XNYS:CFR Cullen Frost Bankers, Inc. Quarterly Report 10-Q Filing - 9/30/2012

Table of Contents

 

 

United States

Securities and Exchange Commission

Washington, D.C. 20549

Form 10-Q

 

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

For the quarterly period ended: September 30, 2012

Or

 

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

For the transition period from                     to

Commission file number: 001-13221

Cullen/Frost Bankers, Inc.

(Exact name of registrant as specified in its charter)

 

Texas		74-1751768
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
100 W. Houston Street, San Antonio, Texas		78205
(Address of principal executive offices)		(Zip code)

(210) 220-4011

(Registrant’s telephone number, including area code)

N/A

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

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

 

Large accelerated filer		x		Accelerated filer		¨
Non-accelerated filer		¨  (Do not check if a smaller reporting company)		Smaller reporting company		¨

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

As of October 18, 2012, there were 61,463,049 shares of the registrant’s Common Stock, $.01 par value, outstanding.

 

 

 

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Table of Contents

Cullen/Frost Bankers, Inc.

Quarterly Report on Form 10-Q

September 30, 2012

Table of Contents

 

						Page
Part I - Financial Information
		Item 1.		Financial Statements (Unaudited)
				Consolidated Balance Sheets			3
				Consolidated Statements of Income			4
				Consolidated Statements of Comprehensive Income			5
				Consolidated Statements of Changes in Shareholders’ Equity			6
				Consolidated Statements of Cash Flows			7
				Notes to Consolidated Financial Statements			8
		Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			40
		Item 3.		Quantitative and Qualitative Disclosures About Market Risk			68
		Item 4.		Controls and Procedures			69
Part II - Other Information
		Item 1.		Legal Proceedings			70
		Item 1A.		Risk Factors			70
		Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			70
		Item 3.		Defaults Upon Senior Securities			70
		Item 4.		Mine Safety Disclosures			70
		Item 5.		Other Information			70
		Item 6.		Exhibits			70
Signatures							71

 

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Part I. Financial Information

Item 1. Financial Statements (Unaudited)

Cullen/Frost Bankers, Inc.

Consolidated Balance Sheets

(Dollars in thousands, except per share amounts)

 

		September 30, 2012				December 31, 2011				September 30, 2011
Assets:
Cash and due from banks		$	637,042			$	574,039			$	571,332
Interest-bearing deposits			2,098,682				2,314,251				3,885,202
Federal funds sold and resell agreements			16,452				19,302				30,827
Total cash and cash equivalents			2,752,176				2,907,592				4,487,361
Securities held to maturity, at amortized cost			364,997				365,996				366,267
Securities available for sale, at estimated fair value			8,717,645				7,789,700				5,339,812
Trading account securities			14,823				13,609				15,823
Loans, net of unearned discounts			8,811,040				7,995,129				8,089,577
Less: Allowance for loan losses			(105,401	)			(110,147	)			(115,433	)
Net loans			8,705,639				7,884,982				7,974,144
Premises and equipment, net			317,197				319,042				321,517
Goodwill			535,509				528,072				528,072
Other intangible assets, net			9,066				10,604				11,656
Cash surrender value of life insurance policies			137,009				133,967				132,899
Accrued interest receivable and other assets			293,480				363,681				312,091
Total assets		$	21,847,541			$	20,317,245			$	19,489,642
Liabilities:
Deposits:
Non-interest-bearing demand deposits		$	7,720,930			$	6,672,555			$	6,541,239
Interest-bearing deposits			10,524,267				10,084,193				9,522,634
Total deposits			18,245,197				16,756,748				16,063,873
Federal funds purchased and repurchase agreements			601,204				722,202				658,246
Junior subordinated deferrable interest debentures			123,712				123,712				123,712
Other long-term borrowings			100,012				100,026				100,031
Accrued interest payable and other liabilities			358,799				331,020				296,904
Total liabilities			19,428,924				18,033,708				17,242,766
Shareholders’ Equity:
Preferred stock, par value $0.01 per share; 10,000,000 shares authorized; none issued			—				—				—
Common stock, par value $0.01 per share; 210,000,000 shares authorized; 61,461,924, shares issued at September 30, 2012, 61,271,603 shares issued at December 31, 2011 and 61,271,603 shares issued at September 30, 2011			615				613				613
Additional paid-in capital			698,038				680,803				676,079
Retained earnings			1,445,241				1,354,759				1,327,587
Accumulated other comprehensive income, net of tax			274,723				247,734				244,053
Treasury stock, 7,640 shares at December 31, 2011 and 26,359 shares at September 30, 2011, at cost			—				(372	)			(1,456	)
Total shareholders’ equity			2,418,617				2,283,537				2,246,876
Total liabilities and shareholders’ equity		$	21,847,541			$	20,317,245			$	19,489,642

See Notes to Consolidated Financial Statements.

 

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Cullen/Frost Bankers, Inc.

