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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
     
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended: December 31, 2006
    or
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from            to           
 
Commission file number: 0-7275
 
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 þ     No o
 
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 o     No þ
 
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 þ     No o
 
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.  o
 
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. (Check one):
Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.)  Yes o     No þ
 
As of June 30, 2006, 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 $3.0 billion.
 
As of January 26, 2007, there were 59,862,627 shares of the registrant’s common stock, $.01 par value, outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Proxy Statement for the 2007 Annual Meeting of Shareholders of Cullen/Frost Bankers, Inc. to be held on April 26, 2007 are incorporated by reference in this Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.
 


 

 
CULLEN/FROST BANKERS, INC.
ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS
 
                 
       
Page
 
       
       
  BUSINESS   3
  RISK FACTORS   14
  UNRESOLVED STAFF COMMENTS   22
  PROPERTIES   22
  LEGAL PROCEEDINGS   22
  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS   22
             
       
       
  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES   23
  SELECTED FINANCIAL DATA   26
  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS   29
  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK   65
  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA   67
  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE   114
  CONTROLS AND PROCEDURES   114
  OTHER INFORMATION   116
             
       
       
  DIRECTORS AND EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE   117
  EXECUTIVE COMPENSATION   117
  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS   117
  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE   117
  PRINCIPAL ACCOUNTING FEES AND SERVICES   117
             
       
       
  EXHIBITS, FINANCIAL STATEMENT SCHEDULES   118
       
  120
 Subsidiaries
 Consent of Independent Registered Public Accounting Firm
 Power of Attorney
 Rule 13a-14(a) Certification of CEO
 Rule 13a-14(a) Certification of CFO
 Section 1350 Certification of CEO
 Section 1350 Certification of CFO


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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, investment banking, insurance brokerage, leasing, asset-based lending, treasury management and item processing services. At December 31, 2006, Cullen/Frost had consolidated total assets of $13.2 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 2006, the Corporation acquired Texas Community Bancshares, Inc. (Dallas market area), Alamo Corporation of Texas (Rio Grande Valley market area) and Summit Bancshares, Inc. (Ft. Worth market area). During 2005, the Corporation acquired Horizon Capital Bank (Houston 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.
 
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.


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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 I, Cullen/Frost Capital Trust II, Alamo Corporation of Texas Trust I and Summit Bancshares Statutory Trust I.
 
Cullen/Frost Capital Trust I, Cullen/Frost Capital Trust II, Alamo Corporation of Texas Trust I and Summit Bancshares Statutory Trust I
 
Cullen/Frost Capital Trust I (“Trust I”) and Cullen/Frost Capital Trust II (“Trust II”) are Delaware statutory business trusts formed in 1997 and 2004, respectively, for the purpose of issuing $100.0 million and $120.0 million, respectively, in trust preferred securities and lending the proceeds to Cullen/Frost. Alamo Corporation of Texas Trust I (“Alamo Trust”) is a Delaware statutory trust formed in 2002 for the purpose of issuing $3.0 million in trust preferred securities. Alamo Trust was acquired by Cullen/Frost through the acquisition of Alamo Corporation of Texas on February 28, 2006. 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 I, Trust II, Alamo Trust and Summit Trust (collectively referred to as the “Capital Trusts”) are variable interest entities (VIEs) 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, which was implemented in the fourth quarter of 2003, the accounts of the Capital Trusts are not included in the Corporation’s consolidated financial statements. Prior to the fourth quarter of 2003, the financial statements of Trust I were included in the consolidated financial statements of the Corporation because Cullen/Frost owns all of the outstanding common equity securities of the Trust. 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.
 
Despite the fact that the accounts of the Capital Trusts are not included in the Corporation’s consolidated financial statements, the $235.0 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 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 $235.0 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. The Corporation expects to redeem the $100 million in trust preferred securities issued by Trust I during the first quarter of 2007. As a result of the anticipated redemption, the Corporation expects to incur approximately $5.3 million in expense related to the prepayment penalty and the write-off of unamortized debt issuance costs. 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.


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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, 2006, Frost Bank had consolidated total assets of $13.2 billion and total deposits of $10.5 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 283 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, 2006, the estimated fair value of trust assets was $23.2 billion, including managed assets of $9.3 billion and custody assets of $13.9 billion.
 
  •  Capital Markets — Fixed-Income Services.  Frost Bank’s Capital Markets Division was formed to meet the transaction needs of fixed-income institutional investors. Services include sales and trading, new issue underwriting, money market trading, and securities safekeeping and clearance.
 
Frost Insurance Agency, Inc.
 
Frost Insurance Agency, Inc. is a wholly owned subsidiary of Frost Bank that provides insurance brokerage services to individuals and businesses covering corporate and personal property and casualty insurance products, as well as group health and life insurance products.
 
Frost Brokerage Services, Inc.
 
Frost Brokerage Services, Inc. (“FBS”) is a wholly owned subsidiary of Frost Bank that provides brokerage services and performs other transactions or operations related to the sale and purchase of securities of all types. FBS is registered as a fully disclosed introducing broker-dealer under the Securities Exchange Act of 1934 and, as such, does not hold any customer accounts.


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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 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.
 
Daltex General Agency, Inc.
 
Daltex General Agency, Inc. is a wholly owned non-banking subsidiary that operates as a managing general insurance agency providing insurance on certain auto loans financed by Frost Bank.
 
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. As a result of the deregulation of the financial services industry (see the discussion of the Gramm-Leach-Bliley Financial Modernization Act of 1999 in the section of this item captioned “Supervision and Regulation”), the Corporation also competes with other providers of financial services, such as savings and loan associations, credit unions, consumer finance companies, securities firms, insurance companies, insurance agencies, commercial finance and leasing companies, full service brokerage firms and discount brokerage firms. Some of the Corporation’s competitors have greater resources and, as such, may have higher lending limits and may offer other services that are not provided by the Corporation. The Corporation generally competes on the basis of customer service and responsiveness to customer needs, available loan and deposit products, the rates of interest charged on loans, the rates of interest paid for funds, and the availability and pricing of trust, brokerage and insurance services.
 
Supervision and Regulation
 
Cullen/Frost, Frost Bank and many of its non-banking subsidiaries are subject to extensive regulation under federal and state laws. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of security holders.
 
Set forth below is a description of the significant elements of the laws and regulations applicable to Cullen/Frost and its subsidiaries. The description is qualified in its entirety by reference to the full text of the statutes, regulations and policies that are described. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to Cullen/Frost and its subsidiaries could have a material effect on the business of the Corporation.


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Regulatory Agencies
 
Cullen/Frost is a legal entity separate and distinct from Frost Bank and its other subsidiaries. As a financial holding company and a bank holding company, Cullen/Frost is regulated under the Bank Holding Company Act of 1956, as amended (“BHC Act”), and is subject to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”). 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 National Association of Securities Dealers, Inc. (“NASD”) and state securities regulators. 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. As a result of the Gramm-Leach-Bliley Financial Modernization Act of 1999 (“GLB Act”), which amended the BHC Act, bank holding companies that are 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.
 
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. Cullen/Frost’s declaration to become a financial holding company was declared effective by the Federal Reserve Board on March 11, 2000.
 
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.


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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, and without adversely affecting its “well capitalized” status, Frost Bank could pay aggregate dividends of approximately $180.6 million to Cullen/Frost, without obtaining affirmative governmental approvals, at December 31, 2006. This amount is not necessarily indicative of amounts that may be paid or available to be paid in future periods.
 
In addition, Cullen/Frost and Frost Bank are subject to other regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a bank holding company or a bank that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The appropriate federal regulatory authorities have indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice and that banking organizations should generally pay dividends only out of current operating earnings.
 
Borrowings
 
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, these restrictions require that any extensions of credit must be secured by designated amounts of specified collateral and are 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.
 
Federal law also provides that 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 it. 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.


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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 and Prompt Corrective Action
 
Banks and bank holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.
 
The Federal Reserve Board, the OCC and the FDIC have substantially similar risk-based capital ratio and leverage ratio guidelines for banking organizations. The guidelines are intended to ensure that banking organizations have adequate capital given the risk levels of assets and off-balance sheet financial instruments. Under the guidelines, banking organizations are required to maintain minimum ratios for Tier 1 capital and total capital to risk-weighted assets (including certain off-balance sheet items, such as letters of credit). For purposes of calculating the ratios, a banking organization’s assets and some of its specified off-balance sheet commitments and obligations are assigned to various risk categories. A depository institution’s or holding company’s capital, in turn, is classified in one of three tiers, depending on type:
 
  •  Core Capital (Tier 1).  Tier 1 capital includes common equity, retained earnings, qualifying non-cumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual stock at the holding company level, minority interests in equity accounts of consolidated subsidiaries, qualifying trust preferred securities, less goodwill, most intangible assets and certain other assets.
 
  •  Supplementary Capital (Tier 2).  Tier 2 capital includes, among other things, perpetual preferred stock and trust preferred securities not meeting the Tier 1 definition, qualifying mandatory convertible debt securities, qualifying subordinated debt, and allowances for possible loan and lease losses, subject to limitations.
 
  •  Market Risk Capital (Tier 3).  Tier 3 capital includes qualifying unsecured subordinated debt.
 
Cullen/Frost, like other bank holding companies, currently is required to maintain Tier 1 capital and “total capital” (the sum of Tier 1, 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.


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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, 2006, 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 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 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 or (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.
 
For 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.
 
The federal regulatory authorities’ risk-based capital guidelines are based upon the 1988 capital accord 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 to replace its 1988 capital accord, with an update in November 2005 (“BIS II”). BIS II provides two


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approaches for setting capital standards for credit risk — an internal ratings-based approach tailored to individual institutions’ circumstances (which for many asset classes is itself broken into a “foundation” approach and an “advanced or A-IRB” approach, the availability of which is subject to additional restrictions) 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. BIS II also would set capital requirements for operational risk and refine the existing capital requirements for market risk exposures.
 
The U.S. banking and thrift agencies are developing proposed revisions to their existing capital adequacy regulations and standards based on BIS II. In September 2006, the agencies issued a notice of proposed rulemaking setting forth a definitive proposal for implementing BIS II in the United States that would apply only to internationally active banking organizations — defined as those with consolidated total assets of $250 billion or more or consolidated on-balance sheet foreign exposures of $10 billion or more — but that other U.S. banking organizations could elect but would not be required to apply. In December 2006, the agencies issued a notice of proposed rulemaking describing proposed amendments to their existing risk-based capital guidelines to make them more risk-sensitive, generally following aspects of the standardized approach of BIS II. These latter proposed amendments, often referred to as “BIS I-A”, would apply to banking organizations that are not internationally active banking organizations subject to the A-IRB approach for internationally active banking organizations and do not “opt in” to that approach. The agencies previously had issued advance notices of proposed rulemaking on both proposals (in August 2003 regarding the A-IRB approach of BIS II for internationally active banking organizations and in October 2005 regarding BIS II).
 
The comment periods for both of the agencies’ notices of proposed rulemakings expire on March 26, 2007. The agencies have indicated their intent to have the A-IRB provisions for internationally active U.S. banking organizations first become effective in March 2009 and that those provisions and the BIS I-A provisions for others will be implemented on similar timeframes.
 
The Corporation is not an internationally active banking organization and has not made a determination as to whether it would opt to apply the A-IRB provisions applicable to internationally active U.S. banking organizations once they become effective.
 
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. Frost Bank was not required to pay any deposit insurance premiums in 2006; however, it is possible that the FDIC could impose assessment rates in the future in connection with declines in the insurance funds or increases in the amount of insurance coverage. An increase in the assessment rate could have a material adverse effect on the Corporation’s earnings, depending on the amount of the increase. 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 that can be applied against future premiums, subject to certain limitations. During 2006, Frost Bank paid $1.2 million in Financing Corporation (“FICO”) assessments related to outstanding FICO bonds to the FDIC as collection agent. 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.
 
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 the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution.


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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 an FDIC-insured depository institution controlled by the same bank holding company, or for any assistance provided by the FDIC to an 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.
 
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.
 
Financial Privacy
 
In accordance with the GLB Act, 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. The privacy provisions of the GLB Act 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


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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.
 
Employees
 
At December 31, 2006, the Corporation employed 3,652 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, 2006, 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
 
T.C. Frost
Senior Chairman of the Board
and Director
    79     Officer and Director of Frost Bank since 1950. Chairman of the Board of Cullen/Frost from 1973 to October 1995. Chief Executive Officer of Cullen/Frost from July 1977 to October 1997. Senior Chairman of Cullen/Frost from October 1995 to present.
         
Richard W. Evans, Jr.
Chairman of the Board,
Chief Executive Officer and Director
    60     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
    46     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
    52     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
    56     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
    44     Office of Frost Bank since January 1989. Group Executive Vice President, Internet Financial Services of Frost Bank from May 2001 to present.


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Name and Position Held   Age     Recent Business Experience
 
Paul H. Bracher
President, State Regions of Frost Bank
    50     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
    60     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
    54     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
    49     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
    62     Officer of Frost Bank since January 1998. Senior Vice President, Human Resources of Frost Bank from July 2000 to October 2003. Group Executive Vice President, Human Resources of Frost Bank from October 2003 to present.
 
There are no arrangements or understandings between any executive officer of Cullen/Frost and any other person pursuant to which such executive officer was or is to be selected as an officer.
 
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.
 
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.

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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 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 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, 2006, approximately 81% of the Corporation’s loan portfolio consisted of commercial and industrial, construction and commercial real estate mortgage loans. These types of loans are generally viewed as having more risk of default than residential real estate loans or consumer loans. These types of loans are also typically larger than residential real estate loans and consumer loans. Because the Corporation’s loan portfolio contains a significant number of commercial and industrial, construction and commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Corporation’s financial condition and results of operations. See the section captioned “Loans” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to commercial and industrial, construction and commercial real estate loans.


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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. Changes 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.
 
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. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets 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.


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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 the Corporation operates. Additionally, various out-of-state banks have entered or have announced plans to enter the market areas in which the Corporation currently 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 upon long-term customer relationships based on top quality service, high ethical standards and safe, sound assets.
 
  •  The ability to expand the Corporation’s market position.
 
  •  The scope, relevance and pricing of products and services offered to meet customer needs and demands.
 
  •  The rate at which the Corporation introduces new products and services relative to its competitors.
 
  •  Customer satisfaction with the Corporation’s level of service.
 
  •  Industry and general economic trends.
 
Failure to perform in any of these areas could significantly weaken the Corporation’s competitive position, which could adversely affect the Corporation’s growth and profitability, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations.
 
The Corporation Is Subject To Extensive Government Regulation and Supervision
 
The Corporation, primarily through Cullen/Frost, Frost Bank and certain non-bank subsidiaries, is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not security holders. These regulations affect the Corporation’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. 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.


