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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
| [ X ] | Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
| For the fiscal year ended: | December 31, 2009 |
Or
| [ ] | 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: | 001-13221 |
CULLEN/FROST BANKERS, INC.
(Exact name of registrant as specified in its charter)
| Texas | 74-1751768 | |
| (State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) | |
| 100 W. Houston Street, San Antonio, Texas | 78205 | |
| (Address of principal executive offices) | (Zip code) | |
(210) 220-4011
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
| Common Stock, $.01 Par Value, | The New York Stock Exchange, Inc. | |
| (Title of each class) | (Name of each exchange on which registered) |
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ X ] No [ ]
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [ X ]
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 has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes [ X ] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
| Large accelerated filer [ X ] | Accelerated filer [ ] | |
| Non-accelerated filer [ ] (Do not check if a smaller reporting company) | Smaller reporting company [ ] |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.) Yes [ ] No [ X ]
As of June 30, 2009, the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the shares of common stock held by non-affiliates, based upon the closing price per share of the registrant’s common stock as reported on The New York Stock Exchange, Inc., was approximately $2.6 billion.
As of January 26, 2010, there were 60,051,274 shares of the registrant’s common stock, $.01 par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the 2010 Annual Meeting of Shareholders of Cullen/Frost Bankers, Inc. to be held on April 29, 2010 are incorporated by reference in this Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.
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ANNUAL REPORT ON FORM 10-K
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| Page | ||||
| Item 1. |
3 | |||
| Item 1A. |
20 | |||
| Item 1B. |
29 | |||
| Item 2. |
29 | |||
| Item 3. |
29 | |||
| Item 4. |
29 | |||
| Item 5. |
30 | |||
| Item 6. |
33 | |||
| Item 7. |
Management’s Discussion and Analysis of Financial Condition and Results of Operations |
36 | ||
| Item 7A. |
76 | |||
| Item 8. |
78 | |||
| Item 9. |
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure |
130 | ||
| Item 9A. |
130 | |||
| Item 9B. |
131 | |||
| Item 10. |
132 | |||
| Item 11. |
132 | |||
| Item 12. |
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |
132 | ||
| Item 13. |
Certain Relationships and Related Transactions, and Director Independence |
132 | ||
| Item 14. |
132 | |||
| Item 15. |
133 | |||
| 135 | ||||
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| ITEM 1. | BUSINESS |
The disclosures set forth in this item are qualified by Item 1A. Risk Factors and the section captioned “Forward-Looking Statements and Factors that Could Affect Future Results” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of this report and other cautionary statements set forth elsewhere in this report.
The Corporation
Cullen/Frost Bankers, Inc. (“Cullen/Frost”), a Texas business corporation incorporated in 1977, is a financial holding company and a bank holding company headquartered in San Antonio, Texas that provides, through its subsidiaries (collectively referred to as the “Corporation”), a broad array of products and services throughout numerous Texas markets. The Corporation offers commercial and consumer banking services, as well as trust and investment management, mutual funds, Section 1031 property exchange services, investment banking, insurance, brokerage, leasing, asset-based lending, treasury management and item processing services. At December 31, 2009, Cullen/Frost had consolidated total assets of $16.3 billion and was one of the largest independent bank holding companies headquartered in the State of Texas.
The Corporation’s philosophy is to grow and prosper, building long-term relationships based on top quality service, high ethical standards, and safe, sound assets. The Corporation operates as a locally oriented, community-based financial services organization, augmented by experienced, centralized support in select critical areas. The Corporation’s local market orientation is reflected in its regional management and regional advisory boards, which are comprised of local business persons, professionals and other community representatives, that assist the Corporation’s regional management in responding to local banking needs. Despite this local market, community-based focus, the Corporation offers many of the products available at much larger money-center financial institutions.
The Corporation serves a wide variety of industries including, among others, energy, manufacturing, services, construction, retail, telecommunications, healthcare, military and transportation. The Corporation’s customer base is similarly diverse. The Corporation is not dependent upon any single industry or customer.
The Corporation’s operating objectives include expansion, diversification within its markets, growth of its fee-based income, and growth internally and through acquisitions of financial institutions, branches and financial services businesses. The Corporation generally seeks merger or acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale and expanded services. The Corporation regularly evaluates merger and acquisition opportunities and conducts due diligence activities related to possible transactions with other financial institutions and financial services companies. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of the Corporation’s tangible book value and net income per common share may occur in connection with any future transaction. The Corporation acquired insurance agencies in both the Dallas and San Marcos market areas during 2009, an insurance agency in the Dallas market area in 2008 and an insurance agency in the Austin market area in 2007. None of these acquisitions had a significant impact on the Corporation’s financial statements during their respective reporting periods.
Although Cullen/Frost is a corporate entity, legally separate and distinct from its affiliates, bank holding companies such as Cullen/Frost are generally required to act as a source of financial strength for their subsidiary banks. The principal source of Cullen/Frost’s income is dividends from its subsidiaries. There are certain regulatory restrictions on the extent to which these subsidiaries can pay dividends or otherwise supply funds to Cullen/Frost. See the section captioned “Supervision and Regulation” for further discussion of these matters.
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Cullen/Frost’s executive offices are located at 100 W. Houston Street, San Antonio, Texas 78205, and its telephone number is (210) 220-4011.
Subsidiaries of Cullen/Frost
The New Galveston Company
Incorporated under the laws of Delaware, The New Galveston Company is a wholly owned second-tier financial holding company and bank holding company, which directly owns all of Cullen/Frost’s banking and non-banking subsidiaries with the exception of Cullen/Frost Capital Trust II and Summit Bancshares Statutory Trust I.
Cullen/Frost Capital Trust II and Summit Bancshares Statutory Trust I
Cullen/Frost Capital Trust II (“Trust II”) is a Delaware statutory business trust formed in 2004 for the purpose of issuing $120.0 million in trust preferred securities and lending the proceeds to Cullen/Frost. Summit Bancshares Statutory Trust I (“Summit Trust”) is a Delaware statutory trust formed in 2004 for the purpose of issuing $12.0 million in trust preferred securities. Summit Trust was acquired by Cullen/Frost through the acquisition of Summit Bancshares, Inc. in 2006. Cullen/Frost guarantees, on a limited basis, payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities.
Trust II and Summit Trust (collectively referred to as the “Capital Trusts”) are variable interest entities for which the Corporation is not the primary beneficiary. As such, the accounts of the Capital Trusts are not included in the Corporation’s consolidated financial statements. See the Corporation’s accounting policy related to consolidation in Note 1 - Summary of Significant Accounting Policies in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.
Although the accounts of the Capital Trusts are not included in the Corporation’s consolidated financial statements, the $132.0 million in trust preferred securities issued by these subsidiary trusts are included in the Tier 1 capital of Cullen/Frost for regulatory capital purposes. The aggregate amount of restricted core capital elements (which includes trust preferred securities, among other things) that may be included in the Tier 1 capital of most bank holding companies, including Cullen/Frost’s, is limited to 25% of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. Amounts of restricted core capital elements in excess of these limits generally may be included in Tier 2 capital. The quantitative limits do not currently preclude the Corporation from including the $132.0 million in trust preferred securities in Tier 1 capital.
The Frost National Bank
The Frost National Bank (“Frost Bank”) is primarily engaged in the business of commercial and consumer banking through more than 110 financial centers across Texas in the Austin, Corpus Christi, Dallas, Fort Worth, Houston, Rio Grande Valley and San Antonio regions. Frost Bank was chartered as a national banking association in 1899, but its origin can be traced to a mercantile partnership organized in 1868. At December 31, 2009, Frost Bank had consolidated total assets of $16.3 billion and total deposits of $13.3 billion and was one of the largest commercial banks headquartered in the State of Texas.
Significant services offered by Frost Bank include:
| ¨ | Commercial Banking. Frost Bank provides commercial banking services to corporations and other business clients. Loans are made for a wide variety of general corporate purposes, including financing for industrial and commercial properties and to a lesser extent, financing for interim construction |
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| related to industrial and commercial properties, financing for equipment, inventories and accounts receivable, and acquisition financing, as well as commercial leasing and treasury management services. |
| ¨ | Consumer Services. Frost Bank provides a full range of consumer banking services, including checking accounts, savings programs, automated teller machines, overdraft facilities, installment and real estate loans, home equity loans and lines of credit, drive-in and night deposit services, safe deposit facilities, and brokerage services. |
| ¨ | International Banking. Frost Bank provides international banking services to customers residing in or dealing with businesses located in Mexico. These services consist of accepting deposits (generally only in U.S. dollars), making loans (in U.S. dollars only), issuing letters of credit, handling foreign collections, transmitting funds, and to a limited extent, dealing in foreign exchange. |
| ¨ | Correspondent Banking. Frost Bank acts as correspondent for approximately 319 financial institutions, which are primarily banks in Texas. These banks maintain deposits with Frost Bank, which offers them a full range of services including check clearing, transfer of funds, fixed income security services, and securities custody and clearance services. |
| ¨ | Trust Services. Frost Bank provides a wide range of trust, investment, agency and custodial services for individual and corporate clients. These services include the administration of estates and personal trusts, as well as the management of investment accounts for individuals, employee benefit plans and charitable foundations. At December 31, 2009, the estimated fair value of trust assets was $22.7 billion, including managed assets of $10.4 billion and custody assets of $12.3 billion. |
| ¨ | Capital Markets - Fixed-Income Services. Frost Bank’s Capital Markets Division was formed to meet the transaction needs of fixed-income institutional investors. Services include sales and trading, new issue underwriting, money market trading, and securities safekeeping and clearance. |
Frost Insurance Agency, Inc.
Frost Insurance Agency, Inc. is a wholly owned subsidiary of Frost Bank that provides insurance brokerage services to individuals and businesses covering corporate and personal property and casualty insurance products, as well as group health and life insurance products.
Frost Brokerage Services, Inc.
Frost Brokerage Services, Inc. (“FBS”) is a wholly owned subsidiary of Frost Bank that provides brokerage services and performs other transactions or operations related to the sale and purchase of securities of all types. FBS is registered as a fully disclosed introducing broker-dealer under the Securities Exchange Act of 1934 and, as such, does not hold any customer accounts.
Frost Premium Finance Corporation
Frost Premium Finance Corporation is a wholly owned subsidiary of Frost Bank that makes loans to qualified borrowers for the purpose of financing their purchase of property and casualty insurance.
Frost Investment Advisors, LLC
Frost Investment Advisors is a registered investment advisor entity and a wholly owned subsidiary of Frost Bank that provides investors access to various Frost-managed mutual funds.
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Frost 1031 Exchange, LLC
Frost 1031 Exchange is a wholly owned subsidiary of Frost Bank that assists customers in structuring the exchange of property such that the transactions result in a tax-deferred exchange in compliance with Section 1031 of the Internal Revenue Code.
Frost Securities, Inc.
Frost Securities, Inc. is a wholly owned subsidiary that provides advisory and private equity services to middle market companies in Texas.
Main Plaza Corporation
Main Plaza Corporation is a wholly owned non-banking subsidiary that occasionally makes loans to qualified borrowers. Loans are funded with current cash or borrowings against internal credit lines.
Other Subsidiaries
Cullen/Frost has various other subsidiaries that are not significant to the consolidated entity.
Operating Segments
Cullen/Frost’s operations are managed along two reportable operating segments consisting of Banking and the Financial Management Group. See the sections captioned “Results of Segment Operations” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 18 -Operating Segments in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which are located elsewhere in this report.
Competition
There is significant competition among commercial banks in the Corporation’s market areas. In addition, the Corporation also competes with other providers of financial services, such as savings and loan associations, credit unions, consumer finance companies, securities firms, insurance companies, insurance agencies, commercial finance and leasing companies, full service brokerage firms and discount brokerage firms. Some of the Corporation’s competitors have greater resources and, as such, may have higher lending limits and may offer other services that are not provided by the Corporation. The Corporation generally competes on the basis of customer service and responsiveness to customer needs, available loan and deposit products, the rates of interest charged on loans, the rates of interest paid for funds, and the availability and pricing of trust, brokerage and insurance services.
Supervision and Regulation
Cullen/Frost, Frost Bank and many of its non-banking subsidiaries are subject to extensive regulation under federal and state laws. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of security holders.
Set forth below is a description of the significant elements of the laws and regulations applicable to Cullen/Frost and its subsidiaries. The description is qualified in its entirety by reference to the full text of the statutes, regulations and policies that are described. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to Cullen/Frost and its subsidiaries could have a material effect on the business of the Corporation.
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Regulatory Agencies
Cullen/Frost is a legal entity separate and distinct from Frost Bank and its other subsidiaries. As a financial holding company and a bank holding company, Cullen/Frost is regulated under the Bank Holding Company Act of 1956, as amended (“BHC Act”), and its subsidiaries are subject to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”). The BHC Act provides generally for “umbrella” regulation of financial holding companies such as Cullen/Frost by the Federal Reserve Board, and for functional regulation of banking activities by bank regulators, securities activities by securities regulators, and insurance activities by insurance regulators. Cullen/Frost is also under the jurisdiction of the Securities and Exchange Commission (“SEC”) and is subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the SEC. Cullen/Frost is listed on the New York Stock Exchange (“NYSE”) under the trading symbol “CFR,” and is subject to the rules of the NYSE for listed companies.
Frost Bank is organized as a national banking association under the National Bank Act. It is subject to regulation and examination by the Office of the Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation (“FDIC”).
Many of the Corporation’s non-bank subsidiaries also are subject to regulation by the Federal Reserve Board and other federal and state agencies. Frost Securities, Inc. and Frost Brokerage Services, Inc. are regulated by the SEC, the Financial Industry Regulatory Authority (“FINRA”) and state securities regulators. Frost Investment Advisors, LLC is subject to the disclosure and regulatory requirements of the Investment Advisors Act of 1940, as administered by the SEC. The Corporation’s insurance subsidiaries are subject to regulation by applicable state insurance regulatory agencies. Other non-bank subsidiaries are subject to both federal and state laws and regulations.
Bank Holding Company Activities
In general, the BHC Act limits the business of bank holding companies to banking, managing or controlling banks and other activities that the Federal Reserve Board has determined to be so closely related to banking as to be a proper incident thereto. Under the BHC Act, bank holding companies that qualify and elect to be financial holding companies may engage in any activity, or acquire and retain the shares of a company engaged in any activity, that is either (i) financial in nature or incidental to such financial activity (as determined by the Federal Reserve Board in consultation with the OCC) or (ii) complementary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally (as solely determined by the Federal Reserve Board). Activities that are financial in nature include securities underwriting and dealing, insurance underwriting and making merchant banking investments.
If a bank holding company seeks to engage in the broader range of activities that are permitted under the BHC Act for financial holding companies, (i) all of its depository institution subsidiaries must be “well capitalized” and “well managed” and (ii) it must file a declaration with the Federal Reserve Board that it elects to be a “financial holding company.” A depository institution subsidiary is considered to be “well capitalized” if it satisfies the requirements for this status discussed in the section captioned “Capital Adequacy and Prompt Corrective Action,” included elsewhere in this item. A depository institution subsidiary is considered “well managed” if it received a composite rating and management rating of at least “satisfactory” in its most recent examination. If any depository institution controlled by a financial holding company ceases to meet certain capital or management standards, the Federal Reserve Board may impose corrective capital and/or managerial requirements on the financial holding company and place limitations on its ability to conduct the broader financial activities permissible for financial holding companies. In addition, the Federal Reserve Board may require divestiture of the holding company’s depository institutions if the deficiencies persist.
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In order for a financial holding company to commence any new activity permitted by the BHC Act or to acquire a company engaged in any new activity permitted by the BHC Act, each insured depository institution subsidiary of the financial holding company must have received a rating of at least “satisfactory” in its most recent examination under the Community Reinvestment Act. See the section captioned “Community Reinvestment Act” included elsewhere in this item.
The BHC Act generally limits acquisitions by bank holding companies that are not qualified as financial holding companies to commercial banks and companies engaged in activities that the Federal Reserve Board has determined to be so closely related to banking as to be a proper incident thereto. Financial holding companies like Cullen/Frost are also permitted to acquire companies engaged in activities that are financial in nature and in activities that are incidental and complementary to financial activities without prior Federal Reserve Board approval. The Federal Reserve Board has the power to order any bank holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when the Federal Reserve Board has reasonable grounds to believe that continuation of such activity or such ownership or control constitutes a serious risk to the financial soundness, safety or stability of any bank subsidiary of the bank holding company.
The BHC Act, the Bank Merger Act, the Texas Banking Code and other federal and state statutes regulate acquisitions of commercial banks. The BHC Act requires the prior approval of the Federal Reserve Board for the direct or indirect acquisition of more than 5.0% of the voting shares of a commercial bank or its parent holding company. Under the Bank Merger Act, the prior approval of the OCC is required for a national bank to merge with another bank or purchase the assets or assume the deposits of another bank. In reviewing applications seeking approval of merger and acquisition transactions, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, the applicant’s performance record under the Community Reinvestment Act (see the section captioned “Community Reinvestment Act” included elsewhere in this item) and fair housing laws and the effectiveness of the subject organizations in combating money laundering activities.
Dividends
The principal source of Cullen/Frost’s cash revenues is dividends from Frost Bank. The prior approval of the OCC is required if the total of all dividends declared by a national bank in any calendar year would exceed the sum of the bank’s net profits for that year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits national banks from paying dividends that would be greater than the bank’s undivided profits after deducting statutory bad debt in excess of the bank’s allowance for loan losses. Under the foregoing dividend restrictions, Frost Bank could pay aggregate dividends of approximately $284.6 million to Cullen/Frost, without obtaining affirmative governmental approvals, at December 31, 2009. This amount is not necessarily indicative of amounts that may be paid or available to be paid in future periods.
In addition, Cullen/Frost and Frost Bank are subject to other regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a bank holding company or a bank that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The appropriate federal regulatory authorities have indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice and that banking organizations should generally pay dividends only out of current operating earnings. In addition, in the current financial and economic environment, the Federal Reserve Board has indicated that bank holding companies should carefully review their dividend policy and has discouraged payment ratios that are at maximum allowable levels unless both asset quality and capital are very strong.
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Transactions with Affiliates
There are various restrictions on the ability of Cullen/Frost and its non-bank subsidiaries to borrow from, and engage in certain other transactions with, Frost Bank. In general, Sections 23A and 23B of the Federal Reserve Act and the Federal Reserve Board’s Regulation W require that any “covered transaction” by Frost Bank (or its subsidiaries) with an affiliate must be secured by designated amounts of specified collateral and must be limited, as to any one of Cullen/Frost or its non-bank subsidiaries, to 10% of Frost Bank’s capital stock and surplus, and, as to Cullen/Frost and all such non-bank subsidiaries in the aggregate, to 20% of Frost Bank’s capital stock and surplus. “Covered transactions” are defined by statute to include a loan or extension of credit, as well as a purchase of securities issued by an affiliate, a purchase of assets (unless otherwise exempted by the Federal Reserve Board) from the affiliate, the acceptance of securities issued by the affiliate as collateral for a loan, and the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.
In addition, extensions of credit and other transactions between Frost Bank and Cullen/Frost or one of its non-bank subsidiaries must be on terms and conditions, including credit standards, that are substantially the same or at least as favorable to Frost Bank as those prevailing at the time for comparable transactions involving other non-affiliated companies or, in the absence of comparable transactions, on terms and conditions, including credit standards, that in good faith would be offered to, or would apply to, non-affiliated companies.
Source of Strength Doctrine
Federal Reserve Board policy requires bank holding companies to act as a source of financial and managerial strength to their subsidiary banks. Under this policy, Cullen/Frost is expected to commit resources to support Frost Bank, including at times when Cullen/Frost may not be in a financial position to provide such resources. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. The BHC Act provides that, in the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.
In addition, under the National Bank Act, if the capital stock of Frost Bank is impaired by losses or otherwise, the OCC is authorized to require payment of the deficiency by assessment upon Cullen/Frost. If the assessment is not paid within three months, the OCC could order a sale of the Frost Bank stock held by Cullen/Frost to make good the deficiency.
Capital Adequacy
Banks and bank holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.
The Federal Reserve Board, the OCC and the FDIC have substantially similar risk-based capital ratio and leverage ratio guidelines for banking organizations. The guidelines are intended to ensure that banking organizations have adequate capital given the risk levels of assets and off-balance sheet financial instruments. Under the guidelines, banking organizations are required to maintain minimum ratios for Tier 1 capital and total capital to risk-weighted assets (including certain off-balance sheet items, such as letters of credit). For purposes of calculating the ratios, a banking organization’s assets and some of its specified off-balance sheet commitments and obligations are assigned to various risk categories. A depository institution’s or holding company’s capital, in turn, is classified in one of three tiers, depending on type:
| ¨ | Core Capital (Tier 1). Tier 1 capital includes common equity, retained earnings, qualifying non-cumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual stock at |
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| the holding company level, minority interests in equity accounts of consolidated subsidiaries, and qualifying trust preferred securities, less goodwill, most intangible assets and certain other assets. |
| ¨ | Supplementary Capital (Tier 2). Tier 2 capital includes, among other things, perpetual preferred stock and trust preferred securities not meeting the Tier 1 definition, qualifying mandatory convertible debt securities, qualifying subordinated debt, and allowances for possible loan and lease losses, subject to limitations. |
| ¨ | Market Risk Capital (Tier 3). Tier 3 capital includes qualifying unsecured subordinated debt. |
Cullen/Frost, like other bank holding companies, currently is required to maintain Tier 1 capital and “total capital” (the sum of Tier 1 and Tier 2 capital) equal to at least 4.0% and 8.0%, respectively, of its total risk-weighted assets (including various off-balance-sheet items, such as letters of credit). Frost Bank, like other depository institutions, is required to maintain similar capital levels under capital adequacy guidelines. In addition, for a depository institution to be considered “well capitalized” under the regulatory framework for prompt corrective action, its Tier 1 and total capital ratios must be at least 6.0% and 10.0% on a risk-adjusted basis, respectively.
Bank holding companies and banks subject to the market risk capital guidelines are required to incorporate market and interest rate risk components into their risk-based capital standards. Under the market risk capital guidelines, capital is allocated to support the amount of market risk related to a financial institution’s ongoing trading activities.
Bank holding companies and banks are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its total adjusted quarterly average assets (as defined for regulatory purposes). The requirements necessitate a minimum leverage ratio of 3.0% for bank holding companies and national banks that either have the highest supervisory rating or have implemented the appropriate federal regulatory authority’s risk-adjusted measure for market risk. All other bank holding companies and national banks are required to maintain a minimum leverage ratio of 4.0%, unless a different minimum is specified by an appropriate regulatory authority. In addition, for a depository institution to be considered “well capitalized” under the regulatory framework for prompt corrective action, its leverage ratio must be at least 5.0%. The Federal Reserve Board has not advised Cullen/Frost, and the OCC has not advised Frost Bank, of any specific minimum leverage ratio applicable to it.
