PROSPERITY BANCSHARES INC - Quarter Report: 2007 September (Form 10-Q)

Index to Financial Statements

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007

OR

FOR THE TRANSITION PERIOD FROM            TO            

COMMISSION FILE NUMBER: 000-25051

PROSPERITY BANCSHARES, INC.^®

(Exact name of registrant as specified in its charter)

Prosperity Bank Plaza

4295 San Felipe

Houston, Texas 77027

(Address of principal executive offices, including zip code)

(713) 693-9300

(Registrant’s telephone number, including area code)

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

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of November 1, 2007, there were 44,126,196 shares of the registrant’s Common Stock, par value $1.00 per share, outstanding.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

INDEX TO FORM 10-Q

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PART I – FINANCIAL INFORMATION

PROSPERITY BANCSHARES, INC^®. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(UNAUDITED)

See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(Table continued on following page)

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See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2007

(UNAUDITED)

1. BASIS OF PRESENTATION

The interim consolidated financial statements include the accounts of Prosperity Bancshares, Inc. ^®(the “Company”) and its wholly-owned subsidiaries, Prosperity Bank ^®(the “Bank”) and Prosperity Holdings of Delaware, L.L.C. All significant inter-company transactions and balances have been eliminated.

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the statements reflect all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows of the Company on a consolidated basis, and all such adjustments are of a normal recurring nature. These financial statements and the notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. Operating results for the nine month period ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007.

2. EARNINGS PER SHARE

The following table illustrates the computation of basic and diluted earnings per share:

Basic earnings per share is computed by dividing net income by the weighted-average number of shares outstanding during the applicable period. Diluted earnings per share is computed using the weighted-average number of shares determined for the basic computation plus the dilutive effect of stock options and non-vested restricted stock granted using the treasury stock method. There were no stock options exercisable at September 30, 2007 and 2006 that would have had an anti-dilutive effect on the above computation.

SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments.” SFAS 155 amends SFAS 133, “Accounting for Derivative Instruments and Hedging Activities” and SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS 155 (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (ii) clarifies which interest-only strips and principal only strips are not subject to the requirements of SFAS 133, (iii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (iv) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (v) amends SFAS 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. Adoption of SFAS 155 on January 1, 2007 did not have a significant impact on the Company’s financial statements.

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PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2007

(UNAUDITED)

SFAS No. 157, “Fair Value Measurements.” SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective for the Company on January 1, 2008 and is not expected to have a significant impact on the Company’s financial statements.

SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115.” SFAS 159 permits entities to choose to measure eligible items at fair value at specified election dates. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date. The fair value option (i) may be applied instrument by instrument, with certain exceptions, (ii) is irrevocable (unless a new election date occurs) and (iii) is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective for the Company on January 1, 2008. The Company is currently evaluating the effect the adoption of SFAS 159 will have on its financial statements.

Financial Accounting Standards Board Interpretations

FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109.” The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109,” effective January 1, 2007. Interpretation 48 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Benefits from tax positions should be recognized in the financial statements only when it is more likely than not that the tax position will be sustained upon examination by the appropriate taxing authority that would have full knowledge of all relevant information. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met, the tax matter is ultimately settled, or the statute of limitations for examination by the appropriate taxing authority expires. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be derecognized in the first subsequent financial reporting period in which that threshold is no longer met. Interpretation 48 also provides guidance on the accounting for and disclosure of unrecognized tax benefits, interest and penalties. The Company’s policy for recording interest and penalties associated with audits is to record such items as a component of income before taxes. Penalties are recorded in other (gains) losses and interest paid or received is recorded in interest expense or interest income, respectively, in the statement of income. The Company has identified its federal tax return and its state franchise tax return in Texas as “major” tax jurisdictions, as defined. The only periods subject to examination for the Company’s federal return are the 2003 through 2006 tax years. The Company believes that its income tax filing positions and deductions will more-likely-than-not be sustained on audit and does not anticipate any adjustments that will result in a material change to its financial position. Therefore, no reserves for uncertain income tax positions have been recorded pursuant to FIN 48. In addition, the Company did not record a cumulative effect adjustment related to the adoption of FIN 48.