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The Corporation’s Controls and Procedures May Fail or Be Circumvented
 
Management regularly reviews and updates the Corporation’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Corporation’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Corporation’s business, results of operations and financial condition.
 
New Lines of Business or New Products and Services May Subject The Corporation to Additional Risks
 
From time to time, the Corporation may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services the Corporation may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of the Corporation’s system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on the Corporation’s business, results of operations and financial condition.
 
Cullen/Frost Relies On Dividends From Its Subsidiaries For Most Of Its Revenue
 
Cullen/Frost is a separate and distinct legal entity from its subsidiaries. It receives substantially all of its revenue from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on the Corporation’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.


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  •  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 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). During 2005, the Corporation acquired Horizon Capital Bank (Houston 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 one or more of the Corporation’s key personnel could have a material adverse impact on the Corporation’s business because of their skills, knowledge of the Corporation’s market, years of industry experience and the difficulty of promptly finding qualified replacement personnel. The Corporation 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.


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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.
 
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


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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, By-Laws and Shareholders Rights Plan As Well As Certain Banking Laws May Have An Anti-Takeover Effect
 
Provisions of the Corporation’s articles of incorporation and by-laws, federal banking laws, including regulatory approval requirements, and the Corporation’s stock purchase rights plan could make it more difficult for a third party to acquire the Corporation, even if doing so would be perceived to be beneficial to the Corporation’s shareholders. The combination of these provisions effectively inhibits a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of the Corporation’s common stock.
 
Risks Associated With The Corporation’s Industry
 
The Earnings Of Financial Services Companies Are Significantly Affected By General Business And Economic Conditions
 
The Corporation’s operations and profitability are impacted by general business and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, and the strength of the U.S. economy and the local economies in which the Corporation operates, all of which are beyond the Corporation’s control. A deterioration in economic conditions 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


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the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on the Corporation’s financial condition and results of operations.
 
ITEM 1B.   UNRESOLVED STAFF COMMENTS
 
None
 
ITEM 2.   PROPERTIES
 
The Corporation’s headquarters are located in downtown San Antonio, Texas. These facilities, which are owned by the Corporation, house the Corporation’s executive and primary administrative offices, as well as the principal banking headquarters of Frost Bank. The Corporation also owns or leases other facilities within its primary market areas in the regions of Austin, Corpus Christi, Dallas, Fort Worth, Houston, Rio Grande Valley and San Antonio. The Corporation considers its properties to be suitable and adequate for its present needs.
 
ITEM 3.   LEGAL PROCEEDINGS
 
The Corporation is subject to various claims and legal actions that have arisen in the normal course of conducting business. Management does not expect the ultimate disposition of these matters to have a material adverse impact on the Corporation’s financial statements.
 
ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
No matters were submitted to a vote of security holders during the fourth quarter of 2006.


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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 2006 and 2005 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.
 
                                 
    2006     2005  
Sales Price Per Share   High     Low     High     Low  
       
 
First quarter
  $ 55.88     $ 52.34     $ 48.97     $ 43.87  
Second quarter
    58.49       52.04       47.99       41.90  
Third quarter
    59.55       54.48       50.60       47.07  
Fourth quarter
    58.67       53.09       56.43       47.33  
 
                 
Cash Dividends Per Share   2006     2005  
       
 
First quarter
  $ 0.30     $ 0.265  
Second quarter
    0.34       0.300  
Third quarter
    0.34       0.300  
Fourth quarter
    0.34       0.300  
     
     
Total
  $ 1.32     $ 1.165  
     
     
 
As of December 31, 2006, there were 59,839,144 shares of the Corporation’s common stock outstanding held by 1,991 holders of record. The closing price per share of common stock on December 29, 2006, the last trading day of the Corporation’s fiscal year, was $55.82.
 
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.
 
Stock-Based Compensation Plans
 
Information regarding stock-based compensation awards outstanding and available for future grants as of December 31, 2006, 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.
 
                         
    Number of Shares
             
    to be Issued Upon
    Weighted-Average
    Number of Shares
 
    Exercise of
    Exercise Price of
    Available for
 
Plan Category   Outstanding Awards     Outstanding Awards     Future Grants  
       
 
Plans approved by shareholders
    4,545,195     $ 41.19       2,386,025  
Plans not approved by shareholders
                 
     
     
Total
    4,545,195     $ 41.19       2,386,025  
     
     


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Stock Repurchase Plans
 
The Corporation has maintained several stock repurchase plans authorized by the Corporation’s board of directors. In general, stock repurchase plans allow the Corporation to proactively manage its capital position and return excess capital to shareholders. Shares purchased under such plans also provide the Corporation with shares of common stock necessary to satisfy obligations related to stock compensation awards. Under the most recent plan, which 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. Under the plan, during 2005, the Corporation repurchased 300 thousand shares at a cost of $14.4 million, all of which occurred during the first quarter. No shares were repurchased during 2006. Over the life of the 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 2006.
 
                                 
                      Maximum
 
                      Number of Shares
 
                Total Number of
    That May Yet Be
 
                Shares Purchased
    Purchased Under
 
    Total Number of
    Average Price
    as Part of Publicly
    the Plans at the
 
Period   Shares Purchased     Paid Per Share     Announced Plans     End of the Period  
       
 
October 1, 2006 to October 31, 2006
        $              
November 1, 2006 to November 30, 2006
    20,103 (1)     54.01              
December 1, 2006 to December 31, 2006
                       
                                 
Total
    20,103     $ 54.01                
                                 
 
 
(1) Includes repurchases made in connection with the exercise of certain employee stock options and 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. The graph assumes an investment of $100 on December 31, 2001 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, 2001
 
GRAPH
 
                                                             
      2001     2002     2003     2004     2005     2006
Cullen/Frost
    $ 100.00       $ 108.60       $ 138.42       $ 169.61       $ 191.84       $ 204.22  
S&P 500
      100.00         77.95         100.27         111.15         116.60         134.97  
S&P 500 Banks
      100.00         99.19         124.76         137.65         133.75         155.08  
                                                             


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ITEM 6.   SELECTED FINANCIAL DATA
 
Selected Financial Data (continued)
 
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, 2006. 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, 2006 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,  
    2006     2005     2004     2003     2002  
       
 
Consolidated Statements of Income
                                       
Interest income:
                                       
Loans, including fees
  $ 502,657     $ 359,587     $ 249,612     $ 233,463     $ 265,514  
Securities
    144,501       131,943       135,035       125,778       120,221  
Interest-bearing deposits
    251       150       63       104       172  
Federal funds sold and resell agreements
    36,550       18,147       8,834       9,601       3,991  
     
     
Total interest income
    683,959       509,827       393,544       368,946       389,898  
Interest expense:
                                       
Deposits
    155,090       78,934       39,150       37,406       55,384  
Federal funds purchased and repurchase agreements
    31,167       16,632       5,775       4,059       5,359  
Junior subordinated deferrable interest debentures
    17,402       14,908       12,143       8,735       8,735  
Subordinated notes payable and other borrowings
    11,137       8,087       5,038       4,988       6,647  
     
     
Total interest expense
    214,796       118,561       62,106       55,188       76,125  
     
     
Net interest income
    469,163       391,266       331,438       313,758       313,773  
Provision for possible loan losses
    14,150       10,250       2,500       10,544       22,546  
     
     
Net interest income after provision for possible loan losses
    455,013       381,016       328,938       303,214       291,227  
Non-interest income:
                                       
Trust fees
    63,469       58,353       53,910       47,486       47,463  
Service charges on deposit accounts
    77,116       78,751       87,415       87,805       78,417  
Insurance commissions and fees
    28,230       27,731       30,981       28,660       25,912  
Other charges, commissions and fees
    28,105       23,125       22,877       22,522       21,446  
Net gain (loss) on securities transactions
    (1 )     19       (3,377 )     40       88  
Other
    43,828       42,400       33,304       28,848       27,643  
     
     
Total non-interest income
    240,747       230,379       225,110       215,361       200,969  
Non-interest expense:
                                       
Salaries and wages
    190,784       166,059       158,039       146,622       139,227  
Employee benefits
    46,231       41,577       40,176       38,316       34,614  
Net occupancy
    34,695       31,107       29,375       29,286       28,883  
Furniture and equipment
    26,293       23,912       22,771       21,768       22,597  
Intangible amortization
    5,628       4,859       5,346       5,886       7,083  
Other
    106,722       99,493       89,323       84,157       79,738  
     
     
Total non-interest expense
    410,353       367,007       345,030       326,035       312,142  
Income from continuing operations before income taxes
    285,407       244,388       209,018       192,540       180,054  
Income taxes
    91,816       78,965       67,693       62,039       57,821  
     
     
Income from continuing operations
    193,591       165,423       141,325       130,501       122,233  
Loss from discontinued operations, net of tax
                            (5,247 )
     
     
Net income
  $ 193,591     $ 165,423     $ 141,325     $ 130,501     $ 116,986  
     
     


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    As of or for the Year Ended December 31,  
    2006     2005     2004     2003     2002  
       
 
Per Common Share Data
                                       
Basic:
                                       
Income from continuing operations
  $ 3.49     $ 3.15     $ 2.74     $ 2.54     $ 2.40  
Net income
    3.49       3.15       2.74       2.54       2.29  
Diluted:
                                       
Income from continuing operations
    3.42       3.07       2.66       2.48       2.33  
Net income
    3.42       3.07       2.66       2.48       2.23  
Cash dividends declared and paid
    1.32       1.165       1.035       0.94       0.875  
Book value
    23.01       18.03       15.84       14.87       13.72  
Common Shares Outstanding
                                       
Period-end
    59,839       54,483       51,924       51,776       51,295  
Weighted-average shares — basic
    55,467       52,481       51,651       51,442       51,001  
Dilutive effect of stock compensation
    1,175       1,322       1,489       1,216       1,422  
Weighted-average shares — diluted
    56,642       53,803       53,140       52,658       52,423  
Performance Ratios
                                       
Return on average assets:
                                       
Income from continuing operations
    1.67 %     1.63 %     1.47 %     1.36 %     1.46 %
Net income
    1.67       1.63       1.47       1.36       1.40  
Return on average equity:
                                       
Income from continuing operations
    18.03       18.78       17.91       17.78       18.77  
Net income
    18.03       18.78       17.91       17.78       17.96  
Net interest income to average earning assets
    4.67       4.45       4.05       3.98       4.58  
Dividend pay-out ratio
    37.91       37.18       38.06       37.15       38.24  
Balance Sheet Data
                                       
Period-end:
                                       
Loans
  $ 7,373,384     $ 6,085,055     $ 5,164,991     $ 4,590,746     $ 4,518,913  
Earning assets
    11,460,741       10,197,059       8,891,859       8,132,479       7,709,980  
Total assets
    13,224,189       11,741,437       9,952,787       9,672,114       9,536,050  
Non-interest-bearing demand deposits
    3,699,701       3,484,932       2,969,387       3,143,473       3,229,052  
Interest-bearing deposits
    6,688,208       5,661,462       5,136,291       4,925,384       4,399,091  
Total deposits
    10,387,909       9,146,394       8,105,678       8,068,857       7,628,143  
Long-term debt and other borrowings
    428,636       415,422       377,677       255,845       271,257  
Shareholders’ equity
    1,376,883       982,236       822,395       770,004       703,790  
Average:
                                       
Loans
  $ 6,523,906     $ 5,594,477     $ 4,823,198     $ 4,497,489     $ 4,536,999  
Earning assets
    10,202,981       8,968,906       8,352,334       8,011,081       6,961,439  
Total assets
    11,581,253       10,143,245       9,618,849       9,583,829       8,353,145  
Non-interest-bearing demand deposits
    3,334,280       3,008,750       2,914,520       3,037,724       2,540,432  
Interest-bearing deposits
    5,850,116       5,124,036       4,852,166       4,539,622       4,353,878  
Total deposits
    9,184,396       8,132,786       7,766,686       7,577,346       6,894,310  
Long-term debt and other borrowings
    405,752       387,612       363,386       264,428       275,136  
Shareholders’ equity
    1,073,599       880,640       789,073       733,994       651,273  
Asset Quality
                                       
Allowance for possible loan losses
  $ 96,085     $ 80,325     $ 75,810     $ 83,501     $ 82,584  
Allowance for possible loan losses to period-end loans
    1.30 %     1.32 %     1.47 %     1.82 %     1.83 %
Net loan charge-offs
  $ 11,110     $ 8,921     $ 10,191     $ 9,627     $ 12,843  
Net loan charge-offs to average loans
    0.17 %     0.16 %     0.20 %     0.21 %     0.28 %
Non-performing assets
  $ 57,749     $ 38,927     $ 39,116     $ 52,794     $ 42,908  
Non-performing assets to:
                                       
Total loans plus foreclosed assets
    0.78 %     0.64 %     0.76 %     1.15 %     0.95 %
Total assets
    0.44       0.33       0.39       0.55       0.45  
Consolidated Capital Ratios
                                       
Tier 1 risk-based capital ratio
    11.25 %     12.24 %     12.83 %     11.41 %     10.46 %
Total risk-based capital ratio
    13.43       14.94       15.99       15.01       14.16  
Leverage ratio
    9.56       9.62       9.18       7.83       7.25  
Average shareholders’ equity to average total assets
    9.27       8.68       8.20       7.66       7.80  


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The following tables set forth unaudited consolidated selected quarterly statement of operations data for the years ended December 31, 2006 and 2005. Dollar amounts are in thousands, except per share data.
 
                                 
    Year Ended December 31, 2006  
    4th
    3rd
    2nd
    1st
 
    Quarter     Quarter     Quarter     Quarter  
       
 
Interest income
  $ 181,974     $ 176,407     $ 168,738     $ 156,840  
Interest expense
    60,745       57,881       51,770       44,400  
     
     
Net interest income
    121,229       118,526       116,968       112,440  
Provision for possible loan losses
    3,400       1,711       5,105       3,934  
Non-interest income(1)
    58,400       60,566       60,750       61,031  
Non-interest expense
    105,595       103,610       100,679       100,469  
     
     
Income before income taxes
    70,634       73,771       71,934       69,068  
Income taxes
    22,272       23,769       23,384       22,391  
     
     
Net income
  $ 48,362     $ 50,002     $ 48,550     $ 46,677  
     
     
Net income per common share:
                               
Basic
  $ 0.85     $ 0.90     $ 0.88     $ 0.86  
Diluted
    0.84       0.88       0.86       0.83  
 
                                 
    Year Ended December 31, 2005  
    4th
    3rd
    2nd
    1st
 
    Quarter     Quarter     Quarter     Quarter  
       
 
Interest income
  $ 146,446     $ 130,198     $ 120,260     $ 112,923  
Interest expense
    38,646       30,913       26,182       22,820  
     
     
Net interest income
    107,800       99,285       94,078       90,103  
Provision for possible loan losses
    2,950       2,725       2,175       2,400  
Non-interest income(2)
    56,553       58,054       57,733       58,039  
Non-interest expense
    95,078       91,992       89,450       90,487  
     
     
Income before income taxes
    66,325       62,622       60,186       55,255  
Income taxes
    21,408       20,167       19,502       17,888  
     
     
Net income
  $ 44,917     $ 42,455     $ 40,684     $ 37,367  
     
     
Net income per common share:
                               
Basic
  $ 0.83     $ 0.81     $ 0.78     $ 0.72  
Diluted
    0.81       0.79       0.77       0.70  
 
 
(1) Includes net loss on securities transactions of $1 thousand during the first quarter of 2006.
 
