ANNUAL REPORT LONE STAR NATIONAL BANCSHARES-TEXAS, INC.

Transcription

1 11 ANNUAL REPORT LONE STAR NATIONAL BANCSHARES-TEXAS, INC.

2 Our Mission Statement The mission of Lone Star National Bank is to be the premier, independent community bank in South Texas by providing the following to our Stakeholders: Customers: Value-added quality sales and service; Employees: Providing a rewarding work environment with opportunities for advancement; Community: Helping our communities to grow, and serving them with pride and integrity; Shareholders: Providing a high rate of return consistent with a high performing bank.

3 4 Letter to Shareholders, Customers & Friends 7 Financial Highlights 8 12 Management s Discussion and Analysis of Financial Conditions and Results of Operations Management s Report on Responsibility for Financial Reporting Independent Auditor s Report Board of Directors Advisory Directors Bank Officers Banking Centers, Mortgage & ATM Locations 57 Our History

4 We deeply value our personal relationship with you. We will never take it for granted. A. Jabier Rodriguez Chief Executive Officer

5 Letter to Our Shareholders, Customers and Friends The financial industry rebounded after four (4) of the most difficult years that the banking industry has ever experienced. We emerged much wiser and committed to implement company-wide Enterprise Risk Management processes in every decision that we make. Our focus is to keep Enterprise Risk at lowto-moderate levels and Rewards at moderate to high return levels. The Business Model for safe and sound Community Banks has changed to one that is based less on credit income and more on non-interest income, with a high level of efficiency. This is due, in part, to the effects of the recession and its long term recovery. The Dodd-Frank Financial Reform Bill that was signed into law, has restricted non-sufficient item charges and debit card fees, causing Banks to reduce the payment of non-sufficient checks and negatively impacting Non- Interest Income. The Dodd-Frank Financial Reform Bill also changes virtually every consumer regulation, whether or not it is related to Mortgages. Time will tell if it has any value to consumers, through the creation of a Consumer Protection Financial Agency, but it will take one (1) or two (2) generations to determine. We only know that it cannot avoid another financial crisis. The Dodd-Frank Financial Reform Bill has brought sweeping changes in the way government regulates the financial in- dustry. The increased oversight includes increased levels of Equity Capital and Allowance for Credit Losses to meet regulatory requirements. The capital ratios required, for banks, have increased from 6% to a general range of 9.5%. The allowance from 1% to a general range of 2.5%. These new levels resulted in an increase of capital and allowance, totalling $96.5 Million Dollars for Lone Star National Bank as follows: Capital: 6% to 9.5% = +3.5% Allowance: 1% to 2.5% = +1.5% Total Assets: $2.2 Billion x 3.5% = $77.0 Million Total Loans: $1.3 Billion x 1.5% = $19.5 Million Total Required Increase In Capital: $96.5 Million As of December 31, 2011, Lone Star National Bancshares - Texas, Inc. has $208 Million in Equity Capital and $31 Million in Allowances for Loan Losses, representing Equity Capital to Total Assets of 9.53% and the Allowance for Loan Losses to Total Loans ratio of 2.48%, clearly meeting Per Share Data Book Value $23.05 $26.37 $28.47 $29.57 $32.88 Shareholders Equity (Dollars in Millions) 07 $ $ $ $ $208 4 l 2011 Annual Report

6 these new guidelines. The increased levels of Capital, now required, has caused bank returns to be lowered significantly. Our Return on Average Assets of.98% and Return on Average Equity of 11.02% for 2011, far exceeded the Return on Average Assets of.61% and 6.16% Return on Average Equity for our Peer Group as of December 31, The lower volume of loans creating higher levels of liquidity, together with low rates has also served to reduce shareholder returns. For the year ending December 31, 2011, Total Assets grew $92 Million to $2.2 Billion, Loans grew $28 Million to $1.3 Billion and Deposits grew $87 Million to $1.8 Billion. The total number of banking centers grew to 31, including three (3) new centers in the Rio Grande Valley and two (2) new centers in San Antonio, to bring the total in San Antonio to four (4) centers, with at least two (2) more planned for Total Assets in San Antonio reached $73 Million, as of December 31, Revenue from Interest Income increased from $94 Million to $98 Million and Non-Interest Income increased from $18 Million to $28 Million, including an $8.6 Million increase in gain from the sale of bonds, for the years ended December 31, 2010 to December 31, Non- Interest Expense increased from $52 Million to $57 Million, including $3 Million in write downs of foreclosed Real Estate Owned Properties, due to falling real estate values, during this same period. Our efficiency ratio, the cost to produce one dollar of revenue, improved to 62%, or $1.00 on the dollar for 2011, from 63% in This compares very favorably to a Peer Group Ratio of 71%. Net Income increased from $3.7 Million, at year-end 2010, to $21.5 Million, at year end 2011, after the net effect of the gain from the sale of bonds and Real Estate Owned Property write-downs. This is another record level of Net Income, clearly evidencing a complete rebound and stabilization, achieved through several executive initiatives implemented by our Team. Our highest reported Net Income had been $18.5 Million in 2007, the initial year of the most severe recession in U.S. history. The Board of Directors and our Team will continue to work hard and create solutions with reduced risk in order to maintain and improve our profitability and Shareholder value. The Book Value of our Stock has increased every year since our inception in Our vision for the future is to continue expanding our franchise in South Texas, primarily in the Rio Grande Valley and San Antonio markets. We deeply value our personal relationship with you. We will never take it for granted. We appreciate your support and look forward to working with you to achieve our mutual success. Yours very truly, A. Jabier Rodriguez Chief Executive Officer Carta a Nuestros Accionistas, Clientes y Amigos El sector financiero se ha recuperado después de los cuatro (4) años más difíciles que la industria bancaria haya experimentado. Nosotros hemos resurgido con más experiencia y con el compromiso de implementar, a lo largo de la compañía, medidas en los procesos de administración de riesgo en cada una de nuestras decisiones. Nuestro enfoque es de mantener el riesgo en niveles bajos a moderados y los rendimientos a un nivel de moderado a alto. Stock Price Per Share Total Assets (Dollars in Millions) Net Income $50.00 $40.00 $36.00 $35.50 $37.50 $1,577 $1,776 $1,857 $2,092 $2,184 (Dollars in Thousands) 07 $18, $13, $9, $3, $21,519 Per Share Data: Net Income-Diluted $3.23 $2.33 $1.62 $0.63 $3.40 Return on Average Stockholders Equity % % % % % 5 Year Compound Annual Growth Rate Assets 4.94% Shareholders Equity Loans Deposits 5.91% 3.71% 14.52% 2011 Annual Report l 5

7 El modelo de negocios para un banco regional seguro y sólido ha cambiado a uno basado en menor medida en ingresos derivados por intereses de crédito y en mayor medida en ingresos generados por tarifas y comisiones con un alto nivel de eficiencia. Esto ha sido en parte por los efectos de la recesión y la lenta recuperación de la economía. La ley sobre la Reforma financiera Dodd-Frank establecida recientemente, ha restringido los cargos de comisiones por los sobregiros de cuentas de cheques y tarjetas de débito, causando que los bancos reduzcan el pago de aquellos cheques sin fondos, impactando de manera negativa el ingreso por comisiones. La ley de Reforma financiera Dodd-Frank también ha cambiado virtualmente todos los reglamentos correspondientes al consumidor, relacionados o no con las hipotecas. Solo el tiempo nos dirá si ésta ley, a través de la creación de la Agencia de Protección Financiera al Consumidor tendrá algún valor para los consumidores, sin embargo, tendrán que pasar de una (1) a dos (2) generaciones para determinar este impacto. Lo único que sí sabemos es que ésta no podría prevenir otra crisis financiera. La ley de Reforma financiera Dodd-Frank ha introducido cambios profundos en la forma en que el gobierno regula a la industria financiera. El aumento en la supervisión incluye un aumento en los niveles de capital y reservas para riesgos crediticios para cumplir con los requisitos regulatorios. El índice de capital para los bancos ha aumentado de un 6% a un índice general de 9.5%. Las reservas de riesgos crediticios se han incrementado del 1% a un índice general del 2.5%. Estos nuevos niveles han dado como resultado un incremento del capital y reservas para riesgos crediticios con un total para Lone Star National Bank de $96.5 millones de dólares. Como se ve a continuación. Capital: 6% al 9.5% = +3.5% Provisiones: 1% al 2.5% = +1.5% Total de Activos: $2.2 Mil millones x 3.5% = $77.0 millones Total de Préstamos: $1.3 Mil millones x 1.5% = $19.5 millones Aumento Total de Capital Requerido: $96.5 millones Al 31 de diciembre del 2011, Lone Star Bancshares-Texas, Inc. cuenta con $208 millones en capital contable y $31 millones en reservas para riesgos crediticios, lo cual representa un índice de capital propio sobre el total de activos del 9.53% y un índice de reservas para riesgos crediticios sobre el total de préstamos del 2.48% lo cual cumple claramente con estos nuevos requisitos. Los incrementos en los niveles de capital actualmente requeridos, han causado que el rendimiento de los bancos haya disminuido considerablemente. Nuestras tasas de rentabilidad con respecto al promedio de los activos fue del.98% y el rendimiento sobre el promedio del capital propio fue del 11.02% en el 2011, siendo superiores a los rendimiento de nuestros competidores del mismo nivel que fueron del.6% y el 6.16%, respectivamente al 31 de diciembre del La disminución en el volumen de créditos ha creado mayores niveles de liquidez que aunado a las bajas tasas de interés han contribuido a la reducción en el rendimiento a los accionistas. A diciembre 31 del 2011, el total de los activos aumentó en $92 millones para llegar a la cantidad de $2.2 mil millones, los préstamos crecieron en $28 millones alcanzando la cifra de $1.3 mil millones y los depósitos aumentaron $87 millones logrando llegar a $1.8 mil millones. El número total de sucursales aumentó a 31, incluyendo tres (3) nuevas sucursales en el Valle del Rio Grande y dos (2) más en San Antonio, lo cúal hace un total de cuatro (4) sucursales en San Antonio, con al menos dos (2) nuevas sucursales programadas para el Al 31 de diciembre del 2011, el total de activos en San Antonio alcanzó los $73 millones. Los ingresos por intereses devengados aumentaron de $94 millones a $98 millones, y los ingresos por otros conceptos aumentaron de $18 millones a $28 millones, incluyendo un aumento de $8.6 millones en ganancias por la venta de bonos correspondientes a los años 2010 y Los gastos operativos aumentaron de $52 millones a $57 millones, incluyendo $3 millones en gastos relacionados con propiedades de bienes raíces adjudicadas al banco, debido a la caída de los valores de los bienes raíces durante este mismo periodo. Nuestro índice de eficiencia, el costo de producir un dólar de ingresos, mejoró de un 63% de un $1.00 en el 2010 a un 62% en el Esto se compara favorablemente con el índice de nuestros competidores del mismo nivel que fue del 71%. El rendimiento neto aumentó de $3.7 millones al fin del 2010 a $21.5 millones al fin del 2011, después del efecto neto por la ganancia de la venta de bonos y los bienes raíces adjudicadas por el banco. Este es otro nivel récord de ingreso neto, evidenciando claramente una recuperación y estabilización completa, obtenida a través de varias iniciativas ejecutivas implementadas por nuestro equipo. Nuestro mayor rendimiento reportado había sido de $18.5 millones en el 2007, el año en que inicio la recesión más severa en la historia de los Estados Unidos. La mesa directiva y nuestro equipo continuarán trabajando arduamente en la creación de soluciones innovadoras de bajo riesgo para poder mantener y mejorar nuestra rentabilidad y el valor de las participaciones de nuestros accionistas. El valor contable de nuestras acciones ha aumentado cada año desde su inicio en Nuestra visión para el futuro es de continuar expandiendo nuestra franquicia en el Sur de Texas, principalmente en el Valle del Rio Grande y en San Antonio. Valoramos profúndame nuestra relación personal con ustedes, misma que nunca subestimaremos. Agradecemos su apoyo y esperamos trabajar con ustedes para lograr un éxito mutuo. Atentamente, A. Jabier Rodriguez Director General Valor Contable por Accion $23.05 $26.37 $28.47 $29.57 $32.88 Participaciones de los Accionistas (En Millones) $120 $145 $161 $184 $208 6 l 2011 Annual Report

8 Financial Highlights (Dollars in Thousands, Except Per Share Data) For the Year Net income Return on average assets Return on average shareholders equity Net interest margin Efficiency ratio Per share data: Net income - basic Net income - diluted Dividends declared Book value at end of period Weighted average shares outstanding (in thousands) - Basic - Diluted Shares outstanding at end of period (in thousands) 2011 $ 21, % 11.02% 3.58% 62.36% $ 3.41 $ $ ,317 6,332 6, $ 3, % 2.14% 3.67% 63.47% $ 0.64 $ $ ,823 5,902 6,226 Change $ 17, % 8.87% -0.09% -1.11% $ 2.77 $ $ %Change % % % -2.45% -1.75% % % 11.16% 8.48% 7.29% 1.69% Capital Ratios Tier 1 risk-based capital ratio Total risk-based capital ratio Leverage capital ratio Shareholders' equity to total assets 18.26% 19.53% 10.48% 9.53% 16.12% 17.38% 10.00% 8.80% 2.14% 2.15% 0.48% 0.73% 13.28% 12.37% 4.80% 8.30% Balance Sheet Data Total assets Loans Allowance for loan losses Investment securities Deposits Shareholders equity $ 2,184,155 1,255,657 31, ,981 1,805, ,129 $ 2,091,672 1,227,398 25, ,329 1,718, ,109 $ 92,483 28,259 5,850 (194,348) 87,433 24, % 2.30% 23.16% % 5.09% 13.05% Asset Quality Ratios Allowance for Loan Losses to Loans Net Loan Charge-offs Net Loan Charge-offs to Average Loans Nonperforming Assets to Loans and Repossessed Assets Allowance for Loan Losses to Nonperforming Assets Provision for Loan Loss to Net Loan Charge-offs 2.48% $ 5, % 6.45% 37.07% % 2.06% $ 23, % 7.37% 26.90% % 0.42% $ (18,239) -1.52% -0.91% 10.17% 97.97% 20.39% % % % 37.81% 86.29% Return on Average Assets % 0.80% 0.52% 0.19% 0.98% Efficiency Ratio % 57.73% 64.14% 63.47% 62.36% Per Share Data Book Value $23.05 $26.37 $28.47 $29.57 $ Annual Report l 7