Consolidated Statements of Income

(Dollars in thousands, except per share amounts)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2012				2011				2012				2011
Interest income:
Loans, including fees		$	101,643			$	99,737			$	297,330			$	298,036
Securities:
Taxable			32,091				30,089				102,556				92,942
Tax-exempt			23,283				23,127				67,911				69,029
Interest-bearing deposits			1,115				1,811				2,948				4,454
Federal funds sold and resell agreements			27				15				75				44
Total interest income			158,159				154,779				470,820				464,505
Interest expense:
Deposits			4,598				5,306				13,717				17,203
Federal funds purchased and repurchase agreements			37				63				105				277
Junior subordinated deferrable interest debentures			1,711				1,710				5,096				5,073
Other long-term borrowings			281				2,339				1,446				10,499
Total interest expense			6,627				9,418				20,364				33,052
Net interest income			151,532				145,361				450,456				431,453
Provision for loan losses			2,500				9,010				5,955				27,445
Net interest income after provision for loan losses			149,032				136,351				444,501				404,008
Non-interest income:
Trust and investment management fees			20,843				19,652				62,774				59,436
Service charges on deposit accounts			20,797				22,072				62,230				64,650
Insurance commissions and fees			9,964				9,569				31,512				27,971
Interchange and debit card transaction fees			4,194				8,719				12,603				25,459
Other charges, commissions and fees			7,265				6,572				22,440				20,625
Net gain (loss) on securities transactions			—				6,409				(121	)			6,414
Other			8,095				6,224				21,462				17,787
Total non-interest income			71,158				79,217				212,900				222,342
Non-interest expense:
Salaries and wages			64,984				61,697				191,310				185,902
Employee benefits			14,019				12,004				44,768				40,365
Net occupancy			13,193				12,080				37,203				35,555
Furniture and equipment			14,193				13,106				41,347				38,015
Deposit insurance			2,593				2,583				7,928				9,941
Intangible amortization			973				1,108				2,978				3,335
Other			34,495				34,829				103,492				101,152
Total non-interest expense			144,450				137,407				429,026				414,265
Income before income taxes			75,740				78,161				228,375				212,085
Income taxes			17,071				23,654				50,611				49,964
Net income		$	58,669			$	54,507			$	177,764			$	162,121
Earnings per common share:
Basic		$	0.95			$	0.89			$	2.89			$	2.64
Diluted			0.95				0.89				2.88				2.64

See Notes to Consolidated Financial Statements.

 

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Cullen/Frost Bankers, Inc.

Consolidated Statements of Comprehensive Income

(Dollars in thousands)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2012				2011				2012				2011
Net income		$	58,669			$	54,507			$	177,764			$	162,121
Other comprehensive income (loss), before tax:
Securities available for sale:
Change in net unrealized gain/loss during the period			40,122				78,552				62,972				169,516
Reclassification adjustment for net (gains) losses included in net income			—				(6,409	)			121				(6,414	)
Total securities available for sale			40,122				72,143				63,093				163,102
Defined-benefit post-retirement benefit plans:
Change in the net actuarial gain/loss			1,427				783				4,084				2,348
Derivatives:
Change in the accumulated gain/loss on effective cash flow hedge derivatives			(269	)			(909	)			(760	)			(2,560	)
Reclassification adjustments for (gains) losses included in net income:
Interest rate swaps on variable-rate loans			(9,345	)			(9,345	)			(28,035	)			(28,035	)
Interest rate swap on junior subordinated deferrable interest debentures			1,063				1,118				3,140				3,304
Total derivatives			(8,551	)			(9,136	)			(25,655	)			(27,291	)
Other comprehensive income (loss), before tax			32,998				63,790				41,522				138,159
Deferred tax expense (benefit) related to other comprehensive income			11,550				22,326				14,533				48,356
Other comprehensive income (loss), net of tax			21,448				41,464				26,989				89,803
Comprehensive income		$	80,117			$	95,971			$	204,753			$	251,924

See Notes to Consolidated Financial Statements.

 

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Cullen/Frost Bankers, Inc.

Consolidated Statements of Changes in Shareholders’ Equity

(Dollars in thousands, except per share amounts)

 

		Nine Months Ended September 30,
		2012				2011
Total shareholders’ equity at beginning of period		$	2,283,537			$	2,061,680
Net income			177,764				162,121
Other comprehensive income			26,989				89,803
Stock option exercises (197,961 shares in 2012 and 144,203 shares in 2011)			10,092				7,239
Stock compensation expense recognized in earnings			7,942				10,016
Tax benefits (deficiencies) related to stock compensation			(425	)			304
Purchase of treasury stock (29,823 shares in 2011)			—				(1,657	)
Common stock issued/sold to the 401(k) stock purchase plan (22,680 shares in 2011)			—				1,360
Cash dividends ($1.42 per share in 2012 and $1.37 per share in 2011)			(87,282	)			(83,990	)
Total shareholders’ equity at end of period		$	2,418,617			$	2,246,876

See Notes to Consolidated Financial Statements.

 

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Cullen/Frost Bankers, Inc.

Consolidated Statements of Cash Flows

(Dollars in thousands)

 

		Nine Months Ended September 30,
		2012				2011
Operating Activities:
Net income		$	177,764			$	162,121
Adjustments to reconcile net income to net cash from operating activities:
Provision for loan losses			5,955				27,445
Deferred tax expense (benefit)			(5,020	)			(137	)
Accretion of loan discounts			(8,321	)			(9,865	)
Securities premium amortization (discount accretion), net			14,952				7,590
Net (gain) loss on securities transactions			121				(6,414	)
Depreciation and amortization			28,374				28,082
Net loss on sale/write-down of assets/foreclosed assets			4,182				4,240
Stock-based compensation			7,942				10,016
Net tax benefit (deficiency) from stock-based compensation			(535	)			(89	)
Excess tax benefits from stock-based compensation			(110	)			(393	)
Earnings on life insurance policies			(3,042	)			(2,977	)
Net change in:
Trading account securities			(1,214	)			(722	)
Accrued interest receivable and other assets			53,120				41,588
Accrued interest payable and other liabilities			(4,945	)			(1,145	)
Net cash from operating activities			269,223				259,340
Investing Activities:
Securities held to maturity:
Purchases			—				(83,184	)
Maturities, calls and principal repayments			766				464
Securities available for sale:
Purchases			(17,484,661	)			(6,195,375	)
Sales			15,987,480				5,587,391
Maturities, calls and principal repayments			617,489				587,650
Net change in loans			(823,627	)			(17,748	)
Net cash paid in acquisitions			(7,199	)			(1,044	)
Proceeds from sales of premises and equipment			3,765				1,256
Purchases of premises and equipment			(19,724	)			(23,266	)
Proceeds from sales of repossessed properties			10,715				11,825
Net cash from investing activities			(1,714,996	)			(132,031	)
Financing Activities:
Net change in deposits			1,488,449				1,584,531
Net change in short-term borrowings			(120,998	)			182,573
Principal payments on long-term borrowings			(14	)			(150,014	)
Proceeds from stock option exercises			10,092				7,239
Excess tax benefits from stock-based compensation			110				393
Purchase of treasury stock			—				(1,657	)
Cash dividends paid			(87,282	)			(83,990	)
Net cash from financing activities			1,290,357				1,539,075
Net change in cash and cash equivalents			(155,416	)			1,666,384
Cash and equivalents at beginning of period			2,907,592				2,820,977
Cash and equivalents at end of period		$	2,752,176			$	4,487,361