4. GOODWILL AND CORE DEPOSIT INTANGIBLES

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles (CDI) for nine months ended September 30, 2007 were as follows:

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PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2007

(UNAUDITED)

Purchase accounting adjustments to prior year acquisitions were made to adjust deferred tax asset and liability balances. Goodwill is recorded on the acquisition date of each entity. The Company may record subsequent adjustments to goodwill for amounts undeterminable at acquisition date, such as deferred taxes and real estate valuations, and therefore the goodwill amounts reflected in the table above may change accordingly. The Company initially records the total premium paid on acquisitions as goodwill. After a third party valuation, core deposit intangibles are identified and reclassified from goodwill to core deposit intangibles on the balance sheet. This reclassification has no effect on total assets, liabilities, shareholders’ equity, net income or cash flows. Management performs an annual evaluation of whether any impairment of the goodwill and other intangibles has occurred. If any such impairment is determined, a write down is recorded. As of September 30, 2007, there were no impairments recorded on goodwill.

Core deposit intangibles are amortized on an accelerated basis over their estimated lives, which the Company believes is between 8 and 10 years. Gross core deposit intangibles outstanding were $67.6 million and $34.6 million at September 30, 2007 and December 31, 2006, respectively. Net core deposit intangibles outstanding were $48.7 million and $23.0 million at the same dates, respectively. Amortization expense related to intangible assets totaled $2.6 million and $1.2 million for the three months ended September 30, 2007 and 2006, respectively and $7.3 million and $3.6 million for the nine months ended September 30, 2007 and 2006, respectively. Both increases are primarily due to the core deposit intangibles from the TXUI and Bank of Navasota acquisitions. The estimated aggregate future amortization expense for intangible assets remaining as of September 30, 2007 is as follows (dollars in thousands):

5. STOCK BASED COMPENSATION

The Company had two stock-based employee compensation plans at September 30, 2007 and five stock option plans assumed in connection with acquisitions under which no additional options will be granted. Prior to 2003, the Company accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The Company adopted SFAS 123 on January 1, 2003 and SFAS 123(R) on January 1, 2006. The Company recognized $1.5 million and $606,000 in stock-based compensation expense for the nine months ended September 30, 2007 and 2006, respectively and $534,000 and $223,000 in stock-based compensation expense for the three months ended September 30, 2007 and 2006, respectively. There was approximately $315,000 and $27,000 of income tax benefit recorded for the stock-based compensation expense for the nine months ended September 30, 2007 and 2006, respectively, and $115,000 and $13,000 of income tax benefit recorded for the stock-based compensation expense for the three months ended September 30, 2007 and 2006, respectively.

The Company has granted shares of common stock subject to forfeitures restrictions (“restricted stock”) to certain directors and associates under the Company’s 2004 Stock Incentive Plan. The awardee is not entitled to the delivery of the shares until the forfeiture restrictions lapse, which is generally over a 1 to 5 year period, however the awardee is entitled to receive dividends on and vote the shares prior to the lapse of such restrictions. The shares granted do not have a cost to the awardee and the only requirement of the lapse of the forfeiture restriction is continued service to the Company. Compensation cost related to restricted stock is calculated based on the fair value of the shares at the date of grant. If the awardee leaves the Company before the forfeiture restrictions lapse, the unvested shares are forfeited. As of September 30, 2007, there were 84,306 shares of restricted stock outstanding with a weighted average grant date fair value of $34.83.

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PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2007

(UNAUDITED)

Stock options are issued at the current market price on the date of the grant, subject to a pre-determined vesting period with a contractual term of 10 years. Options assumed in connection with acquisitions have contractual terms as established in the original option grant agreements entered into prior to acquisition. The fair value of stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. Stock-based compensation expense is recognized ratably over the requisite service period for all awards.

The fair value of options was estimated using an option-pricing model with the following weighted average assumptions:

A summary of changes in outstanding vested and unvested options during the nine months ended September 30, 2007 is set forth below:

A total of 50,000 options were granted during the nine months ended September 30, 2007 and 39,000 options were granted during the nine months ended September 30, 2006. The Company assumed 179,956 options in connection with the TXUI acquisition which were fully vested upon consummation of the transaction. The total intrinsic value of the options exercised during the nine month periods ended September 30, 2007 and 2006 was $7.4 million and $9.7 million, respectively. Excluding the options assumed in the TXUI acquisition in 2007, the total fair value of options vested during the nine month periods ended September 30, 2007 and 2006 was $296,000 and $248,000, respectively.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2007

(UNAUDITED)

A summary of changes in unvested options is set forth below:

The Company received $2.7 million and $7.8 million in cash from the exercise of stock options during the nine month periods ended September 30, 2007 and 2006, respectively. The increase in cash received for the exercise of stock options for the nine months ended September 30, 2006 was primarily due to the exercise of options assumed in connection with the SNB acquisition. There was no tax benefit realized from option exercises of the stock-based compensation arrangements during the nine month periods ended September 30, 2007 and 2006.