9 Management s Discussion and Analysis of Financial Condition and Results of Operations The following discussion addresses information pertaining to the financial condition and results of operation of Lone Star National Bancshares-Texas, Inc. and subsidiaries (the Company ) that may not be otherwise apparent from a review of the audited consolidated financial statements and related footnotes. It should be read in conjunction with those statements as well as other information presented throughout the report. In addition to historical information, this discussion and other sections contained in this Annual Report include certain forwardlooking statements regarding events and trends which may affect the Company s future results. Such statements are subject to risk and uncertainties that could cause the Company s actual results to differ materially. Such factors include, but are not limited to, those described in this discussion and analysis. The Company is a privately held bank holding company headquartered in McAllen, Texas, offering a broad array of financial services through its wholly-owned banking subsidiary, Lone Star National Bank (the Bank ). The Bank operates from thirty-one banking locations: twenty-seven (27) banking centers in the Rio Grande Valley and four (4) banking centers in San Antonio, Texas. The Bank engages in a wide range of commercial and personal banking activities including the usual acceptance of deposits for checking, savings and time deposit accounts; extension of secured and unsecured loans to corporations, individuals and others; issuance of letters of credit; rental of safe deposit boxes; brokerage services and insurance services. The Bank s lending services include commercial, industrial, real estate, installment and credit card loans and participation in loans with other banks. The members of the Bank s management team have significant experience and contacts from their service at the Bank and their prior service with other successful community banks that have operated in the same market. The Bank seeks to provide its products and services through a high quality experienced staff and local decision making. At December 31, 2011, the Company had total assets of $2.2 billion, loans of $1.3 billion, deposits of $1.8 billion and shareholders equity of $208.1 million. The Company s primary goal is to provide a higher quality service for its customers in the South Texas market by providing personal service, relationship banking and innovative technological solutions. In order to broaden the customer base, primarily through expanding the Company s network of fullservice banking offices, the Company opened five new banking centers during 2011 with three in the Rio Grande Valley: McAllen, Rio Grande City and Weslaco; and two in San Antonio. Management constantly monitors profitability of all banking centers in the franchise and as such, a decision was made to close the Mercedes Mall banking center during The Board of Directors is continuing its efforts to expand our banking organization into the San Antonio market. The Company s profitability is dependent on managing interest rate spreads, other operating income and expenses, and credit risk. Net interest income is the largest component of revenue for the Company. The Company manages interest rate risks through a funds management strategy which involves offering deposit and/or loan structures that tend to counter the natural rate risk profile of the Company. The Company addresses loan and deposit pricing, the asset and liability mix and interest rate sensitivity on a periodic basis. Yields on earning assets and rates paid on interest-bearing deposits within the Company declined during Through management s efforts, the net interest margin of 3.58% reflects a slight decline when compared to the net interest margin of 3.67% for The Company manages its credit risk by establishing underwriting guidelines, which address the characteristics of borrowers, industries, geographic locations and risk products. The credit process is controlled by continuous review and credit analysis. The Company evaluates its management of operating expenses through the efficiency ratio, which is approximately 62.4% for The efficiency ratio equates to the cost of recording one dollar s worth of revenue. The Company s efficiency ratio remains very favorable when compared to the peer group ratings of 71.2% for similar size bank holding companies in the United States of America. Analysis of Financial Condition Overview: The Rio Grande Valley economy is improving slightly as reflected in a net growth in the labor market and an increase in commercial building permits. This is partially offset by declines in residential building permits, airline boarding and vehicle and pedestrian bridge crossings to Mexico for 2011 compared to The economy of the Rio Grande Valley is based principally on retailing (including trade with Mexico), government, agriculture, tourism, manufacturing, health care and education. The Company has expanded into the San Antonio area with four banking centers operational in 2011 and a fifth location to be operational in mid Additional locations in San Antonio are being selected for future banking centers. During 2011, San Antonio was ranked #1 Best- Performing Metropolitan Area in the United States per the Milken Institute, December 2011, Best- Performing Cities Total assets of $2.2 billion at December 31, 2011 increased $92.5 million or 4.4% compared to $2.1 billion at December 31, Total deposits of $1.8 billion at December 31, 2011 increased $87.4 million or 5.1% compared to $1.7 billion at December 31, Due from Banks-interest bearing: Due from banks-interest bearing accounts of $340.3 million at December 31, 2011 increased $260.5 million or 326.6% compared to $79.8 million at December 31, These funds represent excess funds deposited with correspondent banks in interest bearing accounts, primarily the Federal Reserve Bank. Management s strategy for 2011 was to fortify the balance sheet by reducing its investment 30 year mortgage-backed securities and shorten the overall duration of the investment portfolio. As a result of this strategy, U.S. Government securities were sold 8 l 2011 Annual Report

10 and the proceeds were deposited into correspondent banks in interest bearing accounts. Investment Securities: Total investment securities (available for sale and held to maturity) of $467.0 million at December 31, 2011 decreased $194.3 million or 29.4% compared to $661.3 million at December 31, The mix of investment securities during 2011 was changed to fortify the balance sheet by reducing its investment 30 year mortgage-backed securities and shortening the overall duration of the investment portfolio. Another strategic move included selling all private-label collateralized mortgagebacked securities that were classified as other-than-temporary impairment bonds. The rationale for selling the investment securities was due to anticipation of a future raising rate environment. This led to the desire to manage the possible unrealized losses (as a result of a rising rate environment) and to manage and thereby sell any bond that was experiencing acceleration of prepayments due to refinancing of individual mortgages within said investment securities. The fixed-rate mortgage-backed securities and collateralized mortgage obligations totaling $394.0 million at December 31, 2011 reflects a decrease of $216.9 million when compared to $610.9 million at December 31, Loans: Year 2011 has proven to be another challenging year for the Company with the U.S. economy in recovery mode, reflecting modest expansion. The national and local economic growth was facing three headwinds of unemployment, housing and government debt. These headwinds continue to affect lending as business owners have deleveraged and remained cautious about putting capital to work. Loans held for sale and held for investment of $1.26 billion at December 31, 2011 increased $28.3 million or 2.3% compared to $1.23 billion at December 31, At December 31, 2011, the loan portfolio consisted primarily of $3.5 million of real estate loans held for sale, $220.5 million of commercial loans, $1.7 million of agriculture loans, $938.6 million of real estate loans and $88.0 million of consumer and other loans. These loans were primarily originated within our market area of the Rio Grande Valley and San Antonio, Texas and are generally secured by residential or commercial real estate or business or personal property. Despite the unprecedented contraction in the credit markets, we continued to lend to creditworthy customers. The Company manages credit risk by establishing and implementing strategies and guidelines appropriate to the characteristics of borrowers, industries, geographic locations and products. Diversification of risk within each of these areas is a primary objective. Policies and procedures are developed to ensure that loan commitments conform to current strategies and guidelines. Management continues to refine the Company s credit policies and procedures to address risks in the current and prospective environment and to reflect management s current strategic focus. The credit process is controlled with continuous credit review and analysis, as well as reviewed by internal and external auditors and regulatory authorities. The Company s loans are widely diversified by borrower and industry group. The Company has lending policies in effect so that lending of all types is approached, to the extent possible, including low-to-moderate income neighborhoods and small business, on a basis consistent with safe and sound standards. Stress testing is utilized to take into consideration the potentially adverse economic conditions under which liquidation of the loan could occur. Generally, collateral accepted to secure the commercial loan portfolio is real estate, accounts receivable, inventory, marketable securities and equipment. Autos, deeds of trust, life insurance and marketable securities are accepted as collateral for the installment loan portfolio. The Company s policy on maturity extensions and rollovers is based on management s assessment of individual loans. Approvals for the extension or renewal of loans without reduction of principal for more than one twelve-month period are generally avoided, unless the loans are fully secured and properly margined by cash or marketable securities, or are revolving lines subject to annual analysis and renewal. Nonperforming Assets: The Company has procedures in place to assist in maintaining the overall quality of its loan portfolio. The Company has established underwriting guidelines to be followed by its officers and monitors its delinquency levels for any negative or adverse trends, particularly with respect to credits which have total exposures of $10,000 or more. Nonperforming assets consist of nonaccrual loans, loans for which the interest rate has been renegotiated below originally contracted rates and real estate or other assets that have been acquired in partial or full satisfaction of loan obligations. At December 31, 2011, nonperforming assets totaled $87.1 million or 6.5% of loans plus repossessed assets. Management has added seasoned personnel to assist in turning nonperforming assets into performing assets. Management believes that it is unlikely that any material loss will be incurred on disposition of the collateral even though the volume of loan losses has increased, while the allowance for loan losses has continually been enhanced to 2.48% of total loans at year end. Management regularly reviews and monitors the loan portfolio to identify borrowers experiencing financial difficulties. Management believes that at December 31, 2011 all such loans have been identified and included in the nonaccrual, restructured or 90 days past due loan totals. Management continues to emphasize maintaining a low level of nonperforming assets and returning nonperforming assets to an earning status. Allowance for Loan Losses: The allowance for loan losses at December 31, 2011 of $31.1 million increased $5.9 million or 23.2% compared to $25.3 million at December 31, The allowance for loan losses at December 31, 2011 was 2.48% of loans outstanding, net of unearned discount. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provision required to maintain an adequate allowance. In assessing the appropriateness of the allowance, management reviews the size, quality and risks of loans in the portfolio and considers factors such as specific known risks, past experience, the status and amount of nonperforming assets and economic conditions. The allowance for loan losses is comprised of three elements which include: 1) allowances established on specific loans, 2) allowances based on loss experience and trends in pools of or loans with similar characteristics and 3) unallocated allowances based on general economic conditions and other internal and external risk factors in our market. Loans identified as losses are charged off. In addition, the loan review committee of the Company reviews the assessments of management in determining the adequacy of the Company s allowance for loan losses. Based on total allocations, the provision is recorded to maintain the allowance at a level deemed appropriate by management. While management uses available information to recognize losses on loans, there can be no assurance that future additions to the allowance will not be necessary. Future adjustments could be necessary to the allowance for loan losses if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. The modest expansion in the national, state and local economy, as well as the high employment rates have resulted in increased levels of nonperforming assets, increased loan loss provisions and reductions to income. Additionally, as an internal part of the examination process, bank regulatory agencies periodically review our allowance for loan losses. The banking regulatory agencies could require the recognition of additions to our loan 2011 Annual Report l 9

11 loss allowance based on their judgment of information available to them at the time of their examination. Premises and Equipment: Premises and equipment of $64.5 million at December 31, 2011 increased $8.9 million or 16.0% compared to $55.6 million at December 31, The net increase in premises and equipment for 2011 is primarily attributable to the addition of five new banking centers, including equipment, with three new banking centers in the Rio Grande Valley and two new banking centers in the San Antonio, Texas market and a second data center. Other Real Estate Owned: Other real estate owned ( OREO ) of $44.7 million at December 31, 2011 decreased $2.3 million or 4.9% compared to $47.0 million at December 31, OREO assets represent property acquired as the result of borrower defaults on loans. Management actively manages the OREO and records the value of each OREO at either the lower of the fair market value less estimated selling costs or at the cost of the asset. Write-downs occurring at foreclosure are charged against the allowance for possible loan losses. On an ongoing basis, OREO is appraised as required by market indications and applicable regulations. Any further writedowns as a result of subsequent declines in value are included in other noninterest expense along with other expenses related to maintaining the properties. Deposits: Deposits at December 31, 2011 of $1.8 billion increased $87.4 million or 5.1% compared to $1.7 billion at December 31, At December 31, 2011, noninterestbearing deposits were 15.0% of total deposits and reflect of source of low cost funds for the Company. Deposits are the Company s primary source of funds. The Company offers a variety of products designed to attract and retain deposit customers, such as: checking accounts, regular savings deposits, NOW accounts, money market accounts, select certificates of deposit savings, an interestbearing club account and certificates of deposits. Deposits are obtained primarily from individuals, partnerships and corporations in our market areas. In addition, we obtain deposits from state and local public entities, commonly referred to as public fund deposits. The Company s policies also permit the acceptance of brokered deposits. Generally, both brokered certificates of deposit and public funds are less expensive than retail deposits and are easily managed. The interest rates paid are competitively priced for each particular deposit product and structured to meet our funding requirements. The Company s management will continue to manage interest expense through deposit pricing. The Company s management believes that additional funds, if needed, can be attracted and deposit growth can be accelerated through deposit pricing as the Company experiences increased loan demand or other liquidity needs. Capital Resources: Shareholders equity of $208.1 million at December 31, 2011 significantly increased $24.0 million or 13.1% compared to $184.1 million at December 31, The increase was primarily attributable to earnings of $21.5. Shareholders equity as a percentage of total year-end assets was 9.5% in 2011 and 8.8% in Bank holding companies are required to maintain capital ratios in accordance with guidelines adopted by the Federal Reserve Board. The guidelines are commonly known as Risk-Based Capital Guidelines. The minimum Total Risk-Based Capital, Tier 1 Risk- Based Capital, and Tier 1 Leverage Capital ratios are 8.0%, 4.0% and 4.0%, respectively. At December 31, 2011, the Company s Total Risk-Based Capital, Tier 1 Risk-Based Capital and Tier 1 Leverage Capital ratios are 19.53%, 18.26% and 10.48%, respectively. At December 31, 2011, the Company and the Bank met the criteria for classification as a well-capitalized institution under the prompt corrective action rules promulgated under the Federal Deposit Insurance Act. Designation as a well-capitalized institution under these regulations does not constitute a recommendation or endorsement of the Company or the Bank by federal bank regulators. Analysis of Results of Operations Earnings Summary: Net income for 2011 was $21.5 million or $3.40 per fully diluted share, reflecting an increase of $17.8 million or $2.77 per fully diluted share, compared to the net income of $3.7 million or $0.63 per fully diluted share for the year Earnings performance for 2011 as compared to the prior year reflects an increase in net interest income and noninterest income, a substantial decrease in the provision for loan losses, partially offset by increases in noninterest expense and income tax expense. A more detailed description of the results of operations is included in the material that follows. Net Interest Income: Net interest income represents the largest source of income for the Company. Net interest income is the difference between interest earned on assets and interest expense incurred for the funds supporting those assets. The largest category of earning assets consists of loans. The second largest category of earning assets is investments, followed by due from banks interest bearing. Earning assets are funded by consumer and commercial deposits and short-term borrowings. In addition to these interest-bearing funds, assets are also supported by interestfree funds, primarily demand deposits and shareholder s equity. Variations in the volume and mix of assets and liabilities and their relative sensitivity to interest rate movements determine changes in net interest income. Net interest income of $72.8 million for 2011, reflects an increase of $6.6 million or 10.0% compared to the prior year of $66.2 million. The increase in net interest income was primarily attributable to management s efforts to control the cost of funds and build noninterest-bearing deposits. The net yield on total interest-earning assets, also referred to as net interest margin, represents net interest income, on a tax equivalent basis, divided by average interest-earning assets. Since a significant portion of the Company s funding is derived from interestfree sources, primarily demand deposits and shareholders equity, the effective rate paid for all funds is lower than the rate paid on interest-bearing liabilities alone. The net interest margin of 3.58% for 2011 decreased 9 basis points compared to 3.67% for the prior year. The Company continued to experience intense market competition for both loans and deposits during The yield on interest-earning assets of 4.84% for 2011 decreased 34 basis points compared to 5.18% for the prior year. The yield on interest-bearing liabilities of 1.49% for 2011 decreased 29 basis points compared to 1.78% for the prior year. Provision for Loan Losses: The amount of provision for loan losses is based on periodic (not less than quarterly) evaluations of the loan portfolio, especially nonperforming and other potential problem loans. During these evaluations, management considers various factors. For additional information concerning the factors in these evaluations, see the Allowance for Loan Losses section of this Report. The provision for loan losses is charged to earnings to bring the allowance for loan losses to a level deemed appropriate by management based on factors such as historical experience, the volume and type of lending conducted by the Company, the amount of nonperforming assets, regulatory policies, generally accepted accounting principles, general economic conditions, particularly as they relate to the Company s lending area, and other factors related to the collectibility of the Company s loan portfolio. The provision for loan losses for the year 2011 of $11.1 million compares very favorably to the $26.7 million provision for loan losses for the prior year. The $11.1 million provision for loan losses for year 2011 was primarily 10 l 2011 Annual Report

