PROSPERITY BANCSHARES INC - Quarter Report: 2008 June (Form 10-Q)

Quarterly Report for the Period Ended June 30, 2008

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2008

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: 000-25051

PROSPERITY BANCSHARES, INC.^®

(Exact name of registrant as specified in its charter)

TEXAS

74-2331986

(State or other jurisdiction of incorporation

or organization)

(I.R.S. Employer

Identification No.)

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, a non-accelerated filer or a smaller reporting company. See definitions of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

Large Accelerated Filer x

Accelerated Filer ¨

Non-accelerated Filer ¨

Smaller Reporting Company ¨

(Do not check if a

smaller reporting company)

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 August 1, 2008, there were outstanding 46,058,699 shares of the registrant’s Common Stock, par value $1.00 per share.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

INDEX TO FORM 10-Q


PART I - FINANCIAL INFORMATION		Page

Item 1.	Interim Consolidated Financial Statements	3
	Consolidated Balance Sheets as of June 30, 2008 (unaudited) and December 31, 2007 (unaudited)	3
	Consolidated Statements of Income for the Three and Six Months Ended June 30, 2008 and 2007 (unaudited)	4
	Consolidated Statements of Shareholders’ Equity for the Year Ended December 31, 2007 (unaudited) and for the Six Months Ended June 30, 2008 (unaudited)	5
	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2008 and 2007 (unaudited)	6
	Notes to Interim Consolidated Financial Statements (unaudited)	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	31
Item 4.	Controls and Procedures	31

PART II - OTHER INFORMATION

Item 1.	Legal Proceedings	31
Item 1A.	Risk Factors	31
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	31
Item 3.	Defaults upon Senior Securities	31
Item 4.	Submission of Matters to a Vote of Security Holders	32
Item 5.	Other Information	32
Item 6.	Exhibits	33
Signatures		34

PART I – FINANCIAL INFORMATION

ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS

PROSPERITY BANCSHARES, INC^®. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)


	June 30, 2008			December 31, 2007
	(In thousands, except share data)
ASSETS
Cash and due from banks	$	170,966		$	178,247
Federal funds sold		13,695			192,843

Total cash and cash equivalents		184,661			371,090
Interest bearing deposits in financial institutions		535			200
Securities available for sale, at fair value (amortized cost of $250,274 and $258,264, respectively)		249,642			260,444
Securities held to maturity, at cost (fair value of $1,969,912 and $1,597,598, respectively)		1,986,061			1,597,162
Loans held for investment		3,311,110			3,132,025
Loans held for sale		2,218			10,946
Less allowance for credit losses		(34,085	)		(32,543	)

Loans, net		3,279,243			3,110,428
Accrued interest receivable		26,375			27,940
Goodwill		811,391			753,909
Core deposit intangibles, net of accumulated amortization of $26,441 and $21,490, respectively		47,536			46,069
Bank premises and equipment, net		125,000			120,044
Other real estate owned		6,655			10,207
Bank Owned Life Insurance (BOLI)		46,357			45,486
Leased assets		3,042			3,559
Other assets		27,236			25,805

TOTAL ASSETS	$	6,793,734		$	6,372,343

LIABILITIES AND SHAREHOLDERS’ EQUITY
LIABILITIES:
Deposits:
Noninterest-bearing	$	1,285,493		$	1,168,069
Interest-bearing		4,011,141			3,798,338

Total deposits		5,296,634			4,966,407
Other borrowings		42,089			31,466
Securities sold under repurchase agreements		99,225			84,581
Accrued interest payable		10,693			11,761
Other liabilities		35,223			37,812
Junior subordinated debentures		92,265			112,885

Total liabilities		5,576,129			5,244,912

COMMITMENTS AND CONTINGENCIES		—			—
SHAREHOLDERS’ EQUITY:
Preferred stock, $1 par value; 20,000,000 shares authorized; none issued or outstanding		—			—
Common stock, $1 par value; 200,000,000 shares authorized; 46,096,589 and 44,188,323 shares issued at June 30, 2008 and December 31, 2007, respectively; 46,059,501 and 44,151,235 shares outstanding at June 30, 2008 and December 31, 2007, respectively		46,096			44,188
Capital surplus		866,201			809,026
Retained earnings		306,326			273,407
Accumulated other comprehensive (loss) gain — net unrealized (loss) gain on available for sale securities, net of tax benefit of $221 and tax of $763, respectively		(411	)		1,417
Less treasury stock, at cost, 37,088 shares		(607	)		(607	)

Total shareholders’ equity		1,217,605			1,127,431

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	6,793,734		$	6,372,343

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)


	Three Months Ended June 30,				Six Months Ended June 30,
	2008		2007		2008		2007
	(In thousands, except per share data)
INTEREST INCOME:
Loans, including fees	$	55,948	$	64,622	$	114,468	$	121,882
Securities:
Taxable		24,781		20,819		48,420		41,480
Nontaxable		944		926		1,872		1,719
70% nontaxable preferred dividends		131		252		347		506
Federal funds sold		174		677		1,334		1,568
Deposits in financial institutions		1		4		3		8

Total interest income		81,979		87,300		166,444		167,163


INTEREST EXPENSE:
Deposits		25,210		31,421		54,155		60,534
Junior subordinated debentures		1,558		2,896		3,577		5,494
Securities sold under repurchase agreements		574		782		1,178		1,384
Note payable and federal funds sold		666		857		1,568		2,319

Total interest expense		28,008		35,956		60,478		69,731


NET INTEREST INCOME		53,971		51,344		105,966		97,432
PROVISION FOR CREDIT LOSSES		1,000		320		2,167		565

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES		52,971		51,024		103,799		96,867


NONINTEREST INCOME:
Customer service fees		10,727		10,613		21,233		19,123
Other		2,339		3,232		4,512		6,393

Total noninterest income		13,066		13,845		25,745		25,516


NONINTEREST EXPENSE:
Salaries and employee benefits		16,751		16,496		32,881		31,798
Net occupancy expense		2,867		2,636		5,677		5,094
Depreciation expense		1,920		1,885		3,857		3,761
Data processing		1,361		1,172		2,652		2,157
Core deposit intangible amortization		2,459		2,566		4,951		4,711
Other		5,502		5,317		9,962		9,822

Total noninterest expense		30,860		30,072		59,980		57,343


INCOME BEFORE INCOME TAXES		35,177		34,797		69,564		65,040
PROVISION FOR INCOME TAXES		11,740		11,804		23,189		21,818


NET INCOME	$	23,437	$	22,993	$	46,375	$	43,222


EARNINGS PER SHARE
Basic	$	0.52	$	0.53	$	1.04	$	1.03


Diluted	$	0.52	$	0.52	$	1.04	$	1.02

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(UNAUDITED)


	Common Stock			Capital Surplus		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Total Shareholders’ Equity
	Shares	Amount		Capital Surplus		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Total Shareholders’ Equity
	(In thousands, except share and per share data)
BALANCE AT JANUARY 1, 2007	32,829,873	$	32,830	$	425,557	$	209,581		$	(2,950	)	$	(607	)	$	664,411
Comprehensive Income:
Net income							84,151									84,151
Net change in unrealized gain on available for sale securities										4,367						4,367

Total comprehensive income																88,518
Common stock issued in connection with the exercise of stock options and restricted stock awards	337,148		337		3,148											3,485
Common stock issued in connection with the TXUI acquisition	10,769,942		10,770		370,116											380,886
Common stock issued in connection with the Bank of Navasota acquisition	251,360		251		8,237											8,488
Stock based compensation expense					1,968											1,968
Cash dividends declared, $0.425 per share							(20,325	)								(20,325	)

BALANCE AT DECEMBER 31, 2007	44,188,323		44,188		809,026		273,407			1,417			(607	)		1,127,431
Cumulative effect—split dollar insurance adjustment							(2,174	)								(2,174	)
Comprehensive income:
Net income							46,375									46,375
Net change in unrealized (loss) gain on available for sale securities										(1,828	)					(1,828	)

Total comprehensive (loss) income																44,547
Common stock issued in connection with the 1^stChoice acquisition	1,757,752		1,758		54,384											56,142
Common stock issued in connection with the exercise of stock options and restricted stock awards	150,513		150		2,150											2,300
Stock based compensation expense					641											641
Cash dividends declared, $0.25 per share							(11,282	)								(11,282	)