(2) Includes net gain on securities transactions of $19 thousand during the fourth quarter of 2005.


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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. 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.
 
  •  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 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.


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  •  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.
 
  •  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.
 
The Corporation
 
Cullen/Frost Bankers, Inc. (Cullen/Frost) is a financial holding company and a bank holding company headquartered in San Antonio, Texas that provides, through its wholly owned 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, investment banking, insurance brokerage, leasing, asset-based lending, treasury management and item processing services.
 
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. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Corporation bases estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ from those estimates.
 
The Corporation considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Corporation’s financial statements.
 
Accounting policies related to the allowance for possible loan losses are considered to be critical, as these policies involve considerable subjective judgment and estimation by management. The allowance for possible loan losses is a reserve established through a provision for possible loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Corporation’s allowance for possible loan loss methodology is based on guidance provided in SEC Staff Accounting Bulletin No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues” and includes allowance allocations calculated in accordance with 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. 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.


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Overview
 
The following discussion and analysis presents the more significant factors affecting the Corporation’s financial condition as of December 31, 2006 and 2005 and results of operations for each of the years in the three-year period ended December 31, 2006. 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. 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.
 
Results of Operations
 
Net income totaled $193.6 million, or $3.42 diluted per common share, in 2006 compared to $165.4 million, or $3.07 diluted per common share, in 2005 and $141.3 million, or $2.66 diluted per common share, in 2004. Selected income statement data, returns on average assets and average equity and dividends per share for the comparable periods were as follows:
 
                         
    2006     2005     2004  
       
 
Taxable-equivalent net interest income
  $ 479,138     $ 398,938     $ 337,102  
Taxable-equivalent adjustment
    9,975       7,672       5,664  
     
     
Net interest income
    469,163       391,266       331,438  
Provision for possible loan losses
    14,150       10,250       2,500  
Non-interest income
    240,747       230,379       225,110  
Non-interest expense
    410,353       367,007       345,030  
     
     
Income before income taxes
    285,407       244,388       209,018  
Income taxes
    91,816       78,965       67,693  
     
     
Net income
  $ 193,591     $ 165,423     $ 141,325  
     
     
Earnings per common share:
                       
Basic
  $ 3.49     $ 3.15     $ 2.74  
Diluted
    3.42       3.07       2.66  
Return on average assets
    1.67 %     1.63 %     1.47 %
Return on average equity
    18.03       18.78       17.91  
 
Net income for 2006 increased $28.2 million, or 17.0%, compared to 2005. The increase was primarily due to a $77.9 million increase in net interest income and a $10.4 million increase in non-interest income. The impact of these items was partly offset by a $43.3 million increase in non-interest expense, a $12.9 million increase in income tax expense and a $3.9 million increase in the provision for possible loan losses. Net income for 2005 increased $24.1 million, or 17.1%, compared to 2004. The increase was primarily due to a $59.8 million increase in net interest income and a $5.3 million increase in non-interest income. The impact of these items was partly offset by a $22.0 million increase in non-interest expense, an $11.3 million increase in income tax expense and a $7.8 million increase in the provision for possible loan losses.
 
Details of the changes in the various components of net income are further discussed below.


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Net Interest Income
 
Net interest income is the difference between interest income on earning assets, such as loans and securities, and interest expense on liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest income is the Corporation’s largest source of revenue, representing 66.1% of total revenue during 2006. Net interest margin is the taxable-equivalent net interest income as a percentage of 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 2004 at 4.00% and increased 25 basis points at end of the second quarter, 50 basis points during the third quarter and 50 basis points during the fourth quarter and ended the year at 5.25%. During 2005, the prime interest rate increased 50 basis points in each of the four quarters to end the year at 7.25%. During 2006, the prime interest rate increased 50 basis points in the first quarter and 50 basis points in the second quarter to end the year at 8.25%. The federal funds rate, which is the cost of immediately available overnight funds, fluctuated in a similar manner. It began 2004 at 1.00% and increased 25 basis points at the end of the second quarter, 50 basis points during the third quarter and 50 basis points during the fourth quarter to end the year at 2.25%. During 2005, the federal funds rate increased 50 basis points in each of the four quarters to end the year at 4.25%. During 2006, the federal funds rate increased 50 basis points in the first quarter and 50 basis points in the second quarter to end the year at 5.25%.
 
The Corporation’s balance sheet is asset sensitive, meaning that earning assets generally reprice more quickly than interest-bearing liabilities. Therefore, the Corporation’s net interest margin is likely to increase in sustained periods of rising interest rates and decrease in sustained periods of declining interest rates. 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. Since 2004, there has been an upward trend in the prime interest rate and the federal funds rate. The Corporation does not currently expect this upward trend to continue in the foreseeable future; however, there can be no assurance to that effect as changes in market interest rates 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 112 and 113 of this report.
 
                                                 
    2006 vs. 2005     2005 vs. 2004  
    Increase (Decrease)
          Increase (Decrease)
       
    Due to Change in           Due to Change in        
    Rate     Volume     Total     Rate     Volume     Total  
       
 
Interest-bearing deposits
  $ 155     $ (54 )   $ 101     $ 92     $ (5 )   $ 87  
Federal funds sold and resell agreements
    6,633       11,770       18,403       11,563       (2,250 )     9,313  
Securities:
                                               
Taxable
    4,474       7,333       11,807       1,334       (5,956 )     (4,622 )
Tax-exempt
    (58 )     1,222       1,164       (394 )     2,777       2,383  
Loans
    66,202       78,758       144,960       55,385       55,745       111,130  
     
     
Total earning assets
    77,406       99,029       176,435       67,980       50,311       118,291  
Savings and interest checking
    1,221       349       1,570       1,782       137       1,919  
Money market deposit accounts
    28,660       15,257       43,917       18,471       5,179       23,650  
Time accounts
    11,088       11,219       22,307       9,339       987       10,326  
Public funds
    6,033       2,329       8,362       3,708       181       3,889  
Federal funds purchased and repurchase agreements
    6,709       7,826       14,535       5,340       5,517       10,857  
Junior subordinated deferrable interest debentures
    2,209       285       2,494       1,724       1,040       2,764  
Subordinated notes payable and other notes
    2,365             2,365       2,652             2,652  
Federal Home Loan Bank advances
    22       663       685       (11 )     409       398  
     
     
Total interest-bearing liabilities
    58,307       37,928       96,235       43,005       13,450       56,455  
     
     
Changes in net interest income
  $ 19,099     $ 61,101     $ 80,200     $ 24,975     $ 36,861     $ 61,836  
     
     
 
Taxable-equivalent net interest income for 2006 increased $80.2 million, or 20.1%, compared to 2005. The increase primarily resulted from an increase in the average volume of earning assets combined with an increase in the net interest margin. The average volume of earning assets for 2006 increased $1.2 billion compared to 2005. Over the same time frame, the net interest margin increased 22 basis points from 4.45% in 2005 to 4.67% in 2006. The increase in the average volume of earning assets was due in part to recent acquisitions (see Note 2 — Mergers and Acquisitions). The increase in the net interest margin was primarily driven by an increase in the average yield on earning assets, which increased from 5.77% during 2005 to 6.76% during 2006. The increase in the average yield on earning assets was partly due to an increase in the relative proportion of loans, which generally carry higher yields compared to other types of earning assets. Loans increased from 62.4% of total average earning assets during 2005 to 63.9% of total average earning assets during 2006. The increase in the net interest margin was also partly due to the aforementioned increases in market interest rates.
 
Taxable-equivalent net interest income for 2005 increased $61.8 million, or 18.3%, compared to 2004. The increase primarily resulted from an increase in the average volume of earning assets combined with an increase in the net interest margin. The average volume of earning assets for 2005 increased $616.6 million compared to 2004. Over the same time frame, the net interest margin increased 40 basis points from 4.05% in 2004 to 4.45% in 2005. The increase in the net interest margin was primarily driven by an increase in the average yield on earning assets, which increased from 4.79% during 2004 to 5.77% during 2005. The increase in the average yield on earning assets was partly the result of the Corporation having a larger proportion of average earning assets invested in higher-


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yielding loans during 2005 compared to 2004. The increase was also partly due to the aforementioned increases in market interest rates.
 
During 2004, the Corporation utilized dollar-roll repurchase agreement transactions to increase net interest income. A dollar-roll repurchase agreement is similar to an ordinary repurchase agreement, except that the security transferred is a mortgage-backed security and the repurchase provisions of the transaction agreement explicitly allow for the return of a “similar” security rather than the identical security initially sold. The Corporation funded investments in federal funds sold and resell agreements utilizing dollar-roll repurchase agreements. By doing this, the Corporation was able to capitalize on the spread between the yield earned on federal funds sold and resell agreements and the cost of the dollar-roll repurchase agreements. The spread had a positive effect on the dollar amount of net interest income, which increased by approximately $989 thousand during 2004 as a result of the dollar-roll transactions. However, because the funds were invested in lower yielding federal funds sold and resell agreements, the dollar-roll transactions had a negative impact on the Corporation’s net interest margin. The average volume of dollar-roll transactions totaled $92.3 million in 2004. The Corporation was not a party to any dollar-roll transactions during 2006 and 2005.
 
The average volume of loans, the Corporation’s primary category of earning assets, increased $929.4 million, or 16.6%, during 2006 compared to 2005 and increased $771.3 million, or 16.0%, during 2005 compared to 2004. The average yield on loans was 7.76% during 2006 compared to 6.46% during 2005 and 5.19% during 2004. As stated above, the Corporation had a larger proportion of average earning assets invested in loans during both 2006 compared 2005 and 2005 compared to 2004. 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 $109.0 million in 2006 compared to 2005 and decreased $111.6 million in 2005 compared to 2004. The average yield on securities was 5.00% during 2006 compared to 4.84% during 2005 and 4.77% during 2004. The fluctuations in securities average balances during the comparable years were primarily in U.S. government agency securities and U.S. Treasury securities. The decline in the average volume of securities during 2005 was primarily due to the use of available funds to support loan growth. Average federal funds sold and resell agreements increased $197.3 million during 2006 compared to the 2005 and decreased $42.6 million during 2005 compared to 2004. The average yield on federal funds sold and resell agreements was 5.08% during 2006 compared to 3.48% during 2005 and 1.57% during 2004.
 
Average deposits increased $1.1 billion during 2006 compared to 2005 and $366.1 million in 2005 compared to 2004. The increase in the average volume of deposits during 2006 was due in part to recent acquisitions (see Note 2 — Mergers and Acquisitions). The increase in average deposits over the comparable years was primarily in interest-bearing deposits. Average interest-bearing deposits increased $726.1 million during 2006 compared to 2005 and $271.9 million during 2005 compared to 2004. The ratio of average interest-bearing deposits to total average deposits was 63.7% during 2006 compared to 63.0% in 2005 and 62.5% in 2004. The average cost of interest-bearing deposits and total deposits was 2.65% and 1.69% during 2006 compared to 1.54% and 0.97% during 2005 and 0.81% and 0.50% during 2004. The increase in the average cost of interest-bearing deposits was primarily the result of increases in interest rates offered on deposit products due to increases in market interest rates. Additionally, the relative proportion of lower-cost savings and interest checking to total interest-bearing deposits has trended downward during the comparable periods.
 
The Corporation’s net interest spread, which represents the difference between the average rate earned on earning assets and the average rate paid on interest-bearing liabilities, was 3.70% in 2006 compared to 3.83% in 2005 and 3.72% in 2004. 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


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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 $14.2 million in 2006 compared to $10.3 million in 2005 and $2.5 million in 2004. 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:
 
                         
    2006     2005     2004  
       
 
Trust fees
  $ 63,469     $ 58,353     $ 53,910  
Service charges on deposit accounts
    77,116       78,751       87,415  
Insurance commissions and fees
    28,230       27,731       30,981  
Other charges, commissions and fees
    28,105       23,125       22,877  
Net gain (loss) on securities transactions
    (1 )     19       (3,377 )
Other
    43,828       42,400       33,304  
     
     
Total
  $ 240,747     $ 230,379     $ 225,110  
     
     
 
Total non-interest income for 2006 increased $10.4 million, or 4.5%, compared to 2005 while total non-interest income for 2005 increased $5.3 million, or 2.3%, compared to 2004. Changes in the various components of non-interest income are discussed in more detail below.
 
Trust Fees.  Trust fee income for 2006 increased $5.1 million, or 8.8%, compared to 2005 while trust fee income for 2005 increased $4.4 million, or 8.2%, compared to 2004. Investment fees are the most significant component of trust fees, making up approximately 70% of total trust fees during the reported years. 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 2006 compared to 2005 was primarily the result of increases in investment fees (up $3.1 million), oil and gas trust management fees (up $994 thousand), custody fees (up $566 thousand) and estate fees (up $358 thousand). The increase in investment fees was primarily due to higher equity valuations during 2006 compared to 2005 and growth in overall trust assets and the number of trust accounts. The increase in oil and gas trust management fees was partly due to increased market prices, new production and new lease bonuses.
 
The increase in trust fee income during 2005 compared to 2004 was primarily the result of increases in investment fees (up $2.8 million), oil and gas trust management fees (up $1.1 million) and custody fees (up $215 thousand). These increases were partly offset by a decrease in securities lending income (down $208 thousand). The increases in investment fees were primarily due to higher equity valuations during 2005 compared to 2004 and growth in overall trust assets and the number of trust accounts. The increase in oil and gas trust management fees was primarily related to higher market prices for these commodities.
 
At December 31, 2006, trust assets, including both managed assets and custody assets, were primarily composed of fixed income securities (42.3% of trust assets), equity securities (40.4% of trust assets) and cash equivalents (10.9% of trust assets). The estimated fair value of trust assets was $23.2 billion (including managed assets of $9.3 billion and custody assets of $13.9 billion) at December 31, 2006 compared to $18.1 billion (including managed assets of $8.3 billion and custody assets of $9.8 billion) at December 31, 2005 and $17.1 billion (including managed assets of $7.8 billion and custody assets of $9.3 billion) at December 31, 2004.