12 attributable to net charge-offs of $5.3 million, loan growth of $28.3 million, and an amount to maintain the allowance for loan losses at a level deemed appropriate by management based on various factors discussed in the Allowance for Loan Loss section of this Report. Non-interest Income: Non-interest income for 2011 of $27.9 million increased $10.0 million or 55.6% compared to $17.9 million for prior year. The net increase in non-interest income for 2011 as compared to the prior year was primarily attributable to increases reflected in: gain on securities, other service charges and fee income, and other noninterest income partially offset by decreases in service charges on deposit accounts and real estate package fee income. Service charges on deposit accounts for 2011 of $6.2 million decrease $522,000 or 7.8% compared to $6.7 million for the prior year. The net decrease for the year was attributable to an $804,000 decrease in nonsufficient check income more commonly referred to as overdraft charges. Other service charge and fee income for 2011 of $6.2 million increased $1.3 million or 25.3% as compared to $5.0 million for the prior year. The net increase in other service charge and fee income for 2011 was primarily attributable to debit card interchange fee income, international fees and merchant services income. Debit card interchange fee income of $3.3 million for 2011 increasing $683,000 or 25.9% compared to $2.6 million for the prior year. The increase in debit card fee income is attributable to management s continuing efforts to increase the volume of debit card business. International fee income of $721,000 for 2011 increasing $173,000 or 31.7% compared to $547,000 for the prior year and was attributable to an increase volume of business. Merchant services income of $279,000 for 2011 increased $175,000 or 167.8% compared to $104,000 for the prior year and was attributable to an increased volume of business. Real estate package fee income for 2011 of $279,000 decreased $19,000 or 6.4% compared to $298,000 for the prior year. The decrease was primarily attributable to a decline in volume of business conducted. Gain on securities for 2011 of $11.4 million increased $8.6 million or 306.5% compared to $2.8 million for the prior year. Gain on securities for year 2011 was partially decreased by the $1.7 million loss on the sale of all private-label collateralized mortgage-backed securities bonds. For additional information concerning the factors in managing the investment portfolio, see the Investment Securities section of this Report. Other non-interest income for 2011 of $3.8 million increased $676,000 or 21.3% compared to $3.2 million for the prior year. The increase in other noninterest income is primarily attributable to $569,000 increase in brokerage gross commissions, partially offset by a decrease of $95,000 in gain on sale of loans held for sale. Non-interest Expense: Non-interest expense for 2011 of $56.8 million increased $5.0 million or 9.8% compared to $51.7 million for prior year. The increase in non-interest expense was primarily attributable to increased employee compensation, net occupancy and equipment expenses, employee benefits, other real estate owned, net expense, advertising expense and business development expense, partially offset by a decrease in FDIC insurance premiums. The largest category of non-interest expense, personnel expense of $27.7 million, which is comprised of employee compensation of $22.8 million and employee benefits of $4.9 million for 2011 increased $2.5 million or 10.0% compared to $25.2 million for the prior year. Personnel expense increase was primarily a result of increases in headcount and increases in commissions and incentive pay related to performance metrics. Net occupancy and equipment expense of $8.0 million for 2011 increased $485,000 or 6.5% compared to $7.5 million for the prior year. The net increase in net occupancy and equipment expense for 2011 is primarily attributable to the addition of five new banking centers and a second data center which reflects a net increase in depreciation expense for property and equipment (up $452,000), net building lease expenses (up $302,000), equipment lease expenses (down $67,000), utility expense (up $33,000), insurance expense (up $39,000), repairs and maintenance expense (down $413,000), ad valorem taxes (up $125,000) and security (up $13,000). FDIC insurance expense of $2.2 million for 2011 decreased $479,000 or 17.7% compared to $2.7 million for the prior year. The net decrease in FDIC insurance expense for 2011 compared to the prior year is primarily attributable to a change in the calculation of the insurance being based on total assets versus deposits. Data processing expense of $4.2 million for 2011 increased $554,000 or 15.2% compared to $3.6 million for the prior year. The net increase in data processing expense is primarily due to the added expense of a second data center, which was operational June 2011 and volume of business conducted by the Company. Legal and profession expense of $2.6 million for 2011 increased $484,000 or 22.9% compared to $2.1 million for the prior year. The net increase in legal and professional expense is primarily due to the added legal fees for loan related collections. Advertising expense of $1.5 million for 2011 decreased $162,000 or 9.8% compared to $1.7 million for the prior year. The net decrease is primarily attributable to television and radio production (down $181,000). The marketing focus is to continue to promote the bank in the communities that we serve and to promote product awareness. The other real estate owned net expense of $4.3 million for 2011 increased $2.5 million or 136.2% compared to $1.8 million for the prior year. This category includes direct expenses for foreclosed real estate including property taxes, maintenance costs, writedowns, less rent income and net gains on the sale of properties. The net increase in expenses for 2011 compared to the prior year is primarily attributable to write-downs of $2.8 million reflecting a net increase of $2.5 million when compared to the prior year. Business development of $702,000 for 2011 decreased $237,000 or 25.2% compared to $939,000 for the prior year. The net decrease is primarily attributable to a promotional program designed to increase customer debit card usage thereby increasing the Company s debit card interchange fee income. See discussion on Other service charge and fee income above concerning increased debit card interchange fee income. The promotional program rewards customers with redeemable points which are paid for by the Company. Total expenses for this program for 2011 of $321,000 reflects a net decrease of $111,000 or 25.7% compared to the prior year. Federal and State Income Taxes: Federal and state income taxes of $11.3 million for the year 2011 increased $9.3 million compared to $2.0 million for the prior year. The increase in federal and state income taxes is attributable to an increased level of pretax income during Net Income: Net income for 2011 was $21.5 million or $3.40 per fully diluted share, reflecting an increase of $17.8 million or $2.77 per fully diluted share, compared to the net income of $3.7 million or $0.63 per fully diluted share for the prior year Annual Report l 11

13 Management s Report on Responsibility for Financial Reporting To Our Shareholders March 23, 2012 Financial Statements The management of Lone Star National Bancshares-Texas, Inc. and its subsidiaries (the Company ) has the responsibility for preparing the consolidated financial statements and for their integrity and objectivity. The consolidated financial statements were prepared in conformity with accounting principles generally accepted in the United States of America. The consolidated financial statements include amounts that are based on management s best estimates and judgments. Internal Control Over Financial Reporting Management is responsible for establishing and maintaining effective internal controls over financial reporting presented in conformity with both accounting principles generally accepted in the United States of America and the instructions of the Board of Governors of the Federal Reserve System for preparation of Consolidated Financial Statements for Bank Holding Companies (Reporting Form FR Y-9C). This internal control contains monitoring mechanisms, and actions to correct deficiencies identified. There are inherent limitations in any internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time. Management assessed the Company s internal control over financial reporting presented in conformity with both accounting principles generally accepted in the United States of America and call report instructions as of December 31, This assessment was based on criteria for effective internal control over financial reporting described in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Tredway Commission. Based on this assessment, management concludes that, as of December 31, 2011, Lone Star National Bancshares-Texas, Inc. and subsidiaries maintained effe- ctive internal control over financial reporting presented in conformity with accounting principles generally accepted in the United States of America and call report instructions. Compliance with Laws and Regulations Management is responsible for compliance with the federal and state laws and regulations concerning dividend restriction and federal laws and regulations concerning loans to insiders designated by the Federal Deposit Insurance Corporation as safety and soundness laws and regulations. Management assessed compliance by the Bank with the designated laws and regulations relating to safety and soundness. Based on this assessment, management concludes that the Bank complied, in all significant respects, with the designated laws and regulations related to safety and soundness for the year ended December 31, A. Jabier Rodriguez Chief Executive Officer George R. Carruthers Executive Vice President & Chief Financial Officer 12 l 2011 Annual Report

14 Certified Public Accountants 801 QUINCE AVENUE P.O. BOX 3125 McALLEN, TEXAS (956) FAX (956) Annual Report l 13

15 LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31, 2011 and 2010 (Dollars in Thousands, Except Share Data) Assets Cash and due from banks $ 36,416 $ 22,303 Due from banks-interest bearing 303,901 57,475 Total cash and cash equivalents 340,317 79,778 Certificates of deposit 2,533 - Securities available for sale 144, ,108 Securities to be held to maturity 322, ,221 Loans held for sale 3,469 1,413 Loans, less allowance for loan losses of $31,112 and $25,262 respectively 1,221,076 1,200,723 Properties and equipment, net 64,510 55,624 Net deferred tax asset 8,409 6,843 Overpayment of federal income tax 868 5,065 Accrued interest receivable 7,132 7,947 Other real estate 44,689 46,991 Other assets 24,171 25,959 Total assets $ 2,184,155 $ 2,091,672 Liabilities Deposits Demand $ 271,117 $ 248,913 NOW accounts 421, ,143 Savings and money market deposit accounts 230, ,528 Time $100 and over 711, ,899 Other time 170, ,026 Total deposits 1,805,942 1,718,509 Accrued interest payable 1,827 2,179 Allowance for off-balance-sheet losses 1,180 1,136 Other liabilities 4,139 1,468 Federal funds purchased and securities sold under repurchase agreements 21,748 25,872 Guaranteed preferred beneficial interest in Company's subordinated debentures 27,837 27,837 Other borrowed money 113, ,562 Total liabilities 1,976,026 1,907,563 Stockholders' equity Common stock, par value $5; authorized 50,000,000 shares; 6,330,918 and 6,225,588 shares issued and outstanding 31,655 31,128 Paid-in capital 58,748 56,700 Retained earnings 113,911 92,424 Accumulated other comprehensive income 3,815 3,857 Total stockholders' equity 208, ,109 Total liabilities and stockholders' equity $ 2,184,155 $ 2,091, l 2011 Annual Report The accompanying notes are an integral part of the consolidated financial statements.

16 LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Consolidated Statements of Income Years Ended December 31, 2011 and 2010 (Dollars in Thousands) Interest income Loans, including fees $ 77,045 $ 76,159 Securities available for sale 9,951 9,432 Securities to be held to maturity 11,035 7,774 Due from banks ,491 93,630 Interest expense Deposits 20,483 21,901 Federal funds purchased and repurchase agreements Subordinated debentures Other borrowed money 4,070 4,276 25,729 27,465 Net interest income 72,762 66,165 Provision for loan losses 11,100 26,650 Net interest income after provision for loan losses 61,662 39,515 Noninterest income Service charges on deposit accounts 6,199 6,721 Other service charge and fee income 6,214 4,958 Real estate package fee income Gain on securities 11,375 2,797 Other noninterest income 3,846 3,171 27,913 17,945 Noninterest expense Employee compensation 22,841 21,118 Net occupancy and equipment expenses 7,956 7,471 Employee benefits 4,872 4,080 FDIC insurance 2,221 2,700 Data processing expense 4,197 3,643 Legal and professional 2,598 2,114 Advertising expense 1,498 1,660 Telephone expense 1,363 1,594 Other real estate, net 4,344 1,839 Supplies Business development Provision for off-balance-sheet losses Other noninterest expense 3,671 3,618 56,803 51,749 Income before income tax expense 32,772 5,711 Income tax expense 11,253 2,000 Net income $ 21,519 $ 3,711 The accompanying notes are an integral part of the consolidated financial statements Annual Report l 15

