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SOUTHSIDE BANCSHARES INC - 10-Q/A - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following is a discussion of the consolidated financial condition, changes in financial condition, and results of our operations, and should be read and reviewed in conjunction with the financial statements, and the notes thereto, in this Quarterly Report on Form 10-Q/A and in our Annual Report on Form 10-K for the year ended December 31, 2012 . We reported an increase in net income for the three and nine months ended September 30, 2013 compared to the same period in 2012 . Net income on a restated basis for the three and nine months ended September 30, 2013 was $8.9 million and $29.0 million , respectively, compared to $8.6 million and $26.5 million , respectively, for the same period in 2012 . As more fully described in Note 2 of the Notes to Financial Statements, certain financial statement components for the three and nine months ended September 30, 2013 have been restated to reflect the recognition of interest income on our municipal securities purchased at a premium based on amortizing the premium to the maturity of the security. Throughout this discussion we will footnote tables that have been restated for the three and nine months ended September 30, 2013 to reflect the impact of this restatement and we have updated our discussion to discuss changes between periods when comparing the restated amounts. Forward Looking Statements Certain statements of other than historical fact that are contained in this document and in written material, press releases and oral statements issued by or on behalf of Southside Bancshares, Inc., a bank holding company, may be considered to be "forward-looking statements" within the meaning of and subject to the protections of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management's views as of any subsequent date. These statements may include words such as "expect," "estimate," "project," "anticipate," "appear," "believe," "could," "should," "may," "intend," "probability," "risk," "target," "objective," "plans," "potential," and similar expressions. Forward-looking statements are statements with respect to our beliefs, plans, expectations, objectives, goals, anticipations, assumptions, estimates, intentions and future performance, and are subject to significant known and unknown risks and uncertainties, which could cause our actual results to differ materially from the results discussed in the forward-looking statements. For example, discussions of the effect of our expansion, trends in asset quality, and earnings from growth, and certain market risk disclosures are based upon information presently available to management and are dependent on choices about key model characteristics and assumptions and are subject to various limitations. By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future. As a result, actual income gains and losses could materially differ from those that have been estimated. Other factors that could cause actual results to differ materially from forward-looking statements include, but are not limited to, the following: • general economic conditions, either globally, nationally, in the State of Texas, or in the specific markets in which we operate, including, without limitation, the deterioration of the commercial real estate, residential real estate, construction and development, credit and liquidity markets, which could cause an adverse change in our net interest margin, or a decline in the value of our assets, which could result in realized losses; • legislation, regulatory changes or changes in monetary or fiscal policy that adversely affect the businesses in which we are engaged, including the impact of the Dodd-Frank Act, the Federal Reserve's actions with respect to interest rates and other regulatory responses to current economic conditions; • adverse changes in the status or financial condition of the Government-Sponsored Enterprises (the "GSEs") impacting the GSEs' guarantees or ability to pay or issue debt; • adverse changes in the credit portfolio of other U.S. financial institutions relative to the performance of certain of our investment securities; • economic or other disruptions caused by acts of terrorism in the United States, Europe or other areas; • changes in the interest rate yield curve such as flat, inverted or steep yield curves, or changes in the interest rate environment that impact interest margins and may impact prepayments on the mortgage-backed securities ("MBS")portfolio; • increases in our nonperforming assets; • our ability to maintain adequate liquidity to fund operations and growth; • the failure of our assumptions underlying allowance for loan losses and other estimates; • unexpected outcomes of, and the costs associated with, existing or new litigation involving us; • changes impacting our balance sheet and leverage strategy; • risks related to actual U.S. agency MBS prepayments exceeding projected prepayment levels; • risks related to U.S. agency MBS prepayments increasing due to U.S. Government programs designed to assist homeowners to refinance their mortgage that might not otherwise have qualified; • our ability to monitor interest rate risk; • significant increases in competition in the banking and financial services industry; 39-------------------------------------------------------------------------------- Table of Contents • changes in consumer spending, borrowing and saving habits; • technological changes; • our ability to increase market share and control expenses; • the effect of changes in federal or state tax laws; • the effect of compliance with legislation or regulatory changes; • the effect of changes in accounting policies and practices; • risks of mergers and acquisitions including the related time and cost of implementing transactions and the potential failure to achieve expected gains, revenue growth or expense savings; • credit risks of borrowers, including any increase in those risks due to changing economic conditions; and • risks related to loans secured by real estate, including the risk that the value and marketability of collateral could decline. All written or oral forward-looking statements made by us or attributable to us are expressly qualified by this cautionary notice. We disclaim any obligation to update any factors or to announce publicly the result of revisions to any of the forward-looking statements included herein to reflect future events or developments. Impact of Dodd-Frank Act On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act represents a significant overhaul of many aspects of the regulation of the financial services industry, although some of its provisions apply to companies that are significantly larger than us. The Dodd-Frank Act directs applicable regulatory authorities to promulgate regulations implementing many of its provisions. Regulatory agencies are still in the process of issuing regulations, rules and reporting requirements as mandated by the Dodd-Frank Act. The effect of the Dodd-Frank Act on us and the financial services industry as a whole will continue to be clarified as further regulations are issued. Major elements of the Dodd-Frank Act include: • A permanent increase in deposit insurance coverage to $250,000 per account, and an increase in the minimum Deposit Insurance Fund reserve requirement from 1.15% to 1.35%, with assessments to be based on assets as opposed to deposits; • New disclosure and other requirements relating to executive compensation and corporate governance; • New prohibitions and restrictions on the ability of a banking entity and nonbank financial company to engage in proprietary trading and have certain interests in, or relationships with, a hedge fund or private equity fund; • Amendments to the Truth in Lending Act aimed at improving consumer protections with respect to mortgage originations, including originator compensation, minimum repayment standards, and prepayment considerations; • The establishment of the Financial Stability Oversight Council, which will be responsible for identifying and monitoring systemic risks posed by financial firms, activities, and practices; • The development of regulations to limit debit card interchange fees; • The elimination of newly issued trust preferred securities as a permitted element of Tier 1 capital; • The creation of a special regime to allow for the orderly liquidation of systemically important financial companies, including the establishment of an orderly liquidation fund; • The development of regulations to address derivatives markets, including clearing and exchange trading requirements and a framework for regulating derivatives-market participants; • Enhanced supervision of credit rating agencies through the Office of Credit Ratings within the SEC; • Increased regulation of asset-backed securities, including a requirement that issuers of asset-backed securities retain at least 5% of the risk of the asset-backed securities; and • The establishment of a Bureau of Consumer Financial Protection with centralized authority, including examination and enforcement authority, for consumer protection in the banking industry. We are continuing to evaluate the potential impact of the Dodd-Frank Act on our business, financial condition and results of operations and expect that some provisions may have adverse effects on us, such as the cost of complying with the numerous new regulations and reporting requirements mandated by the Dodd-Frank Act. Critical Accounting Estimates Our accounting and reporting estimates conform with U.S. generally accepted accounting principles ("GAAP") and general practices within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. We consider our critical accounting policies to include the following: Allowance for Losses on Loans. The allowance for losses on loans represents our best estimate of probable losses inherent in the existing loan portfolio. The allowance for losses on loans is increased by the provision for losses on loans charged to expense and reduced by loans charged-off, net of recoveries. The provision for losses on loans is determined based on our assessment of 40-------------------------------------------------------------------------------- Table of Contents several factors: reviews and evaluations of specific loans, changes in the nature and volume of the loan portfolio, current economic conditions and the related impact on specific borrowers and industry groups, historical loan loss experience, the level of classified and nonperforming loans and the results of regulatory examinations. The loan loss allowance is based on the most current review of the loan portfolio and is validated by multiple processes. The servicing officer has the primary responsibility for updating significant changes in a customer's financial position. Each officer prepares status updates on any credit deemed to be experiencing repayment difficulties which, in the officer's opinion, would place the collection of principal or interest in doubt. Our internal loan review department is responsible for an ongoing review of our loan portfolio with specific goals set for the loans to be reviewed on an annual basis. At each review, a subjective analysis methodology is used to grade the respective loan. Categories of grading vary in severity from loans that do not appear to have a significant probability of loss at the time of review to loans that indicate a probability that the entire balance of the loan will be uncollectible. If full collection of the loan balance appears unlikely at the time of review, estimates of future expected cash flows or appraisals of the collateral securing the debt are used to determine the necessary allowances. The internal loan review department maintains a list of all loans or loan relationships that are graded as having more than the normal degree of risk associated with them. In