Form 10-K
Table of Contents

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, 2008

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,

and attached Stock Purchase Rights

  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 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.  [    ]

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, 2008, 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 $2.8 billion.

As of January 30, 2009, there were 59,416,433 shares of the registrant’s common stock, $.01 par value, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2009 Annual Meeting of Shareholders of Cullen/Frost Bankers, Inc. to be held on April 23, 2009 are incorporated by reference in this Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.


Table of Contents

CULLEN/FROST BANKERS, INC.

ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

         Page

PART I

        

Item 1.

 

Business

   3

Item 1A.

 

Risk Factors

   18

Item 1B.

 

Unresolved Staff Comments

   26

Item 2.

 

Properties

   26

Item 3.

 

Legal Proceedings

   27

Item 4.

 

Submission of Matters to a Vote of Security Holders

   27

PART II

        

Item 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   28

Item 6.

 

Selected Financial Data

   31

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   34

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

   73

Item 8.

 

Financial Statements and Supplementary Data

   75

Item 9.

 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

   128

Item 9A.

 

Controls and Procedures

   128

Item 9B.

 

Other Information

   129

PART III

        

Item 10.

 

Directors, Executive Officers and Corporate Governance

   130

Item 11.

 

Executive Compensation

   130

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   130

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

   130

Item 14.

 

Principal Accounting Fees and Services

   130

PART IV

        

Item 15.

 

Exhibits, Financial Statement Schedules

   131

SIGNATURES

   133

 

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PART I

 

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, 2008, Cullen/Frost had consolidated total assets of $15.0 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 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. During 2008 and 2007, respectively, the Corporation acquired R. G. Seeberger, Inc. (Dallas market area) and Prime Benefits, Inc. (Austin market area), both independent insurance agencies that specialized in providing group employee benefit plans to businesses. During 2006, the Corporation acquired Texas Community Bancshares, Inc. (Dallas market area), Alamo Corporation of Texas (Rio Grande Valley market area) and Summit Bancshares, Inc. (Fort Worth market area). Details of these transactions are presented in Note 2 - Mergers and Acquisitions in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.

 

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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.

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 on December 8, 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 defined in Financial Accounting Standards Board Interpretation (“FIN”) No. 46 “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (Revised December 2003).” In accordance with FIN 46R, 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 as allowed by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”). In February 2005, the Federal Reserve Board issued a final rule that allows the continued inclusion of trust preferred securities in the Tier 1 capital of bank holding companies. The Board’s final rule limits 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 to 25% of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. Large, internationally active bank holding companies (as defined) are subject to a 15% limitation. Amounts of restricted core capital elements in excess of these limits generally may be included in Tier 2 capital. The final rule provides a five-year transition period, ending March 31, 2009, for application of the quantitative limits. The Corporation does not expect that the quantitative limits will preclude it from including the $132.0 million in trust preferred securities in Tier 1 capital. However, the trust preferred securities could be redeemed without penalty if they were no longer permitted to be included in Tier 1 capital.

On January 7, 2008, the Corporation redeemed $3.1 million of floating rate (three-month LIBOR plus a margin of 3.30%) junior subordinated deferrable interest debentures, due January 7, 2033, held of record by Alamo

 

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Corporation of Texas Trust I (“Alamo Trust”). Concurrently, the $3.0 million of floating rate (three-month LIBOR plus a margin of 3.30%) trust preferred securities issued by Alamo Trust were also redeemed. On February 21, 2007, the Corporation redeemed $103.1 million of 8.42% junior subordinated deferrable interest debentures, Series A due February 1, 2027, held of record by Cullen/Frost Capital Trust I, a prior Delaware statutory business trust wholly-owned by the Corporation. As a result of the redemption, the Corporation incurred $5.3 million in expense during the first quarter of 2007 related to a prepayment penalty and the write-off of the unamortized debt issuance costs. Concurrently, the $100 million of 8.42% trust preferred securities issued by Cullen/Frost Capital Trust I were also redeemed. See Note 9 - Borrowed Funds and Note 12 - Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.

The Frost National Bank

The Frost National Bank (“Frost Bank”) is primarily engaged in the business of commercial and consumer banking through more than 100 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, 2008, Frost Bank had consolidated total assets of $15.0 billion and total deposits of $11.5 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 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 317 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, 2008, the estimated fair value of trust assets was $21.7 billion, including managed assets of $9.9 billion and custody assets of $11.8 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.

 

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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 13 Frost-managed mutual funds.

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 19 -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

 

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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.

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 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 that 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.

 

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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.

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 Federal 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 Federal 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 $267.6 million to Cullen/Frost, without obtaining affirmative governmental approvals, at December 31, 2008. This amount would be limited to $210.0 million to avoid adversely affecting Frost Bank’s “well capitalized” status. Furthermore, these amounts are not necessarily indicative of amounts that may be paid or available to be paid in future periods.

 

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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.

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.

 

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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 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.

 

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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.

 

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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, Tier 2 and Tier 3 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. 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 financial 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 financial 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. 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 “BIS”). The BIS 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 BIS 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.

 

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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 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 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).

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. Cullen/Frost believes that, as of December 31, 2008, its bank subsidiary, Frost Bank, was “well capitalized,” based on the ratios and guidelines described above. 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

 

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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.

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, 2008, 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 12 -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”). As of January 1, 2007, the previous nine risk categories utilized in the risk matrix were condensed into four risk categories which continue to be distinguished by capital levels and supervisory ratings. For large, Risk Category 1 institutions (generally those with assets in excess of $10 billion) that have long-term debt issuer ratings, including Frost Bank, assessment rates are determined from weighted-average CAMELS component ratings and long-term debt issuer ratings. The minimum annualized assessment rate for Risk Category 1 institutions is 5 basis points and the maximum annualized assessment rate is 7 basis points. Quarterly assessment rates for large institutions in Risk Category 1 may vary within this range depending upon changes in CAMELS component ratings and long-term debt issuer ratings.

In an effort to restore capitalization levels and to ensure the DIF will adequately cover projected losses from future bank failures, the FDIC, in October 2008, proposed a rule to alter the way in which it differentiates for risk in the risk-based assessment system and to revise deposit insurance assessment rates, including base assessment rates. For Risk Category 1 institutions that have long-term debt issuer ratings, the FDIC proposes (i) to determine

 

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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 and (ii) to revise the uniform amount and the pricing multipliers. The FDIC also proposes to introduce three adjustments that could be made to an institution’s initial base assessment rate, including (i) a potential decrease of up to 2 basis points for long-term unsecured debt, including senior and subordinated debt, (ii) a potential increase for secured liabilities in excess of 15% of domestic deposits and (iii) for non-Risk Category 1 institutions, a potential increase for brokered deposits in excess of 10% of domestic deposits. In addition, the FDIC proposed raising the current rates uniformly by 7 basis points for the assessment for the first quarter of 2009 resulting in annualized assessment rates for Risk Category 1 institutions ranging from 12 to 14 basis points. The proposal for first quarter 2009 assessment rates was adopted as a final rule in December 2008. The FDIC also proposed, effective April 1, 2009, initial base assessment rates for Risk Category 1 institutions of 10 to 14 basis points. After the effect of potential base-rate adjustments, the annualized assessment rate for Risk Category 1 institutions would range from 8 to 21 basis points. A final rule related to this proposal is expected to be issued during the first quarter of 2009. The Corporation cannot provide any assurance as to the amount of any proposed increase in its deposit insurance premium rate, should such an increase occur, as such changes are dependent upon a variety of factors, some of which are beyond the Corporation’s control.

FDIC insurance expense totaled $4.6 million and $1.2 million in 2008 and 2007. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments 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. The assessment credits were mostly utilized for assessments through June 30, 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.

 

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Temporary Liquidity Guarantee Program

On November 21, 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 on October 14, 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 June 30, 2012, certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008, and before June 30, 2009 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 December 31, 2009. Coverage under the TLG Program was available for the first 30 days without charge. The fee assessment for coverage of senior unsecured debt ranges 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 is 10 basis points per quarter on amounts in covered accounts exceeding $250,000. On December 5, 2008, the Corporation elected to participate in both guarantee programs.

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.

 

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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 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.

Legislative Initiatives

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.

 

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Employees

At December 31, 2008, the Corporation employed 3,892 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.

Executive Officers of the Registrant

The names, ages as of December 31, 2008, 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.
Chairman of the Board,
Chief Executive Officer and
Director

  62    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
President of Frost Bank
and Director

  48    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
Group Executive Vice President, Chief Financial Officer

  54    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
President, Chief Business
Banking Officer of Frost Bank

  58    Officer of Frost Bank since July 1973. President, Chief Business Banking Officer of Frost Bank from February 2001 to present.

Robert A. Berman
Group Executive Vice President, Internet Financial Services of Frost Bank

  46    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
President, State Regions of Frost Bank

  52    Officer of Frost Bank since January 1982. President, State Regions of Frost Bank from February 2001 to present.

Richard Kardys
Group Executive Vice President, Executive Trust Officer of Frost Bank

  62    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
Group Executive Vice President, Consumer Banking of Frost Bank

  56    Officer of Frost Bank since August 1976. Group Executive Vice President, Consumer Banking of Frost Bank from May 2001 to present.

William L. Perotti
Group Executive Vice President, Chief Credit Officer and Chief
Risk Officer of Frost Bank

  51    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
Group Executive Vice President, Human Resources of Frost Bank

  64    Officer of Frost Bank since January 1998. Group Executive Vice President, Human Resources of Frost Bank from October 2003 to present.

 

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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.

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, the United States has been in a recession. Business activity across a wide range of industries and regions is greatly reduced and local governments and many businesses are in serious difficulty due to the lack of consumer spending and the lack of liquidity in the credit markets. Unemployment has increased significantly.

Since mid-2007, and particularly during the second half of 2008, the financial services industry and the securities markets generally were materially and adversely affected by significant declines in the values of nearly all asset classes and by a serious lack of liquidity. This was initially triggered by declines in home prices and the values of subprime mortgages, but spread to all mortgage and real estate asset classes, to leveraged bank loans and to nearly all asset classes, including equities. The global markets have been characterized by substantially increased volatility and short-selling and an overall loss of investor confidence, initially in financial institutions, but more recently in companies in a number of other industries and in the broader markets.

Market conditions have also led to the failure or merger of a number of prominent financial institutions. Financial institution failures or near-failures have resulted in further losses as a consequence of defaults on securities issued by them and defaults under contracts entered into with such entities as counterparties. Furthermore, declining asset values, defaults on mortgages and consumer loans, and the lack of market and investor confidence, as well as other factors, have all combined to increase credit default swap spreads, to cause rating agencies to lower credit ratings, and to otherwise increase the cost and decrease the availability of liquidity, despite very significant declines in Federal Reserve borrowing rates and other government actions. Some banks and other lenders have suffered significant losses and have become reluctant to lend, even on a secured basis, due to the increased risk of default and the impact of declining asset values on the value of collateral. The foregoing has significantly weakened the strength and liquidity of some financial institutions worldwide. In 2008, the U.S. government, the Federal Reserve and other regulators have taken numerous steps to increase liquidity and to restore investor confidence, including investing approximately $200 billion in the equity of other banking organizations, but asset values have continued to decline and access to liquidity continues to be very limited.