BALANCE AT JUNE 30, 2008	46,096,588	$	46,096	$	866,201	$	306,326		$	(411	)	$	(607	)	$	1,217,605

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)


	Six Months Ended June 30,
	2008			2007
	(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	46,375		$	43,222
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		8,808			8,472
Stock-based compensation expense		641			957
Net amortization of premium on loans		(1,009	)		—
Provision for credit losses		2,167			565
Net amortization of discount on investments		(1,799	)		(4,272	)
Net loss (gain) on sale of other real estate		439			(100	)
Net (gain) loss on sale of premises and equipment		(680	)		4
Net gain on loans held for sale		(183	)		(914	)
Proceeds from the sale of loans held for sale		8,911			136,629
Origination of loans held for sale		—			(36,308	)
Net decrease in other assets and accrued interest receivable		2,615			2,877
Net (decrease) increase in accrued interest payable and other liabilities		(4,681	)		10,307

Net cash provided by operating activities		61,604			161,439

CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities and principal paydowns of securities held to maturity		333,427			131,109
Purchase of securities held to maturity		(703,164	)		(274,421	)
Proceeds from maturities, sales and principal paydowns of securities available for sale		148,726			422,233
Purchase of securities available for sale		(124,987	)		(257,369	)
Net increase in interest-bearing deposits in financial institutions		—			100
Net (increase) decrease in loans		(323	)		103,450
Purchase of bank premises and equipment		(5,319	)		(4,090	)
Net proceeds acquired from sale of bank premises, equipment and other real estate		10,913			3,243
Purchase of 1^stChoice Bancorp		(19,129	)		—
Cash and cash equivalents acquired from 1^st Choice Bancorp		84,240			—
Purchase of Banco Popular branches		(443	)		—
Cash and cash equivalents acquired in the purchase of Banco Popular branches		112,788			—
Purchase of Texas United Bancshares, Inc.		(74	)		(2,172	)
Cash and cash equivalents acquired in the purchase of Texas United Bancshares, Inc.		—			114,469

Net cash (used in) provided by investing activities		(163,345	)		236,552

Continued

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)


	Six Months Ended June 30,
	2008			2007
	(In thousands)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in noninterest-bearing deposits		22,101			(29,053	)
Net decrease in interest-bearing deposits		(102,454	)		(248,454	)
Net proceeds (repayments) from lines of credit		10,623			(194,749	)
Redemption of junior subordinated debentures		(20,620	)		(24,743	)
Net increase in securities sold under repurchase agreements		14,644			22,614
Proceeds from exercise of stock options		2,300			2,317
Payments of cash dividends		(11,282	)		(9,844	)

Net cash used in financing activities		(84,688	)		(481,912	)


NET DECREASE IN CASH AND CASH EQUIVALENTS	$	(186,429	)	$	(83,921	)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		371,090			269,721

CASH AND CASH EQUIVALENTS, END OF PERIOD	$	184,661		$	185,800


NON-CASH ACTIVITIES:
Issuance of common stock for the acquisition of 1^stChoice Bancorp	$	56,142		$	—
Issuance of common stock for the acquisition of Texas United Bancshares, Inc.		—			380,886

SUPPLEMENTAL DISCLOSURES:
Cash paid for interest	$	61,547		$	69,123
Cash paid for income taxes		23,300			11,750

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2008

(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, LLC. 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, 2007. Operating results for the six-month period ended June 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008 or any other period.

2. INCOME PER COMMON SHARE

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


	Three Months Ended June 30,				Six Months Ended June 30,
	2008		2007		2008		2007
	(In thousands, except per share amounts)
Net income available to common shareholders	$	23,437	$	22,993	$	46,375	$	43,222

Weighted average common shares outstanding		44,852		43,796		44,520		41,816
Potential dilutive common shares		187		420		156		445

Weighted average common shares and equivalents outstanding		45,039		44,216		44,676		42,261

Basic earnings per common share	$	0.52	$	0.53	$	1.04	$	1.03

Diluted earnings per common share	$	0.52	$	0.52	$	1.04	$	1.02

The incremental shares for the assumed exercise of the outstanding options were determined by application of the treasury stock method. There were no stock options exercisable during the quarter ended June 30, 2008 or 2007 that would have had an anti-dilutive effect on the above computation.

3. NEW ACCOUNTING STANDARDS

Statements of Financial Accounting Standards

SFAS No. 141(R), “Business Combinations (Revised 2007).” SFAS 141R replaces SFAS 141, “Business Combinations,” and applies to all transactions and other events in which one entity obtains control over one or more other businesses. SFAS 141R requires an acquirer, upon initially obtaining control of another entity, to recognize the assets, liabilities and any non-controlling interest in the acquiree at fair value as of the acquisition date. Contingent consideration is required to be recognized and measured at fair value on the date of acquisition rather than at a later date when the amount of that consideration may be determinable beyond a reasonable doubt. This fair value approach replaces the cost-allocation process required under SFAS 141 whereby the cost of an acquisition was allocated to the individual assets acquired and liabilities assumed based on their estimated fair value. SFAS 141R requires acquirers to expense acquisition-related costs as incurred rather than allocating such costs to the assets acquired and liabilities assumed, as was previously the case under SFAS 141. Under SFAS 141R, the requirements of SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” would have to be met in order

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2008

(UNAUDITED)

to accrue for a restructuring plan in purchase accounting. Pre-acquisition contingencies are to be recognized at fair value, unless it is a non-contractual contingency that is not likely to materialize, in which case, nothing should be recognized in purchase accounting and, instead, that contingency would be subject to the probable and estimable recognition criteria of SFAS 5, “Accounting for Contingencies.” SFAS 141R is effective for the Company beginning on January 1, 2009. The Company is currently evaluating the impact of the adoption of SFAS 141R on the Company’s accounting for business combinations closing on or after January 1, 2009.

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 its adoption did not have a significant impact on the Company’s financial statements. The implementation of SFAS 157 resulted in expanded disclosures about assets and liabilities measured at fair value as discussed in Note 4 below.

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. The Company adopted SFAS No. 159 effective January 1, 2008. The Company elected not to measure any eligible items using the fair value option in accordance with SFAS 159. Accordingly, SFAS 159 did not have any impact on the Company’s financial statements.

SFAS No. 160, “Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB Statement No. 51.” SFAS 160 amends Accounting Research Bulletin (ARB) No. 51, “Consolidated Financial Statements,” to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies that a non-controlling interest in a subsidiary, which is sometimes referred to as minority interest, is an ownership interest in the consolidated entity that should be reported as a component of equity in the consolidated financial statements. Among other requirements, SFAS 160 requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the non-controlling interest. It also requires disclosure, on the face of the consolidated income statement, of the amounts of consolidated net income attributable to the parent and to the non-controlling interest. SFAS 160 is effective for the Company on January 1, 2009 and is not expected to have a significant impact on the Company’s financial statements.

Financial Accounting Standards Board Staff Positions and Interpretations

FASB Staff Position (FSP) No. 157-2. FSP 157-2 delays the effective date of SFAS 157, Fair Value Measurements, for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The delay is intended to allow the FASB and constituents additional time to consider the effect of various implementation issues that have arisen, or that may arise, from the application of SFAS 157. This FSP defers the effective date of SFAS 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of this FSP. FSP 157-2 was effective for the Company on January 1, 2008 and did not have a significant impact on the Company’s financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2008

(UNAUDITED)

Emerging Issues Task Force Issues

Emerging Issues Task Force (“EITF”) Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split Dollar Life Insurance Arrangements.” EITF 06-4 requires the recognition of a liability and related compensation expense for endorsement split-dollar life insurance policies that provide a benefit to an employee that extends to post-retirement periods. Under EITF 06-4, life insurance policies purchased for the purpose of providing such benefits do not effectively settle an entity’s obligation to the employee. Accordingly, the entity must recognize a liability and related compensation expense during the employee’s active service period based on the future cost of insurance to be incurred during the employee’s retirement. If the entity has agreed to provide the employee with a death benefit, then the liability for the future death benefit should be recognized by following the guidance in SFAS 106, “Employer’s Accounting for Postretirement Benefits Other Than Pensions.” The Company adopted EITF 06-4 effective as of January 1, 2008 as a change in accounting principle through a cumulative-effect adjustment to retained earnings. The amount of the adjustment to retained earnings was $2.2 million.

