Edgar Filing: CULLEN/FROST BANKERS, INC.

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company

Form 10-Q

United States

Securities and Exchange Commission

Washington, D.C. 20549

Form 10-Q

x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended: June 30, 2012

¨	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)

N/A

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

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

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

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

As of July 19, 2012, there were 61,405,024 shares of the registrant’s Common Stock, $.01 par value, outstanding.

Cullen/Frost Bankers, Inc.

Quarterly Report on Form 10-Q

June 30, 2012

Table of Contents


			Page
Part I - Financial Information

	Item 1.	Financial Statements (Unaudited)

		Consolidated Balance Sheets		3

		Consolidated Statements of Income		4

		Consolidated Statements of Comprehensive Income		5

		Consolidated Statements of Changes in Shareholders' Equity		6

		Consolidated Statements of Cash Flows		7

		Notes to Consolidated Financial Statements		8

	Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations		39

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		65

	Item 4.	Controls and Procedures		66

Part II - Other Information

	Item 1.	Legal Proceedings		67

	Item 1A.	Risk Factors		67

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		67

	Item 3.	Defaults Upon Senior Securities		67

	Item 4.	Mine Safety Disclosures		67

	Item 5.	Other Information		67

	Item 6.	Exhibits		67

Signatures				68

Part I. Financial Information

Item 1. Financial Statements (Unaudited)

Cullen/Frost Bankers, Inc.

Consolidated Balance Sheets

(Dollars in thousands, except per share amounts)


	June 30, 2012			December 31, 2011			June 30, 2011
Assets:
Cash and due from banks	$	609,211		$	574,039		$	575,464
Interest-bearing deposits		1,673,538			2,314,251			2,836,046
Federal funds sold and resell agreements		12,502			19,302			9,051

Total cash and cash equivalents		2,295,251			2,907,592			3,420,561
Securities held to maturity, at amortized cost		365,356			365,996			349,997
Securities available for sale, at estimated fair value		8,475,767			7,789,700			5,432,354
Trading account securities		16,563			13,609			14,517
Loans, net of unearned discounts		8,489,763			7,995,129			8,068,212
Less: Allowance for loan losses		(105,648	)		(110,147	)		(122,741	)

Net loans		8,384,115			7,884,982			7,945,471
Premises and equipment, net		319,904			319,042			316,165
Goodwill		535,560			528,072			528,072
Other intangible assets, net		10,039			10,604			12,764
Cash surrender value of life insurance policies		136,041			133,967			131,883
Accrued interest receivable and other assets		327,630			363,681			326,602

Total assets	$	20,866,226		$	20,317,245		$	18,478,386

Liabilities:
Deposits:
Non-interest-bearing demand deposits	$	7,136,674		$	6,672,555		$	5,818,692
Interest-bearing deposits		10,140,443			10,084,193			9,285,439

Total deposits		17,277,117			16,756,748			15,104,131
Federal funds purchased and repurchase agreements		656,025			722,202			574,132
Junior subordinated deferrable interest debentures		123,712			123,712			123,712
Other long-term borrowings		100,017			100,026			250,036
Accrued interest payable and other liabilities		346,744			331,020			249,730

Total liabilities		18,503,615			18,033,708			16,301,741
Shareholders’ Equity:
Preferred stock, par value $0.01 per share; 10,000,000 shares authorized; none issued		—			—			—
Common stock, par value $0.01 per share; 210,000,000 shares authorized; 61,404,274, shares issued at June 30, 2012, 61,271,603 shares issued at December 31, 2011 and 61,271,603 shares issued at June 30, 2011		614			613			613
Additional paid-in capital		692,625			680,803			673,620
Retained earnings		1,416,097			1,354,759			1,301,279
Accumulated other comprehensive income, net of tax		253,275			247,734			202,589
Treasury stock, 7,640 shares at December 31, 2011 and 26,359 shares at June 30, 2011, at cost		—			(372	)		(1,456	)

Total shareholders’ equity		2,362,611			2,283,537			2,176,645


Total liabilities and shareholders’ equity	$	20,866,226		$	20,317,245		$	18,478,386

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Income

(Dollars in thousands, except per share amounts)


	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012			2011
Interest income:
Loans, including fees	$	98,336	$	99,811	$	195,687		$	198,299
Securities:
Taxable		34,399		31,668		70,465			62,853
Tax-exempt		22,125		23,169		44,628			45,902
Interest-bearing deposits		903		1,472		1,833			2,643
Federal funds sold and resell agreements		33		13		48			29

Total interest income		155,796		156,133		312,661			309,726

Interest expense:
Deposits		4,547		5,946		9,119			11,897
Federal funds purchased and repurchase agreements		34		83		68			214
Junior subordinated deferrable interest debentures		1,711		1,691		3,385			3,363
Other long-term borrowings		287		4,080		1,165			8,160

Total interest expense		6,579		11,800		13,737			23,634

Net interest income		149,217		144,333		298,924			286,092
Provision for loan losses		2,355		8,985		3,455			18,435

Net interest income after provision for loan losses		146,862		135,348		295,469			267,657

Non-interest income:
Trust and investment management fees		21,279		20,313		41,931			39,784
Service charges on deposit accounts		20,639		21,328		41,433			42,578
Insurance commissions and fees		9,171		7,908		21,548			18,402
Interchange and debit card transaction fees		4,292		8,695		8,409			16,740
Other charges, commissions and fees		7,825		6,825		15,175			14,053
Net gain (loss) on securities transactions		370		—		(121	)		5
Other		6,187		5,723		13,367			11,563

Total non-interest income		69,763		70,792		141,742			143,125

Non-interest expense:
Salaries and wages		62,624		61,775		126,326			124,205
Employee benefits		14,048		13,050		30,749			28,361
Net occupancy		12,213		11,823		24,010			23,475
Furniture and equipment		13,734		12,628		27,154			24,909
Deposit insurance		2,838		2,598		5,335			7,358
Intangible amortization		994		1,107		2,005			2,227
Other		36,085		33,816		68,997			66,323

Total non-interest expense		142,536		136,797		284,576			276,858


Income before income taxes		74,089		69,343		152,635			133,924
Income taxes		16,027		13,657		33,540			26,310


Net income	$	58,062	$	55,686	$	119,095		$	107,614


Earnings per common share:
Basic	$	0.94	$	0.91	$	1.94		$	1.76
Diluted		0.94		0.91		1.93			1.75

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Comprehensive Income

(Dollars in thousands)


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Net income	$	58,062		$	55,686		$	119,095		$	107,614

Other comprehensive income (loss), before tax:
Securities available for sale:
Change in net unrealized gain/loss during the period		20,968			82,674			22,850			90,964
Reclassification adjustment for net (gains) losses included in net income		(370	)		—			121			(5	)

Total securities available for sale		20,598			82,674			22,971			90,959

Defined-benefit post-retirement benefit plans:
Change in the net actuarial gain/loss		1,428			782			2,657			1,565
Derivatives:
Change in the accumulated gain/loss on effective cash flow hedge derivatives		(64	)		(1,716	)		(491	)		(1,651	)
Reclassification adjustments for (gains) losses included in net income:
Interest rate swaps on variable-rate loans		(9,345	)		(9,345	)		(18,690	)		(18,690	)
Interest rate swap on junior subordinated deferrable interest debentures		1,044			1,100			2,077			2,186

Total derivatives		(8,365	)		(9,961	)		(17,104	)		(18,155	)


Other comprehensive income (loss), before tax		13,661			73,495			8,524			74,369
Deferred tax expense (benefit) related to other comprehensive income		4,782			25,724			2,983			26,030

Other comprehensive income (loss), net of tax		8,879			47,771			5,541			48,339


Comprehensive income	$	66,941		$	103,457		$	124,636		$	155,953

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Changes in Shareholders’ Equity

(Dollars in thousands, except per share amounts)


	Six Months Ended June 30,
	2012			2011
Total shareholders’ equity at beginning of period	$	2,283,537		$	2,061,680

Net income		119,095			107,614
Other comprehensive income		5,541			48,339
Stock option exercises (140,311 shares in 2012 and 144,203 shares in 2011)		7,211			7,239
Stock compensation expense recognized in earnings		5,398			7,583
Tax benefits (deficiencies) related to stock compensation		(414	)		278
Purchase of treasury stock (29,823 shares in 2011)		—			(1,657	)
Common stock issued/sold to the 401(k) stock purchase plan (22,680 shares in 2011)		—			1,360
Cash dividends ($0.94 per share in 2012 and $0.91 per share in 2011)		(57,757	)		(55,791	)


Total shareholders’ equity at end of period	$	2,362,611		$	2,176,645

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Consolidated Statements of Cash Flows

(Dollars in thousands)


	Six Months Ended June 30,
	2012			2011
Operating Activities:
Net income	$	119,095		$	107,614
Adjustments to reconcile net income to net cash from operating activities:
Provision for loan losses		3,455			18,435
Deferred tax expense (benefit)		(3,977	)		245
Accretion of loan discounts		(5,663	)		(5,773	)
Securities premium amortization (discount accretion), net		9,222			4,905
Net (gain) loss on securities transactions		121			(5	)
Depreciation and amortization		18,942			18,500
Net loss on sale/write-down of assets/foreclosed assets		2,598			2,303
Stock-based compensation		5,398			7,583
Net tax benefit (deficiency) from stock-based compensation		(490	)		(89	)
Excess tax benefits from stock-based compensation		(76	)		(367	)
Earnings on life insurance policies		(2,074	)		(1,961	)
Net change in:
Trading account securities		(2,954	)		584
Accrued interest receivable and other assets		23,261			31,745
Accrued interest payable and other liabilities		597			(18,048	)

Net cash from operating activities		167,455			165,671

Investing Activities:
Securities held to maturity:
Purchases		—			(66,688	)
Maturities, calls and principal repayments		489			301
Securities available for sale:
Purchases		(17,060,846	)		(6,195,363	)
Sales		15,987,480			5,548,386
Maturities, calls and principal repayments		401,078			458,171
Net change in loans		(501,622	)		19,018
Net cash paid in acquisitions		(7,199	)		(1,044	)
Proceeds from sales of premises and equipment		3,613			1,131
Purchases of premises and equipment		(16,032	)		(12,272	)
Proceeds from sales of repossessed properties		9,530			8,876

Net cash from investing activities		(1,183,509	)		(239,484	)

Financing Activities:
Net change in deposits		520,369			624,789
Net change in short-term borrowings		(66,177	)		98,459
Principal payments on long-term borrowings		(9	)		(9	)
Proceeds from stock option exercises		7,211			7,239
Excess tax benefits from stock-based compensation		76			367
Purchase of treasury stock		—			(1,657	)
Cash dividends paid		(57,757	)		(55,791	)

Net cash from financing activities		403,713			673,397


Net change in cash and cash equivalents		(612,341	)		599,584
Cash and equivalents at beginning of period		2,907,592			2,820,977


Cash and equivalents at end of period	$	2,295,251		$	3,420,561

See Notes to Consolidated Financial Statements.

Cullen/Frost Bankers, Inc.

Notes to Consolidated Financial Statements

(Table amounts in thousands, except for share and per share amounts)

Note 1 - Significant Accounting Policies

Nature of Operations. Cullen/Frost Bankers, Inc. (Cullen/Frost) is a financial holding company and a bank holding company headquartered in San Antonio, Texas that provides, through its subsidiaries, a broad array of products and services throughout numerous Texas markets. In addition to general commercial and consumer banking, other products and services offered include trust and investment management, investment banking, insurance, brokerage, leasing, asset-based lending, treasury management and item processing.

Basis of Presentation. The consolidated financial statements in this Quarterly Report on Form 10-Q include the accounts of Cullen/Frost and all other entities in which Cullen/Frost has a controlling financial interest (collectively referred to as the “Corporation”). All significant intercompany balances and transactions have been eliminated in consolidation. The accounting and financial reporting policies the Corporation follows conform, in all material respects, to accounting principles generally accepted in the United States and to general practices within the financial services industry.

The consolidated financial statements in this Quarterly Report on Form 10-Q have not been audited by an independent registered public accounting firm, but in the opinion of management, reflect all adjustments necessary for a fair presentation of the Corporation’s financial position and results of operations. All such adjustments were of a normal and recurring nature. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q adopted by the Securities and Exchange Commission (SEC). Accordingly, the financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements and should be read in conjunction with the Corporation’s consolidated financial statements, and notes thereto, for the year ended December 31, 2011, included in the Corporation’s Annual Report on Form 10-K filed with the SEC on February 3, 2012 (the “2011 Form 10-K”). Operating results for the interim periods disclosed herein are not necessarily indicative of the results that may be expected for a full year or any future period.

Use of Estimates. 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 reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates. The allowance for loan losses, the fair value of stock-based compensation awards, the fair values of financial instruments and the status of contingencies are particularly subject to change.

Cash Flow Reporting. Additional cash flow information was as follows:


	Six Months Ended June 30,
	2012		2011
Cash paid for interest	$	16,007	$	24,473
Cash paid for income tax		13,947		12,406

Significant non-cash transactions:
Loans foreclosed and transferred to other real estate owned and foreclosed assets		4,697		13,553
Common stock/treasury stock issued to the Corporation’s 401(k) stock purchase plan		—		1,360

Reclassifications. Certain items in prior financial statements have been reclassified to conform to the current presentation. Mutual fund investment management fees previously reported as a component of other charges, commissions and fees are now included with trust fees and reported as trust and investment management fees in the consolidated statements of income. Additionally, interchange and debit card transaction fees (including automated teller machine fees) previously reported as components of service charges on deposit accounts; other charges, commissions and fees; or other non-interest income are now reported as interchange and debit card transaction fees in the consolidated statements of income.

Note 2 - Securities

A summary of the amortized cost and estimated fair value of securities, excluding trading securities, is presented below.


	June 30, 2012								December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
Held to Maturity
U. S. Treasury	$	247,989	$	31,932	$	—	$	279,921	$	247,797	$	31,715	$	—	$	279,512
Residential mortgage-backed securities		11,367		290		—		11,657		11,874		153		—		12,027
States and political subdivisions		105,000		9,444		—		114,444		105,325		6,597		—		111,922
Other		1,000		—		—		1,000		1,000		—		—		1,000

Total	$	365,356	$	41,666	$	—	$	407,022	$	365,996	$	38,465	$	—	$	404,461

Available for Sale:
U. S. Treasury	$	3,019,137	$	39,063	$	—	$	3,058,200	$	2,020,621	$	36,111	$	—	$	2,056,732
U.S. government agencies/corporations		250,000		528		—		250,528		250,000		884		—		250,884
Residential mortgage-backed securities		2,789,723		157,673		1		2,947,395		3,135,064		154,386		180		3,289,270
States and political subdivisions		2,008,745		175,228		209		2,183,764		1,996,703		158,133		23		2,154,813
Other		35,880		—		—		35,880		38,001		—		—		38,001

Total	$	8,103,485	$	372,492	$	210	$	8,475,767	$	7,440,389	$	349,514	$	203	$	7,789,700

All mortgage-backed securities included in the above table were issued by U.S. government agencies and corporations. Securities with limited marketability, such as stock in the Federal Reserve Bank and the Federal Home Loan Bank, are carried at cost and are reported as other available for sale securities in the above table. The carrying value of securities pledged to secure public funds, trust deposits, repurchase agreements and for other purposes, as required or permitted by law was $2.1 billion at June 30, 2012 and $2.4 billion at December 31, 2011.

As of June 30, 2012, securities, with unrealized losses segregated by length of impairment, were as follows:


	Less than 12 Months				More than 12 Months				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
Available for Sale
Residential mortgage-backed securities	$	—	$	—	$	48	$	1	$	48	$	1
States and political subdivisions		39,348		209		—		—		39,348		209

Total	$	39,348	$	209	$	48	$	1	$	39,396	$	210

Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income. In estimating other-than-temporary impairment losses, management considers, among other things, (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in cost.