17 LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Equity Years Ended December 31, 2011 and 2010 (Dollars in Thousands) Comprehensive Common Paid-in income stock capital Balance at December 31, 2009 $ 28,328 $ 39,450 Comprehensive income Net income $ 3, Other comprehensive income, net of tax Unrealized holding gains arising during period 3,320 Reclassification adjustment for gains included in net income (4,276) Total other comprehensive income (loss) (956) - - Total comprehensive income $ 2,755 Sale of common stock, 555,555 shares 2,778 17,136 Exercise of stock options, 4,450 shares Purchase of treasury stock, 34,953 shares - - Sale of treasury stock, 35,078 shares - - Share-based compensation - 54 Tax benefit from stock options exercised - 8 Balance at December 31, ,128 56,700 Comprehensive income Net income $ 21, Other comprehensive income, net of tax Unrealized holding gains arising during period 13,253 Reclassification adjustment for gains included in net income (13,295) Total other comprehensive income (loss) (42) - - Total comprehensive income $ 21,477 Exercise of stock options, 105,330 shares Purchase of treasury stock, 139,312 shares - - Sale of treasury stock, 139,312 shares - - Loss on purchase of treasury stock - - Share-based compensation Tax benefit from stock options exercised Balance at December 31, 2011 $ 31,655 $ 58,748 The accompanying notes are an integral part of the consolidated financial statements. 16 l 2011 Annual Report

18 Accumulated other Total Retained comprehensive Treasury stockholders' earnings income (loss) stock equity $ 88,713 $ 4,813 $ ( 5) $ 161,299 3, ,711 - (956) - (956) , ( 1,326) (1,326) - - 1,331 1, ,424 3, ,109 21, ,519 - (42) - (42) , ( 4,978) (4,978) - - 4,946 4,946 (32) $ 113,911 $ 3,815 $ - $ 208, Annual Report l 17

19 LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Years Ended December 31, 2011 and 2010 (Dollars in Thousands) Operating activities Net income $ 21,519 $ 3,711 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 4,586 4,201 Amortization (accretion) of investment security premiums and discounts, net 7,006 6,254 Share-based compensation 1, Gain on sale of other real estate (1,981) (506) Gain on sale of investment securities (11,375) (4,169) Gain on sale of properties and equipment (8) - Provision for loan losses 11,100 26,650 Other than temporary impairment of securities held to maturity - 1,372 Writedown of other real estate owned 4, Provision for off-balance-sheet losses Decrease (increase) in overpayment of federal income tax 4,197 (3,496) Increase in deferred income tax benefit (1,546) (1,018) Decrease (increase) in accrued interest receivable 815 (870) Increase in loans held for sale (2,056) (837) Decrease in other assets 897 1,175 Decrease in accrued interest payable (352) (20) Increase (decrease) in other liabilities 2,671 (357) Net cash provided by operating activities 40,968 32,725 Investing activities Proceeds from sale of investment securities available for sale 479, ,383 Proceeds from sale of investment securities held to maturity 9,665 17,218 Proceeds from sale of trading securities - 113,318 Proceeds from maturities and principal reduction of securities available for sale 79, ,916 Proceeds from maturities and principal reduction of securities to be held to maturity 61,913 40,421 Proceeds from mandatory repurchase of FHLB stock 834 1,347 Proceeds from sale of properties and equipment 73 - Purchase of certificates of deposit (2,533) - Purchase of securities available for sale (307,736) (369,421) Purchase of securities to be held to maturity (125,467) (214,113) Purchase of trading securities - (112,892) Purchase of properties and equipment (12,646) (6,993) Net increase in loans (45,435) (74,371) Improvements to other real estate (1,260) (536) Net proceeds from sale of other real estate 15,388 4,930 Net cash provided (used) by investing activities 152,242 (324,793) The accompanying notes are an integral part of the consolidated financial statements. 18 l 2011 Annual Report

20 LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Continued) Years Ended December 31, 2011 and 2010 (Dollars in Thousands) Financing activities Net increase in demand deposits, NOW accounts, savings and money market accounts 129, ,880 Proceeds from sale of common stock 1,261 19,988 Proceeds from sale of treasury stock 4,946 1,331 Repayment of other borrowed money (75,209) (197,207) Proceeds from other borrowed money 58, ,000 Net decrease in federal funds purchased and securities sold under repurchase agreements (4,124) (138) Net increase (decrease) in time deposits (42,527) 139,946 Purchase of treasury stock (4,978) (1,326) Net cash provided by financing activities 67, ,474 Increase (decrease) in cash and cash equivalents 260,539 (60,594) Cash and cash equivalents at beginning of year 79, ,372 Cash and cash equivalents at end of year $ 340,317 $ 79,778 The accompanying notes are an integral part of the consolidated financial statements Annual Report l 19

21 LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2011 and 2010 Note 1 - Summary of Significant Accounting Policies Lone Star National Bancshares--Texas, Inc. (the Parent or Company ), its primary subsidiary, Lone Star National Bank (the Bank ) and its other subsidiaries (collectively the Company ) are headquartered in McAllen, Texas. The Company provides a broad array of customary banking services and operates 31 regulatory banking locations throughout the Rio Grande Valley of Texas and San Antonio, Texas. The accounting principles and reporting policies conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. A summary of the more significant accounting policies follows: Basis of Presentation. The consolidated financial statements include the accounts of Lone Star National Bancshares--Texas, Inc. and its wholly-owned subsidiaries. The Company eliminates all significant intercompany transactions and balances in consolidation. The accounting and financial reporting policies the Company follows conform, in all material respects, to accounting principles generally accepted in the United States of America. The Company determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity or a variable interest entity under accounting principles generally accepted in the United States of America. Voting interest entities are entities in which the total equity investment at risk is sufficient to enable the entity to finance itself independently and provides the equity holders with the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity s activities. The Company consolidates voting interest entities in which it has all, or at least a majority of, the voting interest. As defined in applicable accounting standards, variable interest entities ( VIEs ) are entities that lack one or more of the characteristics of a voting interest entity. A controlling financial interest in an entity is present when an enterprise has a variable interest, or a combination of variable interests, that will absorb a majority of the entity s expected losses, receive a majority of the entity s expected residual returns, or both. The enterprise with a controlling financial interest, known as the primary beneficiary, consolidates the VIE. The Company s whollyowned subsidiaries, Lone Star National Capital Trust II, Lone Star National Capital Trust III and Lone Star National Capital Trust IV are VIEs for which the Company is not the primary beneficiary. Accordingly, the accounts of these entities are not included in the Company s consolidated financial statements. Use of estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. The allowance for possible loan losses, the fair value of financial instruments and the status of contingencies are particularly subject to change. Cash and cash equivalents. For the purpose of reporting cash flows, the Company considers cash on hand, amounts due from banks, deposits with other financial institutions that have an initial maturity less than 90 days when acquired by the Company and federal funds sold to be cash and cash equivalents. Generally, federal funds sold are purchased and sold for one-day periods. The Company has maintained balances in various operating and money market accounts in excess of federally insured limits. Repurchase/Resell Agreements. The Company purchases certain securities under agreements to resell. The amounts advanced under these agreements represent short-term loans and are reflected as assets in the accompanying consolidated balance sheets. The securities underlying these agreements are book entry 20 l 2011 Annual Report

22 securities. The Company also sells certain securities under agreements to repurchase. The agreements are treated as collateralized financing transactions and the obligations to repurchase securities sold are reflected as a liability in the accompanying consolidated balance sheets. The dollar amount of the securities underlying the agreements remain in the asset accounts. Investments in securities. Securities that management has both the positive intent and ability to hold to maturity are classified as securities held to maturity and are carried at cost, adjusted for amortization of premium or accretion of discount, using the level-yield method. Amortization and accretion on mortgagebacked securities are adjusted for prepayments. Securities that may be sold prior to maturity for asset/liability management purposes, or that may be sold in response to changes in interest rates, to changes in prepayment risk, to increase regulatory capital or other similar factors, are classified as securities available for sale and carried at fair value with any adjustments to fair value reported in stockholders equity as a component of accumulated other comprehensive income (loss), net of tax. Declines in the fair value of individual held to maturity and available for sale securities below their cost that are other than temporary result in write-downs of the individual securities to their fair value. The related write-downs are included in net income as realized losses. Securities purchased for trading purposes are held in the trading portfolio at fair value, with changes in fair value included in noninterest income. Interest and dividends on securities, including the amortization of premiums and the accretion of discounts, are reported in interest income on securities using the level-yield method. Gains and losses on the sale of securities are recorded on the trade date and are calculated using the specific identification method. Loans. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts, that the borrower s financial condition is such that collection of interest is doubtful. Assets acquired through foreclosure are carried at the lower of the estimated net realizable value or the balance of the loan and are included in other assets. Revenues and expenses from operations and changes in the valuation allowance of foreclosed assets are included in noninterest expense. Loans are considered impaired when, based on current information and events, it is probable the Company 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 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. 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 inherent in the loan portfolio. The allowance for possible loan losses includes allowance allocations calculated in accordance with Accounting Standards Codification ( ASC ) Topic 310, Receivables and allowance allocations calculated in accordance with ASC Topic 450, Contingencies Annual Report l 21

23 Loans held for sale. The Company originates mortgage loans primarily for sale in the secondary market. These loans are generally sold on a non-recourse basis and are carried at the lower of cost or market on an aggregate basis. Properties and equipment. Land is carried at cost. Other premises and equipment are carried at cost net of accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Depreciation for tax purposes is computed by using the Accelerated Cost Recovery System and the Modified Accelerated Cost Recovery System required by the Internal Revenue Code. Impairment of long-lived assets. Long-lived assets and certain identifiable intangibles are reviewed by the Company for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Earnings per share of common stock. Basic earnings per share are computed by dividing earnings available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect per share amounts that would have resulted if dilutive potential common stock had been converted to common stock. Loan origination fees and costs. Loan origination fees and costs are deferred and recognized over the life of the loan as an adjustment of yield using the interest method. Interest income on loans. Interest income on loans is accrued and credited to income based on the principal amount outstanding. The accrual of interest on loans is discontinued when, in the opinion of management, there is an indication that the borrower may be unable to meet payments as they become due. Upon such discontinuance, all unpaid accrued interest is reversed. Subsequent interest payments received on loans in which accrual of interest has been discontinued are either applied against principal or reported as income, depending upon management s assessment of the ultimate collectability of principal. Advertising. Advertising costs are expensed as they are incurred. Income tax expense. Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities (excluding deferred tax assets and liabilities related to components of other comprehensive income). Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the expected amount most likely to be realized. Realization of deferred tax assets is dependent upon the generation of a sufficient level of future taxable income and recoverable taxes paid in prior years. Although realization is not assured, management believes it is more likely than not that all of the deferred tax assets will be realized. Off-balance-sheet instruments. In the ordinary course of business the Company has entered into offbalance-sheet financial instruments consisting of commitments to extend credit, commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received. Derivative financial instruments. FASB ASC 815 Derivatives and Hedging requires companies to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Changes in fair value of a derivative must be recognized currently in earnings unless specific hedge accounting criteria are met. The Company s risk management activities do not presently include entering into derivative contracts to manage interest rate risk. 22 l 2011 Annual Report

24 Share-based payments. The Company accounts for all stock-based compensation transactions in accordance with ASC 718, Compensation Stock Compensation ("ASC 718"), which requires that stock compensation transactions be recognized as compensation expense in the statement of operations based on their fair values on the measurement date, which is the date of the grant. Cost of the unvested portion of options issued in prior years and the cost of options issued during 2011, is recognized using the Black- Scholes-Merton option pricing model and a single options award approach method to measure the compensation cost of stock options granted in Subsequent events. The Company has evaluated subsequent events for potential recognition and/or disclosure through March 23, 2012, the date on which these consolidated financial statements were available to be issued. Reclassifications. Certain amounts in the prior year s presentation have been reclassified to conform to the current year s presentation. These reclassifications have no effect on previously reported net income. Note 2 - Restriction On Cash and Due From Banks The Company is required to maintain reserve funds in cash or on deposit with the Federal Reserve Bank. The required reserve balance at December 31, 2011 and 2010 was $724,000 and $819,000, respectively. Note 3 - Investment Securities An analysis of securities available for sale as of December 31, 2011 follows: Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in Thousands) Cost Gains Losses Value U.S. government agency $ 30,336 $ 26 ( $ 8 ) $ 30,354 U.S. treasury Mortgage-backed 77,059 5, ,335 Collateralized mortgage obligations 30, ,329 Total $ 138,237 $ 5,789 ( $ 8 ) $ 144,018 The carrying amount and estimated fair value of securities to be held to maturity as of December 31, 2011 follow: Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in Thousands) Cost Gains Losses Value U.S. treasury $ 15,056 $ 981 $ -0- $ 16,037 State and local governments 19, ,229 Mortgage-backed 218,148 10, ,948 Collateralized mortgage obligations 62,204 1, ,058 Other 8, ,304 Total $ 322,963 $ 14,613 $ -0- $ 337, Annual Report l 23

25 An analysis of securities available for sale as of December 31, 2010 follows: Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in Thousands) Cost Gains Losses Value U.S. government agency $ 500 $ 36 ( $ -0- ) $ 536 U.S. treasury 9, ( 437 ) 9,482 Mortgage-backed 172,567 6,052 ( 217 ) 178,402 Collateralized mortgage obligations 198,279 1,806 ( 1,397 ) 198,688 Total $ 381,265 $ 7,894 ( $ 2,051 ) $ 387,108 The carrying amount and estimated fair value of securities to be held to maturity as of December 31, 2010 follow: Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in Thousands) Cost Gains Losses Value U.S. treasury $ 15,070 $ -0- ( $ 555 ) $ 14,515 State and local governments 16, ( 110 ) 16,845 Mortgage-backed 129,295 3,204 ( 33 ) 132,466 Collateralized mortgage obligations 104,534 1,429 ( 2,720 ) 103,243 Other 8, ( -0- ) 8,797 Total $ 274,221 $ 5,063 ( $ 3,418 ) $ 275,866 The net change in unrealized holding gains and losses on securities available for sale, net of related tax effect, of $42,000 and $956,000 net losses for 2011 and 2010, respectively, was included in a separate component of stockholders equity as accumulated other comprehensive income (loss). Provided below is a summary of securities which were in an unrealized loss position at December 31, A total of one security had unrealized losses at December 31, The unrealized loss was a security in a continuous loss position for less than twelve months and was a U.S. government agency security. The Company believes the deterioration in value is attributable to changes in market interest rates and not the credit quality of the issuer. Less than 12 Months More than 12 Months Total Estimated Estimated Estimated Fair Unrealized Fair Unrealized Fair Unrealized (Dollars in Thousands) Value Loss Value Loss Value Loss U.S. government agency $ 20,006 $ (8) $ -0- $ -0- $ 20,006 $ (8) U.S. treasury State and local governments Mortgage-backed Collateralized mortgage obligations Other Total $ 20,006 $ (8) $ -0- $ -0- $ 20,006 $ (8) The amortized cost and estimated market value of securities available for sale and to be held to maturity at December 31, 2011, by contractual maturity, is shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. 24 l 2011 Annual Report

