Edgar Filing: PROSPERITY BANCSHARES INC

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Accelerated Filer

Non-accelerated Filer

¨ (Do not check if a smaller reporting company)

Smaller Reporting Company

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2013

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER: 001-35388

PROSPERITY BANCSHARES, INC.^®

(Exact name of registrant as specified in its charter)

TEXAS

74-2331986

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

Prosperity Bank Plaza

4295 San Felipe

Houston, Texas 77027

(Address of principal executive offices, including zip code)

(713) 693-9300

(Registrant’s telephone number, including area code)

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

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

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

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

As of August 1, 2013, there were 60,343,210 outstanding shares of the registrant’s Common Stock, par value $1.00 per share.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

INDEX TO FORM 10-Q


PART I—FINANCIAL INFORMATION

Item 1.	Interim Consolidated Financial Statements
	Consolidated Balance Sheets as of June 30, 2013 and December 31, 2012 (unaudited)	3
	Consolidated Statements of Income for the Three and Six Months Ended June 30, 2013 and 2012 (unaudited)	4
	Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2013 and 2012 (unaudited)	5
	Consolidated Statements of Changes in Shareholders’ Equity for the Six Months Ended June 30, 2013 and 2012 (unaudited)	6
	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2013 and 2012 (unaudited)	7
	Notes to Interim Consolidated Financial Statements (unaudited)	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	36
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	53
Item 4.	Controls and Procedures	53

PART II—OTHER INFORMATION

Item 1.	Legal Proceedings	53
Item 1A.	Risk Factors	53
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	53
Item 3.	Defaults upon Senior Securities	53
Item 4.	Mine Safety Disclosures	54
Item 5.	Other Information	54
Item 6.	Exhibits	54
Signatures		55

PART I—FINANCIAL INFORMATION

ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS

PROSPERITY BANCSHARES, INC^®. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)


	June 30,			December 31,
	2013			2012
	(Dollars in thousands)
ASSETS
Cash and due from banks	$	250,542		$	325,952
Federal funds sold		606			352

Total cash and cash equivalents		251,148			326,304

Available for sale securities, at fair value		184,349			226,670
Held to maturity securities, at cost (fair value of $7,820,266 and $7,418,695, respectively)		7,833,535			7,215,395

Total securities		8,017,884			7,442,065

Loans held for sale		6,186			10,433
Loans held for investment		6,166,297			5,169,507

Total loans		6,172,483			5,179,940
Less: allowance for credit losses		(56,176	)		(52,564	)

Loans, net		6,116,307			5,127,376

Accrued interest receivable		43,650			42,337
Goodwill		1,350,834			1,217,162
Core deposit intangibles, net		26,688			26,159
Bank premises and equipment, net		227,455			205,268
Other real estate owned		10,244			7,234
Bank owned life insurance (BOLI)		122,199			109,108
Federal Home Loan Bank of Dallas stock		44,933			34,461
Other assets		59,376			46,099

TOTAL ASSETS	$	16,270,718		$	14,583,573

LIABILITIES AND SHAREHOLDERS’ EQUITY
LIABILITIES:
Deposits:
Noninterest-bearing	$	3,283,082		$	3,016,205
Interest-bearing		9,225,568			8,625,639

Total deposits		12,508,650			11,641,844
Other borrowings		781,215			256,753
Securities sold under repurchase agreements		481,170			454,502
Junior subordinated debentures		85,055			85,055
Accrued interest payable		2,189			1,904
Other liabilities		67,157			54,126

Total liabilities		13,925,436			12,494,184
COMMITMENTS AND CONTINGENCIES		—			—
SHAREHOLDERS’ EQUITY:
Preferred stock, $1 par value; 20,000,000 shares authorized; none issued or outstanding		—			—
Common stock, $1 par value; 200,000,000 shares authorized; 60,352,298 and 56,484,234 shares issued at June 30, 2013 and December 31, 2012, respectively; 60,315,210 and 56,447,146 shares outstanding at June 30, 2013 and December 31, 2012, respectively		60,352			56,484
Capital surplus		1,451,064			1,274,290
Retained earnings		828,153			750,236
Accumulated other comprehensive income—net unrealized gain on available for sale securities, net of tax of $3,403 and $4,839, respectively		6,320			8,986
Less treasury stock, at cost, 37,088 shares		(607	)		(607	)

Total shareholders’ equity		2,345,282			2,089,389

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	16,270,718		$	14,583,573

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)


	Three Months Ended June 30,				Six Months Ended June 30,
	2013		2012		2013		2012
	(Dollars in thousands, except per share data)
INTEREST INCOME:
Loans, including fees	$	89,842	$	54,793	$	171,306	$	108,010
Securities		39,384		38,072		75,932		76,393
Federal funds sold		76		9		95		87

Total interest income		129,302		92,874		247,333		184,490

INTEREST EXPENSE:
Deposits		9,170		8,083		17,860		16,874
Other borrowings		472		648		834		1,311
Securities sold under repurchase agreements		312		59		604		96
Junior subordinated debentures		606		418		1,211		697

Total interest expense		10,560		9,208		20,509		18,978

NET INTEREST INCOME		118,742		83,666		226,824		165,512
PROVISION FOR CREDIT LOSSES		2,550		600		5,350		750

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES		116,192		83,066		221,474		164,762

NONINTEREST INCOME:
Nonsufficient funds (NSF) fees		8,346		5,167		16,855		10,556
Credit card, debit card and ATM card income		7,007		4,292		13,494		8,128
Service charges on deposit accounts		3,304		2,432		6,235		4,873
Trust income		896		—		1,913		—
Mortgage income		1,567		65		2,558		124
Other		4,154		1,700		7,660		3,920

Total noninterest income		25,274		13,656		48,715		27,601

NONINTEREST EXPENSE:
Salaries and employee benefits		37,517		23,572		70,726		46,824
Net occupancy and equipment		4,669		3,492		8,947		7,049
Debit card, data processing and software amortization		3,249		1,906		5,819		3,438
Regulatory assessments and FDIC insurance		2,579		1,659		4,974		3,207
Core deposit intangibles amortization		1,341		1,595		3,096		3,290
Depreciation		2,464		2,028		4,842		4,063
Communications (including telephone, courier and postage)		2,410		1,802		4,606		3,550
Other real estate expense		237		383		460		1,074
Other		6,834		4,351		13,597		8,752

Total noninterest expense		61,300		40,788		117,067		81,247

INCOME BEFORE INCOME TAXES		80,166		55,934		153,122		111,116

PROVISION FOR INCOME TAXES		26,322		18,962		49,973		37,657

NET INCOME	$	53,844	$	36,972	$	103,149	$	73,459

EARNINGS PER SHARE:
Basic	$	0.89	$	0.78	$	1.76	$	1.55

Diluted	$	0.89	$	0.78	$	1.76	$	1.55

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(UNAUDITED)


	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(Dollars in thousands)
Net income	$	53,844		$	36,972		$	103,149		$	73,459
Other comprehensive loss, before tax:
Securities available for sale:
Change in unrealized gain during period		(2,330	)		(1,833	)		(4,101	)		(3,018	)

Total other comprehensive loss		(2,330	)		(1,833	)		(4,101	)		(3,018	)
Deferred tax benefit related to other comprehensive income		816			642			1,435			1,057

Other comprehensive loss, net of tax		(1,514	)		(1,191	)		(2,666	)		(1,961	)

Comprehensive income	$	52,330		$	35,781		$	100,483		$	71,498

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(UNAUDITED)


										Accumulated
	Common Stock				Capital Surplus		Retained Earnings			Other Comprehensive Income			Treasury Stock			Total Shareholders’ Equity
	Shares		Amount		Capital Surplus		Retained Earnings			Other Comprehensive Income			Treasury Stock			Total Shareholders’ Equity
	(In thousands, except share and per share data)
BALANCE AT DECEMBER 31, 2011		46,947,415	$	46,947	$	883,575	$	623,878		$	13,472		$	(607	)	$	1,567,265
Net income								73,459									73,459
Other comprehensive loss											(1,961	)					(1,961	)
Common stock issued in connection with the exercise of stock options and restricted stock awards		112,948		113		2,353											2,466
Common stock issued in connection with the acquisition of Texas Bankers, Inc.		314,953		315		12,393											12,708
Common stock issued in connection with the acquisition of The Bank Arlington		135,347		136		6,063											6,199
Stock based compensation expense						2,161											2,161
Cash dividends declared, $0.39 per share								(18,480	)								(18,480	)

BALANCE AT JUNE 30, 2012		47,510,663	$	47,511	$	906,545	$	678,857		$	11,511		$	(607	)	$	1,643,817

BALANCE AT DECEMBER 31, 2012		56,484,234	$	56,484	$	1,274,290	$	750,236		$	8,986		$	(607	)	$	2,089,389
Net income								103,149									103,149
Other comprehensive loss											(2,666	)					(2,666	)
Common stock issued in connection with the exercise of stock options and restricted stock awards		78,406		78		1,727											1,805
Common stock issued in connection with the acquisition of East Texas Financial Services, Inc.		530,940		531		21,769											22,300
Common stock issued in connection with the acquisition of Coppermark Bancshares, Inc.		3,258,718		3,259		151,172											154,431
Stock based compensation expense						2,106											2,106
Cash dividends declared, $0.43 per share								(25,232	)								(25,232	)

BALANCE AT JUNE 30, 2013		60,352,298	$	60,352	$	1,451,064	$	828,153		$	6,320		$	(607	)	$	2,345,282

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)


	Six Months Ended June 30,
	2013			2012
	(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	103,149		$	73,459
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and core deposit intangibles amortization		7,938			7,353
Provision for credit losses		5,350			750
Net amortization of premium on investments		41,694			21,474
Loss (gain) on sale or write down of premises, equipment and other real estate		40			(316	)
Net accretion of discount on loans		(26,323	)		(790	)
Proceeds from sale of loans held for sale		98,228			—
Originations of loans held for sale		(96,492	)		—
Stock based compensation expense		2,106			2,161
Decrease (increase) in accrued interest receivable and other assets		26,407			(32,408	)
Increase in accrued interest payable and other liabilities		5,733			13,298