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, 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, high business and investor confidence, and strong

 

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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; natural disasters; or a combination of these or other factors.

Overall, during 2008, the business environment has been adverse for many households and businesses in the United States and worldwide. The business environment in Texas and the markets in which the Corporation operates has been less adverse than in the United States generally but continues to deteriorate. It is expected that the business environment in the State of Texas, the United States and worldwide will continue to deteriorate for the foreseeable future. There can be no assurance that these conditions will improve in the near term. Such conditions could adversely affect the credit quality of the Corporation’s loans, results of operations and financial condition.

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 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 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, 2008, 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

 

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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’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 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. In addition, 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 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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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 are declining and are expected to continue to decline. 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 affect 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 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.

 

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  ¨  

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. It is likely that there will be significant 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. 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. While the Corporation has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur. See the section captioned “Supervision and Regulation” in Item 1. Business and Note 12 - 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’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.

 

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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 12 - 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.

Potential Acquisitions May Disrupt the Corporation’s Business and Dilute Stockholder Value

The Corporation 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.

  ¨  

Difficulty and expense of integrating the operations and personnel 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.

During 2008, the Corporation acquired R.G. Seeberger Company, Inc. (Dallas market area). During 2007, the Corporation acquired Prime Benefits, Inc. (Austin market area). During 2006, the Corporation acquired Texas Community Bancshares, Inc. (Dallas market area), Alamo Corporation of Texas (Rio Grande Valley market area) and Summit Bancshares, Inc. (Fort Worth market area). Details of these transactions are presented in Note 2 - Mergers and Acquisitions in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.

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 unexpected loss of services of key personnel of the Corporation could

 

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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 does not currently have employment agreements or non-competition agreements with any of its senior officers.

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.

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.

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. 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.

 

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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.

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.

 

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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 deterioration in 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 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.

 

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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 2008.

 

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PART II

 

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 2008 and 2007 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.

 

     2008

   2007

Sales Price Per Share    High    Low    High    Low

First quarter

   $   56.35    $   43.78    $   57.05    $   51.24

Second quarter

     58.78      49.75      54.18      50.49

Third quarter

     65.03      44.42      55.00      48.34

Fourth quarter

     62.41      43.61      54.00      47.55

 

Cash Dividends Per Share    2008    2007

First quarter

   $     0.40    $     0.34

Second quarter

     0.42      0.40

Third quarter

     0.42      0.40

Fourth quarter

     0.42      0.40

Total

   $ 1.66    $ 1.54

As of December 31, 2008, there were 59,416,433 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, 2008, the last trading day of the Corporation’s fiscal year, was $50.68.

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 12 - 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.

 

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Stock-Based Compensation Plans

Information regarding stock-based compensation awards outstanding and available for future grants as of December 31, 2008, 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 13 - 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
Exercise

Price of
Outstanding
Awards

   Number of Shares
Available for
Future Grants

Plans approved by shareholders

   4,272,050    $ 49.98    963,825

Plans not approved by shareholders

   -      -    -
    
  

  

Total

   4,272,050    $   49.98    963,825
    
  

  

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. Under the prior plan, which expired on April 29, 2006, the Corporation was authorized to repurchase up to 2.1 million shares of its common stock from time to time over a two-year period in the open market or through private transactions. No shares were repurchased during 2006. During 2005, the Corporation repurchased 300 thousand shares at a cost of $14.4 million. Over the life of this plan, the Corporation repurchased a total of 833.2 thousand shares at a cost of $39.9 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 2008.

 

   

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

       
       
       
       
Period        

October 1, 2008 to October 31, 2008

  20,852 (1)   $     54.50                   -                       -

November 1, 2008 to November 30, 2008

  -       -   -       -

December 1, 2008 to December 31, 2008

  -       -   -       -
   

       
   

Total

  20,852     $ 54.50   -        
   

       
   

 

(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, 2003 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, 2003

LOGO

 

     2003    2004    2005    2006    2007    2008

Cullen/Frost

   $     100.00    $     122.53    $     138.60    $     147.54    $     137.94    $     142.36

S&P 500

     100.00      110.85      116.28      134.61      141.99      89.54

S&P 500 Banks

     100.00      109.39      110.95      129.41      99.21      63.89

 

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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, 2008. 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, 2008 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,

 
  2008     2007   2006     2005   2004  

Consolidated Statements of Income

 

Interest income:

                                   

Loans, including fees

  $     504,680     $     573,039   $     502,657     $     359,587   $     249,612  

Securities

    167,044       165,517     144,501       131,943     135,035  

Interest-bearing deposits

    429       396     251       150     63  

Federal funds sold and resell agreements

    3,498       29,895     36,550       18,147     8,834  
   


Total interest income

    675,651       768,847     683,959       509,827     393,544  

Interest expense:

                                   

Deposits

    104,871       190,237     155,090       78,934     39,150  

Federal funds purchased and repurchase agreements

    12,954       31,951     31,167       16,632     5,775  

Junior subordinated deferrable interest debentures

    6,972       11,283     17,402       14,908     12,143  

Subordinated notes payable and other borrowings

    16,829       16,639     11,137       8,087     5,038  
   


Total interest expense

    141,626       250,110     214,796       118,561     62,106  
   


Net interest income

    534,025       518,737     469,163       391,266     331,438  

Provision for possible loan losses

    37,823       14,660     14,150       10,250     2,500  
   


Net interest income after provision for possible loan losses

    496,202       504,077     455,013       381,016     328,938  

Non-interest income:

                                   

Trust fees

    74,554       70,359     63,469       58,353     53,910  

Service charges on deposit accounts

    87,566       80,718     77,116       78,751     87,415  

Insurance commissions and fees

    32,904       30,847     28,230       27,731     30,981  

Other charges, commissions and fees

    35,557       32,558     28,105       23,125     22,877  

Net gain (loss) on securities transactions

    (159 )     15     (1 )     19     (3,377 )

Other

    56,900       53,734     43,828       42,400     33,304  
   


Total non-interest income

    287,322       268,231     240,747       230,379     225,110  

Non-interest expense:

                                   

Salaries and wages

    225,943       209,982     190,784       166,059     158,039  

Employee benefits

    47,219       47,095     46,231       41,577     40,176  

Net occupancy

    40,464       38,824     34,695       31,107     29,375  

Furniture and equipment

    37,799       32,821     26,293       23,912     22,771  

Intangible amortization

    7,906       8,860     5,628       4,859     5,346  

Other

    127,314       124,864     106,722       99,493     89,323  
   


Total non-interest expense

    486,645       462,446     410,353       367,007     345,030  
   


Income before income taxes

    296,879       309,862     285,407       244,388     209,018  

Income taxes

    89,624       97,791     91,816       78,965     67,693  
   


Net income

  $ 207,255     $ 212,071   $ 193,591     $ 165,423   $ 141,325  
   


 

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Selected Financial Data (continued)

 

     As of or for the Year Ended December 31,

 
     2008     2007     2006     2005     2004  
    


Per Common Share Data

                                        

Net income - basic

   $ 3.52     $ 3.60     $ 3.49     $ 3.15     $ 2.74  

Net income - diluted

     3.50       3.55       3.42       3.07       2.66  

Cash dividends declared and paid

     1.66       1.54       1.32       1.165       1.035  

Book value

     29.68       25.18       23.01       18.03       15.84  

Common Shares Outstanding

                                        

Period-end

     59,416       58,662       59,839       54,483       51,924  

Weighted-average shares - basic

     58,845       58,952       55,467       52,481       51,651  

Dilutive effect of stock compensation

     440       761       1,175       1,322       1,489  

Weighted-average shares - diluted

     59,285       59,713       56,642       53,803       53,140  

Performance Ratios

                                        

Return on average assets

     1.51 %     1.63 %     1.67 %     1.63 %     1.47 %

Return on average equity

     13.11       15.20       18.03       18.78       17.91  

Net interest income to average earning assets

     4.67       4.69       4.67       4.45       4.05  

Dividend pay-out ratio

     47.36       42.83       37.91       37.18       38.06  

Balance Sheet Data

                                        

Period-end:

                                        

Loans

   $ 8,844,082     $ 7,769,362     $ 7,373,384     $ 6,085,055     $   5,164,991  

Earning assets

     13,001,103       11,556,385       11,460,741       10,197,059       8,891,859  

Total assets

     15,034,142       13,485,014       13,224,189       11,741,437       9,952,787  

Non-interest-bearing demand deposits

     4,152,348       3,597,903       3,699,701       3,484,932       2,969,387  

Interest-bearing deposits

     7,356,589       6,931,770       6,688,208       5,661,462       5,136,291  

Total deposits

     11,508,937       10,529,673       10,387,909       9,146,394       8,105,678  

Long-term debt and other borrowings

     392,661       400,323       428,636       415,422       377,677  

Shareholders’ equity

     1,763,527       1,477,088       1,376,883       982,236       822,395  

Average:

                                        

Loans

   $ 8,314,265     $ 7,464,140     $ 6,523,906     $ 5,594,477     $ 4,823,198  

Earning assets

       11,868,262         11,339,876         10,202,981       8,968,906       8,352,334  

Total assets

     13,684,531       13,041,682       11,581,253         10,143,245       9,618,849  

Non-interest-bearing demand deposits

     3,614,747       3,524,132       3,334,280       3,008,750       2,914,520  

Interest-bearing deposits

     6,916,372       6,688,509       5,850,116       5,124,036       4,852,166  

Total deposits

     10,531,119       10,212,641       9,184,396       8,132,786       7,766,686  

Long-term debt and other borrowings

     394,763       413,700       405,752       387,612       363,386  

Shareholders’ equity

     1,580,311       1,395,022       1,073,599       880,640       789,073  

Asset Quality

                                        

Allowance for possible loan losses

   $ 110,244     $ 92,339     $ 96,085     $ 80,325     $ 75,810  

Allowance for possible loan losses to period-end loans

     1.25 %     1.19 %     1.30 %     1.32 %     1.47 %

Net loan charge-offs

   $ 19,918     $ 18,406     $ 11,110     $ 8,921     $ 10,191  

Net loan charge-offs to average loans

     0.24 %     0.25 %     0.17 %     0.16 %     0.20 %

Non-performing assets

   $ 78,040     $ 29,849     $ 57,749     $ 38,927     $ 39,116  

Non-performing assets to:

                                        

Total loans plus foreclosed assets

     0.88 %     0.38 %     0.78 %     0.64 %     0.76 %

Total assets

     0.52       0.22       0.44       0.33       0.39  

Consolidated Capital Ratios

                                        

Tier 1 risk-based capital ratio

     10.30 %     9.96 %     11.25 %     12.24 %     12.83 %

Total risk-based capital ratio

     12.58       12.59       13.43       14.94       15.99  

Leverage ratio

     8.80       8.37       9.56       9.62       9.18  

Average shareholders’ equity to average total assets

     11.55       10.70       9.27       8.68       8.20  

 

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The following tables set forth unaudited consolidated selected quarterly statement of operations data for the years ended December 31, 2008 and 2007. Dollar amounts are in thousands, except per share data.