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Service Charges on Deposit Accounts.  Service charges on deposit accounts for 2006 decreased $1.6 million, or 2.1%, compared to 2005. The decrease was primarily related to service charges on commercial accounts (down $4.0 million) and consumer accounts (down $561 thousand) partly offset by increases in overdraft/insufficient funds charges on consumer accounts (up $1.8 million) and commercial accounts (up $620 thousand). 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. The earnings credit rate is the value given to deposits maintained by treasury management customers. Because interest rates have trended upwards since the first quarter of 2004, deposit balances have become more valuable and have been yielding higher earnings credit rates relative to 2005. As a result, customers are able to pay for more of their services with earning credits applied to their deposit balances rather than through fees. The decrease in treasury management fees resulting from the higher earnings credit rate was partly offset by the additional fees from an increase in billable services. The increase in overdraft/insufficient funds charges on both commercial and consumer accounts was partly the result of growth in deposit accounts.
 
Service charges on deposit accounts for 2005 decreased $8.7 million, or 9.9%, compared to 2004. The decrease was primarily due to decreases in service charges on commercial accounts (down $7.7 million), service charges on consumer accounts (down $1.3 million) and overdraft/insufficient funds charges on commercial accounts (down $359 thousand). These decreases were partly offset by an increase in overdraft/insufficient funds charges on consumer accounts (up $567 thousand). The decrease in service charges on commercial accounts was primarily related to decreased treasury management fees resulting from higher earnings credit rates.
 
Insurance Commissions and Fees.  Insurance commissions and fees for 2006 increased $499 thousand, or 1.8%, compared to 2005. The increase was primarily related to higher commission income (up $770 thousand) partly offset by a decrease in contingent commissions (down $271 thousand).
 
Insurance commissions and fees for 2005 decreased $3.3 million, or 10.5%, compared to 2004. Commission revenues related to the employee benefits business in the Austin region decreased compared to 2004 (down $3.4 million) due to the loss of certain revenue-producing employees and related business. Revenues related to the affected line of business made up approximately 4.5% of the total insurance commissions and fees reported for 2005 compared to 16.2% for 2004. During the second quarter of 2005, the Corporation recognized income, which is included in other non-interest income in the accompanying consolidated statements of income, of $2.4 million related to the net proceeds from the settlement of legal claims against certain of the former employees. Property and casualty revenues in the Austin region were also negatively impacted in 2005 compared to 2004 (down $1.6 million) by the loss of certain revenue-producing employees during the second half of 2004 and early 2005. The decrease in revenues from the Austin region during 2005 was partly offset by the additional commission income (up $2.0 million in 2005) related to an insurance agency acquired in the Dallas region during the third quarter of 2004. Additional information related to the acquisition of the insurance agency is presented in Note 2 — Mergers and Acquisitions in the accompanying notes to consolidated financial statements included elsewhere in this report.
 
Insurance commissions and fees include contingent commissions totaling $3.1 million during 2006 compared to $3.4 million during 2005 and $3.1 million during 2004. Contingent commissions primarily consist of amounts received from various property and casualty insurance carriers. The carriers use several non-client specific factors to determine the amount of the contingency payments. Such factors include the aggregate loss performance of insurance policies previously placed and the volume of business, among other things. Such commissions are seasonal in nature and are mostly received during the first quarter of each year. These commissions totaled $2.8 million during both 2006 and 2005 and $2.3 million during 2004. 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 $376 thousand, $584 thousand and $849 thousand during 2006, 2005 and 2004.
 
Other Charges, Commissions and Fees.  Other charges, commissions and fees for 2006 increased $5.0 million, or 21.5%, compared to 2005. The increase was primarily related to an increase in investment banking fees related to corporate advisory services (up $2.8 million) and increases in commission income related to the sale of money market accounts (up $846 thousand) and mutual funds (up $645 thousand). These increases were partially offset by decreases in letter of credit fees (down $616 thousand). During the second quarter of 2006, the Corporation


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recognized investment banking fees related to corporate advisory services totaling $2.8 million, which was primarily related to a single transaction. During the third quarter of 2006, the Corporation recognized investment banking fees related to corporate advisory services totaling $1.3 million, which was primarily related to two transactions. Investment banking fees related to corporate advisory services are transaction based and can vary significantly from quarter to quarter.
 
Other charges, commissions and fees for 2005 did not significantly fluctuate compared to 2004. During 2005 compared to 2004, increases in letter of credit fees (up $959 thousand) and mutual fund fees (up $524 thousand) combined with an increase in the accelerated realization of deferred loan fees resulting from loan paydowns (up $325 thousand) were for the most part offset by a decrease in investment banking fees related to corporate advisory services (down $1.2 million), as well as decreases in various other categories of service charges and fees.
 
Net Gain/Loss on Securities Transactions.  During 2006, the Corporation realized a net loss on securities transactions of $1 thousand related to the sales of available-for-sale securities with an amortized cost totaling $26.9 million. During 2005, the Corporation realized a net gain on securities transactions of $19 thousand related to the sales of available-for-sale securities with an amortized cost totaling $19.8 million. During 2004, the Corporation realized a net loss on securities transactions of $3.4 million. During the third quarter of 2004, the Corporation sold $228.5 million (amortized cost) of callable U.S. government agency securities, which resulted in approximately $1.6 million of the net loss. After the sales, the Corporation had no callable U.S. government agency securities. The net loss on securities transactions also included a net loss of $1.7 million related to the sale of $366.4 million (amortized cost) of securities during the first quarter of 2004. This portion of the net loss was primarily related to $176.3 million (amortized cost) of securities sold in connection with a restructuring of the Corporation’s securities portfolio.
 
Other Non-Interest Income.  Other non-interest income increased $1.4 million, or 3.4%, in 2006 compared to 2005. During 2005, the Corporation realized $2.4 million in income from the net proceeds from the settlement of legal claims against certain former employees who were employed within the employee benefits line of business in the Austin region of Frost Insurance Agency. Also during 2005, the Corporation recognized $2.0 million in income related to a distribution received from the sale of the PULSE EFT Association whereby the Corporation and other members of the Association received distributions based in part upon each member’s volume of transactions through the PULSE network. Excluding the income related to these items during 2005, other non-interest income for 2006 increased $5.8 million, or 15.3%, compared to 2005. Contributing to the effective increase during 2006 were increases in income from check card usage (up $2.7 million), earnings on cashier’s check balances (up $1.5 million), income from securities trading activities (up $521 thousand) and mineral interest income (up $462 thousand).
 
Other non-interest income increased $9.1 million, or 27.3%, in 2005 compared to 2004. The increase was impacted by the recognition of the aforementioned $2.4 million settlement and $2.0 million in PULSE EFT distributions. Also contributing to the increase were increases in income from check card usage (up $2.0 million), lease rental income (up $1.1 million), earnings on cashier’s check balances (up $1.1 million) and gains realized on sales of student loans (up $822 thousand). The impact of these items was partly offset by decreases in mineral interest income (down $499 thousand) and income from securities trading activities (down $356 thousand). Also, during 2004, other non-interest income included $1.1 million in non-recurring income related to the termination and settlement of an operational contract.


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Non-Interest Expense
 
The components of non-interest expense were as follows:
 
                         
    2006     2005     2004  
       
 
Salaries and wages
  $ 190,784     $ 166,059     $ 158,039  
Employee benefits
    46,231       41,577       40,176  
Net occupancy
    34,695       31,107       29,375  
Furniture and equipment
    26,293       23,912       22,771  
Intangible amortization
    5,628       4,859       5,346  
Other
    106,722       99,493       89,323  
     
     
Total
  $ 410,353     $ 367,007     $ 345,030  
     
     
 
Total non-interest expense for 2006 increased $43.3 million, or 11.8%, compared to 2005 while total non-interest expense for 2005 increased $22.0 million, or 6.4%, compared to 2004. Changes in the various components of non-interest expense are discussed below.
 
Salaries and Wages.  Salaries and wages expense for 2006 increased $24.7 million, or 14.9%, compared to 2005. The increase was partly related to normal, annual merit increases and an increase in headcount. The increase in headcount was primarily related to the acquisition of Horizon Capital Bank (Horizon) during the fourth quarter of 2005, the acquisitions of Texas Community Bancshares (TCB) and Alamo Corporation of Texas (Alamo) during the first quarter of 2006 and the acquisition of Summit Bancshares (Summit) during the fourth quarter of 2006. Also, effective January 1, 2006, the Corporation began recognizing compensation expense related to stock options in connection with the adoption of a new accounting standard, as further discussed in Note 13 — Employee Benefit Plans. Stock-based compensation expense related to stock options and non-vested stock awards totaled $9.2 million during 2006 compared to $2.0 million during 2005.
 
Salaries and wages expense for 2005 increased $8.0 million, or 5.1%, compared to 2004. The increase was partly related to normal, annual merit increases, an increase in headcount and an increase in the incentive compensation accrual. The increase was also partly due to increases in stock-based compensation expense for non-vested stock awards (up $609 thousand) and overtime expenses (up $473 thousand). The increase in salaries and wages expense was partly offset by decreases in salaries and wages related to Frost Insurance Agency. Salaries and wages for Frost Insurance Agency were down due to a decrease in commissions paid because of lower insurance revenues and a decrease in headcount.
 
Employee Benefits.  Employee benefits expense for 2006 increased $4.7 million, or 11.2%, compared to 2005. The increase was primarily related to increases in medical insurance expense (up $1.8 million), payroll taxes (up $1.4 million), expenses related to the Corporation’s defined benefit retirement and restoration plans (up $796 thousand) and expenses related to the Corporation’s 401(k) and profit sharing plans (up $718 thousand). The increase in employee benefits expense for 2006 was also partly the result of increases in headcount related to the acquisition of Horizon during the fourth quarter of 2005, the acquisitions of TCB and Alamo during the first quarter of 2006 and the acquisition of Summit during the fourth quarter of 2006.
 
Employee benefits expense for 2005 increased $1.4 million, or 3.5%, compared to 2004. The increase was primarily due to increases in expenses related to the Corporation’s 401(k) and profit sharing plans (up $1.0 million) and payroll taxes (up $595 thousand), partly offset by a decrease in expense related to the Corporation’s defined benefit retirement and restoration plans (down $328 thousand).
 
The Corporation’s defined benefit retirement and restoration plans were frozen effective as of December 31, 2001 and were replaced by the profit sharing plan. Management believes these actions help reduce the volatility in retirement plan expense. However, the Corporation still has funding obligations related to the defined benefit and restoration plans and could recognize retirement expense related to these plans in future years, which would be dependent on the return earned on plan assets, the level of interest rates and employee turnover. Employee benefits expense related to the defined benefit retirement and restoration plans totaled $2.7 million in 2006, $1.9 million in 2005 and $2.3 million in 2004. Future expense related to these plans is dependent upon a variety of factors, including the actual return on plan assets.


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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 2006 increased $3.6 million, or 11.5%, compared to 2005. The increase was primarily related to increases in utilities expenses (up $739 thousand), property taxes (up $591 thousand), depreciation expense related to buildings (up $586 thousand) and in lease expense (up $565 thousand), as well as increases in various other categories of occupancy expense. These increases were partly related to the additional facilities added in connection with recent acquisitions during the fourth quarter of 2005 and the first and fourth quarters of 2006 (see Note 2 — Mergers and Acquisitions).
 
Net occupancy expense for 2005 increased $1.7 million, or 5.9%, compared to 2004. The increase was primarily related to increases in utilities expenses (up $740 thousand) and depreciation expense related to buildings (up $432 thousand), a decrease in rental income (down $231 thousand) and increases in various other categories of occupancy expense. These increases were partly offset by a decrease in depreciation expense related to leasehold improvements (down $276 thousand), as well as decreases in various other categories of occupancy expense.
 
Furniture and Equipment.  Furniture and equipment expense for 2006 increased $2.4 million, or 10.0%, compared to 2005. The increase was primarily due to increases in software maintenance (up $1.9 million), depreciation expense related to furniture and fixtures (up $1.4 million) and service contracts expense (up $698 thousand). The impact of these items was partly offset by a decrease in software amortization expense (down $1.9 million). The increase in software maintenance and depreciation expense related to furniture and fixtures was partly due to management’s decision to no longer outsource certain data processing functions.
 
Furniture and equipment expense for 2005 increased $1.1 million, or 5.0%, compared to 2004. The increase was primarily due to increases in software maintenance (up $902 thousand) and depreciation expense related to furniture and fixtures (up $473 thousand) partly offset by a decrease in software amortization expense (down $265 thousand).
 
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 $5.6 million for 2006 compared to $4.9 million for 2005 and $5.3 million for 2004. Intangible amortization for 2006 increased $769 thousand, or 15.8%, compared to 2005 primarily due to the amortization of new intangible assets acquired in connection with recent acquisitions during the fourth quarter of 2005 and the first and fourth quarters of 2006 (see Note 2 — Mergers and Acquisitions and Note 7 — Goodwill and Other Intangible Assets).
 
Intangible amortization for 2005 decreased $487 thousand, or 9.1%, compared to 2004 primarily due to the completion of the amortization for certain intangible assets. The decrease was partly offset by additional amortization related to intangible assets recorded during the fourth quarter of 2005 in connection with the acquisition of Horizon (see Note 2 — Mergers and Acquisitions and Note 7 — Goodwill and Other Intangible Assets).
 
During 2005, the Corporation wrote-off certain customer relationship intangibles totaling $147 thousand and goodwill totaling $2.0 million in connection with the settlement of legal claims against certain former employees of Frost Insurance Agency. Gross settlement proceeds of $4.5 million were reduced by the write-off of these assets in the determination of the $2.4 million net proceeds recognized in the settlement. See the analysis of other non-interest income in the section captioned “Non-Interest Income” included elsewhere in this discussion.
 
Other Non-Interest Expense.  Other non-interest expense for 2006 increased $7.2 million, or 7.3%, compared to 2005. Components of the increase during 2006 included professional service expense (up $5.1 million), amortization of net deferred costs associated with unfunded loan commitments (up $2.2 million), check card expense (up $1.3 million), stationary, printing and supplies expense (up $1.1 million), travel expense (up $930 thousand), meals and entertainment expense (up $866 thousand) and write-downs of other real estate owned (up $743 thousand), among other things. The increases in professional services expense, stationary, printing and supplies expense, travel expense and meals and entertainment expense were partly related to acquisitions and integration activities. The increase in these items was partly offset by a decrease in outside computer service expense (down $6.3 million). The reduction in outside computer services resulted as the Corporation is no longer outsourcing certain data processing functions.