Net cash provided by operating activities		167,830			84,981

CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities and principal paydowns of held to maturity securities		1,380,310			732,832
Purchase of held to maturity securities		(2,022,901	)		(1,545,313	)
Proceeds from maturities, sales and principal paydowns of available for sale securities		1,493,689			956,913
Purchase of available for sale securities		(1,454,999	)		(909,999	)
Net increase in loans held for investment		(50,106	)		(144,906	)
Purchase of bank premises and equipment		(13,626	)		(6,546	)
Proceeds from sale of bank premises, equipment and other real estate		8,667			7,384
Net cash and cash equivalents acquired in the purchase of Texas Bankers, Inc.		—			44,550
Net cash and cash equivalents acquired in the purchase of The Bank Arlington		—			12,037
Net cash and cash equivalents acquired in the purchase of East Texas Financial Services, Inc.		3,471			—
Net cash and cash equivalents acquired in the purchase of Coppermark Banchares, Inc.		288,795			—

Net cash used in investing activities		(366,700	)		(853,048	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease) increase in noninterest-bearing deposits		(42,054	)		82,171
Net (decrease) increase in interest-bearing deposits		(321,225	)		148,683
Net proceeds from other short-term borrowings		524,583			425,000
Repayments of other long-term borrowings		(40,831	)		(512	)
Net increase in securities sold under repurchase agreements		26,668			67,860
Proceeds from stock option exercises		1,805			2,466
Payments of cash dividends		(25,232	)		(18,480	)

Net cash provided by financing activities		123,714			707,188

NET DECREASE IN CASH AND CASH EQUIVALENTS		(75,156	)		(60,879	)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		326,304			213,442

CASH AND CASH EQUIVALENTS, END OF PERIOD	$	251,148		$	152,563

NONCASH ACTIVITIES:
Stock issued in connection with the Texas Bankers, Inc. acquisition	$	—		$	12,708
Stock issued in connection with the The Bank Arlington acquisition		—			6,199
Stock issued in connection with the East Texas Financial Services, Inc. acquisition		22,300			—
Stock issued in connection with the Coppermark Bancshares, Inc. acquisition		154,431			—
Acquisition of real estate through foreclosure of collateral		2,733			9,311
SUPPLEMENTAL INFORMATION:
Income taxes paid	$	44,615		$	36,737
Interest paid		20,071			19,651

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

1. BASIS OF PRESENTATION

The interim consolidated financial statements include the accounts of Prosperity Bancshares, Inc.^® (the “Company”) and its wholly-owned subsidiaries, Prosperity Bank^® (the “Bank”) and Prosperity Holdings of Delaware, LLC. All intercompany transactions and balances have been eliminated.

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the statements reflect all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows of the Company on a consolidated basis, and all such adjustments are of a normal recurring nature. These financial statements and the notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. Operating results for the six-month period ended June 30, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013 or any other period.

2. INCOME PER COMMON SHARE

Outstanding stock options issued by the Company represent the only dilutive effect reflected in diluted weighted average shares. The following table illustrates the computation of basic and diluted earnings per share:


	Three Months Ended June 30,								Six Months Ended June 30,
	2013				2012				2013				2012
	Amount		Per Share Amount		Amount		Per Share Amount		Amount		Per Share Amount		Amount		Per Share Amount
	(In thousands, except per share data)
Net income	$	53,844			$	36,972			$	103,149			$	73,459

Basic:
Weighted average shares outstanding		60,250	$	0.89		47,456	$	0.78		58,629	$	1.76		47,347	$	1.55

Diluted:
Add incremental shares for:
Effect of dilutive securities - options		144				152				145				161

Total		60,394	$	0.89		47,608	$	0.78		58,774	$	1.76		47,508	$	1.55

There were no stock options exercisable during the three and six months ended June 30, 2013 or 2012 that would have had an anti-dilutive effect on the above computation.

3. NEW ACCOUNTING STANDARDS

Accounting Standards Updates

ASU 2012-02 “Intangibles—Goodwill and Other (Topic 350) — Testing Indefinite-Lived Intangible Assets for Impairment.” ASU 2012-02 gives entities the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that an indefinite-lived intangible asset is impaired. If, after assessing the totality of events or circumstances, an entity determines it is more likely than not that an indefinite-lived intangible asset is impaired, then the entity must perform the quantitative impairment test. If, under the quantitative impairment test, the carrying amount of the intangible asset exceeds its fair value, an entity should recognize an impairment loss in the amount of that excess permitting an entity to assess qualitative factors when testing indefinite-lived intangible assets for impairment results in guidance that is similar to the goodwill impairment testing guidance in ASU 2011-08. ASU 2012-02 became effective for the Company on January 1, 2013 and did not have a significant impact on the Company’s financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

ASU 2013-02 “Comprehensive Income (Topic 220) — Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” ASU 2013-02 amends recent guidance related to the reporting of comprehensive income to enhance the reporting of reclassifications out of accumulated other comprehensive income. ASU 2013-02 became effective for the Company on January 1, 2013 and did not have a significant impact on the Company’s financial statements. See Note 10 – Other Comprehensive (Loss) Income for applicable disclosures.

4. SECURITIES

The amortized cost and fair value of investment securities were as follows:


	June 30, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available for Sale
States and political subdivisions	$	33,591	$	1,172	$	—		$	34,763
Collateralized mortgage obligations		547		10		(1	)		556
Mortgage-backed securities		133,199		8,438		(24	)		141,613
Other securities		7,289		141		(13	)		7,417

Total	$	174,626	$	9,761	$	(38	)	$	184,349

Held to Maturity
U.S. Treasury securities and obligations of U.S. Government agencies	$	5,772	$	51	$	—		$	5,823
States and political subdivisions		362,590		2,089		(1,839	)		362,840
Corporate debt securities		522		8		—			530
Collateralized mortgage obligations		75,235		1,530		(60	)		76,705
Mortgage-backed securities		7,376,516		106,996		(124,376	)		7,359,136
Qualified School Construction Bonds (QSCB)		12,900		2,332		—			15,232

Total	$	7,833,535	$	113,006	$	(126,275	)	$	7,820,266


	December 31, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available for Sale
States and political subdivisions	$	34,743	$	1,691	$	—		$	36,434
Collateralized mortgage obligations		616		—		(12	)		604
Mortgage-backed securities		168,701		11,742		(27	)		180,416
Other securities		8,786		430		—			9,216

Total	$	212,846	$	13,863	$	(39	)	$	226,670

Held to Maturity
U.S. Treasury securities and obligations of U.S. Government agencies	$	7,061	$	160	$	—		$	7,221
States and political subdivisions		391,510		7,074		(354	)		398,230
Corporate debt securities		1,500		28		—			1,528
Collateralized mortgage obligations		125,912		2,304		(50	)		128,166
Mortgage-backed securities		6,676,512		196,206		(4,517	)		6,868,201
Qualified School Construction Bonds (QSCB)		12,900		2,449		—			15,349

Total	$	7,215,395	$	208,221	$	(4,921	)	$	7,418,695

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. The investment securities portfolio is evaluated for OTTI by segregating the portfolio into two general segments and applying the appropriate OTTI model.

In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time

When OTTI occurs, the amount of the other-than-temporary impairment recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit-related portion of the impairment loss (“credit loss”) and the noncredit portion of the impairment loss (“noncredit portion”). The amount of the total OTTI related to the credit loss is determined based on the difference between the present value of cash flows expected to be collected and the amortized cost basis and such difference is recognized in earnings. The amount of the total OTTI related to the noncredit portion is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

As of June 30, 2013, the Company does not intend to sell any debt securities and management believes that the Company more likely than not will not be required to sell any debt securities before their anticipated recovery, at which time the Company will receive full value for the securities. Furthermore, as of June 30, 2013, management does not have the intent to sell any of its securities and believes that it is more likely than not that the Company will not have to sell any such securities before a recovery of cost. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe any of the securities are impaired due to reasons of credit quality. Accordingly, as of June 30, 2013, management believes any impairment in the Company’s securities is temporary and no impairment loss has been realized in the Company’s consolidated statements of income.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

Securities with unrealized losses segregated by length of time that have been in a continuous loss position at June 30, 2013 and December 31, 2012 were as follows:


	June 30, 2013
	Less than 12 Months					More than 12 Months					Total
	Estimated Fair Value		Unrealized Losses			Estimated Fair Value		Unrealized Losses			Estimated Fair Value		Unrealized Losses
	(Dollars in thousands)
Available for Sale
Collateralized mortgage obligations	$	—	$	—		$	72	$	(1	)	$	72	$	(1	)
Mortgage-backed securities		459		—			3,638		(24	)		4,097		(24	)
Other securities		1,724		(13	)		—		—			1,724		(13	)

Total	$	2,183	$	(13	)	$	3,710	$	(25	)	$	5,893	$	(38	)

Held to Maturity
States and political subdivisions	$	168,582	$	(1,716	)	$	5,562	$	(123	)	$	174,144	$	(1,839	)
Collateralized mortgage obligations		1,946		(52	)		970		(8	)		2,916		(60	)
Mortgage-backed securities		3,246,129		(124,034	)		11,693		(342	)		3,257,822		(124,376	)

Total	$	3,416,657	$	(125,802	)	$	18,225	$	(473	)	$	3,434,882	$	(126,275	)


	December 31, 2012
	Less than 12 Months					More than 12 Months					Total
	Estimated Fair Value		Unrealized Losses			Estimated Fair Value		Unrealized Losses			Estimated Fair Value		Unrealized Losses
	(Dollars in thousands)
Available for Sale
Collateralized mortgage obligations	$	—	$	—		$	603	$	(12	)	$	603	$	(12	)
Mortgage-backed securities		224		—			3,964		(27	)		4,188		(27	)

Total	$	224	$	—		$	4,567	$	(39	)	$	4,791	$	(39	)

Held to Maturity
States and political subdivisions	$	37,322	$	(335	)	$	1,140	$	(19	)	$	38,462	$	(354	)
Collateralized mortgage obligations		2,366		(50	)		—		—			2,366		(50	)
Mortgage-backed securities		1,081,414		(4,516	)		234		(1	)		1,081,648		(4,517	)

Total	$	1,121,102	$	(4,901	)	$	1,374	$	(20	)	$	1,122,476	$	(4,921	)

At June 30, 2013, there were approximately 353 securities in an unrealized loss position for more than 12 months.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

The amortized cost and fair value of investment securities at June 30, 2013, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations at any time with or without call or prepayment penalties.


	Held to Maturity				Available for Sale
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(Dollars in thousands)
Due in one year or less	$	29,326	$	29,403	$	7,376	$	7,507
Due after one year through five years		125,561		125,618		5,435		5,628
Due after five years through ten years		140,710		140,578		23,021		23,805
Due after ten years		86,187		88,826		5,048		5,240

Subtotal		381,784		384,425		40,880		42,180
Mortgage-backed securities and collateralized mortgage obligations		7,451,751		7,435,841		133,746		142,169

Total	$	7,833,535	$	7,820,266	$	174,626	$	184,349

The Company had no gain or loss on sale of securities for the three and six months ended June 30, 2013 and 2012. As of June 30, 2013, the Company had eight non-agency CMO’s remaining with a total book value of $2.0 million and total market value of $2.0 million.