 

     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 (1)

     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  

 

     Year Ended December 31, 2007

 
    

4th

Quarter

  

3rd

Quarter

   2nd
Quarter
  

1st

Quarter

 
    


Interest income

   $     188,370    $     194,874    $     193,021    $     192,582  

Interest expense

     57,610      64,250      63,501      64,749  
    


Net interest income

     130,760      130,624      129,520      127,833  

Provision for possible loan losses

     3,576      5,784      2,650      2,650  

Non-interest income (2)

     66,383      70,756      64,020      67,072  

Non-interest expense

     114,150      113,567      112,642      122,087  
    


Income before income taxes

     79,417      82,029      78,248      70,168  

Income taxes

     24,717      25,566      24,619      22,889  
    


Net income

   $ 54,700    $ 56,463    $ 53,629    $ 47,279  
    


Net income per common share:

                             

Basic

   $ 0.94    $ 0.97    $ 0.90    $ 0.79  

Diluted

     0.93      0.95      0.89      0.78  

 

(1) 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.

 

(2) Includes net gain on securities transactions of $15 thousand during the fourth quarter of 2007.

 

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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.

  ¨  

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 laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Corporation and its subsidiaries must comply.

  ¨  

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.

Recent Market Developments

In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law. Pursuant to the EESA, the U.S. Treasury was given the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.

On October 14, 2008, the Secretary of the Department of the Treasury announced that the Department of the Treasury will purchase equity stakes in a wide variety of banks and thrifts. Under the program, known as the Troubled Asset Relief Program Capital Purchase Program (the “TARP Capital Purchase Program”), from the $700 billion authorized by the EESA, the Treasury made $250 billion of capital available to U.S. financial institutions in the form of preferred stock. In conjunction with the purchase of preferred stock, the Treasury received, from participating financial institutions, warrants to purchase common stock with an aggregate market price equal to 15% of the preferred investment. Participating financial institutions were required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the TARP Capital Purchase Program. On October 31, 2008, the Corporation announced that it would not apply for funds available through the TARP Capital Purchase Program.

On November 21, 2008, the Board of Directors of the Federal Deposit Insurance Corporation (“FDIC”) adopted a final rule relating to the Temporary Liquidity Guarantee Program (“TLG Program”). The TLG Program was announced by the FDIC on October 14, 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 June 30, 2012, certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008, and before June 30, 2009 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 (“IOLTA”) accounts held at participating FDIC- insured institutions through December 31, 2009. Coverage under the TLG Program was available for the first 30 days without charge. The fee assessment for coverage of senior unsecured debt ranges 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 is 10 basis points per quarter on amounts in covered accounts exceeding $250,000. On December 5, 2008, the Corporation elected to participate in both guarantee programs.

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.

 

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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 Statement of Financial Accounting Standards (SFAS) No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS 118, and allowance allocations determined in accordance with SFAS No. 5, “Accounting for Contingencies.” 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, 2008 and 2007 and results of operations for each of the years in the three-year period ended December 31, 2008. This discussion and analysis should be read in conjunction with the Corporation’s consolidated financial statements, notes thereto and other financial information appearing elsewhere in this report. The Corporation acquired R.G. Seeberger Company, Inc. (“Seeberger”) in 2008, Prime Benefits, Inc. (“Prime Benefits”) in 2007 and Summit Bancshares, Inc. (“Summit”), Alamo Corporation of Texas (“Alamo”) and Texas Community Bancshares, Inc. (“TCB”) in 2006. 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. See Note 2 - Mergers and Acquisitions in the accompanying notes to consolidated financial statements included elsewhere in this report.

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.

 

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Results of Operations

Net income totaled $207.3 million, or $3.50 diluted per common share, in 2008 compared to $212.1 million, or $3.55 diluted per common share, in 2007 and $193.6 million, or $3.42 diluted per common share, in 2006.

Selected income statement data, returns on average assets and average equity and dividends per share for the comparable periods were as follows:

 

     2008     2007     2006  
    


Taxable-equivalent net interest income

   $ 554,353     $ 534,195     $ 479,138  

Taxable-equivalent adjustment

     20,328       15,458       9,975  
    


Net interest income

     534,025       518,737       469,163  

Provision for possible loan losses

     37,823       14,660       14,150  

Non-interest income

     287,322       268,231       240,747  

Non-interest expense

     486,645       462,446       410,353  
    


Income before income taxes

     296,879       309,862       285,407  

Income taxes

     89,624       97,791       91,816  
    


Net income

   $     207,255     $     212,071     $     193,591  
    


Earnings per common share:

                        

Basic

   $ 3.52     $ 3.60     $ 3.49  

Diluted

     3.50       3.55       3.42  

Return on average assets

     1.51 %     1.63 %     1.67 %

Return on average equity

     13.11       15.20       18.03  

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. Net income for 2007 increased $18.5 million, or 9.5%, compared to 2006. The increase was primarily due to a $49.6 million increase in net interest income and a $27.5 million increase in non-interest income. The impact of these items was partly offset by a $52.1 million increase in non-interest expense, a $6.0 million increase in income tax expense and a $510 thousand increase in the provision for possible loan losses.

Details of the changes in the various components of net income are further discussed below.

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 65% of total revenue during 2008. 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 2006 at 7.25% and increased 50 basis points in the first quarter and 50 basis points in the second quarter to end the year at 8.25%. During 2007, the prime interest rate 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%. The federal funds rate, which is the cost of immediately available overnight

 

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funds, fluctuated in a similar manner. It began 2006 at 4.25% and increased 50 basis points in the first quarter and 50 basis points in the second quarter to end the year at 5.25%. During 2007, the federal funds rate 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%.

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 interest rate swaps during the fourth quarter of 2007 that effectively convert $1.2 billion of loans with floating interest rates tied to the prime rate into fixed rate loans for a period of seven years. Furthermore, during the fourth quarter of 2008, the Corporation entered into an interest rate swap contract that effectively converted $120.0 million of junior subordinated deferrable interest debentures issued to Cullen/Frost Capital Trust II to a fixed rate debt instrument for a period of five years. See Note 17 - 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. 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 126 and 127 of this report.

 

     2008 vs. 2007

         2007 vs. 2006

 
     Increase (Decrease)
Due to Change in

               Increase (Decrease)
Due to Change in

       
     Rate     Volume     Total          Rate     Volume     Total  

Interest-bearing deposits

   $ (658 )   $ 691     $ 33          $ (44 )   $ 189     $ 145  

Federal funds sold and resell agreements

     (10,765 )     (15,632 )     (26,397 )          496       (7,151 )     (6,655 )

Securities:

                                                     

Taxable

     2,621       (7,728 )     (5,107 )          6,417       8,866       15,283  

Tax-exempt

     848       9,356       10,204            (138 )     8,973       8,835  

Loans

     (128,189 )     61,130       (67,059 )          -       72,763       72,763  
    


Total earning assets

     (136,143 )     47,817       (88,326 )          6,731       83,640       90,371  

Savings and interest checking

     (4,449 )     1,193       (3,256 )          1,520       456       1,976  

Money market deposit accounts

     (55,925 )     (54 )     (55,979 )          914       14,497       15,411  

Time accounts

     (15,587 )     (971 )     (16,558 )          6,709       10,749       17,458  

Public funds

     (8,120 )     (1,453 )     (9,573 )          707       (405 )     302  

Federal funds purchased and repurchase agreements

     (23,490 )     4,493       (18,997 )          (3,209 )     3,993       784  

Junior subordinated deferrable interest debentures

     (3,137 )     (1,174 )     (4,311 )          (471 )     (5,648 )     (6,119 )

Subordinated notes payable and other notes

     (72 )     799       727            (152 )     5,752       5,600  

Federal Home Loan Bank advances

     229       (766 )     (537 )          47       (145 )     (98 )
    


Total interest-bearing liabilities

     (110,551 )     2,067       (108,484 )          6,065       29,249       35,314  
    


Changes in taxable-equivalent net interest income

   $ (25,592 )   $ 45,750     $ 20,158          $ 666     $ 54,391     $ 55,057  
    


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

 

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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.

Taxable-equivalent net interest income for 2007 increased $55.1 million, or 11.5%, compared to 2006. The increase primarily resulted from an increase in the average volume of earning assets. The average volume of earning assets for 2007 increased $1.1 billion compared to 2006. Over the same time frame, the net interest margin increased 2 basis points from 4.67% in 2006 to 4.69% in 2007. The increase in the average volume of earning assets was due in part to the acquisition of Summit in the fourth quarter of 2006. See Note 2 – Mergers and Acquisitions in the accompanying notes to consolidated financial statements included elsewhere in this report. The increase in net interest margin was primarily due to an increase in the average yield on interest earning assets partly offset by an increase in the average cost of funds. The average yield on interest earning assets during 2007 was 6.89% compared to 6.76% during 2006. This increase was partly due to a 24 basis point increase in the average yield on securities. Furthermore, the Corporation had a larger proportion of average interest earning assets invested in higher-yielding loans during 2007 relative to 2006. During 2006, market interest rates rose during each of the first two quarters while the reductions in market rates during 2007 did not occur until the latter part the year. The positive impact of higher average market rates and the more favorable mix of interest earning assets on the net interest margin was partly offset by an increase in the average cost of funds compared to the increase in the average yield on interest-earning assets. The average cost of funds increased 8 basis points to 3.14% during 2007 from 3.06% during 2006. The increase in cost of funds was partly due to an increase in the relative proportion of average interest-bearing deposits, particularly higher-cost money market and time deposits, to 65.5% of total average deposits during 2007 from 63.7% of total average deposits during 2006.

The average volume of loans, the Corporation’s primary category of earning assets, increased $850.1 million, or 11.4%, during 2008 compared to 2007 and increased $940.2 million, or 14.4%, during 2007 compared to 2006. The average yield on loans was 6.16% during 2008 and 7.76% during 2007. As stated above, the Corporation had a larger proportion of average earning assets invested in loans during both 2008 compared to 2007 and 2007 compared to 2006. Such investments have significantly higher yields compared to securities 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 $38.6 million in 2008 compared to 2007 and increased $332.2 million in 2007 compared to 2006. The average yield on securities was 5.41% during 2008 compared to 5.24% during 2007 and 5.00% during 2006. The increase in the average yield on securities during 2008 compared to 2007 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. Average federal funds sold and resell agreements decreased $438.2 million, or 75.6%, during 2008 compared to the 2007 and decreased $139.0 million, or 19.3%, during 2007 compared to 2006. The average yield on federal funds sold and resell agreements was 2.47% during 2008 compared to 5.15% during 2007 and 5.08% during 2006.