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Other non-interest expense for 2005 increased $10.2 million, or 11.4%, compared to the same period in 2004. Significant components of the increase during 2005 included increases in professional service expense (up $2.5 million), advertising/promotions expense (up $1.7 million), donations (up $1.0 million), depreciation expense related to property leased to customers (up $852 thousand), travel expense (up $850 thousand), meals and entertainment expense (up $725 thousand) and stationary, printing and supplies expense (up $577 thousand). These expenses were partially offset by lower business development expense (down $399 thousand), bank service charges (down $256 thousand), property taxes on foreclosed assets (down $187 thousand), and federal reserve service charges (down $162 thousand).
 
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:
 
                         
    2006     2005     2004  
       
 
Banking
  $ 184,141     $ 159,177     $ 137,744  
Financial Management Group
    22,652       16,666       10,997  
Non-Banks
    (13,202 )     (10,420 )     (7,416 )
     
     
Consolidated net income
  $ 193,591     $ 165,423     $ 141,325  
     
     
 
Banking
 
Net income for 2006 increased $25.0 million, or 15.7%, compared to 2005. The increase was primarily the result of a $71.8 million increase in net interest income and a $2.6 million increase in non-interest income partly offset by a $35.3 million increase in non-interest expense, a $10.3 million increase in income tax expenses and a $4.0 million increase in the provision for possible loan losses. Net income for 2005 increased $21.4 million, or 15.6%, compared to 2004. The increase was primarily the result of a $53.6 million increase in net interest income partly offset by a $15.5 million increase in non-interest expense, a $8.5 million increase in income taxes and a $7.7 million increase in the provision for possible loan losses.
 
Net interest income for 2006 increased $71.8 million, or 18.3%, compared to 2005 while net interest income for 2005 increased $53.6 million, or 15.8%, compared to 2004. The increases primarily resulted from growth in the average volume of earning assets combined with increases in the net interest margin which resulted, in part, from a general increase in market interest rates and an increase in the relative proportion of higher-yielding loans as a percentage of total average 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 2006 totaled $14.2 million compared to $10.2 million in 2005 and $2.5 million in 2004. 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 2006 increased $2.6 million, or 1.6%, compared to 2005. The decrease was primarily due to increases in other charges, commissions and fees partly offset by a decrease in service charges on deposit accounts. Non-interest income for 2005 decreased $503 thousand, or 0.3%, compared to 2004. Non-interest income for 2004 included a $3.4 million net loss on securities transactions. Excluding the net loss, non-interest income would have decreased $3.9 million. This effective decrease was primarily due to decreases in service charges on deposit accounts and insurance commissions and fees partly offset by an increase in other non-interest income. See the analysis of service charges on deposit accounts, insurance commissions and fees and other non-interest income included in the section captioned “Non-Interest Income” included elsewhere in this discussion.
 
Non-interest expense for 2006 increased $35.3 million, or 11.6%, compared to 2005. The increase was primarily related to increases in salaries and wages, employee benefits expense, net occupancy expense, furniture and equipment expense and other non-interest expense. Combined, salaries and wages and employee benefits increased $24.7 million during 2006 compared to 2005. This increase was primarily the result of normal, annual


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merit increases, increases in headcount as well as increases in medical insurance expense, payroll taxes, expenses related to the Corporation’s employee benefit plans and stock-based compensation expense. Other non-interest expense increased $3.9 million, or 5.5%, primarily due to increases in professional service expenses, amortization of net deferred costs associated with unfunded loan commitments, check card expense, stationary, printing and supplies expense, travel expenses and meals and entertainment expense, among other things. These increases were partly offset by a decrease in outside computer service expense. The increase in net occupancy expense was primarily due to an increase in utilities expenses, property taxes, depreciation expense related to buildings and lease expense. The increase in furniture and equipment expense was primarily due to increases in software maintenance expense, depreciation expense related to furniture and fixtures and service contracts expense partly offset by a decrease in software amortization expense. The increases in net occupancy expense and furniture and equipment expense are partly related to the additional facilities added in connection with recent acquisitions during the fourth quarter of 2005 and the first and fourth quarters of 2006 (see Note 2 — Mergers and Acquisitions). See the analysis of these items included in the section captioned “Non-Interest Expense” included elsewhere in this discussion.
 
Non-interest expense for 2005 increased $15.5 million, or 5.4%, compared to 2004. The increase was primarily related to increases in salaries and wages, employee benefits expense and other non-interest expense. Combined, salaries and wages and employee benefits during 2005 increased $6.9 million compared to 2004. This increase was primarily the result of normal, annual merit increases, as well as increases in headcount, the incentive compensation accrual, stock-based compensation expense for non-vested stock awards, overtime, expenses related to the Corporation’s employee benefit plans and payroll taxes. The increase in salaries and wages expense during 2005 was partly offset by a decrease in salaries and wages related to Frost Insurance Agency due to a decrease in commissions paid because of lower insurance revenues and a decrease in headcount. Other non-interest expense increased $6.2 million, or 9.6%, primarily due to increases in professional service expenses, advertising/promotional expenses, donations, depreciation expense related to property leased to customers, travel expenses and meals and entertainment expense, among other things. 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 $28.6 million in 2006 compared to $28.1 million in 2005 and $31.4 million in 2004. Insurance commission revenues increased $517 thousand, or 1.8%, during 2006 compared to 2005. The increase during 2006 compared to 2005 was primarily related to higher commission income (up $787 thousand) partly offset by a decrease in contingent commission income (down $270 thousand). Insurance commission revenues decreased $3.3 million, or 10.5%, during 2005 compared to 2004. The decrease during 2005 compared to 2004 was primarily the result of lower commissions in the Austin region due to the loss of certain revenue-producing employees and increased competition. The decrease in commissions in the Austin region was partly offset by additional commission income related to an insurance agency acquired in the Dallas region during the third quarter of 2004. 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 2006 increased $6.0 million, or 35.9%, compared to 2005. The increase was primarily due to a $8.6 million increase in net interest income and a $7.7 million increase in non-interest income partly offset by a $7.1 million increase in non-interest expense and a $3.2 million increase in income tax expense. Net income for 2005 increased $5.7 million, or 51.6%, compared to 2004. The increase was primarily due to a $9.0 million increase in net interest income and a $6.1 million increase in non-interest income partly offset by a $6.3 million increase in non-interest expense and a $3.1 million increase in income taxes.
 
Net interest income for 2006 increased $8.6 million, or 6.1% compared to 2005. Net interest income for 2005 increased $9.0 million, or 179.7% compared to 2004. The increases during both 2006 and 2005 resulted from increases in the average volume of repurchase agreements as well as increases in average market interest rates, which impacted the funds transfer price paid on FMG’s repurchase agreements.


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Non-interest income for 2006 increased $7.7 million, or 10.9%, compared to 2005 while non-interest income for 2005 increased $6.1 million, or 9.5%, compared to 2004. The increases were primarily due to increases in trust fees (up $5.3 million in 2006 and $4.6 million in 2005).
 
Trust fee income is the most significant income component for FMG. Investment fees are the most significant component of trust fees, making up approximately 70% of total trust fees for both 2006 and 2005 and 71% of total trust fees for 2004. 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. FMG has experienced an increasing trend in investment fees since 2004 primarily due to 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.
 
Non-interest expense for 2006 increased $7.1 million, or 12.1%, compared to 2005 while non-interest expense for 2005 increased $6.3 million, or 12.0%, compared to 2004. The increases were primarily due to increases in salaries and wages and employee benefits and other non-interest expense. The increases in salaries and wages and employee benefits (on a combined basis, up $4.0 million in 2006 and $2.4 million in 2005) were primarily the result of normal, annual merit increases, increases in headcount and increases in expenses related to stock-based compensation, payroll taxes, medical insurance and employee benefit plans. The increases in other non-interest expense (up $3.1 million in 2006 and $3.9 million in 2005) were 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 segment increased $2.8 million during 2006 compared to 2005. The increase was primarily due to a decrease in net interest income due in part to the variable-rate junior subordinated deferrable interest debentures issued in February 2004. As market interest rates have increased, the Non-Banks segment has experienced a corresponding increase in interest cost related to this debt. Additionally, during 2006, the Corporation had added interest cost from the $3.1 million of variable-rate junior subordinated deferrable interest debentures acquired in connection with the acquisition of Alamo in the first quarter and $12.4 million of variable-rate junior subordinated deferrable interest debentures acquired in connection with the acquisition of Summit in the fourth quarter.
 
The net loss for the Non-Banks segment increased $3.0 million during 2005 compared to 2004. The increase was primarily due to a decrease in net interest income due in part to the variable-rate junior subordinated deferrable interest debentures issued in February 2004. As market interest rates have increased, the Non-Banks segment has experienced a corresponding increase in interest cost related to this debt. Additionally, 2004 did not include a full year of interest cost related to this debt as it was issued during the first quarter of that year.
 
Income Taxes
 
The Corporation recognized income tax expense of $91.8 million, for an effective tax rate of 32.2% for 2006 compared to $79.0 million, for an effective rate of 32.3%, in 2005 and $67.7 million, for an effective rate of 32.4%, in 2004. 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.


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Sources and Uses of Funds
 
The following table illustrates, during the years presented, the mix of the Corporation’s funding sources and the assets in which those funds are invested as a percentage of the Corporation’s average total assets for the period indicated. Average assets totaled $11.6 billion in 2006 compared to $10.1 billion in 2005 and $9.6 billion in 2004.
 
                         
    2006     2005     2004  
       
 
Sources of Funds:
                       
Deposits:
                       
Non-interest-bearing
    28.8 %     29.7 %     30.3 %
Interest-bearing
    50.5       50.5       50.4  
Federal funds purchased and repurchase agreements
    6.6       6.0       5.9  
Long-term debt and other borrowings
    3.5       3.8       3.8  
Other non-interest-bearing liabilities
    1.3       1.3       1.4  
Equity capital
    9.3       8.7       8.2  
     
     
Total
    100.0 %     100.0 %     100.0 %
     
     
Uses of Funds:
                       
Loans
    56.3 %     55.1 %     50.1 %
Securities
    25.5       28.1       30.8  
Federal funds sold, resell agreements and other interest-earning assets
    6.3       5.2       5.9  
Other non-interest-earning assets
    11.9       11.6       13.2  
     
     
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 36.3% of total average deposits in 2006 compared to 37.0% in 2005 and 37.5% in 2004. The decrease in the relative proportion of non-interest-bearing deposits to total deposits was partly due to decreases in average correspondent bank deposits (see related information regarding this decrease in the section captioned “Deposits” included elsewhere in this discussion). Federal funds purchased and repurchase agreements increased in relative proportion during 2006 in part due to a $167.5 million increase in repurchase agreements.
 
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 $929.4 million, or 16.6%, in 2006 compared to 2005 and $771.3 million, or 16.0%, in 2005 compared to 2004. The increase in 2006 and 2005 was partly due to the acquisition of $326.3 million in loans in connection with the acquisition of Horizon during the fourth quarter of 2005, $289.6 million in loans in connection with the acquisition of TCB and Alamo during the first quarter of 2006 and $824.5 million in loans in connection with the acquisition of Summit during the fourth quarter of 2006. Excluding the impact of the loans acquired in these acquisitions, average loans increased $379.0 million, or 6.9%, in 2006 compared to 2005. The increase in 2005 compared to 2004 was partly due to improved loan demand that appeared to be the result of improved economic conditions and the movement of business from other lenders to the Corporation. See additional information regarding the Corporation’s loan portfolio in the section captioned “Loans” included elsewhere in this discussion. The relative proportion of funds invested in securities in 2006 decreased compared to 2005, while the relative proportion of funds invested in federal funds sold, resell agreements and other interest-earning assets increased as the Corporation chose to delay the reinvestment of funds in longer-term securities until more favorable investment yields became available. The relative proportion of funds invested in securities as well as federal funds sold, resell agreements and other interest-earning assets during 2005 compared to 2004 decreased in part to provide funding for loan growth.


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Loans
 
Year-end loans were as follows:
 
                                                 
          Percentage
                         
    2006     of Total     2005     2004     2003     2002  
       
 
Commercial and industrial:
                                               
Commercial
  $ 3,229,570       43.8 %   $ 2,610,178     $ 2,361,052     $ 2,081,631     $ 2,048,089  
Leases
    174,075       2.4       148,750       114,016       77,909       57,642  
Asset-based
    33,856       0.4       41,288       34,687       36,683       49,819  
     
     
Total commercial and industrial
    3,437,501       46.6       2,800,216       2,509,755       2,196,223       2,155,550  
Real estate:
                                               
Construction:
                                               
Commercial
    649,140       8.8       590,635       419,141       349,152       315,340  
Consumer
    114,142       1.5       87,746       37,234       23,399       45,152  
Land:
                                               
Commercial
    407,055       5.5       301,907       215,148       178,022       158,271  
Consumer
    5,394       0.1       10,369       3,675       5,169       8,231  
Commercial mortgages
    1,766,469       24.0       1,409,811       1,185,431       1,102,138       1,050,957  
1-4 family residential mortgages
    125,294       1.7       95,032       86,098       113,756       179,077  
Home equity and other consumer
    508,574       6.9       460,941       387,864       292,255       276,429  
     
     
Total real estate
    3,576,068       48.5       2,956,441       2,334,591       2,063,891       2,033,457  
Consumer:
                                               
Indirect
    3,475       0.1       2,418       3,648       8,358       25,262  
Student loans held for sale
    47,335       0.6       51,189       63,568       58,280       43,430  
Other
    310,752       4.2       265,038       247,025       246,173       245,760  
Other
    27,703       0.4       27,201       21,819       28,962       23,295  
Unearned discount
    (29,450 )     (0.4 )     (17,448 )     (15,415 )     (11,141 )     (7,841 )
     
     
Total
  $ 7,373,384       100.0 %   $ 6,085,055     $ 5,164,991     $ 4,590,746     $ 4,518,913  
     
     
 
Overview.  Loans totaled $7.4 billion at December 31, 2006 increasing $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 loans increased $174.2 million, or 2.9%.
 
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 originates 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 $1.3 billion, or 21.2% 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 46.6% and 46.0% of total loans while real estate loans made up 48.5% and 48.6% of total loans at December 31, 2006 and 2005, respectively. Real estate loans include both commercial and consumer balances. Of the $1.1 billion of loans acquired in connection with the acquisition of TCB, Alamo and Summit, 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


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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, 2006, approximately 60% of the outstanding principal balance of the Corporation’s commercial real estate loans were secured by owner-occupied properties.
 
With respect to loans to developers and builders that are secured by non-owner occupied properties that the Corporation may originate from time to time, the Corporation generally requires the borrower to have had an existing relationship with the Corporation and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Corporation until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.
 