At June 30, 2013 and December 31, 2012, the Company did not own securities of any one issuer (other than the U.S. government and its agencies) for which aggregate adjusted cost exceeded 10% of the consolidated shareholders’ equity at such respective dates.

Securities with an amortized cost of $4.08 billion and $4.13 billion and a fair value of $4.08 billion and $4.27 billion at June 30, 2013 and December 31, 2012, respectively, were pledged to collateralize public deposits and for other purposes required or permitted by law.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

5. LOANS AND ALLOWANCE FOR CREDIT LOSSES

The loan portfolio consists of various types of loans made principally to borrowers located in Bryan/College Station, Central Texas, Dallas/Fort Worth, East Texas, Houston, South Texas, West Texas and Oklahoma and is classified by major type as follows:


	June 30, 2013		December 31, 2012
	(Dollars in thousands)
Residential mortgage loans held for sale	$	6,186	$	10,433

Commercial and industrial		999,677		771,114
Real estate:
Construction and land development		694,585		550,768
1-4 family residential (including home equity)		1,654,821		1,432,133
Commercial real estate (including multi-family residential)		2,390,820		1,990,642
Farmland		230,389		211,156
Agriculture		84,556		74,481
Consumer and other (net of unearned discount)		111,449		139,213

Total loans held for investment		6,166,297		5,169,507

Total	$	6,172,483	$	5,179,940

(i) Commercial and Industrial Loans. In nearly all cases, the Company’s commercial loans are made in the Company’s market areas and are underwritten on the basis of the borrower’s ability to service the debt from income. As a general practice, the Company takes as collateral a lien on any available real estate, equipment or other assets owned by the borrower and obtains a personal guaranty of the borrower or principal. Working capital loans are primarily collateralized by short-term assets whereas term loans are primarily collateralized by long-term assets. In general, commercial loans involve more credit risk than residential mortgage loans and commercial mortgage loans and, therefore, usually yield a higher return. The increased risk in commercial loans is due to the type of collateral securing these loans. The increased risk also derives from the expectation that commercial loans generally will be serviced principally from the operations of the business, and those operations may not be successful. Historical trends have shown these types of loans to have higher delinquencies than mortgage loans. As a result of these additional complexities, variables and risks, commercial loans require more thorough underwriting and servicing than other types of loans.

(ii) Commercial Real Estate. The Company makes commercial real estate related loans collateralized by owner-occupied and non-owner-occupied real estate to finance the purchase of real estate. The Company’s commercial real estate related loans are collateralized by first liens on real estate, typically have variable interest rates (or five year or less fixed rates) and amortize over a 15 to 20 year period. Payments on loans secured by such properties are often dependent on the successful operation or management of the properties. Accordingly, repayment of these loans may be subject to adverse conditions in the real estate market or the economy to a greater extent than other types of loans. The Company seeks to minimize these risks in a variety of ways, including giving careful consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition in connection with underwriting these loans. The underwriting analysis also includes credit verification, analysis of global cash flow, appraisals and a review of the financial condition of the borrower. At June 30, 2013, the Company had commercial real estate related loans totaling $2.39 billion which includes commercial real estate loans and multi-family residential loans. At June 30, 2013, approximately 43.8% of the outstanding principal balance of the Company’s commercial real estate related loans was secured by owner-occupied properties.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

(iii) 1-4 Family Residential Loans. The Company originates 1-4 family residential mortgage loans and home equity loans collateralized by owner-occupied residential properties located in the Company’s market areas. The Company offers a variety of mortgage loan products which generally are amortized over five to 25 years. Loans collateralized by 1-4 family residential real estate generally have been originated in amounts of no more than 89% of appraised value or have mortgage insurance. The Company requires mortgage title insurance and hazard insurance. The Company has elected to keep all 1-4 family residential loans for its own account rather than selling such loans into the secondary market. By doing so, the Company is able to realize a higher yield on these loans; however, the Company also incurs interest rate risk as well as the risks associated with nonpayments on such loans.

(iv) Construction and Land Development Loans. The Company makes loans to finance the construction of residential and, to a lesser extent, nonresidential properties. Construction loans generally are collateralized by first liens on real estate and have floating interest rates. The Company conducts periodic inspections, either directly or through an agent, prior to approval of periodic draws on these loans. Underwriting guidelines similar to those described above are also used in the Company’s construction lending activities. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of a project under construction, and the project is of uncertain value prior to its completion. Because of uncertainties inherent in estimating construction costs, the market value of the completed project and the effects of governmental regulation on real property, it can be difficult to accurately evaluate the total funds required to complete a project and the related loan to value ratio. As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If the Company is forced to foreclose on a project prior to completion, there is no assurance that the Company will be able to recover all of the unpaid portion of the loan. In addition, the Company may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time. While the Company has underwriting procedures designed to identify what it believes to be acceptable levels of risks in construction lending, no assurance can be given that these procedures will prevent losses from the risks described above.

(v) Agriculture Loans. The Company provides agriculture loans for short-term crop production, including rice, cotton, milo and corn, farm equipment financing and agriculture real estate financing. The Company evaluates agriculture borrowers primarily based on their historical profitability, level of experience in their particular agriculture industry, overall financial capacity and the availability of secondary collateral to withstand economic and natural variations common to the industry. Because agriculture loans present a higher level of risk associated with events caused by nature, the Company routinely makes on-site visits and inspections in order to identify and monitor such risks.

(vi) Consumer Loans. Consumer loans made by the Company include direct credit automobile loans, recreational vehicle loans, boat loans, home improvement loans, personal loans (collateralized and uncollateralized) and deposit account collateralized loans. The terms of these loans typically range from 12 to 120 months and vary based upon the nature of collateral and size of loan. Generally, consumer loans entail greater risk than do real estate secured loans, particularly in the case of consumer loans that are unsecured or collateralized by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws may limit the amount which can be recovered on such loans.

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

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

Concentrations of Credit. Most of the Company’s lending activity occurs within the states of Texas and Oklahoma. The majority of the Company’s loan portfolio consists of commercial and industrial, commercial real estate and 1-4 family residential loans. As of June 30, 2013 and December 31, 2012, there were no concentrations of loans related to any single industry in excess of 10% of total loans.

Foreign Loans. The Company has U.S. dollar denominated loans and commitments to borrowers in Mexico. The outstanding balance of these loans and the unfunded amounts available under these commitments were not significant at June 30, 2013 or December 31, 2012.

Related Party Loans. As of June 30, 2013 and December 31, 2012, loans outstanding to directors, officers and their affiliates totaled $6.4 million and $6.7 million, respectively. All transactions entered into between the Company and such related parties are done in the ordinary course of business, made on the same terms and conditions as similar transactions with unaffiliated persons.

An analysis of activity with respect to these related party loans is as follows:


	June 30, 2013			December 31, 2012
	(Dollars in thousands)
Beginning balance on January 1	$	6,682		$	9,809
New loans and reclassified related loans		306			967
Repayments		(586	)		(4,094	)

Ending balance	$	6,402		$	6,682

Nonaccrual and Past Due Loans. The Company has several procedures in place to assist it in maintaining the overall quality of its loan portfolio. The Company has established underwriting guidelines to be followed by its officers and the Company also monitors its delinquency levels for any negative or adverse trends. There can be no assurance, however, that the Company’s loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions.

The Company generally places a loan on nonaccrual status and ceases accruing interest when the payment of principal or interest is delinquent for 90 days, or earlier in some cases, unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan.

The Company requires appraisals on loans collateralized by real estate. With respect to potential problem loans, an evaluation of the borrower’s overall financial condition is made to determine the need, if any, for possible writedowns or appropriate additions to the allowance for credit losses.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

An aging analysis of past due loans, segregated by class of loans, is as follows:


	June 30, 2013
	Loans Past Due and Still Accruing						Nonaccrual Loans		Current Loans		Total Loans
	30-89 Days		90 or More Days		Total Past Due Loans		Nonaccrual Loans		Current Loans		Total Loans
	(Dollars in thousands)
Construction and land development	$	3,946	$	—	$	3,946	$	267	$	690,372	$	694,585
Agriculture and agriculture real estate (includes farmland)		2,123		—		2,123		103		312,719		314,945
1-4 family (includes home equity) (1)		9,641		—		9,641		675		1,650,691		1,661,007
Commercial real estate (includes multi-family residential)		15,774		217		15,991		2,002		2,372,827		2,390,820
Commercial and industrial		16,504		58		16,562		1,132		981,983		999,677
Consumer and other		665		50		715		116		110,618		111,449

Total	$	48,653	$	325	$	48,978	$	4,295	$	6,119,210	$	6,172,483


	December 31, 2012
	Loans Past Due and Still Accruing						Nonaccrual Loans		Current Loans		Total Loans
	30-89 Days		90 or More Days		Total Past Due Loans		Nonaccrual Loans		Current Loans		Total Loans
	(Dollars in thousands)
Construction and land development	$	3,863	$	—	$	3,863	$	1,170	$	545,735	$	550,768
Agriculture and agriculture real estate (includes farmland)		310		21		331		396		284,910		285,637
1-4 family (includes home equity) (1)		2,307		310		2,617		1,598		1,438,351		1,442,566
Commercial real estate (includes multi-family residential)		9,163		—		9,163		—		1,981,479		1,990,642
Commercial and industrial		4,843		—		4,843		1,469		764,802		771,114
Consumer and other		856		—		856		749		137,608		139,213

Total	$	21,342	$	331	$	21,673	$	5,382	$	5,152,885	$	5,179,940

(1)	Includes $6.2 million and $10.4 million of residential mortgage loans held for sale at June 30, 2013 and December 31, 2012, respectively.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

The following table presents information regarding past due loans and nonperforming assets as of the dates indicated:


	June 30, 2013			December 31, 2012
	(Dollars in thousands)
Nonaccrual loans	$	4,295		$	5,382
Accruing loans 90 or more days past due		325			331

Total nonperforming loans		4,620			5,713
Repossessed assets		—			68
Other real estate		10,244			7,234

Total nonperforming assets	$	14,864		$	13,015

Nonperforming assets to total loans and other real estate		0.24	%		0.25	%

The Company believes its conservative lending approach has resulted in sound asset quality. The Company had $14.9 million in nonperforming assets at June 30, 2013 compared with $13.0 million at December 31, 2012. If interest on nonaccrual loans had been accrued under the original loan terms, approximately $153 thousand and $176 thousand would have been recorded as income for the six months ended June 30, 2013 and 2012, respectively.