addition, a list of specifically reserved loans or loan relationships of $50,000 or more is updated on a quarterly basis in order to properly determine the necessary allowance and keep management informed on the status of attempts to correct the deficiencies noted with respect to the loan. Loans are considered impaired if, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. In measuring the fair value of the collateral, in addition to relying on third party appraisals, we use assumptions such as discount rates, and methodologies, such as comparison to the recent selling price of similar assets, consistent with those that would be utilized by unrelated third parties performing a valuation. Changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the conditions of the various markets in which collateral may be sold all may affect the required level of the allowance for losses on loans and the associated provision for loan losses. As of September 30, 2013, our review of the loan portfolio indicated that a loan loss allowance of $19.4 million was appropriate to cover probable losses in the portfolio. Refer to "Part II - Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Loan Loss Experience and Allowance for Loan Losses" and "Note 5- Loans and Allowance for Probable Loan Losses" of the Notes to Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2012 for a detailed description of our estimation process and methodology related to the allowance for loan losses. Estimation of Fair Value. The estimation of fair value is significant to a number of our assets and liabilities. In addition, GAAP requires disclosure of the fair value of financial instruments as a part of the notes to the consolidated financial statements. Fair values for securities are volatile and may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates and the shape of yield curves. Fair values for most investment and MBS are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on the quoted prices of similar instruments or estimates from independent pricing services. Where there are price variances outside certain ranges from different pricing services for specific securities, those pricing variances are reviewed with other market data to determine which of the price estimates is appropriate for that period. For securities carried at fair value through income, the change in fair value from the prior period is recorded on our income statement as fair value gain (loss) - securities. At September 30, 2008 and continuing at September 30, 2013, the valuation inputs for our available for sale ("AFS") trust preferred securities ("TRUPs") became unobservable as a result of the significant market dislocation and illiquidity in the marketplace. We continue to rely on nonbinding prices compiled by third party vendors which we have verified to be an appropriate measure of fair value. However, the significant illiquidity in this market results in a fair value not clearly based on observable market data but rather a range of fair value data points from the market place. Accordingly, we determined that the TRUPs security valuation is based on Level 3 inputs. 41-------------------------------------------------------------------------------- Table of Contents Impairment of Investment Securities and Mortgage-backed Securities. Investment and MBS classified as AFS are carried at fair value and the impact of changes in fair value are recorded on our consolidated balance sheet as an unrealized gain or loss in "Accumulated other comprehensive income (loss)," a separate component of shareholders' equity. Securities classified as AFS or held to maturity ("HTM") are subject to our review to identify when a decline in value is other-than-temporary. When it is determined that a decline in value is other-than-temporary, the carrying value of the security is reduced to its estimated fair value, with a corresponding charge to earnings for the credit portion and to other comprehensive income for the noncredit portion. Factors considered in determining whether a decline in value is other-than-temporary include: (1) whether the decline is substantial; the duration of the decline; the reasons for the decline in value; (2) whether the decline is related to a credit event, a change in interest rate or a change in the market discount rate; (3) the financial condition and near-term prospects of the issuer; and (4) whether we have a current intent to sell the security and whether it is not more likely than not that we will be required to sell the security before the anticipated recovery of its amortized cost basis. For certain assets we consider expected cash flows of the investment in determining if impairment exists. At September 30, 2013, we have in AFS Other Stocks and Bonds $2.7 million amortized cost basis in pooled TRUPs. Those securities are structured products with cash flows dependent upon securities issued by U.S. financial institutions, including banks and insurance companies. Our estimate of fair value at September 30, 2013, for the TRUPs is approximately $1.2 million and reflects the market illiquidity. With the exception of the TRUPs, to the best of management's knowledge and based on our consideration of the qualitative factors associated with each security, there were no securities in our investment and MBS portfolio at September 30, 2013, with an other-than-temporary impairment. Given the facts and circumstances associated with the TRUPs, we performed detailed cash flow modeling for each TRUP using an industry accepted model. Prior to loading the required assumptions into the model, we reviewed the financial condition of the underlying issuing banks within the TRUP collateral pool that had not deferred or defaulted as of September 30, 2013. Management's best estimate of a default assumption, based on a third party method, was assigned to each issuing bank based on the category in which it fell. Our analysis of the underlying cash flows contemplated various default, deferral and recovery scenarios to arrive at our best estimate of cash flows. Based on that detailed analysis, we have estimated the credit component at $3.3 million at September 30, 2013 and at December 31, 2012. The noncredit charge to other comprehensive income was estimated at $1.5 million and $1.8 million at September 30, 2013 and December 31, 2012, respectively. The carrying amount of the TRUPs was written down with $42,000 recognized in earnings for the nine months ended September 30, 2013, and $181,000 during the year ended December 31, 2012. The cash flow model assumptions represent management's best estimate and consider a variety of qualitative factors, which include, among others, the credit rating downgrades, severity and duration of the mark-to-market loss, and structural nuances of each TRUP. Management believes the detailed review of the collateral and cash flow modeling support the conclusion that the TRUPs had an other-than-temporary impairment at September 30, 2013. We will continue to update our assumptions and the resulting analysis each reporting period to reflect changing market conditions. Additionally, we do not currently intend to sell the TRUPs and it is not more likely than not that we will be required to sell the TRUPs before the anticipated recovery of their amortized cost basis. Defined Benefit Pension Plan. The plan obligations and related assets of our defined benefit pension plan (the "Plan") are presented in "Note 11 - Employee Benefits" of the Notes to Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2012. Entry into the Plan by new employees was frozen effective December 31, 2005. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using observable market quotations. Plan obligations and the annual pension expense are determined by independent actuaries and through the use of a number of assumptions that are reviewed by management. Key assumptions in measuring the plan obligations include the discount rate, the rate of salary increases and the estimated future return on plan assets. In determining the discount rate, we utilized a cash flow matching analysis to determine a range of appropriate discount rates for our defined benefit pension and restoration plans. In developing the cash flow matching analysis, we constructed a portfolio of high quality noncallable bonds (rated AA- or better) to match as close as possible the timing of future benefit payments of the plans at December 31, 2012. Based on this cash flow matching analysis, we were able to determine an appropriate discount rate. Salary increase assumptions are based upon historical experience and our anticipated future actions. The expected long-term rate of return assumption reflects the average return expected based on the investment strategies and asset allocation on the assets invested to provide for the Plan's liabilities. We considered broad equity and bond indices, long-term return projections, and actual long-term historical Plan performance when evaluating the expected long-term rate of return assumption. At September 30, 2013, the weighted-average actuarial assumptions of the Plan were: a discount rate of 4.08%; a long-term rate of return on Plan assets of 7.25%; and assumed salary increases of 4.50%. Material changes in pension benefit costs may occur in the future due to changes in these assumptions. Future annual amounts could be impacted by changes in the number of Plan participants, changes in the level of benefits provided, changes in the discount rates, changes in the expected long-term rate of return, changes in the level of contributions to the Plan and other factors. 42-------------------------------------------------------------------------------- Table of Contents Long-term Advance Commitments. During 2010 and 2011, we entered into the option to fund between one and a half years and two years forward from the advance commitment date, $200 million par in long-term advance commitments from the FHLB at the FHLB rates on the date the option was purchased. During the first quarter of 2013, the remaining $50 million par of long-term commitments expired unexercised. Off-Balance-Sheet Arrangements, Commitments and Contingencies Details of our off-balance-sheet arrangements, commitments and contingencies as of September 30, 2013, and December 31, 2012, are included in "Note 11 - Off-Balance-Sheet Arrangements, Commitments and Contingencies" in the accompanying Notes to Financial Statements included in this report. Balance Sheet Strategy We utilize wholesale funding and securities to enhance our profitability and balance sheet composition by determining acceptable levels of credit, interest rate and liquidity risk consistent with prudent capital management. This balance sheet strategy consists of borrowing a combination of long and short-term funds from the FHLB, and when determined appropriate, issuing brokered CDs. These funds are invested primarily in U.S. agency MBS, and to a lesser extent, long-term municipal securities. Although U.S. agency MBS often carry lower yields than traditional mortgage loans and other types of loans we make, these securities generally (i) increase the overall quality of our assets because of either the implicit or explicit guarantees of the U.S. Government, (ii) are more liquid than individual loans and (iii) may be used to collateralize our borrowings or other obligations. While the strategy of investing a substantial portion of our assets in U.S. agency MBS and municipal securities has historically resulted in lower interest rate spreads and margins, we believe that the lower operating expenses and reduced credit risk combined with the managed interest rate risk of this strategy have enhanced our overall profitability over the last several years. At this time, we utilize this balance sheet strategy with the goal of enhancing overall profitability by maximizing the use of our capital. Risks associated with the asset structure we maintain include