The Corporation originates consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed, jointly by line and staff personnel. This activity, coupled with relatively small loan amounts 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


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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 $637.3 million, or 22.8% from $2.8 billion at December 31, 2005 to $3.4 billion at December 31, 2006. During 2006, the Corporation acquired approximately $363 million of commercial and industrial loans in connection with the acquisitions of TCB, Alamo and Summit. 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, 2006 and 2005, 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, 2006 and 2005:
 
                 
    2006     2005  
       
 
Industry concentrations:
               
Energy
    8.0 %     7.3 %
Medical services
    5.7       5.6  
Building construction
    4.4       3.9  
Services
    4.1       3.6  
General and specific trade contractors
    3.5       3.0  
Public finance
    3.5       2.8  
Manufacturing, other
    3.4       3.2  
Legal services
    2.4       3.2  
Insurance
    2.4       2.1  
Restaurants
    2.1       2.5  
All other (34 categories in 2006 and 2005)
    60.5       62.8  
     
     
Total loans
    100.0 %     100.0 %
     
     
 
The Corporation’s largest concentration in any single industry is in energy. Year-end energy loans were as follows:
 
                 
    2006     2005  
       
 
Energy loans:
               
Production
  $ 424,474     $ 307,709  
Service
    116,018       117,255  
Traders
    12,501       8,271  
Manufacturing
    32,929       11,557  
Refining
    721        
     
     
Total energy loans
  $ 586,643     $ 444,792  
     
     
 
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


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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.
 
                                                 
    2006     2005  
    Number of
    Period-End Balances     Number of
    Period-End Balances  
    Relationships     Committed     Outstanding     Relationships     Committed     Outstanding  
       
 
Large credit relationships:
                                               
$20.0 million and greater
    91     $ 2,616,299     $ 1,318,739       57     $ 1,656,205     $ 843,163  
$10.0 million to $19.9 million
    123       1,694,956       921,942       119       1,649,324       984,011  
 
Growth in outstanding balances related to credit relationships in excess of $20.0 million resulted from an increase in commitments. Approximately $695.6 million of the net increase in these commitments was related to newly reported large credit relationships. The Corporation acquired approximately $49 million in commitments in excess of $20.0 million and approximately $71 million of commitments in excess of $10.0 million but less than $20.0 million in connection with the acquisition of Summit during the fourth quarter of 2006. The average commitment in excess of $20 million per large credit relationship did not significantly fluctuate and totaled $28.8 million at December 31, 2006 and $29.1 million at December 31, 2005. The average outstanding balance per large credit relationship with a commitment in excess of $20.0 million totaled $14.5 million at December 31, 2006 and $14.8 million at December 31, 2005.
 
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 $360.1 million at December 31, 2006, increasing from $331.6 million at December 31, 2005. At December 31, 2006, 52.4% of outstanding purchased SNCs was related to the energy industry and 19.7% of outstanding SNCs was related to the beer and liquor distribution 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 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.
 
                                                 
    2006     2005  
    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
    17     $ 427,700     $ 215,478       13     $ 320,292     $ 155,896  
$10.0 million to $19.9 million
    18       247,250       129,151       19       283,015       152,568  
 
Real Estate Loans.  Real estate loans totaled $3.6 billion at December 31, 2006, an increase of $619.6 million, or 21.0%, compared to $3.0 billion at December 31, 2005. During 2006, the Corporation acquired approximately $695 million of real estate loans in connection with the acquisitions of TCB, Alamo and Summit. Commercial real estate loans totaled $2.8 billion, or 78.9% of total real estate loans, at December 31, 2006 and $2.3 billion or 77.9% of total real estate loans, at December 31, 2005. 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.


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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, 2006 and 2005:
 
                 
    2006     2005  
       
 
Property type:
               
Office building
    21.3 %     16.9 %
Office/warehouse
    13.1       15.3  
1-4 family
    10.3       8.5  
Medical offices and services
    5.9       6.5  
Retail
    5.1       6.4  
Religious
    4.1       5.1  
All other
    40.2       41.3  
     
     
Total commercial real estate loans
    100.0 %     100.0 %
     
     
Geographic region:
               
Fort Worth
    29.8 %     19.1 %
Houston
    22.3       28.7  
San Antonio
    18.9       20.9  
Dallas
    9.2       11.7  
Austin
    7.8       9.0  
Rio Grande Valley
    6.6       4.3  
Corpus Christi
    5.4       6.3  
     
     
Total commercial real estate loans
    100.0 %     100.0 %
     
     
 
Consumer Loans.  The consumer loan portfolio, including all consumer real estate, totaled $1.1 billion at December 31, 2006, increasing $142.2 million, or 14.6%, from $972.7 million at December 31, 2005. During 2006, the Corporation acquired approximately $56 million of consumer loans in connection with the acquisitions of TCB, Alamo and Summit. Excluding 1-4 family residential mortgages, indirect loans and student loans, total consumer loans increased $114.8 million, or 13.9%, from December 31, 2005.
 
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.
 
                 
    2006     2005  
       
 
Construction
  $ 114,142     $ 87,746  
Land
    5,394       10,369  
Home equity loans
    241,680       237,789  
Home equity lines of credit
    87,103       78,401  
Other consumer real estate
    179,791       144,751  
     
     
Total consumer real estate
    628,110       559,056  
Consumer non-real estate
    310,752       265,038  
Student loans held for sale
    47,335       51,189  
Indirect
    3,475       2,418  
1-4 family residential mortgages
    125,294       95,032  
     
     
Total consumer loans
  $ 1,114,966     $ 972,733  
     
     
 
Consumer real estate loans, excluding 1-4 family mortgages, increased $69.1 million, or 12.4%, from December 31, 2005. Home equity loans were first permitted in the State of Texas beginning January 1, 1998. During September 2003, Texas voters approved an amendment to the Texas constitution that permitted financial institutions to offer home equity lines of credit. As a result, the Corporation added home equity lines of credit to its


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loan offerings and began originating such lines in the fourth quarter of 2003. Combined, home equity loans and lines of credit made up 52.3% and 56.6% of the consumer real estate loan total at December 31, 2006 and 2005. 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 originates 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 $70.3 million of student loans during 2006 compared to $73.2 million during 2005 and $55.9 million during 2004.
 
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.
 
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, 2006 or 2005.
 
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, 2006. 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.
 
                                 
          After One,
             
    Due in One
    but Within
    After Five
       
    Year or Less     Five Years     Years     Total  
       
 
Commercial and industrial
  $ 1,662,765     $ 1,451,271     $ 323,465     $ 3,437,501  
Real estate construction
    379,295       235,074       148,913       763,282  
Commercial real estate and land
    385,037       1,076,995       711,492       2,173,524  
Consumer and other
    173,768       257,686       424,444       855,898  
     
     
Total
  $ 2,600,865     $ 3,021,026     $ 1,608,314     $ 7,230,205  
     
     
Loans with fixed interest rates
  $ 717,500     $ 1,101,987     $ 828,147     $ 2,647,634  
Loans with floating interest rates
    1,883,365       1,919,039       780,167       4,582,571  
     
     
Total
  $ 2,600,865     $ 3,021,026     $ 1,608,314     $ 7,230,205  
     
     
 
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.


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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:
 
                                         
    2006     2005     2004     2003     2002  
       
 
Non-accrual loans:
                                       
Commercial and industrial
  $ 20,813     $ 25,556     $ 27,089     $ 35,914     $ 19,878  
Real estate
    29,580       4,963       2,471       10,766       7,167  
Consumer and other
    1,811       2,660       883       771       7,816  
     
     
Total non-accrual loans
    52,204       33,179       30,443       47,451       34,861  
Restructured loans
                             
Foreclosed assets:
                                       
Real estate
    5,500       4,403       7,369       5,054       8,005  
Other
    45       1,345       1,304       289       42  
     
     
Total foreclosed assets
    5,545       5,748       8,673       5,343       8,047  
     
     
Total non-performing assets
  $ 57,749     $ 38,927     $ 39,116     $ 52,794     $ 42,908  
     
     
Ratio of non-performing assets to:
                                       
Total loans and foreclosed assets
    0.78 %     0.64 %     0.76 %     1.15 %     0.95 %
Total assets
    0.44       0.33       0.39       0.55       0.45  
Accruing past due loans:
                                       
30 to 89 days past due
  $ 56,836     $ 32,908     $ 20,895     $ 24,419     $ 30,766  
90 or more days past due
    10,917       7,921       5,231       14,462       9,081  
     
     
Total accruing past due loans
  $ 67,753     $ 40,829     $ 26,126     $ 38,881     $ 39,847  
     
     
Ratio of accruing past due loans to total loans:
                                       
30 to 89 days past due
    0.77 %     0.54 %     0.41 %     0.53 %     0.68 %
90 or more days past due
    0.15       0.13       0.10       0.32       0.20  
     
     
Total accruing past due loans
    0.92 %     0.67 %     0.51 %     0.85 %     0.88 %
     
     
 
Non-performing assets include non-accrual loans, restructured loans and foreclosed assets. Non-performing assets at December 31, 2006 increased $18.8 million from December 31, 2005. The increase was primarily related to two commercial real estate loans totaling $23.2 million placed on non-accrual status during the fourth quarter of 2006. These loans were first reported as potential problem loans during the third quarter of 2006.
 
Generally, loans are placed on non-accrual status if principal or interest payments become 90 days past due and/or management deems the collectibility of the principal and/or interest to be in question, as well as when required by regulatory requirements. Loans to a customer whose financial condition has deteriorated are considered for non-accrual status whether or not the loan is 90 days or more past due. For consumer loans, collectibility and loss are generally determined before the loan reaches 90 days past due. Accordingly, losses on consumer loans are recorded at the time they are determined. Consumer loans that are 90 days or more past due are generally either in liquidation/payment status or bankruptcy awaiting confirmation of a plan. Once interest accruals are discontinued, accrued but uncollected interest is charged to current year operations. Subsequent receipts on non-accrual loans are recorded as a reduction of principal, and interest income is recorded only after principal recovery is reasonably assured. Classification of a loan as non-accrual does not preclude the ultimate collection of loan principal or interest.
 
Restructured loans are loans on which, due to deterioration in the borrower’s financial condition, the original terms have been modified in favor of the borrower or either principal or interest has been forgiven.
 
Foreclosed assets represent property acquired as the result of borrower defaults on loans. Foreclosed assets are recorded at estimated fair value, less estimated selling costs, at the time of foreclosure. Write-downs occurring at foreclosure are charged against the allowance for possible loan losses. On an ongoing basis, properties are appraised as required by market indications and applicable regulations. Write-downs are provided for subsequent declines in value and are included in other non-interest expense along with other expenses related to maintaining the properties.


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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, 2006, the Corporation had $12.7 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, 2006, potential problem loans consisted of five credit relationships. Of the total outstanding balance at December 31, 2006, approximately 62.2% related to a customer in the insurance industry, approximately 18.2% related to a customer that operates as a retailer of musical instruments and approximately 14.4% related to a customer that operates as a retailer of game room furnishings. 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.
 
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


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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.
 
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:
 
                                                                                 
    2006     2005     2004     2003     2002  
    Allowance
    Percentage
    Allowance
    Percentage
    Allowance
    Percentage
    Allowance
    Percentage
    Allowance
    Percentage
 
    for
    of Loans
    for
    of Loans
    for
    of Loans
    for
    of Loans
    for
    of Loans
 
    Possible
    in each
    Possible
    in each
    Possible
    in each
    Possible
    in each
    Possible
    in each
 
    Loan
    Category to
    Loan
    Category to
    Loan
    Category to
    Loan
    Category to
    Loan
    Category to
 
    Losses     Total Loans     Losses     Total Loans     Losses     Total Loans     Losses     Total Loans     Losses     Total Loans  
       
 
Commercial and industrial
  $ 44,603       46.2 %   $ 50,357       45.7 %   $ 49,696       48.4 %   $ 42,504       47.6 %   $ 45,618       47.6 %
Real estate
    24,955       48.5       16,378       48.6       12,393       45.1       19,752       45.0       13,928       44.9  
Consumer
    8,238       4.9       5,303       5.2       4,436       6.1       3,920       6.8       4,609       7.0  
Other
    2,125       0.4       1,556       0.5       1,081       0.4       1,217       0.6       1,801       0.5  
Unallocated
    16,164             6,731             8,204             16,108             16,628        
     
     
Total
  $ 96,085       100.0 %   $ 80,325       100.0 %   $ 75,810       100.0 %   $ 83,501       100.0 %   $ 82,584       100.0 %
     
     
 
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 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. The decrease in the reserve allocation for commercial and industrial loans during 2006 compared to 2005 was


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primarily due to a decrease in the level of criticized commercial and industrial loans and a decrease in specific valuation allowances determined in accordance with SFAS 114 partly offset by growth in the commercial and industrial loan portfolio. 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. Specific valuation allowances determined in accordance with SFAS 114 related to real estate loans increased approximately $2.7 million in 2006 compared to 2005. Specific valuation allowances determined in accordance with SFAS 114 related to commercial and industrial loans decreased approximately $2.1 million in 2006 compared to 2005. Specific valuation allowances for other types of loans were not significant at December 31, 2006. 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.
 
During 2004, reserve allocations for commercial and industrial loans increased compared to 2003 despite a decline in the level of criticized loans. The increase in reserve allocations was the result of portfolio growth and increases in historical valuation allowances determined in accordance with SFAS 5 based on historical loan loss experience for similar loans with similar characteristics and trends. Specific valuation allowances determined in accordance with SFAS 114 related to commercial and industrial loans decreased in 2004 compared to 2003. The reserve allocations related to real estate loans increased in 2003 primarily due to increases in specific valuation allowances. These allocations were reduced in 2004 as many of the loans were repaid, charged-off or reclassified due to improved performance. The reserve allocations for commercial loans were increased in 2002 in response to the softening economy during 2001. Also, during 2002 the Corporation assessed the impact on consumer loan losses of the decision in 2000 to exit indirect consumer lending. Since exiting indirect lending, consumer loan losses have declined significantly. In response to this decline in loan losses, the consumer reserve allocation was reduced in line with the lower risk in the consumer portfolio.
 
The unallocated reserve increased in 2002 in response to deterioration in the economy. The deteriorating economic conditions helped create a higher risk environment for loan portfolios. The Corporation responded to this higher risk environment by increasing unallocated reserves based on risk factors thought to increase with the slowing economy. During 2004, improving economic conditions appeared to reduce the overall risk environment for loan portfolios. Furthermore, the Corporation began to experience positive trends in several important credit quality measures including the levels of past due loans, potential problem loans and criticized assets. As a result, the level of unallocated reserve was decreased in 2004 through a reduction in the provision for loan losses, as further discussed below, and a reallocation of amounts to commercial and industrial loans as discussed above.


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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.
 