The federal regulatory authorities’ risk-based capital guidelines are based upon the 1988 capital accord (“Basel I”) of the Basel Committee on Banking Supervision (the “Basel Committee”). The Basel Committee is a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies they apply. In 2004, the Basel Committee published a new capital accord (“Basel II”) to replace Basel I. Basel II provides two approaches for setting capital standards for credit risk – an internal ratings-based approach tailored to individual institutions’ circumstances and a standardized approach that bases risk weightings on external credit assessments to a much greater extent than permitted in existing risk-based capital guidelines. Basel II also would set capital requirements for operational risk and refine the existing capital requirements for market risk exposures.
The U.S. banking and thrift agencies are developing proposed revisions to their existing capital adequacy regulations and standards based on Basel II. A definitive final rule for implementing the advanced approaches of Basel II in the United States, which applies only to certain large or internationally active banking organizations, or “core banks” – defined as those with consolidated total assets of $250 billion or more or consolidated on-balance sheet foreign exposures of $10 billion or more, became effective as of April 1, 2008. Other U.S. banking organizations may elect to adopt the requirements of this rule (if they meet applicable qualification requirements), but they are not required to apply them. The rule also allows a banking organization’s primary
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federal supervisor to determine that the application of the rule would not be appropriate in light of the bank’s asset size, level of complexity, risk profile, or scope of operations. The Corporation is not required to comply with the advanced approaches of Basel II.
In July 2008, the agencies issued a proposed rule that would give banking organizations that do not use the advanced approaches the option to implement a new risk-based capital framework. This framework would adopt the standardized approach of Basel II for credit risk, the basic indicator approach of Basel II for operational risk, and related disclosure requirements. While this proposed rule generally parallels the relevant approaches under Basel II, it diverges where United States markets have unique characteristics and risk profiles, most notably with respect to risk weighting residential mortgage exposures. Comments on the proposed rule were due to the agencies by October 27, 2008, but a definitive final rule has not been issued. The proposed rule, if adopted, would replace the agencies’ earlier proposed amendments to existing risk-based capital guidelines to make them more risk sensitive (formerly referred to as the “Basel I-A” approach).
On September 3, 2009, the United States Treasury Department issued a policy statement (the “Treasury Policy Statement”) entitled “Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms.” The Treasury Policy Statement was developed in consultation with the U.S. bank regulatory agencies and contemplates changes to the existing regulatory capital regime that would involve substantial revisions to, if not replacement of, major parts of the Basel I and Basel II capital frameworks and affect all regulated banking organizations and other systemically important institutions. The Treasury Policy Statement calls for, among other things, higher and stronger capital requirements for all banking firms. The Treasury Policy Statement suggested that changes to the regulatory capital framework be phased in over a period of several years. The recommended schedule provides for a comprehensive international agreement by December 31, 2010, with the implementation of reforms by December 31, 2012, although it does remain possible that U.S. bank regulatory agencies could officially adopt, or informally implement, new capital standards at an earlier date.
On December 17, 2009, the Basel Committee issued a set of proposals (the “Capital Proposals”) that would significantly revise the definitions of Tier 1 capital and Tier 2 capital, with the most significant changes being to Tier 1 capital. Most notably, the Capital Proposals would disqualify certain structured capital instruments, such as trust preferred securities, from Tier 1 capital status. The Capital Proposals would also re-emphasize that common equity is the predominant component of Tier 1 capital by adding a minimum common equity to risk-weighted assets ratio and requiring that goodwill, general intangibles and certain other items that currently must be deducted from Tier 1 capital instead be deducted from common equity as a component of Tier 1 capital. The Capital Proposals also leave open the possibility that the Basel Committee will recommend changes to the minimum Tier 1 capital and total capital ratios of 4.0% and 8.0%, respectively.
Concurrently with the release of the Capital Proposals, the Basel Committee also released a set of proposals related to liquidity risk exposure (the “Liquidity Proposals,” and together with the Capital Proposals, the “2009 Basel Committee Proposals”). The Liquidity Proposals have three key elements, including the implementation of (i) a “liquidity coverage ratio” designed to ensure that a bank maintains an adequate level of unencumbered, high-quality assets sufficient to meet the bank’s liquidity needs over a 30-day time horizon under an acute liquidity stress scenario, (ii) a “net stable funding ratio” designed to promote more medium and long-term funding of the assets and activities of banks over a one-year time horizon, and (iii) a set of monitoring tools that the Basel Committee indicates should be considered as the minimum types of information that banks should report to supervisors and that supervisors should use in monitoring the liquidity risk profiles of supervised entities.
Comments on the 2009 Basel Committee Proposals are due by April 16, 2010, with the expectation that the Basel Committee will release a comprehensive set of proposals by December 31, 2010 and that final provisions will be implemented by December 31, 2012. The U.S. bank regulators have urged comment on the 2009 Basel Committee Proposals. Ultimate implementation of such proposals in the U.S. will be subject to the discretion of the U.S. bank regulators and the regulations or guidelines adopted by such agencies may, of course, differ from the 2009 Basel Committee Proposals and other proposals that the Basel Committee may promulgate in the future.
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Prompt Corrective Action
The Federal Deposit Insurance Act, as amended (“FDIA”), requires among other things, the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. The FDIA sets forth the following five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established by regulation. The relevant capital measures are the total capital ratio, the Tier 1 capital ratio and the leverage ratio.
Under the regulations adopted by the federal regulatory authorities, a bank will be: (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater and is not “well capitalized”; (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 4.0%; (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%; and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.
The FDIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The bank holding company must also provide appropriate assurances of performance. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”
“Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.
The appropriate federal banking agency may, under certain circumstances, reclassify a well capitalized insured depository institution as adequately capitalized. The FDIA provides that an institution may be reclassified if the appropriate federal banking agency determines (after notice and opportunity for hearing) that the institution is in an unsafe or unsound condition or deems the institution to be engaging in an unsafe or unsound practice.
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The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution.
Cullen/Frost believes that, as of December 31, 2009, its bank subsidiary, Frost Bank, was “well capitalized” based on the aforementioned ratios. For further information regarding the capital ratios and leverage ratio of Cullen/Frost and Frost Bank see the discussion under the section captioned “Capital and Liquidity” included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 11 -Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, elsewhere in this report.
Deposit Insurance
Substantially all of the deposits of Frost Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating (“CAMELS rating”). The risk matrix utilizes four risk categories which are distinguished by capital levels and supervisory ratings.
In December 2008, the FDIC issued a final rule that raised the then current assessment rates uniformly by 7 basis points for the first quarter of 2009 assessment, which resulted in annualized assessment rates for institutions in the highest risk category (“Risk Category 1 institutions”) ranging from 12 to 14 basis points (basis points representing cents per $100 of assessable deposits). In February 2009, the FDIC issued final rules to amend the DIF restoration plan, change the risk-based assessment system and set assessment rates for Risk Category 1 institutions beginning in the second quarter of 2009. For Risk Category 1 institutions that have long-term debt issuer ratings, the FDIC determines the initial base assessment rate using a combination of weighted-average CAMELS component ratings, long-term debt issuer ratings (converted to numbers and averaged) and the financial ratios method assessment rate (as defined), each equally weighted. The initial base assessment rates for Risk Category 1 institutions range from 12 to 16 basis points, on an annualized basis. After the effect of potential base-rate adjustments, total base assessment rates range from 7 to 24 basis points. The potential adjustments to a Risk Category 1 institution’s initial base assessment rate, include (i) a potential decrease of up to 5 basis points for long-term unsecured debt, including senior and subordinated debt and (ii) a potential increase of up to 8 basis points for secured liabilities in excess of 25% of domestic deposits.
In May 2009, the FDIC issued a final rule which levied a special assessment applicable to all insured depository institutions totaling 5 basis points of each institution’s total assets less Tier 1 capital as of June 30, 2009, not to exceed 10 basis points of domestic deposits. The special assessment was part of the FDIC’s efforts to rebuild the DIF. Deposit insurance expense during 2009 included $7.3 million recognized in the second quarter related to the special assessment.
In November 2009, the FDIC issued a rule that required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC also adopted a uniform three-basis point increase in assessment rates effective on January 1, 2011. In December 2009, the Corporation paid $64.5 million in prepaid risk-based assessments, which included $4.0 million related to the fourth quarter of 2009 that would have otherwise been payable in the first quarter of 2010. This amount is included in deposit insurance expense for 2009. The remaining $60.5 million in pre-paid deposit insurance is included in accrued interest receivable and other assets in the accompanying consolidated balance sheet as of December 31, 2009.
FDIC insurance expense totaled $25.8 million, $4.6 million and $1.2 million in 2009, 2008 and 2007. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments
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related to outstanding FICO bonds. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation. Under the Federal Deposit Insurance Reform Act of 2005, which became law in 2006, Frost Bank received a one-time assessment credit of $8.2 million to be applied against future deposit insurance assessments, subject to certain limitations. This credit was utilized to offset $4.2 million of deposit insurance assessments during 2007 and $4.0 million of assessments during 2008.
Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.
Safety and Soundness Standards
The FDIA requires the federal bank regulatory agencies to prescribe standards, by regulations or guidelines, relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate. Guidelines adopted by the federal bank regulatory agencies establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder. In addition, the agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of FDIA. See “Prompt Corrective Action” above. If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.
Temporary Liquidity Guarantee Program
In November 2008, the Board of Directors of the FDIC adopted a final rule relating to the Temporary Liquidity Guarantee Program (“TLG Program”). The TLG Program was announced by the FDIC in October 2008, preceded by the determination of systemic risk by the Secretary of the Department of Treasury (after consultation with the President), as an initiative to counter the system-wide crisis in the nation’s financial sector. Under the TLG Program, the FDIC will (i) guarantee, through the earlier of maturity or December 31, 2012 (extended from June 30, 2012 by subsequent amendment), certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008, and before October 31, 2009 (extended from June 30, 2009 by subsequent amendment) and (ii) provide full FDIC deposit insurance coverage for non-interest bearing transaction deposit accounts, Negotiable Order of Withdrawal (“NOW”) accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts accounts held at participating FDIC insured institutions through June 30, 2010 (extended from December 31, 2009, subject to an opt-out provision, by subsequent amendment). The Corporation elected to participate in both guarantee programs and did not opt out of the six-month extension of the transaction account guarantee program. Coverage under the TLG Program was available for the first 30 days without charge. The fee assessment for coverage of senior unsecured debt ranged from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt. The fee assessment for deposit insurance coverage was 10 basis points per quarter during 2009 on amounts in covered accounts exceeding $250,000. During the six-month extension period in 2010, the fee assessment increases to 15 basis points per quarter for institutions that are in Risk Category 1 of the risk-based premium system.
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Depositor Preference
The FDIA provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as subrogee of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including depositors whose deposits are payable only outside of the United States and the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution.
Liability of Commonly Controlled Institutions
FDIC-insured depository institutions can be held liable for any loss incurred, or reasonably expected to be incurred, by the FDIC due to the default of another FDIC-insured depository institution controlled by the same bank holding company, or for any assistance provided by the FDIC to another FDIC-insured depository institution controlled by the same bank holding company that is in danger of default. “Default” means generally the appointment of a conservator or receiver. “In danger of default” means generally the existence of certain conditions indicating that default is likely to occur in the absence of regulatory assistance. Such a “cross-guarantee” claim against a depository institution is generally superior in right of payment to claims of the holding company and its affiliates against that depository institution. At this time, Frost Bank is the only insured depository institution controlled by Cullen/Frost for this purpose. However, if Cullen/Frost were to control other FDIC-insured depository institutions in the future, the cross-guarantee would apply to all such FDIC-insured depository institutions.
Community Reinvestment Act
The Community Reinvestment Act of 1977 (“CRA”) requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities. Depository institutions are periodically examined for compliance with the CRA and are assigned ratings. In order for a financial holding company to commence any new activity permitted by the BHC Act, or to acquire any company engaged in any new activity permitted by the BHC Act, each insured depository institution subsidiary of the financial holding company must have received a rating of at least “satisfactory” in its most recent examination under the CRA. Furthermore, banking regulators take into account CRA ratings when considering approval of a proposed transaction. Frost Bank received a rating of “satisfactory” in its most recent CRA examination.
Financial Privacy
The federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. These regulations affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.
Anti-Money Laundering and the USA Patriot Act
A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the “USA Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The United States Treasury Department has issued and, in some cases, proposed
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a number of regulations that apply various requirements of the USA Patriot Act to financial institutions such as Cullen/Frost’s bank and broker-dealer subsidiaries. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. Certain of those regulations impose specific due diligence requirements on financial institutions that maintain correspondent or private banking relationships with non-U.S. financial institutions or persons. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution.
Office of Foreign Assets Control Regulation
The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. These are typically known as the “OFAC” rules based on their administration by the U.S. Treasury Department Office of Foreign Assets Control (“OFAC”). The OFAC-administered sanctions targeting countries take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions against direct or indirect imports from and exports to a sanctioned country and prohibitions on “U.S. persons” engaging in financial transactions relating to making investments in, or providing investment-related advice or assistance to, a sanctioned country; and (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure to comply with these sanctions could have serious legal and reputational consequences.
Regulatory Reform
In June 2009, the U.S. President’s administration proposed a wide range of regulatory reforms that, if enacted, may have significant effects on the financial services industry in the United States. Significant aspects of the administration’s proposals that may affect the Corporation included, among other things, proposals: (i) to reassess and increase capital requirements for banks and bank holding companies and examine the types of instruments that qualify as regulatory capital; (ii) to combine the OCC and the Office of Thrift Supervision into a National Bank Supervisor with a unified federal bank charter; (iii) to expand the current eligibility requirements for financial holding companies such as Cullen/Frost so that the financial holding company must be “well capitalized” and “well managed” on a consolidated basis; (iv) to create a federal consumer financial protection agency to be the primary federal consumer protection supervisor with broad examination, supervision and enforcement authority with respect to consumer financial products and services; (v) to further limit the ability of banks to engage transactions with affiliates; and (vi) to subject all “over-the-counter” derivatives markets to comprehensive regulation.
The U.S. Congress, state lawmaking bodies and federal and state regulatory agencies continue to consider a number of wide-ranging and comprehensive proposals for altering the structure, regulation and competitive relationships of the nation’s financial institutions, including rules and regulations related to the administration’s proposals. Separate comprehensive financial reform bills intended to address the proposals set forth by the administration were introduced in both houses of Congress in the second half of 2009 and remain under review by both the U.S. House of Representatives and the U.S. Senate. In addition, both the U.S. Treasury Department and the Basel Committee have issued policy statements regarding proposed significant changes to the regulatory capital framework applicable to banking organizations as discussed above. The Corporation cannot predict whether or in what form further legislation or regulations may be adopted or the extent to which the Corporation may be affected thereby.
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Incentive Compensation
On October 22, 2009, the Federal Reserve issued a comprehensive proposal on incentive compensation policies (the “Incentive Compensation Proposal”) intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The Incentive Compensation Proposal, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Banking organizations are instructed to begin an immediate review of their incentive compensation policies to ensure that they do not encourage excessive risk-taking and implement corrective programs as needed. Where there are deficiencies in the incentive compensation arrangements, they must be immediately addressed.
The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Corporation, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.
In addition, on January 12, 2010, the FDIC announced that it would seek public comment on whether banks with compensation plans that encourage risky behavior should be charged at higher deposit assessment rates than such banks would otherwise be charged.
The scope and content of the U.S. banking regulators’ policies on executive compensation are continuing to develop and are likely to continue evolving in the near future. It cannot be determined at this time whether compliance with such policies will adversely affect the Corporation’s ability to hire, retain and motivate its key employees.
Other Legislative and Regulatory Initiatives
In addition to the specific proposals described above, from time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Corporation in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. The Corporation cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Corporation. A change in statutes, regulations or regulatory policies applicable to Cullen/Frost or any of its subsidiaries could have a material effect on the business of the Corporation.
Employees
At December 31, 2009, the Corporation employed 3,834 full-time equivalent employees. None of the Corporation’s employees are represented by collective bargaining agreements. The Corporation believes its employee relations to be good.
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Executive Officers of the Registrant
The names, ages as of December 31, 2009, recent business experience and positions or offices held by each of the executive officers of Cullen/Frost are as follows:
| Name and Position Held | Age | Recent Business Experience | ||
| Richard W. Evans, Jr. |
63 | Officer of Frost Bank since 1973. Chairman of the Board and Chief Executive Officer of Cullen/Frost from October 1997 to present. | ||
| Patrick B. Frost |
49 | Officer of Frost Bank since 1985. President of Frost Bank from August 1993 to present. Director of Cullen/Frost from May 1997 to present. | ||
| Phillip D. Green |
55 | Officer of Frost Bank since July 1980. Group Executive Vice President, Chief Financial Officer of Cullen/Frost from October 1995 to present. | ||
| David W. Beck |
59 | Officer of Frost Bank since July 1973. President, Chief Business Banking Officer of Frost Bank from February 2001 to present. | ||
| Robert A. Berman |
47 | Officer of Frost Bank since January 1989. Group Executive Vice President, Internet Financial Services of Frost Bank from May 2001 to present. | ||
| Paul H. Bracher |
53 | Officer of Frost Bank since January 1982. President, State Regions of Frost Bank from February 2001 to present. | ||
| Richard Kardys |
63 | Officer of Frost Bank since January 1977. Group Executive Vice President, Executive Trust Officer of Frost Bank from May 2001 to present. | ||
| Paul J. Olivier |
57 | Officer of Frost Bank since August 1976. Group Executive Vice President, Consumer Banking of Frost Bank from May 2001 to present. | ||
| William L. Perotti |
52 | Officer of Frost Bank since December 1982. Group Executive Vice President, Chief Credit Officer of Frost Bank from May 2001 to present. Chief Risk Officer of Frost Bank from April 2005 to present. | ||
| Emily A. Skillman |
65 | Officer of Frost Bank since January 1998. Group Executive Vice President, Human Resources of Frost Bank from October 2003 to present. | ||
There are no arrangements or understandings between any executive officer of Cullen/Frost and any other person pursuant to which such executive officer was or is to be selected as an officer.
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Available Information
Under the Securities Exchange Act of 1934, Cullen/Frost is required to file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). You may read and copy any document Cullen/Frost files with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information about the public reference room. The SEC maintains a website at http://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. Cullen/Frost files electronically with the SEC.
Cullen/Frost makes available, free of charge through its website, its reports on Forms 10-K, 10-Q and 8-K, and amendments to those reports, as soon as reasonably practicable after such reports are filed with or furnished to the SEC. Additionally, the Corporation has adopted and posted on its website a code of ethics that applies to its principal executive officer, principal financial officer and principal accounting officer. The Corporation’s website also includes its corporate governance guidelines and the charters for its audit committee, its compensation and benefits committee, and its corporate governance and nominating committee. The address for the Corporation’s website is http://www.frostbank.com. The Corporation will provide a printed copy of any of the aforementioned documents to any requesting shareholder.
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| ITEM 1A. | RISK FACTORS |
An investment in the Corporation’s common stock is subject to risks inherent to the Corporation’s business. The material risks and uncertainties that management believes affect the Corporation are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Corporation. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Corporation’s business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Corporation’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the market price of the Corporation’s common stock could decline significantly, and you could lose all or part of your investment.
Risks Related To The Corporation’s Business
The Corporation’s Business May Be Adversely Affected by Conditions in the Financial Markets and Economic Conditions Generally
Since December 2007 and continuing through 2009, business activity across a wide range of industries and regions in the United States has been greatly reduced and local governments and many businesses are in serious difficulty due to decreased consumer spending and the lack of liquidity in the credit markets. Unemployment has increased significantly.
Market conditions have also led to the failure or merger of several prominent financial institutions and numerous regional and community-based financial institutions. These failures, as well as projected future failures, have had a significant negative impact on the capitalization level of the deposit insurance fund of the FDIC, which, in turn, has led to a significant increase in deposit insurance premiums paid by financial institutions.
The Corporation’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services the Corporation offers, is highly dependent upon on the business environment in the markets where the Corporation operates, in the State of Texas and in the United States as a whole. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters; or a combination of these or other factors.
Overall, during 2009, the business environment has been adverse for many households and businesses in the United States and worldwide and has had an adverse effect on our business. While economic conditions in the State of Texas, the United States and worldwide are showing signs of recovery, there can be no assurance that these conditions will continue to improve. Such conditions could adversely affect the credit quality of the Corporation’s loans, results of operations and financial condition.
The Corporation Is Subject To Lending Risk
There are inherent risks associated with the Corporation’s lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Corporation operates as well as those across the State of Texas and the United States. Increases in interest rates
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and/or continuing weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Corporation is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Corporation to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Corporation.
As of December 31, 2009, approximately 83% of the Corporation’s loan portfolio consisted of commercial and industrial, construction and commercial real estate mortgage loans. These types of loans are generally viewed as having more risk of default than residential real estate loans or consumer loans. These types of loans are also typically larger than residential real estate loans and consumer loans. Because the Corporation’s loan portfolio contains a significant number of commercial and industrial, construction and commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Corporation’s financial condition and results of operations. See the section captioned “Loans” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to commercial and industrial, construction and commercial real estate loans.
The Corporation Is Subject To Interest Rate Risk
The Corporation’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Corporation’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Corporation receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) the Corporation’s ability to originate loans and obtain deposits, (ii) the fair value of the Corporation’s financial assets and liabilities, and (iii) the average duration of the Corporation’s mortgage-backed securities portfolio. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Corporation’s net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.
Although management believes it has implemented effective asset and liability management strategies, including the use of derivatives as hedging instruments, to reduce the potential effects of changes in interest rates on the Corporation’s results of operations, any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on the Corporation’s financial condition and results of operations. See the section captioned “Net Interest Income” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the Corporation’s management of interest rate risk.
The Corporation’s Allowance For Possible Loan Losses May Be Insufficient
The Corporation maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense, that represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the
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allowance for possible loan losses inherently involves a high degree of subjectivity and requires the Corporation to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Corporation’s control, may require an increase in the allowance for possible loan losses. In addition, bank regulatory agencies periodically review the Corporation’s allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. Furthermore, if charge-offs in future periods exceed the allowance for possible loan losses, the Corporation will need additional provisions to increase the allowance for possible loan losses. Any increases in the allowance for possible loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Corporation’s financial condition and results of operations. See the section captioned “Allowance for Possible Loan Losses” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the Corporation’s process for determining the appropriate level of the allowance for possible loan losses.