26 Securities Available for Sale Securities Held to Maturity Estimated Estimated Amortized Fair Amortized Fair Cost Value Cost Value (Dollars in Thousands) Due within one year $ -0- $ -0- $ 535 $ 544 Due one to five years 30,336 30,354 4,804 5,014 Due five to ten years ,684 21,031 Due after ten years ,284 9,677 Subtotal 30,336 30,354 34,307 36,266 Mortgage-backed and collateralized mortgage obligations 107, , , ,006 Other ,304 8,304 Total $ 138,237 $ 144,018 $ 322,963 $ 337,576 Securities not due at a single maturity date are included in scheduled maturities on the basis of coupon maturity. Proceeds from sales of securities available for sale were $479,870,000 and $151,383,000, respectively, for the years ended December 31, 2011 and Gross realized gains on sales of securities available for sale were $13,295,000 in 2011 and $4,207,000 in Gross realized losses on sales of securities available for sale were $190,000 in 2010 and $0 in Proceeds from sales of trading securities were $0 in 2011 and $113,318,000 in Gross realized gains on sales of trading securities were $0 in 2011 and $476,000 in Gross realized losses on sales of trading securities were $0 in 2011 and $50,000 in Proceeds from sales of securities to be held to maturity were $9,665,000 and $17,218,000, respectively, for the years ended December 31, 2011 and Gross realized gains on sales of securities to be held to maturity were $76,000 in 2011 and $29,000 in Gross realized losses on sales of securities to be held to maturity were $1,806,000 in 2011 and $493,000 in The Company s decision to sell securities to be held to maturity was to limit its loss exposure on collateralized mortgage obligations with ratings downgrades. 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. In estimating other-thantemporary 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 Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in cost. Realized losses included in earnings for 2011 and 2010 for other-than-temporary declines in the fair value of securities total $0 and $1,372,000, respectively. Investment securities with a carrying amount of $393,481,000 and $351,948,000 at December 31, 2011 and 2010, respectively, were pledged to secure public funds and for other purposes required or permitted by law Annual Report l 25

27 Note 4 - Loans Loans consist of the following: December 31, (Dollars in Thousands) Commercial $ 202,565 $ 217,477 Commercial tax-exempt 17,013 9,014 Overdrafts Total commercial 220, ,287 Agricultural 1,657 1,591 Real estate Construction 183, ,825 Agricultural mortgage 70,660 56, Family mortgage 222, ,881 Multifamily mortgage 34,305 26,821 Commercial mortgage 431, ,073 Total real estate 942, ,764 Consumer 89, ,951 Total principal amount of loans 1,253,800 1,227,593 Unearned discount and unamortized fees and costs ( 1,612 )( 1,608 ) Allowance for loan losses ( 31,112 )( 25,262 ) Total loans $ 1,221,076 $ 1,200,723 The Company 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 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 judgment, the Company s management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial 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 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. 26 l 2011 Annual Report

28 Real estate loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the cash flows of the borrower. Real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company s real estate portfolio are diverse in terms of type and location. This diversity helps reduce the Company s exposure to adverse economic events that affect any single market or industry. Management monitors and evaluates real estate loans based on collateral and risk grade criteria. The Company tracks the level of owner-occupied real estate loans versus non-owner-occupied loans. At December 31, 2011, approximately 42 percent of the outstanding principal balance of the Company s commercial real estate loans were secured by owner-occupied properties. The Company 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. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. 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 percent, collection remedies, the number of such loans a borrower can have at one time and documentation requirements. The Company utilizes independent loan review consultants that review and validate 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 Company s policies and procedures. 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 Company considers the borrower s debt service capacity through the analysis of current financial information, if available, and/or current information with regards to the Company 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. Year-end non-accrual loans, segregated by class of loans, were as follows: (Dollars in Thousands) Commercial $ 2,163 $ 3,449 Agricultural Consumer Real estate 36,633 42,533 Total $ 38,910 $ 46, Annual Report l 27

29 As of December 31, 2011, non-accrual loans reported in the table above included $6,475,000 related to loans that were restructured as troubled debt restructurings during Had non-accrual loans performed in accordance with their original contractual terms, interest income would have increased by $2,488,000 and $2,849,000 for the years ended December 31, 2011 and 2010, respectively. An age analysis of past due loans (including both accruing and non-accruing loans), segregated by class of loans, as of December 31, 2011 follows: (Dollars in Thousands) Loans 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 $ 7,629 $ 1,450 $ 9,079 $ 211,416 $ 220,495 $ 490 Agricultural ,573 1, Consumer 1, ,693 86,883 89, Real estate 38,286 12,727 51, , ,072 2,257 Total $ 47,997 $ 14,872 $ 62,869 $ 1,190,931 $ 1,253,800 $ 3,404 Accruing loans 90 or more days past due totaled $3,396,000 at December 31, Loans are considered impaired when, based on current information and events, it is probable the Company 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 the 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 collectability 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 Company to reevaluate the fair value of collateral supporting impaired collateral dependent loans on at least an annual basis. While the Company s policy is to comply with the regulatory guidelines, the Company s general practice is to reevaluate the fair value of collateral supporting impaired collateral dependent loans on a quarterly basis. Year-end impaired loans are set forth in the following table. Interest income recognized on impaired loans for the time they were impaired was $439,000 and $379,000 during 2011 and 2010, respectively. Unpaid Contractual Principal Balance Recorded Investment With No Allowance Recorded Investment With Allowance Total Recorded Investment Average Recorded Investment (Dollars in Thousands) Related Allowance 2011 Commercial $ 2,612 $ 1,383 $ 779 $ 2,162 $ 238 $ 2,719 Agricultural Consumer Real Estate 44,238 32,372 4,261 36, ,990 Total $ 46,972 $ 33,868 $ 5,041 $ 39,131 $ 1,167 $ 36, l 2011 Annual Report

30 Unpaid Contractual Principal Balance Recorded Investment With No Allowance Recorded Investment With Allowance Total Recorded Investment Average Recorded Investment (Dollars in Thousands) Related Allowance 2010 Commercial $ 4,929 $ 3,276 $ 173 $ 3,833 $ 106 $ 4,772 Agricultural Consumer Real Estate 50,753 31,349 11,184 42, ,358 Total $ 55,820 $ 34,718 $ 11,357 $ 46,459 $ 1,092 $ 44,189 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. Troubled debt restructurings during 2011 and 2010 are set forth in the following tables. Balance at Restructuring Date Balance at December 31, (Dollars in Thousands) Commercial $ 157 $ 103 Agricultural - - Consumer - - Real estate 7,305 6,593 Total $ 7,462 $ 6,696 Balance at Restructuring Date Balance at December 31, (Dollars in Thousands) Commercial $ 168 $ 158 Agricultural - - Consumer - - Real estate 1,863 1,757 Total $ 2,031 $ 1,915 Typically loans identified as troubled debt restructurings by the Company are 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 and the granting of interest-rate concessions. All loans restructured during 2011 that remain outstanding are on non-accrual status as of December 31, 2011, with the exception of one loan with a balance of $222,000. The modifications did not impact the Company s determination of the allowance for loan losses. As of December 31, 2011, there were no loans restructured in 2011 that were in default. As part of the on-going monitoring of the credit quality of the Company s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the weighted-average risk grade of loans, (ii) the level of classified loans, (iii) the delinquency status of the loans, (iv) net charge-offs, (v) non-performing loans and (vi) the general economic conditions of South Texas Annual Report l 29

31 The Company utilized a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 11. A description of the general characteristics of the 11 risk grades is as follows: Risk Grade 1 This category includes all obligors whose balance sheet, current position, capitalization, profitability and cash flow have been demonstrated to be consistently of such high quality that the potential for significant disruption in their financial performance is virtually nonexistent. Only financially strong and publicly traded companies would be rated in this category but all loans secured by the Company s certificates of deposit would qualify for such an internal risk rating. Risk Grade 2 This internal risk rating is assigned to borrowers having a stable record of strong earnings, a substantial current position, sound capitalization, and solid cash flow, and whose management team has experience and depth within a sound and stable industry. Risk Grade 3 Borrowers assigned this internal rating are considered above average with higher than average credit standards based on leverage, liquidity and debt coverage ratios as well as having excellent management in critical areas. Risk Grade 4 This internal risk rating includes borrowers that have average leverage, liquidity and debt service coverage ratios that compare favorably with industry standards. Risk Grade 5 This internal risk rating includes borrowers that have average leverage, liquidity and debt service coverage ratios and management that may be relatively inexperienced or untested. Overall financial ratios may not be as solid on a historical basis or may compare less favorably with industry standards but are still considered acceptable. Risk Grade 6 This internal risk rating exhibits the same characteristics as Risk Grade 5, but requiring added attention due to added factors such as (1) average or unfavorable earnings and cash flow coverage, (2) average or unfavorable debt service coverage ratio, (3) repayment is slow or repayment history is marginal, (4) reliant on liquidation of collateralized assets to repay debt, (5) substantial credit, collateral, or loan policy exceptions exist, and (6) no secondary sources of repayment are evident. Risk Grade 7 This risk grading includes borrowers that exhibit potential weaknesses/early warning signals that deserve close attention. If left uncorrected, these potential weaknesses may result in the borrower being unable to meet its financial obligations at some future date. Alternatively, operating performance has exhibited improvement, which, although not yet stabilized, is improving and provided such performance continues, will result in removal from problem account status. Risk Grade 8 This risk grading indicates that loans are in the category of performing loans which are classified substandard. A substandard credit is inadequately protected by the current sound worthiness and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. These credits are characterized by the distinct possibility that the Company will sustain some loss if deficiencies are not corrected. However, the distinct possibility of loss in these credits, while existing in the aggregate amount of substandard assets, does not necessarily exist in individual assets classified substandard. Risk Grade 9 This risk grading indicates that loans are in the category of substandard loans, which are similar in definition to substandard-performing. The only difference is that substandard-non-accrual loans are not performing or meeting principal and/or interest payments as agreed. Moreover, loans in this category (including situations where the obligor has filed for 30 l 2011 Annual Report

32 bankruptcy or similar protection from creditors, as collection of principal or interest on a timely basis in these situations is unlikely) must be classified as non-accrual. Additionally, these loans generally have a specific valuation allowance. Risk Grade 10 This risk grading includes loans that have all the weaknesses inherent in a substandard classification with the added factor that the weaknesses are pronounced to the point where, on the basis of current facts, conditions and values, collection or liquidation in full is highly questionable or improbable. While the possibility of loss is extremely high, the existence of specific pending factors, which may work to the obligor s advantage, warrants that the estimated loss be deferred until a more exact status is determined. Additionally, these loans generally have a specific valuation allowance. Risk Grade 11 This risk grading is reserved for charge-offs. A loan in this category is considered uncollectible and of such little value that its continuance as an active asset of the Bank is not warranted. This classification does not mean that an asset has absolutely no recovery or salvage value, but simply that it is not practical or desirable to defer writing off all (or sometimes a portion) of a basically worthless asset, even though partial recovery may be effected in the future. Losses should be taken in the period in which they surface as uncollectible. Additionally, these loans generally have a specific valuation allowance. In monitoring credit quality trends in the context of assessing the appropriate level of the allowance for loan losses, the Company monitors portfolio credit quality by the weighted-average risk grade of each class of loan. Individual relationship managers review updated financial information for all loans risk graded 1 through 6 to recalculate the risk grade on at least an annual basis. When a loan has a calculated risk grade of 7, 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 7 or higher, the loan is monitored on an on-going basis. The following table presents weighted average risk grades for all loans by class. December 31, 2011 December 31, 2010 Weighted Average Loans Risk Grade Loans Weighted Average Risk Grade (Dollars in Thousands) Commercial Risk grades $ 209, $ 219,206 Risk grade , ,392 Risk grade , ,444 Risk grade , ,245 Risk grade Risk grade Total commercial $ 220,495 $ 227, Annual Report l 31

33 December 31, 2011 December 31, 2010 Weighted Average Loans Risk Grade Loans Weighted Average Risk Grade (Dollars in Thousands) Risk grades $ 1, $ 1,465 Risk grade Risk grade Risk grade Risk grade Risk grade Total agricultural $ 1,657 $ 1,591 Consumer Risk grades $ 89, $ 112,552 Risk grade Risk grade Risk grade Risk grade Risk grade Total consumer $ 89,577 $ 112,951 Real estate Risk grades $ 833, $ 766,849 Risk grade , ,667 Risk grade , ,138 Risk grade , ,760 Risk grade Risk grade Total real estate $ 942,071 $ 885,764 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 Company 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 Company s regulatory agencies. In that regard, the Company 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 Company s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans or loan pools. The level of the allowance reflects management s continuing evaluation of industry concentrations, specific credit risks, loan loss and recovery experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions 32 l 2011 Annual Report

34 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 Company s control, including, among other things, the performance of the Company s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. The Company 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 Company experiences over time. The Company 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 Company. 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. When a loan has a calculated grade of 7 or higher, the loan is analyzed 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. 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 Company 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 Company s pools of similar loans include similarly risk-graded groups of commercial loans, commercial real estate loans, consumer real estate loans and consumer and other loans. The components of the general valuation allowance include the additional reserves allocated to specific loan portfolio segments as a result of applying an environmental risk adjustment factor to the base historical loss allocation. The environmental adjustment factor is based upon a more qualitative analysis of risk. The various risks that may be considered in the determination of the environmental adjustment factor include, among other things, (i) the effects of the national and local economy; (ii) the change in the nature and volume of the loan portfolio; (iii) changes in lending policies and underwriting compliance risk; (iv) management risk; (v) existence and change in credit concentrations; (vi) credit risk management; (vii) change in residential construction; and (viii) international risk. The following table details activity in the allowance for loan losses by portfolio segment for the years ended December 31, 2011 and Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories Annual Report l 33