a lower net interest rate spread and margin when compared to our peers, changes in the slope of the yield curve, which can reduce our net interest rate spread and margin, increased interest rate risk, the length of interest rate cycles, changes in volatility spreads associated with the MBS and municipal securities, the unpredictable nature of MBS prepayments and credit risks associated with the municipal securities. See "Part I - Item 1A. Risk Factors - Risks Related to Our Business" in our annual report on Form 10-K for the year ended December 31, 2012, for a discussion of risks related to interest rates. Our asset structure, net interest spread and net interest margin require us to closely monitor our interest rate risk. An additional risk is the change in fair value of the AFS securities portfolio as a result of changes in interest rates. Significant increases in interest rates, especially long-term interest rates, could adversely impact the fair value of the AFS securities portfolio, which could also significantly impact our equity capital. Due to the unpredictable nature of MBS prepayments, the length of interest rate cycles, and the slope of the interest rate yield curve, net interest income could fluctuate more than simulated under the scenarios modeled by our ALCO and described under "Item 3. Quantitative and Qualitative Disclosures about Market Risk" in this report. Determining the appropriate size of the balance sheet is one of the critical decisions any bank makes. Our balance sheet is not merely the result of a series of micro-decisions, but rather the size is controlled based on the economics of assets compared to the economics of funding. The management of our securities portfolio as a percentage of earning assets is guided by the current economics associated with increasing the securities portfolio, changes in our overall loan and deposit levels, and changes in our wholesale funding levels. If adequate quality loan growth is not available to achieve our goal of enhancing profitability by maximizing the use of capital, as described above, then we could purchase additional securities, if appropriate, which could cause securities as a percentage of earning assets to increase. Should we determine that increasing the securities portfolio or replacing the current securities maturities and principal payments is not an efficient use of capital, we could decrease the level of securities through proceeds from maturities, principal payments on MBS or sales. Our balance sheet strategy is designed such that our securities portfolio should help mitigate financial performance associated with slower loan growth and higher credit costs. The quarter ended September 30, 2013 , was marked by proactive management of the securities portfolio which included restructuring a portion of the portfolio. During the quarter ended September 30, 2013 , we sold long duration, lower coupon municipal securities, U.S. Agency MBS and to a lesser extent, U.S. Agency debentures. The sale of these securities resulted in a slight overall loss on the sale of available for sale securities of $142,000 during the three months ended September 30, 2013 . Purchases included higher coupon shorter duration municipal securities, U.S. Agency Commercial MBS with maturities ten years or less and shorter duration U.S. Agency MBS at lower premiums that created a favorable risk reward scenario. At September 30, 2013 , total unamortized premium for our MBS decreased to approximately $31.2 million from approximately $60.7 million at 43-------------------------------------------------------------------------------- Table of Contents September 30, 2012 . Our investment securities and U.S. agency MBS increase d from $1.67 billion at December 31, 2012 to $1.91 billion at September 30, 2013 , due to strategic increases in each of the first three quarters. During the third quarter, we reduced our municipal securities by selling lower coupon, longer duration municipals, and the large majority of the increase in the securities portfolio resulted from the purchase of shorter duration U.S. Agency MBS that created an overall favorable risk reward scenario. The average coupon of the MBS portfolio decrease d to 4.43% at September 30, 2013 from 5.11% at December 31, 2012 . The average coupon of the municipal securities portfolio increase d to 4.89% at September 30, 2013 when compared to 4.14% at December 31, 2012 . At September 30, 2013 , securities as a percentage of assets increased to 55.1% as compared to 51.6% at December 31, 2012 . Our balance sheet management strategy is dynamic and will be continually reevaluated as market conditions warrant. As interest rates, yield curves, MBS prepayments, funding costs, security spreads and loan and deposit portfolios change, our determination of the proper types and maturities of securities to own, proper amount of securities to own and funding needs and funding sources will continue to be reevaluated. Should the economics of purchasing securities decrease, we will likely allow this part of the balance sheet to shrink through maturities, prepayments or security sales. However, should the economics become more attractive, we might strategically increase the securities portfolio and the balance sheet. Given the current low interest rate environment and steep yield curve, our portfolio decisions reflect our significant focus on interest rate risk. We will continue to manage the balance sheet with the knowledge that at some point we are likely to transition to a higher interest rate environment. With respect to liabilities, we continue to utilize a combination of FHLB advances and deposits to achieve our strategy of minimizing cost while achieving overall interest rate risk objectives as well as the liability management objectives of the ALCO. Our FHLB borrowings at September 30, 2013, increased 34.1%, or $177.2 million, to $697.2 million from $520.1 million at December 31, 2012, primarily to fund the increase in the securities portfolio. During April 2013, we prepaid $66.2 million of FHLB advances with an average rate of 4.03%. In June 2013 we prepaid an additional $24 million of FHLB advances with an average rate of 3.02%. This represented all of our higher priced advances maturing through February 2014. We paid a prepayment fee of $1.0 million which was more than offset by gains on available for sale securities. During the nine months ended September 30, 2013, our long-term FHLB advances increased $99.0 million, to $468.1 million from $369.1 million at December 31, 2012. We will continue to purchase long-term FHLB advances as a hedge against future potential high interest rates. Our long-term brokered CDs increased from $36.0 million at June 30, 2013, to $50.4 million at September 30, 2013. All of the long-term brokered CDs, except for one $5.0 million CD, have short-term calls that we control. As interest rates have increased, we have started issuing more callable long-term CDs because we believe the value of the call has increased. We utilized long-term callable brokered CDs because the brokered CDs at the time of issuance better matched overall ALCO objectives by protecting us with fixed rates should interest rates increase, while providing us options to call the funding should interest rates decrease. We are actively evaluating the callable brokered CDs and may exercise the call option if there is an economic benefit. Our wholesale funding policy currently allows maximum brokered CDs of $180 million; however, this amount could be increased to match changes in ALCO objectives. The potential higher interest expense and lack of customer loyalty are risks associated with the use of brokered CDs. Overall growth in wholesale funding resulted in an increase in our total wholesale funding as a percentage of deposits, not including brokered CDs, to 31.7% at September 30, 2013, from 25.1% at September 30, 2012 and 23.1% at December 31, 2012. Net Interest Income (2013 Restated) Net interest income is one of the principal sources of a financial institution's earnings stream and represents the difference or spread between interest and fee income generated from interest earning assets and the interest expense paid on deposits and borrowed funds. Fluctuations in interest rates or interest rate yield curves, as well as repricing characteristics and volume, and changes in the mix of interest earning assets and interest bearing liabilities, materially impact net interest income. Net interest income for the nine months ended September 30, 2013 was $73.0 million , an increase of $4.4 million , or 6.5% , compared to the same period in 2012 . During the nine months ended September 30, 2013 , total interest income decrease d $3.0 million , or 3.4% , to $86.6 million compared to $89.6 million , for the same period in 2012 . The decrease in total interest income was the result of a decrease in the average yield on average interest earning assets from 4.23% for the nine months ended September 30, 2012 to 4.16% for the nine months ended September 30, 2013 , which more than offset the increase in average interest earning assets of $48.1 million , or 1.6% , from $3.08 billion to $3.13 billion . Total interest expense decrease d $7.5 million , or 35.4% , to $13.6 million , during the nine months ended September 30, 2013 , as compared to $21.1 million during the same period in 2012 . The decrease was attributable to a decrease in the average yield on interest bearing liabilities for the nine months ended September 30, 2013 , to 0.74% from 1.15% for the same period in 2012 , which more than offset the increase in average interest bearing liabilities of $25.7 million , or 1.1% , from $2.44 billion for the nine months ended September 30, 2012 , to $2.47 billion for the same period in 2013 . Net interest income increase d during the three months ended September 30, 2013 when compared to the same period in 2012 as a result of a decrease in interest expense, combined with an increase in interest income. Our average interest earning assets during 44-------------------------------------------------------------------------------- Table of Contents this period increase d $130.5 million , or 4.2% . The decrease in the average yield on interest bearing liabilities of 41 basis points is a result of a continued low interest rate environment, the repricing of deposits into this low interest rate environment and the repricing of higher priced FHLB advances that matured or were prepaid. For the three months ended September 30, 2013 , our net interest spread and net interest margin increase d to 3.59% and 3.72% , respectively, from 2.99% and 3.22% when compared to the same period in 2012 . During the nine months ended September 30, 2013, average loans increased $126.0 million, or 10.9%, compared to the same period in 2012. 