SEC Staff Accounting Bulletins

SAB No. 109, “Written Loan Commitments Recorded at Fair Value Through Earnings.” SAB No. 109 supersedes SAB 105, “Application of Accounting Principles to Loan Commitments,” and indicates that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. The guidance in SAB 109 is applied on a prospective basis to derivative loan commitments issued or modified in fiscal quarters beginning after December 15, 2007. The adoption of SAB 109 did not significantly impact the Company’s financial statements.

4. FAIR VALUE DISCLOSURES

Effective January 1, 2008, the Company adopted SFAS 157 and SFAS 159, which address aspects of the expanding application of fair value accounting.

SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. Under SFAS 159, the Company may elect to report select financial assets and liabilities at fair value on an instrument-by-instrument basis with changes in fair value reported in earnings. After the initial adoption, the election is made at the acquisition of a financial asset or financial liability and it may not be revoked. Additionally, the transition provisions of SFAS 159 permit a one-time election for existing positions at the adoption date with a cumulative-effect adjustment included in beginning retained earnings and future changes in fair value reported in earnings. The Company elected not to measure any eligible items using the fair value option at adoption date in accordance with SFAS 159.

Fair Value Hierarchy

SFAS 157 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. In accordance with SFAS 157, these inputs are summarized in the three broad levels listed below:

•

Level 1 – Quoted prices in active markets for identical assets or liabilities. Level 1 assets include US Treasury securities that are highly liquid and are actively traded in over-the-counter markets and preferred stock issued by Freddie Mac and Fannie Mae.

•

Level 2 – Other significant observable inputs (including quoted prices in active markets for similar assets or liabilities) 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 2 assets include US government and agency mortgage-backed debt securities, corporate securities, municipal bonds and CRA funds.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2008

(UNAUDITED)

•

Level 3 – 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 similar techniques, as well as instruments for which the determination of fair values requires significant management judgment or estimation.

In determining the appropriate levels, the Company performs a detailed analysis of the assets and liabilities that are subject to SFAS 157.

The following table presents fair value measurements as of June 30, 2008:


	Level 1		Level 2		Level 3		Total
	(In thousands)
Measured on a recurring basis:
Interest bearing deposits in financial institutions	$	535	$	—	$	—	$	535
Available for sale securities (at fair value)		12,775		236,867		—		249,642

TOTAL	$	13,310	$	236,867	$	—	$	250,177

Certain assets and liabilities are measured at fair value on a non-recurring basis; that is, 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). These instruments include other real estate owned, repossessed assets and impaired loans per SFAS 114, “Accounting by Creditors for Impairment of a Loan—an amendment of FASB Statements No. 5 and 15”. Financial assets and financial liabilities measured at fair value on a non-recurring basis which were recorded in 2008 and remained outstanding at June 30, 2008 were not significant.

5. GOODWILL AND CORE DEPOSIT INTANGIBLES

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles (CDI) for the six months ended June 30, 2008 were as follows:


	Goodwill			Core Deposit Intangibles
	(In thousands)
Balance as of December 31, 2007	$	753,909		$	46,069
Amortization		—			(4,951	)
Acquisition of 1^stChoice Bancorp		47,686			5,355
Acquisition of Banco Popular branches		12,576			1,063
Acquisition of The Bank of Navasota		388			—
Acquisitions prior to December 31, 2007 (deferred taxes)		(3,168	)		—

Balance as of June 30, 2008	$	811,391		$	47,536

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2008

(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 finalizing the 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 evaluation annually, and more frequently if a triggering event occurs, 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 June 30, 2008, 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 $74.0 million and $65.6 million at June 30, 2008 and June 30, 2007, respectively. Net core deposit intangibles outstanding were $47.5 million and $49.3 million at the same dates, respectively. Amortization expense related to intangible assets totaled $2.5 million and $2.6 million for the three months ended June 30, 2008 and 2007, respectively and $5.0 million and $4.7 million for the six months ended June 30, 2008 and 2007, respectively. The increase in amortization expense was primarily due to the core deposit intangibles from the acquisition of the Bank of Navasota, six branches of Banco Popular and 1^st Choice. The estimated aggregate future amortization expense for intangible assets remaining as of June 30, 2008 is as follows (dollars in thousands):


Remaining 2008	$	5,169
2009		9,277
2010		8,222
2011		7,063
2012		5,820
Thereafter		11,985

Total	$	47,536

6. STOCK BASED COMPENSATION

The Company had two stock-based employee compensation plans at June 30, 2008 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 $641,000 and $957,000 in stock-based compensation expense for the six months ended June 30, 2008 and 2007, respectively, and $393,000 and $524,000 in stock-based compensation expense for the three months ended June 30, 2008 and 2007, respectively. There was approximately $122,000 and $200,000 of income tax benefit recorded for the stock-based compensation expense for the six months ended June 30, 2008 and 2007, respectively, and $87,000 and $112,000 of income tax benefit recorded for the stock-based compensation expense for the three months ended June 30, 2008 and 2007, respectively.

The Company has granted shares of common stock (“restricted stock”) to certain directors and associates under the Company’s 2004 Stock Incentive Plan. The awardee is not entitled to the shares until they vest, which is generally over a 1 to 5 year period, but the awardee is entitled to receive dividends on and vote the shares prior to vesting. The shares granted do not have a cost to the awardee and the only requirement of vesting 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 shares vest, the unvested shares are forfeited. As of June 30, 2008, there were 85,391 shares of restricted stock outstanding with a weighted average grant date fair value of $32.46.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2008

(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:


	June 30,
	2008		2007
Expected life (years)	4.96		4.44
Risk free interest rate	4.16	%	4.22	%
Volatility	21.21	%	20.99	%
Dividend yield	1.21	%	1.23	%

A summary of changes in outstanding vested and unvested options during the six months ended June 30, 2008 is set forth below:


	Number of Options		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term	Aggregate Intrinsic Value
	(In thousands)					(In thousands)
Options outstanding, beginning of period	1,088		$	23.26
Options granted	—			—
Options forfeited	(2	)		21.67
Options exercised	(140	)		16.46
Options outstanding, end of period	946		$	24.27	5.80	$	2,324

Options exercisable, end of period	288		$	16.42	4.25	$	2,971

No options were granted during the six months ended June 30, 2008 and 30,000 options at a weighted average exercise price of $34.48 were granted during the six months ended June 30, 2007. The total intrinsic value of the options exercised during the six month periods ended June 30, 2008 and 2007 was $1.4 million and $3.3 million, respectively. The total fair value of shares vested during the six month periods ended June 30, 2008 and 2007 was $180,000 and $183,000, respectively.

A summary of changes in non-vested options is set forth below:


	Six Months Ended June 30,
	2008				2007
	Number of Options		Weighted Average Grant Date Fair Value		Number of Options		Weighted Average Grant Date Fair Value
	(In thousands)				(In thousands)
Non-vested options outstanding, beginning of period	707		$	6.52	778		$	5.96
Options granted	—			—	30			9.11
Non-vested options forfeited	—			—	(21	)		5.16
Options vested	(49	)		3.65	(70	)		2.61

Non-vested options outstanding, end of period	658		$	6.73	717		$	6.40

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2008

(UNAUDITED)

The Company received $2.3 million in cash from the exercise of stock options during each six month period ended June 30, 2008 and 2007. There was no tax benefit realized from option exercises of the stock-based compensation arrangements during the six month periods ended June 30, 2008 and 2007.

As of June 30, 2008, there was $3.1 million of total unrecognized compensation expense related to non-vested stock-based compensation arrangements. That cost is expected to be recognized over a weighted average period of 1.8 years.

7. RECENT ACQUISITIONS

On January 10, 2008, the Company completed its acquisition of six (6) Houston retail branches from Banco Popular North America. In connection with the acquisition, the Company assumed approximately $125.0 million in deposits. Since January 11, 2008, all six (6) locations have been operating as full service banking centers of Prosperity Bank.

On June 1, 2008, the Company completed its acquisition of 1st Choice Bancorp, Inc and its wholly-owned subsidiary, 1st Choice Bank. 1st Choice Bancorp operated two (2) banking offices in Houston, Texas, with one location in South Houston and another in the Heights area. Prosperity’s Heights banking center was consolidated with the 1st Choice Bancorp Heights location, with the resulting banking center being located in 1st Choice’s Heights banking office. As of March 31, 2008, 1st Choice Bancorp had, on a consolidated basis, total assets of $313.9 million, loans of $198.9 million, deposits of $285.1 million and stockholders’ equity of $27.5 million. Under the terms of the definitive agreement, Prosperity issued 1,757,752 shares of Prosperity common stock plus approximately $18,758,000 in cash for all outstanding shares of 1st Choice Bancorp capital stock.