35 (Dollars in Thousands) Commercial Agricultural Consumer Real Estate Total 2011 Beginning balance $ 4,648 $ 31 $ 2,188 $ 18,395 $ 25,262 Provision for loan losses 1, ,067 8,494 11,100 Charge-offs (1,389) (38) (1,190) (4,002) (6,619) Recoveries ,369 Net charge-offs (844) (33) (699) (3,674) (5,250) Ending balance $ 5,302 $ 39 $ 2,556 $ 23,215 $ 31,112 Year-end amount allocated to: Loans individually evaluated for impairment $ 238 $ -0- $ 1 $ 928 $ 1,167 Loans collectively evaluated for impairment 5, ,555 22,287 29,945 Ending balance $ 5,302 $ 39 $ 2,556 $ 23,215 $ 31, Beginning balance $ 3,996 $ 41 $ 2,176 $ 15,888 $ 22,101 Provision for loan losses 10,978 (12) 1,351 14,333 26,650 Charge-offs (11,064) -0- (1,919) (12,087) (25,070) Recoveries ,581 Net charge-offs (10,326) 2 1,339) (11,826) (23,489) Ending balance $ 4,648 $ 31 $ 2,188 $ 18,395 $ 25,262 Year-end amount allocated to: Loans individually evaluated for impairment $ 106 $ -0- $ -0- $ 986 $ 1,092 Loans collectively evaluated for impairment 4, ,188 17,409 24,170 Ending balance $ 4,648 $ 31 $ 2,188 $ 18,395 $ 25,262 The Company s recorded investment in loans as of December 31, 2011 and 2010 related to each balance in the allowance for loan losses by portfolio segment and disaggregated on the basis of the Company s impairment methodology follows: (Dollars in Thousands) Commercial Agricultural Consumer Real Estate Total 2011 Loans individually evaluated for impairment $ 882 $ -0- $ 57 $ 27,186 $ 28,125 Loans collectively evaluated for impairment 219,613 1,657 89, ,885 1,225,675 Ending balance $ 220,495 $ 1,657 $ 89,577 $ 942,071 $ 1,253, Loans individually evaluated for impairment $ 2,438 $ -0- $ 18 $ 32,443 $ 34,899 Loans collectively evaluated for impairment 224,849 1, , ,321 1,192,694 Ending balance $ 227,287 $ 1,591 $ 112,951 $ 885,764 $ 1,227,593 Net gains realized on the sale of loans held for sale totaled $232,000 and $342,000 for the years ended December 31, 2011 and 2010, respectively. 34 l 2011 Annual Report

36 Note 5 - Properties and equipment The following is a summary of properties and equipment, at cost less accumulated depreciation at year end: (Dollars in Thousands) Land $ 18,492 $ 14,822 Buildings and improvements 37,603 35,729 Furniture and equipment 30,718 24,198 Construction in progress 1, ,140 75,633 Less accumulated depreciation ( 23,630 ) ( 20,009 ) $ 64,510 $ 55,624 Depreciation expense was $3,695,000 and $3,243,000 for the years ended December 31, 2011 and 2010, respectively. The Company capitalized $30,000 of interest costs as properties and equipment during There was no interest cost capitalized as properties and equipment during Note 6 - Time Deposits Time deposit accounts included in the balance sheet that have a remaining term of more than one year are as follows: Amount Years Ending December 31, (Dollars in Thousands) 2012 $ 575, , , , ,744 Beyond $ 882,398 Note 7 Other Liabilities Major classifications of other liabilities at year end are as follows: (Dollars in Thousands) Accrued expenses $ 2,327 $ 1,070 Federal and state income taxes payable Property taxes payable 1, $ 4,139 $ 1,468 Note 8 Borrowed funds Securities sold under agreements to repurchase are stated at the amount of cash received in connection with the transaction. The agreements have various interest rates ranging from 0.20 percent to 3.25 percent and repurchase dates to June 21, Securities sold under agreements to repurchase totaled $21,748,000 and $25,872,000 at December 31, 2011 and 2010 with accrued interest of $17,000 and $28,000 respectively. The securities sold under the agreements are collateralized by a security interest in securities available for sale Annual Report l 35

37 The following are available lines of credit the Company has with other financial institutions: Financial Institution (Dollars in Thousands) Line of Credit Amount Amount Available Interest Rate Expiration Date Federal Home Loan Bank of Dallas $ 423,939 $ 232,586 Variable None The Independent Bankers Bank 15,000 15,000 Variable None Frost National Bank 30,000 30,000 Variable None Federal Reserve Bank 157, ,975 Variable None $ 626,914 $ 435,561 The Company has received advances in the amount of $113,353,000 from Federal Home Loan Bank of Dallas ( FHLB ) under provisions of its line of credit facility. The advances mature September 13, 2012 through September 18, 2018 with interest due quarterly at rates of percent through percent. The line of credit with FHLB is collateralized by a blanket floating lien on certain mortgage loans. The lines of credit with The Independent Bankers Bank and Frost National Bank are unsecured. The line of credit with the Federal Reserve Bank ( FRB ) is collateralized by a blanket floating lien on certain commercial and agriculture loans. The Company, through a private placement, has issued a total of $27 million of Floating Rate Cumulative Trust Preferred Securities (27,000 shares with a liquidation amount of $1,000 per security) (the Trust Preferred Securities ). The Trust Preferred Securities were issued through newly-formed, wholly-owned subsidiaries, Lone Star National Capital Trust II, Lone Star National Capital Trust III and Lone Star National Capital Trust IV, which are special purpose Delaware statutory business trusts ( Trusts ). Unamortized debt issuance costs related to the Trusts, which are included in other assets, totaled $837,000 at December 31, 2011 and The Trusts invested the total proceeds from the equity contributions and the securities sale in the Floating Rate Junior Subordinated Deferrable Interest Debentures (the Debentures ) issued by the Company. The net proceeds from the sale of the Debentures was used for general corporate purposes, including capital investments in the Bank. The Trust Preferred Securities issued by the trusts rank senior to the common securities. The obligation of the Company under the trust agreements and the guarantees relating to the trusts constitute the full and unconditional guarantee by the Company of the obligations of the trusts with respect to the Trust Preferred Securities and rank subordinate and junior in right to payment to all other liabilities. The Debentures are subject to mandatory redemption pursuant to the terms of the trust agreements. The Company has the option to redeem the debentures, in whole or in part, on or after any interest payment date after September 30, 2008 for the 2003 issue, April 7, 2009 for the 2004 issue and June 30, 2012 for the 2007 issue. In the event the Debentures are redeemed, a like amount of Trust Preferred Securities will be redeemed at the redemption price of $1,000 per security, plus accrued interest to the date of redemption. The table below summarizes the outstanding preferred securities issued by the trusts as of December 31, 2011 and Trust name: Lone Star National Capital Trust II Issuance date: September 26, 2003 Amount: $10,000,000 Stated maturity: September 30, 2033 Floating interest rate: 2.95% per annum over the Three-Month LIBOR Rate Interest payable/distribution dates: Quarterly/March 30, June 30, September 30, and December l 2011 Annual Report

38 Trust name: Lone Star National Capital Trust III Issuance date: March 25, 2004 Amount: $7,000,000 Stated maturity: April 6, 2034 Floating interest rate: 2.75% per annum over the Three-Month LIBOR Rate Interest payable/distribution dates: Quarterly/January 7, April 7, July 7, and October 7 Trust name: Lone Star National Capital Trust IV Issuance date: June 21, 2007 Amount: $10,000,000 Stated maturity: September 15, 2037 Floating interest rate: 1.57% per annum over the Three-Month LIBOR Rate Interest payable/distribution dates: Quarterly/March 15, June 15, September 15, and December 15 Despite the fact that the accounts of the capital trusts are not included in the Company's consolidated financial statements, the trust preferred securities issued by these subsidiary trusts are included in the Tier 1 capital of Lone Star National Bancshares-Texas, Inc. for regulatory capital purposes. Federal Reserve Board rules limit 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 percent of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. The scheduled maturities of borrowings at December 31, 2011, were as follows: Within After One After Two After Three After One But Within But Within But Within Five (Dollars in Thousands) Year TwoYears Three Years Four years Years Total Federal Home Loan Bank borrowings $ 15,000 $ 8,353 $ 15,000 $ -0- $ 75,000 $ 113,353 Securities sold under agreements to repurchase 21, ,748 Trust preferred subordinated debentures ,837 27,837 Total borrowings $ 36,748 $ 8,353 $ 15,000 $ -0- $ 102,837 $ 162,938 Note 9 - Federal and State Income Taxes The components of the provision for income taxes consist of the following: (Dollars in Thousands) Current income tax expense Federal $ 12,596 $ 2,923 State Total current income tax expense 12,798 3,018 Federal deferred income tax benefit ( 1,545 ) ( 1,018 ) Total income tax expense $ 11,253 $ 2, Annual Report l 37

39 The following is a reconciliation between the amount of reported income tax expense and the amount computed by multiplying the income before income tax expense by the federal statutory rate: (Dollars in Thousands) Tax at federal statutory rate $ 11,470 $ 1,909 Additions (reductions) Tax-exempt income ( 478 ) ( 437 ) Non-deductible expenses Non-statutory stock options ( 583 ) ( 8 ) State income tax, net of federal income tax effect Other, net Total income tax expense $ 11,253 $ 2,000 The net deferred tax asset included in the accompanying consolidated balance sheets is comprised of the following deferred tax assets and liabilities: (Dollars in Thousands) Deferred tax liability Properties and equipment Net unrealized gain on securities available for sale $ 3,258 1,966 $ 2,035 1,987 Total deferred tax liability 5,224 4,022 Deferred tax asset Deferred loan fees Allowance for loan losses 10,889 8,589 Allowance for off balance sheet losses Deferred compensation Other real estate 1, Writedown of other than temporarily impaired securities -0-1,102 Total deferred tax asset before valuation allowance 13,633 10,865 Valuation allowance Total deferred tax asset 13,633 10,865 Net deferred tax asset $ 8,409 $ 6,843 Note 10 - Concentrations of Credit Risk Concentrations of credit risk arise when a number of customers are engaged in similar business activities or activities in the same geographic region, or have similar economic features that would cause their ability to meet contractual obligations to be affected similarly by changes in economic conditions. A significant portion of the Company s investments are in securities of the U.S. Government and its agencies and corporations. The Company s lending activities are conducted primarily with customers in the Rio Grande Valley of Texas. The concentrations of credit by type of loan are set forth in Note 4. Based on the nature of the banking business, management does not consider any of these concentrations unusual. 38 l 2011 Annual Report

40 Note 11 - Supplemental Disclosures Supplemental disclosures of cash flow information Years Ended December 31, (Dollars in Thousands) Federal and State income taxes paid $ 12,898 $ 6,439 Interest paid $ 26,081 $ 27,485 Supplemental schedule of non-cash investing and financing activities (Dollars in Thousands) Foreclosures and repossession in satisfaction of loans receivable $ 21,142 $ 19,801 Financing provided for sales of foreclosed and repossessed assets $ 6,832 $ 10,269 Note 12 - Fair Value Measurements ASC Topic 820 Fair Value Measurements and Disclosures defines fair value, establishes a framework for measuring fair value under GAAP and enhances disclosures about fair value measurements. Fair value is defined under ASC Topic 820 as the price that would be received for an asset or paid to transfer a liability (an exit price) in the principal market for the asset or liability in an orderly transaction between market participants on the measurement date. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability. ASC Topic 820 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows: Level 1 Inputs -Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 2 Inputs -Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means. Level 3 Inputs -Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities. In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the Company s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or 2011 Annual Report l 39

41 reflective of future fair values. While management believes the Company's valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value is set forth below. Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company's monthly and/or quarterly valuation process. Financial assets and financial liabilities measured at fair value on a recurring basis include the following: Securities Available for Sale. U.S. Treasury securities are reported at fair value utilizing Level 1 inputs. Other securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond s terms and conditions, among other things. Trading Securities. U.S. Treasury securities and exchange-listed common stock are reported at fair value utilizing Level 1 inputs. Other securities classified as trading are reported at fair value utilizing Level 2 inputs in the same manner as described above for securities available for sale. Derivatives. Derivatives are reported at fair value utilizing Level 2 inputs. The Company s risk management activities do not presently include entering into derivative contracts to manage interest rate risk. In connection with single family mortgage loan originations, the Company enters into commitments with customers to extend mortgage loans and forward sales commitments for individual loans. The Company has identified these as derivative financial instruments and accordingly records these loan origination and sales commitments at estimated fair market value. As of December 31, 2011, the Company has not identified any other financial instruments as derivatives. The following table summarizes the securities available for sale which were the financial assets measured at fair value on a recurring basis at December 31, 2011, segregated by the level of valuation inputs within the fair value hierarchy utilized to measure fair value: Level 1 Inputs $ 18,386 Level 2 Inputs 125,632 Level 3 Inputs -0- Total fair value $ 144,018 Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). Financial assets and liabilities measured at fair value on a non-recurring basis include the following: Impaired Loans. Certain impaired loans are reported at the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using Level 2 inputs based on observable market data or Level 3 inputs based on customized discounting criteria. During 2011, certain impaired loans were remeasured and reported at fair value through a specific valuation allowance allocation of the allowance for possible loan losses based upon the fair value of the underlying collateral. Impaired loans with a carrying value of $5.0 million were reduced by specific valuation allowance allocations totaling $1.2 million to a total reported fair value of $3.8 million based on collateral valuations utilizing Level 2 valuation inputs. 40 l 2011 Annual Report