Average deposits increased $318.5 million, or 3.1%, during 2008 compared to 2007 and $1.0 billion, or 11.2%, in 2007 compared to 2006. The larger increase in the average volume of deposits during 2007 relative to the increase in 2008 was due in part to the acquisition of Summit during the fourth quarter of 2006. The increase in average deposits over the comparable years was primarily in interest-bearing deposits. Average interest-bearing deposits increased $227.9 million during 2008 compared to 2007 and $838.4 million during 2007 compared to 2006. The ratio of average interest-bearing deposits to total average deposits was 65.7% during 2008 compared to 65.5% in 2007 and 63.7% in 2006. The average cost of interest-bearing deposits and total deposits was 1.52% and 1.00% during 2008 compared to 2.84% and 1.86% during 2007 and 2.65% and 1.69% during 2006. The decrease in the average cost of interest-bearing deposits during 2008 compared to 2007 was primarily the result of decreases in interest rates offered on deposit products due to decreases in average market

 

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interest rates combined with an increase in the relative proportion of lower yielding savings and interest on checking deposits. The increase in the average cost of interest-bearing deposits during 2007 compared to 2006 was primarily the result of increases in interest rates offered on deposit products due to higher average market interest rates.

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 4.16% in 2008 compared to 3.75% in 2007 and 3.70% in 2006. 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 17 - 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 $37.8 million in 2008 compared to $14.7 million in 2007 and $14.2 million in 2006. 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:

 

     2008     2007    2006  
    


Trust fees

   $ 74,554     $ 70,359    $ 63,469  

Service charges on deposit accounts

     87,566       80,718      77,116  

Insurance commissions and fees

     32,904       30,847      28,230  

Other charges, commissions and fees

     35,557       32,558      28,105  

Net gain (loss) on securities transactions

     (159 )     15      (1 )

Other

     56,900       53,734      43,828  
    


Total

   $ 287,322     $ 268,231    $ 240,747  
    


Total non-interest income for 2008 increased $19.1 million, or 7.1%, compared to 2007 while total non-interest income for 2007 increased $27.5 million, or 11.4%, compared to 2006. Changes in the various components of non-interest income are discussed in more detail below.

Trust Fees. Trust fee income for 2008 increased $4.2 million, or 6.0%, compared to 2007 while trust fee income for 2007 increased $6.9 million, or 10.9%, compared to 2006. Investment fees are the most significant component of trust fees, making up approximately 67% of total trust fees in 2008, approximately 71% of total

 

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trust fees in 2007 and approximately 70% in 2006. 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 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 increased transaction spreads. Investment fees did not significantly fluctuate in 2008 compared to 2007. The Corporation has been successful with business development activities and customer retention despite the recent market correction in equity valuations. Equity valuations during 2008 have been lower on average compared to 2007 while bond valuations are higher as a result of lower market interest rates.

The increase in trust fee income during 2007 compared to 2006 was primarily the result of increases in investment fees (up $5.7 million), real estate fees (up $545 thousand) and securities lending income (up $506 thousand). This increase was slightly offset by a decrease in oil and gas fees (down $104 thousand). The increases in investment fees were primarily due to higher equity valuations during 2007 compared to 2006 and growth in overall trust assets and the number of trust accounts.

At December 31, 2008, trust assets, including both managed assets and custody assets, were primarily composed of fixed income securities (44.1% of trust assets), equity securities (32.0% of trust assets) and cash equivalents (16.1% of trust assets). The estimated fair value of trust assets was $21.7 billion (including managed assets of $9.9 billion and custody assets of $11.8 billion) at December 31, 2008 compared to $24.8 billion (including managed assets of $10.5 billion and custody assets of $14.3 billion) at December 31, 2007 and $23.2 billion (including managed assets of $9.3 billion and custody assets of $13.9 billion) at December 31, 2006.

Service Charges on Deposit Accounts. 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. 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 in 2008 were lower compared to 2007, 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. 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.

Service charges on deposit accounts for 2007 increased $3.6 million, or 4.7%, compared to 2006. Increases in overdraft/insufficient funds charges on consumer accounts (up $4.4 million) and commercial accounts (up $1.7 thousand) were partly offset by decreases in service charges on commercial accounts (down $2.4 million) and consumer accounts (down $728 thousand). The increases in overdraft/insufficient funds charges on both commercial and consumer accounts were partly the result of growth in deposit accounts and an increase in the per-occurrence fee charged. The decrease in service charges on commercial accounts was primarily related to decreased treasury management fees. The decreased treasury management fees resulted primarily from a higher earnings credit rate.

Insurance Commissions and Fees. 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), partly related to the recent acquisitions (see Note 2-Mergers and Acquisitions). Insurance commissions and fees for 2007 increased $2.6 million, or 9.3%, compared to 2006. The increase was primarily related to higher commission income (up $2.0 million) and an increase in contingent commissions (up $567 thousand).

 

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Insurance commissions and fees include contingent commissions totaling $3.7 million during both 2008 and 2007 and $3.1 million during 2006. 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 $3.0 million during 2008, $3.3 million during 2007 and $2.8 million during 2006. 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 $716 thousand, $366 thousand and $376 thousand during 2008, 2007 and 2006.

Other Charges, Commissions and Fees. 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, a newly formed registered investment advisor subsidiary of the Corporation (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). The increase from these items was 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).

Other charges, commissions and fees for 2007 increased $4.5 million, or 15.8%, compared to 2006. The increase was primarily related to increases in commission income related to the sale of money market accounts (up $1.3 million) and mutual funds (up $898 thousand). The Corporation also recognized account management fees totaling $1.3 million related to a line of business acquired in connection with the acquisition of Summit during the fourth quarter of 2006.

Net Gain/Loss on Securities Transactions. 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. During 2007, the Corporation sold available-for-sale securities with an amortized cost totaling $64.9 million and realized a related net gain of $15 thousand.

Other Non-Interest Income. 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 from various miscellaneous items generally includes various one-time, 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. 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

 

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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. Additional accruals may be required in future periods should the Corporation’s estimate of its obligations under the indemnification agreement change. 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. During the second quarter of 2008, the Corporation began to maintain cashiers check balances in-house. Accordingly, the third-party fees on cashier check balances will continue to decline. The cashier check balances maintained in-house by the Corporation will provide investable funds from which the Corporation will derive interest income in future periods.

Other non-interest income increased $9.9 million, or 22.6%, during 2007 compared to 2006. Contributing to the increase during 2007 were increases in sundry income from various miscellaneous items (up $3.3 million), income from check card usage (up $3.0 million), lease rental income (up $1.4 million), gains on the sales of foreclosed and other assets (up $1.2 million) and income from securities trading and customer derivative activities (up $872 thousand). These increases were partly offset by decreases in gains on the sales of student loans (down $1.0 million) and mineral interest income (down $570 thousand). During 2007 significant components of sundry income included $2.4 million in income recognized from the collection of interest and other charges on loans charged-off in prior years and $1.2 million in income recognized in connection with settlements and other recoveries.

Non-Interest Expense

The components of non-interest expense were as follows:

 

     2008    2007    2006  
    


Salaries and wages

   $     225,943    $ 209,982    $     190,784  

Employee benefits

     47,219      47,095      46,231  

Net occupancy

     40,464      38,824      34,695  

Furniture and equipment

     37,799      32,821      26,293  

Intangible amortization

     7,906      8,860      5,628  

Other

     127,314      124,864      106,722  
    


Total

   $ 486,645    $     462,446    $ 410,353  
    


Total non-interest expense for 2008 increased $24.2 million, or 5.2%, compared to 2007 while total non-interest expense for 2007 increased $52.1 million, or 12.7%, compared to 2006. Changes in the various components of non-interest expense are discussed below.

Salaries and Wages. 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.

 

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Salaries and wages for 2007 increased $19.2 million, or 10.1%, compared to 2006. The increase was primarily related to normal, annual merit increases, an increase in headcount and an increase in commissions related to higher insurance revenues. The increases in headcount were primarily related the acquisitions of TCB and Alamo during the first quarter of 2006 and Summit during the fourth quarter of 2006.

Employee Benefits. 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).

Employee benefits expense for 2007 increased $864 thousand, or 1.9%, compared to 2006. The increase was primarily related to increases in expenses related to the Corporation’s 401(k) and profit sharing plans (up $3.5 million) and payroll taxes (up $943 thousand). These increases were partially offset by decreases in medical costs (down $2.1 million), workers compensation insurance cost (down $834 thousand) and expenses related to the Corporation’s defined benefit retirement and restoration plans (down $778 thousand). The decrease in medical expense was primarily related to a decrease in certain accruals for medical expense as a result of lower projected medical costs. The decrease in workers compensation insurance expense was primarily related to a reversal in certain related accruals based on current projected costs.

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. The Corporation recognized a net benefit of $269 thousand related to the defined benefit retirement and restoration plans in 2008 compared to expense of $1.9 million in 2007 and $2.7 million in 2006. Future benefits/expense related to these plans is dependent upon a variety of factors, including the actual return on plan assets.

For additional information related to the Corporation’s employee benefit plans, see Note 13 - Employee Benefit Plans in the accompanying notes to consolidated financial statements included elsewhere in this report.

Net Occupancy. 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). These increases were partly related to new branches.

Net occupancy expense for 2007 increased $4.1 million, or 11.9%, compared to 2006. The increase was primarily due to an increase in lease expense (up $1.7 million), service contracts expense (up $517 thousand), property tax expense (up $513 thousand), utilities expense (up $422 thousand) and building maintenance (up $382 thousand). These increases were partly related to the additional facilities added in connection with the acquisitions of TCB and Alamo during the first quarter of 2006 and Summit during the fourth quarter of 2006.

Furniture and Equipment. 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.

Furniture and equipment expense for 2007 increased $6.5 million, or 24.8%, compared to 2006. The increase was primarily related to increases in software maintenance expense (up $2.9 million), depreciation expense

 

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related to furniture and fixtures (up $1.7 million), software amortization expense (up $1.1 million) and service contracts expense (up $596 thousand). The increases in various furniture and equipment expenses were partly related to the acquisitions of TCB and Alamo during the first quarter of 2006 and Summit during the fourth quarter of 2006. Additionally, the Corporation entered into software maintenance contracts in connection with new operating platforms related to retail delivery during the second quarter of 2007.