Purchased Credit-Impaired (PCI) Loans. In connection with the acquisition of American State Financial Corporation (ASB) on July 1, 2012, Community National Bank on October 1, 2012, East Texas Financial Services on January 1, 2013 and Coppermark Bancshares, Inc. on April 1, 2013, the Company acquired loans both with and without evidence of credit quality deterioration since origination. The acquired loans were initially recorded at fair value with no carryover of any allowance for loan losses.

Loans acquired with evidence of credit quality deterioration at acquisition for which it was probable that the Company would not be able to collect all contractual amounts due were accounted for as PCI.

The carrying amount of acquired PCI loans included in the consolidated balance sheet and the related outstanding balance at June 30, 2013 and December 31, 2012 were as follows:


	June 30, 2013		December 31, 2012
	(Dollars in thousands)
Acquired PCI loans:
Carrying amount	$	51,699	$	22,880
Outstanding balance		97,259		46,914

The outstanding balance represents the total amount owed as of June 30, 2013 and December 31, 2012, including accrued but unpaid interest and any amounts previously charged off. No allowance for loan losses was required on the acquired PCI loans at both June 30, 2013 and December 31, 2012.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

Changes in the accretable yield for acquired PCI loans for the three and six month periods ended June 30, 2013 and 2012 were as follows:


	Three Month Periods Ended June 30,					Six Month Periods Ended June 30,
	2013			2012		2013			2012
	(Dollars in thousands)
Balance at beginning of period	$	7,459		$	—	$	7,459		$	—
Additions		5,792			—		7,528			—
Reclassifications from nonaccretable		1,222			—		1,255			—
Accretion		(1,462	)		—		(3,231	)		—

Balance at June 30	$	13,011		$	—	$	13,011		$	—

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

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

Impaired loans as of June 30, 2013 are set forth in the following table. No interest income was recognized on impaired loans subsequent to their classification as impaired for the three and six month periods ended June 30, 2013 and 2012. The average recorded investment presented in the table below is reported on a year-to-date basis.


	June 30, 2013
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment
	(Dollars in thousands)
With no related allowance recorded:
Construction and land development	$	267	$	270	$	—	$	194
Agriculture and agriculture real estate (includes farmland)		77		78		—		77
1-4 family (includes home equity)		278		324		—		371
Commercial real estate (includes multi-family residential)		1,430		1,952		—		914
Commercial and industrial		22		1,428		—		55
Consumer and other		—		—		—		—

Total		2,074		4,052		—		1,611

With an allowance recorded:
Construction and land development		—		—		—		—
Agriculture and agriculture real estate (includes farmland)		26		31		23		30
1-4 family (includes home equity)		62		79		44		530
Commercial real estate (includes multi-family residential)		—		—		—		1,225
Commercial and industrial		858		893		819		950
Consumer and other		67		83		66		67

Total		1,013		1,086		952		2,802

Total:
Construction and land development		267		270		—		194
Agriculture and agriculture real estate (includes farmland)		103		109		23		107
1-4 family (includes home equity)		340		403		44		901
Commercial real estate (includes multi-family residential)		1,430		1,952		—		2,139
Commercial and industrial		880		2,321		819		1,005
Consumer and other		67		83		66		67

	$	3,087	$	5,138	$	952	$	4,413

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

Impaired loans as of December 31, 2012 are set forth in the following tables. No interest income was recognized on impaired loans subsequent to their classification as impaired. The average recorded investment is reported on a year-to-date basis.


	December 31, 2012
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment
	(Dollars in thousands)
With no related allowance recorded:
Construction and land development	$	1,144	$	1,175	$	—	$	368
Agriculture and agriculture real estate (includes farmland)		77		77		—		34
1-4 family (includes home equity)		491		522		—		381
Commercial real estate (includes multi-family residential)		450		476		—		676
Commercial and industrial		87		89		—		75
Consumer and other		10		10		—		3

		2,259		2,349		—		1,537

With an allowance recorded:
Construction and land development		—		—		—		451
Agriculture and agriculture real estate (includes farmland)		34		41		29		45
1-4 family (includes home equity)		999		1,017		273		720
Commercial real estate (includes multi-family residential)		2,450		2,451		610		2,725
Commercial and industrial		1,043		1,079		1,002		782
Consumer and other		66		81		67		21

		4,592		4,669		1,981		4,744

Total:
Construction and land development		1,144		1,175		—		819
Agriculture and agriculture real estate (includes farmland)		111		118		29		79
1-4 family (includes home equity)		1,490		1,539		273		1,101
Commercial real estate (includes multi-family residential)		2,900		2,927		610		3,401
Commercial and industrial		1,130		1,168		1,002		857
Consumer and other		76		91		67		24

	$	6,851	$	7,018	$	1,981	$	6,281

Credit Quality Indicators. As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio and methodology for calculating the allowance for credit losses, management assigns and tracks loan grades to be used as credit quality indicators. The following is a general description of the loan grades used (1-7):

Grade 1 – Credits in this category are of the highest standards of credit quality with virtually no risk of loss. These borrowers would represent top rated companies and individuals with unquestionable financial standing with excellent global cash flow coverage, net worth, liquidity and collateral coverage and/or secured by CD/savings accounts.

Grade 2 – Credits in this category are not immune for risk but are well-protected by the collateral and paying capacity of the borrower. These loans may exhibit a minor unfavorable credit factor, but the overall credit is sufficiently strong to minimize the possibility of loss.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

Grade 3 – Credits in this category constitute an undue and unwarranted credit risk, however the factors do not rise to a level of substandard. These credits have potential weaknesses and/or declining trends that, if not corrected, could expose the Company to risk at a future date. Credits graded 3 are monitored on the Company’s internally generated watch list and evaluated on a quarterly basis.

Grade 4 – Credits in this category are deemed “substandard” loans in accordance with regulatory guidelines. Loans in this category have well-defined weakness that, if not corrected, could make default of principal and interest possible, but it is not yet certain. Loans in this category are still accruing interest and may be dependent upon secondary sources of repayment and/or collateral liquidation.

Grade 5 – Credits in this category are deemed “substandard” and “impaired” pursuant to regulatory guidelines. As such, the Company has determined that it is probable that less than 100% of the principal and interest will be collected. Loans graded 5 are individually evaluated for a specific reserve valuation and will typically have the accrual of interest stopped.

Grade 6 – Credits in this category include “doubtful” loans in accordance with regulatory guidance. Such loans are on nonaccrual and factors have indicated a loss is imminent. These loans are also deemed “impaired.” While a specific reserve may be in place while the loan and collateral is being evaluated these loans are typically charged down to an amount the Company deems collectable.

Grade 7 – Credits in this category are deemed a “loss” in accordance with regulatory guidelines and charged off or charged down. The Company may continue collection efforts and may have partial recovery in the future.

The following table presents risk grades and classified loans by class of loan at June 30, 2013. Classified loans include loans in risk grades 5, 6 and 7.


	Construction and Land Development		Agriculture and Agriculture Real Estate (Includes Farmland)		1-4 Family (Includes Home Equity) (1)		Commercial Real Estate (Includes Multi- Family Residential)		Commercial and Industrial		Consumer and Other		Total
	(Dollars in thousands)
Grade 1	$	—	$	4,000	$	244	$	—	$	44,984	$	34,359	$	83,587
Grade 2		668,997		309,985		1,649,194		2,340,613		946,439		77,012		5,992,240
Grade 3		5,642		—		4,472		11,593		3,237		11		24,955
Grade 4		3,057		431		2,792		9,795		840		—		16,915
Grade 5		267		103		329		1,430		880		67		3,076
Grade 6		—		—		11		—		—		—		11
Grade 7		—		—		—		—		—		—		—
PCI Loans		16,622		426		3,965		27,389		3,297		—		51,699

Total	$	694,585	$	314,945	$	1,661,007	$	2,390,820	$	999,677	$	111,449	$	6,172,483

(1)	Includes $6.2 million of residential mortgage loans held for sale at June 30, 2013.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

The following table presents risk grades and classified loans by class of loan at December 31, 2012. Classified loans include loans in risk grades 5, 6 and 7.


	Construction and Land Development		Agriculture and Agriculture Real Estate (Includes Farmland)		1-4 Family (Includes Home Equity) (1)		Commercial Real Estate (Includes Multi- Family Residential)		Commercial and Industrial		Consumer and Other		Total
	(Dollars in thousands)
Grade 1	$	476	$	4,195	$	515	$	—	$	53,965	$	38,789	$	97,940
Grade 2		537,340		277,333		1,431,095		1,945,319		702,587		100,163		4,993,837
Grade 3		7,250		2,024		4,947		11,760		8,926		—		34,907
Grade 4		4,256		1,694		4,303		11,711		1,385		176		23,525
Grade 5		1,144		111		1,477		2,900		1,130		76		6,838
Grade 6		—		—		13		—		—		—		13
Grade 7		—		—		—		—		—		—		—
PCI Loans		302		280		216		18,952		3,121		9		22,880

Total	$	550,768	$	285,637	$	1,442,566	$	1,990,642	$	771,114	$	139,213	$	5,179,940

(1)	Includes $10.4 million of residential mortgage loans held for sale at December 31, 2012.

Allowance for Credit Losses. The allowance for credit losses is a valuation established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company’s loan portfolio. The amount of the allowance for credit losses is affected by the following: (i) charge-offs of loans that occur when loans are deemed uncollectible and decrease the allowance, (ii) recoveries on loans previously charged off that increase the allowance and (iii) provisions for credit losses charged to earnings that increase the allowance. Based on an evaluation of the loan portfolio and consideration of the factors listed below, management presents a quarterly review of the allowance for credit losses to the Bank’s Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance.

The Company’s allowance for credit losses consists of two components: a specific valuation allowance based on probable losses on specifically identified loans and a general valuation allowance based on historical loan loss experience, general economic conditions and other qualitative risk factors both internal and external to the Company.

In setting the specific valuation allowance, the Company follows a loan review program to evaluate the credit risk in the loan portfolio. Through this loan review process, the Company maintains an internal list of impaired loans which, along with the delinquency list of loans, helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for credit losses. All loans that have been identified as impaired are reviewed on a quarterly basis in order to determine whether a specific reserve is required. For each impaired loan, the Company allocates a specific loan loss reserve primarily based on the value of the collateral securing the impaired loan requiring a reserve. The specific reserves are determined on an individual loan basis. Impaired loans are excluded from the general valuation allowance described below.