See Notes to Consolidated Financial Statements.

 

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Cullen/Frost Bankers, Inc.

Notes to Consolidated Financial Statements

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

Note 1 - Significant Accounting Policies

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

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

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

Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates. The allowance for loan losses, the fair value of stock-based compensation awards, the fair values of financial instruments and the status of contingencies are particularly subject to change.

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

 

		Nine Months Ended September 30,
		2012				2011
Cash paid for interest		$	22,913			$	39,809
Cash paid for income tax			38,761				35,612
Significant non-cash transactions:
Loans foreclosed and transferred to other real estate owned and foreclosed assets			5,336				16,803
Loans to facilitate the sale of other real estate owned			—				75
Common stock/treasury stock issued to the Corporation’s 401(k) stock purchase plan			—				1,360

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

 

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Note 2 - Securities

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

 

		September 30, 2012																December 31, 2011
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value				Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
Held to Maturity
U. S. Treasury		$	248,088			$	31,892			$	—			$	279,980			$	247,797			$	31,715			$	—			$	279,512
Residential mortgage-backed securities			11,074				360				—				11,434				11,874				153				—				12,027
States and political subdivisions			104,835				12,009				—				116,844				105,325				6,597				—				111,922
Other			1,000				—				—				1,000				1,000				—				—				1,000
Total		$	364,997			$	44,261			$	—			$	409,258			$	365,996			$	38,465			$	—			$	404,461
Available for Sale:
U. S. Treasury		$	3,019,622			$	41,930			$	—			$	3,061,552			$	2,020,621			$	36,111			$	—			$	2,056,732
U.S. government agencies/corporations			250,000				145				—				250,145				250,000				884				—				250,884
Residential mortgage-backed securities			2,587,218				164,665				—				2,751,883				3,135,064				154,386				180				3,289,270
States and political subdivisions			2,412,514				205,676				12				2,618,178				1,996,703				158,133				23				2,154,813
Other			35,887				—				—				35,887				38,001				—				—				38,001
Total		$	8,305,241			$	412,416			$	12			$	8,717,645			$	7,440,389			$	349,514			$	203			$	7,789,700

All mortgage-backed securities included in the above table were issued by U.S. government agencies and corporations. At September 30, 2012, approximately 99% of the securities in the Corporation’s municipal bond portfolio were issued by political subdivisions or agencies within the State of Texas, of which approximately 84% are either guaranteed by the Texas Permanent School Fund, which has a “triple-A” insurer financial strength, or secured by U.S. Treasury securities via defeasance of the debt by the issuers. Securities with limited marketability, such as stock in the Federal Reserve Bank and the Federal Home Loan Bank, are carried at cost and are reported as other available for sale securities in the above table. The carrying value of securities pledged to secure public funds, trust deposits, repurchase agreements and for other purposes, as required or permitted by law was $2.2 billion at September 30, 2012 and $2.4 billion at December 31, 2011.

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

 

		Less than 12 Months								More than 12 Months								Total
		Estimated Fair Value				Unrealized Losses				Estimated Fair Value				Unrealized Losses				Estimated Fair Value				Unrealized Losses
Available for Sale
States and political subdivisions		$	16,761			$	12			$	—			$	—			$	16,761			$	12

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

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

 

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

 

		Held to Maturity								Available for Sale
		Amortized Cost				Estimated Fair Value				Amortized Cost				Estimated Fair Value
Due in one year or less		$	1,000			$	1,000			$	635,154			$	638,634
Due after one year through five years			248,088				279,980				2,900,392				2,949,445
Due after five years through ten years			3,301				3,672				215,664				234,329
Due after ten years			101,534				113,172				1,930,926				2,107,467
Residential mortgage-backed securities			11,074				11,434				2,587,218				2,751,883
Equity securities			—				—				35,887				35,887
Total		$	364,997			$	409,258			$	8,305,241			$	8,717,645

Sales of securities available for sale were as follows:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2012				2011				2012				2011
Proceeds from sales		$	—			$	39,005			$	15,987,480			$	5,587,391
Gross realized gains			—				6,409				2,508				6,418
Gross realized losses			—				—				(2,629	)			4
Tax (expense) benefit of securities gains/losses			—				(2,243	)			42				(2,245	)

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

 

		September 30, 2012				December 31, 2011
U.S. Treasury		$	13,761			$	13,609
States and political subdivisions			1,062				—
Total		$	14,823			$	13,609

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

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2012				2011				2012				2011
Net gain on sales transactions		$	310			$	303			$	932			$	772
Net mark-to-market gains (losses)			22				4				(57	)			11
Net gain on trading account securities		$	332			$	307			$	875			$	783