The Corporation’s Profitability Depends Significantly On Economic Conditions In The State Of Texas
The Corporation’s success depends primarily on the general economic conditions of the State of Texas and the specific local markets in which the Corporation operates. Unlike larger national or other regional banks that are more geographically diversified, the Corporation provides banking and financial services to customers across Texas through financial centers in the Austin, Corpus Christi, Dallas, Fort Worth, Houston, Rio Grande Valley and San Antonio regions. The local economic conditions in these areas have a significant impact on the demand for the Corporation’s products and services as well as the ability of the Corporation’s customers to repay loans, the value of the collateral securing loans and the stability of the Corporation’s deposit funding sources. Although economic conditions in the State of Texas have experienced less decline than in the United States generally, these conditions could decline further. A significant decline in general economic conditions, whether caused by recession, inflation, unemployment, changes in securities markets, acts of terrorism, outbreak of hostilities or other international or domestic occurrences or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation May Be Adversely Affected By The Soundness Of Other Financial Institutions
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. The Corporation has exposure to many different industries and counterparties, and routinely executes transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose the Corporation to credit risk in the event of a default by a counterparty or client. In addition, the Corporation’s credit risk may be exacerbated when the collateral held by the Corporation cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the Corporation. Any such losses could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation Operates In A Highly Competitive Industry and Market Area
The Corporation faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional, and community banks within the various markets where the Corporation operates. The Corporation also faces competition from many other types of financial institutions, including, without limitation, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, factoring companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually
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any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of the Corporation’s competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Corporation can.
The Corporation’s ability to compete successfully depends on a number of factors, including, among other things:
| ¨ | The ability to develop, maintain and build long-term customer relationships based on top quality service, high ethical standards and safe, sound assets. |
| ¨ | The ability to expand the Corporation’s market position. |
| ¨ | The scope, relevance and pricing of products and services offered to meet customer needs and demands. |
| ¨ | The rate at which the Corporation introduces new products and services relative to its competitors. |
| ¨ | Customer satisfaction with the Corporation’s level of service. |
| ¨ | Industry and general economic trends. |
Failure to perform in any of these areas could significantly weaken the Corporation’s competitive position, which could adversely affect the Corporation’s growth and profitability, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation Is Subject To Extensive Government Regulation and Supervision
The Corporation, primarily through Cullen/Frost, Frost Bank and certain non-bank subsidiaries, is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not security holders. These regulations affect the Corporation’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. The U.S. President’s administration has proposed major changes to the banking and financial institutions regulatory regimes in the near future in light of the recent performance of and government intervention in the financial services sector and legislation to implement these changes is pending in the U.S. House of Representatives and the U.S. Senate. These proposed reforms and other changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Corporation in substantial and unpredictable ways. Such changes could subject the Corporation to additional costs, limit the types of financial services and products the Corporation may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Corporation’s business, financial condition and results of operations. See the section captioned “Supervision and Regulation” in Item 1. Business and Note 11 - Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which are located elsewhere in this report.
The Corporation May Need to Raise Additional Capital in the Future, and Such Capital May Not Be Available When Needed or at All
The Corporation may need to raise additional capital in the future to provide it with sufficient capital resources and liquidity to meet its commitments and business needs, particularly if its asset quality or earnings were to deteriorate significantly. The Corporation’s ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of its control, and its financial
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performance. Economic conditions and the loss of confidence in financial institutions may increase the Corporation’s cost of funding and limit access to certain customary sources of capital, including inter-bank borrowings, repurchase agreements and borrowings from the discount window of the Federal Reserve.
The Corporation cannot assure that such capital will be available on acceptable terms or at all. Any occurrence that may limit the Corporation’s access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of Frost Bank or counterparties participating in the capital markets, or a downgrade of Cullen/Frost’s or Frost Bank’s debt ratings, may adversely affect the Corporation’s capital costs and its ability to raise capital and, in turn, its liquidity. Moreover, if the Corporation needs to raise capital in the future, it may have to do so when many other financial institutions are also seeking to raise capital and would have to compete with those institutions for investors. An inability to raise additional capital on acceptable terms when needed could have a materially adverse effect on the Corporation’s businesses, financial condition and results of operations.
The Corporation’s Controls and Procedures May Fail or Be Circumvented
Management regularly reviews and updates the Corporation’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Corporation’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Corporation’s business, results of operations and financial condition.
New Lines of Business or New Products and Services May Subject The Corporation to Additional Risks
From time to time, the Corporation may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services the Corporation may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of the Corporation’s system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on the Corporation’s business, results of operations and financial condition.
Cullen/Frost Relies On Dividends From Its Subsidiaries For Most Of Its Revenue
Cullen/Frost is a separate and distinct legal entity from its subsidiaries. It receives substantially all of its revenue from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on Cullen/Frost’s common stock and interest and principal on Cullen/Frost’s debt. Various federal and/or state laws and regulations limit the amount of dividends that Frost Bank and certain non-bank subsidiaries may pay to Cullen/Frost. Also, Cullen/Frost’s right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event Frost Bank is unable to pay dividends to Cullen/Frost, Cullen/Frost may not be able to service debt, pay obligations or pay dividends on the Corporation’s common stock. The inability to receive dividends from Frost Bank could have a material adverse effect on the Corporation’s business, financial condition and results of operations. See the section captioned “Supervision and Regulation” in Item 1. Business and Note 11 - Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which are located elsewhere in this report.
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Potential Acquisitions May Disrupt the Corporation’s Business and Dilute Stockholder Value
The Corporation generally seeks merger or acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale or expanded services. Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things:
| ¨ | Potential exposure to unknown or contingent liabilities of the target company. |
| ¨ | Exposure to potential asset quality issues of the target company. |
| ¨ | Potential disruption to the Corporation’s business. |
| ¨ | Potential diversion of the Corporation’s management’s time and attention. |
| ¨ | The possible loss of key employees and customers of the target company. |
| ¨ | Difficulty in estimating the value of the target company. |
| ¨ | Potential changes in banking or tax laws or regulations that may affect the target company. |
The Corporation regularly evaluates merger and acquisition opportunities and conducts due diligence activities related to possible transactions with other financial institutions and financial services companies. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur at any time. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of the Corporation’s tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation acquired insurance agencies in both the Dallas and San Marcos market areas during 2009, an insurance agency in the Dallas market area in 2008 and an insurance agency in the Austin market area in 2007. None of these acquisitions had a significant impact on the Corporation’s financial statements during their respective reporting periods.
The Corporation May Not Be Able To Attract and Retain Skilled People
The Corporation’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities engaged in by the Corporation can be intense and the Corporation may not be able to hire people or to retain them. The Corporation does not currently have employment agreements or non-competition agreements with any of its senior officers. The unexpected loss of services of key personnel of the Corporation could have a material adverse impact on the Corporation’s business because of their skills, knowledge of the Corporation’s market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
The Corporation’s Information Systems May Experience An Interruption Or Breach In Security
The Corporation relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Corporation’s customer relationship management, general ledger, deposit, loan and other systems. While the Corporation has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of the Corporation’s information systems could damage the Corporation’s reputation, result in a loss of customer business, subject the Corporation to additional regulatory scrutiny, or expose the Corporation to civil litigation and possible financial liability, any of which could have a material adverse effect on the Corporation’s financial condition and results of operations.
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The Corporation Continually Encounters Technological Change
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Corporation’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Corporation’s operations. Many of the Corporation’s competitors have substantially greater resources to invest in technological improvements. The Corporation may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations.
The Corporation Is Subject To Claims and Litigation Pertaining To Fiduciary Responsibility
From time to time, customers make claims and take legal action pertaining to the Corporation’s performance of its fiduciary responsibilities. Whether customer claims and legal action related to the Corporation’s performance of its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Corporation they may result in significant financial liability and/or adversely affect the market perception of the Corporation and its products and services as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on the Corporation’s business, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation’s Operations Rely on Certain External Vendors
The Corporation is reliant upon certain external vendors to provide products and services necessary to maintain day-to-day operations of the Corporation. Accordingly, the Corporation’s operations are exposed to risk that these vendors will not perform in accordance with the contracted arrangements under service level agreements. The Corporation maintains a system of comprehensive policies and a control framework designed to monitor vendor risks including, among other things, (i) changes in the vendor’s organizational structure, (ii) changes in the vendor’s financial condition, (iii) changes in the vendor’s support for existing products and services and (iv) changes in the vendor’s strategic focus. While the Corporation believes these policies and procedures help to mitigate risk, the failure of an external vendor to perform in accordance with the contracted arrangements under service level agreements could be disruptive to the Corporation’s operations, which could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations.
The Corporation Is Subject To Environmental Liability Risk Associated With Lending Activities
A significant portion of the Corporation’s loan portfolio is secured by real property. During the ordinary course of business, the Corporation may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Corporation may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Corporation to incur substantial expenses and may materially reduce the affected property’s value or limit the Corporation’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Corporation’s exposure to environmental liability. Although the Corporation has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Corporation’s financial condition and results of operations.
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Severe Weather, Natural Disasters, Acts Of War Or Terrorism and Other External Events Could Significantly Impact The Corporation’s Business
Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on the Corporation’s ability to conduct business. In addition, such events could affect the stability of the Corporation’s deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the Corporation to incur additional expenses. Although management has established disaster recovery policies and procedures, the occurrence of any such event in the future could have a material adverse effect on the Corporation’s business, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations.
Risks Associated With The Corporation’s Common Stock
The Corporation’s Stock Price Can Be Volatile
Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. The Corporation’s stock price can fluctuate significantly in response to a variety of factors including, among other things:
| ¨ | Actual or anticipated variations in quarterly results of operations. |
| ¨ | Recommendations by securities analysts. |
| ¨ | Operating and stock price performance of other companies that investors deem comparable to the Corporation. |
| ¨ | News reports relating to trends, concerns and other issues in the financial services industry. |
| ¨ | Perceptions in the marketplace regarding the Corporation and/or its competitors. |
| ¨ | New technology used, or services offered, by competitors. |
| ¨ | Significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving the Corporation or its competitors. |
| ¨ | Failure to integrate acquisitions or realize anticipated benefits from acquisitions. |
| ¨ | Changes in government regulations. |
| ¨ | Geopolitical conditions such as acts or threats of terrorism or military conflicts. |
General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause the Corporation’s stock price to decrease regardless of operating results.
The Trading Volume In The Corporation’s Common Stock Is Less Than That Of Other Larger Financial Services Companies
Although the Corporation’s common stock is listed for trading on the New York Stock Exchange (NYSE), the trading volume in its common stock is less than that of other, larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Corporation’s common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Corporation has no control. Given the lower trading volume of the Corporation’s common stock, significant sales of the Corporation’s common stock, or the expectation of these sales, could cause the Corporation’s stock price to fall.
Cullen/Frost May Not Continue to Pay Dividends on its Common Stock in the Future
Holders of Cullen/Frost common stock are only entitled to receive such dividends as its board of directors may declare out of funds legally available for such payments. Although Cullen/Frost has historically declared cash
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dividends on its common stock, it is not required to do so and may reduce or eliminate its common stock dividend in the future. This could adversely affect the market price of Cullen/Frost’s common stock. Also, Cullen/Frost is a bank holding company, and its ability to declare and pay dividends is dependent on certain federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends.
An Investment In The Corporation’s Common Stock Is Not An Insured Deposit
The Corporation’s common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation (FDIC), any other deposit insurance fund or by any other public or private entity. Investment in the Corporation’s common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire the Corporation’s common stock, you could lose some or all of your investment.
The Corporation’s Articles Of Incorporation and By-Laws As Well As Certain Banking Laws May Have An Anti-Takeover Effect
Provisions of the Corporation’s articles of incorporation and by-laws and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire the Corporation, even if doing so would be perceived to be beneficial to the Corporation’s shareholders. The combination of these provisions effectively inhibits a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of the Corporation’s common stock.
Risks Associated With The Corporation’s Industry
The Earnings Of Financial Services Companies Are Significantly Affected By General Business And Economic Conditions
The Corporation’s operations and profitability are impacted by general business and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, and the strength of the U.S. economy and the local economies in which the Corporation operates, all of which are beyond the Corporation’s control. The continuing weak economic conditions in the United States and abroad could result in an increase in loan delinquencies and non-performing assets, decreases in loan collateral values and a decrease in demand for the Corporation’s products and services, among other things, any of which could have a material adverse impact on the Corporation’s financial condition and results of operations.
Financial Services Companies Depend On The Accuracy And Completeness Of Information About Customers And Counterparties
In deciding whether to extend credit or enter into other transactions, the Corporation may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. The Corporation may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations.
Consumers May Decide Not To Use Banks To Complete Their Financial Transactions
Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that would have
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historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on the Corporation’s financial condition and results of operations.
| ITEM 1B. | UNRESOLVED STAFF COMMENTS |
None
| ITEM 2. | PROPERTIES |
The Corporation’s headquarters are located in downtown San Antonio, Texas. These facilities, which are owned by the Corporation, house the Corporation’s executive and primary administrative offices, as well as the principal banking headquarters of Frost Bank. The Corporation also owns or leases other facilities within its primary market areas in the regions of Austin, Corpus Christi, Dallas, Fort Worth, Houston, Rio Grande Valley and San Antonio. The Corporation considers its properties to be suitable and adequate for its present needs.
| ITEM 3. | LEGAL PROCEEDINGS |
The Corporation is subject to various claims and legal actions that have arisen in the normal course of conducting business. Management does not expect the ultimate disposition of these matters to have a material adverse impact on the Corporation’s financial statements.
| ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |
No matters were submitted to a vote of security holders during the fourth quarter of 2009.
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| ITEM 5. | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |
Common Stock Market Prices and Dividends
The Corporation’s common stock is traded on the New York Stock Exchange, Inc. (“NYSE”) under the symbol “CFR”. The tables below set forth for each quarter of 2009 and 2008 the high and low intra-day sales prices per share of Cullen/Frost’s common stock as reported by the NYSE and the cash dividends declared per share.
| 2009 |
2008 | |||||||||||
| Sales Price Per Share | High | Low | High | Low | ||||||||
| First quarter |
$ | 50.99 | $ | 35.40 | $ | 56.35 | $ | 43.78 | ||||
| Second quarter |
53.59 | 43.66 | 58.78 | 49.75 | ||||||||
| Third quarter |
53.20 | 43.59 | 65.03 | 44.42 | ||||||||
| Fourth quarter |
51.59 | 45.67 | 62.41 | 43.61 | ||||||||
| Cash Dividends Per Share | 2009 | 2008 | ||||
| First quarter |
$ | 0.42 | $ | 0.40 | ||
| Second quarter |
0.43 | 0.42 | ||||
| Third quarter |
0.43 | 0.42 | ||||
| Fourth quarter |
0.43 | 0.42 | ||||
| Total |
$ | 1.71 | $ | 1.66 | ||
As of December 31, 2009, there were 60,038,276 shares of the Corporation’s common stock outstanding held by 1,687 holders of record. The closing price per share of common stock on December 31, 2009, the last trading day of the Corporation’s fiscal year, was $50.00.
The Corporation’s management is currently committed to continuing to pay regular cash dividends; however, there can be no assurance as to future dividends because they are dependent on the Corporation’s future earnings, capital requirements and financial condition. See the section captioned “Supervision and Regulation” included in Item 1. Business, the section captioned “Capital and Liquidity” included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 11 - Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, all of which are included elsewhere in this report.
Stock-Based Compensation Plans
Information regarding stock-based compensation awards outstanding and available for future grants as of December 31, 2009, segregated between stock-based compensation plans approved by shareholders and stock-based compensation plans not approved by shareholders, is presented in the table below. Additional information regarding stock-based compensation plans is presented in Note 12 - Employee Benefit Plans in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data located elsewhere in this report.
| Plan Category | Number of Shares to be Issued Upon Exercise of Outstanding Awards |
Weighted-Average Price of |
Number of Shares Available for Future Grants | ||||
| Plans approved by shareholders |
4,600,455 | $ | 51.18 | 3,445,507 | |||
| Plans not approved by shareholders |
- | - | - | ||||
| Total |
4,600,455 | $ | 51.18 | 3,445,507 | |||
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Stock Repurchase Plans
The Corporation has maintained several stock repurchase plans authorized by the Corporation’s board of directors. In general, stock repurchase plans allow the Corporation to proactively manage its capital position and return excess capital to shareholders. Shares purchased under such plans also provide the Corporation with shares of common stock necessary to satisfy obligations related to stock compensation awards. Under the most recent plan, which was approved on April 26, 2007, the Corporation was authorized to repurchase up to 2.5 million shares of its common stock from time to time over a two-year period in the open market or through private transactions. Under the plan, the Corporation repurchased 2.1 million shares at a total cost of $109.4 million during 2007, while the remaining 404 thousand shares approved for repurchase were repurchased during the first quarter of 2008 at a total cost of $21.9 million.
The following table provides information with respect to purchases made by or on behalf of the Corporation or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of the Corporation’s common stock during the fourth quarter of 2009.
| Period | Total Number of Shares Purchased |
Average Price Paid Per Share |
Total Number of Shares Purchased as Part of Publicly Announced Plans |
Maximum Number of Shares That May Yet Be Purchased Under the Plans at the End of the Period | ||||||
| October 1, 2009 to October 31, 2009 |
15,777 | (1) | $ | 50.70 | - | - | ||||
| November 1, 2009 to November 30, 2009 |
- | - | - | - | ||||||
| December 1, 2009 to December 31, 2009 |
- | - | - | - | ||||||
| Total |
15,777 | $ | 50.70 | - | - | |||||
| (1) | Represents repurchases made in connection with the vesting of certain share awards. |
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Performance Graph
The performance graph below compares the cumulative total shareholder return on Cullen/Frost Common Stock with the cumulative total return on the equity securities of companies included in the Standard & Poor’s 500 Stock Index and the Standard and Poor’s 500 Bank Index, measured at the last trading day of each year shown. The graph assumes an investment of $100 on December 31, 2004 and reinvestment of dividends on the date of payment without commissions. The performance graph represents past performance and should not be considered to be an indication of future performance.
Cumulative Total Returns
on $100 Investment Made on December 31, 2004
| 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | |||||||||||||
| Cullen/Frost |
$ | 100.00 | $ | 113.11 | $ | 120.40 | $ | 112.57 | $ | 116.18 | $ | 118.71 | ||||||
| S&P 500 |
100.00 | 104.90 | 121.43 | 128.09 | 80.77 | 102.08 | ||||||||||||
| S&P 500 Banks |
100.00 | 101.40 | 119.37 | 96.69 | 77.05 | 72.29 | ||||||||||||
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| ITEM 6. | SELECTED FINANCIAL DATA |
The following consolidated selected financial data is derived from the Corporation’s audited financial statements as of and for the five years ended December 31, 2009. The following consolidated financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and related notes included elsewhere in this report. All of the Corporation’s acquisitions during the five years ended December 31, 2009 were accounted for using the purchase method. Accordingly, the operating results of the acquired companies are included with the Corporation’s results of operations since their respective dates of acquisition. Dollar amounts, except per share data, and common shares outstanding are in thousands.