8. REDEMPTION OF JUNIOR SUBORDINATED DEBENTURES

On April 7, 2008 and June 26, 2008, the Company redeemed in full the junior subordinated debentures held by SNB Capital Trust III and SNB Statutory Trust II in the amount of $10.3 million each, respectively. The debentures redeemed each bore interest at a floating rate of 3 month LIBOR + 3.15%. The trusts in turn redeemed in full the trust preferred securities and common securities they issued.

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 made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on assumptions and involve a number of risks and uncertainties, many of which are beyond the Company’s control. Many possible events or factors could affect the future financial results and performance of the Company and could cause such results or performance to differ materially from those expressed in the forward-looking statements. These possible events or factors include, without limitation:

•

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

•

changes in the levels of loan prepayments and the resulting effects on the value of the Company’s loan portfolio;

•

changes in local economic and business conditions which adversely affect the Company’s customers and their ability to transact profitable business with the company, including the ability of the Company’s borrowers to repay their loans according to their terms or a change in the value of the related collateral;

•

increased competition for deposits and loans adversely affecting rates and terms;

•

the timing, impact and other uncertainties of any future acquisitions, including the Company’s ability to identify suitable future acquisition candidates, the success or failure in the integration of their operations, and the ability to enter new markets successfully and capitalize on growth opportunities;

•

increased credit risk in the Company’s assets and increased operating risk caused by a material change in commercial, consumer and/or real estate loans as a percentage of the total loan portfolio;

•

the failure of assumptions underlying the establishment of and provisions made to the allowance for credit losses;

•

changes in the availability of funds resulting in increased costs or reduced liquidity;

•

a deterioration or downgrade in the credit quality and credit agency ratings of the securities in the Company’s securities portfolio;

•

increased asset levels and changes in the composition of assets and the resulting impact on the Company’s capital levels and regulatory capital ratios;

•

the Company’s ability to acquire, operate and maintain cost effective and efficient systems without incurring unexpectedly difficult or expensive but necessary technological changes;

•

the loss of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensation levels;

•

changes in statutes and government regulations or their interpretations applicable to financial holding companies and the Company’s present and future banking and other subsidiaries, including changes in tax requirements and tax rates;

•

acts of terrorism, an outbreak of hostilities or other international or domestic calamities, weather or other acts of God and other matters beyond the Company’s control; and

•

other risks and uncertainties listed from time to time in the Company’s reports and documents filed with the Securities and Exchange Commission.

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 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.

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company’s interim consolidated financial statements and accompanying notes. This section should be read in conjunction with the Company’s interim consolidated financial statements and accompanying notes included elsewhere in this report and with the consolidated financial statements and accompanying notes and other detailed information appearing in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

COMPLETED ACQUISITIONS

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 June 30, 2008, the Bank operated one hundred thirty-one (131) full-service banking locations; with forty-seven (47) in the Greater Houston Consolidated Metropolitan Statistical Area (“CMSA”), thirty-three (33) in the South Texas area including Corpus Christi and Victoria, twenty-three (23) in the Central Texas area including Austin and Bryan/College Station, two (2) in East Texas and twenty-six (26) in the Dallas/Fort Worth, Texas area. 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.

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 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 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. During 2007, forty-one (41) banking centers were acquired in the acquisition of Texas United Bancshares, Inc. (the “TXUI acquisition”). The acquisition of The Bank of Navasota, N.A. (the “Navasota acquisition”) was completed on September 1, 2007 and added one (1) banking center. On January 10, 2008, the Company purchased six (6) branches of Banco Popular North America and on June 1, 2008 the Company purchased 1^st Choice Bancorp adding one (1) banking center in Houston after the consolidation of an existing Prosperity location into the 1^st Choice Heights location.

Total assets were $6.79 billion at June 30, 2008 compared with $6.37 billion at December 31, 2007, an increase of $421.4 million or 6.6%. Total loans were $3.31 billion at June 30, 2008 compared with $3.14 billion at December 31, 2007, an increase of $170.4 million or 5.4%. Total deposits were $5.30 billion at June 30, 2008 compared with $4.97 billion December 31, 2007, an increase of $330.2 million or 6.7%. Shareholders’ equity increased $90.2 million or 8.0%, to $1.22 billion at June 30, 2008 compared with $1.13 billion at December 31, 2007. The increases were primarily due to the acquisition of 1^st Choice and the branches of Banco Popular.

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, 2007. 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 inherent in the Company’s loan portfolio. Based on an evaluation of the loan portfolio, management presents a quarterly 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 at least 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 completed 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 June 30, 2008. While the Company believes no impairment existed at June 30, 2008 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. 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.

RESULTS OF OPERATIONS

Net income available to common shareholders was $23.4 million ($0.52 per common share on a diluted basis) for the quarter ended June 30, 2008 compared with $23.0 million ($0.52 per common share on a diluted basis) for the quarter ended June 30, 2007, an increase in net income of $444,000, or 1.93%. The Company posted returns on average common equity of 7.96% and 8.54%, returns on average assets of 1.43% and 1.47% and efficiency ratios of 46.17% and 46.19% for the quarters ended June 30, 2008 and 2007, respectively. The efficiency ratio is calculated by dividing total noninterest expense (excluding credit loss provisions) by net interest income plus noninterest income (excluding securities gains and losses and net gain on sale of assets). Additionally, taxes are not part of this calculation.

For the six months ended June 30, 2008, net income available to common shareholders was $46.4 million ($1.04 per common share on a diluted basis) compared with $43.2 million ($1.02 per common share on a diluted basis) for the same period in 2007, an increase in net income of $3.2 million or 7.3%. The Company posted returns on average common equity of 7.99% and 8.59%, returns on average assets of 1.43% and 1.44% and efficiency ratios of 45.62% and 46.68% for the six months ended June 30, 2008 and 2007, 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 before the provision for credit losses and on a tax equivalent basis was $54.7 million for the quarter ended June 30, 2008 compared with $52.1 million for the quarter ended June 30, 2007, an increase of $2.6 million, or 4.9%. Net interest income increased as a result of an increase in average interest-earning assets to $5.37 billion for the quarter ended June 30, 2008 compared with $5.11 billion for the quarter ended June 30, 2007, an increase of $259.6 million, or 5.1%. The increase in average earning assets was primarily attributable to increases in average securities from the quarter ended June 30, 2008 primarily attributable to the acquisition of 1^st Choice partially offset by a decrease in average loans compared with the quarter ended June 30, 2007.

The net interest margin on a tax equivalent basis increased to 4.10% for the quarter ended June 30, 2008 compared with 4.09% for the quarter ended June 30, 2007. The rate paid on interest-bearing liabilities decreased 89 basis points from 3.65% for the quarter ended June 30, 2007 to 2.76% for the quarter ended June 30, 2008. The yield on earning assets decreased 71 basis points from 6.85% for the quarter ended June 30, 2007 to 6.14% for the quarter ended June 30, 2008. The volume of interest-bearing liabilities increased $133.2 million and the volume of interest-earning assets increased $259.6 million for the same periods.

Net interest income before the provision for credit losses and on a tax equivalent basis increased $8.6 million, or 8.7%, to $107.5 million for the six months ended June 30, 2008 compared with $98.9 million for the same period in 2007. This increase was mainly attributable to higher average interest-earning assets resulting from an increase in average loans due to the acquisition of TXUI, Bank of Navasota and 1^st Choice. The net interest margin on a tax equivalent basis increased to 4.07% compared with 4.02% for the same periods principally due to a 65 basis point decrease in the rate paid on interest-bearing liabilities from 3.64% for the six months ended June 30, 2007 to 2.99% for the six months ended June 30, 2008 partially offset by a 50 basis point decrease in the yield on earning assets from 6.80% for the six months ended June 30, 2007 to 6.30% for the six months ended June 30, 2008.

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 three and the six month periods ended June 30, 2008 and 2007. 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.