 

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Note 3 – Loans

Loans were as follows:

 

		September 30, 2012				Percentage of Total				December 31, 2011				Percentage of Total				September 30, 2011				Percentage of Total
Commercial and industrial:
Commercial		$	4,055,807				46.0	%		$	3,553,989				44.5	%		$	3,571,807				44.2	%
Leases			247,210				2.8				193,412				2.4				184,614				2.3
Asset-based			183,284				2.1				169,466				2.1				175,120				2.1
Total commercial and industrial			4,486,301				50.9				3,916,867				49.0				3,931,541				48.6
Commercial real estate:
Commercial mortgages			2,455,488				27.9				2,383,479				29.8				2,370,871				29.3
Construction			584,207				6.6				434,870				5.5				508,182				6.3
Land			210,440				2.4				202,478				2.5				214,436				2.6
Total commercial real estate			3,250,135				36.9				3,020,827				37.8				3,093,489				38.2
Consumer real estate:
Home equity loans			295,735				3.4				282,244				3.5				277,284				3.4
Home equity lines of credit			188,993				2.1				191,960				2.4				190,958				2.4
1-4 family residential mortgages			39,836				0.4				45,943				0.6				47,455				0.6
Construction			18,057				0.2				17,544				0.2				17,965				0.2
Other			225,861				2.6				225,118				2.8				233,053				2.9
Total consumer real estate			768,482				8.7				762,809				9.5				766,715				9.5
Total real estate			4,018,617				45.6				3,783,636				47.3				3,860,204				47.7
Consumer and other:
Consumer installment			311,898				3.5				301,518				3.8				299,417				3.7
Other			13,694				0.2				11,018				0.1				14,926				0.2
Total consumer and other			325,592				3.7				312,536				3.9				314,343				3.9
Unearned discounts			(19,470	)			(0.2	)			(17,910	)			(0.2	)			(16,511	)			(0.2	)
Total loans		$	8,811,040				100.0	%		$	7,995,129				100.0	%		$	8,089,577				100.0	%

Loan Origination/Risk Management. The Corporation has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined that the borrower’s management possesses sound ethics and solid business acumen, the Corporation’s management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Corporation’s commercial real estate portfolio are diverse in terms of type and geographic location. This diversity helps reduce the Corporation’s exposure to adverse economic events that affect any single market or industry. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. As a general rule, the Corporation avoids financing single-purpose

 

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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 September 30, 2012, approximately 56.2% of the outstanding principal balance of the Corporation’s commercial real estate loans were secured by owner-occupied properties.

With respect to loans to developers and builders that are secured by non-owner occupied properties that the Corporation may originate from time to time, the Corporation generally requires the borrower to have had an existing relationship with the Corporation and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the completed project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Corporation until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

The Corporation originates consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed, jointly by line and staff personnel. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a regular basis. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements.

The Corporation maintains an independent loan review department that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to management. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Corporation’s policies and procedures.

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

Foreign Loans. The Corporation has U.S. dollar denominated loans and commitments to borrowers in Mexico. The outstanding balance of these loans and the unfunded amounts available under these commitments were not significant at September 30, 2012 or December 31, 2011.

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

 

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

 

		September 30, 2012				December 31, 2011				September 30, 2011
Commercial and industrial:
Energy		$	—			$	—			$	—
Other commercial			52,819				43,874				58,208
Commercial real estate:
Buildings, land and other			48,674				43,820				45,333
Construction			1,144				1,329				1,821
Consumer real estate			3,069				4,587				4,060
Consumer and other			701				728				756
Total		$	106,407			$	94,338			$	110,178

Had non-accrual loans performed in accordance with their original contract terms, the Corporation would have recognized additional interest income, net of tax, of approximately $646 thousand and $1.9 million for the three and nine months ended September 30, 2012, compared to $823 thousand and $2.6 million for the three and nine months ended September 30, 2011.

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

 

		Loans 30-89 Days Past Due				Loans 90 or More Days Past Due				Total Past Due Loans				Current Loans				Total Loans				Accruing Loans 90 or More Days Past Due
Commercial and industrial:
Energy		$	63			$	—			$	63			$	1,130,840			$	1,130,903			$	—
Other commercial			16,378				17,792				34,170				3,321,228				3,355,398				5,793
Commercial real estate:
Buildings, land and other			14,668				11,547				26,215				2,639,713				2,665,928				400
Construction			467				—				467				583,740				584,207				—
Consumer real estate			7,458				3,162				10,620				757,862				768,482				1,720
Consumer and other			4,147				579				4,726				320,866				325,592				537
Unearned discounts			—				—				—				(19,470	)			(19,470	)			—
Total		$	43,181			$	33,080			$	76,261			$	8,734,779			$	8,811,040			$	8,450

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

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

 

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

 