As of September 30, 2007, there was $3.6 million of total unrecognized compensation expense related to unvested stock-based compensation arrangements. That cost is expected to be recognized over a weighted average period of 2.5 years.

6. RECENT ACQUISITIONS

On January 31, 2007, the Company completed its acquisition of Texas United Bancshares, Inc., La Grange, Texas (“TXUI”). Under the terms of the merger agreement, TXUI was merged into the Company and subsequently each of TXUI’s wholly owned subsidiary banks, State Bank, GNB Financial, n.a., Gateway National Bank and Northwest Bank, was merged into the Bank. The Company issued approximately 10.8 million shares of its common stock for all of the issued and outstanding capital stock of TXUI. In addition, options to acquire 179,956 shares of TXUI common stock were converted into options to acquire 179,956 shares of Company common stock. In connection with the acquisition, the Company assumed $44.8 million in junior subordinated debentures issued to five subsidiary trusts. TXUI was publicly traded and operated forty-one (41) banking offices in Texas, two of which were subsequently consolidated with existing Prosperity banking centers. As of December 31, 2006, TXUI had, on a consolidated basis, total assets of $1.806 billion, loans (including loans held for sale) of $1.212 billion, deposits of $1.362 billion and shareholders’ equity of $161.9 million.

As a result of the acquisition of TXUI, the consolidated statements of income and consolidated statements of cash flows for the three months and nine months ended September 30, 2007 include the results of operations and cash flows, respectively, of TXUI beginning February 1, 2007. In addition, the consolidated balance sheet as of September 30, 2007 includes preliminary estimates of the fair values of assets acquired and liabilities assumed as of the acquisition date for TXUI. The Company has not completed its assessment of the fair values of the acquired TXUI assets and liabilities and therefore, the allocation of the purchase price is subject to revision.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2007

(UNAUDITED)

The table below summarizes select pro forma data for the two combined companies for the periods indicated, assuming that the transaction was consummated on January 1 of the earliest indicated period:

On August 31, 2007, the Company completed its acquisition of The Bank of Navasota, N.A., Navasota, Texas through the merger of the Bank of Navasota into the Bank. The Company issued approximately 251,000 shares of its common stock and paid approximately $8.6 million in cash for all of the issued and outstanding capital stock of the Bank of Navasota. The Bank of Navasota operated one banking office in Navasota, Texas, which became a full-service banking center of Prosperity Bank. As of June 30, 2007, the Bank of Navasota had total assets of $73.4 million, loans of $33.0 million, deposits of $63.8 million and shareholders’ equity of $9.1 million.

7. PENDING ACQUISITION

On October 22, 2007, the Company announced its signing of a definitive agreement by the Bank to purchase the six (6) Houston retail bank branches of Banco Popular North America (BPNA). The Bank will pay a premium of 10.10% on the average deposits of the branches for a 20-day period prior to the closing date and will also purchase certain loans and other assets attributable to the branches. As of September 30, 2007, there were $140 million in deposits in BPNA’s Houston branches.

8. REDEMPTION OF JUNIOR SUBORDINATED DEBENTURES

On September 26, 2007, the Company redeemed in full the debentures held by First Capital Statutory Trust II in the amount of $7.7 million. The debentures redeemed bore interest at a floating rate of 3 month LIBOR + 3.40%. The trust in turn redeemed in full the trust preferred securities and common securities it issued.