Intangible Amortization. Intangible amortization is primarily related to core deposit intangibles and, to a lesser extent, intangibles related to non-compete agreements and customer relationships. Intangible amortization totaled $7.9 million for 2008 compared to $8.9 million for 2007 and $5.6 million for 2006. The decrease in amortization expense during 2008 compared to 2007 is primarily the result of 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, as well as the completion of the amortization for certain intangible assets, partly offset by the impact of the additional amortization of intangible assets acquired in connection with the acquisition of Prime Benefits during the fourth quarter of 2007 and Seeberger during the third quarter of 2008. The increase in intangible amortization in 2007 was primarily due to the amortization of new intangible assets acquired in connection with the acquisitions of TCB and Alamo during the first quarter of 2006 and Summit during the fourth quarter of 2006. See Note 7 - 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 2008 increased $2.5 million, or 2.0%, compared to the same period in 2007. Significant components of other non-interest expense with increases compared to 2007 included increases in FDIC insurance expense (up $3.4 million), sub-advisor investment management fees related to Frost Investment Advisors (up $1.8 million), advertising/promotions expenses (up $1.6 million) and professional service expense (up $1.4 million). The increase in FDIC insurance expense primarily resulted as available assessment credits were mostly utilized for assessments through June 30, 2008. In October 2008, the FDIC proposed a rule to alter the way in which it differentiates for risk in the risk-based assessment system and to revise deposit insurance assessment rates, including base assessment rates. The FDIC proposed raising the current rates uniformly by 7 basis points for the assessment for the first quarter of 2009 resulting in annualized assessment rates for Risk Category 1 institutions ranging from 12 to 14 basis points. The proposal was adopted as a final rule in December 2008. The FDIC also proposed that, effective April 1, 2009, initial base assessment rates for Risk Category 1 institutions would be 10 to 14 basis points. After the effect of potential base-rate adjustments, the annualized assessment rate for Risk Category 1 institutions would range from 8 to 21 basis points. A final rule related to this proposal is expected to be issued during the first quarter of 2009. The Corporation cannot provide any assurance as to the amount of any proposed increase in its deposit insurance premium rate, should such an increase occur, as such changes are dependent upon a variety of factors, some of which are beyond the Corporation’s control. 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. Sundry expense from various miscellaneous items for 2008 included a $1.0 million accrual for costs related to Hurricane Ike which impacted the Corporation’s Houston and Galveston market areas and a $410 thousand accrual related to a lease settlement agreement. Also included in 2008 was $1.1 million in expense related to a settlement, release and license agreement associated with certain patent infringement claims.

Other non-interest expense for 2007 increased $18.1 million, or 17.0%, compared to 2006. Significant components of the increase included increases in sundry expense from various miscellaneous items

 

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(up $5.7 million), advertising/promotions expenses (up $2.6 million), amortization of net deferred costs related to loan commitments (up $1.9 million) and leased property depreciation (up $1.2 million). Included in sundry expense from various miscellaneous items was the aforementioned $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 was $1.0 million in expense related to a contribution for previously unmatched employee contributions to the Corporation’s 401(k) plan, $548 thousand in expense related to indemnification obligations with Visa USA, $373 thousand in expense related to the reimbursement of certain expenses previously paid by the Corporation’s defined benefit pension plan and $275 thousand in expense related to settlements.

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 19 - Operating Segments in the accompanying notes to consolidated financial statements included elsewhere in this report. Net income (loss) by operating segment is presented below:

 

     2008     2007     2006  
    


Banking

   $     188,955     $     200,387     $     184,141  

Financial Management Group

     26,863       27,317       22,652  

Non-Banks

     (8,563 )     (15,633 )     (13,202 )
    


Consolidated net income

   $ 207,255     $ 212,071     $ 193,591  
    


Banking

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 income for 2007 increased $16.2 million, or 8.8%, compared to 2006. The increase was primarily the result of a $47.7 million increase in net interest income and a $16.2 million increase in non-interest income partly offset by a $40.6 million increase in non-interest expense and a $6.5 million increase in income tax expense.

Net interest income for 2008 increased $11.9 million, or 2.3%, compared to 2007. The increase was primarily 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 increase was also due in part to a higher number of days during the period relative to 2007 due to the leap year. The increase in 2007 compared to 2006 was primarily the result of growth in the average volume of earning assets. 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 2008 totaled $37.8 million compared to $14.7 million in 2007 and $14.2 million in 2006. 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.

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. Non-interest income for 2007 increased $16.2 million, or 10.0%, compared to 2006. The increase was primarily due to increases in other non-interest income, service charges on deposits and insurance commissions and fees.

 

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See the analysis of service charges on deposit accounts, other non-interest income and insurance commissions and fees included in the section captioned “Non-Interest Income” 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, 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 FDIC insurance expense, 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.

Non-interest expense for 2007 increased $40.6 million, or 11.9%, compared to 2006. The banking segment experienced increases in all categories of non-interest expense during the comparable periods. These increases were partly related to the acquisitions of TCB and Alamo during the first quarter of 2006 and Summit during the fourth quarter of 2006. Combined, salaries and wages and employee benefits increased $16.1 million. The increase was primarily the result of normal, annual merit increases, increases in headcount, an increase in commissions related to higher insurance revenues, increases in expenses related to the Corporation’s employee benefit plans and an increase in payroll taxes. Other non-interest expense increased $10.8 million during 2007 compared to 2006. Other non-interest expense was most significantly impacted by certain non-recurring sundry charges in addition to increases in advertising/promotions expenses, amortization of net deferred costs related to loan commitments and leased property depreciation, among other items. Net occupancy expense increased due to an increase in lease expense, service contracts expense, property tax expense, utilities expense and building maintenance. Furniture and equipment expense increased primarily due to increases in software maintenance expense, depreciation expense related to furniture and fixtures, software amortization expense and service contracts expense. Intangible amortization increased primarily due to the amortization of new intangible assets acquired in connection with the aforementioned acquisitions. 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 segment, had gross commission revenues of $33.3 million in 2008 compared to $31.2 million in 2007 and $28.6 million in 2006. Insurance commission revenues increased $2.1 million, or 6.7%, during 2008 compared to 2007 and increased $2.6 million, or 9.2%, during 2007 compared to 2006. The increases during both 2008 and 2007 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 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. Net income for 2007 increased $4.7 million compared to 2006. The increase was primarily due to an $11.9 million increase in non-interest income and an $859 thousand increase in net interest income partly offset by a $5.7 million increase in non-interest expense and a $2.5 million increase in income tax expense.

Net interest income for 2008 did not significantly fluctuate compared to 2007. Net interest income for 2007 increased $859 thousand, or 3.8% in 2007 compared to 2006. The increase was primarily related to higher average market interest rates in 2007 relative to 2006, which impacted the funds transfer price paid on FMG’s repurchase agreements.

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),

 

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partially offset by a decrease in other income (down $849 thousand). Non-interest income for 2007 increased $11.9 million, or 15.2%, compared to 2006. The increase was primarily due to an increase in trust fees (up $7.0 million), other charges, commissions and fees (up $4.2 million) and other income (up $924 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 67% of total trust fees in 2008, approximately 71% of total trust fees in 2007 and approximately 70% in 2006. 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 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. The increase in trust fee income during 2007 compared to 2006 was primarily due to increased investment fees resulting from higher equity valuations and growth in overall trust assets and the number of trust accounts. See the analysis of trust fees included in the section captioned “Non-Interest Income” included elsewhere in this discussion.

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 increase in other charges, commissions and fees during 2007 compared to 2006, was primarily due to increases in commission income related to the sales of money market accounts, mutual funds and annuities. FMG also recognized account management fees totaling $1.3 million related to a line of business acquired in connection with the acquisition of Summit during the fourth quarter of 2006. The decrease in other income during 2008 compared to 2007 was partly due to a decrease in earnings on cashier check balances. The increase in other income during 2007 compared to 2006 was primarily due to increases in income from securities trading as well as other miscellaneous income.

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, LLC, a newly formed registered investment advisor subsidiary of the Corporation and component of the FMG operating segment.

Non-interest expense for 2007 increased $5.7 million, or 8.6%, compared to 2006. The increase was primarily due to salaries and wages and employee benefits (combined up $4.6 million) and an increase in other non-interest expense (up $960 thousand). The increase in salaries and wages and employee benefits was primarily the result of normal, annual merit increases and increases in expenses related to employee benefit plans and payroll taxes. The increase in other non-interest expense was primarily due to general increases in the various components of other non-interest expense, including cost allocations.

Non-Banks

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 have decreased, the Non-Banks segment has experienced a corresponding decrease in interest cost related to its variable-rate junior subordinated deferrable interest debentures issued in February 2004. Additionally, the $3.1 million of variable-rate junior subordinated deferrable interest debentures acquired in connection with the acquisition of Alamo Corporation of Texas were redeemed in the first quarter of 2008.

 

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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 17 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to this swap.

The net loss for the Non-Banks operating segment increased $2.4 million for 2007 compared to 2006. The increase was primarily due to $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 aforementioned redemption of debentures.

Income Taxes

The Corporation recognized income tax expense of $89.6 million, for an effective tax rate of 30.2% for 2008 compared to $97.8 million, for an effective rate of 31.6%, in 2007 and $91.8 million, for an effective rate of 32.2%, in 2006. 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 2008 was primarily the result of an increase in holdings of tax-exempt municipal securities.

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 $13.7 billion in 2008 compared to $13.0 billion in 2007 and $11.6 billion in 2006.

 

     2008      2007      2006  

Sources of Funds:

                    

Deposits:

                    

Non-interest-bearing

   26.4 %    27.0 %    28.8 %

Interest-bearing

   50.5      51.3      50.5  

Federal funds purchased and repurchase agreements

   7.4      6.6      6.6  

Long-term debt and other borrowings

   2.9      3.2      3.5  

Other non-interest-bearing liabilities

   1.3      1.2      1.3  

Equity capital

   11.5      10.7      9.3  
    

Total

   100.0 %    100.0 %    100.0 %
    

Uses of Funds:

                    

Loans

   60.7 %    57.2 %    56.3 %

Securities

   24.3      25.2      25.5  

Federal funds sold, resell agreements and other interest-earning assets

   1.7      4.5      6.3  

Other non-interest-earning assets

   13.3      13.1      11.9  
    

Total

   100.0 %    100.0 %    100.0 %
    

Deposits continue to be the Corporation’s primary source of funding. Although trending down as a percentage of total funding sources, 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 2008 compared to 34.5% in 2007 and 36.3% in 2006.

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 $850.1 million, or 11.4%, in 2008 compared to

 

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2007 and $940.2 million, or 14.4%, in 2007 compared to 2006. The increase in 2008 was primarily due to strong loan growth. The increase in 2007 was partly due to the acquisition of $824.5 million in loans in connection with the acquisition of Summit during the fourth quarter of 2006. See additional information regarding the Corporation’s loan portfolio in the section captioned “Loans” included elsewhere in this discussion.