                                         
    2006     2005     2004     2003     2002  
       
 
Balance of allowance for possible loan losses at beginning of year
  $ 80,325     $ 75,810     $ 83,501     $ 82,584     $ 72,881  
Provision for possible loan losses
    14,150       10,250       2,500       10,544       22,546  
Allowance for possible loan losses acquired
    12,720       3,186                    
Charge-offs:
                                       
Commercial and industrial
    (10,983 )     (8,448 )     (12,570 )     (11,627 )     (13,112 )
Real estate
    (727 )     (531 )     (2,724 )     (1,607 )     (2,249 )
Consumer and other
    (7,223 )     (6,126 )     (4,721 )     (3,761 )     (3,363 )
     
     
Total charge-offs
    (18,933 )     (15,105 )     (20,015 )     (16,995 )     (18,724 )
     
     
Recoveries:
                                       
Commercial and industrial
    3,019       2,409       6,219       5,581       3,940  
Real estate
    483       351       718       272       452  
Consumer and other
    4,321       3,424       2,887       1,515       1,489  
     
     
Total recoveries
    7,823       6,184       9,824       7,368       5,881  
     
     
Net charge-offs
    (11,110 )     (8,921 )     (10,191 )     (9,627 )     (12,843 )
     
     
Balance at end of year
  $ 96,085     $ 80,325     $ 75,810     $ 83,501     $ 82,584  
     
     
Net charge-offs as a percentage of average loans
    0.17 %     0.16 %     0.20 %     0.21 %     0.28 %
Allowance for possible loan losses as a percentage of year-end loans
    1.30       1.32       1.47       1.82       1.83  
Allowance for possible loan losses as a percentage of year-end non-accrual loans
    184.1       242.1       249.0       176.0       236.9  
Average loans outstanding during the year
  $ 6,523,906     $ 5,594,477     $ 4,823,198     $ 4,497,489     $ 4,536,999  
Loans outstanding at year-end
    7,373,384       6,085,055       5,164,991       4,590,746       4,518,913  
Non-accrual loans outstanding at year-end
    52,204       33,179       30,443       47,451       34,861  
 
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 $3.9 million in 2006 to $14.2 million compared to $10.3 million in 2005 and increased $7.8 million in 2005 compared to $2.5 million in 2004. The increase in the provision for possible loan losses in 2006 was primarily due to growth in the loan portfolio. The provision for possible loan losses increased in 2005 in part due to an increase in the level of criticized loans. The increase in the provision for possible loan losses in 2005 was also partly due to the overall growth in the loan portfolio. During 2004, the lower provision levels reflect the fact that the Corporation was experiencing positive trends in several important credit quality measures including the levels of past due loans, potential problem loans and criticized assets. The Corporation did not record a provision for possible loan losses in the third or fourth quarters of 2004 primarily due to a reduction in the overall level of criticized loans.
 
Net charge-offs in 2006 increased $2.2 million compared to 2005 while net charge-offs in 2005 decreased $1.3 million compared to 2004. Net charge-offs as a percentage of average loans increased one basis point in 2006 compared to 2005 and decreased four basis points in 2005 compared to 2004.
 
Management believes the level of the allowance for possible loan losses was adequate as of December 31, 2006. 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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Securities
 
Year-end securities were as follows:
 
                                                 
    2006     2005     2004  
          Percentage
          Percentage
          Percentage
 
    Amount     of Total     Amount     of Total     Amount     of Total  
       
 
Held to maturity:
                                               
U.S. government agencies and corporations
  $ 9,096       0.3 %   $ 11,701       0.4 %   $ 15,614       0.6 %
Other
    1,000             1,000             1,100        
     
     
Total
    10,096       0.3       12,701       0.4       16,714       0.6  
Available for sale:
                                               
U.S. Treasury
    89,683       2.7       84,309       2.7              
U.S. government agencies and corporations
    2,902,609       86.6       2,676,103       87.0       2,676,796       89.9  
States and political subdivisions
    310,376       9.3       271,293       8.8       252,145       8.5  
Other
    28,285       0.8       27,406       0.9       28,355       0.9  
     
     
Total
    3,330,953       99.4       3,059,111       99.4       2,957,296       99.3  
Trading:
                                               
U.S. Treasury
    8,515       0.3       6,217       0.2       4,671       0.1  
States and political subdivisions
    891                                
     
     
Total
    9,406       0.3       6,217       0.2       4,671       0.1  
     
     
Total securities
  $ 3,350,455       100.0 %   $ 3,078,029       100.0 %   $ 2,978,681       100.0 %
     
     


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The following tables summarize the maturity distribution schedule with corresponding weighted-average yields of securities held to maturity and securities available for sale as of December 31, 2006. Weighted-average yields have been computed on a fully taxable-equivalent basis using a tax rate of 35%. Mortgage-backed securities and collateralized mortgage obligations are included in maturity categories based on their stated maturity date. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Other securities classified as available for sale include stock in the Federal Reserve Bank and the Federal Home Loan Bank, which have no maturity date. These securities have been included in the total column only.
 
                                                                                 
    Within 1 Year     1-5 Years     5-10 Years     After 10 Years     Total  
          Weighted
          Weighted
          Weighted
          Weighted
          Weighted
 
          Average
          Average
          Average
          Average
          Average
 
    Amount     Yield     Amount     Yield     Amount     Yield     Amount     Yield     Amount     Yield  
       
 
Held to maturity:
                                                                               
U.S. government agencies and corporations
  $       %   $ 459       8.42 %   $ 392       8.59 %   $ 8,245       5.51 %   $ 9,096       5.79 %
Other
    1,000       4.10                                           1,000       4.10  
                                                                                 
Total
  $ 1,000       4.10     $ 459       8.42     $ 392       8.59     $ 8,245       5.51     $ 10,096       5.62  
                                                                                 
Available for Sale:
                                                                               
U.S. Treasury
  $ 89,683       3.91 %   $       %   $       %   $       %   $ 89,683       3.91 %
U.S. government agencies and corporations
    118,841       5.33       20,406       4.99       150,376       5.15       2,612,986       4.99       2,902,609       5.00  
States and political subdivisions
    5,524       6.55       96,300       6.12       118,763       6.12       89,789       6.09       310,376       6.12  
Other
                                                    28,285        
                                                                                 
Total
  $ 214,048       4.76     $ 116,706       5.92     $ 269,139       5.58     $ 2,702,775       5.02     $ 3,330,953       5.08  
                                                                                 
 
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, 2006, 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 of the securities portfolio was 5.00% in 2006 compared to 4.84% in 2005 and 4.77% in 2004. During 2006 and 2005, market yields on mortgage-backed securities increased as a result of the general increase in market rates as further discussed in 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:
 
                                                 
    2006     2005     2004  
    Average
    Average
    Average
    Average
    Average
    Average
 
    Balance     Rate Paid     Balance     Rate Paid     Balance     Rate Paid  
       
 
Non-interest-bearing:
                                               
Commercial and individual
  $ 3,005,811             $ 2,639,071             $ 2,395,663          
Correspondent banks
    277,332               323,712               469,635          
Public funds
    51,137               45,967               49,222          
                                                 
Total
    3,334,280               3,008,750               2,914,520          
Interest-bearing:
                                               
Private accounts:
                                               
Savings and interest checking
    1,283,830       0.36 %     1,206,055       0.25 %     1,171,883       0.09 %
Money market deposit accounts
    3,022,866       3.05       2,646,975       1.82       2,444,734       1.00  
Time accounts of $100,000 or more
    617,790       3.93       501,040       2.45       471,200       1.28  
Time accounts under $100,000
    505,189       3.67       393,419       2.09       393,976       1.05  
Public funds
    420,441       3.72       376,547       1.93       370,373       0.91  
                                                 
Total
    5,850,116       2.65       5,124,036       1.54       4,852,166       0.81  
                                                 
Total deposits
  $ 9,184,396       1.69     $ 8,132,786       0.97     $ 7,766,686       0.50  
                                                 
 
Average deposits increased $1.1 billion in 2006 compared to 2005 and increased $366.1 million in 2005 compared to 2004. Approximately $633.9 million of the increase in average deposits during 2006 compared to 2005 resulted from the Corporation’s acquisition of $319.1 million of deposits in connection with the acquisition of Horizon during the fourth quarter of 2005, $381.6 million of deposits in connection with the acquisitions of TCB and Alamo during the first quarter of 2006 and $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). The deposits acquired during 2005 included approximately $152.1 million of non-interest-bearing commercial and individual deposits and approximately $167.0 million of interest-bearing deposits (encompassing $44.6 million of savings and interest checking accounts, $56.7 million of money market accounts and $65.7 million of time accounts). Approximately $75.2 million of the increase in average deposits during 2005 compared to 2004 was due to the deposits acquired in connection with the acquisition of Horizon.
 
The increase in average deposits over the comparable years was primarily in average interest-bearing deposits. The ratio of average interest-bearing deposits to total average deposits increased to 63.7% in 2006 from 63.0% in 2005 and 62.5% in 2004. The average cost of interest-bearing deposits and total deposits was 2.65% and 1.69% during 2006 compared to 1.54% and 0.97% during 2005 and 0.81% and 0.50% during 2004. The increase in the average cost of interest-bearing deposits during 2006 compared to 2005 and during 2005 compared to 2004 was primarily the result of increases in interest rates offered on deposit products due to increases in market interest rates. Additionally, the relative proportion of lower-cost savings and interest checking to total interest-bearing deposits has trended downward during the comparable 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:
 
                         
    2006     2005     2004  
       
 
Commercial and individual
    90.2 %     87.7 %     82.2 %
Correspondent banks
    8.3       10.8       16.1  
Public funds
    1.5       1.5       1.7  
     
     
Total
    100.0 %     100.0 %     100.0 %
     
     
 
Average non-interest-bearing deposits increased $325.5 million, or 10.8%, in 2006 compared to 2005 while average non-interest-bearing deposits increased $94.2 million, or 3.2%, in 2005 compared to 2004. The increase in 2006 was primarily due to a $366.7 million, or 13.9%, increase in average commercial and individual demand deposits partly offset by a $46.4 million, or 14.3%, decrease in average correspondent bank deposits. The increase in average commercial and individual demand deposits was partly due to the added deposits acquired in the aforementioned acquisitions. Average commercial and individual demand deposits during 2006 and 2005 included approximately $68.6 million and $10.3 million of that were received under a contractual relationship assumed in connection with the acquisition of Horizon. The Corporation expects this contractual relationship will be terminated in 2007. The decrease in correspondent bank deposits was partly due to declines in volumes related to four large customers, the largest of which had unusually high average volumes during the latter part of 2005. The increase in 2005 was primarily due to a $243.4 million, or 10.2%, increase in average commercial and individual deposits partly offset by a $145.9 million, or 31.1%, decrease in average correspondent bank deposits. The increase in average commercial and individual deposits was primarily attributable to an increase in the number of accounts and the maintenance of higher cash balances by customers. The decrease in average correspondent bank deposits during 2005 was partly the result of the loss of deposits related to a large customer in the business of mortgage processing who was acquired by another financial institution.
 
The following table presents the proportion of each component of average interest-bearing deposits to the total of such deposits during the years presented:
 
                         
    2006     2005     2004  
       
 
Private accounts:
                       
Savings and interest checking
    21.9 %     23.5 %     24.2 %
Money market deposit accounts
    51.7       51.7       50.4  
Time accounts of $100,000 or more
    10.6       9.8       9.7  
Time accounts under $100,000
    8.6       7.7       8.1  
Public funds
    7.2       7.3       7.6  
     
     
Total
    100.0 %     100.0 %     100.0 %
     
     
 
Total average interest-bearing deposits increased $726.1 million, or 14.2%, in 2006 compared to 2005 and increased $271.9 million, or 5.6%, in 2005 compared to 2004. The growth in average deposits during 2006 was partly due to the added deposits acquired in the aforementioned acquisitions. The Corporation has experienced a shift in the relative mix of interest-bearing deposits during the comparable years as the proportion of higher-yielding time accounts and money market deposit accounts has increased while the proportion of savings and interest checking accounts has decreased. The shift in relative proportions appears to be related to the increasing interest rate environment experienced over that last two years as many customers appear to have become more 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.
 
                         
    2006     2005     2004  
       
 
San Antonio
    35.7 %     38.5 %     38.7 %
Houston
    20.4       18.8       18.1  
Fort Worth
    14.6       14.3       13.7  
Austin
    10.9       11.0       10.6  
Corpus Christi
    6.8       7.6       7.7  
Dallas
    4.9       4.3       3.8  
Rio Grande Valley
    4.0       1.5       1.5  
Statewide
    2.7       4.0       5.9  
     
     
Total
    100.0 %     100.0 %     100.0 %
     
     
 
The Corporation experienced deposit growth in all regions during 2006 and 2005 with the exception of the Statewide region. Average deposits for the Statewide region decreased $81.5 million, or 24.9%, in 2006 compared to 2005 and $131.9 million, or 28.7%, in 2005 compared to 2004. The decreases were primarily related to the declines in correspondent bank deposits discussed above. The geographic concentrations of average deposits for certain regions was impacted by the recent acquisitions. The Houston region was impacted by the acquisition of Horizon, while the Dallas region was impacted by the acquisition of TCB, the Rio Grande Valley region was impacted by the acquisition of Alamo and the Fort Worth region was impacted by the acquisition of Summit. Excluding the impact of these acquisitions, the San Antonio region had the largest dollar volume increase during 2006 and 2005, increasing $146.5 million, or 4.7%, in 2006 compared to 2005 and $129.9 million, or 4.3%, in 2005 compared to 2004. In terms of percentage growth and excluding the impact of acquisitions, the Austin and Rio Grande Valley regions had the largest increases during 2006. Average deposits in the Austin region increased $105.1 million, or 11.7%, in 2006 compared to 2005. Average deposits in the Rio Grande Valley region increased $13.8 million, or 11.3%, in 2006 compared to 2005. During 2005, the largest percentage growth was in the Dallas and Austin regions. Average deposits in the Dallas region increased $55.0 million, or 18.5%, in 2005 compared to 2004. Average deposits in the Austin region increased $71.5 million, or 10.1%, in 2005 compared to 2004.
 
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 $711.0 million in 2006, $641.2 million in 2005 and $666.3 million in 2004.
 
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 $864.2 million, $740.5 million and $506.3 million at December 31, 2006, 2005 and 2004. The maximum amount of these borrowings outstanding at any month-end was $864.2 million in 2006, $740.5 million in 2005 and $792.8 million in 2004. The weighted-average interest rate on federal funds purchased was 5.05%, 3.93% and 2.14% at December 31, 2006, 2005 and 2004.