		Unpaid Contractual Principal Balance				Recorded Investment With No Allowance				Recorded Investment With Allowance				Total Recorded Investment				Related Allowance				Average  Recorded Investment
																						Quarter To Date				Year To Date
September 30, 2012
Commercial and industrial:
Energy		$	—			$	—			$	—			$	—			$	—			$	—			$	—
Other commercial			61,081				37,231				11,845				49,076				4,059				44,140				43,087
Commercial real estate:
Buildings, land and other			54,690				39,691				6,401				46,092				823				42,569				41,283
Construction			1,515				1,144				—				1,144				—				1,671				1,465
Consumer real estate			974				894				—				894				—				1,087				1,805
Consumer and other			443				420				—				420				—				430				487
Total		$	118,703			$	79,380			$	18,246			$	97,626			$	4,882			$	89,897			$	88,127
December 31, 2011
Commercial and industrial:
Energy		$	—			$	—			$	—			$	—			$	—			$	—			$	—
Other commercial			57,723				34,712				4,619				39,331				2,696				46,151				53,830
Commercial real estate:
Buildings, land and other			51,163				38,686				2,243				40,929				1,113				41,522				48,635
Construction			1,568				1,281				—				1,281				—				1,527				4,339
Consumer real estate			2,499				1,719				751				2,470				95				2,484				1,845
Consumer and other			562				554				—				554				—				561				265
Total		$	113,515			$	76,952			$	7,613			$	84,565			$	3,904			$	92,245			$	108,914
September 30, 2011
Commercial and industrial:
Energy		$	—			$	—			$	—			$	—			$	—			$	—			$	—
Other commercial			79,327				42,583				10,387				52,970				6,883				60,696				57,455
Commercial real estate:
Buildings, land and other			52,193				34,267				7,848				42,115				1,283				44,453				50,562
Construction			2,162				1,773				—				1,773				—				2,265				5,104
Consumer real estate			2,510				2,498				—				2,498				—				2,227				1,689
Consumer and other			568				568				—				568				—				335				193
Total		$	136,760			$	81,689			$	18,235			$	99,924			$	8,166			$	109,976			$	115,003

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

During the nine months ended September 30, 2012, the Corporation had one troubled debt restructuring. The troubled debt restructuring related to an other commercial and industrial loan which had a restructuring date balance of $445 thousand. During the nine months ended September 30, 2011, the Corporation had troubled debt restructurings with an aggregate restructuring date balance of $9.1 million (including $7.5 million related to commercial real estate – buildings, land and other; $969 thousand related to consumer real estate; $469 thousand related to consumer and $191 thousand related to commercial and industrial – other). All of the loans identified as troubled debt restructurings by the Corporation during the reported periods were previously on non-accrual status and reported as impaired loans prior to restructuring. The modifications primarily related to extending the amortization periods of the loans. The Corporation did not grant interest-rate concessions on any restructured loan. All loans restructured during the reported periods were on non-accrual status as of the end of those periods. Because the loans were classified and on non-accrual status both before and after restructuring, the modifications did not impact the Corporation’s determination of the allowance for loan losses. During the nine months ended September 30, 2012, defaults on loans restructured during 2011 were not significant and such defaults did not significantly impact the Corporation’s determination of the allowance for loan losses.

 

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

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

 

•

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

 

•

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

 

•

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

 

•

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

 

•

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

 

•

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

 

•

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

 

•

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

 

•

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

 

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

 

		September 30, 2012								December 31, 2011								September 30, 2011
		Weighted Average Risk Grade				Loans				Weighted Average Risk Grade				Loans				Weighted Average Risk Grade				Loans
Commercial and industrial:
Energy
Risk grades 1-8			5.36			$	1,128,700				5.21			$	868,561				5.18			$	912,728
Risk grade 9			9.00				2,203				9.00				2,025				9.00				1,419
Risk grade 10			10.00				—				10.00				—				10.00				—
Risk grade 11			11.00				—				11.00				—				11.00				—
Risk grade 12			12.00				—				12.00				—				12.00				—
Risk grade 13			13.00				—				13.00				—				13.00				—
Total energy			5.37			$	1,130,903				5.22			$	870,586				5.19			$	914,147
Other commercial
Risk grades 1-8			6.05			$	3,110,022				6.20			$	2,802,037				6.20			$	2,687,564
Risk grade 9			9.00				83,799				9.00				55,105				9.00				94,687
Risk grade 10			10.00				44,530				10.00				49,982				10.00				52,753
Risk grade 11			11.00				61,845				11.00				96,046				11.00				124,603
Risk grade 12			12.00				50,670				12.00				39,826				12.00				47,875
Risk grade 13			13.00				4,532				13.00				3,285				13.00				9,912
Total other commercial			6.37			$	3,355,398				6.55			$	3,046,281				6.67			$	3,017,394
Commercial real estate:
Buildings, land and other
Risk grades 1-8			6.64			$	2,397,984				6.69			$	2,266,576				6.65			$	2,259,305
Risk grade 9			9.00				102,689				9.00				103,894				9.00				91,035
Risk grade 10			10.00				31,755				10.00				45,278				10.00				72,975
Risk grade 11			11.00				83,818				11.00				126,594				11.00				116,659
Risk grade 12			12.00				48,859				12.00				41,747				12.00				42,391
Risk grade 13			13.00				823				13.00				1,868				13.00				2,942
Total commercial real estate			7.01			$	2,665,928				7.14			$	2,585,957				7.12			$	2,585,307
Construction
Risk grades 1-8			6.92			$	548,019				6.95			$	378,530				6.98			$	439,502
Risk grade 9			9.00				31,366				9.00				30,376				9.00				30,358
Risk grade 10			10.00				1,754				10.00				16,186				10.00				28,255
Risk grade 11			11.00				1,924				11.00				8,449				11.00				8,246
Risk grade 12			12.00				1,144				12.00				1,329				12.00				1,821
Risk grade 13			13.00				—				13.00				—				13.00				—
Total construction			7.06			$	584,207				7.30			$	434,870				7.35			$	508,182