Loans

Year-end loans were as follows:

 

    2008     Percentage
of Total
    2007     2006     2005     2004  

Commercial and industrial:

                                             

Commercial

  $     3,950,648     44.7 %   $     3,472,759     $ 3,229,570     $     2,610,178     $     2,361,052  

Leases

    205,290     2.3       184,140       174,075       148,750       114,016  

Asset-based

    85,865     1.0       32,963       33,856       41,288       34,687  
   


Total commercial and industrial

    4,241,803     48.0       3,689,862       3,437,501       2,800,216       2,509,755  

Real estate:

                                             

Construction:

                                             

Commercial

    755,704     8.6       560,176       649,140       590,635       419,141  

Consumer

    55,947     0.6       61,595       114,142       87,746       37,234  

Land:

                                             

Commercial

    346,591     3.9       397,319       407,055       301,907       215,148  

Consumer

    1,716     -       2,996       5,394       10,369       3,675  

Commercial mortgages

    2,250,442     25.5       1,982,786       1,766,469       1,409,811       1,185,431  

1-4 family residential mortgages

    79,446     0.9       98,077       125,294       95,032       86,098  

Home equity and other consumer

    707,974     8.0       587,721       508,574       460,941       387,864  
   


Total real estate

    4,197,820     47.5       3,690,670       3,576,068       2,956,441       2,334,591  

Consumer:

                                             

Indirect

    1,186     -       2,031       3,475       2,418       3,648  

Student loans held for sale

    28,889     0.3       62,861       47,335       51,189       63,568  

Other

    348,455     3.9       323,320       310,752       265,038       247,025  

Other

    53,662     0.6       29,891       27,703       27,201       21,819  

Unearned discount

    (27,733 )   (0.3 )     (29,273 )     (29,450 )     (17,448 )     (15,415 )
   


Total

  $     8,844,082     100.0 %   $     7,769,362     $     7,373,384     $     6,085,055     $     5,164,991  
   


Overview. Total loans at December 31, 2008 increased $1.1 billion, or 13.8%, compared to December 31, 2007. The Corporation stopped originating mortgage and indirect consumer loans during 2000, and as such, these portfolios are 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, the indirect lending portfolio and student loans, loans increased $1.1 billion, or 14.8%, from December 31, 2007. Total loans at December 31, 2007 increased $396.0 million, or 5.4%, compared to December 31, 2006. Total loans at December 31, 2006 increased $1.3 billion, or 21.2%, compared to December 31, 2005. During 2006, the Corporation acquired $1.1 billion in loans in connection with the acquisitions of TCB, Alamo and Summit. Excluding these acquired loans, total year-end loans increased $174.2 million, or 2.9%, from December 31 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 48.0% and 47.5% of total loans at December 31, 2008 and

 

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2007 while real estate loans made up 47.5% total loans at both December 31, 2008 and 2007. Real estate loans include both commercial and consumer balances. Of the $1.1 billion of loans acquired in connection with the acquisitions of TCB, Alamo and Summit during 2006, approximately 33% were commercial and industrial loans and approximately 62% were real estate loans.

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. 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, 2008, approximately 58% 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

 

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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.

Commercial and Industrial Loans. Commercial and industrial loans increased $551.9 million, or 15.0% from $3.7 billion at December 31, 2007 to $4.2 billion at December 31, 2008. 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, 2008 and 2007, 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, 2008 and 2007:

 

     2008     2007  

Industry concentrations:

            

Energy

   9.7 %   8.6 %

Medical services

   5.0     5.5  

Building construction

   3.9     4.6  

Services

   3.8     3.9  

Public finance

   3.5     4.4  

Manufacturing, other

   3.5     3.4  

Insurance

   3.2     2.8  

General and specific trade contractors

   2.9     2.8  

Religion

   2.7     2.6  

Legal services

   2.1     2.5  

Restaurants

   2.1     2.1  

All other (35 categories in 2008 and 2007)

   57.6     56.8  
    

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:

 

     2008    2007  

Energy loans:

               

Production

   $     666,202    $     468,204  

Service

     135,859      133,733  

Traders

     5,006      13,621  

Manufacturing

     46,168      46,868  

Refining

     1,832      2,072  
    


Total energy loans

   $     855,067    $     664,498  
    


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.

 

    2008

  2007

 

Number of

Relationships

  Period-End Balances  

Number of

Relationships

  Period-End Balances
    Committed   Outstanding     Committed   Outstanding

Large credit relationships:

                               

$20.0 million and greater

  132   $  4,417,378   $  2,252,480   110   $  3,421,582   $  1,555,253

$10.0 million to $19.9 million

  153     2,139,635     1,232,404   147     2,078,651     1,131,512

Growth in outstanding balances related to large credit relationships primarily resulted from an increase in commitments. The average commitment per large credit relationship in excess of $20.0 million totaled $33.5 million at December 31, 2008 and $31.1 million at December 31, 2007. The average outstanding balance per large credit relationship with a commitment in excess of $20.0 million totaled $17.1 million at December 31, 2008 and $14.1 million at December 31, 2007. The average commitment per large credit relationship between $10.0 million and $19.9 million totaled $14.0 million at December 31, 2008 and $14.1 million at December 31, 2007. The average outstanding balance per large credit relationship with a commitment between $10 million and $19.9 million totaled $8.1 million at December 31, 2008 and $7.7 million at December 31, 2007.

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 $534.1 million at December 31, 2008, increasing from $411.9 million at December 31, 2007. At December 31, 2008, 62.2% 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 Corporation’s market areas. In

 

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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.

 

    2008

  2007

  Number of   Period-End Balances   Number of   Period-End Balances
  Relationships   Committed   Outstanding   Relationships   Committed   Outstanding

Purchased shared national credits:

                               

$20.0 million and greater

  27   $     681,816   $     375,817   22   $     532,860   $     264,475

$10.0 million to $19.9 million

  21     307,971     150,577   18     242,225     137,606

Real Estate Loans. Real estate loans totaled $4.2 billion at December 31, 2008, an increase of $507.2 million, or 13.7%, compared to $3.7 billion at December 31, 2007. Commercial real estate loans totaled $3.4 billion, or 79.9% of total real estate loans, at December 31, 2008 and $2.9 billion or 79.7% of total real estate loans, at December 31, 2007. 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, 2008 and 2007:

 

     2008     2007  
    

Property type:

            

Office/warehouse

   17.7 %   15.8 %

Office building

   16.1     16.0  

1-4 family

   7.2     9.6  

Retail

   6.8     6.4  

Medical offices and services

   5.3     5.4  

Non-farm/non-residential

   5.3     5.0  

Religious

   5.2     5.0  

Land in development

   3.4     5.0  

All other

   33.0     31.8  
    

Total commercial real estate loans

   100.0 %   100.0 %
    

 

     2008     2007  
    

Geographic region:

            

Fort Worth

   27.8 %   29.0 %

Houston

   21.9     22.8  

San Antonio

   20.9     21.0  

Dallas

   9.9     8.3  

Austin

   9.4     8.2  

Rio Grande Valley

   5.1     5.5  

Corpus Christi

   5.0     5.2  
    

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 December 31, 2008, increasing $85.0 million, or 7.5%, from $1.1 billion at December 31, 2007. Excluding 1-4 family residential mortgages, indirect loans and student loans, total consumer loans increased $138.5 million, or 14.2%, from December 31, 2007.

As the following table illustrates as of year-end, the consumer loan portfolio has five distinct segments, including consumer real estate, consumer non-real estate, student loans held for sale, indirect consumer loans and 1-4 family residential mortgages.

 

     2008    2007  
    


Construction

   $ 55,947    $ 61,595  

Land

     1,716      2,996  

Home equity loans

     320,220      282,947  

Home equity lines of credit

     122,608      86,873  

Other consumer real estate

     265,146      217,901  
    


Total consumer real estate

     765,637      652,312  

Consumer non-real estate

     348,455      323,320  

Student loans held for sale

     28,889      62,861  

Indirect

     1,186      2,031  

1-4 family residential mortgages

     79,446      98,077  
    


Total consumer loans

   $     1,223,613    $     1,138,601  
    


Consumer real estate loans, excluding 1-4 family mortgages, increased $113.3 million, or 17.4%, from December 31, 2007. Combined, home equity loans and lines of credit made up 57.8% and 56.7% of the consumer real estate loan total at December 31, 2008 and 2007. 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.

The Corporation primarily originated student loans for resale. 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 $67.6 million of student loans during 2008 compared to $63.1 million during 2007 and $70.3 million during 2006. During the second quarter of 2008, the Corporation elected to discontinue the origination of student loans for resale, aside from previously outstanding commitments. The Corporation expects to complete the sale of the remainder of the student loan portfolio in 2009.

The indirect consumer loan segment has continued to decrease since the Corporation’s decision to discontinue originating these types of loans during 2000. Indirect loans increased $1.1 million during 2006 compared to 2005 as a result of loans acquired in connection with the acquisitions of TCB, Alamo and Summit.

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 the acquisitions of TCB, Alamo and Summit.

 

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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, 2008 or 2007.

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, 2008. 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

   $ 2,081,268    $ 1,670,867    $ 489,668    $ 4,241,803  

Real estate construction

     369,675      279,311      162,665      811,651  

Commercial real estate and land

     416,819      1,048,061      1,132,153      2,597,033  

Consumer and other

     184,443      319,144      609,406      1,112,993  
    


Total

   $ 3,052,205    $ 3,317,383    $ 2,393,892    $ 8,763,480  
    


Loans with fixed interest rates

   $ 813,600    $ 1,128,418    $ 1,329,291    $ 3,271,309  

Loans with floating interest rates

     2,238,605      2,188,965      1,064,601      5,492,171  
    


Total

   $     3,052,205    $     3,317,383    $     2,393,892    $     8,763,480  
    


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 $1.2 billion 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 17 - 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:

 

     2008     2007     2006     2005     2004  
    


Non-accrual loans:

                                        

Commercial and industrial

   $ 27,123     $ 11,445     $ 20,813     $ 25,556     $ 27,089  

Real estate

     36,764       12,026       29,580       4,963       2,471  

Consumer and other

     1,287       972       1,811       2,660       883  
    


Total non-accrual loans

     65,174       24,443       52,204       33,179       30,443  

Restructured loans

     -       -       -       -       -  

Foreclosed assets:

                                        

Real estate

     12,312       4,596       5,500       4,403       7,369  

Other

     554       810       45       1,345       1,304  
    


Total foreclosed assets

     12,866       5,406       5,545       5,748       8,673  
    


Total non-performing assets

   $ 78,040     $ 29,849     $ 57,749     $ 38,927     $ 39,116  
    


Ratio of non-performing assets to:

                                        

Total loans and foreclosed assets

     0.88 %     0.38 %     0.78 %     0.64 %     0.76 %

Total assets

     0.52       0.22       0.44       0.33       0.39  

Accruing past due loans:

                                        

30 to 89 days past due

   $ 102,053     $ 45,290     $ 56,836     $ 32,908     $ 20,895  

90 or more days past due

     19,751       14,347       10,917       7,921       5,231  
    


Total accruing past due loans

   $ 121,804     $ 59,637     $ 67,753     $ 40,829     $ 26,126  
    


Ratio of accruing past due loans to total loans:

                                        

30 to 89 days past due

     1.16 %     0.58 %     0.77 %     0.54 %     0.41 %

90 or more days past due

     0.22       0.19       0.15       0.13       0.10  
    


Total accruing past due loans

     1.38 %     0.77 %     0.92 %     0.67 %     0.51 %
    


Non-performing assets include non-accrual loans, restructured loans and foreclosed assets. 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 is also 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.