| Year Ended December 31, | ||||||||||||||||||
| 2009 | 2008 | 2007 | 2006 | 2005 | ||||||||||||||
| Consolidated Statements of Income |
||||||||||||||||||
| Interest income: |
||||||||||||||||||
| Loans, including fees |
$ | 432,222 | $ | 504,680 | $ | 573,039 | $ | 502,657 | $ | 359,587 | ||||||||
| Securities |
188,446 | 167,044 | 165,517 | 144,501 | 131,943 | |||||||||||||
| Interest-bearing deposits |
2,161 | 429 | 396 | 251 | 150 | |||||||||||||
| Federal funds sold and resell agreements |
207 | 3,498 | 29,895 | 36,550 | 18,147 | |||||||||||||
| Total interest income |
623,036 | 675,651 | 768,847 | 683,959 | 509,827 | |||||||||||||
| Interest expense: |
||||||||||||||||||
| Deposits |
56,015 | 104,871 | 190,237 | 155,090 | 78,934 | |||||||||||||
| Federal funds purchased and repurchase agreements |
1,052 | 12,954 | 31,951 | 31,167 | 16,632 | |||||||||||||
| Junior subordinated deferrable interest debentures |
7,231 | 6,972 | 11,283 | 17,402 | 14,908 | |||||||||||||
| Subordinated notes payable and other borrowings |
22,059 | 16,829 | 16,639 | 11,137 | 8,087 | |||||||||||||
| Total interest expense |
86,357 | 141,626 | 250,110 | 214,796 | 118,561 | |||||||||||||
| Net interest income |
536,679 | 534,025 | 518,737 | 469,163 | 391,266 | |||||||||||||
| Provision for possible loan losses |
65,392 | 37,823 | 14,660 | 14,150 | 10,250 | |||||||||||||
| Net interest income after provision for possible loan losses |
471,287 | 496,202 | 504,077 | 455,013 | 381,016 | |||||||||||||
| Non-interest income: |
||||||||||||||||||
| Trust fees |
67,268 | 74,554 | 70,359 | 63,469 | 58,353 | |||||||||||||
| Service charges on deposit accounts |
102,474 | 87,566 | 80,718 | 77,116 | 78,751 | |||||||||||||
| Insurance commissions and fees |
33,096 | 32,904 | 30,847 | 28,230 | 27,731 | |||||||||||||
| Other charges, commissions and fees |
27,699 | 35,557 | 32,558 | 28,105 | 23,125 | |||||||||||||
| Net gain (loss) on securities transactions |
(1,260 | ) | (159 | ) | 15 | (1 | ) | 19 | ||||||||||
| Other |
64,429 | 56,900 | 53,734 | 43,828 | 42,400 | |||||||||||||
| Total non-interest income |
293,706 | 287,322 | 268,231 | 240,747 | 230,379 | |||||||||||||
| Non-interest expense: |
||||||||||||||||||
| Salaries and wages |
230,643 | 225,943 | 209,982 | 190,784 | 166,059 | |||||||||||||
| Employee benefits |
55,224 | 47,219 | 47,095 | 46,231 | 41,577 | |||||||||||||
| Net occupancy |
44,188 | 40,464 | 38,824 | 34,695 | 31,107 | |||||||||||||
| Furniture and equipment |
44,223 | 37,799 | 32,821 | 26,293 | 23,912 | |||||||||||||
| Deposit insurance |
25,812 | 4,597 | 1,220 | 1,162 | 1,110 | |||||||||||||
| Intangible amortization |
6,537 | 7,906 | 8,860 | 5,628 | 4,859 | |||||||||||||
| Other |
125,611 | 122,717 | 123,644 | 105,560 | 98,383 | |||||||||||||
| Total non-interest expense |
532,238 | 486,645 | 462,446 | 410,353 | 367,007 | |||||||||||||
| Income before income taxes |
232,755 | 296,879 | 309,862 | 285,407 | 244,388 | |||||||||||||
| Income taxes |
53,721 | 89,624 | 97,791 | 91,816 | 78,965 | |||||||||||||
| Net income |
$ | 179,034 | $ | 207,255 | $ | 212,071 | $ | 193,591 | $ | 165,423 | ||||||||
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Selected Financial Data (continued)
| As of or for the Year Ended December 31, |
||||||||||||||||||||
| 2009 | 2008 | 2007 | 2006 | 2005 | ||||||||||||||||
| Per Common Share Data |
||||||||||||||||||||
| Net income - basic |
$ | 3.00 | $ | 3.51 | $ | 3.59 | $ | 3.48 | $ | 3.14 | ||||||||||
| Net income - diluted |
3.00 | 3.50 | 3.57 | 3.44 | 3.09 | |||||||||||||||
| Cash dividends declared and paid |
1.71 | 1.66 | 1.54 | 1.32 | 1.165 | |||||||||||||||
| Book value |
31.55 | 29.68 | 25.18 | 23.01 | 18.03 | |||||||||||||||
| Common Shares Outstanding |
||||||||||||||||||||
| Period-end |
60,038 | 59,416 | 58,662 | 59,839 | 54,483 | |||||||||||||||
| Weighted-average shares - basic |
59,456 | 58,846 | 58,952 | 55,467 | 52,481 | |||||||||||||||
| Dilutive effect of stock compensation |
58 | 324 | 645 | 1,043 | 1,235 | |||||||||||||||
| Weighted-average shares - diluted |
59,514 | 59,170 | 59,597 | 56,510 | 53,716 | |||||||||||||||
| Performance Ratios |
||||||||||||||||||||
| Return on average assets |
1.14 | % | 1.51 | % | 1.63 | % | 1.67 | % | 1.63 | % | ||||||||||
| Return on average equity |
9.78 | 13.11 | 15.20 | 18.03 | 18.78 | |||||||||||||||
| Net interest income to average earning assets |
4.23 | 4.67 | 4.69 | 4.67 | 4.45 | |||||||||||||||
| Dividend pay-out ratio |
57.05 | 47.36 | 42.83 | 37.91 | 37.18 | |||||||||||||||
| Balance Sheet Data |
||||||||||||||||||||
| Period-end: |
||||||||||||||||||||
| Loans |
$ | 8,367,780 | $ | 8,844,082 | $ | 7,769,362 | $ | 7,373,384 | $ | 6,085,055 | ||||||||||
| Earning assets |
14,437,267 | 13,001,103 | 11,556,385 | 11,460,741 | 10,197,059 | |||||||||||||||
| Total assets |
16,288,038 | 15,034,142 | 13,485,014 | 13,224,189 | 11,741,437 | |||||||||||||||
| Non-interest-bearing demand deposits |
4,645,802 | 4,152,348 | 3,597,903 | 3,699,701 | 3,484,932 | |||||||||||||||
| Interest-bearing deposits |
8,667,508 | 7,356,589 | 6,931,770 | 6,688,208 | 5,661,462 | |||||||||||||||
| Total deposits |
13,313,310 | 11,508,937 | 10,529,673 | 10,387,909 | 9,146,394 | |||||||||||||||
| Long-term debt and other borrowings |
392,646 | 392,661 | 400,323 | 428,636 | 415,422 | |||||||||||||||
| Shareholders’ equity |
1,894,424 | 1,763,527 | 1,477,088 | 1,376,883 | 982,236 | |||||||||||||||
| Average: |
||||||||||||||||||||
| Loans |
$ | 8,652,563 | $ | 8,314,265 | $ | 7,464,140 | $ | 6,523,906 | $ | 5,594,477 | ||||||||||
| Earning assets |
13,803,919 | 11,868,262 | 11,339,876 | 10,202,981 | 8,968,906 | |||||||||||||||
| Total assets |
15,701,960 | 13,684,531 | 13,041,682 | 11,581,253 | 10,143,245 | |||||||||||||||
| Non-interest-bearing demand deposits |
4,258,484 | 3,614,747 | 3,524,132 | 3,334,280 | 3,008,750 | |||||||||||||||
| Interest-bearing deposits |
8,161,143 | 6,916,372 | 6,688,509 | 5,850,116 | 5,124,036 | |||||||||||||||
| Total deposits |
12,419,627 | 10,531,119 | 10,212,641 | 9,184,396 | 8,132,786 | |||||||||||||||
| Long-term debt and other borrowings |
576,161 | 394,763 | 413,700 | 405,752 | 387,612 | |||||||||||||||
| Shareholders’ equity |
1,831,133 | 1,580,311 | 1,395,022 | 1,073,599 | 880,640 | |||||||||||||||
| Asset Quality |
||||||||||||||||||||
| Allowance for possible loan losses |
$ | 125,309 | $ | 110,244 | $ | 92,339 | $ | 96,085 | $ | 80,325 | ||||||||||
| Allowance for possible loan losses to period-end loans |
1.50 | % | 1.25 | % | 1.19 | % | 1.30 | % | 1.32 | % | ||||||||||
| Net loan charge-offs |
$ | 50,327 | $ | 19,918 | $ | 18,406 | $ | 11,110 | $ | 8,921 | ||||||||||
| Net loan charge-offs to average loans |
0.58 | % | 0.24 | % | 0.25 | % | 0.17 | % | 0.16 | % | ||||||||||
| Non-performing assets |
$ | 146,867 | $ | 78,040 | $ | 29,849 | $ | 57,749 | $ | 38,927 | ||||||||||
| Non-performing assets to: |
||||||||||||||||||||
| Total loans plus foreclosed assets |
2.14 | % | 0.88 | % | 0.38 | % | 0.78 | % | 0.64 | % | ||||||||||
| Total assets |
1.11 | 0.52 | 0.22 | 0.44 | 0.33 | |||||||||||||||
| Consolidated Capital Ratios |
||||||||||||||||||||
| Tier 1 risk-based capital ratio |
11.91 | % | 10.30 | % | 9.96 | % | 11.25 | % | 12.24 | % | ||||||||||
| Total risk-based capital ratio |
14.19 | 12.58 | 12.59 | 13.43 | 14.94 | |||||||||||||||
| Leverage ratio |
8.50 | 8.80 | 8.37 | 9.56 | 9.62 | |||||||||||||||
| Average shareholders’ equity to average total assets |
11.66 | 11.55 | 10.70 | 9.27 | 8.68 | |||||||||||||||
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The following tables set forth unaudited consolidated selected quarterly statement of operations data for the years ended December 31, 2009 and 2008. Dollar amounts are in thousands, except per share data.
| Year Ended December 31, 2009 | ||||||||||||
| 4th Quarter |
3rd Quarter |
2nd Quarter |
1st Quarter | |||||||||
| Interest income |
$ | 156,265 | $ | 155,490 | $ | 157,225 | $ | 154,056 | ||||
| Interest expense |
17,671 | 21,501 | 22,761 | 24,424 | ||||||||
| Net interest income |
138,594 | 133,989 | 134,464 | 129,632 | ||||||||
| Provision for possible loan losses |
22,250 | 16,940 | 16,601 | 9,601 | ||||||||
| Non-interest income (1) |
86,345 | 69,491 | 68,006 | 69,864 | ||||||||
| Non-interest expense |
134,216 | 132,234 | 136,289 | 129,499 | ||||||||
| Income before income taxes |
68,473 | 54,306 | 49,580 | 60,396 | ||||||||
| Income taxes |
16,979 | 9,607 | 11,721 | 15,414 | ||||||||
| Net income |
$ | 51,494 | $ | 44,699 | $ | 37,859 | $ | 44,982 | ||||
| Net income per common share: |
||||||||||||
| Basic |
$ | 0.86 | $ | 0.75 | $ | 0.64 | $ | 0.76 | ||||
| Diluted |
0.86 | 0.75 | 0.63 | 0.76 | ||||||||
| Year Ended December 31, 2008 | ||||||||||||
| 4th Quarter |
3rd Quarter |
2nd Quarter |
1st Quarter | |||||||||
| Interest income |
$ | 167,417 | $ | 166,676 | $ | 165,855 | $ | 175,703 | ||||
| Interest expense |
29,336 | 31,940 | 34,527 | 45,823 | ||||||||
| Net interest income |
138,081 | 134,736 | 131,328 | 129,880 | ||||||||
| Provision for possible loan losses |
8,550 | 18,940 | 6,328 | 4,005 | ||||||||
| Non-interest income (2) |
69,198 | 77,315 | 70,581 | 70,228 | ||||||||
| Non-interest expense |
123,543 | 122,972 | 120,090 | 120,040 | ||||||||
| Income before income taxes |
75,186 | 70,139 | 75,491 | 76,063 | ||||||||
| Income taxes |
22,223 | 21,174 | 22,944 | 23,283 | ||||||||
| Net income |
$ | 52,963 | $ | 48,965 | $ | 52,547 | $ | 52,780 | ||||
| Net income per common share: |
||||||||||||
| Basic |
$ | 0.90 | $ | 0.83 | $ | 0.89 | $ | 0.90 | ||||
| Diluted |
0.89 | 0.82 | 0.89 | 0.89 | ||||||||
| (1) | Includes net losses on securities transactions of $1.3 million during the fourth quarter of 2009 and net gains of $49 thousand during the second quarter of 2009. |
| (2) | Includes net losses on securities transactions of $133 thousand during the fourth quarter of 2008, net gains of $78 thousand during the third quarter of 2008, net losses of $56 thousand during the second quarter of 2008 and net losses of $48 thousand during the first quarter of 2008. |
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| ITEM 7. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
Forward-Looking Statements and Factors that Could Affect Future Results
Certain statements contained in this Annual Report on Form 10-K that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”), notwithstanding that such statements are not specifically identified as such. In addition, certain statements may be contained in the Corporation’s future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Corporation that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, expenses, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of Cullen/Frost or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and (iv) statements of assumptions underlying such statements. Words such as “believes”, “anticipates”, “expects”, “intends”, “targeted”, “continue”, “remain”, “will”, “should”, “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.
Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:
| ¨ | Local, regional, national and international economic conditions and the impact they may have on the Corporation and its customers and the Corporation’s assessment of that impact. |
| ¨ | Volatility and disruption in national and international financial markets. |
| ¨ | Government intervention in the U.S. financial system. |
| ¨ | Changes in the level of non-performing assets and charge-offs. |
| ¨ | Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements. |
| ¨ | The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board. |
| ¨ | Inflation, interest rate, securities market and monetary fluctuations. |
| ¨ | The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Corporation and its subsidiaries must comply. |
| ¨ | Political instability. |
| ¨ | Acts of God or of war or terrorism. |
| ¨ | The timely development and acceptance of new products and services and perceived overall value of these products and services by users. |
| ¨ | Changes in consumer spending, borrowings and savings habits. |
| ¨ | Changes in the financial performance and/or condition of the Corporation’s borrowers. |
| ¨ | Technological changes. |
| ¨ | Acquisitions and integration of acquired businesses. |
| ¨ | The ability to increase market share and control expenses. |
| ¨ | Changes in the competitive environment among financial holding companies and other financial service providers. |
| ¨ | The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters. |
| ¨ | Changes in the Corporation’s organization, compensation and benefit plans. |
| ¨ | The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews. |
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| ¨ | Greater than expected costs or difficulties related to the integration of new products and lines of business. |
| ¨ | The Corporation’s success at managing the risks involved in the foregoing items. |
Forward-looking statements speak only as of the date on which such statements are made. The Corporation undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events.
Application of Critical Accounting Policies and Accounting Estimates
The accounting and reporting policies followed by the Corporation conform, in all material respects, to accounting principles generally accepted in the United States and to general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Corporation bases estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ from those estimates.
The Corporation considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Corporation’s financial statements.
Accounting policies related to the allowance for possible loan losses are considered to be critical, as these policies involve considerable subjective judgment and estimation by management. The allowance for possible loan losses is a reserve established through a provision for possible loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Corporation’s allowance for possible loan loss methodology is based on guidance provided in SEC Staff Accounting Bulletin No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues” and includes allowance allocations calculated in accordance with Accounting Standards Codification (ASC) Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio, as well as trends in the foregoing. 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. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including the performance of the Corporation’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. See the section captioned “Allowance for Possible Loan Losses” elsewhere in this discussion for further details of the risk factors considered by management in estimating the necessary level of the allowance for possible loan losses.
Overview
The following discussion and analysis presents the more significant factors affecting the Corporation’s financial condition as of December 31, 2009 and 2008 and results of operations for each of the years in the three-year period ended December 31, 2009. This discussion and analysis should be read in conjunction with the Corporation’s consolidated financial statements, notes thereto and other financial information appearing
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elsewhere in this report. The Corporation acquired insurance agencies in both the Dallas and San Marcos market areas during 2009, an insurance agency in the Dallas market area in 2008 and an insurance agency in the Austin market area in 2007. All of the Corporation’s acquisitions during the reported periods were accounted for as purchase transactions, and as such, their related results of operations are included from the date of acquisition, though none of these acquisitions had a significant impact on the Corporation’s financial statements during their respective reporting periods.
Taxable-equivalent adjustments are the result of increasing income from tax-free loans and investments by an amount equal to the taxes that would be paid if the income were fully taxable based on a 35% federal tax rate, thus making tax-exempt yields comparable to taxable asset yields.
Dollar amounts in tables are stated in thousands, except for per share amounts.
Results of Operations
Net income totaled $179.0 million, or $3.00 diluted per common share, in 2009 compared to $207.3 million, or $3.50 diluted per common share, in 2008 and $212.1 million, or $3.55 diluted per common share, in 2007.
Selected income statement data, returns on average assets and average equity and dividends per share for the comparable periods were as follows:
| 2009 | 2008 | 2007 | ||||||||||
| Taxable-equivalent net interest income |
$ | 577,716 | $ | 554,353 | $ | 534,195 | ||||||
| Taxable-equivalent adjustment |
41,037 | 20,328 | 15,458 | |||||||||
| Net interest income |
536,679 | 534,025 | 518,737 | |||||||||
| Provision for possible loan losses |
65,392 | 37,823 | 14,660 | |||||||||
| Non-interest income |
293,706 | 287,322 | 268,231 | |||||||||
| Non-interest expense |
532,238 | 486,645 | 462,446 | |||||||||
| Income before income taxes |
232,755 | 296,879 | 309,862 | |||||||||
| Income taxes |
53,721 | 89,624 | 97,791 | |||||||||
| Net income |
$ | 179,034 | $ | 207,255 | $ | 212,071 | ||||||
| Earnings per common share: |
||||||||||||
| Basic |
$ | 3.00 | $ | 3.51 | $ | 3.59 | ||||||
| Diluted |
3.00 | 3.50 | 3.57 | |||||||||
| Return on average assets |
1.14 | % | 1.51 | % | 1.63 | % | ||||||
| Return on average equity |
9.78 | 13.11 | 15.20 | |||||||||
Net income for 2009 decreased $28.2 million, or 13.6%. The decrease was primarily the result of a $45.6 million increase in non-interest expense and a $27.6 million increase in the provision for possible loan losses partly offset by a $35.9 million decrease in income tax expense, a $6.4 million increase in non-interest income and a $2.7 million increase in net interest income. Net income for 2008 decreased $4.8 million, or 2.3%, compared to 2007. The decrease was primarily due to a $24.2 million increase in non-interest expense and a $23.2 million increase in the provision for possible loan losses. The impact of these items was partly offset by a $19.1 million increase in non-interest income, a $15.3 million increase in net interest income and a $8.2 million decrease in income tax expense.
Details of the changes in the various components of net income are further discussed below.
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Net Interest Income
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. Net interest income is the Corporation’s largest source of revenue, representing 64.6% of total revenue during 2009. Net interest margin is the ratio of taxable-equivalent net interest income to average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and net interest margin.
The Federal Reserve Board influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. The Corporation’s loan portfolio is significantly affected by changes in the prime interest rate. The prime interest rate, which is the rate offered on loans to borrowers with strong credit, began 2007 at 8.25% and decreased 50 basis points in the third quarter and 50 basis points in the fourth quarter to end the year at 7.25%. During 2008, the prime interest rate decreased 200 basis points in the first quarter, 25 basis points in the second quarter and 175 basis points in the fourth quarter to end the year at 3.25%. During 2009, the prime interest rate remained at 3.25% for the entire year. The Corporation’s loan portfolio is also impacted, to a lesser extent, by changes in the London Interbank Offered Rate (LIBOR). At December 31, 2009, the one-month and three-month U.S. dollar LIBOR rates were 0.23% and 0.25%, respectively, while at December 31, 2008, the one-month and three-month U.S. dollar LIBOR rates were 0.44% and 1.43%, respectively. The intended federal funds rate, which is the cost of immediately available overnight funds, fluctuated in a similar manner to the prime interest rate. It began 2007 at 5.25% and decreased 50 basis points in the third quarter and 50 basis points in the fourth quarter to end the year at 4.25%. During 2008, the federal funds rate decreased 200 basis points in the first quarter, 25 basis points in the second quarter and 175 basis points in the fourth quarter to end the year at 0.25%. During 2009, the intended federal funds rate remained at zero to 0.25% for the entire year.
The Corporation’s balance sheet has historically been asset sensitive, meaning that earning assets generally reprice more quickly than interest-bearing liabilities. Therefore, the Corporation’s net interest margin was likely to increase in sustained periods of rising interest rates and decrease in sustained periods of declining interest rates. In an effort to make the Corporation’s balance sheet less sensitive to changes in interest rates, the Corporation entered into various interest rate swaps which effectively convert certain floating rate loans and borrowings into fixed rate instruments for a period of time. See Note 16 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to these interest rate swaps. As a result, the Corporation’s balance sheet is more interest-rate neutral and changes in interest rates are expected to have a less significant impact on the Corporation’s net interest margin than would have otherwise been the case. The Corporation is primarily funded by core deposits, with non-interest-bearing demand deposits historically being a significant source of funds. This lower-cost funding base is expected to have a positive impact on the Corporation’s net interest income and net interest margin in a rising interest rate environment. The Corporation currently believes it is reasonably possible the federal funds rate and the prime interest rate will remain at the current, historically-low levels for the foreseeable future; however, there can be no assurance to that effect or as to the magnitude of any change in market interest rates should a change occur, as such changes are dependent upon a variety of factors that are beyond the Corporation’s control. Further analysis of the components of the Corporation’s net interest margin is presented below.
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The following table presents the changes in taxable-equivalent net interest income and identifies the changes due to differences in the average volume of earning assets and interest-bearing liabilities and the changes due to changes in the average interest rate on those assets and liabilities. The changes in net interest income due to changes in both average volume and average interest rate have been allocated to the average volume change or the average interest rate change in proportion to the absolute amounts of the change in each. The Corporation’s consolidated average balance sheets along with an analysis of taxable-equivalent net interest income are presented on pages 128 and 129 of this report.
| 2009 vs. 2008 |
2008 vs. 2007 |
|||||||||||||||||||||||||
| Increase (Decrease) Due to Change in |
Increase (Decrease) Due to Change in |
|||||||||||||||||||||||||
| Rate | Volume | Total | Rate | Volume | Total | |||||||||||||||||||||
| Interest-bearing deposits |
$ | (298 | ) | $ | 2,030 | $ | 1,732 | $ | (658 | ) | $ | 691 | $ | 33 | ||||||||||||
| Federal funds sold and resell agreements |
(1,961 | ) | (1,330 | ) | (3,291 | ) | (10,765 | ) | (15,632 | ) | (26,397 | ) | ||||||||||||||
| Securities: |
||||||||||||||||||||||||||
| Taxable |
(16,080 | ) | (2,196 | ) | (18,276 | ) | 2,621 | (7,728 | ) | (5,107 | ) | |||||||||||||||
| Tax-exempt |
3,232 | 59,590 | 62,822 | 848 | 9,356 | 10,204 | ||||||||||||||||||||
| Loans |
(95,098 | ) | 20,205 | (74,893 | ) | (128,189 | ) | 61,130 | (67,059 | ) | ||||||||||||||||
| Total earning assets |
(110,205 | ) | 78,299 | (31,906 | ) | (136,143 | ) | 47,817 | (88,326 | ) | ||||||||||||||||
| Savings and interest checking |
(799 | ) | 515 | (284 | ) | (4,449 | ) | 1,193 | (3,256 | ) | ||||||||||||||||
| Money market deposit accounts |
(35,015 | ) | 8,217 | (26,798 | ) | (55,925 | ) | (54 | ) | (55,979 | ) | |||||||||||||||
| Time accounts |
(23,893 | ) | 6,946 | (16,947 | ) | (15,587 | ) | (971 | ) | (16,558 | ) | |||||||||||||||
| Public funds |
(4,922 | ) | 95 | (4,827 | ) | (8,120 | ) | (1,453 | ) | (9,573 | ) | |||||||||||||||
| Federal funds purchased and repurchase agreements |
(8,188 | ) | (3,714 | ) | (11,902 | ) | (23,490 | ) | 4,493 | (18,997 | ) | |||||||||||||||
| Junior subordinated deferrable interest debentures |
262 | (3 | ) | 259 | (3,137 | ) | (1,174 | ) | (4,311 | ) | ||||||||||||||||
| Subordinated notes payable and other notes |
- | - | - | (72 | ) | 799 | 727 | |||||||||||||||||||
| Federal Home Loan Bank advances |
(370 | ) | 5,600 | 5,230 | 229 | (766 | ) | (537 | ) | |||||||||||||||||
| Total interest-bearing liabilities |
(72,925 | ) | 17,656 | (55,269 | ) | (110,551 | ) | 2,067 | (108,484 | ) | ||||||||||||||||
| Changes in taxable-equivalent net interest income |
$ | (37,280 | ) | $ | 60,643 | $ | 23,363 | $ | (25,592 | ) | $ | 45,750 | $ | 20,158 | ||||||||||||
Taxable-equivalent net interest income for the 2009 increased $23.4 million, or 4.2%, compared to 2008. The increase primarily resulted from an increase in the average volume of interest-earning assets partly offset by a decrease in the net interest margin and the effect of a decrease in the number of days in 2009 due to a leap year in 2008. The average volume of interest-earning assets for 2009 increased $1.9 billion, or 16.3%, compared to the same period in 2008. Over the same time frame, the net interest margin decreased 44 basis points from 4.67% in 2008 to 4.23% in 2009. Taxable-equivalent net interest income for 2009 included 365 days compared to 366 days for 2008. The additional day added approximately $1.5 million to taxable-equivalent net interest income during 2008. Excluding the impact of the additional day during 2008 results in an effective increase in taxable-equivalent net interest income of approximately $24.9 million during 2009 compared to 2008. This effective increase was the result of the aforementioned increase in the average volume of interest-earning assets. The net interest margin decreased during 2009 compared to 2008 in part due to the decrease in market interest rates discussed above. The net interest margin was also partly impacted by an increase in the proportion of average interest-earning assets invested in lower yielding interest-bearing deposits during 2009 compared to 2008, while the proportion of average interest-earning assets invested in loans decreased. The average yield on interest-earning assets decreased 100 basis points from 5.86% during 2008 to 4.86% during 2009, while the average cost of funds decreased 78 basis points from 1.70% during 2008 to 0.92% during 2009. The average yield on interest-
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earning assets is primarily impacted by changes in market interest rates as well as changes in the volume and relative mix of interest-earning assets. As stated above, market interest rates decreased to historically low levels during 2008 and remained at those levels during 2009. The effect of lower average market interest rates on the average yield on average interest-earning assets was partly limited by the aforementioned interest rate swaps on variable-rate loans.
Taxable-equivalent net interest income for 2008 increased $20.2 million, or 3.8%, compared to 2007. The increase primarily resulted from an increase in the average volume of interest-earning assets partly offset by a decrease in the average yield on interest-earning assets. The average volume of interest-earning assets for 2008 increased $528.4 million, or 4.7%, compared to 2007. The increase in taxable-equivalent net interest income was also partly due to an increase in the number of days in 2008, due to the leap year. The additional day added approximately $1.5 million to taxable-equivalent net interest income during 2008. Excluding the impact of the additional day results in an effective increase in taxable-equivalent net interest income of approximately $18.6 million during 2008 compared to 2007. This effective increase was the result of the aforementioned increase in the average volume of interest-earning assets. The Corporation’s net interest margin was 4.67% for 2008 compared to 4.69% for 2007 despite significantly lower average market interest rates during 2008. As a result of the lower interest rates, the average yield on interest-earning assets decreased 103 basis points from 6.89% in 2007 to 5.86% in 2008. The effect of the lower average market interest rates on the average yield on interest-earning assets was substantially mitigated by a corresponding decrease in the average cost of funds, which decreased 144 basis points from 3.14% in 2007 to 1.70% in 2008. The effect of lower average market interest rates on the average yield on interest-earning assets was partly limited by the aforementioned interest rate swaps on variable-rate loans. In addition to lower average market interest rates, the cost of funds was further impacted by an increase in the relative proportion of lower-cost savings and interest checking deposits in 2008 relative to 2007. The negative impact of lower average market interest rates on the average yield on interest-earning assets was partly limited as the Corporation had a larger proportion of average interest-earning assets invested in higher-yielding loans, which increased from 65.8% of total average interest-earning assets during 2007 to 70.1% of total average interest-earning assets during 2008, and a lower proportion of average interest-earning assets invested in lower-yielding federal funds sold and resell agreements during 2008 relative to 2007.
The average volume of loans, the Corporation’s primary category of earning assets, increased $338.3 million, or 4.1%, during 2009 compared to 2008 and increased $850.1 million, or 11.4%, during 2008 compared to 2007. Loans made up approximately 62.7% of average interest-earning assets during 2009 compared to 70.1% during 2008 and 65.8% during 2007. The average yield on loans was 5.05% during the 2009 compared to 6.16% during 2008. Loans generally have significantly higher yields compared to securities, interest-bearing deposits and federal funds sold and resell agreements and, as such, have a more positive effect on the net interest margin. The average volume of securities increased $936.0 million in 2009 compared to 2008 and increased $38.6 million in 2008 compared to 2007. Securities made up approximately 30.9% of average interest-earning assets during 2009 compared to 28.0% during 2008 and 29.0% during 2007. The average yield on securities was 5.45% during 2009 compared to 5.41% during 2008 and 5.24% during 2007. The increase in the average yield on securities during the comparable periods primarily resulted as the relative proportion of higher-yielding, tax-exempt municipal securities increased from 12.5% of average securities in 2007 to 16.7% of average securities in 2008 and 34.0% of average securities in 2009. Average federal funds sold, resell agreements and interest-bearing deposits during 2009 increased $661.3 million, or 291.2%, compared to 2008 and decreased $438.2 million, or 75.6%, during 2008 compared to the 2007. Federal funds sold, resell agreements and interest-bearing deposits made up approximately 6.4% of average interest-earning assets during 2009 compared to 1.9% during 2008. The combined average yield on federal funds sold, resell agreements and interest-bearing deposits was 0.27% during 2009 compared to 1.73% during 2008 and 5.16% during 2007.
Average deposits increased $1.9 billion, or 17.9%, in 2009 compared to 2008 and $318.5 million, or 3.1%, during 2008 compared to 2007. The increase in average deposits over the comparable years was primarily in interest-bearing deposits. Average interest-bearing deposits increased $1.2 billion during 2009 compared to 2008 and $227.9 million during 2008 compared 2007. The ratio of average interest-bearing deposits to total average
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deposits was 65.7% during 2009 and 2008 and 65.5% in 2007. The average cost of interest-bearing deposits and total deposits was 0.69% and 0.45% during 2009 compared to 1.52% and 1.00% during 2008 and 2.84% and 1.86% during 2007. The decrease in the average cost of interest-bearing deposits during the comparable periods was primarily the result of decreases in interest rates offered on deposit products due to decreases in average market interest rates. The decrease in the average cost of interest-bearing deposits during 2008 compared to 2007 was also partly related to an increase in the relative proportion of lower yielding savings and interest on checking deposits.
The Corporation’s net interest spread, which represents the difference between the average rate earned on earning assets and the average rate paid on interest-bearing liabilities, was 3.94% in 2009 compared to 4.16% in 2008 and 3.75% in 2007. The net interest spread, as well as the net interest margin, will be impacted by future changes in short-term and long-term interest rate levels, as well as the impact from the competitive environment. A discussion of the effects of changing interest rates on net interest income is set forth in Item 7A. Quantitative and Qualitative Disclosures About Market Risk included elsewhere in this report.
The Corporation’s hedging policies permit the use of various derivative financial instruments, including interest rate swaps, caps and floors, to manage exposure to changes in interest rates. Details of the Corporation’s derivatives and hedging activities are set forth in Note 16 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report. Information regarding the impact of fluctuations in interest rates on the Corporation’s derivative financial instruments is set forth in Item 7A. Quantitative and Qualitative Disclosures About Market Risk included elsewhere in this report.
Provision for Possible Loan Losses
The provision for possible loan losses is determined by management as the amount to be added to the allowance for possible loan losses after net charge-offs have been deducted to bring the allowance to a level which, in management’s best estimate, is necessary to absorb probable losses within the existing loan portfolio. The provision for possible loan losses totaled $65.4 million in 2009 compared to $37.8 million in 2008 and $14.7 million in 2007. During the third quarter of 2008, the Corporation recorded a provision for possible loan losses totaling approximately $10 million for probable loan losses related to Hurricane Ike, which impacted the Corporation’s Houston and Galveston market areas. See the section captioned “Allowance for Possible Loan Losses” elsewhere in this discussion for further analysis of the provision for possible loan losses.
Non-Interest Income
The components of non-interest income were as follows:
| 2009 | 2008 | 2007 | |||||||||
| Trust fees |
$ | 67,268 | $ | 74,554 | $ | 70,359 | |||||
| Service charges on deposit accounts |
102,474 | 87,566 | 80,718 | ||||||||
| Insurance commissions and fees |
33,096 | 32,904 | 30,847 | ||||||||
| Other charges, commissions and fees |
27,699 | 35,557 | 32,558 | ||||||||
| Net gain (loss) on securities transactions |
(1,260 | ) | (159 | ) | 15 | ||||||
| Other |
64,429 | 56,900 | 53,734 | ||||||||
| Total |
$ | 293,706 | $ | 287,322 | $ | 268,231 | |||||
Total non-interest income for 2009 increased $6.4 million, or 2.2%, compared to 2008 while total non-interest income for 2008 increased $19.1 million, or 7.1%, compared to 2007. Changes in the various components of non-interest income are discussed in more detail below.
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Trust Fees. Trust fee income for 2009 decreased $7.3 million, or 9.8%, compared to 2008 while trust fee income for 2008 increased $4.2 million, or 6.0%, compared to 2007. Investment fees are the most significant component of trust fees, making up approximately 74% of total trust fees in 2009, approximately 67% of total trust fees in 2008 and approximately 71% of total trust fees in 2007. Investment and other custodial account fees are generally based on the market value of assets within a trust account. Volatility in the equity and bond markets impacts the market value of trust assets and the related investment fees.
The decrease in trust fee income during 2009 compared to 2008 was primarily the result of decreases in oil and gas trust management fees (down $4.7 million), securities lending income (down $929 thousand), custody fees (down $668 thousand), investment fees (down $521 thousand) and estate fees (down $434 thousand). The decrease in oil and gas trust management fees was primarily due to decreases in oil and natural gas prices, which impacted the amount of royalties received and decreases in new lease bonuses. The decrease in securities lending income was due in part to higher transaction spreads in 2008. The decreases in investment and custody fees were primarily due to the general decline in the market values of assets in trust accounts on which these fees are generally based. Equity valuations during 2009 have been lower on average compared to 2008, the impact of which was partly mitigated as bond valuations have been higher as a result of lower market interest rates. The Corporation has been successful with business development activities and customer retention, which has helped dampen the effect of the lower average equity valuations.
The increase in trust fee income during 2008 compared to the same period in 2007 was primarily the result of increases in oil and gas trust management fees (up $3.4 million) and securities lending income (up $1.7 million). The increase in oil and gas trust management fees was partly related to new lease bonuses and increased production. The increase in securities lending income was due in part to higher transaction spreads in 2008. Investment fees did not significantly fluctuate in 2008 compared to 2007. The Corporation was successful with business development activities and customer retention despite the market correction in equity valuations that occurred during 2008. Equity valuations during 2008 were lower on average compared to 2007 while bond valuations were higher as a result of lower market interest rates.
At December 31, 2009, trust assets, including both managed assets and custody assets, were primarily composed of fixed income securities (44.1% of trust assets), equity securities (37.8% of trust assets) and cash equivalents (11.1% of trust assets). The estimated fair value of trust assets was $22.7 billion (including managed assets of $10.4 billion and custody assets of $12.3 billion) at December 31, 2009 compared to $21.7 billion (including managed assets of $9.9 billion and custody assets of $11.8 billion) at December 31, 2008 and $24.8 billion (including managed assets of $10.5 billion and custody assets of $14.3 billion) at December 31, 2007.
Service Charges on Deposit Accounts. Service charges on deposit accounts for 2009 increased $14.9 million, or 17.0%, compared to 2008. The increase was primarily related to service charges on commercial accounts (up $13.2 million). The increase in service charges on commercial accounts was primarily related to increased treasury management fees. The increased treasury management fees resulted primarily from a lower earnings credit rate. The earnings credit rate is the value given to deposits maintained by treasury management customers. Because average market interest rates were lower during 2009 compared to 2008, deposit balances have become less valuable and are yielding a lower earnings credit rate. As a result, customers are paying for more of their services through fees rather than with earnings credits applied to their deposit balances.
Service charges on deposit accounts for 2008 increased $6.8 million, or 8.5%, compared to 2007. During 2008 increases in service charges on commercial accounts (up $7.3 million) were partly offset by decreases in service charges on consumer accounts (down $2.0 million). The increase in service charges on commercial accounts was primarily related to increased treasury management fees which resulted primarily from a lower earnings credit rate. The decrease in service charges on consumer accounts is partly the result of a shift in the relative mix of deposit products towards lower cost/free accounts, which is partly related to a restructuring of the Corporation’s deposit product offerings.
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Overdraft/insufficient funds charges totaled $41.1 million during 2009 compared to $40.5 million in 2008 and $39.7 million in 2007. Overdraft/insufficient funds charges included $32.6 million, $32.0 million and $31.7 million related to consumer accounts during 2009, 2008 and 2007, respectively, and $8.5 million, $8.5 million and $8.0 million related to commercial accounts during 2009, 2008 and 2007, respectively.
In November 2009, the Federal Reserve Board issued a final rule that, effective July 1, 2010, prohibits financial institutions from charging consumers fees for paying overdrafts on automated teller machine and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. Consumers must be provided a notice that explains the financial institution’s overdraft services, including the fees associated with the service, and the consumer’s choices. Because the Corporation’s customers must provide advance consent to the overdraft service for automated teller machine and one-time debit card transactions, the Corporation cannot provide any assurance as to the ultimate impact of this rule on the amount of overdraft/insufficient funds charges reported in future periods.
Insurance Commissions and Fees. Insurance commissions and fees for 2009 increased $192 thousand, or 0.6%, compared to 2008. The increase was related to an increase in commission income (up $140 thousand). Insurance commissions and fees for 2008 increased $2.1 million, or 6.7%, compared to 2007. The increase was primarily related to higher commission income (up $2.0 million), primarily related to acquisitions.
Insurance commissions and fees include contingent commissions totaling $3.8 million during 2009 and $3.7 million during both 2008 and 2007. Contingent commissions primarily consist of amounts received from various property and casualty insurance carriers. The carriers use several non-client specific factors to determine the amount of the contingency payments. Such factors include the aggregate loss performance of insurance policies previously placed and the volume of business, among other things. Such commissions are seasonal in nature and are mostly received during the first quarter of each year. These commissions totaled $2.8 million during 2009, $3.0 million during 2008 and $3.3 million during 2007. Contingent commissions also include amounts received from various benefit plan insurance companies related to the volume of business generated and/or the subsequent retention of such business. These commissions totaled $972 thousand, $716 thousand, and $366 thousand during 2009, 2008 and 2007.
Other Charges, Commissions and Fees. Other charges, commissions and fees for 2009 decreased $7.9 million, or 22.1%, compared to 2008. The decrease was primarily due to a decrease in investment banking fees related to corporate advisory services (down $4.2 million) and decreases in commission income related to the sale of money market accounts (down $2.9 million), account management fees (down $877 thousand), annuities (down $752 thousand), federal funds agent fees (down $564 thousand) and receivables factoring income (down $414 thousand), as well as decreases in various other categories of service charges. Investment banking fees related to corporate advisory services are transaction based and can vary significantly from year to year. Decreases in commission income related to the sale of money market accounts, annuities and mutual funds are partly related to decreases in volumes due to weaker market conditions. Additionally, the decrease in commission income related to the sale of money market accounts was also related to a reduction in marketing fees paid by fund companies. The decrease in account management fees relates to a line of business acquired in a 2006 acquisition that was phased-out in 2009. The decrease in federal funds agent fees was primarily related to decreases in pricing for competitive purposes. These decreases were partly offset by increases in mutual fund management fees related to Frost Investment Advisors, LLC, a registered investment advisor subsidiary of the Corporation which began operations in 2008 (up $795 thousand) and loan processing fees (up $409 thousand).
Other charges, commissions and fees for 2008 increased $3.0 million, or 9.2%, compared to the same period in 2007. The increase was primarily related to increases in mutual fund management fees related to Frost Investment Advisors, LLC, (up $1.9 million), commission income related to the sale of money market accounts (up $1.3 million), brokerage commissions (up $577 thousand), investment banking fees related to corporate advisory services (up $471 thousand), loan processing fees (up $462 thousand) and unused balance fees on loan commitments (up $459 thousand). These increases were partly offset by decreases in commission income related to the sale of mutual funds (down $987 thousand), receivables factoring income (down $653 thousand) and ATM fees (down $491 thousand).
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Net Gain/Loss on Securities Transactions. During 2009, the Corporation sold available-for-sale securities with an amortized cost totaling $206.2 million and realized a net gain of $283 thousand on those sales. The majority of the securities sold were Freddie Mac mortgage-backed securities. During the fourth quarter of 2009, the Corporation purchased approximately $404.9 million of Freddie Mac TBA (to be announced) mortgage-backed securities. The Corporation subsequently sold these securities prior to settlement and realized a net loss of $1.5 million. The Corporation instead invested the funds in mortgage-backed securities issued by Ginnie Mae. During 2008, the Corporation sold available-for-sale securities with an amortized cost totaling $4.9 billion and realized a related net loss of $159 thousand. The Corporation sold $599.1 million of securities during the first quarter of 2008 in connection with a restructuring of the Corporation’s securities portfolio to help improve net interest income in light of actions taken by the Federal Reserve that resulted in 200 basis point declines in both the federal funds rate and the prime interest rate. The proceeds from the sales were reinvested in longer-term securities with higher yields. The Corporation sold $257.2 million of securities during the second quarter of 2008, of which approximately $190.0 million were primarily sold for liquidity management purposes to fund loan growth. During the third quarter of 2008, the Corporation sold its entire portfolio (with a book value totaling $32.0 million) of unsecured, non-mortgage-backed securities issued by U.S. government agencies and corporations due to increasing risks associated with these investments. During the fourth quarter of 2008, the Corporation purchased and subsequently sold $4.0 billion of securities in connection with certain tax planning strategies.
Other Non-Interest Income. Other non-interest income increased $7.5 million, or 13.2%, for 2009 compared to the same period in 2008. The increase was primarily related to a $17.7 million gain related to the termination of interest rate swaps on certain Federal Home Loan Bank advances. See Note 16 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to the interest rate swaps. The increase in other non-interest income also included an increase in income from check card usage (up $1.4 million). These increases were partly offset by decreases in income from securities trading and customer derivative activities (down $2.4 million), sundry income from various miscellaneous items (down $2.4 million), gains on the sale of student loans (down $1.7 million), mineral interest income (down $1.5 million), earnings on cashier check balances (down $1.4 million), lease rental income (down $884 thousand) and gains on sale of assets (down $805 thousand). The decrease in income from securities trading and customer derivative activities primarily relates to a decrease in the volume of customer interest rate swap transactions. Sundry income from various miscellaneous items generally includes income from non-recurring items. Sundry income for 2008 included $2.8 million in income recognized from the collection of loan interest and other charges written-off in prior years, as well as $1.9 million related to the partial redemption of shares received from the VISA, Inc. initial public offering, as further discussed below. During the second quarter of 2008, the Corporation elected to discontinue the origination of student loans for resale, aside from previously outstanding commitments. Sales of student loans during 2009 have been limited as the Corporation’s student loan servicer has not been able to obtain the necessary funding required to purchase the loans. Mineral interest income is related to bonus, rental and shut-in payments and oil and gas royalties received from severed mineral interests on property owned by Main Plaza Corporation, a wholly owned non-banking subsidiary of the Corporation. Earnings on cashier check balances decreased as the Corporation began maintaining cashiers check balances in-house during the second quarter of 2008. While the Corporation no longer receives third-party fees on cashier check balances, maintaining such balances in-house provides investable funds from which the Corporation derives interest income. Gains on the sale of assets during 2008 included a $1.1 million gain related to a tract of land sold in connection with an eminent domain condemnation.
Other non-interest income increased $3.2 million, or 5.9%, during 2008 compared to the same period in 2007. Contributing to the increase were increases in mineral interest income (up $2.6 million), income from check card usage (up $2.1 million), income from securities trading and customer derivative activities (up $1.4 million) and sundry income from various miscellaneous items (up $827 thousand). Mineral interest income is related to bonus, rental and shut-in payments and oil and gas royalties received from severed mineral interests on property owned by Main Plaza Corporation, a wholly owned non-banking subsidiary of the Corporation. Sundry income for 2008 included $2.8 million in income recognized from the collection of loan interest and other charges
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written-off in prior years. Sundry income from various miscellaneous items also included $1.9 million recognized during the first quarter of 2008 related to the partial redemption of shares received from the VISA, Inc. initial public offering resulting from the Corporation’s membership interest in VISA USA. A portion of the shares allocated to the Corporation in the initial public offering were withheld to cover the costs and liabilities associated with certain litigation for which the Corporation, based on its prior proportionate membership interest in VISA USA, is obligated to indemnify VISA under its indemnification agreement with VISA USA. The Corporation accrued $548 thousand in connection with its obligations under the indemnification agreement during the fourth quarter of 2007. Since a portion of the shares allocated to the Corporation in the initial public offering were withheld, the Corporation was not required to make any cash payments related to the indemnification agreement. As such, the indemnification accrual related to certain pending litigation was reversed during the first quarter of 2008 and included in the aforementioned $1.9 million of income. The increases in the aforementioned items were partly offset by a decrease in earnings on cashier check balances (down $2.6 million) and lease rental income (down $757 thousand). The decrease in earnings on cashier check balances was primarily due to a decrease in fees received on balances maintained with the Corporation’s third-party processor as such fees are tied to market interest rates which were comparatively lower in 2008 relative to 2007. Also, as mentioned above, during the second quarter of 2008, the Corporation began to maintain cashiers check balances in-house.
Non-Interest Expense
The components of non-interest expense were as follows:
| 2009 | 2008 | 2007 | |||||||
| Salaries and wages |
$ | 230,643 | $ | 225,943 | $ | 209,982 | |||
| Employee benefits |
55,224 | 47,219 | 47,095 | ||||||
| Net occupancy |
44,188 | 40,464 | 38,824 | ||||||
| Furniture and equipment |
44,223 | 37,799 | 32,821 | ||||||
| Deposit insurance |
25,812 | 4,597 | 1,220 | ||||||
| Intangible amortization |
6,537 | 7,906 | 8,860 | ||||||
| Other |
125,611 | 122,717 | 123,644 | ||||||
| Total |
$ | 532,238 | $ | 486,645 | $ | 462,446 | |||
Total non-interest expense for 2009 increased $45.6 million, or 9.4%, compared to 2008 while total non-interest expense for 2008 increased $24.2 million, or 5.2%, compared to 2007. Changes in the various components of non-interest expense are discussed below.
Salaries and Wages. Salaries and wages for 2009 increased $4.7 million, or 2.1%, compared to 2008. The increase was primarily related to normal annual merit increases, a decrease in cost deferrals related to lending activity and an increase in stock-based compensation expense. The impact of these items was partly offset by a decrease in incentive compensation expense (down $7.2 million).
Salaries and wages for 2008 increased $16.0 million, or 7.6%, compared to 2007. The increase was primarily related to normal, annual merit increases, increases in headcount and increases in commissions related to higher insurance revenues and incentive compensation related to higher investment banking fees from corporate advisory services.
Employee Benefits. Employee benefits expense for 2009 increased $8.0 million, or 17.0%, compared to 2008. The increase was primarily related to increases in expenses related to the Corporation’s defined benefit retirement and restoration plans (up $3.3 million), expenses related to the Corporation’s 401(k) and profit sharing plans (up $2.4 million) and medical insurance expense (up $2.1 million).
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Employee benefits expense for 2008 did not significantly fluctuate compared to 2007 as increases in medical insurance expense (up $1.8 million), payroll taxes (up $797 thousand) and workers compensation insurance expense (up $412 thousand) were mostly offset by decreases in expenses related to the Corporation’s defined benefit retirement and restoration plans (down $2.2 million) and expenses related to the Corporation’s 401(k) and profit sharing plans (down $685 thousand).
The Corporation’s defined benefit retirement and restoration plans were frozen effective as of December 31, 2001 and were replaced by the profit sharing plan. Management believes these actions help reduce the volatility in retirement plan expense. However, the Corporation still has funding obligations related to the defined benefit and restoration plans and could recognize retirement expense related to these plans in future years, which would be dependent on the return earned on plan assets, the level of interest rates and employee turnover. Expense related to the defined benefit retirement and restoration plans totaled $3.1 million in 2009 compared to a net benefit of $269 thousand in 2008 and expense of $1.9 million in 2007. Future benefits/expense related to these plans is dependent upon a variety of factors, including the actual return on plan assets. The increase in expenses related to the Corporation’s defined benefit retirement plan during the 2009 compared to 2008 was partly the result of a weaker return on plan assets during 2008.
For additional information related to the Corporation’s employee benefit plans, see Note 12 - Employee Benefit Plans in the accompanying notes to consolidated financial statements included elsewhere in this report.
Net Occupancy. Net occupancy expense for 2009 increased $3.7 million, or 9.2%, compared to 2008. The increase was primarily due to increases in lease expense (up $1.6 million), property taxes (up $1.0 million) and building depreciation (up $790 thousand) as well as increases in various other categories of net occupancy expense. The increases in these items were partly related to the additional costs associated with new branch locations.
Net occupancy expense for 2008 increased $1.6 million, or 4.2%, compared to 2007. The increase was primarily due to an increase in utilities (up $649 thousand), lease expense (up $598 thousand), building maintenance (up $332 thousand) and service contracts expense (up $239 thousand). The increases in these items were partly related to the additional costs associated with new branch locations.
Furniture and Equipment. Furniture and equipment expense for 2009 increased $6.4 million, or 17.0%, compared to 2008. The increase was primarily related to increases in software amortization expense (up $2.3 million), depreciation expense related to furniture and fixtures (up $1.6 million) and software maintenance expense (up $1.6 million). The increases in software amortization and software maintenance expense were primarily related to certain applications related to data management, internet banking, treasury management and teller/retail delivery systems. The increases in depreciation expense related to furniture and fixtures were partly related to new branch locations.
Furniture and equipment expense for 2008 increased $5.0 million, or 15.2%, compared to 2007. The increase during 2008 was primarily related to increases in software amortization expense (up $1.5 million), software maintenance expense (up $1.4 million), depreciation expense related to furniture and fixtures (up $1.3 million) and service contracts expense (up $742 thousand). The increases in software amortization and software maintenance expense were related to the implementation of new software applications. The increase in depreciation expense related to furniture and fixtures was partly due to depreciation expense related to scanners utilized in the Corporations remote capture operations.
Deposit Insurance. Deposit insurance expense totaled $25.8 million for 2009, compared to $4.6 million in 2008 and $1.2 million in 2007. The increase in deposit insurance expense during 2009 compared to 2008 was due to increases in the fee assessment rates during 2009 and a special assessment applied to all insured institutions as of June 30, 2009. With regard to the increase in fee assessment rates, the FDIC finalized a rule in December 2008 that raised the then current assessment rates uniformly by 7 basis points for the first quarter of 2009 assessment.
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The new rule resulted in annualized assessment rates for Risk Category 1 institutions ranging from 12 to 14 basis points. In February 2009, the FDIC issued final rules to amend the deposit insurance fund restoration plan, change the risk-based assessment system and set assessment rates for Risk Category 1 institutions beginning in the second quarter of 2009. The new initial base assessment rates for Risk Category 1 institutions range from 12 to 16 basis points, on an annualized basis, and from 7 to 24 basis points after the effect of potential base-rate adjustments, in each case depending upon various factors. The increase in deposit insurance expense during 2009 compared to 2008 was also partly related to the Corporation’s utilization of available credits to offset assessments during the first half of 2008. Also affecting the 2009 increase was the additional 10 basis point assessment paid on covered transaction accounts exceeding $250 thousand under the Temporary Liquidity Guaranty Program.
In May 2009, the FDIC issued a final rule which levied a special assessment applicable to all insured depository institutions totaling 5 basis points of each institution’s total assets less Tier 1 capital as of June 30, 2009, not to exceed 10 basis points of domestic deposits. The special assessment was part of the FDIC’s efforts to rebuild the Deposit Insurance Fund (“DIF”). Deposit insurance expense during 2009 included $7.3 million recognized in the second quarter related to the special assessment.
In November 2009, the FDIC issued a rule that required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC also adopted a uniform three-basis point increase in assessment rates effective on January 1, 2011. In December 2009, the Corporation paid $64.5 million in prepaid risk-based assessments, which included $4.0 million related to the fourth quarter of 2009 that would have otherwise been payable in the first quarter of 2010. This amount is included in deposit insurance expense for 2009. The remaining $60.5 million in pre-paid deposit insurance is included in accrued interest receivable and other assets in the accompany consolidated balance sheet as of December 31, 2009.
Intangible Amortization. Intangible amortization is primarily related to core deposit intangibles and, to a lesser extent, intangibles related to customer relationships and non-compete agreements. Intangible amortization totaled $6.5 million for 2009 compared to $7.9 million for 2008 and $8.9 million for 2007. The decrease in amortization expense during the comparable years was primarily the result of the completion of amortization of certain intangible assets, as well as a reduction in the annual amortization rate of certain intangible assets as the Corporation uses an accelerated amortization approach which results in higher amortization rates during the earlier years of the useful lives of intangible assets. The decreases in amortization were partly offset by the additional amortization related to intangible assets recorded in connection with acquisitions during 2008 and 2009. See Note 6 - Goodwill and Other Intangible Assets in the accompanying notes to consolidated financial statements included elsewhere in this report.
Other Non-Interest Expense. Other non-interest expense for 2009 increased $2.9 million, or 2.4%, compared to 2008. Significant components of other non-interest expense with increases compared to 2008 included losses on the sale/write-down of foreclosed assets (up $2.3 million), property tax expense on foreclosed assets (up $2.1 million), cost deferrals related to lending activity (down $971 thousand), professional services expense (up $759 thousand) and sub-advisor investment management fees related to Frost Investment Advisors, LLC (up $670 thousand). Other non-interest expense also included $1.4 million related to a prepayment penalty on the early repayment of certain Federal Home Loan Bank advances as further discussed in Note 8—Borrowed Funds. The increases in foreclosed asset related expenses/losses were primarily related to a significant increase in real estate foreclosures in 2009 as a result of weaker economic conditions. Significant components of other non-interest expense with decreases compared to 2008 included sundry expense from various miscellaneous items (down $2.8 million), amortization of net deferred costs related to loan commitments (down $1.3 million), travel expense (down $628 thousand) and meals and entertainment expense (down $584 thousand). Sundry expense from various miscellaneous items for 2008 included $1.1 million related to a settlement of certain patent infringement claims, $1.0 million related to costs associated with Hurricane Ike which impacted the Corporation’s Houston and Galveston market areas and $410 thousand related to a lease settlement.
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Other non-interest expense for 2008 decreased $927 thousand, or 0.7%, compared to 2007. Significant components of other non-interest expense with decreases compared to 2007 included decreases in sundry expense from various miscellaneous items (down $4.4 million), armored motor service expense (down $1.0 million), depreciation expense on leased property (down $750 thousand) and outside computer services expense (down $717 thousand). Sundry expense from various miscellaneous items in 2007 included $5.3 million in expense related to a prepayment penalty and the write-off of the unamortized debt issuance costs incurred in connection with the redemption of $103.1 million of 8.42% junior subordinated deferrable interest debentures. Also included in 2007, among other things, was $1.0 million in expense related to a contribution for previously unmatched employee contributions to the Corporation’s 401(k) plan and $548 thousand in expense related to indemnification obligations with Visa USA. As previously mentioned, sundry expense from various miscellaneous items for 2008 included $1.1 million related to a settlement of certain patent infringement claims, $1.0 million related to costs associated with Hurricane Ike and $410 thousand related to a lease settlement. Significant components of other non-interest expense with increases compared to 2007 included increases in sub-advisor investment management fees related to Frost Investment Advisors, LLC (up $1.8 million), advertising/promotions expenses (up $1.6 million) and professional service expense (up $1.4 million).
Results of Segment Operations
The Corporation’s operations are managed along two operating segments: Banking and the Financial Management Group (“FMG”). A description of each business and the methodologies used to measure financial performance is described in Note 18 - Operating Segments in the accompanying notes to consolidated financial statements included elsewhere in this report. Net income (loss) by operating segment is presented below:
| 2009 | 2008 | 2007 | ||||||||||
| Banking |
$ | 179,404 | $ | 188,955 | $ | 200,387 | ||||||
| Financial Management Group |
8,642 | 26,863 | 27,317 | |||||||||
| Non-Banks |
(9,012 | ) | (8,563 | ) | (15,633 | ) | ||||||
| Consolidated net income |
$ | 179,034 | $ | 207,255 | $ | 212,071 | ||||||
Banking
Net income for 2009 decreased $9.6 million, or 5.1%, compared to 2008. The decrease was primarily the result of a $44.1 million increase in non-interest expense and a $27.6 million increase in the provision for possible loan losses partly offset by a $25.7 million decrease in income tax expense, a $19.6 million increase in non-interest income and a $16.8 million increase in net interest income. Net income for 2008 decreased $11.4 million, or 5.7%, compared to 2007. The decrease was primarily the result of a $23.1 million increase in the provision for possible loan losses and a $22.3 million increase in non-interest expense partly offset by an $11.6 million increase in non-interest income, an $11.9 million increase in net interest income and a $10.5 million decrease in income tax expense.
Net interest income for 2009 increased $16.8 million, or 3.2%, compared to 2008 while net interest income for 2008 increased $11.9 million, or 2.3%, compared to 2007. The increases were for the most part the result of growth in the average volume of earning assets partly offset by a decrease in the average yield on interest-earning assets. The changes in net interest income during the comparable years were also partly impacted by a differences in the number of days as 2008 included an extra day due to leap year. See the analysis of net interest income included in the section captioned “Net Interest Income” included elsewhere in this discussion.
The provision for possible loan losses for 2009 totaled $65.4 million compared to $37.8 million in 2008 and $14.7 million in 2007. During the third quarter of 2008, the Banking segment recorded a provision for possible loan losses totaling approximately $10 million for probable loan losses related to Hurricane Ike which impacted the Corporation’s Houston and Galveston market areas. See the analysis of the provision for possible loan losses included in the section captioned “Allowance for Possible Loan Losses” included elsewhere in this discussion.
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Non-interest income for 2009 increased $19.6 million, or 10.4%, compared to 2008. The increase was primarily due to an increase in service charges on deposit accounts and other non-interest income partly offset by decreases in other charges commissions and fees and a larger net loss on securities transactions. The increase in service charges on deposit accounts was primarily related to increased treasury management fees on commercial accounts. The increase in other non-interest income was primarily related to a $17.7 million gain related to the termination of interest rate swaps on certain Federal Home Loan Bank advances. See Note 16 - Derivative Financial Instruments for additional information related to the interest rate swaps. The decrease in other charges, commissions and fees was primarily related to decreases in investment banking fees related to corporate advisory services, federal funds agent fees and receivables factoring income. Non-interest income for 2008 increased $11.6 million, or 6.5%, compared to 2007. The increase was due to increases in service charges on deposit accounts, other non-interest income and insurance commissions. See further analysis of these categories of non-interest income included in the section captioned “Non-Interest Income” included elsewhere in this discussion.
Non-interest expense for 2009 increased $44.1 million, or 10.9%, compared to 2008. The increase was primarily due to an increase in deposit insurance expense due to increases in the fee assessment rates during 2009 and a special assessment applied to all insured depository institutions as of June 30, 2009. The increase was also partly due to increases in employee benefits, furniture and equipment expense, net occupancy expense and salaries and wages. The increase in employee benefits expense was primarily related to increases in expenses related to the Corporation’s defined benefit retirement and restoration plans, expenses related to the Corporation’s 401(k) and profit sharing plans and medical insurance expense. The increase in furniture and equipment expense was primarily related to increases in software amortization expense, depreciation expense related to furniture and fixtures and software maintenance expense. The increase in salaries and wages were primarily related to normal annual merit increases, a decrease in cost deferrals related to lending activity and an increase in stock-based compensation expense. The impact of these items was partly offset by a decrease in incentive compensation expense. The increase in net occupancy expense was primarily due to increases in lease expense, property taxes and building depreciation. See the analysis of these items included in the section captioned “Non-Interest Expense” included elsewhere in this discussion.
Non-interest expense for 2008 increased $22.3 million, or 5.9%, compared to 2007. The increase was primarily related to increases in salaries and wages, furniture and equipment expense, deposit insurance expense, other non-interest expense and net occupancy expense. The increases in salaries and wages were primarily related to normal, annual merit increases, increases in headcount and increases in commissions and incentive compensation. The increase in furniture and equipment expense was primarily related to increases in software amortization expense, software maintenance expense, depreciation expense related to furniture and fixtures and service contracts expense. The increase in other non-interest expense included increases in advertising/promotions expenses and professional service expense. The increase in net occupancy expense was primarily due to an increase in utilities, lease expense, building maintenance and service contracts expense. See the analysis of these items included in the section captioned “Non-Interest Expense” included elsewhere in this discussion.
Frost Insurance Agency, which is included in the Banking operating segment, had gross commission revenues of $33.6 million in 2009 compared to $33.3 million in 2008 and $31.2 million in 2007. Insurance commission revenues increased $304 thousand, or 0.9%, during 2009 compared to 2008 and increased $2.1 million, or 6.7%, during 2008 compared to 2007. The increases during both 2009 and 2008 were primarily related to higher commission income See the analysis of insurance commissions and fees included in the section captioned “Non-Interest Income” included elsewhere in this discussion.
Financial Management Group (FMG)
Net income for 2009 decreased $18.2 million, or 67.8%, compared to 2008. The decrease was primarily due to a $13.9 million decrease in net interest income, a $12.6 million decrease in non-interest income and a $1.6 million increase in non-interest expense partly offset by a $9.8 million decrease in income tax expense. Net income for 2008 decreased $454 thousand compared to 2007. The decrease was primarily due to a $6.4 million increase in non-interest expense partly offset by a $6.0 million increase in non-interest income.
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Net interest income for 2009 decreased $13.9 million, or 59.9%, compared to 2008. The decrease was due to a decrease in the average volume of funds provided due to a decrease in the average volume of FMGs repurchase agreements which resulted from lower interest rates offered combined with a decrease in the funds transfer price received for providing those funds due to the lower interest rate environment. Net interest income for 2008 did not significantly fluctuate compared to 2007.
Non-interest income for 2009 decreased $12.6 million, or 13.0%, compared to 2008. The decrease was primarily due to decreases in trust fees (down $7.7 million) and other charges, commissions and fees (down $4.1 million). Non-interest income for 2008 increased $6.0 million, or 6.6%, compared to 2007. The increase was primarily due to increases in trust fees (up $4.2 million) and other charges, commissions and fees (up $2.7 million), partially offset by a decrease in other income (down $849 thousand).
Trust fee income is the most significant income component for FMG. Investment fees are the most significant component of trust fees, making up approximately 74% of total trust fees in 2009, approximately 67% of total trust fees in 2008 and approximately 71% in 2007. Investment and other custodial account fees are generally based on the market value of assets within a trust account. Volatility in the equity and bond markets impacts the market value of trust assets and the related investment fees. The decrease in trust fee income during 2009 compared to 2008 was primarily the result of decreases in oil and gas trust management fees, securities lending income, custody fees, investment fees and estate fees. The increase in trust fee income during 2008 compared to 2007 was primarily the result of increases in oil and gas trust management fees and securities lending income. See the analysis of trust fees included in the section captioned “Non-Interest Income” included elsewhere in this discussion.
The decrease in other charges, commissions and fees during 2009 compared to 2008 was primarily due to decreases in commission income related to the sale of money market accounts, annuities and mutual funds and a decrease in account management fees related to a line of business that was phased-out in 2009 offset by an increase in mutual fund management fees related to Frost Investment Advisors. Decreases in commission income related to the sale of money market accounts, annuities and mutual funds were partly related to decreases in volumes due to weaker market conditions. Additionally, the decrease in commission income related to the sale of money market accounts was also related to a reduction in marketing fees paid by fund companies. The increase in other charges, commissions and fees during 2008 compared to 2007 was primarily due to increases in commission income related to the sales of money market accounts, mutual funds and annuities as well as an increase in brokerage commissions. The decrease in other income during 2008 compared to 2007 was partly due to a decrease in earnings on cashier check balances.
Non-interest expense for 2009 increased $1.6 million, or 2.0%, compared to the same periods in 2008. The increase was primarily due to an increase in salaries and wages and employee benefits (up $1.4 million on a combined basis). The increase in salaries and wages and employee benefits was primarily the result of increases in incentive and stock-based compensation expense and expenses related to employee benefit plans and medical insurance.
Non-interest expense for 2008 increased $6.4 million, or 9.0%, compared to the same period in 2007. The increase was primarily due to an increase in salaries and wages and employee benefits (up $4.0 million on a combined basis) and other non-interest expense (up $2.4 million). The increase in salaries and wages and employee benefits was primarily related to normal, annual merit increases, increases in headcount and increases in commissions and incentive compensation. The increase in other non-interest expense was mostly related to sub-advisor investment management fees for Frost Investment Advisors, which began operations during 2008.
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Non-Banks
The net loss for the Non-Banks operating segment increased $449 thousand for 2009 compared to 2008. The increased loss was largely related to a decrease in mineral interest income. Mineral interest income is related to bonus, rental and shut-in payments and oil and gas royalties received from severed mineral interests on property owned by Main Plaza Corporation.
The net loss for the Non-Banks operating segment for 2008 decreased $7.1 million compared to 2007. During 2007, the net loss included $5.3 million in expense recognized during the first quarter of 2007 related to a prepayment penalty and the write-off of the unamortized debt issuance costs incurred in connection with the redemption of $103.1 million of 8.42% junior subordinated deferrable interest debentures. The decrease in the net loss was also partly the result of a decrease in interest expense on certain borrowings. As market interest rates decreased, the Non-Banks segment experienced a corresponding decrease in interest cost related to its variable-rate junior subordinated deferrable interest debentures issued in February 2004. Additionally, $3.1 million of variable-rate junior subordinated deferrable interest debentures were redeemed in the first quarter of 2008.
During the fourth quarter of 2008, the Non-Banks operating segment entered into an interest rate swap contract related to its variable-rate junior subordinated deferrable interest debentures issued in February 2004. The terms of the swap effectively convert the variable-rate debentures to a fixed rate for a period of five years. See Note 16 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to this swap.
Income Taxes
The Corporation recognized income tax expense of $53.7 million, for an effective rate of 23.1%, in 2009, compared to $89.6 million, for an effective tax rate of 30.2% in 2008 and $97.8 million, for an effective rate of 31.6%, in 2007. The effective income tax rates differed from the U.S. statutory rate of 35% during the comparable periods primarily due to the effect of tax-exempt income from loans, securities and life insurance policies. The decrease in the effective tax rate during the comparable years was primarily the result of an increase in holdings of tax-exempt municipal securities.
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Sources and Uses of Funds
The following table illustrates, during the years presented, the mix of the Corporation’s funding sources and the assets in which those funds are invested as a percentage of the Corporation’s average total assets for the period indicated. Average assets totaled $15.7 billion in 2009 compared to $13.7 billion in 2008 and $13.0 billion in 2007.
| 2009 | 2008 | 2007 | |||||||
| Sources of Funds: |
|||||||||
| Deposits: |
|||||||||
| Non-interest-bearing |
27.1 | % | 26.4 | % | 27.0 | % | |||
| Interest-bearing |
52.0 | 50.5 | 51.3 | ||||||
| Federal funds purchased and repurchase agreements |
3.9 | 7.4 | 6.6 | ||||||
| Long-term debt and other borrowings |
3.7 | 2.9 | 3.2 | ||||||
| Other non-interest-bearing liabilities |
1.7 | 1.3 | 1.2 | ||||||
| Equity capital |
11.6 | 11.5 | 10.7 | ||||||
| Total |
100.0 | % | 100.0 | % | 100.0 | % | |||
| Uses of Funds: |
|||||||||
| Loans |
55.1 | % | 60.7 | % | 57.2 | % | |||
| Securities |
27.1 | 24.3 | 25.2 | ||||||
| Federal funds sold, resell agreements and other interest-earning assets |
5.7 | 1.7 | 4.5 | ||||||
| Other non-interest-earning assets |
12.1 | 13.3 | 13.1 | ||||||
| Total |
100.0 | % | 100.0 | % | 100.0 | % | |||
Deposits continue to be the Corporation’s primary source of funding. Average deposits increased $1.2 billion, or 18.0% in 2009 compared to 2008 and $318.5 million, or 3.1% in 2008 compared to 2007. Non-interest-bearing deposits remain a significant source of funding, which has been a key factor in maintaining the Corporation’s relatively low cost of funds. Non-interest-bearing deposits totaled 34.3% of total average deposits in 2009 and 2008 and 34.5% in 2007.
The Corporation primarily invests funds in loans and securities. Loans continue to be the largest component of the Corporation’s mix of invested assets. Average loans increased $338.3 million, or 4.1%, in 2009 compared to 2008 and $850.1 million, or 11.4%, in 2008 compared to 2007. Average securities increased $936.0 million, or 28.1%, in 2009 compared to 2008 and $38.6 million, or 1.2% in 2008 compared to 2007. Average federal funds sold, resell agreements and other interest-earning assets increased $661.3 million in 2009 compared to 2008. The increases in average securities and average federal funds sold, resell agreements and other interest-earning assets were funded by deposit growth.