	Three Months Ended June 30,
	2008							2007
	Average Outstanding Balance			Interest Earned/ Paid		Average Yield/ Rate (2)		Average Outstanding Balance			Interest Earned/ Paid		Average Yield/ Rate (2)
	(Dollars in thousands)
Assets
Interest-earning assets:
Loans	$	3,203,305		$	55,948	7.02	%	$	3,219,900		$	64,622	8.05	%
Securities (1)		2,131,370			25,856	4.85			1,837,702			21,996	4.79
Federal funds sold and other temporary investments		33,803			175	2.08			51,238			682	5.34

Total interest-earning assets		5,368,478			81,979	6.14	%		5,108,840			87,300	6.85	%

Less allowance for credit losses		(32,813	)						(36,348	)

Total interest-earning assets, net of allowance		5,335,665							5,072,492
Noninterest-earning assets		1,203,599							1,175,434

Total assets	$	6,539,264						$	6,247,926

Liabilities and shareholders’ equity
Interest-bearing liabilities:
Interest-bearing demand deposits	$	745,413		$	1,652	0.89	%	$	839,596		$	4,193	2.00	%
Savings and money market accounts		1,370,964			6,678	1.96			1,241,951			9,030	2.92
Certificates of deposit		1,708,251			16,880	3.97			1,588,052			18,198	4.60
Junior subordinated debentures		102,575			1,558	6.11			141,236			2,896	8.22
Federal funds purchased and other borrowings		76,132			666	3.52			65,892			857	5.22
Securities sold under repurchase agreements		82,408			574	2.80			75,809			782	4.14

Total interest-bearing liabilities		4,085,743			28,008	2.76	%		3,952,536			35,956	3.65	%

Noninterest-bearing liabilities:
Noninterest-bearing demand deposits		1,215,176							1,168,630
Other liabilities		61,187							49,799

Total liabilities		5,362,106							5,170,965

Shareholders’ equity		1,177,158							1,076,961

Total liabilities and shareholders’ equity	$	6,539,264						$	6,247,926

Net interest rate spread						3.38	%						3.20	%
Net interest income and margin (3)				$	53,971	4.04	%				$	51,344	4.03	%

Net interest income and margin (tax-equivalent basis) (4)				$	54,692	4.10	%				$	52,141	4.09	%

(1)

Yield is based on amortized cost and does not include any component of unrealized gains or losses.

(2)

Annualized.

(3)

The net interest margin is equal to net interest income divided by average interest-earning assets.

(4)

In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax-equivalent adjustment has been computed using a federal income tax rate of 35%.


	Six Months Ended June 30,
	2008							2007
	Average Outstanding Balance			Interest Earned/ Paid		Average Yield/ Rate (2)		Average Outstanding Balance			Interest Earned/ Paid		Average Yield/ Rate (2)
	(Dollars in thousands)
Assets
Interest-earning assets:
Loans	$	3,173,240		$	114,468	7.25	%	$	3,045,020		$	121,882	8.07	%
Securities (1)		2,054,440			50,639	4.93			1,852,538			43,705	4.72
Federal funds sold and other temporary investments		82,702			1,337	3.25			61,288			1,576	5.19

Total interest-earning assets		5,310,382			166,444	6.30	%		4,958,846			167,163	6.80	%

Less allowance for credit losses		(32,381	)						(34,173	)

Total interest-earning assets, net of allowance		5,278,001							4,924,673
Noninterest-earning assets		1,199,982							1,090,636

Total assets	$	6,477,983						$	6,015,309

Liabilities and shareholders’ equity
Interest-bearing liabilities:
Interest-bearing demand deposits	$	807,570		$	4,773	1.19	%	$	848,943		$	8,923	2.12	%
Savings and money market accounts		1,311,655			14,092	2.16			1,209,377			17,297	2.88
Certificates of deposit		1,684,444			35,290	4.21			1,520,229			34,314	4.55
Junior subordinated debentures		106,012			3,577	6.79			133,763			5,494	8.28
Federal funds purchased and other borrowings		86,554			1,568	3.64			88,075			2,319	5.31
Securities sold under repurchase agreements		74,241			1,178	3.19			67,515			1,384	4.13

Total interest-bearing liabilities		4,070,476			60,478	2.99	%		3,867,902			69,731	3.64	%

Noninterest-bearing liabilities:
Noninterest-bearing demand deposits		1,184,121							1,097,824
Other liabilities		63,032							43,344

Total liabilities		5,317,629							5,009,070

Shareholders’ equity		1,160,354							1,006,239

Total liabilities and shareholders’ equity	$	6,477,983						$	6,015,309

Net interest rate spread						3.31	%						3.16	%
Net interest income and margin (3)				$	105,966	4.01	%				$	97,432	3.96	%

Net interest income and margin
(tax-equivalent basis) (4)				$	107,524	4.07	%				$	98,905	4.02	%

(1)

Yield is based on amortized cost and does not include any component of unrealized gains or losses.

(2)

Annualized.

(3)

The net interest margin is equal to net interest income divided by average interest-earning assets.

(4)

The following tables present the dollar amount of changes in interest income and interest expense for the major components of interest-earning assets and interest-bearing liabilities and distinguishes between the increase (decrease) related to changes in outstanding balances and the volatility of interest rates. For purposes of these tables, changes attributable to both rate and volume that cannot be segregated have been allocated to rate.


	Three Months Ended June 30,
	2008 vs. 2007
	Increase (Decrease) Due to
	Volume			Rate			Total
	(In thousands)
Interest-earning assets:
Loans	$	(333	)	$	(8,341	)	$	(8,674	)
Securities		3,515			345			3,860
Federal funds sold and other temporary investments		(232	)		(275	)		(507	)

Total increase (decrease) in interest income		2,950			(8,271	)		(5,321	)

Interest-bearing liabilities:
Interest-bearing demand deposits		(470	)		(2,071	)		(2,541	)
Savings and money market accounts		938			(3,290	)		(2,352	)
Certificates of deposit		1,377			(2,695	)		(1,318	)
Junior subordinated debentures		(793	)		(545	)		(1,338	)
Federal funds purchased and other borrowings		133			(324	)		(191	)
Securities sold under repurchase agreements		68			(276	)		(208	)

Total increase (decrease) in interest expense		1,253			(9,201	)		(7,948	)

Increase in net interest income	$	1,697		$	930		$	2,627


	Six Months Ended June 30,
	2008 vs. 2007
	Increase (Decrease) Due to
	Volume			Rate			Total
	(In thousands)
Interest-earning assets:
Loans	$	5,132		$	(12,546	)	$	(7,414	)
Securities		4,763			2,171			6,934
Federal funds sold and other temporary investments		551			(790	)		(239	)

Total increase (decrease) in interest income		10,446			(11,165	)		(719	)

Interest-bearing liabilities:
Interest-bearing demand deposits		(435	)		(3,715	)		(4,150	)
Savings and money market accounts		1,463			(4,668	)		(3,205	)
Certificates of deposit		3,707			(2,731	)		976
Junior subordinated debentures		(1,140	)		(777	)		(1,917	)
Federal funds purchased and other borrowings		(40	)		(711	)		(751	)
Securities sold under repurchase agreements		138			(344	)		(206	)

Total increase (decrease) in interest expense		3,693			(12,946	)		(9,253	)

Increase in net interest income	$	6,753		$	1,781		$	8,534

Provision for Credit Losses

Management actively monitors the Company’s asset quality and provides specific loss provisions when necessary. Provisions for credit losses are charged to income to bring the total allowance for credit losses to a level deemed appropriate by management of the Company based on such factors as historical credit loss experience, industry diversification of the Company’s commercial loan portfolio, the amount of nonperforming loans and related collateral, the volume growth and composition of the loan portfolio, current economic conditions that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the loan portfolio through the internal loan review process and other relevant factors.

Loans are charged-off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the provision for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations.

The Company made a $1.0 million provision for credit losses for the quarter ended June 30, 2008 and a $320,000 provision for the quarter ended June 30, 2007. For the quarter ended June 30, 2008, net charge-offs were $1.2 million compared with net charge-offs of $531,000 for the quarter ended June 30, 2007. The Company made a $2.2 million provision for credit losses for the six months ended June 30, 2008 and a $565,000 provision for the six months ended June 30, 2007. Net charge-offs were $2.8 million for the six months ended June 30, 2008 compared with $1.2 million for the six months ended June 30, 2007.

Noninterest Income

The Company’s primary sources of noninterest income are service charges on deposit accounts and other banking service related fees. Noninterest income does not include loan origination fees which are recognized over the life of the related loan as an adjustment to yield using the interest method. Banking related service fees include check cashing fees, official check fees, safe deposit box rent and currency handling fees. Noninterest income totaled $13.1 million for the three months ended June 30, 2008 compared with $13.8 million for the same period in 2007, a decrease of $779,000, or 5.6%. Noninterest income increased $229,000, or 0.9%, to $25.7 million for the six months ended June 30, 2008 compared with $25.5 million for the same period in 2007.

The net gain on sale of held-for-sale loans was $110,000 for the three months ended June 30, 2008 compared with $310,000 for the three months ended June 30, 2007. The net gain on sale of held-for-sale loans was $183,000 for the six months ended June 30, 2008 compared with $913,000 for the same period in 2007. In the fourth quarter of 2007 the Company discontinued the origination of mortgage loans for sale, which was part of the mortgage banking activities of Texas United Bancshares, Inc. As a result, the Company does not expect to have significant gains and losses from this activity in the future.

Investment income was $91,000 for the three months ended June 30, 2008 compared with $507,000 for the three months ended June 30, 2007. Investment income was $171,000 for the six months ended June 30, 2008 compared with $976,000 for the same period in 2007. The decrease in both periods was due to the dissolution in the second quarter of 2007 of the trust department acquired in the TXUI acquisition.

Other noninterest income decreased $256,000 or 31.7% from $807,000 for the second quarter of 2007 compared with $551,000 for the same period in 2008. Other noninterest income decreased $496,000 or 29.5% from $1.7 million for the six months ended June 30, 2007 to $1.2 million for the six months ended June 30, 2008. The changes include decreases in Federal Home Loan Bank stock dividends.

The following table presents, for the periods indicated, the major categories of noninterest income:


	Three Months Ended June 30,				Six Months Ended June 30,
	2008		2007		2008		2007
	(In thousands)
Service charges on deposit accounts	$	10,727	$	10,613	$	21,233	$	19,123
Banking related service fees		484		440		923		842
Brokered mortgage income		113		254		222		386
Investment income		91		507		171		976
Income from leased assets		349		328		683		627
Bank owned life insurance income (BOLI)		443		504		904		872
Net gain on sale of assets		198		82		241		96
Net gain on sale of held-for-sale loans		110		310		183		913
Other noninterest income		551		807		1,185		1,681

Total noninterest income	$	13,066	$	13,845	$	25,745	$	25,516

Noninterest Expense

Noninterest expense totaled $30.9 million for the quarter ended June 30, 2008 compared with $30.1 million for the quarter ended June 30, 2007, an increase of $788,000, or 2.6%. This increase occurred mainly in salaries and employee benefits and depreciation expense and primarily resulted from the acquisition of 1^st Choice, the Bank of Navasota and the six branches of Banco Popular. Noninterest expense totaled $60.0 million for the six months ended June 30, 2008 compared with $57.3 million for the six months ended June 30, 2007, an increase of $2.6 million, or 4.6%. The increase was primarily due to the acquisition of 1^st Choice, the Bank of Navasota, TXUI and the six branches of Banco Popular. The following table presents, for the periods indicated, the major categories of noninterest expense:


	Three Months Ended June 30,				Six Months Ended June 30,
	2008		2007		2008		2007
	(In thousands)
Salaries and employee benefits (1)	$	16,751	$	16,496	$	32,881	$	31,798
Non-staff expenses:
Net occupancy expense		2,867		2,636		5,677		5,094
Depreciation		1,920		1,885		3,857		3,761
Data processing		1,361		1,172		2,652		2,157
Communications expense		1,660		1,587		3,169		2,974
Printing and supplies		435		396		881		692
Professional fees		635		471		545		836
Regulatory assessments and FDIC insurance		287		320		546		538
Ad valorem and franchise taxes		685		688		1,361		1,285
Core deposit intangibles amortization		2,459		2,566		4,951		4,711
Other		1,800		1,855		3,460		3,497

Total non-staff expenses		14,109		13,576		27,099		25,545

Total noninterest expense	$	30,860	$	30,072	$	59,980	$	57,343

(1)

Includes stock based compensation expense of $393,000 and $524,000 for the three months ended June 30, 2008 and 2007, respectively, and $641,000 and $957,000 for the six months ended June 30, 2008 and 2007, respectively.

Salaries and employee benefit expenses were $16.8 million for the quarter ended June 30, 2008 compared with $16.5 million for the quarter ended June 30, 2007, an increase of $255,000, or 1.5%. The increase was principally due to annual employee pay increases, the Bank of Navasota and 1^st Choice acquisitions and the acquisition of six branches of Banco Popular. For the six months ended June 30, 2008, salaries and employee benefit expenses were $32.9 million, an increase of $1.1 million or 3.4% compared with $31.8 million for the six months ended June 30, 2007. The increase was principally due to annual employee pay increases, the Bank of Navasota and 1^st Choice acquisitions, the acquisition of six branches of Banco Popular and the full year effect of the TXUI acquisition. The number of full-time equivalent (FTE) associates employed by the Company was 1,408 at June 30, 2007, 1,374 at March 31, 2008 and 1,397 at June 30, 2008.

Non-staff expenses increased $533,000 or 3.9% to $14.1 million for the quarter ended June 30, 2008 compared with $13.6 million during the same period in 2007. The increase was principally due to the acquisition of 1^st Choice, the Bank of Navasota and the six branches of Banco Popular. Non-staff expenses increased $1.6 million or 6.1% to $27.1 million for the six months ended June 30, 2008 compared with $25.5 million during the same period in 2007. The increase was principally due to the acquisition of TXUI, the Bank of Navasota, 1^st Choice and the six branches of Banco Popular.

Income Taxes

Income tax expense decreased $64,000 or 0.5% to $11.7 million for the quarter ended June 30, 2008 compared with $11.8 million for the same period in 2007. For the six months ended June 30, 2008, income tax expense totaled $23.2 million, an increase of $1.4 million or 6.3% compared with $21.8 million for the same period in 2007. The increase was primarily attributable to higher pretax net earnings for the six months ended June 30, 2008 compared with the same respective periods in 2007. The effective tax rate for the three months ended June 30, 2008 and 2007 was 33.4% and 33.9%, respectively. The effective tax rate for the six months ended June 30, 2008 and 2007 was 33.3% and 33.5%, respectively.

FINANCIAL CONDITION

Loan Portfolio

Total loans were $3.31 billion at June 30, 2008, an increase of $170.4 million or 5.4% compared with $3.14 billion at December 31, 2007. The increase was due to loans acquired in the 1^st Choice acquisition. At June 30, 2008, total loans outstanding acquired from 1^st Choice totaled $184.5 million.

The following table summarizes the loan portfolio of the Company by type of loan as of June 30, 2008 and December 31, 2007:


	June 30, 2008				December 31, 2007
	Amount		Percent		Amount		Percent
	(Dollars in thousands)
Commercial and industrial	$	470,719	14.2	%	$	436,338	13.9	%
Real estate:
Construction and land development		658,669	19.9			683,171	21.7
1-4 family residential		568,376	17.2			526,338	16.7
Home equity		95,774	2.9			93,877	3.0
Commercial mortgages		1,170,730	35.3			1,075,285	34.3
Farmland		78,311	2.4			63,873	2.0
Multifamily residential		71,143	2.1			73,424	2.3
Agriculture		57,111	1.7			50,146	1.6
Consumer (net of unearned discount)		126,397	3.8			123,213	3.9
Other		16,098	0.5			17,306	0.6

Total loans	$	3,313,328	100.0	%	$	3,142,971	100.0	%

Nonperforming Assets

The Company had $11.7 million in nonperforming assets at June 30, 2008 and $15.4 million in nonperforming assets at December 31, 2007, a decrease of $3.7 million or 24.3%. The ratio of nonperforming assets to loans and other real estate was 0.35% at June 30, 2008 compared with 0.49% at December 31, 2007.

The Company generally places a loan on nonaccrual status and ceases accruing interest when the payment of principal or interest is delinquent for 90 days, or earlier in some cases, unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan. The Company generally charges off all loans before attaining nonaccrual status.