The Corporation has established maximum loan to value standards to be applied during the origination process of commercial and consumer real estate loans. The Corporation does not subsequently monitor loan-to-value ratios (either individually or on a weighted-average basis) for loans that are subsequently considered to be of a pass grade (grades 9 or better) and/or current with respect to principal and interest payments. As stated above, when an individual commercial real estate loan has a calculated risk grade of 10 or higher, a special assets officer analyzes the loan to determine whether the loan is impaired. At that time, the Corporation reassesses the loan to value position in the loan. If the loan is determined to be collateral dependent, specific allocations of the allowance for loan losses are made for the amount of any collateral deficiency. If a collateral deficiency is ultimately deemed to be uncollectible, the amount is charged-off. These loans and related assessments of collateral position are monitored on an individual, case-by-case basis. The Corporation does not monitor loan-to-value ratios on a weighted-average basis for commercial real estate loans having a calculated risk grade of 10 or higher. Nonetheless, there were three commercial real estate loans having a calculated risk grade of 10 or higher in excess of $5 million as of September 30, 2012, which totaled $31.8 million and had a weighted-average loan-to-value ratio of

 

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68.0%. When an individual consumer real estate loan becomes past due by more than 10 days, the assigned relationship manager will begin collection efforts. The Corporation only reassesses the loan to value position in a consumer real estate loan if, during the course of the collection process, it is determined that the loan has become collateral dependent, and any collateral deficiency is recognized as a charge-off to the allowance for loan losses. Accordingly, the Corporation does not monitor loan-to-value ratios on a weighted-average basis for collateral dependent consumer real estate loans.

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

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

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2012				2011				2012				2011
Commercial and industrial:
Energy		$	—			$	1			$	4			$	5
Other commercial			(4,656	)			(13,602	)			(9,511	)			(25,154	)
Commercial real estate:
Buildings, land and other			2,678				(1,162	)			811				(8,689	)
Construction			14				(121	)			36				(473	)
Consumer real estate			(156	)			(750	)			(441	)			(1,642	)
Consumer and other			(627	)			(684	)			(1,600	)			(2,375	)
Total		$	(2,747	)		$	(16,318	)		$	(10,701	)		$	(38,328	)

In assessing the general economic conditions in the State of Texas, management monitors and tracks the Texas Leading Index (“TLI”), which is produced by the Federal Reserve Bank of Dallas. The TLI is a single summary statistic that is designed to signal the likelihood of the Texas economy’s transition from expansion to recession and vice versa. Management believes this index provides a reliable indication of the direction of overall credit quality. The TLI is a composite of the following eight leading indicators: (i) Texas Value of the Dollar, (ii) U.S. Leading Index, (iii) real oil prices (iv) well permits, (v) initial claims for unemployment insurance, (vi) Texas Stock Index, (vii) Help-Wanted Index and (viii) average weekly hours worked in manufacturing. The TLI totaled 122.2 at July 31, 2012 (most recent date available), 120.3 at December 31, 2011 and 118.3 at September 30, 2011. A higher TLI value implies more favorable economic conditions.

Allowance for Loan Losses. The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Corporation’s allowance for loan loss methodology follows the accounting guidance set forth in U.S. generally accepted accounting principles and the Interagency Policy Statement on the Allowance for Loan and Lease Losses, which was jointly issued by the U.S. bank regulatory agencies. In that regard, the Corporation’s allowance for loan losses includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Corporation’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans or loan pools.

 

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The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss and recovery experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate determination of the appropriate level of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including, among other things, the performance of the Corporation’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. The Corporation monitors whether or not the allowance for loan loss allocation model, as a whole, calculates an appropriate level of allowance for loan losses that moves in direct correlation to the general macroeconomic and loan portfolio conditions the Corporation experiences over time.

The Corporation’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with ASC Topic 310 based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with ASC Topic 450 based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with ASC Topic 450 based on general economic conditions and other risk factors both internal and external to the Corporation.

The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. This analysis is performed at the relationship manager level for all commercial loans. When a loan has a calculated grade of 10 or higher, a special assets officer analyzes the loan to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for loan losses to the loan. Specific valuation allowances are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, the relative risk grade of the loan and economic conditions affecting the borrower’s industry, among other things.

Historical valuation allowances are calculated based on the historical gross loss experience of specific types of loans and the internal risk grade of such loans at the time they were charged-off. The Corporation calculates historical gross loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool. The historical gross loss ratios are periodically updated based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical gross loss ratio and the total dollar amount of the loans in the pool. The Corporation’s pools of similar loans include similarly risk-graded groups of commercial and industrial loans, commercial real estate loans, consumer real estate loans and consumer and other loans.

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

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

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

 

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

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

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

 

		Commercial and Industrial				Commercial Real Estate				Consumer Real Estate				Consumer and Other				Unallocated				Total
September 30, 2012
Historical valuation allowances		$	30,785			$	15,455			$	3,010			$	7,479			$	—			$	56,729
Specific valuation allowances			4,059				823				—				—				—				4,882
General valuation allowances:
Environmental risk adjustment			6,018				3,722				702				1,924				—				12,366
Distressed industries			4,998				1,173				—				—				—				6,171
Excessive industry concentrations			3,469				3,229				—				—				—				6,698
Large relationship concentrations			1,419				1,030				—				—				—				2,449
Highly-leveraged credit relationships			3,656				1,055				—				—				—				4,711
Policy exceptions			—				—				—				—				2,319				2,319
Credit and collateral exceptions			—				—				—				—				1,582				1,582
Loans not reviewed by concurrence			2,235				2,446				2,370				1,183				—				8,234
Adjustment for recoveries			(5,097	)			(1,292	)			(688	)			(6,684	)			—				(13,761	)
General macroeconomic risk			—				—				—				—				13,021				13,021
Total		$	51,542			$	27,641			$	5,394			$	3,902			$	16,922			$	105,401
December 31, 2011
Historical valuation allowances		$	30,368			$	15,153			$	2,742			$	9,876			$	—			$	58,139
Specific valuation allowances			2,696				1,113				95				—				—				3,904
General valuation allowances:
Environmental risk adjustment			5,656				3,724				703				2,759				—				12,842
Distressed industries			4,054				922				—				—				—				4,976
Excessive industry concentrations			—				—				—				—				6,995				6,995
Large relationship concentrations			—				—				—				—				2,232				2,232
Highly-leveraged credit relationships			—				—				—				—				3,530				3,530
Policy exceptions			—				—				—				—				2,121				2,121
Credit and collateral exceptions			—				—				—				—				1,603				1,603
Loans not reviewed by concurrence			—				—				—				—				9,030				9,030
Adjustment for recoveries			—				—				—				—				(13,071	)			(13,071	)
General macroeconomic risk			—				—				—				—				17,846				17,846
Total		$	42,774			$	20,912			$	3,540			$	12,635			$	30,286			$	110,147