In determining the amount of the general valuation allowance, management considers factors such as historical loan loss experience, industry diversification of the Company’s commercial loan portfolio, concentration risk of specific loan types, the volume, growth and composition of the Company’s loan portfolio, current economic conditions that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process, general economic conditions and other qualitative risk factors both internal and external to the Company and other relevant factors.

Based on a review of these factors for each loan type, the Company applies an estimated percentage to the outstanding balance of each loan type, excluding any impaired loan. The Company uses this information to establish the amount of the general valuation allowance.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

In connection with its review of the loan portfolio, the Company considers risk elements attributable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements include:

•

for 1-4 family residential mortgage loans, the borrower’s ability to repay the loan, including a consideration of the debt to income ratio and employment and income stability, the loan to value ratio, and the age, condition and marketability of collateral;

•

for commercial mortgage loans and multifamily residential loans, the debt service coverage ratio (income from the property in excess of operating expenses compared to loan payment requirements), operating results of the owner in the case of owner-occupied properties, the loan to value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type;

•

for construction and land development loans, the perceived feasibility of the project including the ability to sell developed lots or improvements constructed for resale or the ability to lease property constructed for lease, the quality and nature of contracts for presale or prelease, if any, experience and ability of the developer and loan to value ratio;

•

for commercial and industrial loans, the operating results of the commercial, industrial or professional enterprise, the borrower’s business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral;

•

for agriculture real estate loans, the experience and financial capability of the borrower, projected debt service coverage of the operations of the borrower and loan to value ratio; and

•

for non-real estate agriculture loans, the operating results, experience and financial capability of the borrower, historical and expected market conditions and the value, nature and marketability of collateral.

In addition, for each category, the Company considers secondary sources of income and the financial strength and credit history of the borrower and any guarantors.

At June 30, 2013, the allowance for credit losses totaled $56.2 million or 0.91% of total loans. At December 31, 2012, the allowance aggregated $52.6 million or 1.01% of total loans.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

The following table details the recorded investment in loans and activity in the allowance for credit losses by portfolio segment for the three and six months ended June 30, 2013. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.


	Construction and Land Development			Agriculture and Agriculture Real Estate (includes Farmland)			1-4 Family (includes Home Equity)			Commercial Real Estate (includes Multi-Family residential)			Commercial and Industrial			Consumer and Other			Total
	(Dollars in thousands)
Allowance for credit losses:
Three Months Ended
Balance March 31, 2013	$	12,235		$	887		$	14,112		$	21,869		$	5,400		$	546		$	55,049
Provision for credit losses		(120	)		108			(642	)		1,763			1,041			400			2,550
Charge-offs		(257	)		(13	)		(51	)		(826	)		(258	)		(587	)		(1,992	)
Recoveries		133			—			16			25			110			285			569

Net charge-offs		(124	)		(13	)		(35	)		(801	)		(148	)		(302	)		(1,423	)

Balance June 30, 2013	$	11,991		$	982		$	13,435		$	22,831		$	6,293		$	644		$	56,176

Six Months Ended
Balance January 1, 2013	$	11,909		$	764		$	13,942		$	19,607		$	5,777		$	565		$	52,564
Provision for credit losses		150			223			(370	)		3,969			723			655			5,350
Charge-offs		(257	)		(13	)		(162	)		(895	)		(413	)		(1,192	)		(2,932	)
Recoveries		189			8			25			150			206			616			1,194

Net charge-offs		(68	)		(5	)		(137	)		(745	)		(207	)		(576	)		(1,738	)

Balance June 30, 2013	$	11,991		$	982		$	13,435		$	22,831		$	6,293		$	644		$	56,176

Allowance for credit losses related to:
June 30, 2013
Individually evaluated for impairment	$	—		$	23		$	44		$	—		$	819		$	66		$	952
Collectively evaluated for impairment		11,991			959			13,391			22,831			5,474			578			55,224
PCI loans		—			—			—			—			—			—			—

Total allowance for credit losses	$	11,991		$	982		$	13,435		$	22,831		$	6,293		$	644		$	56,176

Recorded investment in loans:
June 30, 2013
Individually evaluated for impairment	$	267		$	103		$	340		$	1,430		$	880		$	67		$	3,087
Collectively evaluated for impairment		677,696			314,416			1,656,702			2,362,001			995,500			111,382			6,117,697
PCI loans		16,622			426			3,965			27,389			3,297			—			51,699

Total loans evaluated for impairment	$	694,585		$	314,945		$	1,661,007		$	2,390,820		$	999,677		$	111,449		$	6,172,483

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

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


	Construction and Land Development			Agriculture and Agriculture Real Estate (includes Farmland)		1-4 Family (Includes Home Equity)			Commercial Real Estate (Commercial Mortgage and Multi-Family)			Commercial and Industrial			Consumer and Other			Total
Allowance for credit losses:		(Dollars in thousands)
Three Months Ended
Balance March 31, 2012	$	11,340		$	620	$	12,523		$	21,910		$	4,012		$	1,237		$	51,642
Provision for credit losses		(96	)		119		894			(209	)		406			(514	)		600
Charge-offs		(1,183	)		—		(99	)		(346	)		(243	)		(235	)		(2,106	)
Recoveries		4			3		8			51			63			117			246

Net charge-offs		(1,179	)		3		(91	)		(295	)		(180	)		(118	)		(1,860	)

Balance June 30, 2012	$	10,065		$	742	$	13,326		$	21,406		$	4,238		$	605		$	50,382

Six Months Ended
Balance January 1, 2012	$	12,094		$	511	$	12,645		$	21,460		$	3,826		$	1,058		$	51,594
Provision for credit losses		(828	)		228		822			259			577			(308	)		750
Charge-offs		(1,209	)		—		(151	)		(369	)		(321	)		(438	)		(2,488	)
Recoveries		8			3		10			56			156			293			526

Net charge-offs		(1,201	)		3		(141	)		(313	)		(165	)		(145	)		(1,962	)

Balance June 30, 2012	$	10,065		$	742	$	13,326		$	21,406		$	4,238		$	605		$	50,382

Allowance for credit losses related to:
June 30, 2012
Individually evaluated for impairment	$	17		$	35	$	220		$	1,026		$	354		$	5		$	1,657
Collectively evaluated for impairment		10,048			707		13,106			20,380			3,884			600			48,725

Total allowance for credit losses	$	10,065		$	742	$	13,326		$	21,406		$	4,238		$	605		$	50,382

Recorded investment in loans:
June 30, 2012
Individually evaluated for impairment	$	327		$	44	$	630		$	3,121		$	503		$	6		$	4,631
Collectively evaluated for impairment		466,557			192,418		1,238,453			1,481,666			459,170			107,437			3,945,701

Total loans evaluated for impairment	$	466,884		$	192,462	$	1,239,083		$	1,484,787		$	459,673		$	107,443		$	3,950,332

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

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

During the six months ended June 30, 2013, a $249 thousand loan was restructured. Default is determined at 90 or more days past due. The restructured loans from prior periods are performing and accruing loans.

6. FAIR VALUE

The Company uses fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Fair values represent the estimated price that would be received from selling an asset or paid to transfer a liability, otherwise known as an “exit price.” Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis such as certain loans including loans held-for-sale, goodwill and other intangible assets and other real estate owned. These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or write downs of individual assets.

Fair Value Hierarchy

The Company groups financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

•

Level 1—Quoted prices in active markets for identical assets or liabilities.

•

Level 2—Other significant observable inputs (including quoted prices in active markets for similar assets or liabilities) or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

•

Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair values requires significant management judgment or estimation.

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability.

The fair value disclosures below represent the Company’s estimates based on relevant market information and information about the financial instruments. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of the various instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in the above methodologies and assumptions could significantly affect the estimates.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

The following tables present fair values for assets measured at fair value on a recurring basis:


	As of June 30, 2013
	Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
Available for sale securities:
States and political subdivisions	$	—	$	34,763	$	—	$	34,763
Collateralized mortgage obligations		—		556		—		556
Mortgage-backed securities		—		141,613		—		141,613
Other securities		7,417		—		—		7,417

Total	$	7,417	$	176,932	$	—	$	184,349


	As of December 31, 2012
	Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
Available for sale securities:
States and political subdivisions	$	—	$	36,434	$	—	$	36,434
Collateralized mortgage obligations		—		604		—		604
Mortgage-backed securities		—		180,416		—		180,416
Other securities		7,688		1,528		—		9,216

Total	$	7,688	$	218,982	$	—	$	226,670

Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). Financial assets measured at fair value on a non-recurring basis during the reported periods include certain impaired loans reported at the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using Level 2 inputs based on observable market data, typically in the case of real estate collateral. For the six months ended June 30, 2013, the Company had additions to impaired loans of $5.4 million, of which $1.5 million were outstanding at June 30, 2013.

Financial assets measured at fair value on a non-recurring basis during the reported periods also include other real estate owned and repossessed assets. For the three and six months ended June 30, 2013, the Company had additions to other real estate owned of $1.1 million and $2.7 million, of which $432 thousand and $1.4 million were outstanding at June 30, 2013, respectively. The remaining financial assets and financial liabilities measured at fair value on a non-recurring basis that were recorded in 2013 and remained outstanding at June 30, 2013 were not significant. During the reported periods, all fair value measurements for other real estate owned and repossessed assets utilized Level 2 inputs based on observable market data. There were no transfers between Level 1 and Level 2 assets during the six months ended June 30, 2013.

These fair value disclosures represent the Company’s estimates based on relevant market information and information about the financial instruments. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of the various instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in the above methodologies and assumptions could significantly affect the estimates.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and due from banks—For these short-term instruments, the carrying amount is a reasonable estimate of fair value. The Company classifies the estimated fair value of these instruments as Level 1.

Federal funds sold—For these short-term instruments, the carrying amount is a reasonable estimate of fair value. The Company classifies the estimated fair value of these instruments as Level 1.

Securities — Fair value measurements based upon quoted prices are considered Level 1 inputs. Level 1 securities consist of U.S. Treasury securities and certain equity securities which are included in the available for sale portfolio. For all other available for sale and held to maturity securities, if quoted prices are not available, fair values are measured using Level 2 inputs. For these securities, the Company generally obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. The Company reviews the prices supplied by the independent pricing service, as well as their underlying pricing methodologies, for reasonableness.

Securities available for sale are recorded at fair value on a recurring basis.

Loans held for investment — The Company does not record loans at fair value on a recurring basis. As such, valuation techniques discussed herein for loans are primarily for estimating fair value disclosures. However, from time to time, the Company records nonrecurring fair value adjustments to impaired loans to reflect (1) partial write downs that are based on the observable market price or current appraised value of the collateral, or (2) the full charge-off of the loan carrying value. Where appraisals are not available, estimated cash flows are discounted using a rate commensurate with the credit risk associated with those cash flows. Assumptions regarding credit risk, cash flows and discount rates are judgmentally determined using available market information and specific borrower information.

The estimated fair value approximates carrying value for variable-rate loans that reprice frequently and with no significant change in credit risk. The fair value of fixed-rate loans and variable-rate loans which reprice on an infrequent basis is estimated by discounting future cash flows using the current interest rates at which similar loans with similar terms would be made to borrowers of similar credit quality. An overall valuation adjustment is made for specific credit risks as well as general portfolio credit risk. The Company classifies the estimated fair value of loans held for investment as Level 3.

Loans held for sale— Loans held for sale are carried at the lower of cost or estimated fair value. Fair value for consumer mortgages held for sale is based on commitments on hand from investors or prevailing market prices. As such, the Company classifies loans subjected to nonrecurring fair value adjustments as Level 1.

Federal Home Loan Bank of Dallas Stock— The fair value of FHLB stock is estimated to be equal to its carrying amount as reported in the accompanying Consolidated Balance Sheets, given it is not a publicly traded equity security, it has an adjustable dividend rate, and all transactions in the stock are executed at the stated par value. FHLB stock is considered a Level 1 fair value.

Other real estate owned— Other real estate owned is primarily foreclosed properties securing residential loans and commercial real estate. Foreclosed assets are adjusted to fair value less estimated costs to sell upon transfer of the loans to other real estate owned. Subsequently, these assets are carried at the lower of carrying value or fair value less estimated costs to sell. Other real estate carried at fair value based on an observable market price or a current appraised value is classified by the Company as Level 2. When management determines that the fair value of other real estate requires additional adjustments, either as a result of a non-current appraisal or when there is no observable market price, the Company classifies the other real estate as Level 3.

Deposits—The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. Deposits fair value measurements utilize Level 2 inputs.

Junior subordinated debentures—The fair value of the junior subordinated debentures was calculated using the quoted market prices, if available. If quoted market prices are not available, fair value is estimated using quoted market prices for similar subordinated debentures. Junior subordinated debentures fair value measurements utilize Level 2 inputs.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

Other borrowings—Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the fair value of other borrowings using a discounted cash flows methodology and are measured utilizing Level 2 inputs.

Securities sold under repurchase agreements—The fair value of securities sold under repurchase agreements is the amount payable on demand at the reporting date and are measured utilizing Level 2 inputs.

Off-balance sheet financial instruments—The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the present creditworthiness of the counterparties. The Company has reviewed the unfunded portion of commitments to extend credit as well as standby and other letters of credit, and has determined that the fair value of such financial instruments is not material. The Company classifies the estimated fair value of credit-related financial instruments as Level 3.

The following table summarizes the carrying values and estimated fair values of certain financial instruments not recorded at fair value on a regular basis:


	As of June 30, 2013
	Carrying Amount		Estimated Fair Value
	Carrying Amount		Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
Assets
Cash and due from banks	$	250,542	$	250,542	$	—	$	—	$	250,542
Federal funds sold		606		606		—		—		606
Held to maturity securities		7,833,535		—		7,820,266		—		7,820,266
Loans held for sale		6,186		6,186		—		—		6,186
Loans held for investment, net of allowance		6,110,121		—		—		6,145,277		6,145,277
Federal Home Loan Bank of Dallas stock		44,933		44,933		—		—		44,933
Liabilities
Deposits:
Noninterest-bearing	$	3,283,082	$	—	$	3,283,527	$	—	$	3,283,527
Interest-bearing		9,225,568		—		9,241,538		—		9,241,538
Other borrowings		781,215		—		782,863		—		782,863
Securities sold under repurchase agreements		481,170		—		481,314		—		481,314
Junior subordinated debentures		85,055		—		81,656		—		81,656

	As of December 31, 2012
	Carrying Amount		Estimated Fair Value
	Carrying Amount		Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
Assets
Cash and due from banks	$	325,952	$	325,952	$	—	$	—	$	325,952
Federal funds sold		352		352		—		—		352
Held to maturity securities		7,215,395		—		7,418,695		—		7,418,695
Loans held for sale		10,433		10,433		—		—		10,433
Loans held for investment, net of allowance		5,116,943		—		—		5,186,779		5,186,779
Federal Home Loan Bank of Dallas stock		34,461		34,461		—		—		34,461
Liabilities
Deposits:
Noninterest-bearing	$	3,016,205	$	—	$	3,016,205	$	—	$	3,016,205
Interest-bearing		8,625,639		—		8,640,625		—		8,640,625
Other borrowings		256,753		—		258,819		—		258,819
Securities sold under repurchase agreements		454,502		—		454,596		—		454,596
Junior subordinated debentures		85,055		—		72,705		—		72,705

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

The Company’s off-balance sheet commitments including letters of credit, which totaled $1.20 billion at June 30, 2013, are funded at current market rates at the date they are drawn upon. It is management’s opinion that the fair value of these commitments would approximate their carrying value, if drawn upon.

The fair value estimates presented herein are based on pertinent information available to management at June 30, 2013. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.

7. GOODWILL AND CORE DEPOSIT INTANGIBLES

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles (“CDI”) for six months ended June 30, 2013 and the year ended December 31, 2012 were as follows:


				Core Deposit
	Goodwill			Intangibles
	(Dollars in thousands)
Balance as of December 31, 2011	$	924,537		$	20,996
Less:
Amortization		—			(7,229	)
Add:
Acquisition of Texas Bankers, Inc.		6,077			—
Acquisition of The Bank Arlington		2,102			—
Acquisition of ASB		274,119			12,392
Acquisition of Community National Bank		10,327			—

Balance as of December 31, 2012		1,217,162			26,159
Less:
Amortization		—			(3,096	)
Add:
Measurement period adjustment of The Bank Arlington		(130	)		—
Measurement period adjustment of ASB		(3,094	)		2,110
Measurement period adjustment of Community National Bank		2,006			—
Acquisition of East Texas Financial Services, Inc.		16,944			—
Acquisition of Coppermark Bancshares, Inc.		117,946			1,515

Balance as of June 30, 2013	$	1,350,834		$	26,688

Goodwill is recorded on the acquisition date of each entity. The Company may record subsequent adjustments to goodwill for amounts undeterminable at acquisition date, such as deferred taxes and real estate valuations, and therefore the goodwill amounts reflected in the table above may change accordingly. The Company initially records the total premium paid on acquisitions as goodwill. After finalizing the valuation, core deposit intangibles are identified and reclassified from goodwill to core deposit intangibles on the balance sheet. This reclassification has no effect on total assets, liabilities, shareholders’ equity, net income or cash flows. Management performs an evaluation annually, and more frequently if a triggering event occurs, of whether any impairment of the goodwill and other intangibles has occurred. If any such impairment is determined, a write-down is recorded. As of June 30, 2013, there were no impairments recorded on goodwill.

The measurement period for the Company to determine the fair value of acquired identifiable assets and assumed liabilities will be at the end of the earlier of (i) twelve months from the date of acquisition or (ii) as soon as the Company receives the information it was seeking about facts and circumstances that existed as of the date of acquisition. As such, certain acquisitions completed during 2012 and 2013 may be subject to adjustment.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

Core deposit intangibles are amortized on an accelerated basis over their estimated lives, which the Company believes is between 8 and 15 years. Amortization expense related to intangible assets totaled $1.3 million and $1.6 million for the three months ended June 30, 2013 and 2012, respectively, and $3.1 million and $3.3 million for the six months ended June 30, 2013 and 2012, respectively. The estimated aggregate future amortization expense for intangible assets remaining as of June 30, 2013 was as follows (dollars in thousands):


Remaining 2013	$	2,938
2014		4,841
2015		4,201
2016		3,761
2017		2,076
Thereafter		8,871

Total	$	26,688

8. STOCK BASED COMPENSATION

At June 30, 2013, the Company had four stock-based employee compensation plans and one stock option plan assumed in connection with an acquisition under which no additional options will be granted. Two of the four plans adopted by the Company have expired and therefore no additional awards may be issued under those plans.

During 2004, the Company’s Board of Directors adopted the Prosperity Bancshares, Inc. 2004 Stock Incentive Plan (the “2004 Plan”) which authorizes the issuance of up to 1,250,000 shares of common stock pursuant to the exercise or grant, as the case may be, of awards under such plan and the shareholders approved the 2004 Plan in 2005. The Company has granted shares with forfeiture restrictions (“restricted stock”) to certain directors, officers and associates under the 2004 Plan. The awardee is not entitled to the shares until they vest, which is generally over a one to five year period, but the awardee is entitled to receive dividends on and vote the shares prior to vesting. The shares granted do not have a cost to the awardee and the only requirement of vesting is continued service to the Company. Compensation cost related to restricted stock is calculated based on the fair value of the shares at the date of grant. If the awardee leaves the Company before the shares vest, the unvested shares are forfeited.

On February 22, 2012, the Company’s Board of Directors adopted the Prosperity Bancshares, Inc. 2012 Stock Incentive Plan (the “2012 Plan”), subject to approval by the Company’s shareholders. The Company’s shareholders approved the 2012 Plan at the annual meeting of shareholders on April 17, 2012. The 2012 Plan authorizes the issuance of up to 1,250,000 shares of common stock upon the exercise of options granted under the 2012 Plan or pursuant to the grant or exercise, as the case may be, of other awards granted under the 2012 Plan, including restricted stock, stock appreciation rights, phantom stock awards and performance awards. As of June 30, 2013, no options or other awards have been granted under the 2012 Plan.

The Company received $1.1 million and $1.8 million in cash from the exercise of stock options during the three-month periods ended June 30, 2013 and 2012, respectively, and $1.8 million and $2.5 million during the six-month periods ended June 30, 2013 and 2012, respectively. There was no tax benefit realized from option exercises of the share-based payment arrangements during the three and six month periods ended June 30, 2013 and 2012.

