forward Looking Information

 

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

 

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

 

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

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

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

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

·                  The loss of senior management or operating personnel.

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

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

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

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

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

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

·                  Political instability in the United States and Mexico.

·                  Technological changes.

·                  Acts of war or terrorism.

·                  Natural disasters.

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

 

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

 

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Overview

 

The Company, which is headquartered in Laredo, Texas, with more than 260 facilities and more than 405 ATMs, provides banking services for commercial, consumer and international customers of South, Central and Southeast Texas and the State of Oklahoma.  The Company is one of the largest independent commercial bank holding companies headquartered in Texas.  The Company, through its bank subsidiaries, is in the business of gathering funds from various sources and investing those funds in order to earn a return.  The Company either directly or through a bank subsidiary owns two insurance agencies, a broker/dealer and a majority interest in an investment banking unit that owns a broker/dealer.  The Company’s primary earnings come from the spread between the interest earned on interest-bearing assets and the interest paid on interest-bearing liabilities.  In addition, the Company generates income from fees on products offered to commercial, consumer and international customers.

 

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

 

Expense control is an essential element in the Company’s long-term profitability.  As a result, one of the key ratios the Company monitors is the efficiency ratio, which is a measure of non-interest expense to net interest income plus non-interest income.  The first quarter of 2007 was negatively affected by an impairment charge of $13.1 million, after tax, arising from a charge on certain investment securities.  This impairment charge negatively affected the efficiency ratio but does not necessarily reflect a long-term negative trend.  Additionally, the Company’s efficiency ratio has been negatively impacted over the last few years because of the Company’s aggressive branch expansion which has added 46 branches in 2007 and the first three months of 2008.  During rapid expansion periods, the Company’s efficiency ratio will suffer but the long-term benefits of the expansion should be realized in future periods and the benefits should positively impact the efficiency ratio in future periods.  The Company monitors this ratio over time to assess the Company’s efficiency relative to its peers taking into account the Company’s branch expansion.  The Company uses this measure as one factor in determining if the Company is accomplishing its long-term goals of providing superior returns to the Company’s shareholders.

 

Results of Operations

 

Summary

 

Consolidated Statements of Condition Information

 

		March 31, 2008			December 31, 2007			Percent Increase (Decrease)
		(Dollars in Thousands)
Assets		$	11,016,786		$	11,167,161		(1.3	)%
Net loans		5,539,323			5,474,902			1.2
Deposits		7,206,566			7,157,606			0.7
Other borrowed funds		1,049,779			1,456,936			(27.9	)
Junior subordinated deferrable interest debentures		200,969			200,929			—
Shareholders’ equity		967,363			935,905			3.4

 

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Consolidated Statements of Income Information

 

		Quarter Ended March 31, 2008			Quarter Ended March 31, 2007			Percent Increase (Decrease)
		(Dollars in Thousands)
Interest income		$	148,661		$	162,855		(8.7	)%
Interest expense		71,030			88,079			(19.4	)
Net interest income		77,631			74,776			3.8
Provision for possible loan losses		1,552			1,361			14.0
Non-interest income		46,294			26,240			76.4
Non-interest expense		70,997			72,068			(1.5	)
Net income		33,480			18,644			79.6
Per common share (adjusted for stock dividends):
Basic		$	.49		$	.27		81.5	%
Diluted		.49			.27			81.5

 

Net Income

 

Net income for the first quarter of 2008 increased by 79.6% as compared to the same period in 2007.  During the first quarter of 2007, net income was negatively impacted by an impairment charge of $13.1 million, after tax, on certain investments.  A significant portion of the impairment charge is a result of the Company’s strategic identification in 2007 of certain investment securities that were sold with the proceeds from the sales to be used to reduce Federal Home Loan Bank (“FHLB”) borrowings.  The investments identified for sale were certain hybrid mortgage backed securities with a coupon re-set date that exceeded 30 months and a weighted average yield to coupon re-set that was approximately 100 basis points less than the FHLB certificate of indebtedness short-term rate.  The sale of the securities facilitated the Company’s re-positioning of the balance sheet to a more neutral position in terms of interest rate risk and was done to improve operating ratios.  As a result of this decision, the Company marked the securities to market.

 

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