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

Special Cautionary Notice Regarding Forward-Looking Statements

Statements and financial discussion and analysis contained in this quarterly report on Form 10-Q that are not historical facts are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and are including this statement for purposes of invoking these safe harbor provisions. These forward-looking statements include information about possible or assumed future results of the Company’s operations or performance. By using any of the words “believe,” “expect”, “anticipate”, “estimate”, “continue”, “intend”, “may”, “will”, “should”, or similar expressions, the Company identifies these forward-looking statements. Many possible factors or events could affect the future financial results and performance of the Company and could cause those financial results or performance to differ materially from those expressed in the forward-looking statement. These possible events or factors include, without limitation:

A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these assumptions or bases in good faith and that they are reasonable. However, the Company cautions you that assumptions or bases almost always vary from actual results, and the differences

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between assumptions or bases and actual results can be material. The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise.

COMPLETION OF ACQUISITION OF TEXAS UNITED BANCSHARES, INC. AND THE BANK OF NAVASOTA

On January 31, 2007, the Company completed its acquisition of Texas United Bancshares, Inc., La Grange, Texas (“TXUI”). Under the terms of the merger agreement, TXUI was merged into the Company and subsequently each of TXUI’s wholly owned subsidiary banks, State Bank, GNB Financial, n.a., Gateway National Bank and Northwest Bank, was merged into the Bank. The Company issued approximately 10.8 million shares of its common stock for all of the issued and outstanding capital stock of TXUI. In addition, options to acquire 179,956 shares of TXUI common stock were converted into options to acquire 179,956 shares of Company common stock. In connection with the acquisition, the Company assumed $44.8 million in junior subordinated debentures issued to five subsidiary trusts. TXUI was publicly traded and operated forty-one (41) banking offices in Texas, two of which were subsequently consolidated with existing Prosperity banking centers. As of December 31, 2006, TXUI had, on a consolidated basis, total assets of $1.806 billion, loans (including loans held for sale) of $1.212 billion, deposits of $1.362 billion and shareholders’ equity of $161.9 million.

On August 31, 2007, the Company completed its acquisition of The Bank of Navasota, N.A., Navasota, Texas through the merger of the Bank of Navasota into the Bank. The Company issued approximately 251,000 shares of its common stock and paid approximately $8.6 million in cash for all of the issued and outstanding capital stock of the Bank of Navasota. The Bank of Navasota operated one banking office in Navasota, Texas, which became a full-service banking center of the Bank. As of June 30, 2007, the Bank of Navasota had total assets of $73.4 million, loans of $33.0 million, deposits of $63.8 million and shareholders’ equity of $9.1 million.

PENDING ACQUISITION

On October 22, 2007, the Company announced its signing of a definitive agreement by the Bank to purchase the six (6) Houston retail bank branches of Banco Popular North America (BPNA). The Bank will pay a premium of 10.10% on the average deposits of the branches for a 20-day period prior to the closing date and will also purchase certain loans and other assets attributable to the branches. As of September 30, 2007, there were $140 million in deposits in BPNA’s Houston branches.

OVERVIEW

The Company, a Texas corporation, was formed in 1983 as a vehicle to acquire the former Allied First Bank in Edna, Texas which was chartered in 1949 as The First National Bank of Edna. The Company is a registered financial holding company that derives substantially all of its revenues and income from the operation of its bank subsidiary, Prosperity Bank^® (“Prosperity Bank^®” or the “Bank”). The Bank provides a wide array of financial products and services to small and medium-sized businesses and consumers. At September 30, 2007, the Bank operated one hundred twenty-four (124) full-service banking locations in Texas; with forty (40) in the Greater Houston Consolidated Metropolitan Statistical Area (“CMSA”), thirty-three (33) in the south Texas area including Corpus Christi and Victoria, twenty-seven (27) in the Dallas/Fort Worth area, two (2) in East Texas, twenty-two (22) in the Central Texas area including Austin and Bryan/College Station and one (1) loan production office in San Antonio. The Greater Houston CMSA includes Austin, Brazoria, Chambers, Fort Bend, Galveston, Harris, Liberty, Montgomery, San Jacinto and Waller counties. The Company’s headquarters are located at Prosperity Bank Plaza, 4295 San Felipe in Houston, Texas and its telephone number is (713) 693-9300. The Company’s website address is www.prosperitybanktx.com. Information contained on the Company’s website is not incorporated by reference into this quarterly report on Form 10-Q and is not part of this or any other report.