Management has the ability and intent to hold the securities classified as held to maturity in the table above until they mature, at which time the Corporation will receive full value for the securities. Furthermore, as of June 30, 2012, management does not have the intent to sell any of the securities classified as available for sale in the table above and believes that it is more likely than not that the Corporation will not have to sell any such securities before a recovery of cost. Any unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the bonds approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe any of the securities are impaired due to reasons of credit quality. Accordingly, as of June 30, 2012, management believes the impairments detailed in the table above are temporary and no impairment loss has been realized in the Corporation’s consolidated income statement.

The amortized cost and estimated fair value of securities, excluding trading securities, at June 30, 2012 are presented below by contractual maturity. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Residential mortgage-backed securities and equity securities are shown separately since they are not due at a single maturity date.


	Held to Maturity				Available for Sale
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Due in one year or less	$	1,000	$	1,000	$	14,302	$	14,480
Due after one year through five years		247,989		279,921		3,394,320		3,443,606
Due after five years through ten years		3,311		3,653		201,784		217,308
Due after ten years		101,689		110,791		1,667,476		1,817,098
Residential mortgage-backed securities		11,367		11,657		2,789,723		2,947,395
Equity securities		—		—		35,880		35,880

Total	$	365,356	$	407,022	$	8,103,485	$	8,475,767

Sales of securities available for sale were as follows:


	Three Months Ended June 30,					Six Months Ended June 30,
	2012			2011		2012			2011
Proceeds from sales	$	6,002,402		$	845	$	15,987,480		$	5,548,386
Gross realized gains		371			—		2,508			9
Gross realized losses		(1	)		—		(2,629	)		4
Tax (expense) benefit of securities gains/losses		(130	)		—		42			(2	)

Trading account securities, at estimated fair value, were as follows:


	June 30,		December 31,
	2012		2011
U.S. Treasury	$	13,410	$	13,609
States and political subdivisions		3,153		—

Total	$	16,563	$	13,609

Net gains and losses on trading account securities were as follows:


	Three Months Ended June 30,					Six Months Ended June 30,
	2012			2011		2012			2011
Net gain on sales transactions	$	299		$	161	$	622		$	469
Net mark-to-market gains (losses)		(19	)		7		(79	)		7

Net gain on trading account securities	$	280		$	168	$	543		$	476

Note 3 - Loans

Loans were as follows:


	June 30,			Percentage			December 31,			Percentage			June 30,			Percentage
	2012			of Total			2011			of Total			2011			of Total
Commercial and industrial:
Commercial	$	3,911,502			46.1	%	$	3,553,989			44.5	%	$	3,510,738			43.5	%
Leases		236,891			2.8			193,412			2.4			184,991			2.3
Asset-based		161,496			1.9			169,466			2.1			146,421			1.8

Total commercial and industrial		4,309,889			50.8			3,916,867			49.0			3,842,150			47.6
Commercial real estate:
Commercial mortgages		2,396,609			28.2			2,383,479			29.8			2,403,350			29.8
Construction		538,681			6.3			434,870			5.5			533,132			6.6
Land		184,612			2.2			202,478			2.5			220,617			2.7

Total commercial real estate		3,119,902			36.7			3,020,827			37.8			3,157,099			39.1
Consumer real estate:
Home equity loans		288,917			3.4			282,244			3.5			276,869			3.4
Home equity lines of credit		189,910			2.2			191,960			2.4			189,356			2.4
1-4 family residential mortgages		39,006			0.5			45,943			0.6			49,849			0.6
Construction		19,498			0.2			17,544			0.2			17,952			0.2
Other		224,729			2.7			225,118			2.8			239,043			3.0

Total consumer real estate		762,060			9.0			762,809			9.5			773,069			9.6

Total real estate		3,881,962			45.7			3,783,636			47.3			3,930,168			48.7
Consumer and other:
Consumer installment		306,130			3.6			301,518			3.8			298,327			3.7
Other		10,873			0.1			11,018			0.1			15,978			0.2

Total consumer and other		317,003			3.7			312,536			3.9			314,305			3.9
Unearned discounts		(19,091	)		(0.2	)		(17,910	)		(0.2	)		(18,411	)		(0.2	)

Total loans	$	8,489,763			100.0	%	$	7,995,129			100.0	%	$	8,068,212			100.0	%

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 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. 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 June 30, 2012, approximately 57% 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 completed 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 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.

Concentrations of Credit. Most of the Corporation’s lending activity occurs within the State of Texas, including the four largest metropolitan areas of Austin, Dallas/Ft. Worth, Houston and San Antonio, as well as other markets. The majority of the Corporation’s loan portfolio consists of commercial and industrial and commercial real estate loans. Other than energy loans, as of June 30, 2012 there were no concentrations of loans related to any single industry in excess of 10% of total loans.

Foreign Loans. The Corporation has 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 June 30, 2012 or December 31, 2011.

Non-Accrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. In determining whether or not a borrower may be unable to meet payment obligations for each class of loans, the Corporation considers the borrower’s debt service capacity through the analysis of current financial information, if available, and/or current information with regards to the Corporation’s collateral position. Regulatory provisions would typically require the placement of a loan on non-accrual status if (i) principal or interest has been in default for a period of 90 days or more unless the loan is both well secured and in the process of collection or (ii) full payment of principal and interest is not expected. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income on non-accrual loans is recognized only to the extent that cash payments are received in excess of principal due. A loan may be returned to accrual status when all the principal and interest amounts contractually due are brought current and future principal and interest amounts contractually due are reasonably assured, which is typically evidenced by a sustained period (at least six months) of repayment performance by the borrower.

Non-accrual loans, segregated by class of loans, were as follows:


	June 30,		December 31,		June 30,
	2012		2011		2011
Commercial and industrial:
Energy	$	—	$	—	$	—
Other commercial		43,855		43,874		73,686
Commercial real estate:
Buildings, land and other		42,226		43,820		49,787
Construction		2,245		1,329		2,942
Consumer real estate		3,241		4,587		3,683
Consumer and other		688		728		430

Total	$	92,255	$	94,338	$	130,528

Had non-accrual loans performed in accordance with their original contract terms, the Corporation would have recognized additional interest income, net of tax, of approximately $639 thousand and $1.3 million for the three and six months ended June 30, 2012, compared to $861 thousand and $1.7 million for the same periods in 2011.

An age analysis of past due loans (including both accruing and non-accruing loans), segregated by class of loans, as of June 30, 2012 was as follows:


	Loans 30-89 Days Past Due		Loans 90 or More Days Past Due		Total Past Due Loans		Current Loans			Total Loans			Accruing Loans 90 or More Days Past Due
Commercial and industrial:
Energy	$	—	$	—	$	—	$	1,063,480		$	1,063,480		$	—
Other commercial		27,667		22,549		50,216		3,196,193			3,246,409			7,210
Commercial real estate:
Buildings, land and other		20,699		10,433		31,132		2,550,089			2,581,221			3,300
Construction		571		1,203		1,774		536,907			538,681			146
Consumer real estate		6,610		3,385		9,995		752,065			762,060			2,042
Consumer and other		3,086		168		3,254		313,749			317,003			126
Unearned discounts		—		—		—		(19,091	)		(19,091	)		—

Total	$	58,633	$	37,738	$	96,371	$	8,393,392		$	8,489,763		$	12,824

Impaired Loans. Loans are considered impaired when, based on current information and events, it is probable the Corporation will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectibility of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

Regulatory guidelines require the Corporation to reevaluate the fair value of collateral supporting impaired collateral dependent loans on at least an annual basis. While the Corporation’s policy is to comply with the regulatory guidelines, the Corporation’s general practice is to reevaluate the fair value of collateral supporting impaired collateral dependent loans on a quarterly basis. Thus, appraisals are never considered to be outdated, and the Corporation does not need to make any adjustments to the appraised values. The fair value of collateral supporting impaired collateral dependent loans is evaluated by the Corporation’s internal appraisal services using a methodology that is consistent with the Uniform Standards of Professional Appraisal Practice. The fair value of collateral supporting impaired collateral dependent construction loans is based on an “as is” valuation.

Impaired loans are set forth in the following table. No interest income was recognized on impaired loans subsequent to their classification as impaired.


	Unpaid		Recorded		Recorded						Average Recorded
	Contractual		Investment		Investment		Total				Investment
	Principal		With No		With		Recorded		Related		Quarter		Year
	Balance		Allowance		Allowance		Investment		Allowance		To Date		To Date
June 30, 2012
Commercial and industrial:
Energy	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Other commercial		51,506		22,115		17,088		39,203		5,140		41,970		41,090
Commercial real estate:
Buildings, land and other		47,785		32,892		6,154		39,046		1,148		39,055		39,680
Construction		2,541		2,197		—		2,197		—		1,717		1,572
Consumer real estate		1,343		1,279		—		1,279		—		1,928		2,109
Consumer and other		456		439		—		439		—		487		509

Total	$	103,631	$	58,922	$	23,242	$	82,164	$	6,288	$	85,157	$	84,960

December 31, 2011
Commercial and industrial:
Energy	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Other commercial		57,723		34,712		4,619		39,331		2,696		46,151		53,830
Commercial real estate:
Buildings, land and other		51,163		38,686		2,243		40,929		1,113		41,522		48,635
Construction		1,568		1,281		—		1,281		—		1,527		4,339
Consumer real estate		2,499		1,719		751		2,470		95		2,484		1,845
Consumer and other		562		554		—		554		—		561		265

Total	$	113,515	$	76,952	$	7,613	$	84,565	$	3,904	$	92,245	$	108,914

June 30, 2011
Commercial and industrial:
Energy	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Other commercial		82,311		48,401		20,021		68,422		16,983		60,705		58,950
Commercial real estate:
Buildings, land and other		57,117		40,937		5,854		46,791		1,316		49,164		53,377
Construction		3,181		2,756		—		2,756		—		4,672		6,214
Consumer real estate		1,956		1,540		416		1,956		100		1,871		1,420
Consumer and other		102		101		—		101		—		101		67

Total	$	144,667	$	93,735	$	26,291	$	120,026	$	18,399	$	116,513	$	120,028

Troubled Debt Restructurings. The restructuring of a loan is considered a “troubled debt restructuring” if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses.

There were no troubled debt restructurings during the six months ended June 30, 2012. During the six months ended June 30, 2011, the Corporation had troubled debt restructurings of commercial real estate loans with an aggregate restructuring date balance of $4.2 million. All of the loans identified as troubled debt restructurings by the Corporation during the six months ended June 30, 2011 were previously on non-accrual status and reported as impaired loans prior to restructuring. The modifications primarily related to extending the amortization periods of the loans. The Corporation did not grant interest-rate concessions on any restructured loan. All loans restructured during the reported periods were on non-accrual status as of the end of those periods. Because the loans were classified and on non-accrual status both before and after restructuring, the modifications did not impact the Corporation’s determination of the allowance for loan losses. During the six months ended June 30, 2012, defaults on loans restructured during 2011 were not significant and such defaults did not significantly impact the Corporation’s determination of the allowance for loan losses.

Credit Quality Indicators. As part of the on-going monitoring of the credit quality of the Corporation’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the weighted-average risk grade of commercial loans, (ii) the level of classified commercial loans, (iii) the delinquency status of consumer loans (see details above) (iv) net charge-offs, (v) non-performing loans (see details above) and (vi) the general economic conditions in the State of Texas.

The Corporation utilizes a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 14. A description of the general characteristics of the 14 risk grades is as follows:

•

Grades 1, 2 and 3 – These grades include loans to very high credit quality borrowers of investment or near investment grade. These borrowers are generally publicly traded (grades 1 and 2), have significant capital strength, moderate leverage, stable earnings and growth, and readily available financing alternatives. Smaller entities, regardless of strength, would generally not fit in these grades.

•

Grades 4 and 5 – These grades include loans to borrowers of solid credit quality with moderate risk. Borrowers in these grades are differentiated from higher grades on the basis of size (capital and/or revenue), leverage, asset quality and the stability of the industry or market area.

•

Grades 6, 7 and 8 – These grades include “pass grade” loans to borrowers of acceptable credit quality and risk. Such borrowers are differentiated from Grades 4 and 5 in terms of size, secondary sources of repayment or they are of lesser stature in other key credit metrics in that they may be over-leveraged, under capitalized, inconsistent in performance or in an industry or an economic area that is known to have a higher level of risk, volatility, or susceptibility to weaknesses in the economy.

•

Grade 9 – This grade includes loans on management’s “watch list” and is intended to be utilized on a temporary basis for pass grade borrowers where a significant risk-modifying action is anticipated in the near term.

•

Grade 10 – This grade is for “Other Assets Especially Mentioned” in accordance with regulatory guidelines. This grade is intended to be temporary and includes loans to borrowers whose credit quality has clearly deteriorated and are at risk of further decline unless active measures are taken to correct the situation.

•

Grade 11 – This grade includes “Substandard” loans, in accordance with regulatory guidelines, for which the accrual of interest has not been stopped. By definition under regulatory guidelines, a “Substandard” loan has defined weaknesses which make payment default or principal exposure likely, but not yet certain. Such loans are apt to be dependent upon collateral liquidation, a secondary source of repayment or an event outside of the normal course of business.

•

Grade 12 – This grade includes “Substandard” loans, in accordance with regulatory guidelines, for which the accrual of interest has been stopped. This grade includes loans where interest is more than 120 days past due and not fully secured and loans where a specific valuation allowance may be necessary, but generally does not exceed 30% of the principal balance.

•

Grade 13 – This grade includes “Doubtful” loans in accordance with regulatory guidelines. Such loans are placed on non-accrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks certainty. Additionally, these loans generally have a specific valuation allowance in excess of 30% of the principal balance.

•

Grade 14 – This grade includes “Loss” loans in accordance with regulatory guidelines. Such loans are to be charged-off or charged-down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.

In monitoring credit quality trends in the context of assessing the appropriate level of the allowance for loan losses, the Corporation monitors portfolio credit quality by the weighted-average risk grade of each class of commercial loan. Individual relationship managers review updated financial information for all pass grade loans to recalculate the risk grade on at least an annual basis. When a loan has a calculated risk grade of 9, it is still considered a pass grade loan; however, it is considered to be on management’s “watch list,” where a significant risk-modifying action is anticipated in the near term. When a loan has a calculated risk grade of 10 or higher, a special assets officer monitors the loan on an on-going basis. The following table presents weighted average risk grades for all commercial loans by class.


	June 30, 2012				December 31, 2011				June 30, 2011
	Weighted				Weighted				Weighted
	Average				Average				Average
	Risk Grade		Loans		Risk Grade		Loans		Risk Grade		Loans
Commercial and industrial:
Energy
Risk grades 1-8		5.42	$	1,061,572		5.21	$	868,561		5.36	$	800,855
Risk grade 9		9.00		1,908		9.00		2,025		9.00		1,477
Risk grade 10		10.00		—		10.00		—		10.00		—
Risk grade 11		11.00		—		11.00		—		11.00		—
Risk grade 12		12.00		—		12.00		—		12.00		—
Risk grade 13		13.00		—		13.00		—		13.00		—

Total energy		5.43	$	1,063,480		5.22	$	870,586		5.37	$	802,332

Other commercial
Risk grades 1-8		6.11	$	3,003,954		6.20	$	2,802,037		6.17	$	2,648,041
Risk grade 9		9.00		58,491		9.00		55,105		9.00		146,112
Risk grade 10		10.00		51,870		10.00		49,982		10.00		51,458
Risk grade 11		11.00		88,239		11.00		96,046		11.00		119,946
Risk grade 12		12.00		38,671		12.00		39,826		12.00		52,428
Risk grade 13		13.00		5,184		13.00		3,285		13.00		21,833

Total other commercial		6.44	$	3,246,409		6.55	$	3,046,281		6.71	$	3,039,818

Commercial real estate:
Buildings, land and other
Risk grades 1-8		6.68	$	2,292,826		6.69	$	2,266,576		6.68	$	2,282,540
Risk grade 9		9.00		99,230		9.00		103,894		9.00		113,400
Risk grade 10		10.00		33,207		10.00		45,278		10.00		73,031
Risk grade 11		11.00		113,673		11.00		126,594		11.00		105,209
Risk grade 12		12.00		40,857		12.00		41,747		12.00		47,484
Risk grade 13		13.00		1,428		13.00		1,868		13.00		2,303

Total commercial real estate		7.09	$	2,581,221		7.14	$	2,585,957		7.15	$	2,623,967

Construction
Risk grades 1-8		6.94	$	498,707		6.95	$	378,530		7.04	$	455,036
Risk grade 9		9.00		31,139		9.00		30,376		9.00		26,637
Risk grade 10		10.00		4,915		10.00		16,186		10.00		34,332
Risk grade 11		11.00		1,675		11.00		8,449		11.00		14,185
Risk grade 12		12.00		2,245		12.00		1,329		12.00		2,942
Risk grade 13		13.00		—		13.00		—		13.00		—

Total construction		7.12	$	538,681		7.30	$	434,870		7.46	$	533,132

The Corporation has established maximum loan to value standards to be applied during the origination process of commercial and consumer real estate loans. The Corporation does not subsequently monitor loan-to-value ratios (either individually or on a weighted-average basis) for loans that are subsequently considered to be of a pass grade (grades 9 or better) and/or current with respect to principal and interest payments. As stated above, when an individual commercial real estate loan has a calculated risk grade of 10 or higher, a special assets officer analyzes the loan to determine whether the loan is impaired. At that time, the Corporation reassesses the loan to value position in the loan. If the loan is determined to be collateral dependent, specific allocations of the allowance for loan losses are made for the amount of any collateral deficiency. If a collateral deficiency is ultimately deemed to be uncollectible, the amount is charged-off. These loans and related assessments of collateral position are monitored on an individual, case-by-case basis. The Corporation does not monitor loan-to-value ratios on a weighted-average basis for commercial real estate loans having a calculated risk grade of 10 or higher. Nonetheless, there were four commercial real estate loans having a calculated risk grade of 10 or higher in excess of $5 million as of June 30, 2012, which totaled $41.3 million and had a weighted-average loan-to-value ratio of 70.8%.

When an individual consumer real estate loan becomes past due by more than 10 days, the assigned relationship manager will begin collection efforts. The Corporation only reassesses the loan to value position in a consumer real estate loan if, during the course of the collections process, it is determined that the loan has become collateral dependent, and any collateral deficiency is recognized as a charge-off to the allowance for loan losses. Accordingly, the Corporation does not monitor loan-to-value ratios on a weighted-average basis for collateral dependent consumer real estate loans.

Generally, a commercial loan, or a portion thereof, is charged-off immediately when it is determined, through the analysis of any available current financial information with regards to the borrower, that the borrower is incapable of servicing unsecured debt, there is little or no prospect for near term improvement and no realistic strengthening action of significance is pending or, in the case of secured debt, when it is determined, through analysis of current information with regards to the Corporation’s collateral position, that amounts due from the borrower are in excess of the calculated current fair value of the collateral. Notwithstanding the foregoing, generally, commercial loans that become past due 180 cumulative days are classified as a loss and charged-off. Generally, a consumer loan, or a portion thereof, is charged-off in accordance with regulatory guidelines which provide that such loans be charged-off when the Corporation becomes aware of the loss, such as from a triggering event that may include new information about a borrower’s intent/ability to repay the loan, bankruptcy, fraud or death, among other things, but in no case should the charge-off exceed specified delinquency timeframes. Such delinquency timeframes state that closed-end retail loans (loans with pre-defined maturity dates, such as real estate mortgages, home equity loans and consumer installment loans) that become past due 120 cumulative days and open-end retail loans (loans that roll-over at the end of each term, such as home equity lines of credit) that become past due 180 cumulative days should be classified as a loss and charged-off.

Net (charge-offs)/recoveries, segregated by class of loans, were as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Commercial and industrial:
Energy	$	—		$	2		$	4		$	4
Other commercial		(3,180	)		(4,720	)		(4,855	)		(11,552	)
Commercial real estate:
Buildings, land and other		493			(4,362	)		(1,867	)		(7,527	)
Construction		12			(196	)		22			(352	)
Consumer real estate		(519	)		(362	)		(285	)		(892	)
Consumer and other		(694	)		(927	)		(973	)		(1,691	)

Total	$	(3,888	)	$	(10,565	)	$	(7,954	)	$	(22,010	)

In assessing the general economic conditions in the State of Texas, management monitors and tracks the Texas Leading Index (“TLI”), which is produced by the Federal Reserve Bank of Dallas. The TLI is a single summary statistic that is designed to signal the likelihood of the Texas economy’s transition from expansion to recession and vice versa. Management believes this index provides a reliable indication of the direction of overall credit quality. The TLI is a composite of the following eight leading indicators: (i) Texas Value of the Dollar, (ii) U.S. Leading Index, (iii) real oil prices (iv) well permits, (v) initial claims for unemployment insurance, (vi) Texas Stock Index, (vii) Help-Wanted Index and (viii) average weekly hours worked in manufacturing. The TLI totaled 123.2 at May 31, 2012 (most recent date available), 120.4 at December 31, 2011 and 121.5 at June 30, 2011. A higher TLI value implies more favorable economic conditions.

Allowance for Loan Losses. The allowance for loan losses is a reserve established through a provision for 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 loan loss methodology follows the accounting guidance set forth in U.S. generally accepted accounting principles and the Interagency Policy Statement on the Allowance for Loan and Lease Losses, which was jointly issued by the U.S. bank regulatory agencies. In that regard, the Corporation’s allowance for loan losses 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 loan losses is designed to account for credit deterioration as it occurs. The provision for 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 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 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.

The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss and recovery 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 determination of the appropriate level of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including, among other things, 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 monitors whether or not the allowance for loan loss allocation model, as a whole, calculates an appropriate level of allowance for loan losses that moves in direct correlation to the general macroeconomic and loan portfolio conditions the Corporation experiences over time.

The Corporation’s allowance for 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 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 problem 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. When a loan has a calculated grade of 10 or higher, 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 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 gross 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 gross 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 gross 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 gross 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 real estate loans and consumer and other loans.

The components of the general valuation allowance include (i) the additional reserves allocated as a result of applying an environmental risk adjustment factor to the base historical loss allocation, (ii) the additional reserves allocated for loans to borrowers in distressed industries and (iii) the additional reserves allocated for groups of similar loans with risk characteristics that exceed certain concentration limits established by management.

The environmental adjustment factor is based upon a more qualitative analysis of risk and is calculated through a survey of senior officers who are involved in credit making decisions at a corporate-wide and/or regional level. On a quarterly basis, survey participants rate the degree of various risks utilizing a numeric scale that translates to varying grades of high, moderate or low levels of risk. The results are then input into a risk-weighting matrix to determine an appropriate environmental risk adjustment factor. The various risks that may be considered in the determination of the environmental adjustment factor include, 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) the impact of legislative and governmental influences affecting industry sectors; (v) the effectiveness of the internal loan review function; (vi) the impact of competition on loan structuring and pricing; and (vii) the impact of rising interest rates on portfolio risk. In periods where the surveyed risks are perceived to be higher, the risk-weighting matrix will generally result in a higher environmental adjustment factor, which, in turn will result in higher levels of general valuation allowance allocations. The opposite holds true in periods where the surveyed risks are perceived to be lower.

During the fourth quarter of 2011, the Corporation refined its methodology for the determination of the allowance for loan losses to provide reserves for loans to borrowers in distressed industries. To determine the amount of the allocation, management calculates the weighted-average risk grade for all loans to borrowers in distressed industries by loan portfolio segment. A multiple is then applied to the amount by which the weighted-average risk grade for loans to borrowers in distressed industries exceeds the weighted-average risk grade for all pass-grade loans within the loan portfolio segment to derive an allocation factor for loans to borrowers in distressed industries. The amount of the allocation for each loan portfolio

segment is the product of this allocation factor and the outstanding balance of pass-grade loans within the identified distressed industries that have a risk grade of 6 or higher. This change in the Corporation’s methodology for the determination of the allowance for loan losses did not significantly impact the provision for loan losses recorded during 2011. Management identifies potential distressed industries by analyzing industry trends related to delinquencies, classifications and charge-offs. At June 30, 2012 and December 31, 2011, contractors were considered to be a distressed industry based on elevated levels of delinquencies, classifications and charge-offs relative to other industries within the Corporation’s loan portfolio. Furthermore, the Corporation determined, through a review of borrower financial information that, as a whole, contractors have experienced, among other things, decreased revenues, reduced backlog of work, compressed margins and little, if any, net income.

General valuation allowances include allocations for groups of loans with similar risk characteristics that exceed certain concentration limits established by management and/or the Corporation’s board of directors. 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, credit and/or collateral exceptions that exceed specified risk grades. Additionally, general valuation allowances are provided for loans that did not undergo a separate, independent concurrence review during the underwriting process (generally those loans under $1.0 million at origination). The Corporation’s allowance methodology for general valuation allowances also includes a reduction factor for recoveries of prior charge-offs to compensate for the fact that historical loss allocations are based upon gross charge-offs rather than net. The adjustment for recoveries is based on the lower of annualized, year-to-date gross recoveries or the total gross recoveries for the preceding four quarters, adjusted, when necessary, for expected future trends in recoveries.

The following table presents details of the allowance for loan losses, segregated by loan portfolio segment. Prior to June 30, 2012, certain general valuation allowances were not allocated to specific loan portfolio segments.


	Commercial and Industrial			Commercial Real Estate			Consumer Real Estate			Consumer and Other			Unallocated			Total
June 30, 2012
Historical valuation allowances	$	32,083		$	14,979		$	2,980		$	7,281		$	—		$	57,323
Specific valuation allowances		5,140			1,148			—			—			—			6,288
General valuation allowances:
Environmental risk adjustment		5,335			3,266			642			1,731			—			10,974
Distressed industries		4,732			1,373			—			—			—			6,105
Excessive industry concentrations		5,017			4,263			—			—			—			9,280
Large relationship concentrations		1,342			973			—			—			—			2,315
Highly-leveraged credit relationships		2,874			1,120			—			—			—			3,994
Policy exceptions		—			—			—			—			2,258			2,258
Credit and collateral exceptions		—			—			—			—			2,252			2,252
Loans not reviewed by concurrence		2,249			2,444			2,332			1,155			—			8,180
Adjustment for recoveries		(5,297	)		(1,935	)		(719	)		(6,518	)		—			(14,469	)
General macroeconomic risk		—			—			—			—			11,148			11,148

Total	$	53,475		$	27,631		$	5,235		$	3,649		$	15,658		$	105,648

December 31, 2011
Historical valuation allowances	$	30,368		$	15,153		$	2,742		$	9,876		$	—		$	58,139
Specific valuation allowances		2,696			1,113			95			—			—			3,904
General valuation allowances:
Environmental risk adjustment		5,656			3,724			703			2,759			—			12,842
Distressed industries		4,054			922			—			—			—			4,976
Excessive industry concentrations		—			—			—			—			6,995			6,995
Large relationship concentrations		—			—			—			—			2,232			2,232
Highly-leveraged credit relationships		—			—			—			—			3,530			3,530
Policy exceptions		—			—			—			—			2,121			2,121
Credit and collateral exceptions		—			—			—			—			1,603			1,603
Loans not reviewed by concurrence		—			—			—			—			9,030			9,030
Adjustment for recoveries		—			—			—			—			(13,071	)		(13,071	)
General macroeconomic risk		—			—			—			—			17,846			17,846

Total	$	42,774		$	20,912		$	3,540		$	12,635		$	30,286		$	110,147

The Corporation monitors whether or not the allowance for loan loss allocation model, as a whole, calculates an appropriate level of allowance for loan losses that moves in direct correlation to the general macroeconomic and loan portfolio conditions the Corporation experiences over time. In assessing the general macroeconomic trends/conditions, the Corporation analyzes trends in the components of the TLI, as well as any available information related to regional, national and international economic conditions and events and the impact such conditions and events may have on the Corporation and its customers. With regard to assessing loan portfolio conditions, the Corporation analyzes trends in weighted-average portfolio risk-grades, classified and non-performing loans and charge-off activity. In periods where general macroeconomic and loan portfolio conditions are in a deteriorating trend or remain at deteriorated levels, based on historical trends, the Corporation would expect to see the allowance for loan loss allocation model, as a whole, calculate higher levels of required allowances than in periods where general macroeconomic and loan portfolio conditions are in an improving trend or remain at an elevated level, based on historical trends.

The following table details activity in the allowance for loan losses by portfolio segment for the three and six months ended June 30, 2012 and 2011. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.


	Commercial
	and			Commercial			Consumer			Consumer
	Industrial			Real Estate			Real Estate			and Other			Unallocated			Total
Three months ended:
June 30, 2012
Beginning balance	$	45,869		$	20,003		$	3,699		$	8,715		$	28,895		$	107,181
Provision for loan losses		10,786			7,123			2,055			(4,372	)		(13,237	)		2,355
Charge-offs		(4,474	)		(353	)		(606	)		(2,229	)		—			(7,662	)
Recoveries		1,294			858			87			1,535			—			3,774

Net charge-offs		(3,180	)		505			(519	)		(694	)		—			(3,888	)

Ending balance	$	53,475		$	27,631		$	5,235		$	3,649		$	15,658		$	105,648

June 30, 2011
Beginning balance	$	52,800		$	24,551		$	3,485		$	12,941		$	30,544		$	124,321
Provision for loan losses		8,484			908			560			597			(1,564	)		8,985
Charge-offs		(5,576	)		(4,694	)		(459	)		(2,397	)		—			(13,126	)
Recoveries		858			136			97			1,470			—			2,561

Net charge-offs		(4,718	)		(4,558	)		(362	)		(927	)		—			(10,565	)

Ending balance	$	56,566		$	20,901		$	3,683		$	12,611		$	28,980		$	122,741

Six months ended:
June 30, 2012
Beginning balance	$	42,774		$	20,912		$	3,540		$	12,635		$	30,286		$	110,147
Provision for loan losses		15,552			8,564			1,980			(8,013	)		(14,628	)		3,455
Charge-offs		(7,486	)		(3,195	)		(895	)		(4,214	)		—			(15,790	)
Recoveries		2,635			1,350			610			3,241			—			7,836

Net charge-offs		(4,851	)		(1,845	)		(285	)		(973	)		—			(7,954	)

Ending balance	$	53,475		$	27,631		$	5,235		$	3,649		$	15,658		$	105,648

June 30, 2011
Beginning balance	$	57,789		$	28,534		$	3,223		$	11,974		$	24,796		$	126,316
Provision for loan losses		10,325			246			1,352			2,328			4,184			18,435
Charge-offs		(13,173	)		(8,572	)		(1,279	)		(4,699	)		—			(27,723	)
Recoveries		1,625			693			387			3,008			—			5,713

Net charge-offs		(11,548	)		(7,879	)		(892	)		(1,691	)		—			(22,010	)

Ending balance	$	56,566		$	20,901		$	3,683		$	12,611		$	28,980		$	122,741

The following table details the amount of the allowance for loan losses allocated to each portfolio segment as of June 30, 2012 and 2011, detailed on the basis of the impairment methodology used by the Corporation.


	Commercial and Industrial		Commercial Real Estate		Consumer Real Estate		Consumer and Other		Unallocated		Total
June 30, 2012
Loans individually evaluated for impairment	$	17,983	$	2,728	$	—	$	—	$	—	$	20,711
Loans collectively evaluated for impairment		35,492		24,903		5,235		3,649		15,658		84,937

Balance at June 30, 2012	$	53,475	$	27,631	$	5,235	$	3,649	$	15,658	$	105,648

June 30, 2011
Loans individually evaluated for impairment	$	32,981	$	4,089	$	100	$	—	$	—	$	37,170
Loans collectively evaluated for impairment		23,585		16,812		3,583		12,611		28,980		85,571

Balance at June 30, 2011	$	56,566	$	20,901	$	3,683	$	12,611	$	28,980	$	122,741

The Corporation’s recorded investment in loans as of June 30, 2012, December 31, 2011 and June 30, 2011 related to each balance in the allowance for loan losses by portfolio segment and detailed on the basis of the impairment methodology used by the Corporation was as follows:


	Commercial and Industrial		Commercial Real Estate		Consumer Real Estate		Consumer and Other		Unearned Discounts			Total
June 30, 2012
Loans individually evaluated for impairment	$	183,964	$	198,000	$	1,279	$	439	$	—		$	383,682
Loans collectively evaluated for impairment		4,125,925		2,921,902		760,781		316,564		(19,091	)		8,106,081

Ending balance	$	4,309,889	$	3,119,902	$	762,060	$	317,003	$	(19,091	)	$	8,489,763

December 31, 2011
Loans individually evaluated for impairment	$	189,139	$	241,451	$	2,470	$	554	$	—		$	433,614
Loans collectively evaluated for impairment		3,727,728		2,779,376		760,339		311,982		(17,910	)		7,561,515

Ending balance	$	3,916,867	$	3,020,827	$	762,809	$	312,536	$	(17,910	)	$	7,995,129

June 30, 2011
Loans individually evaluated for impairment	$	245,665	$	279,486	$	416	$	—	$	—		$	525,567
Loans collectively evaluated for impairment		3,596,485		2,877,613		772,653		314,305		(18,411	)		7,542,645

Ending balance	$	3,842,150	$	3,157,099	$	773,069	$	314,305	$	(18,411	)	$	8,068,212

Note 4 - Goodwill and Other Intangible Assets

Goodwill and other intangible assets are presented in the table below. The increases in goodwill and certain other intangible assets were related to the acquisition of Stone Partners Inc. (“Stone”), a human resource consulting firm that specializes in compensation, benefits and outsourcing services, on January 1, 2012. Stone was based in Houston with additional offices in Dallas and Austin. Stone was fully integrated into Frost Insurance Agency subsequent to acquisition. The acquisition of Stone did not significantly impact the Corporation’s financial statements.


	June 30,		December 31,
	2012		2011
Goodwill	$	535,560	$	528,072

Other intangible assets:
Core deposits	$	6,729	$	8,234
Customer relationship		2,612		2,113
Non-compete agreements		698		257

	$	10,039	$	10,604

The estimated aggregate future amortization expense for intangible assets remaining as of June 30, 2012 is as follows:


Remainder of 2012	$	1,892
2013		3,115
2014		2,270
2015		1,490
2016		777
Thereafter		495

	$	10,039

Note 5 - Deposits

Deposits were as follows:


	June 30,		Percentage			December 31,		Percentage			June 30,		Percentage
	2012		of Total			2011		of Total			2011		of Total
Non-interest-bearing demand deposits:
Commercial and individual	$	6,432,259		37.2	%	$	5,848,840		34.9	%	$	5,220,598		34.6	%
Correspondent banks		327,297		1.9			370,275		2.2			274,465		1.8
Public funds		377,118		2.2			453,440		2.7			323,629		2.1

Total non-interest-bearing demand deposits		7,136,674		41.3			6,672,555		39.8			5,818,692		38.5
Interest-bearing deposits:
Private accounts:
Savings and interest checking		2,970,908		17.2			2,912,937		17.4			2,449,434		16.2
Money market accounts		5,763,163		33.3			5,664,780		33.8			5,331,994		35.3
Time accounts of $100,000 or more		533,311		3.1			533,682		3.2			582,183		3.9
Time accounts under $100,000		496,210		2.9			522,887		3.1			539,715		3.6

Total private accounts		9,763,592		56.5			9,634,286		57.5			8,903,326		59.0
Public funds:
Savings and interest checking		190,021		1.1			265,747		1.6			194,778		1.3
Money market accounts		48,378		0.3			44,590		0.3			49,561		0.3
Time accounts of $100,000 or more		134,503		0.8			136,422		0.8			133,508		0.9
Time accounts under $100,000		3,949		—			3,148		—			4,266		—

Total public funds		376,851		2.2			449,907		2.7			382,113		2.5

Total interest-bearing deposits		10,140,443		58.7			10,084,193		60.2			9,285,439		61.5

Total deposits	$	17,277,117		100.0	%	$	16,756,748		100.0	%	$	15,104,131		100.0	%

The following table presents additional information about the Corporation’s deposits:


	June 30,		December 31,		June 30,
	2012		2011		2011
Money market deposits obtained through brokers	$	—	$	24,500	$	34,302
Deposits from the Certificate of Deposit Account Registry Service (CDARS) deposits		24,110		45,005		49,833
Deposits from foreign sources (primarily Mexico)		774,239		744,669		753,092

Note 6 - Commitments and Contingencies

Financial Instruments with Off-Balance-Sheet Risk. In the normal course of business, the Corporation enters into various transactions, which, in accordance with generally accepted accounting principles are not included in its consolidated balance sheets. The Corporation enters into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The Corporation minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures.

The Corporation enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of the Corporation’s commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. Standby letters of credit are written conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Corporation would be required to fund the commitment. The maximum potential amount of future payments the Corporation could be required to make is represented by the contractual amount of the commitment. If the commitment were funded, the Corporation would be entitled to seek recovery from the customer. The Corporation’s policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.

The Corporation considers the fees collected in connection with the issuance of standby letters of credit to be representative of the fair value of its obligation undertaken in issuing the guarantee. In accordance with applicable accounting standards related to guarantees, the Corporation defers fees collected in connection with the issuance of standby letters of credit. The fees are then recognized in income proportionately over the life of the standby letter of credit agreement. The deferred standby letter of credit fees represent the fair value of the Corporation’s potential obligations under the standby letter of credit guarantees.

Financial instruments with off-balance-sheet risk were as follows:


	June 30,		December 31,
	2012		2011
Commitments to extend credit	$	5,443,898	$	5,147,363
Standby letters of credit		194,093		235,903
Deferred standby letter of credit fees		1,203		1,488

Lease Commitments. The Corporation leases certain office facilities and office equipment under operating leases. Rent expense for all operating leases totaled $5.6 million and $11.0 million during the three and six months ended June 30, 2012 and $5.3 million and $10.8 million during the three and six months ended June 30, 2011. There has been no significant change in the future minimum lease payments payable by the Corporation since December 31, 2011. See the 2011 Form 10-K for information regarding these commitments.

Litigation. The Corporation is subject to various claims and legal actions that have arisen in the 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.

Note 7 - Regulatory Matters

Regulatory Capital Requirements. 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.

Quantitative measures established by regulations to ensure capital adequacy require the maintenance of minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to adjusted quarterly average assets (as defined).

Cullen/Frost’s and Frost Bank’s Tier 1 capital consists of shareholders’ equity excluding unrealized gains and losses on securities available for sale, the accumulated gain or loss on effective cash flow hedging derivatives, the net actuarial gain/loss on the Corporation’s defined benefit post-retirement benefit plans, goodwill and other intangible assets. Tier 1 capital for Cullen/Frost also includes $120 million of trust preferred securities issued by its unconsolidated subsidiary trust. Cullen/Frost’s and Frost Bank’s total capital is comprised of Tier 1 capital for each entity plus a permissible portion of the allowance for loan losses. The Corporation’s aggregate $100 million of floating rate subordinated notes are not included in Tier 1 capital but are included in total capital of Cullen/Frost.

The Tier 1 and total capital ratios are calculated by dividing the respective capital amounts by risk-weighted assets. Risk-weighted assets are calculated based on regulatory requirements and include total assets, excluding goodwill and other intangible assets, allocated by risk weight category, and certain off-balance-sheet items (primarily loan commitments). The leverage ratio is calculated by dividing Tier 1 capital by adjusted quarterly average total assets, which exclude goodwill and other intangible assets.

Actual and required capital ratios for Cullen/Frost and Frost Bank were as follows:


	Actual					Minimum Required for Capital Adequacy Purposes					Required to be Considered Well Capitalized
	Capital Amount		Ratio			Capital Amount		Ratio			Capital Amount		Ratio
June 30, 2012
Total Capital to Risk-Weighted Assets
Cullen/Frost	$	1,877,320		15.61	%	$	962,114		8.00	%	$	1,202,642		10.00	%
Frost Bank		1,680,513		13.98			961,624		8.00			1,202,029		10.00
Tier 1 Capital to Risk-Weighted Assets
Cullen/Frost		1,691,672		14.07			481,057		4.00			721,585		6.00
Frost Bank		1,574,865		13.10			480,812		4.00			721,218		6.00
Leverage Ratio
Cullen/Frost		1,691,672		8.65			782,248		4.00			977,809		5.00
Frost Bank		1,574,865		8.06			781,770		4.00			977,212		5.00
December 31, 2011
Total Capital to Risk-Weighted Assets
Cullen/Frost	$	1,835,428		16.24	%	$	903,970		8.00	%	$	1,129,962		10.00	%
Frost Bank		1,641,921		14.54			903,427		8.00			1,129,284		10.00
Tier 1 Capital to Risk-Weighted Assets
Cullen/Frost		1,625,281		14.38			451,985		4.00			677,977		6.00
Frost Bank		1,531,774		13.56			451,713		4.00			677,570		6.00
Leverage Ratio
Cullen/Frost		1,625,281		8.66			750,643		4.00			938,304		5.00
Frost Bank		1,531,774		8.17			750,249		4.00			937,811		5.00

Management believes that, as of June 30, 2012, Cullen/Frost and its bank subsidiary, Frost Bank, were “well capitalized” based on the ratios presented above.

Cullen/Frost and Frost Bank are subject to the regulatory capital requirements administered by the Federal Reserve (see the section captioned “Charter Conversion” below) and, for Frost Bank, the Federal Deposit Insurance Corporation (“FDIC”). Regulatory authorities can initiate certain mandatory actions if Cullen/Frost or Frost Bank fail to meet the minimum capital requirements, which could have a direct material effect on the Corporation’s financial statements. Management believes, as of June 30, 2012, that Cullen/Frost and Frost Bank meet all capital adequacy requirements to which they are subject.

Dividend Restrictions. In the ordinary course of business, Cullen/Frost is dependent upon dividends from Frost Bank to provide funds for the payment of dividends to shareholders and to provide for other cash requirements. Banking regulations may limit the amount of dividends that may be paid. Approval by regulatory authorities is required if the effect of dividends declared would cause the regulatory capital of Frost Bank to fall below specified minimum levels. Approval is also required if dividends declared exceed the net profits for that year combined with the retained net profits for the preceding two years. Under the foregoing dividend restrictions and while maintaining its “well capitalized” status, at June 30, 2012, Frost Bank could pay aggregate dividends of up to $257.0 million to Cullen/Frost without prior regulatory approval.

Trust Preferred Securities. In accordance with the applicable accounting standard related to variable interest entities, the accounts of the Corporation’s wholly owned subsidiary trust, Cullen/Frost Capital Trust II, have not been included in the Corporation’s consolidated financial statements. However, the $120.0 million in trust preferred securities issued by this subsidiary trust have been included in the Tier 1 capital of Cullen/Frost for regulatory capital purposes pursuant to guidance from the Federal Reserve. On July 21, 2010, financial regulatory reform legislation entitled the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”) was signed into law. Certain provisions of the Dodd-Frank Act will require the Corporation to deduct, over three years beginning on January 1, 2013, all trust preferred securities from the Corporation’s Tier 1 capital. Nonetheless, excluding trust preferred securities from Tier 1 capital at June 30, 2012 would not affect the Corporation’s ability to meet all capital adequacy requirements to which it is subject.

Charter Conversion. On June 22, 2012, Frost Bank, the sole banking subsidiary of the Corporation, became a Texas state chartered bank and a member of the Federal Reserve System. Accordingly, the Texas Department of Banking and the Federal Reserve are now the primary regulators of Frost Bank, and Frost Bank will no longer be regulated by the Office of the Comptroller of the Currency (“OCC”). Deposits at Frost Bank continue to be insured by the FDIC up to applicable limits.

Note 8 - Derivative Financial Instruments

The fair value of derivative positions outstanding is included in accrued interest receivable and other assets and accrued interest payable and other liabilities in the accompanying consolidated balance sheets and in the net change in each of these financial statement line items in the accompanying consolidated statements of cash flows.

Interest Rate Derivatives. The Corporation utilizes interest rate swaps, caps and floors to mitigate exposure to interest rate risk and to facilitate the needs of its customers. The Corporation’s objectives for utilizing these derivative instruments is described below:

The Corporation has entered into certain interest rate swap contracts that are matched to specific fixed-rate commercial loans or leases that the Corporation has entered into with its customers. These contracts have been designated as hedging instruments to hedge the risk of changes in the fair value of the underlying commercial loan/lease due to changes in interest rates. The related contracts are structured so that the notional amounts reduce over time to generally match the expected amortization of the underlying loan/lease.

In October 2007, the Corporation entered into three interest rate swap contracts on variable-rate loans with a total notional amount of $1.2 billion. The interest rate swap contracts were designated as hedging instruments in cash flow hedges with the objective of protecting the overall cash flows from the Corporation’s monthly interest receipts on a rolling portfolio of $1.2 billion of variable-rate loans outstanding throughout the 84-month period beginning in October 2007 and ending in October 2014 from the risk of variability of those cash flows such that the yield on the underlying loans would remain constant. As more fully discussed in the 2011 Form 10-K, the Corporation terminated portions of the hedges and settled portions of the interest rate swap contracts during November 2009 and terminated the remaining portions of the hedges and settled the remaining portions of the interest rate swap contracts during November 2010. The deferred accumulated after-tax gain applicable to the settled interest rate swap contracts included in accumulated other comprehensive income totaled $56.3 million at June 30, 2012. The deferred gain will be recognized ratably in earnings through October 2014.

In October 2008, the Corporation entered into an interest rate swap contract on junior subordinated deferrable interest debentures with a total notional amount of $120.0 million. The interest rate swap contract was designated as a hedging instrument in a cash flow hedge with the objective of protecting the quarterly interest payments on the Corporation’s $120.0 million of junior subordinated deferrable interest debentures issued to Cullen/Frost Capital Trust II throughout the five-year period beginning in December 2008 and ending in December 2013 from the risk of variability of those payments resulting from changes in the three-month LIBOR interest rate. Under the swap, the Corporation will pay a fixed interest rate of 5.47% and receive a variable interest rate of three-month LIBOR plus a margin of 1.55% on a total notional amount of $120.0 million, with quarterly settlements.

The Corporation has entered into certain interest rate swap, cap and floor contracts that are not designated as hedging instruments. These derivative contracts relate to transactions in which the Corporation enters into an interest rate swap, cap and/or floor with a customer while at the same time entering into an offsetting interest rate swap, cap and/or floor with another financial institution. In connection with each swap transaction, the Corporation agrees to pay interest to the customer on a notional amount at a variable interest rate and receive interest from the customer on a similar notional amount at a fixed interest rate. At the same time, the Corporation agrees to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows the Corporation’s customer to effectively convert a variable rate loan to a fixed rate. Because the Corporation acts as an intermediary for its customer, changes in the fair value of the underlying derivative contracts for the most part offset each other and do not significantly impact the Corporation’s results of operations.

The notional amounts and estimated fair values of interest rate derivative contracts outstanding at June 30, 2012 and December 31, 2011 are presented in the following table. The Corporation obtains dealer quotations to value its interest rate derivative contracts designated as hedges of cash flows, while the fair values of other interest rate derivative contracts are estimated utilizing internal valuation models with observable market data inputs.


	June 30, 2012					December 31, 2011
	Notional Amount		Estimated Fair Value			Notional Amount		Estimated Fair Value
Interest rate derivatives designated as hedges of fair value:
Commercial loan/lease interest rate swaps	$	90,094	$	(8,244	)	$	71,181	$	(8,376	)
Interest rate derivatives designated as hedges of cash flows:
Interest rate swap on junior subordinated deferrable interest debentures		120,000		(6,216	)		120,000		(7,807	)
Non-hedging interest rate derivatives:
Commercial loan/lease interest rate swaps		621,391		62,825			613,883		61,137