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The following table presents the Corporation’s average net funding position during the years indicated:
 
                                                 
    2006     2005     2004  
       
    Average
    Average
    Average
    Average
    Average
    Average
 
    Balance     Rate     Balance     Rate     Balance     Rate  
       
 
Federal funds sold and resell agreements
  $ 718,950       5.08 %   $ 521,674       3.48 %   $ 564,286       1.57 %
Federal funds purchased and repurchase agreements
    (764,173 )     4.08       (605,965 )     2.74       (564,489 )     1.02  
                                                 
Net funds position
  $ (45,223 )           $ (84,291 )           $ (203 )        
                                                 
 
The net funds purchased position decreased in 2006 compared to 2005 primarily due to a $141.7 million increase in average federal funds sold, a $55.6 million increase in average resell agreements and a $9.3 million decrease in average federal funds purchased partly offset by a $167.5 million increase in average repurchase agreements. The net funds purchased position increased in 2005 compared to 2004 primarily due to a $136.6 million increase in average repurchase agreements. The net funds purchased position was impacted in 2004 by the use of dollar-roll repurchase agreements. Average dollar-roll repurchase agreements outstanding totaled $92.3 million in 2004. There were no dollar-roll repurchase agreements outstanding in 2006 and 2005. A dollar-roll repurchase agreement is similar to an ordinary repurchase agreement, except that the security transferred is a mortgage-backed security and the repurchase provisions of the transaction agreement explicitly allow for the return of a “similar” security rather than the identical security initially sold. The basic strategy of utilizing dollar-roll repurchase agreements is to leverage earning assets to capitalize on the spread between the yield earned on federal funds sold and resell agreements and the cost of the dollar-roll repurchase agreements. This spread has a positive effect on the dollar amount of net interest income; however, because the funds are invested in lower yielding federal funds sold and resell agreements, net interest margin is negatively impacted. See the section captioned “Net Interest Income” included elsewhere in this discussion.


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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, 2006. 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  
       
          More than
                   
          1 year but
    3 years or
             
    1 year or
    less than
    more but less
    5 years or
       
    less     3 years     than 5 years     more     Total  
       
 
Contractual obligations:
                                       
Subordinated notes payable
  $     $     $     $ 150,000     $ 150,000  
Junior subordinated deferrable interest debentures
                      242,270       242,270  
Federal Home Loan Bank advances
    25,220       4,585       6,536       25       36,366  
Operating leases
    15,175       26,951       16,432       31,545       90,103  
Deposits with stated maturity dates
    1,358,650       225,002       15,076             1,598,728  
     
     
      1,399,045       256,538       38,044       423,840       2,117,467  
Other commitments:
                                       
Commitments to extend credit
    69,489       2,895,501       471,624       524,957       3,961,571  
Standby letters of credit
    1,607       241,457       10,191       1,520       254,775  
     
     
      71,096       3,136,958       481,815       526,477       4,216,346  
     
     
Total contractual obligations and other commitments
  $ 1,470,141     $ 3,393,496     $ 519,859     $ 950,317     $ 6,333,813  
     
     
 
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 specified rates and for specific purposes. Substantially all of the Corporation’s commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. Commitments to extend credit outstanding at December 31, 2006 are included in the table above.
 
Standby Letters of Credit.  Standby letters of credit are written conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Corporation would be required to fund the commitment. The maximum potential amount of future payments the Corporation could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, the Corporation would be entitled to seek recovery from the customer. The Corporation’s policies generally require that standby letter of


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credit arrangements contain security and debt covenants similar to those contained in loan agreements. Standby letters of credit outstanding at December 31, 2006 are included in the table above.
 
Trust Accounts.  The Corporation also holds certain assets in fiduciary or custodial capacity on behalf of its trust customers. The estimated fair value of trust assets was approximately $23.2 billion (including managed assets of $9.3 billion and custody assets of $13.9 billion) at December 31, 2006. These assets were primarily composed of fixed income securities (42.3% of trust assets), equity securities (40.4% of trust assets) and cash equivalents (10.9% of trust assets).
 
Securities Lending.  The Corporation lends certain customer securities to creditworthy brokers on behalf of those customers. If the borrower fails to return these securities, the Corporation indemnifies its customers based on the fair value of the securities. The Corporation holds collateral received in securities lending transactions as an agent. Accordingly, such collateral assets are not assets of the Corporation. The Corporation requires borrowers to provide collateral equal to or in excess of 100% of the fair value of the securities borrowed. The collateral is valued daily and additional collateral is requested as necessary. The maximum future payments guaranteed by the Corporation under these contractual agreements (representing the fair value of securities lent to brokers) totaled $2.1 billion at December 31, 2006. At December 31, 2006, the Corporation held liquid assets with a fair value of $2.2 billion as collateral for these agreements.
 
Capital and Liquidity
 
Capital.  At December 31, 2006, shareholders’ equity totaled $1.4 billion compared to $982.2 million at December 31, 2005. In addition to net income of $193.6 million, other significant changes in shareholders’ equity during 2006 included $215.3 million of common stock issued in connection with the acquisition of Summit, $73.4 million of dividends paid, $42.7 million of proceeds from stock option exercises and the related tax benefits of $16.4 million, $9.2 million related to stock-based compensation and $4.7 million in treasury stock purchases, which were primarily made in connection with the exercise of certain employee stock options and the vesting of certain share awards. The accumulated other comprehensive loss component of shareholders’ equity totaled $54.9 million at December 31, 2006 compared to accumulated other comprehensive loss of $50.4 million at December 31, 2005. This fluctuation was primarily related to the after-tax effect of changes in the fair value of securities available for sale and changes in the funded status of the Corporation’s defined benefit post-retirement benefit plans. Under regulatory requirements, amounts reported as accumulated other comprehensive income/loss related to the net unrealized gain or loss on securities available for sale and the funded status of the Corporation’s defined benefit post-retirement benefit plans do not increase or reduce regulatory capital and are not included in the calculation of risk-based capital and leverage ratios. Regulatory agencies for banks and bank holding companies utilize capital guidelines designed to measure Tier 1 and total capital and take into consideration the risk inherent in both on-balance sheet and off-balance sheet items. See Note 12 — Regulatory Matters in the accompanying notes to consolidated financial statements included elsewhere in this report.
 
The Corporation paid quarterly dividends of $0.30, $0.34, $0.34 and $0.34 per common share during the first, second, third and fourth quarters of 2006, respectively, and $0.265, $0.30, $0.30 and $0.30 per common share during the first, second, third and fourth quarters of 2005. This equates to a dividend payout ratio of 37.9% in 2006 and 37.2% in 2005.
 
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 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. Under the plan, during 2005, the Corporation repurchased 300 thousand shares at a cost of $14.4 million, all of which occurred during the first quarter. No shares were repurchased during 2006. Over the life of the plan, the Corporation repurchased a total of 833.2 thousand shares at a cost of $39.9 million. Also see Part II, Item 5 — Market For


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Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities, included elsewhere in this report.
 
Liquidity.  Liquidity measures the ability to meet current and future cash flow needs as they become due. The liquidity of a financial institution reflects its ability to meet loan requests, to accommodate possible outflows in deposits and to take advantage of interest rate market opportunities. The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets, and its access to alternative sources of funds. The Corporation seeks to ensure its funding needs are met by maintaining a level of liquid funds through asset/liability management.
 
Asset liquidity is provided by liquid assets which are readily marketable or pledgeable or which will mature in the near future. Liquid assets include cash, interest-bearing deposits in banks, securities available for sale, maturities and cash flow from securities held to maturity, and federal funds sold and resell agreements.
 
Liability liquidity is provided by access to funding sources which include core deposits and correspondent banks in the Corporation’s natural trade area that maintain accounts with and sell federal funds to Frost Bank, as well as federal funds purchased and repurchase agreements from upstream banks.
 
Since Cullen/Frost is a holding company and does not conduct operations, its primary sources of liquidity are dividends upstreamed from Frost Bank and borrowings from outside sources. Banking regulations may limit the amount of dividends that may be paid by Frost Bank. See Note 12 — Regulatory Matters in the accompanying notes to consolidated financial statements included elsewhere in this report regarding such dividends. At December 31, 2006, Cullen/Frost had liquid assets, including cash and resell agreements, totaling $104.2 million. Cullen/Frost also had outside funding sources available, including a $25.0 million short-term line of credit with another financial institution. The line of credit matures annually and bears interest at a fixed LIBOR-based rate or floats with the prime rate. There were no borrowings outstanding on this line of credit at December 31, 2006.
 
The Corporation expects to redeem the $100 million in trust preferred securities issued by Cullen/Frost Capital Trust I during the first quarter of 2007. As a result of the anticipated redemption, the Corporation expects to incur approximately $5.3 million in expense related to the prepayment penalty and the write-off of unamortized debt issuance costs.
 
Impact of Inflation and Changing Prices
 
The Corporation’s financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). GAAP presently requires the Corporation to measure financial position and operating results primarily in terms of historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered. The primary effect of inflation on the operations of the Corporation is reflected in increased operating costs. In management’s opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. Interest rates are highly sensitive to many factors that are beyond the control of the Corporation, including changes in the expected rate of inflation, the influence of general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities, among other things, as further discussed in the next section.
 
Regulatory and Economic Policies
 
The Corporation’s business and earnings are affected by general and local economic conditions and by the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities, among other things. The Federal Reserve Board regulates the supply of money in order to influence general economic conditions. Among the instruments of monetary policy available to the Federal Reserve


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Board are (i) conducting open market operations in United States government obligations, (ii) changing the discount rate on financial institution borrowings, (iii) imposing or changing reserve requirements against financial institution deposits, and (iv) restricting certain borrowings and imposing or changing reserve requirements against certain borrowings by financial institutions and their affiliates. These methods are used in varying degrees and combinations to affect directly the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. For that reason alone, the policies of the Federal Reserve Board have a material effect on the earnings of the Corporation.
 
Governmental policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future; however, the Corporation cannot accurately predict the nature, timing or extent of any effect such policies may have on its future business and earnings.
 
Recently Issued Accounting Pronouncements
 
See Note 21 — New Accounting Standards in the accompanying notes to consolidated financial statements included elsewhere in this report for details of recently issued accounting pronouncements and their expected impact on the Corporation’s financial statements.


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ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
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” included 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.
 
Market risk refers to the risk of loss arising from adverse changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates and prices, such as equity prices. The risk of loss can be assessed from the perspective of adverse changes in fair values, cash flows, and future earnings. Due to the nature of its operations, the Corporation is primarily exposed to interest rate risk and, to a lesser extent, liquidity risk.
 
Interest rate risk on the Corporation’s balance sheets consists of reprice, option, and basis risks. Reprice risk results from differences in the maturity, or repricing, of asset and liability portfolios. Option risk arises from “embedded options” present in many financial instruments such as loan prepayment options, deposit early withdrawal options and interest rate options. These options allow customers opportunities to benefit when market interest rates change, which typically results in higher costs or lower revenue for the Corporation. Basis risk refers to the potential for changes in the underlying relationship between market rates and indices, which subsequently result in a narrowing of profit spread on an earning asset or liability. Basis risk is also present in administered rate liabilities, such as savings accounts, negotiable order of withdrawal accounts, and money market accounts where historical pricing relationships to market rates may change due to the level or directional change in market interest rates.
 
The Corporation seeks to avoid fluctuations in its net interest margin and to maximize net interest income within acceptable levels of risk through periods of changing interest rates. Accordingly, the Corporation’s interest rate sensitivity and liquidity are monitored on an ongoing basis by its Asset and Liability Committee (“ALCO”), which oversees market risk management and establishes risk measures, limits and policy guidelines for managing the amount of interest rate risk and its effect on net interest income and capital. A variety of measures are used to provide for a comprehensive view of the magnitude of interest rate risk, the distribution of risk, the level of risk over time and the exposure to changes in certain interest rate relationships.
 
The Corporation utilizes an earnings simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next 12 months. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the next 12 months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the repricing and maturity characteristics of the existing and projected balance sheet. The impact of interest rate derivatives, such as interest rate swaps, caps and floors, is also included in the model. Other interest rate-related risks such as prepayment, basis and option risk are also considered.
 
The Committee continuously monitors and manages the balance between interest rate-sensitive assets and liabilities. The objective is to manage the impact of fluctuating market rates on net interest income within acceptable levels. In order to meet this objective, management may lengthen or shorten the duration of assets or liabilities or enter into derivative contracts to mitigate potential market risk.
 
As of December 31, 2006, the model simulations projected that 100 and 200 basis point increases in interest rates would result in positive variances in net interest income of 1.6% and 2.3%, respectively, relative to the base case over the next 12 months, while decreases in interest rates of 100 and 200 basis points would result in negative variances in net interest income of 1.7% and 4.7%, respectively, relative to the base case over the next 12 months. As of December 31, 2005, the model simulations projected that 100 and 200 basis point increases in interest rates would result in positive variances in net interest income of 2.0% and 3.9%, respectively, relative to the base case over the next 12 months, while decreases in interest rates of 100 and 200 basis points would result in negative variances in net interest income of 1.8% and 3.8%, respectively, relative to the base case over the next 12 months. The decrease in the projected positive variance in net interest income resulting from the hypothetical 200 basis point increase in interest rates from 3.9% in 2005 to 2.3% in 2006 was partly due to the impact of longer duration fixed-rate loans acquired in connection with the acquisition of Summit Bancshares, Inc. during the fourth quarter of 2006.


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See Note 2 — Mergers and Acquisitions in the accompanying notes to consolidated financial statements included elsewhere in this report. The increase in the projected negative variance in net interest income resulting from the hypothetical 200 basis point decrease in interest rates from 3.8% in 2005 to 4.7% in 2006 was partly due to the interest rate floors on variable-rate loans purchased during the fourth quarter of 2005 moving further out of the money as a result of increases in the prime interest rate during 2006. See Note 17 — Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report.
 
The impact of hypothetical fluctuations in interest rates on the Corporation’s derivative holdings was not a significant portion of these variances in any of the reported periods. As of December 31, 2006, the effect of a 200 basis point increase in interest rates on the Corporation’s derivative holdings would result in a 0.03% positive variance in net interest income. The effect of a 200 basis point decrease in interest rates on the Corporation’s derivative holdings would result in a 0.02% negative variance in net interest income.
 
The effects of hypothetical fluctuations in interest rates on the Corporation’s securities classified as “trading” under SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities,” are not significant, and, as such, separate quantitative disclosure is not presented.


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ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
Report of Ernst & Young LLP
Independent Registered Public Accounting Firm
 
 
The Board of Directors and Shareholders
of Cullen/Frost Bankers, Inc.
 
We have audited the accompanying consolidated balance sheets of Cullen/Frost Bankers, Inc. (the “Corporation”) as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cullen/Frost Bankers, Inc. at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
 
As discussed in Note 1 to the financial statements, effective January 1, 2006, the Corporation adopted Statement of Financial Accounting Standards No. 123R, Share Based Payment, to account for stock based compensation.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Cullen/Frost Bankers, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 2, 2007 expressed an unqualified opinion thereon.
 
(ERNST & YOUNG LLP)
 
San Antonio, Texas
February 2, 2007


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Table of Contents

Cullen/Frost Bankers, Inc.
Consolidated Statements of Income
(Dollars in thousands, except per share amounts)