The Company generates the majority of its revenues from interest income on loans, service charges on customer accounts and income from investment in securities. The revenues are partially offset by interest expense paid on deposits and other borrowings and non-interest expenses such as administrative and occupancy expenses. Net interest income is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as deposits and borrowings which are used to fund those assets. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and margin. The Company has recognized increased net interest income primarily due to an increase in the volume of interest-earning assets.

Three principal components of the Company’s growth strategy are internal growth, stringent cost control practices and strategic merger transactions. The Company focuses on continual internal growth. Each banking center is operated as a separate profit center, maintaining separate data with respect to its net interest income, efficiency ratio, deposit growth, loan

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growth and overall profitability. Banking center presidents and managers are accountable for performance in these areas and compensated accordingly. The Company also focuses on maintaining stringent cost control practices and policies. The Company has invested significantly in the infrastructure required to centralize many of its critical operations, such as data processing and loan application processing. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale. The Company also intends to continue to seek expansion opportunities. On April 1, 2006, the Company acquired SNB Bancshares, Inc. (the “SNB acquisition”) which added six (6) banking centers. On January 31, 2007, the Company acquired TXUI which added thirty-nine (39) banking centers after two locations were consolidated with existing Prosperity banking centers and on August 31, 2007, the Company acquired the Bank of Navasota which added one banking center.

Total assets were $6.17 billion at September 30, 2007 compared with $4.59 billion at December 31, 2006, an increase of $1.58 billion or 34.5%. Total loans were $3.13 billion at September 30, 2007 compared with $2.18 billion at December 31, 2006, an increase of $951.0 million or 43.7%. Total deposits were $4.78 billion at September 30, 2007 compared with $3.73 billion December 31, 2006, an increase of $1.06 billion or 28.4%. Shareholders’ equity increased $446.8 million or 67.3%, to $1.11 billion at September 30, 2007 compared with $664.4 million at December 31, 2006. The increases were primarily due to the TXUI and Bank of Navasota acquisitions.

CRITICAL ACCOUNTING POLICIES

The Company’s accounting policies are integral to understanding the financial results reported. Accounting policies are described in detail in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. The Company believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity:

Allowance for Credit Losses—The allowance for credit losses is established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company’s loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank’s Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company’s commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company’s loan portfolio, current economic changes that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process and other relevant factors. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. Charge-offs occur when loans are deemed to be uncollectible. The allowance for credit losses includes allowance allocations calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS 118, and allowance allocations determined in accordance with SFAS No. 5, “Accounting for Contingencies.”

Goodwill—Goodwill and intangible assets that have indefinite useful lives are subject to an annual impairment test and more frequently if circumstances indicate their value may not be recoverable. Goodwill is tested for impairment using a two-step process that begins with an estimation of the fair value of each of the Company’s reporting units compared with its carrying value. If the carrying amount exceeds the fair value of a reporting unit, a second test is conducted comparing the implied fair value of the reporting unit’s goodwill to its carrying value to measure the amount of impairment. Intangible assets that are not amortized will be tested for impairment at least annually by comparing the fair values of those assets to their carrying values. Other identifiable intangible assets that are subject to amortization are amortized on an accelerated basis over the years expected to be benefited, which the Company believes is between eight and ten years. These amortizable intangible assets are reviewed for impairment if circumstances indicate their value may not be recoverable based on a comparison of fair value to carrying value. Based on the Company’s annual goodwill impairment test as of September 30, 2007, management does not believe any of its goodwill is impaired as of September 30, 2007. While the Company believes no impairment existed at September 30, 2007 under accounting standards applicable at that date, different conditions or assumptions, or changes in cash flows or profitability, if significantly negative or unfavorable, could have a material adverse effect on the outcome of the Company’s impairment evaluation and financial condition or future results of operations.

Stock-Based Compensation—The Company adopted the provisions of SFAS No. 123R “Share-Based Payment (Revised 2004),” on January 1, 2006 and its adoption did not have a material impact on the Company’s financial statements. The Company had previously adopted SFAS No. 123 on January 1, 2003. Among other things, SFAS No. 123R eliminates the ability to account for stock-based compensation using the intrinsic value based method of accounting and requires that such transactions be recognized as compensation expense in the income statement based on their fair values on the date of the grant.

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SFAS No. 123R requires that management make assumptions including stock price volatility and employee turnover that are utilized to measure compensation expense. The fair value of stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. This model requires the input of highly subjective assumptions.

