form_10q.htm


 

 UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q
 

     (Mark One)

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

For the quarterly period ended June 30, 2008

OR

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

For the transition period from ____________ to ____________
 
Commission file number 0-12247


SOUTHSIDE BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
   
TEXAS
75-1848732
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)
   
1201 S. Beckham, Tyler, Texas
75701
(Address of principal executive offices)
(Zip Code)
903-531-7111
(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  o .

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

Large accelerated filer o
Accelerated filer  x
Non-accelerated filer o
Small reporting company o
(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 Act).  Yes  o    No  x 

The number of shares of the issuer's common stock, par value $1.25, outstanding as of July 25, 2008 was 13,892,083 shares.




 

 
 
 
 
 
TABLE OF CONTENTS
   
   
 
 
 
 
 
            ITEM 4.  CONTROLS AND PROCEDURES
 
 
 
 
 
 
 
 
 
 
 
 
 


 

 

PART I.   FINANCIAL INFORMATION
ITEM 1.   FINANCIAL STATEMENTS

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(in thousands, except share amounts)
   
June 30,
   
December 31,
 
ASSETS
 
2008
   
2007
 
Cash and due from banks
  $ 63,848     $ 74,040  
Interest earning deposits
    401       1,414  
Federal funds sold
    2,150       550  
Total cash and cash equivalents
    66,399       76,004  
Investment securities:
               
Available for sale, at estimated fair value
    110,581       109,928  
Held to maturity, at cost
    477       475  
Mortgage-backed and related securities:
               
Available for sale, at estimated fair value
    851,331       727,553  
Held to maturity, at cost
    173,453       189,965  
Federal Home Loan Bank and FRB stock, at cost
    28,859       19,850  
Other investments, at cost
    2,067       2,069  
Loans held for sale
    2,792       3,361  
Loans:
               
Loans
    978,269       961,230  
Less:  allowance for loan loss
    (11,527 )     (9,753 )
      Net Loans
    966,742       951,477  
Premises and equipment, net
    39,881       40,249  
Goodwill
    22,034       21,639  
Other intangible assets, net
    1,694       1,925  
Interest receivable
    12,363       11,784  
Deferred tax asset
    6,227       4,320  
Other assets
    38,888       35,723  
TOTAL ASSETS
  $ 2,323,788     $ 2,196,322  
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Deposits:
               
Noninterest bearing
  $ 411,213     $ 357,083  
Interest bearing
    1,086,859       1,173,408  
Total Deposits
    1,498,072       1,530,491  
Short-term obligations:
               
Federal funds purchased and repurchase agreements
    9,245       7,023  
FHLB advances
    212,956       353,792  
Other obligations
    2,500       2,500  
Total Short-term obligations
    224,701       363,315  
Long-term obligations:
               
FHLB  advances
    362,584       86,247  
Long-term debt
    60,311       60,311  
Total Long-term obligations
    422,895       146,558  
Other liabilities
    36,844       23,132  
TOTAL LIABILITIES
    2,182,512       2,063,496  
                 
       Off-Balance-Sheet Arrangements, Commitments and Contingencies (Note 12)
               
                 
Minority interest in Southside Financial Group
    287       498  
                 
Shareholders' equity:
               
Common stock - $1.25 par, 20,000,000 shares authorized, 15,623,653 shares
               
 issued in 2008 and 14,865,134 shares issued in 2007
    19,529       18,581  
Paid-in capital
    129,620       115,250  
Retained earnings
    22,290       26,187  
Treasury stock (1,731,570 and 1,724,857 shares at cost)
    (23,115 )     (22,983 )
Accumulated other comprehensive loss
    (7,335 )     (4,707 )
TOTAL SHAREHOLDERS' EQUITY
    140,989       132,328  
                 
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
  $ 2,323,788     $ 2,196,322  

The accompanying notes are an integral part of these consolidated financial statements.

 
1

 

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(in thousands, except per share data)
   
Three Months
   
Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2008
   
2007
   
2008
   
2007
 
Interest income
                       
Loans
  $ 17,767     $ 12,733     $ 36,063     $ 25,247  
Investment securities – taxable
    390       616       1,070       1,452  
Investment securities – tax-exempt
    1,160       505       1,978       1,012  
Mortgage-backed and related securities
    12,020       10,163       23,993       21,097  
Federal Home Loan Bank stock and other investments
    214       330       476       700  
Other interest earning assets
    24       33       91       69  
Total interest income
    31,575       24,380       63,671       49,577  
Interest expense
                               
Deposits
    7,868       10,025       18,623       19,590  
Short-term obligations
    1,839       2,776       5,139       6,722  
Long-term obligations
    3,973       1,518       6,644       3,178  
Total interest expense
    13,680       14,319       30,406       29,490  
Net interest income
    17,895       10,061       33,265       20,087  
Provision for loan losses
    2,947       217       5,186       334  
Net interest income after provision for loan losses
    14,948       9,844       28,079       19,753  
Noninterest income
                               
Deposit services
    4,667       4,270       9,084       8,198  
Gain on securities available for sale
    3,660       6       5,752       435  
Gain on sale of loans
    847       724       1,312       1,069  
Trust income
    619       576       1,212       1,040  
Bank owned life insurance income
    758       268       1,068       532  
Other
    736       818       1,561       1,526  
Total noninterest income
    11,287       6,662       19,989       12,800  
Noninterest expense
                               
Salaries and employee benefits
    8,806       7,298       17,519       14,402  
Occupancy expense
    1,427       1,190       2,815       2,358  
Equipment expense
    329       242       641       470  
Advertising, travel & entertainment
    496       449       960       870  
ATM and debit card expense
    304       242       592       496  
Director fees
    147       141       291       268  
Supplies
    206       188       383       336  
Professional fees
    353       240       787       551  
Postage
    182       155       366       303  
Telephone and communications
    257       193       515       384  
Other
    1,974       1,118       3,963       2,254  
Total noninterest expense
    14,481       11,456       28,832       22,692  
                                 
Income before income tax expense
    11,754       5,050       19,236       9,861  
Provision for income tax expense
    3,223       463       5,159       1,511  
Net Income
  $ 8,531     $ 4,587     $ 14,077     $ 8,350  
Earnings per common share –basic
  $ 0.62     $ 0.33     $ 1.02     $ 0.61  
Earnings per common share –diluted
  $ 0.60     $ 0.32     $ 0.99     $ 0.59  
Dividends declared per common share
  $ 0.13     $ 0.12     $ 0.25     $ 0.23  

The accompanying notes are an integral part of these consolidated financial statements.

 
2

 

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(UNAUDITED)
(in thousands, except share amounts)
   
Comprehensive
Income
   
Common Stock
   
Paid-in Capital
   
Retained Earnings
   
Treasury Stock
   
Accumulated
Other
Compre-
hensive
Income (Loss)
   
Total Share-holders
Equity
 
                                           
Balance at December 31, 2006
        $ 17,594     $ 100,736     $ 29,648     $ (22,850 )   $ (14,524 )   $ 110,604  
Net Income
  $ 8,350                       8,350                       8,350  
Other comprehensive 
 income, net of tax 
 Unrealized losses on securities,  
 net of reclassification
 adjustment (see Note 3)
    (1,533 )                                     (1,533 )     (1,533 )
  Adjustment to net periodic
  benefit cost (see Note 3)
    173                                       173       173  
Comprehensive income
  $ 6,990                                                  
Common stock issued (108,634 shares)
            137       788                               925  
Stock compensation expense
                    14                               14  
Tax benefit of incentive stock options
                    21                               21  
Dividends paid on common stock
                            (2,927 )                     (2,927 )
Purchase of 6,120 shares of common stock
                                    (133 )             (133 )
Stock dividend
            776       12,903       (13,679 )                     -  
Balance at June 30, 2007
          $ 18,507     $ 114,462     $ 21,392     $ (22,983 )   $ (15,884 )   $ 115,494  
                                                         
Balance at December 31, 2007
          $ 18,581     $ 115,250     $ 26,187     $ (22,983 )   $ (4,707 )   $ 132,328  
Net Income
  $ 14,077                       14,077                       14,077  
Other comprehensive income, net
 of tax
 Unrealized losses on
 securities, net of
 reclassification adjustment (see 
 Note 3)
    (2,913 )                                     (2,913 )     (2,913 )
 Adjustment to net periodic
 benefit cost (see Note 3)
    285                                       285       285  
Comprehensive income
  $ 11,449                                                  
Common stock issued (99,306 shares)
            124       796                               920  
Stock compensation expense
                    7                               7  
Tax benefit of incentive stock options
                    145                               145  
Cumulative effect of adoption of a new accounting principle on January 1, 2008 (see Note 11)
                            (351 )                     (351 )
Dividends paid on common stock
                            (3,377 )                     (3,377 )
Purchase of 6,713 shares of common stock
                                    (132 )             (132 )
Stock dividend
            824       13,422       (14,246 )                     -  
Balance at June 30, 2008
          $ 19,529     $ 129,620     $ 22,290     $ (23,115 )   $ (7,335 )   $ 140,989  


The accompanying notes are an integral part of these consolidated financial statements.