The following table presents information regarding nonperforming assets as of the dates indicated:


	June 30, 2008			December 31, 2007
	(Dollars in thousands)
Nonaccrual loans	$	2,727		$	1,035
Restructured loans		—			—
Accruing loans 90 or more days past due		2,130			4,092

Total nonperforming loans		4,857			5,127
Repossessed assets		139			56
Other real estate		6,655			10,207

Total nonperforming assets	$	11,651		$	15,390

Nonperforming assets to total loans and other real estate		0.35	%		0.49	%

Allowance for Credit Losses

Management actively monitors the Company’s asset quality and provides specific loss allowances when necessary. Loans are charged-off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the allowance for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations. As of June 30, 2008, the allowance for credit losses amounted to $34.1 million or 1.03% of total loans compared with $32.5 million or 1.04% of total loans at December 31, 2007.

Set forth below is an analysis of the allowance for credit losses for the six months ended June 30, 2008 and the year ended December 31, 2007:


	Six Months Ended June 30, 2008			Year Ended December 31, 2007
	(Dollars in thousands)
Average loans outstanding	$	3,173,240		$	3,092,797

Gross loans outstanding at end of period	$	3,313,328		$	3,142,971

Allowance for credit losses at beginning of period	$	32,543		$	23,990
Balance acquired with acquisitions		2,181			13,386
Provision for credit losses		2,167			760
Charge-offs:
Commercial and industrial		(938	)		(1,045	)
Real estate and agriculture		(1,542	)		(4,143	)
Consumer		(1,281	)		(2,974	)
Recoveries:
Commercial and industrial		219			1,175
Real estate and agriculture		152			208
Consumer		584			1,186

Net charge-offs		(2,806	)		(5,593	)

Allowance for credit losses at end of period	$	34,085		$	32,543

Ratio of allowance to end of period loans		1.03	%		1.04	%
Ratio of net charge-offs to average loans (annualized)		0.18	%		0.18	%
Ratio of allowance to end of period nonperforming loans		701.8	%		634.7	%

Securities

Carrying cost of securities totaled $2.24 billion at June 30, 2008 compared with $1.86 billion at December 31, 2007, an increase of $378.1 million or 20.4%. The increase was principally due to securities acquired in the 1^st Choice acquisition. At June 30, 2008, securities represented 32.9% of total assets compared with 29.2% of total assets at December 31, 2007.

The following table summarizes the amortized cost of securities as of the dates shown (available-for-sale securities are not adjusted for unrealized gains or losses):


	June 30, 2008		December 31, 2007
	(In thousands)
U.S. Treasury securities and obligations of U.S. government agencies	$	73,611	$	229,119
70% nontaxable preferred stock		14,025		14,025
States and political subdivisions		84,846		87,517
Corporate debt securities		3,218		3,215
Collateralized mortgage obligations		199,289		223,952
Mortgage-backed securities		1,846,059		1,282,338
Qualified Zone Academy Bond (QZAB)		8,000		8,000
Equity securities		7,288		7,260

Total amortized cost	$	2,236,336	$	1,855,426

Total fair value	$	2,219,554	$	1,858,042

Prosperity owns Fannie Mae and Freddie Mac preferred stock with a par value of $24.0 million. In the fourth quarter of 2007, the net book value of the preferred stock was reduced to its December 31, 2007 market value of $14.0 million, or 0.21% of total assets at June 30, 2008, due to an other-than-temporary impairment charge of $10.0 million pre-tax. The market value of the Fannie Mae and Freddie Mac preferred stock was $11.8 million as of June 30, 2008, or 0.17% of total assets, resulting in an unrealized loss of $2.3 million as of June 30, 2008.

Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers, among other things, (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 Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

Management has the ability and intent to hold the securities classified as held to maturity until they mature, at which time the Company will receive full value for the securities. Furthermore, management has the ability and intent to hold the securities classified as available for sale that were in a loss position as of June 30, 2008 for a period of time sufficient for a recovery of cost. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe any of the securities are impaired due to reasons of credit quality. Accordingly, as of June 30, 2008, management believes any impairment in the Company’s securities are temporary and no impairment loss has been realized in the Company’s consolidated income statement.

Premises and Equipment

Premises and equipment, net of accumulated depreciation, totaled $125.0 million and $120.0 million at June 30, 2008 and December 31, 2007, respectively, an increase of $5.0 million or 4.1%. The increase was primarily due to the addition of one banking center acquired in the 1^st Choice acquisition and the acquisition of six branches of Banco Popular.

Deposits

Total deposits were $5.30 billion at June 30, 2008 compared with $4.97 billion at December 31, 2007, an increase of $330.2 million or 6.6%. The increase was primarily due to deposits assumed in the acquisition of six branches of Banco Popular and 1^st Choice. At June 30, 2008, deposits attributed to these two acquisitions totaled $416.0 million. At June 30, 2008, noninterest-bearing deposits accounted for approximately 24.3% of total deposits compared with 23.5% of total deposits at December 31, 2007. Interest-bearing demand deposits totaled $4.01 billion or 75.7% of total deposits at June 30, 2008 compared with $3.80 billion or 76.5% of total deposits at December 31, 2007.

The following table summarizes the daily average balances and weighted average rates paid on deposits for the periods presented below:


	Six Months Ended June 30, 2008				Year Ended December 31, 2007
	Average Balance		Average Rate		Average Balance		Average Rate
	(Dollars in thousands)
Interest-bearing demand	$	807,570	1.19	%	$	829,757	1.97	%
Regular savings		239,154	0.75			222,397	0.99
Money market savings		1,072,501	2.47			983,187	3.34
Time deposits		1,684,444	4.21			1,549,064	4.60

Total interest-bearing deposits		3,803,669	2.86			3,584,405	3.42
Noninterest-bearing deposits		1,184,121	—			1,143,114	—

Total deposits	$	4,987,790	2.18	%	$	4,727,519	2.60	%

Other Borrowings

The Company utilizes borrowings to supplement deposits to fund its lending and investment activities. Borrowings consist of funds from the Federal Home Loan Bank (“FHLB”) and correspondent banks. FHLB advances are considered short-term, overnight borrowings. At June 30, 2008, the Company had $42.1 million in FHLB borrowings, of which $12.0 million consisted of FHLB advances and $30.1 million consisted of long-term FHLB notes payable compared with $31.5 million in FHLB borrowings at December 31, 2007, all of which consisted of long-term FHLB notes payable. The $10.6 million increase was primarily attributable to the $12.0 million outstanding FHLB advance. The maturity dates on the FHLB notes payable range from the years 2008 to 2028 and have interest rates ranging from 3.08% to 6.26%. The highest outstanding balance of FHLB advances during the six months ended June 30, 2008 was $230.0 million compared with $240.0 million during the year ended December 31, 2007. The Company had no federal funds purchased at June 30, 2008 or December 31, 2007.

At June 30, 2008, the Company had $99.2 million in securities sold under repurchase agreements compared with $84.6 million at December 31, 2007, an increase of $14.6 million or 17.3%. The increase was primarily due to normal customer activity.

The following table presents the Company’s borrowings at June 30, 2008 and December 31, 2007:


	June 30, 2008		December 31, 2007
	(In thousands)
FHLB advances	$	12,000	$	—
FHLB long-term notes payable		30,089		31,466

Total other borrowings		42,089		31,466
Securities sold under repurchase agreements		99,225		84,581

Total	$	141,314	$	116,047

Junior Subordinated Debentures

At June 30, 2008 and December 31, 2007, the Company had outstanding $92.3 million and $112.9 million, respectively, in junior subordinated debentures issued to the Company’s unconsolidated subsidiary trusts. The decrease of $20.6 million was due to the Company’s redemption of $10.3 million in junior subordinated debentures issued to each of SNB Statutory Trust II and SNB Capital Trust III on June 26, 2008 and April 7, 2008, respectively. Each issue of debentures redeemed bore interest at a floating rate of 3 month LIBOR + 3.15%. The trusts in turn redeemed in full the trust preferred securities and common securities they issued.