As of June 30, 2013, there was $6.7 million of total unrecognized compensation expense related to stock-based compensation arrangements. That cost is expected to be recognized over a weighted average period of 2.1 years.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

9. CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ITEMS

Contractual Obligations

The following table summarizes the Company’s contractual obligations and other commitments to make future payments as of June 30, 2013 (other than deposit obligations). The payments do not include pre-payment options that may be available to the Company. The Company’s future cash payments associated with its contractual obligations pursuant to its junior subordinated debentures, FHLB borrowings and operating leases as of June 30, 2013 are summarized below. Payments for junior subordinated debentures include interest of $47.3 million that will be paid over the future periods. The future interest payments were calculated using the current rate in effect at June 30, 2013. The current principal balance of the junior subordinated debentures at June 30, 2013 was $85.1 million. Payments for FHLB borrowings include interest of $2.5 million that will be paid over the future periods. Payments related to leases are based on actual payments specified in underlying contracts.


	1 year or less		More than 1 year but less than 3 years		3 years or more but less than 5 years		5 years or more		Total
	(Dollars in thousands)
Junior subordinated debentures	$	1,169	$	4,676	$	4,675	$	121,870	$	132,390
Federal Home Loan Bank notes payable and other borrowings		770,683		3,836		2,312		6,899		783,730
Operating leases		2,650		7,785		3,264		380		14,079

Total	$	774,502	$	16,297	$	10,251	$	129,149	$	930,199

Off-Balance Sheet Items

In the normal course of business, the Company enters into various transactions, which, in accordance with accounting principles generally accepted in the United States, are not included in its consolidated balance sheets. The Company enters into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.

The Company’s commitments associated with outstanding standby letters of credit and commitments to extend credit as of June 30, 2013 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements.


	1 year or less		More than 1 year but less than 3 years		3 years or more but less than 5 years		5 years or more		Total
	(Dollars in thousands)
Standby letters of credit	$	37,788	$	2,612	$	30	$	—	$	40,430
Commitments to extend credit		299,677		495,644		76,598		286,697		1,158,616

Total	$	337,465	$	498,256	$	76,628	$	286,697	$	1,199,046

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

10. OTHER COMPREHENSIVE (LOSS) INCOME

The tax effects allocated to each component of other comprehensive (loss) income were as follows:


	Three Months Ended June 30,
	2013								2012
	Before Tax Amount			Tax Benefit		Net of Tax Amount			Before Tax Amount			Tax Benefit		Net of Tax Amount
	(Dollars in thousands)
Other comprehensive loss:
Securities available for sale:
Change in unrealized gain during period	$	(2,330	)	$	816	$	(1,514	)	$	(1,833	)	$	642	$	(1,191	)

Total securities available for sale		(2,330	)		816		(1,514	)		(1,833	)		642		(1,191	)

Total other comprehensive loss	$	(2,330	)	$	816	$	(1,514	)	$	(1,833	)	$	642	$	(1,191	)


	Six Months Ended June 30,
	2013								2012
	Before Tax Amount			Tax Benefit		Net of Tax Amount			Before Tax Amount			Tax Benefit		Net of Tax Amount
	(Dollars in thousands)
Other comprehensive loss:
Securities available for sale:
Change in unrealized gain during period	$	(4,101	)	$	1,435	$	(2,666	)	$	(3,018	)	$	1,057	$	(1,961	)

Total securities available for sale		(4,101	)		1,435		(2,666	)		(3,018	)		1,057		(1,961	)

Total other comprehensive loss	$	(4,101	)	$	1,435	$	(2,666	)	$	(3,018	)	$	1,057	$	(1,961	)

Activity in accumulated other comprehensive income, net of tax, was as follows:


	Securities Available for Sale			Accumulated Other Comprehensive Income
	(Dollars in thousands)
Balance at January 1, 2013	$	8,986		$	8,986
Other comprehensive loss		(2,666	)		(2,666	)

Balance at June 30, 2013	$	6,320		$	6,320

Balance at January 1, 2012	$	13,472		$	13,472
Other comprehensive loss		(1,961	)		(1,961	)

Balance at June 30, 2012	$	11,511		$	11,511

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

11. ACQUISITIONS

Acquisition of Coppermark Bancshares, Inc.- On April 1, 2013, the Company completed the acquisition of Coppermark Bancshares, Inc. and its wholly-owned subsidiary, Coppermark Bank (collectively, “Coppermark”). Coppermark operated nine (9) full-service banking offices: six (6) in Oklahoma City, Oklahoma and surrounding areas and three (3) in the Dallas, Texas area. The Company acquired Coppermark to expand its market into Oklahoma. The acquisition was not considered significant to the Company’s financial statements and therefore pro forma financial data and related disclosures are not included.

As of March 31, 2013, Coppermark reported, on a consolidated basis, total assets of $1.25 billion, total loans of $847.6 million and total deposits of $1.11 billion. Under the terms of the acquisition agreement, the Company issued 3,258,718 shares of Company common stock plus $60.0 million in cash for all outstanding shares of Coppermark Bancshares, Inc. capital stock, for total merger consideration of $214.4 million based on the Company’s closing stock price of $47.39. The Company recognized initial goodwill of $91.7 million which does not include subsequent fair value adjustments that are still being finalized. Goodwill is calculated as the excess of both the consideration exchanged and liabilities assumed as compared to the fair value of identifiable assets acquired, none of which is expected to be deductible for tax purposes. Additionally, the Company recognized $1.5 million of core deposit intangibles. For the six months ended June 30, 2013, the Company incurred approximately $630 thousand of pre-tax merger related expenses related to the Coppermark acquisition.

Acquisition of East Texas Financial Services, Inc. – On January 1, 2013, the Company completed the acquisition of East Texas Financial Services, Inc. (OTC BB: FFBT) and its wholly-owned subsidiary, First Federal Bank Texas. East Texas Financial Services operated four (4) banking offices in the Tyler MSA, including three locations in Tyler, Texas and one location in Gilmer, Texas. The Company acquired East Texas Financial Services to increase its market share in the East Texas area. The acquisition was not considered significant to the Company’s financial statements and therefore pro forma financial data and related disclosures are not included.

As of December 31, 2012, East Texas Financial Services reported, on a consolidated basis, total assets of $165.0 million, total loans of $129.3 million and total deposits of $112.3 million. Under the terms of the acquisition agreement, the Company issued 530,940 shares of Company common stock for all outstanding shares of East Texas Financial Services capital stock, for total merger consideration of $22.3 million based on the Company’s closing stock price of $42.00. The Company recognized initial goodwill of $7.0 million which does not include subsequent fair value adjustments that are still being finalized. Goodwill is calculated as the excess of both the consideration exchanged and liabilities assumed as compared to the fair value of identifiable assets acquired, none of which is expected to be deductible for tax purposes.

Acquisition of Community National Bank—On October 1, 2012, the Company completed the acquisition of Community National Bank, Bellaire, Texas. Community National Bank operated one (1) banking office in Bellaire, Texas, in the Houston Metropolitan Area. The Company acquired Community National Bank to increase its market share in the Houston area. The acquisition is not considered significant to the Company’s financial statements and therefore pro forma financial data is not included.

As of September 30, 2012, Community National Bank reported total assets of $182.0 million, total loans of $68.0 million and total deposits of $164.6 million. Under the terms of the acquisition agreement, the Company issued 372,282 shares of Company common stock plus $11.4 million in cash for all outstanding shares of Community National Bank capital stock, for total merger consideration of $27.3 million, based on the Company’s closing stock price of $42.62. The Company recognized initial goodwill of $10.6 million which does not include subsequent fair value adjustments that are still being finalized. Goodwill is calculated as the excess of both the consideration exchanged and liabilities assumed as compared to the fair value of identifiable assets acquired, none of which is expected to be deductible for tax purposes.

Acquisition of American State Financial Corporation—On July 1, 2012, the Company completed the acquisition of American State Financial Corporation and its wholly owned subsidiary American State Bank (collectively referred to as “ASB”). ASB operated thirty-seven (37) full service banking offices in eighteen (18) counties across West Texas. The Company acquired ASB to increase its market share in the West Texas area.

Under the terms of the acquisition agreement, the Company issued 8,524,835 shares of Company common stock plus $178.5 million in cash for all outstanding shares of American State Financial Corporation capital stock, for total merger consideration of $536.8 million based on the Company’s closing stock price of $42.03. The Company recognized goodwill of $271.0 million which is

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

calculated as the excess of both the consideration exchanged and liabilities assumed as compared to the fair value of identifiable assets acquired. Goodwill resulted from a combination of expected operational synergies, an enhanced branching network, and cross-selling opportunities. Goodwill is not expected to be deductible for tax purposes. Additionally, the Company recognized $14.5 million of core deposit intangibles.

Acquisition of The Bank Arlington—On April 1, 2012, the Company completed the acquisition of The Bank Arlington. The Bank Arlington operated one banking office in Arlington, Texas, in the Dallas/Fort Worth CMSA. The Company acquired The Bank Arlington to increase its market share in the Dallas/Fort Worth area. The acquisition is not considered significant to the Company’s financial statements and therefore pro forma financial data and related disclosures are not included.

As of March 31, 2012, The Bank Arlington reported total assets of $37.3 million, total loans of $22.9 million and total deposits of $33.2 million. Under the terms of the acquisition agreement, the Company issued 135,347 shares of Company common stock for all outstanding shares of The Bank Arlington capital stock, for total merger consideration of $6.2 million, based on the Company’s closing stock price of $45.80. The Company recognized goodwill of $2.0 million which is calculated as the excess of both the consideration exchanged and liabilities assumed as compared to the fair value of identifiable assets acquired, none of which is expected to be deductible for tax purposes.

Acquisition of Texas Bankers, Inc.—On January 1, 2012, the Company completed the acquisition of Texas Bankers, Inc. and its wholly-owned subsidiary, Bank of Texas, Austin, Texas. The three (3) Bank of Texas banking offices in the Austin, Texas CMSA consisted of a location in Rollingwood, which was consolidated with the Company’s Westlake location and remains in Bank of Texas’ Rollingwood banking office; one banking center in downtown Austin, which was consolidated into the Company’s downtown Austin location; and another banking center in Thorndale. The Company acquired Texas Bankers, Inc. to increase is its market share in the Central Texas area. The acquisition is not considered significant to the Company’s financial statements and therefore pro forma financial data and related disclosures are not included.

Texas Bankers, Inc. on a consolidated basis, reported total assets of $77.0 million, total loans of $27.6 million and total deposits of $70.4 million as of December 31, 2011. Under the terms of the acquisition agreement, the Company issued 314,953 shares of Company common stock for all outstanding shares of Texas Bankers capital stock, for total merger consideration of $12.7 million, based on the Company’s closing stock price of $40.35. The Company recognized goodwill of $6.1 million which is calculated as the excess of both the consideration exchanged and liabilities assumed as compared to the fair value of identifiable assets acquired, none of which is expected to be deductible for tax purposes.