1-4 Family Residential loans represent a large part of this increase. The average yield on loans decreased from 6.36% for the nine months ended September 30, 2012 to 5.98% for the nine months ended September 30, 2013. The increase in interest income on loans of $2.5 million, or 4.9%, to $54.7 million for the nine months ended September 30, 2013, when compared to $52.1 million for the same period in 2012 was the result of an increase in the average balance which more than offset the decrease in the average yield. The decrease in the yield on loans was due to overall lower interest rates. For the three months ended September 30, 2013, average loans increased $97.0 million, or 8.1%, to $1.30 billion, when compared to $1.20 billion for the same period in 2012. The average yield on loans decreased from 6.30% for the three months ended September 30, 2012 to 5.97% for the three months ended September 30, 2013. Due to the competitive loan pricing environment, we anticipate that we may be required to continue to offer lower interest rate loans that compete with those offered by other financial institutions in order to retain quality loan relationships. Offering lower interest rate loans could impact the overall yield on loans and, therefore, profitability. Average investment and MBS decrease d $104.0 million , or 5.6% , from $1.87 billion to $1.77 billion , for the nine months ended September 30, 2013 , when compared to the same period in 2012 . At September 30, 2013 , most of our MBS were fixed rate securities and less than two percent were variable rate MBS. The overall yield on average investment and MBS decrease d to 2.99% during the nine months ended September 30, 2013 , from 3.01% during the same period in 2012 . The decrease in the average yield primarily reflects the purchase of new securities in an overall lower interest rate environment due to the decrease in the average interest rates during the majority of the first six months of 2013 . Interest income on investment and MBS decrease d $5.6 million during the nine months ended September 30, 2013 , or 15.0% , compared to the same period in 2012 due to a decrease in the average yield and average balance. For the three months ended September 30, 2013 , average investment and MBS increase d $25.4 million , or 1.4% , to $1.89 billion , when compared to $1.87 billion for the same period in 2012 . The overall yield on average investment and MBS increase d to 3.15% during the three months ended September 30, 2013 , from 2.68% during the same period in 2012 primarily as a result of an increase in municipal securities. Interest income from investment and MBS increase d $1.6 million , or 15.0% , to $12.1 million for the three months ended September 30, 2013 , compared to $10.6 million for the same period in 2012 . The increase in interest income for the three months is due to an increase in the average yield and the average balance. Average FHLB stock and other investments decreased $5.1 million, or 14.7%, to $29.8 million, for the nine months ended September 30, 2013, when compared to $35.0 million for the same period in 2012 due to a decrease in average FHLB advances during 2013 and the corresponding requirement to hold stock associated with those advances. Interest income from our FHLB stock and other investments decreased $55,000, or 28.9%, during the nine months ended September 30, 2013, when compared to the same period in 2012 due to a decrease in the average balance and average yield from 0.73% for the nine months ended September 30, 2012, compared to 0.60% for the same period in 2013. For the three months ended September 30, 2013, average FHLB stock and other investments decreased $2.3 million, or 6.5%, to $33.5 million, when compared to $35.8 million for the same period in 2012. Interest income from FHLB stock and other investments decreased $21,000, or 36.8%, to $36,000, for the three months ended September 30, 2013, when compared to $57,000 for the same period in 2012 as a result of the decrease in the average balance and average yield from 0.63% in 2012 to 0.43% in 2013. The FHLB stock is a variable instrument with the rate typically tied to the federal funds rate. We are required as a member of the FHLB to own a specific amount of stock that changes as the level of our FHLB advances and asset size change. Average interest earning deposits increased $31.5 million, or 223.7%, to $45.6 million, for the nine months ended September 30, 2013, when compared to $14.1 million for the same period in 2012. Interest income from interest earning deposits increased $74,000, or 389.5%, for the nine months ended September 30, 2013, when compared to the same period in 2012, as a result of the increase in the average balance and the average yield from 0.18% in 2012 to 0.27% in 2013. Average interest earning deposits increased $11.7 million, or 91.4%, to $24.5 million, for the three months ended September 30, 2013, when compared to $12.8 million for the same period in 2012. Interest income from interest earning deposits increased $11,000 for the three months ended September 30, 2013, when compared to the same period in 2012, as a result of an increase in the average balance and the average yield from 0.12% in 2012 to 0.24% in 2013. During the nine months ended September 30, 2013 , our average loans increase d while our average securities decrease d compared to the same period in 2012 . The mix of our average interest earning assets reflected a decrease in average total securities as a percentage of total average interest earning assets as average securities decrease d to 57.5% during the nine months ended September 30, 2013 , compared to 61.9% during the same period in 2012 . Average loans increase d to 41.1% of average total interest earning 45-------------------------------------------------------------------------------- Table of Contents assets and other interest earning asset categories averaged 1.4% for the nine months ended September 30, 2013 . During 2012 , the comparable mix was 37.7% in loans and 0.4% in the other interest earning asset categories. Total interest expense decreased $7.5 million, or 35.4%, to $13.6 million during the nine months ended September 30, 2013, as compared to $21.1 million during the same period in 2012. The decrease was primarily attributable to decreased funding costs as the average yield on interest bearing liabilities decreased from 1.15% for the nine months ended September 30, 2012, to 0.74% for the nine months ended September 30, 2013, which more than offset an increase in average interest bearing liabilities during this same period. The increase in average interest bearing liabilities of $25.7 million, or 1.1%, included an increase in interest bearing deposits of $43.9 million, or 2.5%, and an increase in long-term FHLB advances of $101.1 million, or 31.9%, which was partially offset by a decrease in short-term interest bearing liabilities of $119.3 million, or 39.0%. For the three months ended September 30, 2013, total interest expense decreased $2.3 million, or 35.4%, to $4.2 million, compared to $6.5 million for the same period in 2012, as a result of a decrease in the average yield which more than offset an increase in the average balance of interest bearing liabilities. Average interest bearing liabilities increased $137.6 million, or 5.6%, and the average yield decreased from 1.05% for the three months ended September 30, 2012, to 0.64% for the three months ended September 30, 2013. Average interest bearing deposits increased $43.9 million, or 2.5%, from $1.76 billion to $1.80 billion, while the average rate paid decreased from 0.65% for the nine months ended September 30, 2012, to 0.45% for the nine months ended September 30, 2013. For the three months ended September 30, 2013, average interest bearing deposits increased $91.4 million, or 5.3%, to $1.82 billion, when compared to $1.73 billion for the same period in 2012, while the average rate paid decreased from 0.56% for the three months ended September 30, 2012, to 0.44% for the three months ended September 30, 2013. Average time deposits decreased $161.9 million, or 20.4%, from $794.4 million to $632.5 million, and the average rate paid decreased to 0.74% for the nine months ended September 30, 2013, as compared to 1.00% for the same period in 2012. Average interest bearing demand deposits increased $193.8 million, or 22.3%, while the average rate paid decreased to 0.31% for the nine months ended September 30, 2013, as compared to 0.39% for the same period in 2012. Average savings deposits increased $11.9 million, or 12.4%, while the average rate paid decreased to 0.13% for the nine months ended September 30, 2013, as compared to 0.15% for the same period in 2012. Interest expense for interest bearing deposits for the nine months ended September 30, 2013, decreased $2.5 million, or 29.4%, when compared to the same period in 2012 due to the decrease in the average yield which more than offset the increase in the average balance. Average noninterest bearing demand deposits increased $1.9 million, or 0.3%, during the nine months ended September 30, 2013. The latter three categories, interest bearing demand deposits, savings deposits and noninterest bearing demand deposits, are considered the lowest cost deposits and comprised 73.3% of total average deposits during the nine months ended September 30, 2013 compared to 65.8% during the same period in 2012. The increase in our average total deposits is primarily the result of an increase in public fund deposits and deposit growth due to market penetration. At September 30, 2013, we had $50.4 million in brokered CDs that represented 2.1% of deposits, all with maturities of less than seven years. At December 31, 2012, we had $19.5 million in brokered CDs that represented 0.8% of deposits, all with maturities of less than five years. Average short-term interest bearing liabilities, consisting primarily of FHLB advances, federal funds purchased and repurchase agreements, were $186.5 million, a decrease of $119.3 million, or 39.0%, for the nine months ended September 30, 2013 when compared to the same period in 2012. Interest expense associated with short-term interest bearing liabilities decreased $3.1 million, or 64.0%, and the average rate paid decreased to 1.26% for the nine months ended September 30, 2013, when compared to 2.13% for the same period in 2012. For the three months ended September 30, 2013, average short-term interest bearing liabilities decreased $39.4 million, or 13.4%, when compared to the same period in 2012. Interest expense associated with short-term interest bearing liabilities decreased $1.4 million, or 92.5%, and the average rate paid decreased to 0.18% for the three months ended September 30, 2013, when compared to 2.10% for the same period in 2012. The decrease in the interest expense was due to a decrease in the average balance and average rate paid. Average long-term interest bearing liabilities consisting of FHLB advances increased $101.1 million, or 31.9%, during the nine months ended September 30, 2013 to $418.1 million, as compared to $317.0 million for the nine months ended September 30, 2012. Interest expense associated with long-term FHLB advances decreased $404,000, or 7.9%, and the average rate paid decreased 65 basis points for the nine months ended September 30, 2013, when compared to the same period in 2012. For the three months ended September 30, 2013, long-term interest bearing liabilities increased $85.6 million, or 23.1%, when compared to the same period in 2012. Interest expense associated with long-term FHLB advances increased $61,000, or 3.8%, while the average rate paid decreased to 1.46% for the three months ended September 30, 2013, when compared to 1.74% for the same period in 2012. The increase in the average long-term FHLB advances is due primarily to the increase in the purchase of long-term advances during the 12 months ended September 30, 2013, when compared to the same period in 2012. In addition, as $50 million of the $200 million par in long-term advance commitments from the FHLB expired, long-term advances at rates below the advance commitment rates that expired were obtained. During 2010 and 2011, we entered into the option to fund between one and a half years and two years forward from the advance commitment date, $200 million par in long-term advance commitments from the 46-------------------------------------------------------------------------------- Table of Contents FHLB at the FHLB rates on the date the option was purchased. During the first quarter of 2013, the remaining $50 million par of long-term commitments expired unexercised. In order to obtain these commitments from the FHLB, we paid fees of $10.95 million. During 2012, the value of the FHLB advance option fees became further impaired resulting in a total charge of $2.03 million in 2012 which resulted in the FHLB advance option fees being fully impaired and completely written down. Average long-term debt, consisting of our junior subordinated debentures was $60.3 million for the three and nine months ended September 30, 2013 and 2012. Interest expense associated with long-term debt decreased $1.4 million, or 56.3%, to $1.1 million for the nine months ended September 30, 2013, when compared to $2.5 million for the same period in 2012, as a result of a decrease in the average yield of 310 basis points during the nine months ended September 30, 2013, when compared to the same period in 2012. Interest expense was $364,000 for the three months ended September 30, 2013, a decrease of $468,000, or 56.3%, when compared to the same period in 2012, as a result of a decrease in the average yield of 310 basis points. The interest rate on the $20.6 million of long-term debentures issued to Southside Statutory Trust III adjusts quarterly at a rate equal to three-month LIBOR plus 294 basis points. The interest rate on the $23.2 million of long-term debentures issued to Southside Statutory Trust IV adjusts quarterly at a rate equal to three-month LIBOR plus 130 basis points. The interest rate on the $12.9 million of long-term debentures issued to Southside Statutory Trust V adjusts quarterly at a rate equal to three-month LIBOR plus 225 basis points. The interest rate on the $3.6 million of long-term debentures issued to Magnolia Trust Company I, adjusts quarterly at a rate equal to three-month LIBOR plus 180 basis points. 