Valuation of Securities—The Company’s available for sale securities portfolio is reported at fair value. When the fair value of a security is below its amortized cost, and depending on the length of time the condition exists and the extent the fair market value is below amortized cost, additional analysis is performed to determine whether an impairment exists. Available for sale and held to maturity securities are analyzed quarterly for possible other-than-temporary impairment. The analysis considers the (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Often, the information available to conduct these assessments is limited and rapidly changing, making estimates of fair value subject to judgment. If actual information or conditions are different than estimated, the extent of the impairment of the security may be different than previously estimated, which could have a material effect on the Company’s results of operations and financial condition.

RESULTS OF OPERATIONS

Net income available to common shareholders was $23.8 million ($0.54 per common share on a diluted basis) for the quarter ended September 30, 2007 compared with $16.4 million ($0.49 per common share on a diluted basis) for the quarter ended September 30, 2006, an increase in net income of $7.5 million, or 45.7%. The Company posted returns on average common equity of 8.67% and 10.17%, returns on average assets of 1.53% and 1.46% and efficiency ratios of 46.41% and 44.31% for the quarters ended September 30, 2007 and 2006, respectively. The efficiency ratio is calculated by dividing total non-interest expense (excluding credit loss provisions) by net interest income plus non-interest income (excluding net gains and losses on the sale of securities and on the sale assets). Additionally, taxes are not part of this calculation.

For the nine months ended September 30, 2007, net income available to common shareholders was $67.1 million ($1.56 per common share on a diluted basis) compared with $45.1 million ($1.43 per common share on a diluted basis) for the same period in 2006, an increase in net income of $21.9 million or 48.6%. The Company posted returns on average common equity of 8.62% and 10.32%, returns on average assets of 1.47% and 1.43% and efficiency ratios of 46.58% and 46.08% for the nine months ended September 30, 2007 and 2006, respectively.

Net Interest Income

The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “rate change.”

Net interest income on a tax equivalent basis was $52.2 million for the quarter ended September 30, 2007 compared with $36.5 million for the quarter ended September 30, 2006, an increase of $15.7 million, or 43.1%. Net interest income increased as a result of an increase in average interest-earning assets to $5.09 billion for the quarter ended September 30, 2007 compared with $3.83 billion for the quarter ended September 30, 2006, an increase of $1.25 billion, or 32.7%. The increase in average interest-earning assets is primarily attributable to increases in average loans and securities in the quarter ended September 30, 2007 compared with the quarter ended September 30, 2006 resulting from the TXUI and Bank of Navasota acquisitions.

The net interest margin on a tax equivalent basis increased to 4.07% for the quarter ended September 30, 2007 compared with 3.77% for the quarter ended September 30, 2006. The average rate paid on interest-bearing liabilities increased 26 basis points from 3.47% for the quarter ended September 30, 2006 compared with 3.73% for the quarter ended September 30, 2007, while the average yield on earning assets increased 43 basis points from 6.43% for the quarter ended September 30, 2006 compared with 6.86% for the quarter ended September 30, 2007. Average interest-bearing liabilities increased $906.3 million and average interest-earning assets increased $1.25 billion for the same periods.

Net interest income on a tax equivalent basis increased $48.0 million, or 46.6%, to $151.1 million for the nine months ended September 30, 2007 compared with $103.1 million for the same period in 2006. This increase is mainly attributable to higher average interest-earning assets resulting from an increase in average loans and securities due to the TXUI and Bank of Navasota acquisitions. The net interest margin on a tax equivalent basis for the nine months ended September 30, 2006 increased 23 basis points to 4.04% compared with 3.81% for the same period in 2006. The average rate paid on interest-bearing liabilities increased 49 basis points from 3.18% for the nine months ended September 30, 2006 compared with 3.67% for the same period in 2007 and the average yield on earning assets increased 59 basis points from 6.23% for the nine months ended September 30, 2006 compared with 6.82% for the nine months ended September 30, 2007.

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Index to Financial Statements

The following tables set forth, for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest earned or paid on such amounts, and the average rate earned or paid for the quarters ended September 30, 2007 and 2006 and the nine months ended September 30, 2007 and 2006. The tables also set forth the average rate paid on total interest-bearing liabilities, and the net interest margin on average total interest-earning assets for the same periods. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield.