SBSI

Business Context and Reporting Period

Company: Southside Bancshares, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2009
Business Overview: Southside Bancshares operates Southside Bank, a Texas-based financial institution. The company utilizes a balance sheet strategy involving wholesale funding (FHLB advances and brokered CDs) to invest primarily in U.S. Agency mortgage-backed securities and municipal securities, alongside a traditional loan portfolio. The company also consolidates Southside Financial Group (SFG), a variable interest entity that purchases subprime automobile loan portfolios.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability Surge: Net income for the nine months ended September 30, 2009, increased 66.6% to $34.0 million compared to $20.3 million in the same period of 2008. This was driven by a 58.7% increase in noninterest income.
• Noninterest Income: Significant gains on the sale of available-for-sale (AFS) securities contributed $26.4 million to noninterest income for the nine-month period, compared to $6.6 million in 2008. This was partially offset by a $2.4 million other-than-temporary impairment (OTTI) charge on Trust Preferred Securities (TRUPs).
• Net Interest Income: Increased 26.9% to $67.4 million for the nine months ended September 30, 2009, due to a 21.1% increase in average interest-earning assets, which offset lower yields caused by the declining interest rate environment.
• Asset Quality Deterioration: Nonperforming assets rose 47.1% to $23.2 million from $15.8 million at year-end 2008. Nonaccrual loans increased to $16.7 million, with a significant portion (41.2%) attributed to SFG automobile loans. Net charge-offs for the nine months were $7.6 million, up from $5.2 million in the prior year.
• Expense Growth: Noninterest expenses increased 18.5% to $52.6 million for the nine-month period, primarily due to higher salaries, FDIC insurance assessments (up 362.2%), and health insurance costs.

Guidance, Outlook, Risks, and Unusual Items

• Unusual Items: The company recorded a $2.4 million credit loss charge related to TRUPs (pooled trust preferred securities) classified as other-than-temporary impairment. Management does not intend to sell these securities and believes the fair value decline is largely due to market illiquidity rather than fundamental credit failure of the underlying issuers.
• Balance Sheet Strategy: Management continues to utilize wholesale funding to invest in mortgage-backed securities to maximize capital usage. Securities now represent 59.5% of total assets. The company repositioned its portfolio in Q3 2009 to increase the average coupon and reduce funding risk.
• Capital Position: The company is well-capitalized, with a Total Capital ratio of 19.01% and a Tier 1 Capital ratio of 17.76% as of September 30, 2009, significantly exceeding regulatory requirements.
• Risks:
  • Interest Rate Risk: Simulations indicate that a 200 basis point decrease in interest rates would result in a 14.29% negative variance in net interest income over the next 12 months.
  • Credit Risk: Continued economic weakness is driving higher nonperforming assets, particularly in the SFG automobile loan portfolio and construction loans.
  • Liquidity: While liquidity is adequate, the company relies heavily on FHLB advances and brokered CDs.
• Outlook: Management anticipates continued pressure on loan yields due to competitive pricing. Security gains of the magnitude seen in 2009 are unlikely to be repeated. Expansion plans include new branches in Tyler and Gresham, Texas.

Investor Verification Checklist

• TRUPs Valuation: Verify the assumptions used in the cash flow modeling for the $3.6 million amortized cost TRUPs portfolio, specifically the deferral and default rates applied to underlying issuers.
• SFG Loan Performance: Monitor the delinquency and charge-off trends of the $74.2 million SFG automobile loan portfolio, which accounts for a significant portion of nonaccrual loans.
• Security Sales Sustainability: Assess the remaining unrealized gains in the AFS portfolio ($39.4 million) to determine the potential for future earnings volatility if the company continues to sell securities to manage the balance sheet.
• FDIC Assessments: Confirm the impact of the special FDIC assessments and increased rates on future expense lines.
• Interest Rate Sensitivity: Review the Asset/Liability Committee (ALCO) reports regarding the company's exposure to falling interest rates, given the heavy concentration in mortgage-backed securities.