47-------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS The analysis below shows average interest earning assets and interest bearing liabilities together with the average yield on the interest earning assets and the average cost of the interest bearing liabilities. AVERAGE BALANCES AND YIELDS (dollars in thousands) (unaudited) Nine Months Ended September 30, 2013 (1) September 30, 2012 AVG AVG AVG AVG BALANCE INTEREST YIELD BALANCE INTEREST YIELD ASSETS INTEREST EARNING ASSETS: Loans (2)(3) $ 1,285,612 $ 57,531 5.98 % $ 1,159,643 $ 55,180 6.36 % Loans Held For Sale 1,421 35 3.29 % 1,717 45 3.50 % Securities: Investment Securities (Taxable) (5) 54,150 672 1.66 % 5,452 73 1.79 % Investment Securities (Tax-Exempt) (4)(5) 660,537 25,211 5.10 % 341,673 14,352 5.61 % Mortgage-backed and Related Securities (5) 1,054,822 13,685 1.73 % 1,526,375 27,730 2.43 % Total Securities 1,769,509 39,568 2.99 % 1,873,500 42,155 3.01 % FHLB stock and other investments, at cost 29,843 135 0.60 % 34,966 190 0.73 % Interest Earning Deposits 45,620 93 0.27 % 14,092 19 0.18 % Total Interest Earning Assets 3,132,005 97,362 4.16 % 3,083,918 97,589 4.23 % NONINTEREST EARNING ASSETS: Cash and Due From Banks 44,416 41,908 Bank Premises and Equipment 50,409 50,455 Other Assets 121,650 168,140 Less: Allowance for Loan Loss (18,917 ) (19,761 ) Total Assets $ 3,329,563 $ 3,324,660 LIABILITIES AND SHAREHOLDERS' EQUITY INTEREST BEARING LIABILITIES: Savings Deposits $ 107,571 106 0.13 % $ 95,691 108 0.15 % Time Deposits 632,518 3,479 0.74 % 794,370 5,945 1.00 % Interest Bearing Demand Deposits 1,064,743 2,497 0.31 % 870,904 2,562 0.39 % Total Interest Bearing Deposits 1,804,832 6,082 0.45 % 1,760,965 8,615 0.65 % Short-term Interest Bearing Liabilities 186,520 1,755 1.26 % 305,818 4,877 2.13 % Long-term Interest Bearing Liabilities - FHLB Dallas 418,074 4,690 1.50 % 316,964 5,094 2.15 % Long-term Debt (6) 60,311 1,088 2.41 % 60,311 2,487 5.51 % Total Interest Bearing Liabilities 2,469,737 13,615 0.74 % 2,444,058 21,073 1.15 % NONINTEREST BEARING LIABILITIES: Demand Deposits 562,545 560,636 Other Liabilities 46,693 51,888 Total Liabilities 3,078,975 3,056,582 SHAREHOLDERS' EQUITY 250,588 268,078 Total Liabilities and Shareholders' Equity $ 3,329,563 $ 3,324,660 NET INTEREST INCOME $ 83,747 $ 76,516 NET INTEREST MARGIN ON AVERAGE EARNING ASSETS 3.58 % 3.31 % NET INTEREST SPREAD 3.42 % 3.08 % (1) Restated (2) Interest on loans includes fees on loans that are not material in amount. (3) Interest income includes taxable-equivalent adjustments of $2,886 and $3,082 for the nine months ended September 30, 2013 and 2012 , respectively. (4) Interest income includes taxable-equivalent adjustments of $7,889 and $4,885 for the nine months ended September 30, 2013 and 2012 , respectively. (5) For the purpose of calculating the average yield, the average balance of securities is presented at historical cost. (6) Represents junior subordinated debentures issued by us to Southside Statutory Trust III, IV, and V in connection with the issuance by Southside Statutory Trust III of $20 million of trust preferred securities, Southside Statutory Trust IV of $22.5 million of trust preferred securities, Southside Statutory Trust V of $12.5 million of trust preferred securities and junior subordinated debentures issued by FWBS to Magnolia Trust Company I in connection with the issuance by Magnolia Trust Company I of $3.5 million of trust preferred securities. Note: As of September 30, 2013 and 2012 , loans totaling $8,370 and $11,879 , respectively, were on nonaccrual status. The policy is to reverse previously accrued but unpaid interest on nonaccrual loans; thereafter, interest income is recorded to the extent received when appropriate. 48-------------------------------------------------------------------------------- Table of Contents AVERAGE BALANCES AND YIELDS (dollars in thousands) (unaudited) Three Months Ended September 30, 2013 (1) September 30, 2012 AVG AVG AVG AVG BALANCE INTEREST YIELD BALANCE INTEREST YIELD ASSETS INTEREST EARNING ASSETS: Loans (2)(3) $ 1,300,606 $ 19,581 5.97 % $ 1,203,651 $ 19,048 6.30 % Loans Held For Sale 702 7 3.96 % 1,877 14 2.97 % Securities: Investment Securities (Taxable) (5) 33,128 139 1.66 % 6,016 22 1.45 % Investment Securities (Tax-Exempt) (4)(5) 773,187 9,819 5.04 % 466,776 5,879 5.01 % Mortgage-backed and Related Securities (5) 1,087,403 5,069 1.85 % 1,395,563 6,695 1.91 % Total Securities 1,893,718 15,027 3.15 % 1,868,355 12,596 2.68 % FHLB stock and other investments, at cost 33,472 36 0.43 % 35,782 57 0.63 % Interest Earning Deposits 24,472 15 0.24 % 12,789 4 0.12 % Total Interest Earning Assets 3,252,970 34,666 4.23 % 3,122,454 31,719 4.04 % NONINTEREST EARNING ASSETS: Cash and Due From Banks 40,344 41,718 Bank Premises and Equipment 50,879 50,265 Other Assets 109,716 170,885 Less: Allowance for Loan Loss (18,667 ) (20,276 ) Total Assets $ 3,435,242 $ 3,365,046 LIABILITIES AND SHAREHOLDERS' EQUITY INTEREST BEARING LIABILITIES: Savings Deposits $ 109,789 35 0.13 % $ 97,755 35 0.14 % Time Deposits 660,771 1,199 0.72 % 740,203 1,574 0.85 % Interest Bearing Demand Deposits 1,052,529 777 0.29 % 893,773 846 0.38 % Total Interest Bearing Deposits 1,823,089 2,011 0.44 % 1,731,731 2,455 0.56 % Short-term Interest Bearing Liabilities 254,256 116 0.18 % 293,692 1,551 2.10 % Long-term Interest Bearing Liabilities - FHLB Dallas 456,448 1,679 1.46 % 370,815 1,618 1.74 % Long-term Debt (6) 60,311 364 2.39 % 60,311 832 5.49 % Total Interest Bearing Liabilities 2,594,104 4,170 0.64 % 2,456,549 6,456 1.05 % NONINTEREST BEARING LIABILITIES: Demand Deposits 568,023 587,315 Other Liabilities 38,048 48,929 Total Liabilities 3,200,175 3,092,793 SHAREHOLDERS' EQUITY 235,067 272,253 Total Liabilities and Shareholders' Equity $ 3,435,242 $ 3,365,046 NET INTEREST INCOME $ 30,496 $ 25,263 NET INTEREST MARGIN ON AVERAGE EARNING ASSETS 3.72 % 3.22 % NET INTEREST SPREAD 3.59 % 2.99 % (1) Restated (2) Interest on loans includes fees on loans that are not material in amount. (3) Interest income includes taxable-equivalent adjustments of $963 and $1,215 for the three months ended September 30, 2013 and 2012 , respectively. (4) Interest income includes taxable-equivalent adjustments of $2,892 and $2,040 for the three months ended September 30, 2013 and 2012 , respectively. (5) For the purpose of calculating the average yield, the average balance of securities is presented at historical cost. (6) Represents junior subordinated debentures issued by us to Southside Statutory Trust III, IV, and V in connection with the issuance by Southside Statutory Trust III of $20 million of trust preferred securities, Southside Statutory Trust IV of $22.5 million of trust preferred securities, Southside Statutory Trust V of $12.5 million of trust preferred securities and junior subordinated debentures issued by FWBS to Magnolia Trust Company I in connection with the issuance by Magnolia Trust Company I of $3.5 million of trust preferred securities. Note: As of September 30, 2013 and 2012 , loans totaling $8,370 and $11,879 , respectively, were on nonaccrual status. The policy is to reverse previously accrued but unpaid interest on nonaccrual loans; thereafter, interest income is recorded to the extent received when app ropriate. 49-------------------------------------------------------------------------------- Table of Contents Noninterest Income (2013 Restated) Noninterest income consists of revenue generated from a broad range of financial services and activities including deposit related fee based services such as ATM, overdraft, and check processing fees. In addition, we earn income from the sale of loans and securities, trust services, bank owned life insurance ("BOLI"), brokerage services, and other fee generating programs that we either provide or in which we participate. Noninterest income was $6.4 million and $27.7 million for the three and nine months ended September 30, 2013 , respectively, compared to $10.5 million and $29.4 million for the same periods in 2012 , a decrease of $4.1 million , or 38.9% , and $1.6 million , or 5.5% , respectively. The primary reason for the decrease in noninterest income for the three and nine months ended September 30, 2013 , was due to the decrease in gain on sale of securities available for sale. During the nine months ended September 30, 2013 , we had gain on sale of AFS securities of $9.2 million , compared to $13.6 million for the same period in 2012 . For the three months ended September 30, 2013 , the loss on sale of AFS securities was $142,000 , compared to a gain on sale of AFS securities of $4.3 million for the same period in 2012 . The fair value of the AFS securities portfolio at September 30, 2013 was $1.23 billion with a net unrealized gain on that date of $1.1 million . The net unrealized gain is comprised of $22.4 million in unrealized gains and $21.3 million in unrealized losses. The fair value of the HTM securities portfolio at September 30, 2013 was $672.6 million with a net unrealized loss on that date of $13.3 million . The net unrealized loss is comprised of $6.9 million in unrealized gains and $20.2 million in unrealized losses. During the nine months ended September 30, 2013 , we pro-actively managed the investment portfolio which included restructuring a portion of our investment portfolio. During the quarter ended September 30, 2013 , we sold long duration, lower coupon municipal securities, U.S. Agency MBS and to a lesser extent, U.S. Agency debentures. The sale of these securities resulted in a loss on the sale of available for sale securities of $142,000 . For the nine months ended September 30, 2013 , sales of available for sale securities have resulted in a gain on sale of $9.2 million . There can be no assurance that the level of security gains reported during the nine months ended September 30, 2013 , will continue in future periods. For the three and nine months ended September 30, 2012 , the value of the FHLB advance options fees became further impaired resulting in a $195,000 and $2.0 million impairment charge, respectively. At September 30, 2012, the value of the FHLB advance option fees was completely impaired and written down. Gain on sale of loans decrease d $184,000 , or 58.6% , and $53,000 , or 7.1% , for the three and nine months ended September 30, 2013 , respectively, when compared to the same periods in 2012 . The decrease for the three and nine months ended September 30, 2013 was due primarily to a decrease in the dollar amount of loans sold and the related servicing release and secondary market fees. Other income increase d $129,000 , or 10.7% , for the three