 
3

 

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
   
Six Months Ended
June 30,
 
   
2008
   
2007
 
             
OPERATING ACTIVITIES:
           
Net income
  $ 14,077     $ 8,350  
Adjustments to reconcile net income to net cash provided by operations:
               
Depreciation
    1,209       1,085  
Amortization of premium
    3,667       2,445  
Accretion of discount and loan fees
    (1,900 )     (1,314 )
Provision for loan losses
    5,186       334  
Stock compensation expense
    7       14  
(Increase) decrease in interest receivable
    (579 )     189  
(Increase) decrease in other assets
    (1,457 )     1,585  
Net change in deferred taxes
    (382 )     (1,077 )
Decrease in interest payable
    (638 )     (134 )
Increase (decrease) in other liabilities
    1,886       (434 )
Decrease (increase) in loans held for sale
    569       (1,133 )
Gain on securities available-for-sale
    (5,752 )     (435 )
Loss on sale of assets
    18       -  
Loss on sale of other real estate owned
    86       1  
Earnings allocated to minority interest
    196       -  
Net cash provided by operating activities
    16,193       9,476  
                 
INVESTING ACTIVITIES:
               
Proceeds from sales of investment securities available for sale
    73,858       4,953  
Proceeds from sales of mortgage-backed securities available for sale
    148,645       51,430  
Proceeds from maturities of investment securities available for sale
    64,505       57,891  
Proceeds from maturities of mortgage-backed securities available for sale
    62,586       50,874  
Proceeds from maturities of mortgage-backed securities held to maturity
    17,776       20,596  
Proceeds from redemption of Federal Home Loan Bank stock
    619       10,729  
Purchases of investment securities available for sale
    (136,184 )     (51,789 )
Purchases of mortgage-backed securities available for sale
    (326,961 )     (60,474 )
Purchases of mortgage-backed securities held to maturity
    (1,664 )     (2,180 )
Purchases of Federal Home Loan Bank stock and other investments
    (9,626 )     (654 )
Net increase in loans
    (22,266 )     (10,048 )
Purchases of premises and equipment
    (1,201 )     (3,712 )
Proceeds from sales of premises and equipment
    358       -  
Proceeds from sales of other real estate owned
    139       334  
Proceeds from sales of repossessed assets
    2,108       191  
Net cash (used in) provided by investing activities
    (127,308 )     68,141  

The accompanying notes are an integral part of these consolidated financial statements.


 
4

 

SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(UNAUDITED)
(in thousands)
   
Six Months Ended
 
   
June 30,
 
   
2008
   
2007
 
FINANCING ACTIVITIES:
           
 Net increase in demand and savings accounts
   
88,978
     
21,773
 
 Net (decrease) increase in certificates of deposit
   
(122,340
)
   
31,944
 
 Net increase (decrease) in federal funds purchased and repurchase agreements
   
2,222
     
(5,675
)
 Proceeds from FHLB Advances
   
9,423,627
     
2,786,999
 
 Repayment of FHLB Advances
   
(9,288,126
)
   
(2,909,400
)
 Net capital distributions from minority interest investment in consolidated entities
   
(407
)
   
-
 
 Tax benefit of incentive stock options
   
145
     
21
 
 Purchases of common stock
   
(132
)
   
(133
)
 Proceeds from the issuance of common stock
   
920
     
925
 
 Dividends paid
   
(3,377
)
   
(2,927
)
      Net cash provided by (used in) financing activities
   
101,510
     
(76,473
)
                 
Net (decrease) increase in cash and cash equivalents
   
(9,605
)
   
1,144
 
Cash and cash equivalents at beginning of period
   
76,004
     
55,012
 
Cash and cash equivalents at end of period
 
$
66,399
   
$
56,156
 
                 
SUPPLEMENTAL DISCLOSURES FOR CASH FLOW INFORMATION:
               
 Interest paid
 
$
31,044
   
$
29,624
 
 Income taxes paid
   
5,425
     
2,000
 
                 
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES:
               
 Acquisition of other repossessed assets and real estate through foreclosure
 
$
3,484
   
$
197
 
 Payment of 5% stock dividend
   
14,246
     
13,679
 
 Adjustment to pension liability
   
(262
)
   
(262
)
 Unsettled trades to purchase securities
   
(17,874
)
   
(941
)
 Unsettled trades to sell securities
   
725
     
-
 

The accompanying notes are an integral part of these consolidated financial statements



 
5

 


SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS

1.         Basis of Presentation

In this report, the words “the Company,” “we,” “us,” and “our” refer to the combined entities of Southside Bancshares, Inc. and its subsidiaries.  The words “Southside” and “Southside Bancshares” refer to Southside Bancshares, Inc.  The words “Southside Bank” and “Fort Worth National Bank” refer to those entities, respectively, and the words “the Banks” refers to those entities collectively.  The word “SFG” refers to Southside Financial Group, LLC., of which Southside owns a 50% interest.

The consolidated balance sheet as of June 30, 2008, and the related consolidated statements of income, shareholders' equity and cash flows and notes to the financial statements for the three and six month periods ended June 30, 2008 and 2007 are unaudited; in the opinion of management, all adjustments necessary for a fair presentation of such financial statements have been included.  Such adjustments consisted only of normal recurring items.  All significant intercompany accounts and transactions are eliminated in consolidation.  The preparation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires the use of management’s estimates. These estimates are subjective in nature and involve matters of judgment.  Actual amounts could differ from these estimates.

Interim results are not necessarily indicative of results for a full year.  These financial statements should be read in conjunction with the financial statements and notes thereto in our Annual Report on Form 10-K for the year ended December 31, 2007.  All share data has been adjusted to give retroactive recognition to stock splits and stock dividends.  For a description of our significant accounting and reporting policies, refer to Note 1 of the Notes to Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2007.

2.         Earnings Per Share

Earnings per share on a basic and diluted basis has been adjusted to give retroactive recognition to stock splits and stock dividends and is calculated as follows (in thousands, except per share amounts):

   
Three Months
   
Six Months
 
   
Ended June 30,
   
Ended June 30,
 
                         
   
2008
   
2007
   
2008
   
2007
 
    Basic Earnings and Shares:
                       
       Net Income
 
$
8,531
   
$
4,587
   
$
14,077
   
$
8,350
 
       Weighted-average basic shares outstanding
   
13,843
     
13,688
     
13,824
     
13,660
 
                                 
    Basic Earnings Per Share:
                               
       Net Income
 
$
0.62
   
$
0.33
   
$
1.02
   
$
0.61
 
                                 
    Diluted Earnings and Shares:
                               
       Net Income
 
$
8,531
   
$
4,587
   
$
14,077
   
$
8,350
 
       Weighted-average basic shares outstanding
   
13,843
     
13,688
     
13,824
     
13,660
 
       Add:   Stock options
   
347
     
421
     
351
     
442
 
       Weighted-average diluted shares outstanding
   
14,190
     
14,109
     
14,175
     
14,102
 
                                 
    Diluted Earnings Per Share:
                               
       Net Income
 
$
0.60
   
$
0.32
   
$
0.99
   
$
0.59
 

For the three and six month periods ended June 30, 2008 and 2007, there were no antidilutive options.

 
6

 


3.  Comprehensive Income (Loss)

The components of other comprehensive income (loss) are as follows (in thousands):


 
Six Months Ended June 30, 2008
 
 
Before-Tax
 
Tax (Expense)
 
Net-of-Tax
 
 
Amount
 
Benefit
 
Amount
 
Unrealized losses on securities:
           
Unrealized holding gains arising during period
  $ 1,337     $ (511 )   $ 826  
Less:  reclassification adjustment for gains
                       
  included in net income
    5,752       (2,013 )     3,739  
Net unrealized losses on securities
    (4,415 )     1,502       (2,913 )
   Change in pension plans
    262       23       285  
Other comprehensive loss
  $ (4,153 )   $ 1,525     $ (2,628 )


 
Three Months Ended June 30, 2008
 
 
Before-Tax
 
Tax (Expense)
 
Net-of-Tax
 
 
Amount
 
Benefit
 
Amount
 
Unrealized losses on securities:
           
Unrealized holding losses arising during period
  $ (9,626 )   $ 3,369     $ (6,257 )
Less:  reclassification adjustment for gains
                       
  included in net income
    3,660       (1,281 )     2,379  
Net unrealized losses on securities
    (13,286 )     4,650       (8,636 )
   Change in pension plans
    141       (49 )     92  
Other comprehensive loss
  $ (13,145 )   $ 4,601     $ (8,544 )


 
Six Months Ended June 30, 2007
 
 
Before-Tax
 
Tax (Expense)
 
Net-of-Tax
 
 
Amount
 
Benefit
 
Amount
 
Unrealized losses on securities:
           
Unrealized holding losses arising during period
  $ (1,888 )   $ 642     $ (1,246 )
Less:  reclassification adjustment for gains
                       
  included in net income
    435       (148 )     287  
Net unrealized losses on securities
    (2,323 )     790       (1,533 )
Change in pension plans
    262       (89 )     173  
Other comprehensive loss
  $ (2,061 )   $ 701     $ (1,360 )


 
Three Months Ended June 30, 2007
 
 
Before-Tax
 
Tax (Expense)
 
Net-of-Tax
 
 
Amount
 
Benefit
 
Amount
 
Unrealized losses on securities:
           
Unrealized holding losses arising during period
  $ (5,556 )   $ 1,889     $ (3,667 )
Less:  reclassification adjustment for gains
                       
  included in net income
    6       (2 )     4  
Net unrealized losses on securities
    (5,562 )     1,891       (3,671 )
   Change in pension plans
    104       (35 )     69  
Other comprehensive loss
  $ (5,458 )   $ 1,856     $ (3,602 )


 
7

 


4.         Securities

The amortized cost and estimated market value of investment and mortgage-backed securities as of June 30, 2008 and December 31, 2007, are reflected in the tables below (in thousands):

   
June 30, 2008
 
AVAILABLE FOR SALE:
 
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Estimated Market Value
 
Investment Securities:
                       
   U.S. Treasury
  $ 4,865     $ -     $ 3     $ 4,862  
   Government Sponsored Enterprise Debentures
    16,367       -       18       16,349  
   State and Political Subdivisions
    83,144       1,334       944       83,534  
   Other Stocks and Bonds
    6,711       -       875       5,836  
Mortgage-backed Securities:
                               
   U.S. Government Agencies
    96,447       1,202       576       97,073  
   Government Sponsored Enterprises
    753,126       4,810       3,678       754,258  
Total
  $ 960,660     $ 7,346     $ 6,094     $ 961,912  


   
June 30, 2008
 
HELD TO MATURITY:
 
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Estimated Market Value
 
Investment Securities:
                       
   Other Stocks and Bonds
  $ 477     $ 9     $ -     $ 486  
Mortgage-backed Securities:
                               
   U.S. Government Agencies
    24,346       76       63       24,359  
   Government Sponsored Enterprises
    149,107       607       352       149,362  
Total
  $ 173,930     $ 692     $ 415     $ 174,207  


   
December 31, 2007
 
AVAILABLE FOR SALE:
 
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Estimated Market Value
 
Investment Securities:
                       
   U.S. Treasury
  $ 4,880     $ 8     $ 2     $ 4,886  
   Government Sponsored Enterprise Debentures
    31,764       3       8       31,759  
   State and Political Subdivisions
    64,868       1,599       223       66,244  
   Other Stocks and Bonds
    7,586       -       547       7,039  
Mortgage-backed Securities:
                               
   U.S. Government Agencies
    88,937       1,234       451       89,720  
   Government Sponsored Enterprises
    628,768       5,847       1,555       633,060  
   Other Private Issues
    4,773       -       -       4,773  
Total
  $ 831,576     $ 8,691     $ 2,786     $ 837,481  


   
December 31, 2007
 
HELD TO MATURITY:
 
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Estimated Market Value
 
Investment Securities:
                       
   Other Stocks and Bonds
  $ 475     $ 2     $ -     $ 477  
Mortgage-backed Securities:
                               
   U.S. Government Agencies
    25,965       36       58       25,943  
   Government Sponsored Enterprises
    164,000       501       531       163,970  
Total
  $ 190,440     $ 539     $ 589     $ 190,390  


 
8

 


The Company concluded that, based on the creditworthiness of the issuer, the unrealized loss on each security in the above table represents a temporary impairment and does not require adjustment to the carrying amount of any of the individual securities.  Additionally, the Company has the ability and the intent to hold such securities through recovery of the unrealized losses.

Investment and mortgage-backed securities with book values of $620.4 million at June 30, 2008 and $496.8 million at December 31, 2007 were pledged to collateralize Federal Home Loan Bank (“FHLB”) advances, repurchase agreements, public funds and trust deposits or for other purposes as required by law.

5. Loans and Allowance for Probable Loan Losses

The following table sets forth loan totals by category for the periods presented (in thousands):

 
At
   
At
 
 
June 30,
   
December 31,
 
 
2008
   
2007
 
Real Estate Loans:
         
   Construction
  $ 97,083     $ 96,356  
   1-4 Family Residential
    240,149       237,888  
   Other
    203,109       211,280  
Commercial Loans
    167,963       154,171  
Municipal Loans
    120,194       112,523  
Loans to Individuals
    149,771       149,012  
Total Loans
  $ 978,269     $ 961,230  

The summaries of the Allowance for Loan Losses and Reserve for Unfunded Loan Commitments are as follows (in thousands):

   
Three Months
Ended June 30,
   
Six Months
Ended June 30,
 
 
   
2008
   
2007
   
2008
   
2007
 
   Allowance for Loan Losses
                       
                         
Balance at beginning of period
 
$
10,611
   
$
7,261
   
$
9,753
   
$
7,193
 
Provision for loan losses
   
2,947
     
217
     
5,186
     
334
 
Loans charged off
   
(2,542
)
   
(616
)
   
(4,400
)
   
(1,209
)
Recoveries of loans charged off
   
511
     
505
     
988
     
1,049
 
Balance at end of period
 
$
11,527
   
$
7,367
   
$
11,527
   
$
7,367
 
                                 
  Reserve for Unfunded Loan Commitments
                               
                                 
  Balance at beginning of period
 
$
70
   
$
   
$
50
   
$
 
     Provision for losses on unfunded loan
      commitments
   
(64
)
   
     
(44
)
   
 
  Balance at end of period
 
$
6
   
$
   
$
6
   
$
 


 
9

 


6.  Goodwill and Core Deposit Intangible Assets

Goodwill.  Goodwill totaled $22.0 million at June 30, 2008 and $21.6 million at December 31, 2007.  During the first quarter of 2008, we recorded goodwill totaling $395,000 in connection with the acquisition of Fort Worth National Bancshares, Inc.

Core Deposit Intangibles.  Core deposit intangible assets totaled $1.7 million at June 30, 2008 and $1.9 million at December 31, 2007.

During the fourth quarter of 2007, we recorded core deposit intangibles totaling $2.0 million in connection with the acquisition of Fort Worth National Bancshares, Inc.  Core deposit intangibles are amortized on an accelerated basis over their estimated lives, which range from 4 to 10 years.

For the three and six months ended June 30, 2008, amortization expense related to intangible assets totaled $114,000 and $231,000, respectively.  The estimated aggregate future amortization expense for intangible assets remaining as of June 30, 2008 is as follows (in thousands):

Remainder of 2008
  $ 215  
2009
    383  
2010
    319  
2011
    255  
2012
    198  
Thereafter
    324  
    $ 1,694  


7.  
Long-term Obligations

Long-term obligations are summarized as follows:

   
June 30,
   
December 31,
 
   
2008
   
2007
 
   
(dollars in thousands)
 
Federal Home Loan Bank Advances (1)
           
   Varying maturities to 2028
  $ 362,584     $ 86,247  
                 
Long-term Debt (2)
               
   Southside Bancshares Statutory Trust III Due 2033 (3)
    20,619       20,619  
   Southside Statutory Trust IV Due 2037 (4)
    23,196       23,196  
   Southside Statutory Trust V Due 2037 (5)
    12,887       12,887  
   Magnolia Trust Company I Due 2035 (6)
    3,609       3,609  
      Total Long-term Debt
    60,311       60,311  
      Total Long-term Obligations
  $ 422,895     $ 146,558  
 
(1)           At June 30, 2008, the weighted average cost of these advances was 3.76%.
 
(2)
This long-term debt consists of trust preferred securities that qualify under the risk-based capital guidelines as Tier 1 capital, subject to certain limitations.
 
(3)
This debt carries an adjustable rate of 5.74063% through September 29, 2008 and adjusts quarterly at a rate equal to three-month LIBOR plus 294 basis points.
 
(4)
This debt carries a fixed rate of 6.518% through October 30, 2012 and thereafter, adjusts quarterly at a rate equal to three-month LIBOR plus 130 basis points.
 
(5)
This debt carries a fixed rate of 7.48% through December 15, 2012 and thereafter, adjusts quarterly at a rate equal to three-month LIBOR plus 225 basis points.
 
(6)
This debt carries an adjustable rate of 4.43813% through August 24, 2008 and adjust quarterly at a rate equal to three-month LIBOR plus 180 basis points.


 
10

 


8.  Employee Benefit Plans

The components of net periodic benefit cost are as follows (in thousands):


   
Six Months Ended June 30,
 
   
Defined Benefit
             
   
Pension Plan
   
Restoration Plan
 
   
2008
   
2007
   
2008
   
2007
 
Service cost
 
$
620
   
$
665
   
$
43
   
$
31
 
Interest cost
   
1,212
     
1,156
     
114
     
84
 
Expected return on assets
   
(1,495
)
   
(1,264
)
   
     
 
Transition obligation recognition
   
     
     
     
1
 
Net loss recognition
   
208
     
241
     
76
     
42
 
Prior service credit amortization
   
(21
)
   
(21
)
   
(1
)
   
(1
)
Net periodic benefit cost
 
$
524
   
$
777
   
$
232
   
$
157
 
                                 


   
Three Months Ended June 30,
 
   
Defined Benefit
             
   
Pension Plan
   
Restoration Plan
 
   
2008
   
2007
   
2008
   
2007
 
Service cost
 
$
293
   
$
356
   
$
28
   
$
16
 
Interest cost
   
594
     
566
     
69
     
39
 
Expected return on assets
   
(763
)
   
(631
)
   
     
 
Transition obligation recognition
   
     
     
     
 
Net loss recognition
   
95
     
105
     
57
     
10
 
Prior service credit amortization
   
(11
)
   
(11
)
   
     
 
Net periodic benefit cost
 
$
208
   
$
385
   
$
154
   
$
65
 
                                 

Employer Contributions

We previously disclosed in our financial statements for the year ended December 31, 2007, that we expected to contribute $3.0 million to our defined benefit pension plan and $80,000 to our post retirement benefit plan in 2008.  As of June 30, 2008, we had contributed $1.5 million to the defined benefit pension plan, and contributions of $ 40,000 had been made to the post retirement benefit plan.

9.  Incentive Stock Options

In April 1993, we adopted the Southside Bancshares, Inc. 1993 Incentive Stock Option Plan ("the ISO Plan"), a stock-based incentive compensation plan.  The ISO Plan expired March 31, 2003.

A summary of the status of our nonvested shares as of June 30, 2008 is as follows:

   
Six Months Ended
June 30, 2008
 
   
Number of Options
   
Weighted Average Grant-Date Fair Value
 
Nonvested at beginning of the period
   
6,030
   
$
4.91
 
Vested
   
(6,030
)
 
$
4.91
 
Nonvested at end of period
   
   
$
 


11

For the six months ended June 30, 2008 and 2007, we recorded approximately $7,000 and $14,000, respectively, of stock-based compensation expense.  As of June 30, 2008, there was no unrecognized compensation cost related to the ISO Plan for nonvested options granted in March 2003.  At June 30, 2007, there was $20,000 of total unrecognized cost.

The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes method of option pricing with the following weighted-average assumptions for grants in 2003: dividend yield of 1.93%; risk-free interest rate of 4.93%; expected life of six years; and expected volatility of 28.90%.

Under the ISO Plan, we were authorized to issue shares of common stock pursuant to "Awards" granted in the form of incentive stock options (intended to qualify under Section 422 of the Internal Revenue Code of 1986, as amended).  Before the ISO Plan expired, awards were granted to selected employees and directors.  No stock options have been available for grant under the ISO Plan since its expiration in March 2003.  Currently, we do not offer stock-based payment programs to our employees.

The ISO Plan provided that the exercise price of any stock option not be less than the fair market value of the common stock on the date of grant.  The outstanding stock options have contractual terms of 10 years.  All options vest on a graded schedule, 20% per year for five years, beginning on the first anniversary date of the grant date.

A summary of the status of our stock options as of June 30, 2008 and the changes during the six months ended on those dates is presented below:

 
Number of Options
 
Weighted Average Exercise Prices
Weighted Average Remaining Contract Life (Years)
 
Aggregate Intrinsic Value
 (in thousands)
 
               
Outstanding at December 31, 2007
500,510
 
$
5.52
   
 
Exercised
(78,334
$
6.05
   
 
Cancelled
 
$
   
 
Outstanding at June 30, 2008
422,176
 
$
5.42
1.75
 
$
5,694
 
Exercisable at June 30, 2008
422,176
 
$
5.42
1.75
 
$
5,694
 

The total intrinsic value (i.e., the amount by which the fair value of the underlying common stock exceeds the exercise price of a stock option on exercise date) of stock options exercised during the six months ended June 30, 2008 and 2007 were $1.2 million and $1.5 million, respectively.

Cash received from stock option exercises for the six months ended June 30, 2008 and 2007 was $342,000 and $360,000, respectively.  The tax benefit realized for the deductions related to the stock option exercises were $145,000 and $21,000 for the six months ended June 30, 2008 and 2007, respectively.

10.  Fair Value Measurement

Effective January 1, 2008, we adopted the provisions of SFAS No. 157, "Fair Value Measurements," for financial assets. In accordance with Financial Accounting Standards Board Staff Position (FSP) No. 157-2, "Effective Date of FASB Statement No. 157," we will delay application of SFAS 157 for non-financial assets, until January 1, 2009. SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements.

FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

SFAS 157 requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach.  Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability.  Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.  SFAS 157 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:
12


Level 1 Inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 Inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

Level 3 Inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity's own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

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

Securities Available for Sale - Securities classified as available for sale are reported at fair value utilizing Level 1 and Level 2 inputs.  The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond's terms and conditions, among other things.

Loans Held for Sale - These loans are reported at the lower of cost or fair value. Fair value is determined based on expected proceeds based on sales contracts and commitments and are considered Level 2 inputs.

Impaired Loans – Certain impaired loans may be reported at the fair value of the underlying collateral if repayment is expected solely from the collateral.  Collateral values are estimated using Level 3 inputs based on customized discounting criteria.

The following table summarizes financial assets and financial liabilities measured at fair value on a recurring basis as of June 30, 2008, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value (dollars in thousands):

   
Level 1
   
Level 2
   
Level 3
   
Total
 
   
Input
   
Input
   
Input
   
Fair Value
 
                         
Securities available for sale
  $ 5,364     $ 956,548     $ -     $ 961,912  

11.  Accounting Pronouncements

Statements of Financial Accounting Standards

SFAS No. 141, “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.  Under SFAS 141R, the requirements of SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” would have to be met in order 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 expected to have a significant impact on our accounting for business combinations closing on or after January 1, 2009.
 
13

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 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 us on January 1, 2009 and is not expected to have a significant impact on our financial statements.

SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115.”  SFAS 159, issued by the Financial Accounting Standards Board (“FASB”) in February 2007, allows entities to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities that are not otherwise required to be measured at fair value, with changes in fair value recognized in earnings as they occur.  We adopted SFAS 159 on January 1, 2008.  We did not identify any financial assets or liabilities for which we elected the fair value option.  In future periods, we will consider if, or to what extent, we will elect to use the fair value option to value our financial assets and liabilities.

SFAS No. 157, “Fair Value Measurements.”  SFAS 157 defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. We adopted SFAS 157 on January 1, 2008 and it did not have a material impact on our consolidated financial statements.

Emerging Issues Task Force Consensuses

In September 2006, the Emerging Issues Task Force (“EITF”) reached a final consensus on Issue 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.”  EITF 06-4 requires that for a split-dollar life insurance arrangement, an employer should recognize a liability for future benefits in accordance with SFAS 106, “Employers' Accounting for Postretirement Benefits Other Than Pensions.”  Under the guidance, the purchase of an endorsement type policy does not constitute a settlement since the policy does not qualify as nonparticipating because the policyholders are subject to the favorable and unfavorable experience of the insurance company.  EITF 06-4 is effective for fiscal years beginning after December 15, 2007.  We adopted EITF 06-4 as of January 1, 2008 as a change in accounting principle through a cumulative-effect adjustment to retained earnings.  The amount of the adjustment was $351,000.

In September 2006, the EITF reached a final consensus on Issue 06-5, “Accounting for Purchases of Life Insurance.”  EITF 06-5 provides guidance on FASB Technical Bulletin No. 85-4, “Accounting for Purchases of Life Insurance.”  Under the guidance, the policyholder should consider any additional amounts included in the contractual terms of the policy in determining the amount that could be realized under the insurance contract.  In addition, the policyholder should also determine the amount that could be realized under the life insurance contract assuming the surrender of an individual-life by individual-life policy.  EITF 06-5 was effective for fiscal years beginning after December 15, 2006.  The adoption of EITF 06-5 did not have a material impact on our consolidated financial statements.

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 became effective on January 1, 2008 and did not have a material impact on our financial statements.

12.  Off-Balance-Sheet Arrangements, Commitments and Contingencies

Financial Instruments with Off-Balance-Sheet-Risk. In the normal course of business, we are a party to certain financial instruments, with off-balance-sheet risk, to meet the financing needs of our customers. These off-balance-sheet instruments include commitments to extend credit and standby letters of credit.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount reflected in the financial statements.  The contract or notional amounts of these instruments reflect the extent of involvement and exposure to credit loss we have in these particular classes of financial instruments.

Commitments to extend credit are agreements to lend to a customer provided that the terms established in the contract are met.  Commitments generally have fixed expiration dates and may require payment of fees.  Since some commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  These guarantees are primarily issued to support public and private
14

 
borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.

We had outstanding unused commitments to extend credit of $145.7 million and $118.0 million at June 30, 2008 and 2007, respectively.  Each commitment has a maturity date and the commitment expires on that date with the exception of credit card and ready reserve commitments, which have no stated maturity date.  Unused commitments for credit card and ready reserve at June 30, 2008 and 2007 were $8.7 million and $9.3 million, respectively, and are reflected in the due after one year category.  We had outstanding standby letters of credit of $4.9 million and $3.9 million at June 30, 2008 and 2007, respectively.

The scheduled maturities of unused commitments as of June 30, 2008 and 2007 were as follows (in thousands):

   
June 30,
 
   
2008
   
2007
 
Unused commitments:
           
Due in one year or less
 
$
84,096
   
$
87,271
 
Due after one year
   
61,578
     
30,691
 
Total
 
$
145,674
   
$
117,962
 

We apply the same credit policies in making commitments and standby letters of credit as we do for on-balance-sheet instruments.  We evaluate each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary, upon extension of credit is based on management's credit evaluation of the borrower.  Collateral held varies but may include cash or cash equivalents, negotiable instruments, real estate, accounts receivable, oil, gas and mineral interests, inventory and property, plant, and equipment.

Lease Commitments. We lease certain branch facilities and office equipment under operating leases.  It is expected that certain leases will be renewed or equipment replaced with new leased equipment as these leases expire.

Securities. In the normal course of business we buy and sell securities.  There were $17.9 million of unsettled trades to purchase and $725,000 of unsettled trades to sell securities at June 30, 2008.  At December 31, 2007, there were $6.1 million unsettled trades to purchase securities.  There were no unsettled trades to sell securities at December 31, 2007.

Litigation. We are subject to litigation in the normal course of business.  Management, after consulting with our legal counsel, believes that any liability resulting from litigation will not have a material effect on our financial position and results of operations or our liquidity.

13.  Variable Interest Entities

Effective December 31, 2003, we adopted FASB Interpretation No. 46 (R) (“FIN 46 (R)”), Consolidation of Variable Interest Entities in connection with our consolidated financial statements.  FIN 46 (R) requires companies to consolidate “variable interest entities” (“VIEs”) if those companies are the primary beneficiaries of those VIEs.

Southside Bank, our wholly-owned subsidiary, is the sole owner of Southside Venue I, LLC (“Venue”).  On August 21, 2007, SFG was formed and is considered a VIE in accordance with FIN 46 (R).  Venue has 50% ownership rights and 51% voting rights of SFG based on their investment of $500,000 in the entity.  The remaining 50% ownership rights are held by an unrelated third party.  Southside Bank currently has extended credit to finance SFG’s activities.  Based on the credit facility and investment, Southside Bank and Venue are obligated to absorb the majority of SFG’s expected losses and receive a majority of SFG’s expected residual returns, and therefore Southside Bank is considered the primary beneficiary of SFG.  SFG is accordingly consolidated by Southside Bank in accordance with FIN 46 (R).

SFG is a limited liability company that buys consumer loans secured by automobiles, primarily through the purchase of existing automobile loan portfolios from lenders throughout the United States.  As of June 30, 2008, SFG had purchased approximately $63.0 million in automobile loan portfolios.


 
15

 

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

The following is a discussion of the consolidated financial condition, changes in financial condition, and results of our operations, and should be read and reviewed in conjunction with the financial statements, and the notes thereto, in this presentation and in our Annual Report on Form 10-K for the year ended December 31, 2007.

We reported an increase in net income for the three and six months ended June 30, 2008 compared to the same period in 2007.  Net income for the three and six months ended June 30, 2008 was $8.5 million and $14.1 million, respectively, compared to $4.6 million and $8.4 million, respectively, for the same periods in 2007.

All share data has been adjusted to give retroactive recognition to stock splits and stock dividends.

Forward Looking Statements

Certain statements of other than historical fact that are contained in this document and in written material, press releases and oral statements issued by or on behalf of Southside Bancshares, Inc., a bank holding company, may be considered to be “forward-looking statements” within the meaning of and subject to the protections of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date.  These statements may include words such as "expect," "estimate," "project," "anticipate," “appear,” "believe," "could," "should," "may," "intend," "probability," "risk," "target," "objective," “plans,” “potential,” and similar expressions.  Forward-looking statements are statements with respect to our beliefs, plans, expectations, objectives, goals, anticipations, assumptions, estimates, intentions and future performance, and are subject to significant known and unknown risks and uncertainties, which could cause our actual results to differ materially from the results discussed in the forward-looking statements.  For example, discussions of the effect of our expansion, trends in asset quality and earnings from growth, and certain market risk disclosures are based upon information presently available to management and are dependent on choices about key model characteristics and assumptions and are subject to various limitations.  By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future.  As a result, actual income gains and losses could materially differ from those that have been estimated.  Other factors that could cause actual results to differ materially from forward-looking statements include, but are not limited to, the following:

·  
general economic conditions, either globally, nationally, in the State of Texas, or in the specific markets
in which we operate, including, without limitation, the recent deterioration of the subprime, mortgage, credit and liquidity markets, which could cause compression of the Company’s net interest margin, or a decline in the value of the Company’s assets, which could result in realized losses;
·  
legislation, regulatory changes or changes in monetary or fiscal policy that adversely affect the businesses in which we are engaged, including the Federal Reserve’s actions with respect to interest rates;
·  
adverse changes in the status or financial condition of the Government Sponsored Enterprises (the “GSEs”) impacting the GSEs’ guarantees or ability to pay or issue debt;
·  
economic or other disruptions caused by acts of terrorism in the United States, Europe or other areas;
·  
changes in the interest rate yield curve such as flat, inverted or steep yield curves, or changes in the interest rate environment that impact interest margins and may impact prepayments on the mortgage-backed securities portfolio;
·  
unexpected outcomes of, and the costs associated with, existing or new litigation involving us;
·  
changes impacting the leverage strategy;
·  
our ability to monitor interest rate risk;
·  
significant increases in competition in the banking and financial services industry;
·  
changes in consumer spending, borrowing and saving habits;
·  
technological changes;
·  
our ability to increase market share and control expenses;
·  
the effect of changes in federal or state tax laws;
·  
the effect of compliance with legislation or regulatory changes;
·  
the effect of changes in accounting policies and practices;
·  
risks of mergers and acquisitions including the related time and cost of implementing transactions and the potential failure to achieve expected gains, revenue growth or expense savings;
·  
credit risks of borrowers, including any increase in those risks due to changing economic conditions;
·  
risks related to loans secured by real estate, including the risk that the value and marketability of collateral could decline;
·  
increases in the Company’s non-performing assets;
·  
the Company’s ability to maintain adequate liquidity to fund its operations and growth; and
·  
failure of assumptions underlying allowance for loan losses and other estimates.

 
16

 


Additional information concerning us and our business, including additional factors that could materially affect our financial results, is included in our filings with the Securities and Exchange Commission.  All written or oral forward-looking statements made by us or attributable to us are expressly qualified by this cautionary notice.  We disclaim any obligation to update any factors or to announce publicly the result of revisions to any of the forward-looking statements included herein to reflect future events or developments.

Critical Accounting Estimates

Our accounting and reporting estimates conform with accounting principles generally accepted in the United States (“GAAP”) and general practices within the financial services industry.  The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  Actual results could differ from those estimates.  We consider our critical accounting policies to include the following:

Allowance for Losses on Loans.  The allowance for losses on loans represents our best estimate of probable losses inherent in the existing loan portfolio.  The allowance for losses on loans is increased by the provision for losses on loans charged to expense and reduced by loans charged-off, net of recoveries.  The provision for losses on loans is determined based on our assessment of several factors:  reviews and evaluations of specific loans, changes in the nature and volume of the loan portfolio, and current economic conditions and the related impact on specific borrowers and industry groups, historical loan loss experience, the level of classified and nonperforming loans and the results of regulatory examinations.

The loan loss allowance is based on the most current review of the loan portfolio.  The servicing officer has the primary responsibility for updating significant changes in a customer's financial position.  Each officer prepares status updates on any credit deemed to be experiencing repayment difficulties which, in the officer's opinion, would place the collection of principal or interest in doubt.  Our internal loan review department is responsible for an ongoing review of our loan portfolio with specific goals set for the loans to be reviewed on an annual basis.

At each review, a subjective analysis methodology is used to grade the respective loan.  Categories of grading vary in severity from loans that do not appear to have a significant probability of loss at the time of review to loans that indicate a probability that the entire balance of the loan will be uncollectible.  If full collection of the loan balance appears unlikely at the time of review, estimates or appraisals of the collateral securing the debt are used to allocate the necessary allowances.  The internal loan review department maintains a list of all loans or loan relationships that are graded as having more than the normal degree of risk associated with them.  In addition, a list of loans or loan relationships of $50,000 or more is updated on a periodic basis in order to properly allocate necessary allowance and keep management informed on the status of attempts to correct the deficiencies noted with respect to the loan.

Loans are considered impaired if, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on fair value of the collateral.  In measuring the fair value of the collateral, we use assumptions, such as discount rates, and methodologies, such as comparison to the recent selling price of similar assets, consistent with those that would be utilized by unrelated third parties performing a valuation.

Changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the conditions of the various markets in which collateral may be sold may all affect the required level of the allowance for losses on loans and the associated provision for loan losses.

As of June 30, 2008, our review of the loan portfolio indicated that a loan loss allowance of $11.5 million was adequate to cover probable losses in the portfolio.

Refer to “Part II - Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Loan Loss Experience and Allowance for Loan Losses” and “Note 1 – Summary of Significant Accounting and Reporting Policies” of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2007 for a detailed description of our estimation process and methodology related to the allowance for loan losses.

 
17

 

Estimation of Fair Value. On January 1, 2008, we adopted SFAS 157, “Fair Value Measurements”, as presented in “Note 10 – Fair Value Measurement” in the accompanying Notes to Financial Statements included in this report.  The estimation of fair value is significant to a number of our assets and liabilities.  GAAP requires disclosure of the fair value of financial instruments as a part of the notes to the consolidated financial statements.  Fair values are volatile and may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates and the shape of yield curves. Fair values for most investment and mortgage-backed securities are based on quoted market prices, where available.  If quoted market prices are not available, fair values are based on the quoted prices of similar instruments.  

Impairment of Investment Securities and Mortgage-backed Securities.  Investment and mortgage-backed securities classified as available for sale (“AFS”) are carried at fair value and the impact of changes in fair value are recorded on our consolidated balance sheet as an unrealized gain or loss in “Accumulated other comprehensive income (loss),” a separate component of shareholders’ equity.  Securities classified as AFS or held to maturity (“HTM”) are subject to our review to identify when a decline in value is other than temporary.  Factors considered in determining whether a decline in value is other than temporary include: whether the decline is substantial; the duration of the decline; the reasons for the decline in value; whether the decline is related to a credit event or to a change in interest rate; our ability and intent to hold the investment for a period of time that will allow for a recovery of value; and the financial condition and near-term prospects of the issuer.  When it is determined that a decline in value is other than temporary, the carrying value of the security is reduced to its estimated fair value, with a corresponding charge to earnings.

Defined Benefit Pension Plan. The plan obligations and related assets of the defined benefit pension plan (the “Plan”) are presented in “Note 14 – Employee Benefits” of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2007.  Plan assets, which consist primarily of marketable equity and debt instruments, are valued using market quotations.  Plan obligations and the annual pension expense are determined by independent actuaries and through the use of a number of assumptions.  Key assumptions in measuring the plan obligations include the discount rate, the rate of salary increases and the estimated future return on plan assets.  In determining the discount rate, we utilized a cash flow matching analysis to determine a range of appropriate discount rates for our defined benefit pension and restoration plans.  In developing the cash flow matching analysis, we constructed a portfolio of high quality non-callable bonds (rated AA- or better) to match as closely as possible the timing of future benefit payments of the Plan at December 31, 2007.  Based on this cash flow matching analysis, we were able to determine an appropriate discount rate.