42 ASC Topic 825, Financial Instruments, requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or nonrecurring basis are discussed above. The estimated fair value approximates carrying value for cash and cash equivalents, accrued interest and the cash surrender value of life insurance policies. The methodologies for other financial assets and financial liabilities are discussed below: Loans. The estimated fair value approximates carrying value for variable-rate loans that reprice frequently and with no significant change in credit risk. The fair value of fixed-rate loans and variablerate loans which reprice on an infrequent basis is estimated by discounting future cash flows using the current interest rates at which similar loans with similar terms would be made to borrowers of similar credit quality. An overall valuation adjustment is made for specific credit risks as well as general portfolio credit risk. Deposits. The estimated fair value approximates carrying value for demand deposits. The fair value of fixed-rate deposit liabilities with defined maturities is estimated by discounting future cash flows using the interest rates currently offered for deposits of similar remaining maturities. The estimated fair value of deposits does not take into account the value of the Company s long-term relationships with depositors, commonly known as core deposit intangibles, which are separate intangible assets, and not considered financial instruments. Nonetheless, the Company would likely realize a core deposit premium if its deposit portfolio were sold in the principal market for such deposits. Borrowed Funds. The estimated fair value approximates carrying value for short-term borrowings. The fair value of long-term fixed-rate borrowings is estimated using quoted market prices, if available, or by discounting future cash flows using current interest rates for similar financial instruments. The estimated fair value approximates carrying value for variable-rate junior subordinated deferrable interest debentures that reprice quarterly. Loan Commitments, Standby and Commercial Letters of Credit. The Company s lending commitments have variable interest rates and escape clauses if the customer s credit quality deteriorates. Therefore, the fair values of these items are not significant and are not included in the following table. The estimated fair values of the Company s financial instruments at December 31, 2011 are as follows: Carrying Fair (Dollars in Thousands) Amount Value Financial assets Cash and due from banks $ 36,416 $ 36,416 Due from banks-interest bearing 303, ,901 Certificates of deposit 2,533 2,533 Investment securities 466, ,535 Loans Accrued interest receivable Loans held for sale 1,221,076 7,132 3,469 1,261,491 7,132 3,469 Financial liabilities Deposits 1,805,942 1,743,124 Repurchase agreements/borrowed funds Subordinated debentures Accrued interest payable 135,101 27,837 1, ,986 27,837 1, Annual Report l 41

43 ASC Topic 825 permits the Company to choose to measure eligible items at fair value at specified election dates. Unrealized gains and losses on items for which the fair value measurement option has been elected are reported in earnings at each subsequent reporting date. The fair value option (i) may be applied instrument by instrument, with certain exceptions, thus the Company may record identical financial assets and liabilities at fair value or by another measurement basis permitted under generally accepted accounting principles, (ii) is irrevocable (unless a new election date occurs) and (iii) is applied only to entire instruments and not to portions of instruments. Unrealized gains and losses on items for which the fair value measurement option has been elected must be reported in earnings at each subsequent reporting date. During the reported periods, the Company had no financial instruments measured at fair value under the fair value measurement option. Note 13 - Related-Party Transactions The Company has entered into transactions with its officers, directors and significant stockholders. Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present unfavorable features. Activity in related party loans is presented in the following table: (Dollars in Thousands) Balance at beginning of year $ 46,317 $ 41,078 Additions Advances 15,460 14,183 Changes to related status Reductions Collections ( 14,348 ) ( 8,897 ) Changes to unrelated status ( 115 ) ( 47 ) Charge-offs Balance at end of year $ 47,877 $ 46,317 As of December 31, 2011 and 2010, the total amount of deposits of the Company s officers, directors and significant stockholders were $22,988,000 and $28,459,000, respectively. The Company has construction contracts with one of its principal stockholders. The outstanding contracts, totaling $3,477,000, of which $924,000 were entered into in years prior to 2011, are for the construction and improvements of branch facilities. Payments made under construction contracts to related parties during 2011 and 2010 totaled $2,311,000 and $2,182,000, respectively. The Company leases various facilities under operating leases with related parties that expire at various dates through July 2015 with some containing provisions that allow renewal at similar terms. Total rental expense in 2011 and 2010 for all operating leases with related parties was approximately $281,000 and $271,000, respectively. The following is a schedule by year of future minimum lease payments under operating leases with related parties as of December 31, 2011 that have initial or remaining lease terms in excess of one year: 42 l 2011 Annual Report

44 Year ended December 31, 2012 $ 281, , , , ,000 The Company engaged in other related party transactions with an aggregate amount of $489,000 during These transactions included payments to related parties for office supplies, printing, maintenance and repair of other real estate owned property and the Company s marketing program. Note 14 - Employee Benefits Employee Stock Ownership Plan. The Company has an employee stock ownership plan containing Internal Revenue Code Section 401(k) provisions in effect for substantially all full-time employees. An employee becomes a participant after completing three months of service provided he or she has attained age 18. The Company makes a discretionary matching contribution up to a certain percentage of contributions made by the participant. Additional contributions are made at the discretion of the Board of Directors. Employee benefits include $350,000 and $183,000 for the employee stock ownership plan for 2011 and 2010, respectively. Incentive Compensation Agreement. Effective January 1, 2010 the Board of Directors terminated an existing incentive compensation agreement with certain officers. This plan provided for additional compensation to the officers based upon the Bank achieving certain levels of Return on Average Equity. There was no compensation accrued under the plan in The Company did not enter into any incentive compensation plans in Note 15 - Share-Based Payments The Company has granted stock options providing for the purchase of common stock by certain key employees and directors under option plans approved by the stockholders. The 2006 Stock Option Plan authorized the issuance of stock options for 150,000 shares at fair value on the date of grant. As of December 31, 2011, no shares were available for granting under this plan. During 2011, the Company terminated the plan except for outstanding awards. Any forfeiture will be terminated. The options have a vesting period of five years. A summary of the status of the Company s stock option plan as of December 31, 2011 and 2010, and changes during the years ended on those dates are presented below: Years Ended December 31, Weighted Weighted Shares Average Shares Average Underlying Exercise Underlying Exercise Options Price Options Price Outstanding at beginning of year 185,442 $ ,892 $ Granted 84, , Rescinded -0- N/A ( 80,688 ) Exercised ( 105,330 ) ( 4,450 ) Expired/forfeited ( 5,500 ) ( 1,000 ) Outstanding at end of year 158,800 $ ,442 $ Options exercisable at end of year 156,798 $ ,337 $ Annual Report l 43

45 Years Ended December 31, Range of exercise prices $ $45.00 $ $45.00 Weighted average remaining contractual life 0.50 years 0.76 years The following table summarizes information about stock options outstanding at December 31, 2011 and 2010: Weighted Average Exercise Price Years Ended December 31, Shares Underlying Options Shares Underlying Options $ ,830 $ ,600 31,600 $ ,000 18,500 $ ,000 2,000 $35.50 $36.00 $43.50 $ , ,000 37,500 1,000 1,000 20,012 21, , ,442 The Company recognizes the cost of the unvested portion of options issued in prior years and the cost of options issued during 2011, using the Black-Scholes-Merton option pricing model and a single options award approach method to measure the compensation cost of stock options granted in This option pricing model relies on highly subjective and variable assumptions, including the expected life of the options; the price volatility of the underlying stock; and the rate of return a prudent investor could expect in a stable market. The Company utilized the following assumptions, based on historical values and industry averages: risk-free interest rate (2.82 percent) based upon a U. S. Treasury instrument with a life similar to the expected life of the option grant at the grant date; a dividend payout rate of zero; and an expected option life of 60 months. The expected stock price volatility assumption of was determined using a combination of historical and implied volatility of the Company s common stock. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. The forfeiture rate utilized is based on the Company s historical experience with respect to stock options issued in prior periods. Total compensation cost for share-based payments was $475,000 in 2011 and $35,000 in 2010 net of taxes of $256,000 and $19,000, respectively. Note 16 - Commitments and Contingent Liabilities In the normal course of business, the Company makes various commitments and incurs certain contingent liabilities that are not presented in the accompanying financial statements. These commitments and contingent liabilities include commitments to extend credit, standby letters of credit and credit card guarantees. Commitments under standby letters of credit aggregated $4,554,000 and $5,378,000 at December 31, 2011 and 2010, respectively. Commitments to fund loans were approximately $76,852,000 and $93,073,000 at December 31, 2011 and 2010, respectively. At December 31, 2011 and 2010, the Company had guarantees on credit cards to its customers totaling $10,000 and $520,000, respectively. 44 l 2011 Annual Report

46 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company evaluates each customer s creditworthiness on a case by case basis. The amount of the collateral obtained, if it is deemed necessary by the Company upon extension of credit, is based on management s credit evaluation of the counterparty. Collateral held varies but may include certificates of deposit, accounts receivable, inventory, equipment and real estate. Standby letters of credit and financial guarantees written are a conditional commitment issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds various types of collateral supporting those commitments for which collateral is deemed necessary, which may include certificates of deposit, accounts receivable, inventory, equipment and real estate. The Company did not incur any loss on its commitments in 2011 or Management does not anticipate any material losses as a result of its commitments and contingent liabilities. The Company has entered into long-term agreements for certain data processing and computer software products and services. The data processing and computer software contracts provide for minimum monthly payments and additional charges based upon volume. These agreements expire in various years through 2014 and contain provisions that allow renewal at similar terms. Total expense from these agreements amounted to $1,596,000 and $1,106,000 in 2011 and 2010, respectively. Aggregate minimum contractual payments under these agreements for the next five years are as follows: Year ended December 31, 2012 $ 1,794, ,462, , The Company leases various facilities under operating leases expiring at various dates through August 2020 with some containing provisions that allow renewal at similar terms. Total rental expense in 2011 and 2010 for all operating leases was approximately $934,000 and $682,000, respectively. The following is a schedule by year of future minimum lease payments under operating leases as of December 31, 2011 that have initial or remaining lease terms in excess of one year: Year ended December 31, 2012 $ 653, , , , ,000 The Company is a defendant in legal actions arising in connection with its ordinary course of business that are in various stages of litigation and investigation by the Company and its legal counsel. After reviewing with counsel the actions pending involving the Company, management believes that the ultimate resolution of these matters will not materially affect the Company s financial position Annual Report l 45

47 Note 17 - Earnings Per Share Basic net income per share ( EPS ) was computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the year. Diluted net income per share was computed by dividing net income by the weighted average number of common shares and common stock equivalents outstanding during the year. The diluted net income per share computations include the effects of common stock equivalents applicable to stock option contracts and are determined using the treasury stock method. The table below presents a reconciliation of basic and diluted net income per share computations. Years ended December 31, (Dollars in Thousands, Except Per Share Data) Net income available to common shareholders $ 21,519 $ 3,711 Weighted average number of common shares outstanding used in basic EPS calculation 6,317,240 5,823,291 Add assumed exercise of dilutive securities outstanding - stock options 15,227 78,629 Weighted average number of common shares outstanding used in diluted basic EPS calculation 6,332,467 5,901,920 Basic EPS $ 3.41 $ 0.64 Diluted EPS $ 3.40 $ 0.63 Note 18 - Regulatory Matters The Bank, as a National Bank, is subject to the dividend restrictions set forth by the Comptroller of the Currency (the OCC ). Under such restrictions, the Bank may not, without the prior approval of the OCC, declare dividends in excess of the current year s earnings (as defined) plus the retained earnings (as defined) from the prior two years or pay any dividend which would cause the Bank to become undercapitalized. The Company is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet the minimum regulatory capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that if undertaken, could have a direct material effect on the Company and the consolidated financial statements. Under the regulatory capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines involving quantitative measures of the Company s assets, liabilities, and certain offbalance-sheet items as calculated under regulatory accounting practices. The Company s capital amounts and classification under the prompt corrective action guidelines are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of total risk-based capital and Tier I capital to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined). Management believes, as of December 31, 2011, that the Company meets all the capital adequacy requirements to which it is subject. As of December 31, 2011, the most recent notification from the regulators categorized the Company and the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Company and the Bank have to maintain minimum or greater total risk-based, Tier I risk-based, and Tier I leverage ratios as disclosed in the table below. 46 l 2011 Annual Report

48 There are no conditions or events since the most recent notification that management believes have changed the Bank s prompt corrective action category. To Be Well Capitalized For Capital Under Prompt Actual Adequacy Purposes Action Provisions (Dollars in Thousands) Amount Ratio Amount Ratio Amount Ratio Lone Star National Bancshares-Texas, Inc. December 31, 2011 Total Capital (to Risk-Weighted Assets) $ 247, % $ 101,343 8% $ 126,679 10% Tier 1 Capital (to Risk-Weighted Assets) $ 231, % $ 50,672 4% $ 76,008 6% Tier 1 Capital (to Average Assets) $ 231, % $ 88,325 4% $ 110,406 5% December 31, 2010 Total Capital (to Risk-Weighted Assets) $ 223, % $ 102,879 8% $ 128,599 10% Tier 1 Capital (to Risk-Weighted Assets) $ 207, % $ 51,440 4% $ 77,160 6% Tier 1 Capital (to Average Assets) $ 207, % $ 82,908 4% $ 103,635 5% Lone Star National Bank December 31, 2011 Total Capital (to Risk-Weighted Assets) $ 231, % $ 100,506 8% $ 125,632 10% Tier 1 Capital (to Risk-Weighted Assets) $ 215, % $ 50,253 4% $ 75,379 6% Tier 1 Capital (to Average Assets) $ 215, % $ 88,029 4% $ 110,036 5% December 31, 2010 Total Capital (to Risk-Weighted Assets) $ 207, % $ 102,783 8% $ 128,479 10% Tier 1 Capital (to Risk-Weighted Assets) $ 191, % $ 51,392 4% $ 77,088 6% Tier 1 Capital (to Average Assets) $ 191, % $ 82,411 4% $ 103,014 5% Note 19 - Recent Accounting Pronouncements FASB ASC Topic 810, Consolidation ("ASC 810") was amended to change how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity's purpose and design and a company's ability to direct the activities of the entity that most significantly impact the entity's economic performance. The new authoritative accounting guidance requires additional disclosures about the reporting entity's involvement with variable-interest entities and any significant changes in risk exposure due to that involvement as well as its effect on the entity's financial statements. The new authoritative accounting guidance under ASC 810 was effective January 1, 2010 and did not have a significant impact on the Company s financial statements. ASU No , Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures About Fair Value Measurements. ASU requires expanded disclosures related to fair value measurements including (i) the amounts of significant transfers of assets or liabilities between Levels 1 and 2 of the fair value hierarchy and the reasons for the transfers, (ii) the reasons for transfers of assets or liabilities in or out of Level 3 of the fair value hierarchy, with significant transfers disclosed separately, (iii) the policy for determining when transfers between levels of the fair value hierarchy are recognized and (iv) for recurring fair value measurements of assets and liabilities in Level 3 of the fair value hierarchy, a gross presentation of information about purchases, sales, issuances and settlements. ASU further clarifies that (i) fair value measurement disclosures should be provided for each class of assets and liabilities (rather than major category), which would generally be a subset of assets or liabilities within a line item in the statement of financial position and (ii) companies should provide 2011 Annual Report l 47

49 disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements for each class of assets and liabilities included in Levels 2 and 3 of the fair value hierarchy. The disclosures related to the gross presentation of purchases, sales, issuances and settlements of assets and liabilities included in Level 3 of the fair value hierarchy were required for the Company beginning January 1, The remaining disclosure requirements and clarifications made by ASU became effective for the Company on January 1, The new authoritative accounting guidance under ASC 820 did not have a significant impact on the Company s financial statements. ASU No , Receivables (Topic 310) A Creditor s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. ASU clarifies which loan modifications constitute troubled debt restructurings and is intended to assist creditors in determining whether a modification of the terms of a receivable meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude, under the guidance clarified by ASU , that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. ASU became effective for the Company on July 1, 2011, and applies retrospectively to restructurings occurring on or after January 1, The new authoritative accounting guidance under ASU did not have a significant impact on the Company s financial statements. ASU , Balance Sheet (Topic 210) Disclosures about Offsetting Assets and Liabilities. ASU amends Topic 210, Balance Sheet, to require an entity to disclose both gross and net information about financial instruments, such as sales and repurchase agreements and reverse sales and repurchase agreements and securities borrowing/lending arrangements, and derivative instruments that are eligible for offset in the statement of financial position and/or subject to a master netting arrangement or similar agreement. ASU is effective for annual and interim periods beginning on January 1, 2013, and is not expected to have a significant impact on the Company s financial statements. 48 l 2011 Annual Report

50 2011 Annual Report l 49

51 Board of Directors Alonzo Cantu Chairman of the Board Lone Star National Bank Cantu Construction, Inc. Oscar R. Gonzalez Vice Chairman of the Board Lone Star National Bank Certified Public Accountant Cruz Cantu III Land Development George R. Carruthers Executive Vice President & Chief Financial Officer Lone Star National Bancshares-Texas, Inc. S. David Deanda, Jr. President & Chief Operating Officer Lone Star National Bank Lazaro H. Fernandez, Jr. Dos Rios Textiles Corp. Abdala Kalifa Kalifa s Western Wear Nolan E. Perez, M.D. Gastroenterology A. Jabier Rodriguez Chief Executive Officer Lone Star National Bank 50 l 2011 Annual Report

52 Ruben M. Torres, M.D. Obstetrics & Gynecology Manny Vela Attorney at Law Angie Vera-Oliva Executive Vice President & Chief Operations Officer Lone Star National Bank Joe D. Zayas, D.D.S. Dentist 2011 Annual Report l 51

53 Advisory Directors Hidalgo County Rolando Ayala Executive Vice President Lone Star National Bank Raul C. Garza Spirit Truck Lines, Inc. Jaime A. Gonzalez, Jr. Attorney at Law Arturo E. Guerra, Jr. Attorney at Law/Rancher Alberto Gutierrez, Jr., M.D. Family Practice Victor Haddad, M.D. Surgeon Ambrosio Hernandez, M.D. Pediatric Surgeon Jorge Medina Joe Brand Jose F. Peña, M.D. Internal Medicine David M. Penoli Executive Vice President & Chief Financial Officer Sunil Wadhwani Watchzone.com Richard Walsh Healds Valley Farms Marketing Consultant Starr County Arturo S. Perez Gilberto Perez Properties, LLC Managing Partner Jose A. Vazquez, M.D. Internal Medicine The Honorable Judge Eloy Vera 52 l 2011 Annual Report

54 Cameron County Rusty Brechot Senior Vice President Corporate Sales Manager Raymond Cisneros Executive Vice President & Chief Credit Officer Narciso Escareño Travel Agency Inc. Mike Garcia El Devisadero Ranch David G. Oliveira Attorney at Law Jose L. Peña Educator/Rancher Rodolfo A. Saca, M.D. Pediatric Neonatologist Aldon Williams, M.D. Pain Medicine Specialist Asim Zamir, M.D., F.A.A.P. Pediatrician Bexar County Ricardo Castillo, M.D. Family Practice Edmundo O. Garcia, M.D. Heritage Medical Clinic Eliot Garza NSIDE Magazine Damaso A. Oliva, M.D. Alamo Psychiatric Care, P.A. Dipen J. Parekh, M.D. Urologic Oncology, Robotic Surgery Larry E. Safir Media/Health Care Executive 2011 Annual Report l 53

55 Bank Officers Corporate Office A. Jabier Rodriguez Chief Executive Officer Director S. David Deanda, Jr. President & Chief Operating Officer Director Angie Vera-Oliva Executive Vice President & Chief Operations Officer Director Raymond Cisneros Executive Vice President & Chief Credit Officer Advisory Director D. M. Penoli Executive Vice President & Chief Financial Officer Advisory Director Rolando Ayala Executive Vice President Advisory Director Edward Borges Executive Vice President & Chief Risk Officer Lawrence DesPres Executive Vice President & Chief Information Officer Sam De La Garza Executive Vice President Tony Gorman Executive Vice President & Human Resources & Training Director Roger G. Leblond Executive Vice President & Chief Technology Officer Rusty Brechot Senior Vice President Advisory Director Rueben Cole Senior Vice President Brian Disque Senior Vice President Fred Flores Senior Vice President Adan Garcia Senior Vice President Abby G. Gonzalez Senior Vice President Gloria Guerra Senior Vice President Lawrence Kentz Senior Vice President & Compliance Officer Olga Lee Hinojosa Senior Vice President Efrain Martinez Senior Vice President & BSA Officer Adam Pearson Senior Vice President & Information Security Officer Pedro Salazar Senior Vice President Sameer Saxena Senior Vice President Ted P. Sunderland Senior Vice President Christine M. Villaseñor Senior Vice President Desiraee Walker Senior Vice President Celeste De La Garza First Vice President Edna X. De Saro First Vice President Leticia E. Hinojosa First Vice President Armando Martinez, Jr. First Vice President Vipul Patel First Vice President J. Edgar Ruiz II First Vice President Veronica Vizcarra-Prinkey First Vice President Betty Bran Vice President Hope Cadenas Vice President Veronica Cantu Vice President Enrique Espinoza Vice President Jose Leal Vice President Cindy Lopez-Ybarra Vice President Marco Perez Vice President Ismael Rodriguez Vice President Gregory Shoultz Vice President & Controller Lone Star National Bancshares-Texas, Inc. George R. Carruthers Executive Vice President & Chief Financial Officer Janie Sandoval Executive Vice President & Financial Analysis Manager Joe M. Araiza, Jr. First Vice President McAllen Arden Peterson Senior Vice President Jose X. Villescas Senior Vice President Dustin A. Wells Senior Vice President Cristobal Escobedo, Jr. First Vice President Paul Garcia First Vice President 54 l 2011 Annual Report

56 Rafael Gonzalez First Vice President Homer Guerra First Vice President Eva Markum First Vice President Carmen Raymundo First Vice President Ixchetl Romero First Vice President Edna Yaccarino First Vice President Daniel Algranatti Vice President Magda Ramirez Vice President Lydia Sandoval Vice President Leticia Zavala Vice President Pharr, Edinburg & Weslaco Joel A. Gonzalez Senior Vice President Elias Longoria, Jr. Senior Vice President Norma Quintanilla Senior Vice President Martin Volpe Senior Vice President Julia De Leon First Vice President Erika Degollado First Vice President Michael Trippel First Vice President Nena Gutierrez Vice President Olga G. Lopez Vice President Robyn Rodriguez Vice President Susan Trevino Vice President Maria I. Villarreal Vice President Rio Grande City & Roma Ruben C. Chapa Senior Vice President Alejandra Gonzalez Vice President Hidalgo, Mission & Palmview Juan J. Acosta Senior Vice President Jesse A. Villarreal Senior Vice President Harlingen, Brownsville Port Isabel & South Padre Island Eduardo Caso Executive Vice President Jackie Russell Senior Vice President Norma P. Weaver Senior Vice President Margarita Gonzalez First Vice President Michele Robinson First Vice President Michael Alvarado Vice President San Antonio A. Jabier Rodriguez Chief Executive Officer Director Ezequiel Rick Acevedo, Jr. Executive Vice President Gustavo Parra Executive Vice President Cynthia Gutierrez Senior Vice President Roland Luna First Vice President Ryan Parker First Vice President Anthony Trevino First Vice President Raymond Chan Vice President Mary Guajardo Vice President Lone Star Insurance Services* Jim Hansen President Ruben Garza Vice President LSNB Investment Services** Yvonne L. Silguero LPL Branch Manager/Financial Consultant Enrique Lopez Financial Consultant *Insurance Products Offered by Lone Star Insurance Services, Inc. are not insured by the FDIC or Any Other Federal Government Agency, are not Deposits of or Guaranteed by the Bank or Any Affiliate, and May Lose Value. **Investment Products Offered by LSNB Investment Services are not insured by the FDIC or Any Other Federal Government Agency, are not Deposits of or Guaranteed by the Bank or Any Affiliate, and May Lose Value. Securities and Insurance products offered through LPL Financial and its affiliates, Member FINRA/SIPC Annual Report l 55

57 Banking Centers, Mortgage & ATM Locations San Antonio Rio Grande Valley Rio Grande Valley Locations Brownsville 3300 N. Expressway 83 - Mortgage Center - ATM - Motor Bank 2100 Boca Chica Boulevard - ATM - Motor Bank Edinburg 117 S. 10th Avenue - ATM - Motor Bank Harlingen 1901 N. Ed Carey Drive, Suite ATM (2) - Motor Bank 918 W. Harrison Avenue (Motor Bank) - ATM Hidalgo 633 S. International Boulevard - ATM - Motor Bank McAllen 520 E. Nolana Avenue (Corporate Office) 5515 N. 10th Street - ATM - Motor Bank 200 Lindberg Avenue - ATM - Motor Bank 1300 E. Ridge Road - ATM - Motor Bank 600 E. Nolana Avenue - ATM - Motor Bank 5537 N. McColl Road - ATM - Motor Bank 800 N. Main Street, Suite 600 (Located at the Art Village on Main) - ATM 2109 S. 10th Street - ATM - Motor Bank Mission 2003 E. Griffin Parkway - ATM - Motor Bank 1100 S. Bryan Road - ATM - Motor Bank Palmview 720 E. Veterans Boulevard - ATM - Motor Bank Pharr 206 W. Ferguson Avenue - ATM - Motor Bank 1201 S. Cage Boulevard (Motor Bank) - ATM 118 South Cage Boulevard (Located at the Pharr City Hall Building) - ATM - Motor Bank Port Isabel 202 E. Queen Isabella Boulevard (Motor Bank) - ATM Rio Grande City 2300 E. Highway 83 - ATM - Motor Bank 201 N. Texas Street - ATM - Motor Bank Roma 305 E. Grant Street - ATM - Motor Bank South Padre Island 601 Padre Boulevard - ATM - Motor Bank Weslaco 214 S. Texas Boulevard - ATM - Motor Bank 620 W. Expressway 83 - ATM - Motor Bank San Antonio Locations 7954 Fredericksburg Road - ATM - Motor Bank 40 NE Loop 410, Suite 408 (Annex Corporate Office- The Mercantile Building) - Motor Bank San Pedro Avenue - ATM - Motor Bank 6986 S. Zarzamora Street - ATM - Motor Bank Mortgage Centers Brownsville 3300 N. Expressway 83 McAllen 4500 N. 10th Street, Suite 305 San Antonio 930 Proton, Suite 106 Offsite ATM Locations Alto Bonito 760 FM 2360 N (Located Inside Alto County Stop) Edinburg 5502 S. McColl Road (Located Inside The Women s Hospital at Renaissance) 5501 S. McColl Road (Located Inside Doctors Hospital at Renaissance) McAllen 3700 Buddy Owens Avenue (Located at Burger King) 114 S. Main Street (Located Inside Colors Name Brand Clothing) Pharr 1210 W. Expressway 83, Suite 6 (Located Inside Mas Building) 3000 N. Cage Boulevard (Located Inside The Pharr Events Center) Progreso 251 S. International Boulevard (Located at the Progreso International Bridge) Rio Grande City 100 FM 3167 (Located Inside the Starr County Court House-Annex Building) Roma 4996 E. Highway 83 (Located at Pueblo Express Mart) Lone Star Insurance Services* 520 E. Nolana Avenue, Suite 110 McAllen, Texas LSNB Investment Services** 520 E. Nolana Avenue, Suite 120 McAllen, Texas *Insurance Products Offered by Lone Star Insurance Services, Inc. are not insured by the FDIC or Any Other Federal Government Agency, are not Deposits of or Guaranteed by the Bank or Any Affiliate, and May Lose Value. **Investment Products Offered by LSNB Investment Services are not insured by the FDIC or Any Other Federal Government Agency, are not Deposits of or Guaranteed by the Bank or Any Affiliate, and May Lose Value. Securities and Insurance products offered through LPL Financial and its affiliates, Member FINRA/SIPC. 56 l 2011 Annual Report

58 Our History Lone Star National Bank opened for business on January 23, 1983 in Pharr, Texas. Conducting business in a small, 3,000 square-foot, temporary building and with only ten employees, the bank opened its doors with the objective of making the future more prosperous for the community. Over the next two decades, Lone Star National Bank expanded continuously opening banking centers throughout the Valley, beginning with its first banking center in Hidalgo County on April 4, 1994, at 200 Lindberg in McAllen. In August 2000, the bank opened the banking center outside Hidalgo County in Rio Grande City and then entered the Cameron County market in July 2001, with a banking center at 3300 N. Expressway 83 in Brownsville. In March 2010, the bank opened the first banking center in Bexar County at 40 NE Loop 410, Suite 408, in San Antonio. By December 2011, the bank opened the fourth banking center in San Antonio. Today, Lone Star National Bank is a technologically advanced, full-service, independent, community bank with over 500 employees and 31 locations across South Texas. Our rapid growth is attributable to several factors such as offering personal value added customer service and providing a rewarding environment for our employees. Staying true to our mission of supporting individuals and small businesses who contribute to the growth of their communities. And staying at the forefront of technological advances like LSNB Mobile (mobile banking) and Office Banker (remote capture) which let us bring the bank to our customers. These factors, combined with the support of our stockholders, customers, neighbors and friends, have made Lone Star National Bank a well-known success, and a leader in financial services in South Texas.