months ended September 30, 2013 due to the receipt of a force placed insurance refund of $298,000, and decrease d $261,000 , or 7.6% , for the nine months ended September 30, 2013 , when compared to the same periods in 2012 . The decrease for the nine months ended September 30, 2013 was due primarily to a decrease in the fair value of written loan commitments, credit life income, and trading income. Noninterest Expense We incur numerous types of noninterest expenses associated with the operation of our various business activities, the largest of which are salaries and employee benefits. In addition, we incur numerous other expenses, the largest of which are detailed in the consolidated statements of income. Noninterest expense was $20.3 million and $61.7 million for the three and nine months ended September 30, 2013, respectively, compared to $19.1 million and $56.7 million for the same periods in 2012, respectively, representing an increase of $1.2 million, or 6.2%, and $5.1 million, or 8.9%, for the three and nine months ended September 30, 2013, respectively. Salaries and employee benefits expense increased $1.2 million, or 10.5%, and $3.9 million, or 10.8%, during the three and nine months ended September 30, 2013, respectively, when compared to the same periods in 2012. The increase for the three and nine months ended September 30, 2013 was primarily the result of increases in the number of personnel over the prior year, share-based compensation associated with the 2012 awards, retirement expense, and increased health insurance expense. Direct salary expense and payroll taxes increased $812,000, or 8.2%, and $2.8 million, or 9.4%, during the three and nine months ended September 30, 2013, respectively, when compared to the same periods in 2012. Retirement expense, included in salary and benefits, increased $249,000, or 23.3%, and $687,000, or 21.3%, for the three and nine months ended September 30, 2013, respectively, when compared to the same periods in 2012. The increase was primarily 50-------------------------------------------------------------------------------- Table of Contents related to the increase in the defined benefit and restoration plans. The defined benefit and restoration plan increased primarily due to the changes in the actuarial assumptions used to determine net periodic pension costs for 2013 when compared to 2012. Specifically, the assumed discount rate decreased to 4.08%. We will continue to evaluate the assumed long-term rate of return and the discount rate to determine if either should be changed in the future. If either of these assumptions decreased, the cost and funding required for the retirement plan could increase. Health and life insurance expense, included in salary and benefits, increased $188,000, or 20.7%, for the three months ended September 30, 2013 and increased $387,000, or 14.5% for the nine months ended September 30, 2013, when compared to the same periods in 2012. The increase for the three and nine months ended September 30, 2013 is due to increases in total personnel and additional claims cost. We have a self-insured health plan which is supplemented with stop loss insurance policies. Health insurance costs are rising nationwide and these costs may continue to increase during the remainder of 2013. ATM and debit card expense increased $59,000, or 23.5% and $177,000, or 21.7%, for the three and nine months ended September 30, 2013, when compared to the same periods in 2012 due to an increase in processing expenses and a nonrecurring transaction expense of $80,000. FHLB prepayment fees were $1.0 million during the nine months ended September 30, 2013 as a result of the prepayment of $90.2 million of FHLB advances during the second quarter. I ncome Taxes (2013 Restated) Pre-tax income for the three and nine months ended September 30, 2013 was $9.2 million and $32.8 million , respectively, compared to $10.2 million and $32.7 million , for the same periods in 2012 . Income tax expense was $257,000 and $3.8 million for the three and nine months ended September 30, 2013 , respectively, compared to $1.6 million and $6.3 million for the three and nine months ended September 30, 2012 , respectively. The effective tax rate as a percentage of pre-tax income was 2.8% and 11.6% for the three and nine months ended September 30, 2013 , respectively, compared to 15.3% and 19.1% , for the same periods in 2012 . The decrease in the effective tax rate for the three and nine months ended September 30, 2013 was due to an increase in tax-exempt income as a percentage of taxable income, as compared to the same period in 2012 . The increase in tax-exempt income as a percentage of taxable income is primarily due to the significant increase in our average tax-exempt securities portfolio for the nine months ended September 30, 2013 compared to the same period in 2012 . The net deferred assets totaled $23.2 million at September 30, 2013 , as compared to $4.1 million at December 31, 2012. Capital Resources (2013 Restated) Our total shareholders' equity at September 30, 2013 , was $241.0 million , representing a decrease of 6.5% , or $16.8 million from December 31, 2012 and represented 6.9% of total assets at September 30, 2013 , compared to 8.0% of total assets at December 31, 2012 . Increases to our shareholders' equity consisted of net income of $29.0 million , the issuance of $1.0 million in common stock ( 43,733 shares) through our dividend reinvestment plan and $571,000 of stock compensation expense, which was more than offset by a decrease in accumulated other comprehensive income of $35.0 million , the repurchase of $1.9 million of common stock, and $10.5 million in cash dividends paid. On March 28, 2013, our board of directors declared a 5% stock dividend to common stock shareholders of record as of April 18, 2013, which was paid on May 9, 2013. Under the Federal Reserve Board's risk-based capital guidelines for bank holding companies, the minimum ratio of total capital to risk-adjusted assets (including certain off-balance sheet items, such as standby letters of credit) is currently 8%. The minimum Tier 1 capital to risk-adjusted assets is 4%. Our $20 million, $22.5 million, $12.5 million and $3.5 million of trust preferred securities issued by our subsidiaries, Southside Statutory Trust III, IV, V and Magnolia Trust Company I, respectively, are considered Tier 1 capital by the Federal Reserve Board. The Federal Reserve Board also requires bank holding companies to comply with the minimum leverage ratio guidelines. The leverage ratio is the ratio of bank holding company's Tier 1 capital to its total consolidated quarterly average assets, less goodwill and certain other intangible assets. The guidelines require a minimum leverage ratio of 4% for bank holding companies that meet certain specified criteria. Failure to meet minimum capital requirements could result in certain mandatory and possibly additional discretionary actions by our regulators that, if undertaken, could have a direct material effect on our financial statements. Management believes that, as of September 30, 2013, we met all capital adequacy requirements to which we were subject. 51-------------------------------------------------------------------------------- Table of Contents The Federal Deposit Insurance Act requires bank regulatory agencies to take "prompt corrective action" with respect to FDIC-insured depository institutions that do not meet minimum capital requirements. A depository institution's treatment for purposes of the prompt corrective action provisions will depend on how its capital levels compare to various capital measures and certain other factors, as established by regulation. Prompt corrective action and other discretionary actions could have a direct material effect on our financial statements. It is management's intention to maintain our capital at a level acceptable to all regulatory authorities and future dividend payments will be determined accordingly. Regulatory authorities require that any dividend payments made by either us or the Bank, not exceed earnings for that year. Shareholders should not anticipate a continuation of the cash dividend simply because of the existence of a dividend reinvestment program. The payment of dividends will depend upon future earnings, our financial condition, and other related factors including the discretion of the board of directors. To be categorized as well capitalized we must maintain minimum Total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following table: To Be Well Capitalized Under Prompt For Capital Corrective Actions Actual Adequacy Purposes Provisions Amount Ratio Amount Ratio Amount Ratio As of September 30, 2013: (dollars in thousands) Total Capital (to Risk Weighted Assets) Consolidated $ 328,507 21.27 % $ 123,574 8.00 % N/A N/A Bank Only $ 323,867 20.98 % $ 123,505 8.00 % $ 154,382 10.00 % Tier 1 Capital (to Risk Weighted Assets) Consolidated $ 309,208 20.02 % $ 61,787 4.00 % N/A N/A Bank Only $ 304,568 19.73 % $ 61,753 4.00 % $ 92,629 6.00 % Tier 1 Capital (to Average Assets) (1) Consolidated $ 309,208 9.09 % $ 136,123 4.00 % N/A N/A Bank Only $ 304,568 8.96 % $ 136,008 4.00 % $ 170,010 5.00 % As of December 31, 2012: Total Capital (to Risk Weighted Assets) Consolidated $ 308,133 22.42 % $ 109,962 8.00 % N/A N/A Bank Only $ 300,196 21.86 % $ 109,852 8.00 % $ 137,315 10.00 % Tier 1 Capital (to Risk Weighted Assets) Consolidated $ 290,873 21.16 % $ 54,981 4.00 % N/A N/A Bank Only $ 282,936 20.60 % $ 54,926 4.00 % $ 82,389 6.00 % Tier 1 Capital (to Average Assets) (1) Consolidated $ 290,873 9.11 % $ 127,698 4.00 % N/A N/A Bank Only $ 282,936 8.87 % $ 127,531 4.00 % $ 159,413 5.00 % (1) Refers to quarterly average assets as calculated by bank regulatory agencies. Basel III Capital Rules. In July 2013, the Federal Reserve, our primary federal regulator, published final rules (the "Basel III Capital Rules") establishing a new comprehensive capital framework for U.S. banking organizations. The rules implement the Basel Committee's December 2010 framework known as "Basel III" for strengthening international capital standards as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions, including Southside Bancshares and Southside Bank, compared to the current U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions' regulatory capital ratios. The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions' regulatory capital ratios and replace the existing risk-weighting approach, which was derived from the Basel I capital accords of the Basel Committee, with a more risk-sensitive approach based, in part, on the standardized approach in the Basel Committee's 2004 "Basel II" capital accords. The Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking 52-------------------------------------------------------------------------------- Table of Contents agencies' rules. The Basel III Capital Rules are effective for Southside Bancshares and Southside Bank on January 1, 2015 (subject to a phase-in period). The Basel III Capital Rules, among other things, (i) introduce a new capital measure called "Common Equity Tier 1" ("CET1"), (ii) specify that Tier 1 capital consist of CET1 and "Additional Tier 1 capital" instruments meeting specified requirements, (iii) define CET1 narrowly by requiring that most deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expand the scope of the deductions/adjustments as compared to existing regulations. When fully phased in on January 1, 2019, the Basel III Capital Rules will require Southside Bancshares and Southside Bank to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% "capital conservation buffer" (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to average assets (as compared to a current minimum leverage ratio of 3% for banking organizations that either have the highest supervisory rating or have implemented the appropriate federal regulatory authority's risk-adjusted measure for market risk). The Basel III Capital Rules also provide for a "countercyclical capital buffer" that is applicable to only certain covered institutions and is not expected to have any current applicability to Southside Bancshares and Southside Bank. The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. Under the Basel III Capital Rules, the initial minimum capital ratios as of January 1, 2015 will be as follows: • 4.5% CET1 to risk-weighted assets. • 6.0% Tier 1 capital to risk-weighted assets. • 8.0% Total capital to risk-weighted assets. The Basel III Capital Rules provide for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. Currently, the effects of accumulated other comprehensive income items included in capital are excluded for the purposes of determining regulatory capital ratios. Under the Basel III Capital Rules, the effects of certain accumulated other comprehensive items are not excluded; however, non-advanced approaches banking organizations, including Southside Bancshares and Southside Bank, may make a one-time permanent election to continue to exclude these items. Southside Bancshares and Southside Bank expect to make this election in order to avoid significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of our securities portfolio. The Basel III Capital Rules provide that depository holding companies with less than $15 billion in total assets as of December 31, 2009, such as Southside Bancshares, may permanently include trust preferred securities and certain other non-qualifying instruments issued and included in Tier 1 or Tier 2 capital before May 19, 2010 in additional Tier 1 (subject to a maximum of 25% of Tier 1 capital) or Tier 2 capital until maturity or redemption. Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2015 and will be phased-in over a four-year period (beginning at 40% on January 1, 2015 and an additional 20% per year thereafter). The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019). With respect to insured depository institutions, such as Southside Bank, the Basel III Capital Rules also revise the "prompt corrective action" regulations pursuant to Section 38 of the Federal Deposit Insurance Act, by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category (other than critically undercapitalized), with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%); and (iii) eliminating the current provision that 53-------------------------------------------------------------------------------- Table of Contents provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The Basel III Capital Rules do not change the total risk-based capital requirement for any prompt corrective action category. The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories from the current four categories under the Basel I framework (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. Specific changes to current rules impacting our determination of risk-weighted assets include, among other things: • Applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial real estate acquisition, development and construction loans. • Assigning a 150% risk weight to exposures (other than residential mortgage exposures) that are 90 days past due. • Providing for a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancelable (currently set at 0%). • Providing for a risk weight, generally not less than 20% with certain exceptions, for securities lending transactions based on the risk weight category of the underlying collateral securing the transaction. • Providing for a 100% risk weight for claims on securities firms. • Eliminating the current 50% cap on the risk weight for OTC derivatives. In addition, the Basel III Capital Rules provide more advantageous risk weights for derivatives and repurchase-style transactions cleared through a qualifying central counterparty and increase the scope of eligible guarantors and eligible collateral for purposes of credit risk mitigation. Management believes that, as of September 30, 2013, Southside Bancshares and Southside Bank would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were currently in effect. The Basel III Capital Rules adopted in July 2013 do not address the proposed liquidity coverage ratio test and net stable funding ratio test called for by the Basel III liquidity framework. See the section captioned "Supervision and Regulation" in Item 1. Business of our 2012 Form 10-K for more information on these topics. The table below summarizes our key equity ratios for the three and nine months ended September 30, 2013 and 2012 : Nine Months Ended September 30, 2013 2012 Return on Average Assets 1.16 % 1.06 % Return on Average Shareholders' Equity 15.47 13.19 Dividend Payout Ratio - Basic 37.04 40.00 Dividend Payout Ratio - Diluted 37.04 40.00 Average Shareholders' Equity to Average Total Assets 7.53 8.06 Three Months Ended September 30, 2013 2012 Return on Average Assets 1.03 % 1.02 % Return on Average Shareholders' Equity 15.01 12.58 Dividend Payout Ratio - Basic 40.00 42.55 Dividend Payout Ratio - Diluted 40.00 42.55 Average Shareholders' Equity to Average Total Assets 6.84 8.09 54-------------------------------------------------------------------------------- Table of Contents Liquidity and Interest Rate Sensitivity Liquidity management involves our ability to convert assets to cash with a minimum of loss to enable us to meet our obligations to our customers at any time. This means addressing (1) the immediate cash withdrawal requirements of depositors and other funds providers; (2) the funding requirements of all lines and letters of credit; and (3) the short-term credit needs of customers. Liquidity is provided by short-term investments that can be readily liquidated with a minimum risk of loss. Cash, interest earning deposits, federal funds sold and short-term investments with maturities or repricing characteristics of one year or less continue to be a substantial percentage of total assets. At September 30, 2013, these investments were 14.0% of total assets as compared with 18.6% for December 31, 2012 and 17.4% for September 30, 2012. The decrease to 14.0% at September 30, 2013 is primarily reflective of changes in the investment portfolio. Liquidity is further provided through the matching, by time period, of rate sensitive interest earning assets with rate sensitive interest bearing liabilities. Southside Bank has three lines of credit for the purchase of overnight federal funds at prevailing rates. One $25.0 million and two $15.0 million unsecured lines of credit have been established with Frost Bank, Comerica Bank and TIB - The Independent Bankers Bank, respectively. There were no federal funds purchased at September 30, 2013. Southside Bank has a $5.0 million line of credit with Frost Bank to be used to issue letters of credit. At September 30, 2013, the amount of additional funding Southside Bank could obtain from FHLB using unpledged securities at FHLB was approximately $342.2 million, net of FHLB stock purchases required. Southside Bank obtained no letters of credit from FHLB as collateral for a portion of its public fund deposits. Interest rate sensitivity management seeks to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates. The ALCO closely monitors various liquidity ratios, interest rate spreads and margins. The ALCO performs interest rate simulation tests that apply various interest rate scenarios including immediate shocks and market value of portfolio equity ("MVPE") with interest rates immediately shocked plus and minus 200 basis points to assist in determining our overall interest rate risk and adequacy of the liquidity position. In addition, the ALCO utilizes a simulation model to determine the impact on net interest income of several different interest rate scenarios. By utilizing this technology, we can determine changes that need to be made to the asset and liability mixes to minimize the change in net interest income under these various interest rate scenarios. Composition of Loans One of our main objectives is to seek attractive lending opportunities in Texas, primarily in the counties in which we operate. Refer to "Part I - Item 1. Business - Market Area" in our Annual Report on Form 10-K for the year ended December 31, 2012 for a discussion of our primary market area and the geographic concentration of our loan portfolio as of December 31, 2012. There were no substantial changes in these concentrations during the nine months ended September 30, 2013. Substantially all of our loan originations are made to borrowers who live in and conduct business in our primary market area, with the exception of municipal loans which are made almost entirely in Texas, and purchases of automobile loan portfolios throughout the United States. Municipal loans are made to municipalities, counties, school districts and colleges primarily throughout the state of Texas. Through SFG, we purchase portfolios of automobile loans from a variety of lenders throughout the United States. These high yield loans represent existing subprime automobile loans with payment histories that are collateralized by new and used automobiles. At September 30, 2013, the SFG loans totaled approximately $89.0 million. We look forward to the possibility that our loan growth will accelerate in the future when the economy in the markets we serve improves and as we work to identify and develop additional markets and strategies that will allow us to expand our lending territory. Total loans increased $54.6 million, or 4.3%, to $1.32 billion for the nine months ended September 30, 2013 from $1.26 billion at December 31, 2012, and increased $96.0 million, or 7.9%, from $1.22 billion at September 30, 2012. Average loans increased $126.0 million, or 10.9%, during the nine months ended September 30, 2013 when compared to the same period in 2012. Our market areas to date have not experienced the level of downturn in the economy and real estate prices that some of the harder hit areas of the country have experienced. However, we did experience weakening conditions associated with the real estate led downturn during 2008 through 2011 and strengthened our underwriting standards, especially related to all aspects of real estate lending. Our real estate loan portfolio does not have Alt-A or subprime mortgage exposure. 