 

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

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

 

		Commercial and Industrial				Commercial Real Estate				Consumer Real Estate				Consumer and Other				Unallocated				Total
Three months ended:
September 30, 2012
Beginning balance		$	53,475			$	27,631			$	5,235			$	3,649			$	15,658			$	105,648
Provision for loan losses			2,723				(2,682	)			315				880				1,264				2,500
Charge-offs			(5,837	)			(520	)			(209	)			(2,391	)			—				(8,957	)
Recoveries			1,181				3,212				53				1,764				—				6,210
Net (charge-offs) recoveries			(4,656	)			2,692				(156	)			(627	)			—				(2,747	)
Ending balance		$	51,542			$	27,641			$	5,394			$	3,902			$	16,922			$	105,401
September 30, 2011
Beginning balance		$	56,566			$	20,901			$	3,683			$	12,611			$	28,980			$	122,741
Provision for loan losses			3,920				1,194				513				880				2,503				9,010
Charge-offs			(15,084	)			(1,689	)			(834	)			(2,359	)			—				(19,966	)
Recoveries			1,483				406				84				1,675				—				3,648
Net charge-offs			(13,601	)			(1,283	)			(750	)			(684	)			—				(16,318	)
Ending balance		$	46,885			$	20,812			$	3,446			$	12,807			$	31,483			$	115,433
Nine months ended:
September 30, 2012
Beginning balance		$	42,774			$	20,912			$	3,540			$	12,635			$	30,286			$	110,147
Provision for loan losses			18,275				5,882				2,295				(7,133	)			(13,364	)			5,955
Charge-offs			(13,323	)			(3,715	)			(1,104	)			(6,605	)			—				(24,747	)
Recoveries			3,816				4,562				663				5,005				—				14,046
Net (charge-offs) recoveries			(9,507	)			847				(441	)			(1,600	)			—				(10,701	)
Ending balance		$	51,542			$	27,641			$	5,394			$	3,902			$	16,922			$	105,401
September 30, 2011
Beginning balance		$	57,789			$	28,534			$	3,223			$	11,974			$	24,796			$	126,316
Provision for loan losses			14,245				1,440				1,865				3,208				6,687				27,445
Charge-offs			(28,258	)			(10,261	)			(2,113	)			(7,058	)			—				(47,690	)
Recoveries			3,109				1,099				471				4,683				—				9,362
Net charge-offs			(25,149	)			(9,162	)			(1,642	)			(2,375	)			—				(38,328	)
Ending balance		$	46,885			$	20,812			$	3,446			$	12,807			$	31,483			$	115,433

 

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The following table details the amount of the allowance for loan losses allocated to each portfolio segment as of September 30, 2012, December 31, 2011 and September 30, 2011, detailed on the basis of the impairment methodology used by the Corporation.

 

		Commercial and Industrial				Commercial Real Estate				Consumer Real Estate				Consumer and Other				Unallocated				Total
September 30, 2012
Loans individually evaluated for impairment		$	14,301			$	2,149			$	—			$	—			$	—			$	16,450
Loans collectively evaluated for impairment			37,241				25,492				5,394				3,902				16,922				88,951
Balance at September 30, 2012		$	51,542			$	27,641			$	5,394			$	3,902			$	16,922			$	105,401
December 31, 2011
Loans individually evaluated for impairment		$	15,829			$	3,625			$	95			$	—			$	—			$	19,549
Loans collectively evaluated for impairment			26,945				17,287				3,445				12,635				30,286				90,598
Balance at December 31, 2011		$	42,774			$	20,912			$	3,540			$	12,635			$	30,286			$	110,147
September 30, 2011
Loans individually evaluated for impairment		$	23,263			$	4,075			$	—			$	—			$	—			$	27,338
Loans collectively evaluated for impairment			23,622				16,737				3,446				12,807				31,483				88,095
Balance at September 30, 2011		$	46,885			$	20,812			$	3,446			$	12,807			$	31,483			$	115,433

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

 

		Commercial and Industrial				Commercial Real Estate				Consumer Real Estate				Consumer and Other				Unearned Discounts				Total
September 30, 2012
Loans individually evaluated for impairment		$	161,577			$	170,077			$	894			$	420			$	—			$	332,968
Loans collectively evaluated for impairment			4,324,724				3,080,058				767,588				325,172				(19,470	)			8,478,072
Ending balance		$	4,486,301			$	3,250,135			$	768,482			$	325,592			$	(19,470	)		$	8,811,040
December 31, 2011
Loans individually evaluated for impairment		$	189,139			$	241,451			$	2,470			$	554			$	—			$	433,614
Loans collectively evaluated for impairment			3,727,728				2,779,376				760,339				311,982				(17,910	)			7,561,515
Ending balance		$	3,916,867			$	3,020,827			$	762,809			$	312,536			$	(17,910	)		$	7,995,129
September 30, 2011
Loans individually evaluated for impairment		$	235,143			$	273,289			$	—			$	—			$	—			$	508,432
Loans collectively evaluated for impairment			3,696,398				2,820,200				766,715				314,343				(16,511	)			7,581,145
Ending balance		$	3,931,541			$	3,093,489			$	766,715			$	314,343			$	(16,511	)		$	8,089,577

 

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Note 4 - Goodwill and Other Intangible Assets

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

 

		September 30, 2012				December 31, 2011
Goodwill		$	535,509			$	528,072
Other intangible assets:
Core deposits		$	5,990			$	8,234
Customer relationship			2,433				2,113
Non-compete agreements			643				257
		$	9,066			$	10,604

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

 

Remainder of 2012		$	919
2013			3,115
2014			2,270
2015			1,490
2016			777
Thereafter			495
		$	9,066

Note 5 - Deposits

Deposits were as follows:

 

		September 30, 2012				Percentage of Total				December 31, 2011				Percentage of Total				September 30, 2011				Percentage of Total
Non-interest-bearing demand deposits:
Commercial and individual		$	6,907,201				37.9	%		$	5,848,840				34.9	%		$	5,759,723				35.8	%
Correspondent banks			350,895				1.9				370,275				2.2				350,082				2.2
Public funds			462,834				2.5				453,440				2.7				431,434				2.7
Total non-interest-bearing demand deposits			7,720,930				42.3				6,672,555				39.8				6,541,239				40.7
Interest-bearing deposits:
Private accounts:
Savings and interest checking			3,198,939				17.5				2,912,937				17.4				2,579,745				16.1
Money market accounts			5,906,083				32.4				5,664,780				33.8				5,469,492				34.0
Time accounts of $100,000 or more			535,308				3.0				533,682				3.2				581,192				3.6
Time accounts under $100,000			477,168				2.6				522,887				3.1				546,583				3.4
Total private accounts			10,117,498				55.5				9,634,286				57.5				9,177,012				57.1
Public funds:
Savings and interest checking			224,427				1.2				265,747				1.6				164,183				1.0
Money market accounts			49,709				0.3				44,590				0.3				46,099				0.3
Time accounts of $100,000 or more			129,843				0.7				136,422				0.8				132,657				0.9
Time accounts under $100,000			2,790				—				3,148				—				2,683				—
Total public funds			406,769				2.2				449,907				2.7				345,622				2.2
Total interest-bearing deposits			10,524,267				57.7				10,084,193				60.2				9,522,634				59.3
Total deposits		$	18,245,197				100.0	%		$	16,756,748				100.0	%		$	16,063,873				100.0	%

 

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

 

		September 30, 2012				December 31, 2011				September 30, 2011
Money market deposits obtained through brokers		$	—			$	24,500			$	28,246
Deposits from the Certificate of Deposit Account Registry Service (CDARS) deposits			9,399				45,005				60,979
Deposits from foreign sources (primarily Mexico)			787,304				744,669				729,933

Note 6 - Commitments and Contingencies

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

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

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

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

 

		September 30, 2012				December 31, 2011
Commitments to extend credit		$	5,569,362			$	5,147,363
Standby letters of credit			195,216				235,903
Deferred standby letter of credit fees			1,305				1,488

Lease Commitments. The Corporation leases certain office facilities and office equipment under operating leases. Rent expense for all operating leases totaled $5.9 million and $16.9 million during the three and nine months ended September 30, 2012 and $5.3 million and $16.1 million during the three and nine months ended September 30, 2011. There has been no significant change in the future minimum lease payments payable by the Corporation since December 31, 2011. See the 2011 Form 10-K for information regarding these commitments.

Litigation. The Corporation is subject to various claims and legal actions that have arisen in the course of conducting business. Management does not expect the ultimate disposition of these matters to have a material adverse impact on the Corporation’s financial statements.

 

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Note 7 - Regulatory Matters

Regulatory Capital Requirements. Banks and bank holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.

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

Cullen/Frost’s and Frost Bank’s Tier 1 capital consists of shareholders’ equity excluding unrealized gains and losses on securities available for sale, the accumulated gain or loss on effective cash flow hedging derivatives, the net actuarial gain/loss on the Corporation’s defined benefit post-retirement benefit plans, goodwill and other intangible assets. Tier 1 capital for Cullen/Frost also includes $120 million of trust preferred securities issued by its unconsolidated subsidiary trust. Cullen/Frost’s and Frost Bank’s total capital is comprised of Tier 1 capital for each entity plus a permissible portion of the allowance for loan losses. The Corporation’s aggregate $100 million of floating rate subordinated notes are not included in Tier 1 capital but the permissible portion (which decreases 20% per year during the final five years of the term of the notes) totaling $80 million at September 30, 2012, is included in total capital of Cullen/Frost.

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

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

 

		Actual								Minimum Required for Capital Adequacy Purposes								Required to be Considered Well Capitalized
		Capital Amount				Ratio				Capital Amount				Ratio				Capital Amount				Ratio
September 30, 2012
Total Capital to Risk-Weighted Assets
Cullen/Frost		$	1,912,550				15.62	%		$	979,742				8.00	%		$	1,224,678				10.00	%
Frost Bank			1,705,199				13.93				979,294				8.00				1,224,117				10.00
Tier 1 Capital to Risk-Weighted Assets
Cullen/Frost			1,727,149				14.10				489,871				4.00				734,807				6.00
Frost Bank			1,599,798				13.07				489,647				4.00				734,470				6.00
Leverage Ratio
Cullen/Frost			1,727,149				8.59				804,371				4.00				1,005,464				5.00
Frost Bank			1,599,798				7.96				803,878				4.00				1,004,848				5.00
December 31, 2011
Total Capital to Risk-Weighted Assets
Cullen/Frost