Salary increase assumptions are based upon historical experience and our anticipated future actions.  The expected long-term rate of return assumption reflects the average return expected based on the investment strategies and asset allocation on the assets invested to provide for the Plan’s liabilities.  We considered broad equity and bond indices, long-term return projections, and actual long-term historical Plan performance when evaluating the expected long-term rate of return assumption.  At June 30, 2008, the weighted-average actuarial assumptions of the Plan were: a discount rate of 6.25%; a long-term rate of return on plan assets of 7.50%; and assumed salary increases of 4.50%.  Material changes in pension benefit costs may occur in the future due to changes in these assumptions.  Future annual amounts could be impacted by changes in the number of Plan participants, changes in the level of benefits provided, changes in the discount rates, changes in the expected long-term rate of return, changes in the level of contributions to the Plan and other factors.

Off-Balance-Sheet Arrangements, Commitments and Contingencies

Details of our off-balance-sheet arrangements, commitments and contingencies as of June 30, 2008 and 2007, are included in “Note 12 – Off-Balance-Sheet Arrangements, Commitments and Contingencies” in the accompanying Notes to Financial Statements included in this report.

Leverage Strategy

We utilize wholesale funding and securities to enhance our profitability and balance sheet composition by determining acceptable levels of credit, interest rate and liquidity risk consistent with prudent capital management.  The leverage strategy consists of borrowing a combination of long and short-term funds from the FHLB and, when determined appropriate, issuing brokered certificates of deposit (“CDs”). These funds are invested primarily in U. S. Agency mortgage-backed securities, and to a lesser extent, long-term municipal securities.  Although U. S. Agency mortgage-backed securities often carry lower yields than traditional mortgage loans and other types of loans we make, these securities generally increase the overall quality of our assets because of underlying insurance or guarantees, are more liquid than individual loans and may be used to collateralize our borrowings or other obligations.  While the strategy of investing a substantial portion of our assets in U. S. Agency mortgage-backed securities and to a lesser extent municipal securities has resulted in lower interest rate spreads and margins, we believe that the lower operating expenses and reduced credit risk combined with the managed interest rate risk of this strategy have enhanced our overall profitability over the last several years.  At this time, we utilize the leverage strategy with the goal of enhancing overall profitability by maximizing the use of our capital.

 
18

 


Risks associated with the asset structure we maintain include a lower net interest rate spread and margin when compared to our peers, changes in the slope of the yield curve, which can reduce our net interest rate spread and margin, increased interest rate risk, the length of interest rate cycles, and the unpredictable nature of mortgage-backed securities prepayments.  See “Part I - Item 1A.  Risk Factors – Risks Related to Our Business.” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 for a discussion of risks related to interest rates.  During the first half of 2007, the interest rate yield curve was relatively flat to only slightly positively sloped.  During the second half of 2007 and the first half of 2008, the Federal Reserve decreased the overnight federal funds rate by 325 basis points while at the same time short-term U. S. Treasury interest rates decreased more than long-term U. S. Treasury interest rates.  These changes during 2007 and the first half of 2008 resulted in a positively sloped U. S. Treasury yield curve at June 30, 2008.  Our asset structure, net interest spread and net interest margin require us to closely monitor our interest rate risk.  An additional risk is the change in market value of the AFS securities portfolio as a result of changes in interest rates.  Significant increases in interest rates, especially long-term interest rates, could adversely impact the market value of the AFS securities portfolio, which could also significantly impact our equity capital.  Due to the unpredictable nature of mortgage-backed securities prepayments, the length of interest rate cycles, and the slope of the interest rate yield curve, net interest income could fluctuate more than simulated under the scenarios modeled by our Asset/Liability Committee (“ALCO”) and described under “Item 3.  Quantitative and Qualitative Disclosures about Market Risk” in this report.

Determining the appropriate size of the balance sheet is one of the critical decisions any bank makes.  Our balance sheet is not merely the result of a series of micro-decisions, but rather the size is controlled based on the economics of assets compared to the economics of funding.  The management of our securities portfolio as a percentage of earning assets is guided by changes in our overall loan and deposit levels combined with changes in our wholesale funding levels.  If adequate quality loan growth is not available to achieve our goal of enhancing profitability by maximizing the use of capital, as described above, then we could purchase additional securities, if appropriate, which could cause securities as a percentage of earning assets to increase.  Should we determine that increasing the securities portfolio or replacing the current securities maturities and principal payments is not an efficient use of capital, we could decrease the level of securities through proceeds from maturities, principal payments on mortgage-backed securities or sales.  During the quarter ended June 30, 2008, credit and volatility spreads remained wide which, combined with the steeper yield curve, led to buying opportunities primarily in U. S. Agency mortgage-backed securities.  While we experienced modest loan growth during the first half of 2008, we took advantage of buying opportunities for securities which resulted in an increase in securities as a percentage of assets.  At June 30, 2008, the securities portfolio as a percentage of total assets increased to 50.2% from 47.8% at December 31, 2007 as the increase in investment securities exceeded the growth in loans during the first six months of 2008.  The current interest rate yield curve and spreads remain investment friendly and changes to the securities portfolio as a percentage of earning assets will be guided by the availability of attractive investment opportunities and funding options as well as changes in our loan and deposit levels during the third quarter of 2008.  During the six months ended June 30, 2008, we increased our investment and U. S. Agency mortgage-backed securities approximately $107.9 million as investment and U. S. Agency mortgage-backed securities increased from $1.028 billion at December 31, 2007 to $1.136 billion at June 30, 2008.  During the first six months of 2008, the Company restructured a portion of the securities portfolio by selling lower coupon fixed rate mortgage-backed securities and replacing them with higher coupon fixed rate mortgage-backed securities.  As a result, the coupon of the Company’s fixed rate mortgage-backed securities has increased approximately 30 basis points from December 31, 2007 to approximately 6.00% at June 30, 2008.  Our balance sheet management strategy is dynamic and requires ongoing management and will be reevaluated as market conditions warrant.  As interest rates, yield curves, mortgage-backed securities prepayments, funding costs, security spreads and loan and deposit portfolios change, our determination of the proper types and maturities of securities to own, proper amount of securities to own and funding needs and funding sources will continue to be reevaluated.

With respect to liabilities, we will continue to utilize a combination of FHLB advances and deposits to achieve our strategy of minimizing cost while achieving overall interest rate risk objectives as well as the liability management objectives of the ALCO.  The FHLB funding and the brokered CDs represent wholesale funding sources we currently have available to utilize.  Our FHLB borrowings at June 30, 2008 increased 30.8%, or $135.5 million, to $575.5 million from $440.0 million at December 31, 2007 primarily as a result of a $127.9 million decrease in brokered CDs and an increase in securities.  At December 31, 2007, our callable brokered CDs totaled $123.4 million and our other brokered CDs, all of which were acquired through Fort Worth National Bank, were $9.5 million, for total brokered CDs of $132.9 million.  Due to the significant decrease in interest rates, including brokered CD rates during the first six months of 2008, we called $123.4 million of the callable brokered CDs.  During the first six months, another $4.5 million of brokered CDs issued by Fort Worth National Bank matured.  As we integrate our funds management processes, the Banks will likely issue similar structures of brokered CDs when needed.  We utilized long-term brokered CDs because the brokered CDs better matched overall ALCO objectives at the time of issuance by protecting us with fixed rates should interest rates increase, while providing us options to call the funding should interest rates decrease.  Our wholesale funding policy currently allows maximum brokered CDs of $150 million; however, this amount could be increased to match changes in ALCO objectives.  The potential higher interest expense and lack of customer loyalty are risks associated with the use of brokered CDs.   We replaced the long-term callable brokered CDs with long-term FHLB advances.  For the six months ended June 30, 2008, the increase in FHLB borrowings was almost completely offset by the decrease in brokered CDs while overall deposits, net of brokered deposits, increased which resulted in a decrease in our total wholesale funding as a percentage of deposits, not including brokered CDs, from 41.0% at December 31, 2007, to 38.9% at June 30, 2008.
19


Net Interest Income

Net interest income is the difference between interest income earned on assets (loans and investments) and interest expense due on our funding sources (deposits and borrowings) during a particular period.