55-------------------------------------------------------------------------------- Table of Contents The following table sets forth loan totals for the periods presented: At At At September 30, December 31, September 30, 2013 2012 2012 (in thousands) Real Estate Loans: Construction $ 126,922 $ 113,744 $ 116,079 1-4 Family Residential 387,964 368,845 349,419 Other 252,827 236,760 225,854 Commercial Loans 153,019 160,058 140,479 Municipal Loans 223,063 220,947 220,590 Loans to Individuals 173,773 162,623 169,174 Total Loans $ 1,317,568 $ 1,262,977 $ 1,221,595 Our 1-4 family residential mortgage loans increased $19.1 million, or 5.2%, to $388.0 million at September 30, 2013, from $368.8 million at December 31, 2012, and $38.5 million, or 11.0%, from $349.4 million at September 30, 2012, due primarily to the low interest rate environment and increased activity in the Dallas-Fort Worth market. Other real estate loans, which are comprised primarily of commercial real estate loans, increased $16.1 million, or 6.8%, to $252.8 million at September 30, 2013, from $236.8 million at December 31, 2012, and increased $27.0 million, or 11.9%, from $225.9 million at September 30, 2012. Construction loans increased $13.2 million, or 11.6%, to $126.9 million at September 30, 2013 from $113.7 million at December 31, 2012, and $10.8 million, or 9.3%, from $116.1 million at September 30, 2012, due to increased activity in the Austin and Dallas-Fort Worth markets. Municipal loans increased $2.1 million, or 1.0%, to $223.1 million at September 30, 2013, from $220.9 million at December 31, 2012, and increased $2.5 million, or 1.1%, from $220.6 million at September 30, 2012. Commercial loans decreased $7.0 million, or 4.4%, to $153.0 million at September 30, 2013, from $160.1 million at December 31, 2012, and increased $12.5 million, or 8.9% from $140.5 million at September 30, 2012. Loans to individuals, which includes SFG loans, increased $11.2 million, or 6.9%, to $173.8 million at September 30, 2013, from $162.6 million at December 31, 2012, and increased $4.6 million, or 2.7%, from $169.2 million at September 30, 2012. The increase for the nine months ended September 30, 2013 is due to an increase in SFG loans purchased. Loan Loss Experience and Allowance for Loan Losses The allowance for loan losses is based on the most current review of the loan portfolio and is validated by multiple processes. First, the bank utilizes historical data to establish general reserve amounts for each class of loans. An average three-year history of annualized net charge-offs against the average portfolio balance for that time period is utilized. The historical charge-off figure is further adjusted through qualitative factors that include general trends in past dues, nonaccruals and classified loans to more effectively and promptly react to both positive and negative movements. Second, our lenders have the primary responsibility for identifying problem loans and estimating necessary reserves based on customer financial stress and underlying collateral. These recommendations are reviewed by senior loan administration, the Special Assets department, and the Loan Review department. Third, the Loan Review department does independent reviews of the portfolio on an annual basis. The Loan Review department follows a board-approved annual loan review scope. The loan review scope encompasses a number of metrics that takes into consideration the size of the loan, the type of credit extended, the seasoning of the loan along with the performance of the loan. The loan review scope as it relates to size, focuses more on larger dollar loan relationships, typically, for example, aggregate debt of $500,000 or greater. The loan review officer also tracks specific reserves for loans by type compared to general reserves to determine trends in comparative reserves as well as losses not reserved for prior to charge-off to determine the effectiveness of the specific reserve process. 56-------------------------------------------------------------------------------- Table of Contents At each review, a subjective analysis methodology is used to grade the respective loan. Categories of grading vary in severity from loans that do not appear to have a significant probability of loss at the time of review to loans that indicate a probability that the entire balance of the loan will be uncollectible. If full collection of the loan balance appears unlikely at the time of review, estimates of future expected cash flows or appraisals of the collateral securing the debt are used to determine the necessary allowances. The internal loan review department maintains a list of all loans or loan relationships that are graded as having more than the normal degree of risk associated with them. In addition, a list of specifically reserved loans or loan relationships of $50,000 or more is updated on a quarterly basis in order to properly determine necessary allowances and keep management informed on the status of attempts to correct the deficiencies noted with respect to the loan. For loans to individuals, the methodology associated with determining the appropriate allowance for losses on loans primarily consists of an evaluation of individual payment histories, remaining term to maturity and underlying collateral support. Consumer loans at SFG are reserved for based on general estimates of loss at the time of purchase for current loans. SFG loans experiencing past due status or extension of maturity characteristics are reserved for at significantly higher levels based on the circumstances associated with each specific loan. In general the reserves for SFG are calculated based on the past due status of the loan. For reserve purposes, the portfolio has been segregated by past due status and by the remaining term variance from the original contract. During repayment, loans that pay late will take longer to pay out than the original contract. Additionally, some loans may be granted extensions for extenuating payment circumstances and evaluated for troubled debt classification. The remaining term extensions increase the risk of collateral deterioration and accordingly, reserves are increased to recognize this risk. New pools purchased are reserved at their estimated annual loss. Additionally, we use data mining measures to track migration within risk tranches. Reserves are adjusted quarterly to match the migration metrics. Industry and our own experience indicates that a portion of our loans will become delinquent and a portion of the loans will require partial or full charge-off. Regardless of the underwriting criteria utilized, losses may be experienced as a result of various factors beyond our control, including, among other things, changes in market conditions affecting the value of properties used as collateral for loans and problems affecting the credit of the borrower and the ability of the borrower to make payments on the loan. Our determination of the appropriateness of the allowance for loan losses is based on various considerations, including an analysis of the risk characteristics of various classifications of loans, previous loan loss experience, specific loans which would have loan loss potential, delinquency trends, estimated fair value of the underlying collateral, current economic conditions, the views of the bank regulators (who have the authority to require additional allowances in accordance with GAAP), and geographic and industry loan concentration. After all of the data in the loan portfolio is accumulated, the reserve allocations are separated into various loan classes. At September 30, 2013, the unallocated portion of the allowance for loan loss was $47,000. As of September 30, 2013, our review of the loan portfolio indicated that a loan loss allowance of $19.4 million was appropriate to cover probable losses in the portfolio. Changes in economic and other conditions may require future adjustments to the allowance for loan losses. For the three and nine months ended September 30, 2013, loan charge-offs were $3.5 million and $9.4 million, and recoveries were $860,000 and $2.0 million, resulting in net charge-offs of $2.7 million and $7.4 million, respectively. For the three and nine months ended September 30, 2012, loan charge-offs were $3.1 million and $8.1 million, and recoveries were $451,000 and $1.9 million, resulting in net charge-offs of $2.6 million and $6.2 million, respectively. The increase in net charge-offs for the three and nine months ended September 30, 2013, was primarily related to an increase in SFG charge-offs due to the higher average balance. The necessary provision expense was estimated at $3.6 million and $6.2 million for the three and nine months ended September 30, 2013, compared to $3.3 million and $8.5 million for the comparable period in 2012. The decrease in provision expense for the nine months ended September 30, 2013, compared to the same period in 2012 was primarily a result of the increase in the credit quality of the loans and to a lesser extent, a decrease in nonperforming assets. 57-------------------------------------------------------------------------------- Table of Contents Nonperforming Assets Nonperforming assets consist of delinquent loans 90 days or more past due, nonaccrual loans, OREO, repossessed assets and restructured loans. Nonaccrual loans are those loans which are 90 days or more delinquent and collection in full of both the principal and interest is in doubt. Additionally, some loans that are not delinquent may be placed on nonaccrual status due to doubts about full collection of principal or interest. When a loan is categorized as nonaccrual, the accrual of interest is discontinued and the accrued balance is reversed for financial statement purposes. Restructured loans represent loans that have been renegotiated to provide a reduction or deferral of interest or principal because of deterioration in the financial position of the borrowers. 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. Categorization of a loan as nonperforming is not in itself a reliable indicator of potential loan loss. Other factors, such as the value of collateral securing the loan and the financial condition of the borrower must be considered in judgments as to potential loan loss. OREO represents real estate taken in full or partial satisfaction of debts previously contracted. The dollar amount of OREO is based on a current evaluation of the OREO at the time it is recorded on our books, net of estimated selling costs. Updated valuations are obtained as needed and any additional impairments are recognized. The following tables set forth nonperforming assets for the periods presented (in thousands): At At At September 30, December 31, September 30, 2013 2012 2012 Nonaccrual loans $ 8,370 $ 10,314 $ 11,879 Accruing loans past due more than 90 days 2 15 9 Restructured loans 3,802 2,998 2,897 Other real estate owned 740 686 708 Repossessed assets 739 704 322 Total Nonperforming Assets $ 13,653 $ 14,717 $ 15,815 At At At September 30, December 31, September 30, 2013 2012 2012 Asset Quality Ratios: Nonaccruing loans to total loans 0.64 % 0.82 % 0.97 % Allowance for loan losses to nonaccruing loans 231.25 199.58 175.50 Allowance for loan losses to nonperforming assets 141.77 139.87 131.82 Allowance for loan losses to total loans 1.47 1.63 1.71 Nonperforming assets to total assets 0.39 0.45 0.49 Net charge-offs to average loans 0.77 0.74 0.71 Total nonperforming assets at September 30, 2013 were $13.7 million, a decrease of $1.1 million, or 7.2%, from $14.7 million at December 31, 2012 and a decrease of $2.2 million, or 13.7%, from $15.8 million at September 30, 2012. The decrease in nonperforming assets for the nine months ended September 30, 2013 is primarily a result of a decrease in nonaccrual loans. From December 31, 2012 to September 30, 2013, nonaccrual loans decreased $1.9 million, or 18.8%, to $8.4 million, and from September 30, 2012, decreased $3.5 million, or 29.5%. Of the total nonaccrual loans at September 30, 2013, 16.7% are residential real estate loans, 6.5% are commercial real estate loans, 27.2% are commercial loans, 31.8% are loans to individuals, primarily SFG automobile loans, and 17.8% are construction loans. Accruing loans past due more than 90 days decreased $13,000, or 86.7%, at September 30, 2013, from $15,000 at December 31, 2012 and from September 30, 2012, decreased $7,000, or 77.8%. Restructured loans increased $804,000, or 26.8%, to $3.8 million at September 30, 2013, from $3.0 million at December 31, 2012 and $905,000, or 31.2%, from $2.9 million at September 30, 2012. OREO increased $54,000, or 7.9%, to $740,000 at September 30, 2013 from $686,000 at December 31, 2012 and increased $32,000, or 4.5%, from $708,000 at September 30, 2012. The OREO at September 30, 2013, consisted primarily of residential and commercial real estate property. We are actively 58-------------------------------------------------------------------------------- Table of Contents marketing all properties and none are being held for investment purposes. Repossessed assets increased $35,000, or 5.0%, to $739,000 at September 30, 2013, from $704,000 at December 31, 2012 and $417,000, or 129.5%, from $322,000 at September 30, 2012. Reorganization During the second quarter of 2013, we completed the closure of Southside Securities, Inc. Recent Accounting Pronouncements See "Note 1 - Basis of Presentation" in our financial statements included in this report. 59 -------------------------------------------------------------------------------- Table of Contents |