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Loans
Year-end loans were as follows:
| 2009 | Percentage of Total |
2008 | 2007 | 2006 | 2005 | ||||||||||||||||||
| Commercial and industrial: |
|||||||||||||||||||||||
| Commercial |
$ | 3,577,758 | 42.7 | % | $ | 3,950,648 | $ | 3,472,759 | $ | 3,229,570 | $ | 2,610,178 | |||||||||||
| Leases |
197,605 | 2.4 | 205,290 | 184,140 | 174,075 | 148,750 | |||||||||||||||||
| Asset-based |
117,213 | 1.4 | 85,865 | 32,963 | 33,856 | 41,288 | |||||||||||||||||
| Total commercial and industrial |
3,892,576 | 46.5 | 4,241,803 | 3,689,862 | 3,437,501 | 2,800,216 | |||||||||||||||||
| Real estate: |
|||||||||||||||||||||||
| Construction: |
|||||||||||||||||||||||
| Commercial |
659,459 | 7.9 | 755,704 | 560,176 | 649,140 | 590,635 | |||||||||||||||||
| Consumer |
30,325 | 0.4 | 55,947 | 61,595 | 114,142 | 87,746 | |||||||||||||||||
| Land: |
|||||||||||||||||||||||
| Commercial |
259,200 | 3.1 | 346,591 | 397,319 | 407,055 | 301,907 | |||||||||||||||||
| Consumer |
1,677 | - | 1,716 | 2,996 | 5,394 | 10,369 | |||||||||||||||||
| Commercial mortgages |
2,327,471 | 27.8 | 2,250,442 | 1,982,786 | 1,766,469 | 1,409,811 | |||||||||||||||||
| 1-4 family residential mortgages |
66,351 | 0.8 | 79,446 | 98,077 | 125,294 | 95,032 | |||||||||||||||||
| Home equity and other consumer |
730,079 | 8.7 | 707,974 | 587,721 | 508,574 | 460,941 | |||||||||||||||||
| Total real estate |
4,074,562 | 48.7 | 4,197,820 | 3,690,670 | 3,576,068 | 2,956,441 | |||||||||||||||||
| Consumer: |
|||||||||||||||||||||||
| Student loans held for sale |
24,201 | 0.3 | 28,889 | 62,861 | 47,335 | 51,189 | |||||||||||||||||
| Other |
346,255 | 4.2 | 349,641 | 325,351 | 314,227 | 267,456 | |||||||||||||||||
| Other |
52,406 | 0.6 | 53,662 | 29,891 | 27,703 | 27,201 | |||||||||||||||||
| Unearned discount |
(22,220 | ) | (0.3 | ) | (27,733 | ) | (29,273 | ) | (29,450 | ) | (17,448 | ) | |||||||||||
| Total |
$ | 8,367,780 | 100.0 | % | $ | 8,844,082 | $ | 7,769,362 | $ | 7,373,384 | $ | 6,085,055 | |||||||||||
Overview. Year-end total loans decreased $476.3 million, or 5.4%, during 2009 compared to 2008. The Corporation stopped originating 1-4 family residential mortgage loans in 2000, and as such, this portfolio is excluded when analyzing the growth of the loan portfolio. Student loans are similarly excluded because the Corporation primarily originated these loans for resale. Accordingly, student loans are classified as held for sale. Excluding 1-4 family residential mortgages and student loans, loans decreased $458.5 million, or 5.3%, from December 31, 2008. Year-end total loans increased $1.1 billion, or 13.8%, during 2008 compared to 2007, $396.0 million, or 5.4% during 2007 compared to 2006 and $1.3 billion, or 21.2%, during 2006 compared to 2005. During 2006, the Corporation acquired $1.1 billion in loans in connection with acquisitions. Excluding these acquired loans, total year-end loans increased $174.2 million, or 2.9%, from 2005.
The majority of the Corporation’s loan portfolio is comprised of commercial and industrial loans and real estate loans. Commercial and industrial loans made up 46.5% and 48.0% of total loans at December 31, 2009 and 2008 while real estate loans made up 48.7% and 47.5% total loans at December 31, 2009 and 2008. Real estate loans include both commercial and consumer balances.
Loan Origination/Risk Management. The Corporation has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves
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these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.
Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined that the borrower’s management possesses sound ethics and solid business acumen, the Corporation’s management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.
Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. As detailed in the discussion of real estate loans below, the properties securing the Corporation’s commercial real estate portfolio are diverse in terms of type and geographic location. This diversity helps reduce the Corporation’s exposure to adverse economic events that affect any single market or industry. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. As a general rule, the Corporation avoids financing single-purpose projects unless other underwriting factors are present to help mitigate risk. The Corporation also utilizes third-party experts to provide insight and guidance about economic conditions and trends affecting market areas it serves. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans. At December 31, 2009, approximately 59% of the outstanding principal balance of the Corporation’s commercial real estate loans were secured by owner-occupied properties.
With respect to loans to developers and builders that are secured by non-owner occupied properties that the Corporation may originate from time to time, the Corporation generally requires the borrower to have had an existing relationship with the Corporation and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Corporation until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.
The Corporation originates consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed, jointly by line and staff personnel. This activity, coupled with relatively small loan amounts
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that are spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a regular basis. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements.
The Corporation maintains an independent loan review department that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to management. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Corporation’s policies and procedures.
Commercial and Industrial Loans. Commercial and industrial loans decreased $349.2 million, or 8.2% from $4.2 billion at December 31, 2008 to $3.9 billion at December 31, 2009. The Corporation’s commercial and industrial loans are a diverse group of loans to small, medium and large businesses. The purpose of these loans varies from supporting seasonal working capital needs to term financing of equipment. While some short-term loans may be made on an unsecured basis, most are secured by the assets being financed with collateral margins that are consistent with the Corporation’s loan policy guidelines. The commercial and industrial loan portfolio also includes the commercial lease and asset-based lending portfolios as well as purchased shared national credits (“SNCs”), which are discussed in more detail below.
Industry Concentrations. As of December 31, 2009 and 2008, there were no concentrations of loans within any single industry in excess of 10% of total loans, as segregated by Standard Industrial Classification code (“SIC code”). The SIC code is a federally designed standard industrial numbering system used by the Corporation to categorize loans by the borrower’s type of business. The following table summarizes the industry concentrations of the Corporation’s loan portfolio, as segregated by SIC code. Industry concentrations are stated as a percentage of year-end total loans as of December 31, 2009 and 2008:
| 2009 | 2008 | |||||
| Industry concentrations: |
||||||
| Energy |
9.9 | % | 9.7 | % | ||
| Medical services |
5.7 | 5.0 | ||||
| Public finance |
4.1 | 3.5 | ||||
| Services |
3.7 | 3.8 | ||||
| Building construction |
3.2 | 3.9 | ||||
| Insurance |
3.1 | 3.2 | ||||
| Manufacturing, other |
2.9 | 3.5 | ||||
| Religion |
2.8 | 2.7 | ||||
| General and specific trade contractors |
2.6 | 2.9 | ||||
| Restaurants |
2.1 | 2.1 | ||||
| Legal services |
2.0 | 2.1 | ||||
| All other (35 categories in 2009 and 2008) |
57.9 | 57.6 | ||||
| Total loans |
100.0 | % | 100.0 | % | ||
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The Corporation’s largest concentration in any single industry is in energy. Year-end energy loans were as follows:
| 2009 | 2008 | |||||
| Energy loans: |
||||||
| Production |
$ | 647,177 | $ | 666,202 | ||
| Service |
113,903 | 135,859 | ||||
| Traders |
25,986 | 5,006 | ||||
| Manufacturing |
37,395 | 46,168 | ||||
| Refining |
5,124 | 1,832 | ||||
| Total energy loans |
$ | 829,585 | $ | 855,067 | ||
Large Credit Relationships. The market areas served by the Corporation include three of the top ten most populated cities in the United States. These market areas are also home to a significant number of Fortune 500 companies. As a result, the Corporation originates and maintains large credit relationships with numerous commercial customers in the ordinary course of business. The Corporation considers large credit relationships to be those with commitments equal to or in excess of $10.0 million, excluding treasury management lines exposure, prior to any portion being sold. Large relationships also include loan participations purchased if the credit relationship with the agent is equal to or in excess of $10.0 million. In addition to the Corporation’s normal policies and procedures related to the origination of large credits, the Corporation’s Central Credit Committee (CCC) must approve all new and renewed credit facilities which are part of large credit relationships. The CCC meets regularly and reviews large credit relationship activity and discusses the current pipeline, among other things. The following table provides additional information on the Corporation’s large credit relationships outstanding at year-end.
| 2009 |
2008 | |||||||||||||||
| Number of Relationships |
Period-End Balances | Number of Relationships |
Period-End Balances | |||||||||||||
| Committed | Outstanding | Committed | Outstanding | |||||||||||||
| Large credit relationships: |
||||||||||||||||
| $20.0 million and greater |
120 | $ | 4,103,100 | $ | 2,049,732 | 132 | $ | 4,417,378 | $ | 2,252,480 | ||||||
| $10.0 million to $19.9 million |
135 | 1,883,661 | 1,192,125 | 153 | 2,139,635 | 1,232,404 | ||||||||||
The decrease in outstanding balances related to large credit relationships primarily resulted from a decrease in commitments and customers paying down existing lines. The average commitment per large credit relationship in excess of $20.0 million totaled $34.2 million at December 31, 2009 and $33.5 million at December 31, 2008. The average outstanding balance per large credit relationship with a commitment in excess of $20.0 million totaled $17.1 million at both December 31, 2009 and 2008. The average commitment per large credit relationship between $10.0 million and $19.9 million totaled $14.0 million at both December 31, 2009 and 2008. The average outstanding balance per large credit relationship with a commitment between $10 million and $19.9 million totaled $8.8 million at December 31, 2009 and $8.1 million at December 31, 2008.
Purchased Shared National Credits. Purchased SNCs are participations purchased from upstream financial organizations and tend to be larger in size than the Corporation’s originated portfolio. The Corporation’s purchased SNC portfolio totaled $463.4 million at December 31, 2009, decreasing $70.7 million, or 13.2%, from $534.1 million at December 31, 2008. At December 31, 2009, 63.0% of outstanding purchased SNCs was related to the energy industry. The remaining purchased SNCs were diversified throughout various other industries, with no other single industry exceeding 10% of the total purchased SNC portfolio. Additionally, almost all of the outstanding balance of purchased SNCs was included in the commercial and industrial portfolio, with the remainder included in the real estate categories. SNC participations are originated in the normal course of business to meet the needs of the Corporation’s customers. As a matter of policy, the Corporation generally only participates in SNCs for companies headquartered in or which have significant operations within the
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Corporation’s market areas. In addition, the Corporation must have direct access to the company’s management, an existing banking relationship or the expectation of broadening the relationship with other banking products and services within the following 12 to 24 months. SNCs are reviewed at least quarterly for credit quality and business development successes. The following table provides additional information about certain credits within the Corporation’s purchased SNCs portfolio as of year-end.
| 2009 |
2008 | |||||||||||||||
| Number of Relationships |
Period-End Balances | Number of Relationships |
Period-End Balances | |||||||||||||
| Committed | Outstanding | Committed | Outstanding | |||||||||||||
| Purchased shared national credits: |
||||||||||||||||
| $20.0 million and greater |
33 | $ | 774,196 | $ | 340,830 | 25 | $ | 629,747 | $ | 353,740 | ||||||
| $10.0 million to $19.9 million |
16 | 229,133 | 108,106 | 21 | 314,523 | 158,567 | ||||||||||
Real Estate Loans. Real estate loans totaled $4.1 billion at December 31, 2009, decreasing $123.3 million, or 2.9%, compared to $4.2 billion at December 31, 2008. Commercial real estate loans totaled $3.2 billion or 79.7% of total real estate loans, at December 31, 2009 and $3.4 billion, or 79.9% of total real estate loans, at December 31, 2008. The majority of this portfolio consists of commercial real estate mortgages, which includes both permanent and intermediate term loans. The Corporation’s primary focus for the commercial real estate portfolio has been growth in loans secured by owner-occupied properties. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Consequently, these loans must undergo the analysis and underwriting process of a commercial and industrial loan, as well as that of a real estate loan.
The following tables summarize the Corporation’s commercial real estate loan portfolio, as segregated by (i) the type of property securing the credit and (ii) the geographic region in which the property is located. Property type concentrations are stated as a percentage of year-end total commercial real estate loans as of December 31, 2009 and 2008:
| 2009 | 2008 | |||||
| Property type: |
||||||
| Office/warehouse |
17.3 | % | 17.7 | % | ||
| Office building |
16.7 | 16.1 | ||||
| Retail |
8.2 | 6.8 | ||||
| Medical offices and services |
7.0 | 5.3 | ||||
| Non-farm/non-residential |
6.0 | 5.3 | ||||
| Religious |
5.6 | 5.2 | ||||
| 1-4 family |
5.1 | 7.2 | ||||
| All other |
34.1 | 36.4 | ||||
| Total commercial real estate loans |
100.0 | % | 100.0 | % | ||
| 2009 | 2008 | |||||
| Geographic region: |
||||||
| Fort Worth |
27.4 | % | 27.8 | % | ||
| San Antonio |
22.4 | 20.9 | ||||
| Houston |
21.2 | 21.9 | ||||
| Austin |
9.4 | 9.4 | ||||
| Dallas |
9.3 | 9.9 | ||||
| Rio Grande Valley |
5.3 | 5.1 | ||||
| Corpus Christi |
5.0 | 5.0 | ||||
| Total commercial real estate loans |
100.0 | % | 100.0 | % | ||
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Consumer Loans. The consumer loan portfolio, including all consumer real estate, totaled $1.2 billion at both December 31, 2009, and 2008. As the following table illustrates as of year-end, the consumer loan portfolio has four distinct segments, including consumer real estate, consumer non-real estate, student loans held for sale and 1-4 family residential mortgages.
| 2009 | 2008 | |||||
| Construction |
$ | 30,325 | $ | 55,947 | ||
| Land |
1,677 | 1,716 | ||||
| Home equity loans |
289,535 | 320,220 | ||||
| Home equity lines of credit |
166,441 | 122,608 | ||||
| Other consumer real estate |
274,103 | 265,146 | ||||
| Total consumer real estate |
762,081 | 765,637 | ||||
| Consumer non-real estate |
346,255 | 349,641 | ||||
| Student loans held for sale |
24,201 | 28,889 | ||||
| 1-4 family residential mortgages |
66,351 | 79,446 | ||||
| Total consumer loans |
$ | 1,198,888 | $ | 1,223,613 | ||
Consumer real estate loans, excluding 1-4 family mortgages, decreased $3.6 million, or 0.5%, from December 31, 2008. Combined, home equity loans and lines of credit made up 59.8% and 57.8% of the consumer real estate loan total at December 31, 2009 and 2008. The Corporation offers home equity loans up to 80% of the estimated value of the personal residence of the borrower, less the value of existing mortgages and home improvement loans.
The consumer non-real estate loan portfolio primarily consists of automobile loans, unsecured revolving credit products, personal loans secured by cash and cash equivalents, and other similar types of credit facilities.
During 2008, the Corporation elected to discontinue the origination of student loans for resale, aside from previously outstanding commitments. Student loans were primarily originated for resale on the secondary market. Accordingly, these loans are considered “held for sale.” Student loans are included in total loans in the consolidated balance sheet. Student loans are generally sold on a non-recourse basis after the deferment period has ended; however, from time to time, the Corporation has sold such loans prior to the end of the deferment period. The Corporation sold approximately $4.6 million of student loans during 2009 compared to $67.6 million during 2008 and $63.1 million during 2007.
The Corporation also discontinued originating 1-4 family residential mortgage loans in 2000. This portfolio will continue to decline due to the decision to withdraw from the mortgage origination business. 1-4 family residential mortgage loans increased $30.3 million during 2006 compared to 2005 as a result of loans acquired in connection with acquisitions.
Foreign Loans. The Corporation makes U.S. dollar-denominated loans and commitments to borrowers in Mexico. The outstanding balance of these loans and the unfunded amounts available under these commitments were not significant at December 31, 2009 or 2008.
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Maturities and Sensitivities of Loans to Changes in Interest Rates. The following table presents the maturity distribution of the Corporation’s loans, excluding 1-4 family residential real estate loans, student loans and unearned discounts, at December 31, 2009. The table also presents the portion of loans that have fixed interest rates or variable interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index such as the prime rate or LIBOR.
| Due in One Year or Less |
After One, but Within Five Years |
After Five Years |
Total | |||||||||
| Commercial and industrial |
$ | 1,946,685 | $ | 1,510,887 | $ | 435,004 | $ | 3,892,576 | ||||
| Real estate construction |
313,781 | 250,781 | 125,222 | 689,784 | ||||||||
| Commercial real estate and land |
446,562 | 1,069,901 | 1,070,208 | 2,586,671 | ||||||||
| Consumer and other |
196,641 | 276,014 | 657,762 | 1,130,417 | ||||||||
| Total |
$ | 2,903,669 | $ | 3,107,583 | $ | 2,288,196 | $ | 8,299,448 | ||||
| Loans with fixed interest rates |
$ | 722,735 | $ | 991,653 | $ | 1,241,863 | $ | 2,956,251 | ||||
| Loans with floating interest rates |
2,180,934 | 2,115,930 | 1,046,333 | 5,343,197 | ||||||||
| Total |
$ | 2,903,669 | $ | 3,107,583 | $ | 2,288,196 | $ | 8,299,448 | ||||
The Corporation may renew loans at maturity when requested by a customer whose financial strength appears to support such renewal or when such renewal appears to be in the Corporation’s best interest. In such instances, the Corporation generally requires payment of accrued interest and may adjust the rate of interest, require a principal reduction or modify other terms of the loan at the time of renewal. The Corporation has entered into interest rate swaps that effectively convert $800 million of loans with floating interest rates tied to the prime rate reported in the table above into fixed rate loans for a period of seven years. See Note 16 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to these interest rate swaps.
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Non-Performing Assets and Potential Problem Loans
Non-Performing Assets. Year-end non-performing assets and accruing past due loans were as follows:
| 2009 | 2008 | 2007 | 2006 | 2005 | ||||||||||||||||
| Non-accrual loans: |
||||||||||||||||||||
| Commercial and industrial |
$ | 78,638 | $ | 27,123 | $ | 11,445 | $ | 20,813 | $ | 25,556 | ||||||||||
| Real estate |
54,592 | 36,764 | 12,026 | 29,580 | 4,963 | |||||||||||||||
| Consumer and other |
13,637 | 1,287 | 972 | 1,811 | 2,660 | |||||||||||||||
| Total non-accrual loans |
146,867 | 65,174 | 24,443 | 52,204 | 33,179 | |||||||||||||||
| Restructured loans |
- | - | - | - | - | |||||||||||||||
| Foreclosed assets: |
||||||||||||||||||||
| Real estate |
33,305 | 12,312 | 4,596 | 5,500 | 4,403 | |||||||||||||||
| Other |
7 | 554 | 810 | 45 | 1,345 | |||||||||||||||
| Total foreclosed assets |
33,312 | 12,866 | 5,406 | 5,545 | 5,748 | |||||||||||||||
| Total non-performing assets |
$ | 180,179 | $ | 78,040 | $ | 29,849 | $ | 57,749 | $ | 38,927 | ||||||||||
| Ratio of non-performing assets to: |
||||||||||||||||||||
| Total loans and foreclosed assets |
2.14 | % | 0.88 | % | 0.38 | % | 0.78 | % | 0.64 | % | ||||||||||
| Total assets |
1.11 | 0.52 | 0.22 | 0.44 | 0.33 | |||||||||||||||
| Accruing past due loans: |
||||||||||||||||||||
| 30 to 89 days past due |
$ | 90,173 | $ | 102,053 | $ | 45,290 | $ | 56,836 | $ | 32,908 | ||||||||||
| 90 or more days past due |
23,911 | 19,751 | 14,347 | 10,917 | 7,921 | |||||||||||||||
| Total accruing past due loans |
$ | 114,084 | $ | 121,804 | $ | 59,637 | $ | 67,753 | $ | 40,829 | ||||||||||
| Ratio of accruing past due loans to total loans: |
||||||||||||||||||||
| 30 to 89 days past due |
1.08 | % | 1.16 | % | 0.58 | % | 0.77 | % | 0.54 | % | ||||||||||
| 90 or more days past due |
0.28 | 0.22 | 0.19 | 0.15 | 0.13 | |||||||||||||||
| Total accruing past due loans |
1.36 | % | 1.38 | % | 0.77 | % | 0.92 | % | 0.67 | % | ||||||||||
Non-performing assets include non-accrual loans and foreclosed assets. Non-performing assets at December 31, 2009 increased $102.1 million from December 31, 2008. In general, the increasing trend in non-performing assets is reflective of the current weak economic conditions. The increase in non-accrual commercial loans was partly related to the addition of two credit relationships with an aggregate total of $31.4 million. The increase in non-accrual commercial loans also included $16.3 million in loans to certain Mexican borrowers primarily due to a deterioration in the U.S. dollar exchange rate of the Mexican peso. These loans have third party insurance covering between 80% to 90% of the outstanding balance. The increase in non-accrual real estate loans was primarily related to land development and 1-4 family residential construction credit relationships.
Non-performing assets at December 31, 2008 increased $48.2 million from December 31, 2007. The increase in non-performing assets was primarily related to land development and 1-4 family residential construction credit relationships. The increase was reflective of the deterioration of economic conditions during 2008, as well as overall growth in the loan portfolio. Non-performing assets at December 31, 2007 decreased $27.9 million from December 31, 2006. The decrease was largely related to a single credit relationship totaling $23.1 million. The properties securing this credit relationship were sold at auction during 2007. Due to the shortfall in the proceeds from the sale of the properties, the Corporation recognized charge-offs totaling $6.3 million, as further discussed in the section captioned “Allowance For Possible Loan Losses” included elsewhere in this discussion. This credit relationship was first reported as a potential problem during the third quarter of 2006 and was the primary cause of the increase in non-accrual loans reported at December 31, 2006 compared to December 31, 2005.
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Generally, loans are placed on non-accrual status if principal or interest payments become 90 days past due and/or management deems the collectibility of the principal and/or interest to be in question, as well as when required by regulatory requirements. Loans to a customer whose financial condition has deteriorated are considered for non-accrual status whether or not the loan is 90 days or more past due. For consumer loans, collectibility and loss are generally determined before the loan reaches 90 days past due. Accordingly, losses on consumer loans are recorded at the time they are determined. Consumer loans that are 90 days or more past due are generally either in liquidation/payment status or bankruptcy awaiting confirmation of a plan. Once interest accruals are discontinued, accrued but uncollected interest is charged to current year operations. Subsequent receipts on non-accrual loans are recorded as a reduction of principal, and interest income is recorded only after principal recovery is reasonably assured. Classification of a loan as non-accrual does not preclude the ultimate collection of loan principal or interest.
Restructured loans are loans on which, due to deterioration in the borrower’s financial condition, the original terms have been modified in favor of the borrower or either principal or interest has been forgiven.
Foreclosed assets represent property acquired as the result of borrower defaults on loans. Foreclosed assets are recorded at estimated fair value, less estimated selling costs, at the time of foreclosure. Write-downs occurring at foreclosure are charged against the allowance for possible loan losses. On an ongoing basis, properties are appraised as required by market indications and applicable regulations. Write-downs are provided for subsequent declines in value and are included in other non-interest expense along with other expenses related to maintaining the properties.