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.

 

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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, 2008, the Corporation had $50.2 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, 2008, potential problem loans consisted of ten credit relationships. Of the total outstanding balance at December 31, 2008, approximately 37.8% related to a customer that operates a restaurant franchise, approximately 22.2% related to a customer in the credit collections industry and approximately 14.6% related to three customers in the real estate lot development/construction industry. Weakness in these companies’ operating performance 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 SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS 118, and allowance allocations calculated in accordance with SFAS No. 5, “Accounting for 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.

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.

 

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The Corporation’s allowance for possible loan losses consists of three elements: (i) specific valuation allowances determined in accordance with SFAS 114 based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with SFAS 5 based on historical loan loss experience for similar loans with similar characteristics and trends; and (iii) general valuation allowances determined in accordance with SFAS 5 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. If after review, a specific valuation allowance is not assigned to the loan, and the loan is not considered to be impaired, the loan is included with a pool of similar loans that is assigned a historical valuation allowance calculated based on historical loss experience.

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.

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.

 

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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:

 

    2008     2007     2006     2005     2004  
   


    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

  $ 51,534   48.0 %   $ 50,245   47.1 %   $ 44,603   46.2 %   $ 50,357   45.7 %   $ 49,696   48.4 %

Real estate

    29,145   47.5       20,800   47.5       24,955   48.5       16,378   48.6       12,393   45.1  

Consumer

    11,490   4.2       10,721   5.0       8,238   4.9       5,303   5.2       4,436   6.1  

Other

    7,356   0.3       2,705   0.4       2,125   0.4       1,556   0.5       1,081   0.4  

Unallocated

    10,719   -       7,868   -       16,164   -       6,731   -       8,204   -  
   


Total

  $  110,244   100.0 %   $  92,339   100.0 %   $  96,085   100.0 %   $  80,325   100.0 %   $  75,810   100.0 %
   


During 2008, the reserve allocated to all categories of loans increased compared to 2007 primarily due 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 determined in accordance with SFAS 114 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 determined in accordance with SFAS 114. Specific valuation allowances related to commercial and 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 the acquisition of Summit 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 determined in accordance

 

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with SFAS 114. 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 determined in accordance with SFAS 5 based on historical loan loss experience for similar loans with similar characteristics and trends. The reserves allocated in accordance with SFAS 5 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 the acquisition of Summit during the fourth quarter of 2006.

During 2005, the reserve allocation related to real estate loans increased compared to 2004 primarily due to growth in the real estate loan portfolio combined with an increase in the level of criticized loans. 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. The increase in the reserve allocation for commercial and industrial loans during 2005 compared to 2004 was primarily due to an increase in the level of criticized loans combined with growth in the commercial and industrial loan portfolio. The growth in real estate and commercial and industrial loans as well as the level of criticized loans in these portfolios resulted in an increase in historical valuation allowances determined in accordance with SFAS 5 based on historical loan loss experience for similar loans with similar characteristics and trends. The reserves allocated in accordance with SFAS 5 for all types of loans were impacted by a reduction in the relative percentage by which the historical valuation allowances are adjusted to compensate for current qualitative risk factors. Specific valuation allowances determined in accordance with SFAS 114 related to commercial and industrial loans decreased approximately $2.1 million in 2005 compared to 2004. Specific valuation allowances for other types of loans were not significant at December 31, 2005.

 

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Activity in the allowance for possible loan losses is presented in the following table. There were no charge-offs or recoveries related to foreign loans during any of the periods presented.

 

    2008     2007     2006     2005     2004  
   


Balance of allowance for possible loan losses at beginning of year

  $ 92,339     $ 96,085     $ 80,325     $ 75,810     $ 83,501  

Provision for possible loan losses

    37,823       14,660       14,150       10,250       2,500  

Allowance for possible loan losses acquired

    -       -       12,720       3,186       -  

Charge-offs:

                                       

Commercial and industrial

    (13,910 )     (7,541 )     (10,983 )     (8,448 )     (12,570 )

Real estate

    (6,855 )     (9,309 )     (727 )     (531 )     (2,724 )

Consumer and other

    (8,422 )     (8,309 )     (7,223 )     (6,126 )     (4,721 )
   


Total charge-offs

    (29,187 )     (25,159 )     (18,933 )     (15,105 )     (20,015 )
   


Recoveries:

                                       

Commercial and industrial

    3,285       2,125       3,019       2,409       6,219  

Real estate

    1,101       331       483       351       718  

Consumer and other

    4,883       4,297       4,321       3,424       2,887  
   


Total recoveries

    9,269       6,753       7,823       6,184       9,824  
   


Net charge-offs

    (19,918 )     (18,406 )     (11,110 )     (8,921 )     (10,191 )
   


Balance at end of year

  $ 110,244     $ 92,339     $ 96,085     $ 80,325     $ 75,810  
   


Net charge-offs as a percentage of average loans

    0.24 %     0.25 %     0.17 %     0.16 %     0.20 %

Allowance for possible loan losses as a percentage of year-end loans

    1.25       1.19       1.30       1.32       1.47  

Allowance for possible loan losses as a percentage of year-end non-accrual loans

    169.15       377.77       184.06       242.10       249.02  

Average loans outstanding during the year

  $ 8,314,265     $   7,464,140     $   6,523,906     $   5,594,477     $   4,823,198  

Loans outstanding at year-end

    8,844,082       7,769,362       7,373,384       6,085,055       5,164,991  

Non-accrual loans outstanding at year-end

    65,174       24,443       52,204       33,179       30,443  

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 $23.2 million in 2008 to $37.8 million compared to $14.7 million in 2007 and increased $510 thousand in 2007 compared to $14.2 million in 2006. 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. The increase in the provision for possible loan losses in 2007 was primarily due to an increase in net charge-offs as well growth in the loan portfolio. The ratio of the allowance for possible loan losses to total loans increased 6 basis points from 1.19% at December 31, 2007 to 1.25% at December 31, 2008. Management believes the level of the allowance for possible loan losses continues to remain adequate. 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.

 

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Net charge-offs in 2008 increased $1.5 million compared to 2007 while net charge-offs in 2007 increased $7.3 million compared to 2006. Net charge-offs as a percentage of average loans decreased 1 basis points in 2008 compared to 2007 and increased 8 basis points in 2007 compared to 2006. During 2007, the 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 in 2008, as well as overall growth in the loan portfolio. The deterioration of economic conditions has particularly affected the performance of many of the Corporation’s land development and 1-4 family residential construction credit relationships.

Management believes the level of the allowance for possible loan losses was adequate as of December 31, 2008. 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:

 

     2008     2007     2006  
    


     Amount    Percentage
of Total
    Amount    Percentage
of Total
    Amount    Percentage
of Total
 
    


Held to maturity:

                                       

U.S. government agencies and corporations

   $ 5,948    0.2 %   $ 7,125    0.2 %   $ 9,096    0.3 %

Other

     1,000    -       1,000    -       1,000    -  
    


Total

     6,948    0.2       8,125    0.2       10,096    0.3  

Available for sale:

                                       

U.S. Treasury

     24,999    0.7       -    -       89,683    2.7  

U.S. government agencies and corporations

     2,560,871    71.6       2,845,311    83.0       2,902,609    86.6  

States and political subdivisions

     931,073    26.0       524,085    15.3       310,376    9.3  

Other

     37,586    1.1       37,616    1.1       28,285    0.8  
    


Total

     3,554,529    99.4       3,407,012    99.4       3,330,953    99.4  

Trading:

                                       

U.S. Treasury

     14,489    0.4       11,913    0.4       8,515    0.3  

States and political subdivisions

     -    -       -    -       891    -  

Common stock

     63    -       -    -       -    -  
    


Total

     14,552    0.4       11,913    0.4       9,406    0.3  
    


Total securities

   $   3,576,029    100.0 %   $   3,427,050    100.0 %   $   3,350,455    100.0 %
    


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, 2008. 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

 

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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:

                                                           

U.S. government agencies and corporations

  $ -   - %   $ 89   10.25 %   $ 1,316   6.37 %   $ 4,543   4.96 %   $ 5,948   5.35 %

Other

    1,000   2.04       -   -       -   -       -   -       1,000   2.04  
   

       

       

       

       

     

Total

  $ 1,000   2.04     $ 89   10.25     $ 1,316   6.37     $ 4,543   4.96     $ 6,948   4.87  
   

       

       

       

       

     

Available for Sale:

                                                           

U.S. Treasury

  $ 24,999   0.83 %   $ -   - %   $ -   - %   $ -   - %   $ 24,999   0.83 %

U.S. government agencies and corporations

    416   4.69       10   10.05       684,590   4.72       1,875,855   5.43       2,560,871   5.24  

States and political subdivisions

    29,446   6.56       98,543   5.91       84,073   6.16       719,011   7.25       931,073   6.99  

Other

    -           -           -           -           37,586   -  
   

       

       

       

       

     

Total

  $   54,861   3.93     $   98,553   5.91     $   768,663   4.87     $   2,594,866   5.94     $   3,554,529   5.67  
   

       

       

       

       

     

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, 2008, 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 5.41% in 2008 compared to 5.24% in 2007 and 5.00% in 2006. The increase in the average taxable-equivalent yield on the securities portfolio in 2008 compared to 2007 was primarily related to an increase in the relative proportion of higher-yielding tax-exempt municipal securities. The increase in the average taxable-equivalent yield on the securities portfolio in 2007 compared to 2006 was primarily related to higher reinvestment yields on mortgage-backed securities. 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:

 

     2008     2007     2006  
  


     Average
Balance
   Average
Rate Paid
    Average
Balance
   Average
Rate Paid
    Average
Balance
   Average
Rate Paid
 
    


Non-interest-bearing:

                                       

Commercial and individual

   $ 3,246,169          $ 3,224,741          $ 3,005,811       

Correspondent banks

     311,034            248,591            277,332       

Public funds

     57,544            50,800            51,137       
    

        

        

      

Total

     3,614,747            3,524,132            3,334,280       

Interest-bearing:

                                       

Private accounts:

                                       

Savings and interest checking

     1,694,688    0.19 %     1,401,437    0.47 %     1,283,830    0.36 %

Money market accounts

     3,492,935    1.47       3,494,704    3.08       3,022,866    3.05  

Time accounts of $100,000 or more

     755,598    3.24       773,324    4.44       617,790    3.93  

Time accounts under $100,000

     604,391    3.18       609,383    4.25       505,189    3.67  

Public funds

     368,760    1.72       409,661    3.89       420,441    3.72  
    

        

        

      

Total

     6,916,372    1.52       6,688,509    2.84       5,850,116    2.65  
    

        

        

      

Total deposits

   $ 10,531,119    1.00     $ 10,212,641    1.86     $ 9,184,396    1.69  
    

        

        

      

Average deposits increased $318.5 million, or 3.1% in 2008 compared to 2007 and increased $1.0 billion, or 11.2% in 2007 compared to 2006. The increase in average deposits during 2008 compared to 2007 was primarily related to growth in savings and interest checking accounts. The increase in average deposits during 2007 compared to 2006 was primarily related to the full year impact of the acquisition of $973.9 million in deposits in connection with the acquisition of Summit in the fourth quarter of 2006. During 2006, the Corporation acquired $381.6 million of deposits in connection with the acquisitions of TCB and Alamo during the first quarter of 2006 and the aforementioned $973.9 million of deposits in connection with the acquisition of Summit during the fourth quarter of 2006. The deposits acquired during 2006 included approximately $426.6 million of non-interest-bearing commercial and individual deposits and approximately $928.9 million of interest-bearing deposits (encompassing $246.1 million of savings and interest checking accounts, $314.2 million of money market accounts and $368.6 million of time accounts).