Net interest income for the six months ended June 30, 2008 was $33.3 million, an increase of $13.2 million, or 65.6%, when compared to the same period in 2007.  Average interest earning assets increased $338.8 million, or 19.6%, to $2.1 billion, the net interest spread increased from 1.68% for the six months ended June 30, 2007 to 2.80% for the same period in 2008, and the net interest margin increased from 2.52% for the six months ended June 30, 2007 to 3.44% for the same period in 2008.  Net interest income increased as a result of increases in our average earning assets, net interest spread and net interest margin during the six months of 2008 when compared to the same period in 2007.

Net interest income increased $7.8 million, or 77.9%, to $17.9 million for the three months ended June 30, 2008, when compared to $10.1 million for the same period in 2007.  This is a result of an increase in the average yield on our interest earning assets combined with a decrease in the average yield on the average interest bearing liabilities. The increase in the yield on interest earning assets is reflective of the purchase of $63.0 million of high yield auto loans by SFG, the addition of approximately $90.5 million of loans associated with the acquisition of Fort Worth National Bank, an 11 basis point increase in the yield on our securities portfolio and an increase in average interest earning assets of $392.1 million, or 23.2%.  The decrease in the average yield on interest bearing liabilities is a result of an overall decrease in interest rates and calling $123.4 million of high yield brokered deposits during 2008.  For the three months ended June 30, 2008, our net interest spread increased to 3.06% from 1.71% and our net interest margin increased to 3.65% from 2.57% when compared to the same period in 2007.  The net interest margin and net interest spread for the three months ended June 30, 2008, increased to 3.65% and 3.06%, respectively, from 3.22% and 2.55% for the three months ended March 31, 2008.

During the six months ended June 30, 2008, average loans increased $209.9 million, or 27.4%, to $977.1 million, compared to $767.2 million for the same period in 2007.  Approximately half of this increase is the result of the Fort Worth National Bank loans acquired on October 10, 2007.  Automobile loans purchased through SFG represent the next largest part of this increase.  The average yield on loans increased from 6.90% for the six months ended June 30, 2007 to 7.65% for the six months ended June 30, 2008.  The increase in interest income on loans of $10.8 million, or 42.8%, to $36.1 million for the six months ended June 30, 2008, when compared to $25.2 million for the same period in 2007, and the increase in interest income on loans of $5.0 million, or 39.5%, to $17.8 million for the three months ended June 30, 2008, when compared to $12.7 million for the same period in 2007 was the result of an increase in average loans and the average yield.  For the three months ended June 30, 2008, average loans increased $209.4 million, or 27.2%, to $978.1 million, compared to $768.7 million for the same period in 2007.  The average yield on loans increased from 6.91% for the three months ended June 30, 2007 to 7.54% for the three months ended June 30, 2008.  The increase in the yield on loans was due to the increase in credit spreads, the repricing characteristics of Southside Bank’s loan portfolio and the addition of higher yielding subprime automobile loan portfolios purchased during the second half of 2007 and first six months of 2008.  Due to the competitive loan pricing environment, we anticipate that we may be required to continue to offer lower interest rate loans that compete with those offered by other financial institutions in order to retain quality loan relationships.  Offering lower interest rate loans could impact the overall loan yield and, therefore, profitability.

Average investment and mortgage-backed securities increased $120.6 million, or 12.9%, to $1.1 billion, for the six months ended June 30, 2008, when compared to $933.4 million for the same period in 2007.  The increase was the result of securities purchased due to buying opportunities available during the last half of 2007 and the first six months and quarter ended June 30, 2008.  The overall yield on average investment and mortgage-backed securities increased to 5.32% during the six months ended June 30, 2008, from 5.18% during the same period in 2007.  Interest income on investment and mortgage-backed securities for the six months ended June 30, 2008 increased $3.5 million, or 14.8%, to $27.0 million compared to $23.6 million for the same period in 2007.  For the three months ended June 30, 2008, average investment and mortgage-backed securities increased $171.2 million, or 19.1%, to $1.1 billion, when compared to $895.4 million for the same period in 2007.  The overall yield on average investment and mortgage-backed securities increased to 5.26% during the three months ended June 30, 2008, from 5.15% during the same period in 2007.  Interest income from investment and mortgage-backed securities increased $2.3 million, or 20.3%, to $13.6 million for the three months ended June 30, 2008, compared to $11.3 million for the same period in 2007.  The increase in interest income for the three and six month periods ending June 30, 2008 was due to the increase in the average balance and the increase in the average yield.  The increase in the average yield primarily reflects purchases of higher-yielding securities combined with reinvestment of proceeds from lower-yielding matured securities into higher-yielding securities.  This was due primarily to increased credit and volatility spreads.  A return to lower long-term interest rate and prepayment levels similar to that experienced in May and June of 2003 could negatively impact our net interest margin in the future due to increased prepayments and repricing.
20


Average FHLB stock and other investments increased $5.2 million, or 24.2%, to $26.7 million, for the six months ended June 30, 2008 when compared to $21.5 million for the same period in 2007.  The average yield on FHLB stock and other investments decreased to 3.58% for the six months ended June 30, 2008, when compared to 6.56% for the same period in 2007 due to the lower average short-term interest rates.  Interest income from our FHLB stock and other investments decreased $224,000, or 32.0%, to $476,000 for the six months ended June 30, 2008, when compared to $700,000 for the same period in 2007 due to a decrease in the average yield.  For the three months ended June 30, 2008, average FHLB stock and other investments increased $10.7 million, or 60.2%, to $28.5 million, when compared to $17.8 million for the same period in 2007.  We are required as a member of FHLB to own a specific amount of stock that changes as the level of our FHLB advances change.  For the three months ended June 30, 2008, interest income from FHLB stock and other investments decreased $116,000, or 35.2%, to $214,000, when compared to $330,000 for the same period in 2007 as a result of the decrease in the average yield from 7.45% in 2007 to 3.02% in 2008.  

Average federal funds sold and other interest earning assets increased $3.9 million, or 143.1%, to $6.5 million, for the six months ended June 30, 2008, when compared to $2.7 million for the same period in 2007.  Interest income from federal funds sold and other interest earning assets increased $22,000, or 31.9%, for the six months ended June 30, 2008, when compared to the same period in 2007, as a result of the increase in the average balance, which more than offset the decrease in the average yield from 5.17% in 2007 to 2.80% in 2008.  Average federal funds sold and other interest earning assets increased $2.1 million, or 82.9%, to $4.6 million, for the three months ended June 30, 2008, when compared to $2.5 million for the same period in 2007.  Interest income from federal funds sold and other interest earning assets decreased $9,000, or 27.3%, for the three months ended June 30, 2008, when compared to the same period in 2007, as a result of the decrease in the average yield from 5.31% in 2007 to 2.12% in 2008.

Total interest expense increased $ 916,000, or 3.1%, to $30.4 million during the six months ended June 30, 2008 as compared to $29.5 million during the same period in 2007.    The increase in interest expense was attributable to an increase in the average balance which more than offset a decrease in the yield on interest bearing liabilities from 4.28% for the six months ended June 30, 2007 to 3.59% for the six months ended June 30, 2008.  Average interest bearing liabilities increased $315.3 million, or 22.7%, for the six months ended June 30, 2008 as compared to the same period in 2007.  For the three months ended June 30, 2008, total interest expense decreased $639,000, or 4.5%, to $13.7 million, compared to $14.3 million for the same period in 2007 as a result of a decrease in the average yield on interest bearing liabilities which more than offset the increase in average interest bearing liabilities.  Average interest bearing liabilities increased $361.2 million, or 26.9%, while the average yield decreased from 4.27% for the three months ended June 30, 2007 as compared to 3.23% for the three months ended June 30, 2008.

Av