Potential Problem Loans. Potential problem loans consist of loans that are performing in accordance with contractual terms but for which management has concerns about the ability of an obligor to continue to comply with repayment terms because of the obligor’s potential operating or financial difficulties. Management monitors these loans closely and reviews their performance on a regular basis. As of December 31, 2009, the Corporation had $17.4 million in loans of this type which are not included in either of the non-accrual or 90 days past due loan categories. At December 31, 2009, potential problem loans consisted of eight credit relationships. Of the total outstanding balance at December 31, 2009, 26.0% related to a customer in the legal profession, 25.2% related to three customers in the real estate lot development/single-family residential construction industry and 20.8% related to an individual, non-commercial borrower. Weakness in these borrowers’ operating performance and/or ability to repay has caused the Corporation to heighten the attention given to these credits.
Allowance For Possible Loan Losses
The allowance for possible loan losses is a reserve established through a provision for possible loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Corporation’s allowance for possible loan loss methodology is based on guidance provided in SEC Staff Accounting Bulletin No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues” and includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools, and specific loss allocations, with adjustments for current events and conditions. The Corporation’s process for determining the appropriate level of the allowance for possible loan losses is designed to account for credit deterioration as it occurs. The provision for possible loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for possible loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for possible loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans or loan pools.
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The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. 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. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including the performance of the Corporation’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.
The Corporation’s allowance for possible loan losses consists of three elements: (i) specific valuation allowances determined in accordance with ASC Topic 310 based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with ASC Topic 450 based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with ASC Topic 450 based on general economic conditions and other qualitative risk factors both internal and external to the Corporation.
The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of classified loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. This analysis is performed at the relationship manager level for all commercial loans. Loans with a calculated grade that is below a predetermined grade are adversely classified. Once a loan is classified, a special assets officer analyzes the loan to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for possible loan losses to the loan. Specific valuation allowances are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, the relative risk grade of the loan and economic conditions affecting the borrower’s industry, among other things.
Historical valuation allowances are calculated based on the historical loss experience of specific types of loans and the internal risk grade of such loans at the time they were charged-off. The Corporation calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool. The historical loss ratios are periodically updated based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical loss ratio and the total dollar amount of the loans in the pool. The Corporation’s pools of similar loans include similarly risk-graded groups of commercial and industrial loans, commercial real estate loans, consumer loans and 1-4 family residential mortgages.
General valuation allowances are based on general economic conditions and other qualitative risk factors both internal and external to the Corporation. In general, such valuation allowances are determined by evaluating, among other things: (i) the experience, ability and effectiveness of the bank’s lending management and staff; (ii) the effectiveness of the Corporation’s loan policies, procedures and internal controls; (iii) changes in asset quality; (iv) changes in loan portfolio volume; (v) the composition and concentrations of credit; (vi) the impact of competition on loan structuring and pricing; (vii) the effectiveness of the internal loan review function; (viii) the impact of environmental risks on portfolio risks; and (ix) the impact of rising interest rates on portfolio risk. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Each component is determined to have either a high, moderate or low degree of risk. The results are then input into a “general allocation matrix” to determine an appropriate general valuation allowance.
Included in the general valuation allowances are allocations for groups of similar loans with risk characteristics that exceed certain concentration limits established by management. Concentration risk limits have been established, among other things, for certain industry concentrations, large balance and highly leveraged credit relationships that exceed specified risk grades, and loans originated with policy exceptions that exceed specified risk grades.
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Loans identified as losses by management, internal loan review and/or bank examiners are charged-off. Furthermore, consumer loan accounts are charged-off automatically based on regulatory requirements.
The table below provides an allocation of the year-end allowance for possible loan losses by loan type; however, allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories:
| 2009 | 2008 | 2007 | 2006 | 2005 | ||||||||||||||||||||||||||
| Allowance for Possible Loan Losses |
Percentage of Loans in each Category to Total Loans |
Allowance for Possible Loan Losses |
Percentage of Loans in each Category to Total Loans |
Allowance for Possible Loan Losses |
Percentage of Loans in each Category to Total Loans |
Allowance for Possible Loan Losses |
Percentage of Loans in each Category to Total Loans |
Allowance for Possible Loan Losses |
Percentage of Loans in each Category to Total Loans |
|||||||||||||||||||||
| Commercial and industrial |
$ | 57,394 | 46.5 | % | $ | 51,534 | 48.0 | % | $ | 50,245 | 47.1 | % | $ | 44,603 | 46.2 | % | $ | 50,357 | 45.7 | % | ||||||||||
| Real estate |
31,074 | 48.7 | 29,145 | 47.5 | 20,800 | 47.5 | 24,955 | 48.5 | 16,378 | 48.6 | ||||||||||||||||||||
| Consumer |
10,681 | 4.4 | 11,490 | 4.2 | 10,721 | 5.0 | 8,238 | 4.9 | 5,303 | 5.2 | ||||||||||||||||||||
| Other |
6,248 | 0.4 | 7,356 | 0.3 | 2,705 | 0.4 | 2,125 | 0.4 | 1,556 | 0.5 | ||||||||||||||||||||
| Unallocated |
19,912 | - | 10,719 | - | 7,868 | - | 16,164 | - | 6,731 | - | ||||||||||||||||||||
| Total |
$ | 125,309 | 100 | % | $ | 110,244 | 100.0 | % | $ | 92,339 | 100.0 | % | $ | 96,085 | 100.0 | % | $ | 80,325 | 100.0 | % | ||||||||||
During 2009, the reserve allocated to commercial and industrial loans and real estate loans increased compared to 2008 primarily due to an increase in the historical loss allocation factors applied to non-classified loans. The base historical loss allocation for each category of loans is the product of the volume of loans within each level of risk classification and the historical loss allocation factor for that particular level of risk classification, adjusted, as necessary to reflect the impact of current conditions. The base historical loss allocation is then adjusted upwards utilizing an environmental adjustment factor that is based upon a more qualitative analysis of risk. The historical loss allocation factors for non-classified loans determined based upon actual historical experience were adjusted upwards in 2009 given the significant increase in net charge-offs relative to historical average and the continued uncertain economic conditions. Specific valuation allowances related to commercial and industrial loans increased approximately $4.8 million in 2009 compared to 2008 while specific valuation allowances related to real estate loans decreased $461 thousand in 2009 compared to 2008. The increase in the unallocated portion of the allowance for possible loan losses during 2009 compared to 2008 is reflective of continued recessionary economic conditions which began in 2008.
During 2008, the reserve allocated to all categories of loans increased compared to 2007 primarily due to increases in the level of classified loans which impacted the level of allocations required based upon historical loss experience combined with overall growth in loans. Specific valuation allowances also increased in 2008. Specific valuation allowances related to commercial and industrial loans and real estate loans increased approximately $4.1 million and $2.0 million in 2008 compared to 2007, respectively. The increase in the reserve allocated to commercial and industrial loans due to the increase in classified loans and specific valuation allowances was mostly offset by a decrease in general valuation allowances related to large balance and highly leveraged credit relationships that exceed specified risk grades. The increase in the reserve allocated to real estate loans due to the increase in classified loans and specific valuation allowances was partly offset by a decrease in general valuation allowances previously allocated to compensate for concentration risk related to certain higher-risk categories of real estate loans. The increase in the unallocated portion of the allowance for possible loan losses during 2008 compared to 2007 is reflective of the deterioration of economic conditions during 2008.
During 2007, the reserve allocated to commercial and industrial loans increased compared to 2006 primarily due to an increase in general valuation allowances related to large balance and highly leveraged credit relationships that exceed specified risk grades and an increase in the level of classified loans which impacted the level of allocations required based upon historical loss experience. The increase from these items was partly offset by a decrease in specific valuation allowances. Specific valuation allowances related to commercial and
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industrial loans decreased approximately $5.5 million in 2007 compared to 2006. The decrease in the reserve allocated to real estate loans during 2007 compared to 2006 was primarily related to a decrease in specific valuation allowances of approximately $3.0 million and a decrease in general valuation allowances previously allocated to compensate for concentration risk related to certain higher-risk categories of real estate loans. The decrease in specific valuation allowances related to real estate loans was primarily due to the charge-off of a large credit relationship during 2007, as further discussed below. Specific valuation allowances related to this credit relationship totaled $2.0 million at December 31, 2006. The increase in the reserve allocated to consumer loans during 2007 compared to 2006 was primarily due to growth in the consumer loan portfolio combined with an increase in the historical loss ratio associated with consumer loans. The unallocated portion of the allowance for possible loan losses decreased during 2007 compared to 2006. During 2006, higher unallocated reserves were maintained in part due to the relative uncertainty of the credit quality of certain loans acquired in connection with an acquisition during the fourth quarter of 2006.
During 2006, the reserve allocation related to real estate loans increased compared to 2005 primarily due to growth in the real estate loan portfolio and an increase in specific valuation allowances. The overall growth in real estate loans included growth in several of the higher-risk categories of real estate loans, which resulted in higher reserve allocations to compensate for the additional concentration risk. Specific valuation allowances related to real estate loans increased approximately $2.7 million in 2006 compared to 2005. The decrease in the reserve allocation for commercial and industrial loans during 2006 compared to 2005 was primarily due to a decrease in the level of criticized commercial and industrial loans and a decrease in specific valuation allowances partly offset by growth in the commercial and industrial loan portfolio. Specific valuation allowances related to commercial and industrial loans decreased approximately $2.1 million in 2006 compared to 2005. The increase in the reserve allocation for consumer loans during 2006 compared to 2005 was primarily due to growth in the consumer loan portfolio. The overall growth in loans resulted in an increase in historical valuation allowances based on historical loan loss experience for similar loans with similar characteristics and trends. The reserves allocated for all types of loans were also impacted by an increase in the relative percentage by which the historical valuation allowances are adjusted to compensate for current qualitative risk factors. The increase in the unallocated portion of the allowance for possible loan losses during 2006 compared to 2005 was partly related to the relative uncertainty of the credit quality of certain loans acquired in connection with an acquisition during the fourth quarter of 2006.
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Activity in the allowance for possible loan losses is presented in the following table.
| 2009 | 2008 | 2007 | 2006 | 2005 | ||||||||||||||||
| Balance of allowance for possible loan losses at beginning of year |
$ | 110,244 | $ | 92,339 | $ | 96,085 | $ | 80,325 | $ | 75,810 | ||||||||||
| Provision for possible loan losses |
65,392 | 37,823 | 14,660 | 14,150 | 10,250 | |||||||||||||||
| Allowance for possible loan losses acquired |
- | - | - | 12,720 | 3,186 | |||||||||||||||
| Charge-offs: |
||||||||||||||||||||
| Commercial and industrial |
(35,818 | ) | (13,910 | ) | (7,541 | ) | (10,983 | ) | (8,448 | ) | ||||||||||
| Real estate |
(11,751 | ) | (6,855 | ) | (9,309 | ) | (727 | ) | (531 | ) | ||||||||||
| Consumer and other |
(12,042 | ) | (8,422 | ) | (8,309 | ) | (7,223 | ) | (6,126 | ) | ||||||||||
| Total charge-offs |
(59,611 | ) | (29,187 | ) | (25,159 | ) | (18,933 | ) | (15,105 | ) | ||||||||||
| Recoveries: |
||||||||||||||||||||
| Commercial and industrial |
2,526 | 3,285 | 2,125 | 3,019 | 2,409 | |||||||||||||||
| Real estate |
496 | 1,101 | 331 | 483 | 351 | |||||||||||||||
| Consumer and other |
6,262 | 4,883 | 4,297 | 4,321 | 3,424 | |||||||||||||||
| Total recoveries |
9,284 | 9,269 | 6,753 | 7,823 | 6,184 | |||||||||||||||
| Net charge-offs |
(50,327 | ) | (19,918 | ) | (18,406 | ) | (11,110 | ) | (8,921 | ) | ||||||||||
| Balance at end of year |
$ | 125,309 | $ | 110,244 | $ | 92,339 | $ | 96,085 | $ | 80,325 | ||||||||||
| Net charge-offs as a percentage of average loans |
0.58 | % | 0.24 | % | 0.25 | % | 0.17 | % | 0.16 | % | ||||||||||
| Allowance for possible loan losses as a percentage of year-end loans |
1.50 | 1.25 | 1.19 | 1.30 | 1.32 | |||||||||||||||
| Allowance for possible loan losses as a percentage of year-end non-accrual loans |
85.32 | 169.15 | 377.77 | 184.06 | 242.10 | |||||||||||||||
| Average loans outstanding during the year |
$ | 8,652,563 | $ | 8,314,265 | $ | 7,464,140 | $ | 6,523,906 | $ | 5,594,477 | ||||||||||
| Loans outstanding at year-end |
8,367,780 | 8,844,082 | 7,769,362 | 7,373,384 | 6,085,055 | |||||||||||||||
| Non-accrual loans outstanding at year-end |
146,867 | 65,174 | 24,443 | 52,204 | 33,179 | |||||||||||||||
As stated above, the provision for possible loan losses reflects loan quality trends, including the level of net charge-offs or recoveries, among other factors. The provision for possible loan losses increased $27.6 million in 2009 to $65.4 million compared to $37.8 million in 2008 and increased $23.2 million in 2008 compared to $14.7 million in 2007. The increase in the provision for possible loan losses during 2009 was partly due to higher levels of net charge-offs and an increase in classified loans related to the weaker economic conditions. The weak economic conditions have particularly affected the performance of many of the Corporation’s land development and 1-4 family residential construction credit relationships. The increase in 2008 compared to 2007 was partly due to a provision totaling approximately $10 million for probable loan losses related to Hurricane Ike which impacted the Corporation’s Houston and Galveston market areas during the third quarter of 2008. In determining the amount of the provision, the Corporation identified customers that were likely impacted by the hurricane based on their geographic location. The Corporation adjusted risk grades for loans to these customers based on estimated loan payment abilities and loss of collateral value. Furthermore, the Corporation increased the historical loss allocation factors for all lower-risk, “pass” loans to customers within the areas directly impacted by Hurricane Ike and the greater Houston/Galveston market area as a whole. The increase in the provision for possible loan losses was also partly due to an increase in classified loans and the overall growth in loans, which increased $1.1 billion, or 13.8%, during 2008 compared to 2007.
Net charge-offs during 2009 increased $30.4 million compared to 2008 while net charge-offs in 2008 increased $1.5 million compared to 2007. As a percentage of average loans, net charge-offs increased 34 basis points in 2009 compared to 2008 and decreased 1 basis point in 2008 compared to 2007. The increase in net charge-offs in 2009 is related to the deterioration of economic conditions which began in 2008. During 2007, the
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Corporation recognized real estate related charge-offs totaling $6.3 million related to a single credit relationship. Excluding the effect of the charge-offs related to this credit relationship from 2007, net charge-offs for 2008 would have increased $7.8 million and 8 basis points as a percentage of average loans. This effective increase in net charge-offs is reflective of the increase in classified assets related to the deterioration of economic conditions, as well as overall growth in the loan portfolio during 2008.
The ratio of the allowance for possible loan losses to total loans increased 25 basis points from 1.25% at December 31, 2008 to 1.5% at December 31, 2009, which is reflective of the increase in classified assets and the generally weaker economic conditions. Management believes the level of the allowance for possible loan losses was adequate as of December 31, 2009. Should any of the factors considered by management in evaluating the adequacy of the allowance for possible loan losses change, the Corporation’s estimate of probable loan losses could also change, which could affect the level of future provisions for possible loan losses.
Securities
Year-end securities were as follows:
| 2009 | 2008 | 2007 | ||||||||||||||||
| Amount | Percentage of Total |
Amount | Percentage of Total |
Amount | Percentage of Total |
|||||||||||||
| Held to maturity: |
||||||||||||||||||
| Residential mortgage-backed securities issued by U.S. government agencies and corporations |
$ | 5,115 | 0.1 | % | $ | 5,948 | 0.2 | % | $ | 7,125 | 0.2 | % | ||||||
| Other |
1,000 | - | 1,000 | - | 1,000 | - | ||||||||||||
| Total |
6,115 | 0.1 | 6,948 | 0.2 | 8,125 | 0.2 | ||||||||||||
| Available for sale: |
||||||||||||||||||
| U.S. Treasury |
400,255 | 8.2 | 24,999 | 0.7 | - | - | ||||||||||||
| Residential mortgage-backed securities issued by U.S. government agencies and corporations |
2,577,309 | 52.5 | 2,560,871 | 71.6 | 2,845,311 | 83.0 | ||||||||||||
| States and political subdivisions |
1,868,658 | 38.1 | 931,073 | 26.0 | 524,085 | 15.3 | ||||||||||||
| Other |
38,035 | 0.8 | 37,586 | 1.1 | 37,616 | 1.1 | ||||||||||||
| Total |
4,884,257 | 99.6 | 3,554,529 | 99.4 | 3,407,012 | 99.4 | ||||||||||||
| Trading: |
||||||||||||||||||
| U.S. Treasury |
16,126 | 0.3 | 14,489 | 0.4 | 11,913 | 0.4 | ||||||||||||
| Common stock |
- | - | 63 | - | - | - | ||||||||||||
| Total |
16,126 | 0.3 | 14,552 | 0.4 | 11,913 | 0.4 | ||||||||||||
| Total securities |
$ | 4,906,498 | 100.0 | % | $ | 3,576,029 | 100.0 | % | $ | 3,427,050 | 100.0 | % | ||||||
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The following tables summarize the maturity distribution schedule with corresponding weighted-average yields of securities held to maturity and securities available for sale as of December 31, 2009. Weighted-average yields have been computed on a fully taxable-equivalent basis using a tax rate of 35%. Mortgage-backed securities and collateralized mortgage obligations are included in maturity categories based on their stated maturity date. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Other securities classified as available for sale include stock in the Federal Reserve Bank and the Federal Home Loan Bank, which have no maturity date. These securities have been included in the total column only.
| Within 1 Year |
1-5 Years |
5-10 Years |
After 10 Years |
Total |
||||||||||||||||||||||||||
| Amount | Weighted Average Yield |
Amount | Weighted Average Yield |
Amount | Weighted Average Yield |
Amount | Weighted Average Yield |
Amount | Weighted Average Yield |
|||||||||||||||||||||
| Held to maturity: |
||||||||||||||||||||||||||||||
| Residential mortgage- backed securities issued by U.S. government agencies and corporations |
$ | 2 | 8.26 | % | $ | 18 | 10.09 | % | $ | 1,089 | 5.54 | % | $ | 4,006 | 3.97 | % | $ | 5,115 | 4.33 | % | ||||||||||
| Other |
- | - | 1,000 | 1.45 | - | - | - | - | 1,000 | 1.45 | ||||||||||||||||||||
| Total |
$ | 2 | 8.26 | $ | 1,018 | 1.60 | $ | 1,089 | 5.54 | $ | 4,006 | 3.97 | $ | 6,115 | 3.86 | |||||||||||||||
| Available for Sale: |
||||||||||||||||||||||||||||||
| U.S. Treasury |
$ | 199,919 | 0.45 | % | $ | 200,336 | 0.96 | % | $ | - | - | % | $ | - | - | % | $ | 400,255 | 0.71 | % | ||||||||||
| Residential mortgage- backed securities issued by U.S. government agencies and corporations |
- | - | 14 | 9.63 | 623,407 | 4.64 | 1,953,888 | 4.85 | 2,577,309 | 4.80 | ||||||||||||||||||||
| States and political subdivisions |
58,521 | 2.83 | 72,703 | 5.78 | 128,088 | 5.57 | 1,609,346 | 7.33 | 1,868,658 | 7.00 | ||||||||||||||||||||
| Other |
- | - | - | - | - | - | - | - | 38,035 | - | ||||||||||||||||||||
| Total |
$ | 258,440 | 0.99 | $ | 273,053 | 2.21 | $ | 751,495 | 4.80 | $ | 3,563,234 | 5.96 | $ | 4,884,257 | 5.29 | |||||||||||||||
Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax. The remaining securities are classified as trading. Trading securities are held primarily for sale in the near term and are carried at their fair values, with unrealized gains and losses included immediately in other income. Management determines the appropriate classification of securities at the time of purchase. Securities with limited marketability, such as stock in the Federal Reserve Bank and the Federal Home Loan Bank, are carried at cost.
At December 31, 2009, there were no holdings of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of the Corporation’s shareholders’ equity.
The average taxable-equivalent yield on the securities portfolio was 5.45% in 2009 compared to 5.41% in 2008 and 5.24% in 2007. The increase in the average taxable-equivalent yield on the securities portfolio in 2009 compared to the prior years was primarily related to an increase in the relative proportion of higher-yielding tax-exempt municipal securities, which, for the most part, was related to investments in local school district general obligation bonds guaranteed by the Texas Permanent School Fund, which has a “triple-A” insurer financial strength rating. See the section captioned “Net Interest Income” included elsewhere in this discussion. The overall growth in the securities portfolio over the comparable periods was primarily funded by deposit growth.
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Deposits
The table below presents the daily average balances of deposits by type and weighted-average rates paid thereon during the years presented:
| 2009 | 2008 | 2007 | ||||||||||||||||
| Average Balance |
Average Rate Paid |
Average Balance |
Average Rate Paid |
Average Balance |
Average Rate Paid |
|||||||||||||
| Non-interest-bearing demand deposits: |
||||||||||||||||||
| Commercial and individual |
$ | 3,793,195 | $ | 3,246,169 | $ | 3,224,741 | ||||||||||||
| Correspondent banks |
360,238 | 311,034 | 248,591 | |||||||||||||||
| Public funds |
105,051 | 57,544 | 50,800 | |||||||||||||||
| Total |
4,258,484 | 3,614,747 | 3,524,132 | |||||||||||||||
| Interest-bearing deposits: |
||||||||||||||||||
| Private accounts: |
||||||||||||||||||
| Savings and interest checking |
2,024,867 | 0.15 | % | 1,694,688 | 0.19 | % | 1,401,437 | 0.47 | % | |||||||||
| Money market accounts |
4,152,225 | 0.60 | 3,492,935 | 1.47 | 3,494,704 | 3.08 | ||||||||||||
| Time accounts of $100,000 or more |
841,063 | 1.76 | 755,598 | 3.24 | 773,324 | 4.44 | ||||||||||||
| Time accounts under $100,000 |
768,615 | 1.56 | 604,391 | 3.18 | 609,383 | 4.25 | ||||||||||||
| Public funds |
374,373 | 0.41 | 368,760 | 1.72 | 409,661 | 3.89 | ||||||||||||
| Total |
8,161,143 | 0.69 | 6,916,372 | 1.52 | 6,688,509 | 2.84 | ||||||||||||
| Total deposits |
$ | |||||||||||||||||