As mentioned above, the majority of the increase in average deposits during the comparable years was in interest-bearing savings and interest checking accounts. The ratio of average interest-bearing deposits to total average deposits increased to 65.7% in 2008 from 65.5% in 2007 and 63.7% in 2006. The average cost of interest-bearing deposits and total deposits was 1.52% and 1.00% during 2008 compared to 2.84% and 1.86% during 2007 and 2.65% and 1.69% during 2006. The decrease in the average cost of interest-bearing deposits during 2008 compared to 2007 was primarily the result of lower interest rates offered on deposit products due to lower average market interest rates combined with an increase in the relative proportion of lower-cost savings and interest checking accounts to total interest-bearing deposits. The increase in the average cost of interest-bearing deposits during 2007 compared to 2006 was primarily the result of higher interest rates offered on deposit products due to higher average market interest rates. Additionally, the relative proportion of lower-cost savings and interest checking accounts to total interest-bearing deposits had trended downward from prior periods.

 

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The following table presents the proportion of each component of average non-interest-bearing deposits to the total of such deposits during the years presented:

 

     2008     2007     2006  
    

Commercial and individual

   89.8 %   91.5 %   90.2 %

Correspondent banks

   8.6     7.1     8.3  

Public funds

   1.6     1.4     1.5  
    

Total

   100.0 %   100.0 %   100.0 %
    

Average non-interest-bearing deposits increased $90.6 million, or 2.6%, in 2008 compared to 2007 while average non-interest-bearing deposits increased $189.9 million, or 5.7%, in 2007 compared to 2006. The increase in 2008 compared to 2007 was primarily due to a $62.4 million, or 25.1%, increase in average correspondent bank deposits and a $21.4 million, or 0.7%, increase in average commercial and individual deposits. The increase in 2007 compared to 2006 was primarily due to a $218.9 million, or 7.3% increase in average commercial and individual deposits partly offset by a $28.7 million decrease in average correspondent bank deposits. The increase in average commercial and individual demand deposits during 2007 was partly due to the added deposits acquired in the aforementioned acquisitions. Average commercial and individual demand deposits during 2008, 2007 and 2006 included approximately $88.5 million, $116.0 million and $68.6 million of deposits that were received under a contractual relationship assumed in connection with the acquisition of Horizon in 2005. This contractual relationship was terminated in 2008.

The following table presents the proportion of each component of average interest-bearing deposits to the total of such deposits during the years presented:

 

     2008     2007     2006  
    

Private accounts:

                  

Savings and interest checking

   24.5 %   21.0 %   21.9 %

Money market accounts

   50.5     52.2     51.7  

Time accounts of $100,000 or more

   10.9     11.6     10.6  

Time accounts under $100,000

   8.8     9.1     8.6  

Public funds

   5.3     6.1     7.2  
    

Total

   100.0 %   100.0 %   100.0 %
    

Total average interest-bearing deposits increased $227.9 million, or 3.4%, in 2008 compared to 2007 and increased $838.4 million, or 14.3%, in 2007 compared to 2006. The Corporation has experienced a shift in the relative mix of interest-bearing deposits during 2008 compared to 2007 and 2006 as the proportion of savings and interest checking accounts has increased while the proportion of time accounts and money market deposit accounts has decreased. The shift in relative proportions appears to be related to the lower interest rate environment experienced over the last year as many customers appear to have become less inclined to invest their funds for extended periods.

 

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Geographic Concentrations. The following table summarizes the Corporation’s average total deposit portfolio, as segregated by the geographic region from which the deposit accounts were originated. Certain accounts, such as correspondent bank deposits, are recorded at the statewide level. Geographic concentrations are stated as a percentage of average total deposits during the years presented.

 

     2008     2007     2006  
    

San Antonio

   32.0 %   32.1 %   35.7 %

Houston

   18.1     18.6     20.4  

Fort Worth

   22.1     22.1     14.6  

Austin

   10.6     10.6     10.9  

Corpus Christi

   6.6     6.4     6.8  

Dallas

   4.2     4.2     4.9  

Rio Grande Valley

   3.3     3.7     4.0  

Statewide

   3.1     2.3     2.7  
    

Total

   100.0 %   100.0 %   100.0 %
    

The Corporation experienced deposit growth in all regions during 2008 compared to 2007 with the exception of the Rio Grande Valley and the Houston regions. Average deposits in the Rio Grande Valley region decreased $30.6 million, or 8.1%, and average deposits for the Houston region decreased $1.9 million, or 0.1%. The decrease in the Rio Grande Valley region was partly due to run-off of money market balances and certificates of deposit in connection with a competitive rate environment. The decrease in the Houston region was related to certain deposits received under a contractual relationship assumed in connection with the acquisition of Horizon. The contractual relationship was terminated in 2008. Excluding these deposits, average deposits for the Houston region would have increased $25.6 million, or 1.4%. The San Antonio region had the largest dollar volume increase during 2008, increasing $90.3 million, or 2.75%. The Statewide region had the largest percentage increase, increasing $86.5 million, or 35.5%, primarily due to growth in correspondent bank deposits as banks kept higher balances to pay for services. Average deposits for the Fort Worth region increased $73.7 million, or 3.3%, while average deposits for the Corpus Christi, Austin and Dallas regions increased $42.0 million, or 6.4%, $36.9 million, or 3.4%, and $21.6 million, or 5.1%, respectively.

The Corporation experienced deposit growth in all regions during 2007 compared to 2006 with the exception of the Dallas and Statewide regions. Average deposits in the Dallas region decreased $27.0 million, or 6.0%, and average deposits for the Statewide region decreased $2.6 million, or 1.1%. The increase in the Fort Worth region was impacted by the $973.9 million in deposits acquired in connection with the acquisition of Summit in December 2006. Excluding the impact of this acquisition, the Austin region had the largest dollar volume and percentage increase during 2007 compared to 2006, increasing $74.7 million, or 7.5%. Average deposits for the Corpus Christi region increased $35.9 million, or 5.8%. Changes in the average volume of deposits during 2007 compared to 2006 for other regions were not significant.

Foreign Deposits. Mexico has historically been considered a part of the natural trade territory of the Corporation’s banking offices. Accordingly, U.S. dollar-denominated foreign deposits from sources within Mexico have traditionally been a significant source of funding. Average deposits from foreign sources, primarily Mexico, totaled $686.2 million in 2008, $699.5 million in 2007 and $711.0 million in 2006.

Short-Term Borrowings

The Corporation’s primary source of short-term borrowings is federal funds purchased from correspondent banks and repurchase agreements in the natural trade territory of the Corporation, as well as from upstream banks. Federal funds purchased and repurchase agreements totaled $1.1 billion, $933.1 million and $864.2 million at December 31, 2008, 2007 and 2006. The maximum amount of these borrowings outstanding at

 

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any month-end was $1.4 billion in 2008, $945.0 million in 2007 and $864.2 million in 2006. The weighted- average interest rate on federal funds purchased and repurchase agreements was 0.24%, 3.69% and 5.05% at December 31, 2008, 2007 and 2006.

The following table presents the Corporation’s average net funding position during the years indicated:

 

    2008     2007     2006  
   


    Average
Balance
    Average
Rate
    Average
Balance
    Average
Rate
    Average
Balance
    Average
Rate
 
   


Federal funds sold and resell agreements

  $ 141,724     2.47 %   $     579,964     5.15 %   $     718,950     5.08 %

Federal funds purchased and repurchase agreements

    (1,008,019 )   1.29       (867,152 )   3.68       (764,173 )   4.08  
   


       


       


     

Net funds position

  $ (866,295 )         $ (287,188 )         $ (45,223 )      
   


       


       


     

The net funds purchased position increased in 2008 compared to 2007 primarily due to a $437.7 million decrease in average federal funds sold and a $183.8 million increase in average federal funds purchased, partly offset by a $42.9 million decrease in average repurchase agreements. The decrease in average federal funds sold was primarily related to the utilization of these funds to support loan growth. The net funds purchased position increased in 2007 compared to 2006 primarily due to a $82.3 million decrease in average federal funds sold and a $56.7 million decrease in average resell agreements combined with a $95.2 million increase in average repurchase agreements and a $7.8 million increase in average federal funds purchased.

Off Balance Sheet Arrangements, Commitments, Guarantees, and Contractual Obligations

The following table summarizes the Corporation’s contractual obligations and other commitments to make future payments as of December 31, 2008. Payments for borrowings do not include interest. Payments related to leases are based on actual payments specified in the underlying contracts. Loan commitments and standby letters of credit are presented at contractual amounts; however, since many of these commitments are expected to expire unused or only partially used, the total amounts of these commitments do not necessarily reflect future cash requirements.

 

     Payments Due by Period  
    


     1 Year or Less    More than 1
Year but Less
than 3 Years
   3 Years or
More but Less
than 5 Years
   5 Years or
More
   Total  
    


Contractual obligations:

                                    

Subordinated notes payable

   $ -    $ 150,000    $ -    $ 100,000    $ 250,000  

Junior subordinated deferrable interest debentures

     -      -      -      136,084      136,084  

Federal Home Loan Bank advances

     16      6,536      25      -      6,577  

Operating leases

     16,311      26,040      19,070      43,227      104,648  

Deposits with stated maturity dates

     1,467,044      115,730      -      -      1,582,774  
    


       1,483,371      298,306      19,095      279,311      2,080,083  

Other commitments:

                                    

Commitments to extend credit

     95,099      3,568,228      558,458      534,511      4,756,296  

Standby letters of credit

     3,345      262,447      11,626      10,953      288,371  
    


       98,444      3,830,675      570,084      545,464      5,044,667  
    


Total contractual obligations and other commitments

   $     1,581,815    $     4,128,981    $     589,179    $     824,775    $     7,124,750  
    


 

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Financial Instruments with Off-Balance-Sheet Risk. In the normal course of business, the Corporation enters into various transactions, which, in accordance with accounting principles generally accepted in the United States, are not included in its consolidated balance sheets. The 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 also holds certain assets which are not included in its consolidated balance sheets including assets held in fiduciary or custodial capacity on behalf of its trust customers and certain collateral funds resulting from acting as an agent in its securities lending program.

Commitments to Extend Credit. The Corporation enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at s