A summary of pertinent information related to the Company’s eight issues of junior subordinated debentures outstanding at June 30, 2008 is set forth in the table below:

Description

Issuance Date

Trust
Preferred
Securities
Outstanding

Interest Rate⁽¹⁾

Junior
Subordinated
Debt Owed
to Trusts

Maturity
Date⁽²⁾

Prosperity Statutory Trust II

July 31, 2001

15,000,000

3 month LIBOR

+ 3.58%, not to exceed 12.50%

15,464,000

July 31, 2031

Prosperity Statutory Trust III

Aug. 15, 2003

12,500,000

6.50%⁽³⁾

12,887,000

Sept. 17, 2033

Prosperity Statutory Trust IV

Dec. 30, 2003

12,500,000

6.50%⁽⁴⁾

12,887,000

Dec. 30, 2033

SNB Capital Trust IV⁽⁵⁾

Sept. 25, 2003

10,000,000

3 month LIBOR

+3.00%

10,310,000

Sept. 25, 2033

TXUI Statutory Trust I⁽⁶⁾

Sept. 07, 2000

7,000,000

10.60%

7,210,000

Sept. 07, 2030

TXUI Statutory Trust II⁽⁶⁾

Dec. 19, 2003

5,000,000

6.45%⁽⁷⁾

5,155,000

Dec. 19, 2033

TXUI Statutory Trust III⁽⁶⁾

Nov. 30, 2005

15,500,000

3 month LIBOR

+1.39%

15,980,000

Dec. 15, 2035

TXUI Statutory Trust IV⁽⁶⁾

Mar. 31, 2006

12,000,000

3 month LIBOR

+1.39%

12,372,000

June 30, 2036

(1)

The 3-month LIBOR in effect as of June 30, 2008 was 2.78%.

(2)

All debentures are callable five years from issuance date except for TXUI Statutory Trust I which is callable ten years from issuance date.

(3)

The debentures bear a fixed interest rate until September 17, 2008, when the rate begins to float on a quarterly basis based on the three-month LIBOR plus 3.00%.

(4)

The debentures bear a fixed interest rate until December 30, 2008, when the rate begins to float on a quarterly basis based on the three-month LIBOR plus 2.85%.

(5)

Assumed in connection with the SNB acquisition on April 1, 2006.

(6)

Assumed in connection with the TXUI acquisition on January 31, 2007.

(7)

The debentures bear a fixed interest rate until December 19, 2008, when the rate begins to float on a quarterly basis based on the three-month LIBOR plus 2.85%.

Liquidity

Liquidity involves the Company’s ability to raise funds to support asset growth or reduce assets to meet deposit withdrawals and other payment obligations, to maintain reserve requirements and otherwise to operate the Company on an ongoing basis. The Company’s liquidity needs have primarily been met by growth in core deposits and the issuance of junior subordinated debentures. Although access to purchased funds from correspondent banks is available and has been utilized on occasion to take advantage of investment opportunities, the Company does not generally rely on these external funding sources. The cash and federal funds sold position, supplemented by amortizing investment and loan portfolios, have generally created an adequate liquidity position.

Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. As of June 30, 2008, the Company had cash and cash equivalents of $184.7 million compared with $371.1 million at December 31, 2007. The decrease of $186.4 million is related to a reduction in federal funds sold of $179.1 million.

Contractual Obligations

The following table summarizes the Company’s contractual obligations and other commitments to make future payments as of June 30, 2008 (other than deposit obligations). The Company’s future cash payments associated with its contractual obligations pursuant to its junior subordinated debentures, FHLB notes payable and operating leases as of June 30, 2008 are summarized below. Payments for FHLB notes payable includes interest of $7.3 million that will be paid over the future periods presented. Payments related to leases are based on actual payments specified in underlying contracts.


	Payments due in:
	Remaining Fiscal 2008		Fiscal 2009-2010		Fiscal 2011-2012		Thereafter		Total
	(In thousands)
Junior subordinated debentures	$	—	$	—	$	—	$	92,265	$	92,265
Federal Home Loan Bank notes payable		1,265		17,621		4,013		14,440		37,339
Operating leases		1,772		5,217		2,797		2,688		12,474

Total	$	3,037	$	22,838	$	6,810	$	109,393	$	142,078

Off-Balance Sheet Items

In the normal course of business, the Company enters into various transactions, which, in accordance with accounting principles generally accepted in the United States, are not included in its consolidated balance sheets. The Company enters into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.

The Company’s commitments associated with outstanding standby letters of credit and commitments to extend credit as of June 30, 2008 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:


	Remaining Fiscal 2008		Fiscal 2009-2010		Fiscal 2011-2012		Thereafter		Total
	(In thousands)
Standby letters of credit	$	17,269	$	6,985	$	787	$	437	$	25,478
Commitments to extend credit		241,956		274,129		7,853		100,267		624,205

Total	$	259,225	$	281,114	$	8,640	$	100,704	$	649,683

Capital Resources

Total shareholders’ equity was $1.22 billion at June 30, 2008 compared with $1.13 billion at December 31, 2007, an increase of $90.2 million or 8.0%. The increase was due primarily to net earnings of $46.4 million, the issuance of common stock in connection with the 1^st Choice acquisition of $56.1 million and the issuance of common stock in connection with the exercise of stock options of $2.3 million, partially offset by dividends paid of $11.3 million for the six months ended June 30, 2008.

Both the Board of Governors of the Federal Reserve System, with respect to the Company, and the Federal Deposit Insurance Corporation (“FDIC”), with respect to the Bank, have established certain minimum risk-based capital standards that apply to bank holding companies and federally insured banks. As of June 30, 2008, the Company’s Tier 1 risk-based capital, total risk-based capital and leverage capital ratios were 12.70%, 13.67% and 7.87%, respectively. As of June 30, 2008, the Bank’s risk-based capital ratios were above the levels required for the Bank to be designated as “well capitalized” by the FDIC, with Tier-1 risk-based capital, total risk-based capital and leverage capital ratios of 11.87%, 12.84% and 7.38%, respectively.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company manages market risk, which for the Company is primarily interest rate risk, through its Asset Liability Committee which is composed of senior officers of the Company, in accordance with policies approved by the Company’s Board of Directors.

The Company uses simulation analysis to examine the potential effects of market changes on net interest income and market value. The Company considers macroeconomic variables, Company strategy, liquidity and other factors as it quantifies market risk. See the Company’s Annual Report on Form 10-K, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Interest Rate Sensitivity and Liquidity” which was filed on March 1, 2008 for further discussion.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply judgment in evaluating its controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) were effective as of the end of the period covered by this report.

Changes in internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended June 30, 2008 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Not applicable

ITEM 1A. RISK FACTORS

There have been no material changes in the Company’s risk factors from those disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

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

Not applicable

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable

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

On April 17, 2008, the Company held its Annual Meeting of Shareholders to consider and act upon the items listed below:

William H. Fagan, MD, Perry Mueller, Jr., DDS, James D. Rollins III and Harrison Stafford II, were elected as Class I directors to serve on the Board of Directors of the Company until the Company’s 2011 Annual Meeting of Shareholders and until their successors are duly elected and qualified, or until their earlier resignation or removal. The table below contains a summary of shares voted for or withheld for each nominated director:


	For	Withheld
William H. Fagan, MD	37,633,749	812,487
Perry Mueller, Jr., DDS	37,338,056	1,108,180
James D. Rollins III	37,387,869	1,058,367
Harrison Stafford II	37,662,446	783,790

The following Class II and Class III directors continued in office after the Annual Meeting: James A. Bouligny, Leah Henderson, Ned S. Holmes, S. Reed Morian, Tracy T. Rudolph, Robert Steelhammer, H.E. Timanus, Jr. and David Zalman.

The shareholders ratified the appointment of Deloitte & Touche LLP as the Company’s independent registered public accounting firm for the year ending December 31, 2008. A total of 38,148,910 shares were voted in favor of the appointment, 284,114 shares were voted against the appointment and 13,212 shares abstained from voting.

ITEM 5. OTHER INFORMATION

Not applicable

ITEM 6. EXHIBITS

Exhibits:


Exhibit Number		Description of Exhibit
3.1		Amended and Restated Articles of Incorporation of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267) (the “Registration Statement”))

3.2		Articles of Amendment to Amended and Restated Articles of Incorporation of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006)

3.3		Amended and Restated Bylaws of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on October 19, 2007)

4.1		Form of certificate representing shares of the Company’s common stock (incorporated by reference to Exhibit 4 to the Registration Statement)

31.1	*	Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended

31.2	*	Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended

32.1	**	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2	**	Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Filed with this Quarterly Report on Form 10-Q.

Furnished with this Quarterly Report on Form 10-Q.

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.


		PROSPERITY BANCSHARES, INC. ^®
		(Registrant)

		Date: 08/08/08		/s/ David Zalman
				David Zalman
				Chairman and Chief Executive Officer

		Date: 08/08/08		/s/ David Hollaway
				David Hollaway
				Chief Financial Officer

PROSPERITY BANCSHARES INC - Quarter Report: 2008 June (Form 10-Q)

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