The following pro forma information presents the results of operations for the three and six months ended June 30, 2013 and 2012, as if the Coppermark, East Texas Financial Services, Community National Bank, ASB and The Bank Arlington acquisitions had occurred on January 1, 2012.


	Three months ended June 30,				Six months ended June 30,
	2013		2012 (1)		2013		2012 (1)
	(Dollars in thousands, except per share data)				(Dollars in thousands, except per share data)
Net interest income	$	118,742	$	132,233	$	234,743	$	261,184
Net income		53,844		69,174		100,531		121,220
Basic earnings per share		0.89		1.15		1.62		2.01
Diluted earnings per share		0.89		1.15		1.62		2.01

(1)	Includes gain on sale of securities of $23.4 million by ASB during the second quarter of 2012.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2013

(UNAUDITED)

12. SUBSEQUENT EVENTS

Pending Acquisition of FVNB Corp. – On July 1, 2013, the Company announced the signing of a definitive merger agreement to acquire FVNB Corp. and its wholly-owned subsidiary First Victoria National Bank (collectively, “FVNB”) headquartered in Victoria, Texas. FVNB operates thirty-four (34) banking locations; seven (7) in the South Texas area including Corpus Christi; six (6) in the Bryan/College Station area; five (5) in the Central Texas area including New Braunfels; and twelve (12) in the Houston area including The Woodlands and Huntsville. As of June 30, 2013, FVNB Corp., on a consolidated basis, reported total assets of $2.4 billion, total loans of $1.6 billion and total deposits of $2.2 billion. Under the terms of the definitive agreement, the Company will issue approximately 5,570,818 shares of Company common stock plus $91.25 million in cash for all outstanding shares of FVNB Corp. capital stock, subject to certain conditions and potential adjustments. The transaction is subject to customary closing conditions, including the receipt of customary regulatory approvals and approval by FVNB’s shareholders.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Special Cautionary Notice Regarding Forward-Looking Statements

Statements and financial discussion and analysis contained in this quarterly report on Form 10-Q that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on assumptions and involve a number of risks and uncertainties, many of which are beyond the Company’s control. Many possible events or factors could affect the future financial results and performance of the Company and could cause such results or performance to differ materially from those expressed in the forward-looking statements. These possible events or factors include, without limitation:

•

changes in the strength of the United States economy in general and the strength of the local economies in which the Company conducts operations resulting in, among other things, a deterioration in credit quality or reduced demand for credit, including the result and effect on the Company’s loan portfolio and allowance for credit losses;

•

changes in interest rates and market prices, which could reduce the Company’s net interest margins, asset valuations and expense expectations;

•

changes in the levels of loan prepayments and the resulting effects on the value of the Company’s loan portfolio;

•

changes in local economic and business conditions which adversely affect the Company’s customers and their ability to transact profitable business with the company, including the ability of the Company’s borrowers to repay their loans according to their terms or a change in the value of the related collateral;

•

increased competition for deposits and loans adversely affecting rates and terms;

•

the timing, impact and other uncertainties of any future acquisitions, including the Company’s ability to identify suitable future acquisition candidates, the success or failure in the integration of their operations, and the ability to enter new markets successfully and capitalize on growth opportunities;

•

the possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on the results of operations;

•

increased credit risk in the Company’s assets and increased operating risk caused by a material change in commercial, consumer and/or real estate loans as a percentage of the total loan portfolio;

•

the concentration of the Company’s loan portfolio in loans collateralized by real estate;

•

the failure of assumptions underlying the establishment of and provisions made to the allowance for credit losses;

•

changes in the availability of funds resulting in increased costs or reduced liquidity;

•

a deterioration or downgrade in the credit quality and credit agency ratings of the securities in the Company’s securities portfolio;

•

increased asset levels and changes in the composition of assets and the resulting impact on the Company’s capital levels and regulatory capital ratios;

•

the Company’s ability to acquire, operate and maintain cost effective and efficient systems without incurring unexpectedly difficult or expensive but necessary technological changes;

•

the loss of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensation levels;

•

government intervention in the U.S. financial system;

•

changes in statutes and government regulations or their interpretations applicable to financial holding companies and the Company’s present and future banking and other subsidiaries, including changes in tax requirements and tax rates;

•

increases in FDIC deposit insurance assessments;

•

acts of terrorism, an outbreak of hostilities or other international or domestic calamities, weather or other acts of God and other matters beyond the Company’s control; and

•

other risks and uncertainties listed from time to time in the Company’s reports and documents filed with the Securities and Exchange Commission.

A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these assumptions or bases in good faith and that they are reasonable. However, the Company cautions you that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material. The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company’s interim consolidated financial statements and accompanying notes. This section should be read in conjunction with the Company’s interim consolidated financial statements and accompanying notes included elsewhere in this report and with the consolidated financial statements and accompanying notes and other detailed information appearing in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

OVERVIEW

The Company, a Texas corporation, was formed in 1983 as a vehicle to acquire the former Allied First Bank in Edna, Texas which was chartered in 1949 as The First National Bank of Edna and is now known as Prosperity Bank. The Company is a registered financial holding company that derives substantially all of its revenues and income from the operation of its bank subsidiary, Prosperity Bank^® (“Prosperity Bank^®” or the “Bank”). The Bank provides a wide array of financial products and services to small and medium-sized businesses and consumers. As of June 30, 2013, the Bank operated two hundred nineteen (219) full-service banking locations; with fifty-eight (58) in the Houston area; twenty (20) in the South Texas area including Corpus Christi and Victoria; thirty-five (35) in the Dallas/Fort Worth area; twenty-two (22) in East Texas area; thirty-four (34) in the Central Texas area including Austin and San Antonio; thirty-four (34) in the West Texas area including Lubbock, Midland-Odessa and Abilene; ten (10) in the Bryan/College Station area and six (6) in the Central Oklahoma area. The Company’s headquarters are located at Prosperity Bank Plaza, 4295 San Felipe in Houston, Texas and its telephone number is (713) 693-9300. The Company’s website address is www.prosperitybankusa.com. Information contained on the Company’s website is not incorporated by reference into this quarterly report on Form 10-Q and is not part of this or any other report.

The Company generates the majority of its revenues from interest income on loans, service charges on customer accounts and income from investment in securities. The revenues are partially offset by interest expense paid on deposits and other borrowings and noninterest expenses such as administrative and occupancy expenses. Net interest income is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as deposits and borrowings which are used to fund those assets. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and margin.

Three principal components of the Company’s growth strategy are internal growth, stringent cost control practices and acquisitions, including strategic merger transactions and FDIC assisted transactions. The Company focuses on continuous internal growth. Each banking center is operated as a separate profit center, maintaining separate data with respect to its net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking center presidents and managers are accountable for performance in these areas and compensated accordingly. The Company also focuses on maintaining stringent cost control practices and policies. The Company has centralized many of its critical operations, such as data processing and loan processing. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale. During 2012, the Company completed four acquisitions including Texas Bankers, Inc., The Bank Arlington, ASB and Community National Bank. In 2013, the Company completed the acquisitions of East Texas Financial Services, Inc. and Coppermark Bancshares, Inc. and has announced the pending acquisition of FVNB Corp.

Total assets were $16.27 billion at June 30, 2013 compared with $14.58 billion at December 31, 2012, an increase of $1.69 billion or 11.6%. Total loans were $6.17 billion at June 30, 2013 compared with $5.18 billion at December 31, 2012, an increase of $992.5 million or 19.2%. Total deposits were $12.51 billion at June 30, 2013 compared with $11.64 billion December 31, 2012, an increase of $866.8 million or 7.4%. Total shareholders’ equity was $2.35 billion at June 30, 2013 compared with $2.09 billion at December 31, 2012, an increase of $255.9 million or 12.2%.

CRITICAL ACCOUNTING POLICIES

The Company’s accounting policies are integral to understanding the financial results reported. Accounting policies are described in detail in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. The Company believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity:

Allowance for Credit Losses—The allowance for credit losses is established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company’s loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank’s Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company’s commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company’s loan portfolio, current economic conditions that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process and other relevant factors. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. Charge-offs occur when loans are deemed to be uncollectible.

Goodwill and Intangible Assets—Goodwill and intangible assets that have indefinite useful lives are subject to an impairment test at least annually, or more often, if events or circumstances indicate that it is more likely than not that the fair value of Prosperity Bank, the Company’s only reporting unit with assigned goodwill, is below the carrying value of its equity. The Company has the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining the need to perform step one of the annual test for goodwill impairment. An entity has an unconditional option to bypass the qualitative assessment described in the preceding paragraph for any reporting unit in any period and proceed directly to performing the first step of the goodwill impairment test. An entity may resume performing the qualitative assessment in any subsequent period.

If the Company bypasses the qualitative assessment, a two-step goodwill impairment test is performed. The two-step process begins with an estimation of the fair value of the Company’s reporting unit compared with its carrying value. If the carrying amount exceeds the fair value of the reporting unit, a second test is completed comparing the implied fair value of the reporting unit’s goodwill to its carrying value to measure the amount of impairment.

Estimating the fair value of the Company’s reporting unit is a subjective process involving the use of estimates and judgments, particularly related to future cash flows of the reporting unit, discount rates (including market risk premiums) and market multiples. Material assumptions used in the valuation models include the comparable public company price multiples used in the terminal value, future cash flows and the market risk premium component of the discount rate. The estimated fair values of the reporting unit is determined using a blend of two commonly used valuation techniques: the market approach and the income approach. The Company gives consideration to both valuation techniques, as either technique can be an indicator of value. For the market approach, valuations of the reporting unit were based on an analysis of relevant price multiples in market trades in companies with similar characteristics. For the income approach, estimated future cash flows (derived from internal forecasts and economic expectations) and terminal value (value at the end of the cash flow period, based on price multiples) were discounted. The discount rate was based on the imputed cost of equity capital.

The Company had no intangible assets with indefinite useful lives at June 30, 2013. Other identifiable intangible assets that are subject to amortization are amortized on an accelerated basis over the years expected to be benefited, which the Company believes is between eight and fifteen years. These amortizable intangible assets are reviewed for impairment if circumstances indicate their value may not be recoverable based on a comparison of fair value to carrying value. Based on the Company’s annual goodwill impairment test as of September 30, 2012, management does not believe any of its goodwill is impaired as of June 30, 2013 because the fair value of the Company’s equity substantially exceeded its carrying value. While the Company believes no impairment existed at June 30,

2013, under accounting standards applicable at that date, different conditions or assumptions, or changes in cash flows or profitability, if significantly negative or unfavorable, could have a material adverse effect on the outcome of the Company’s impairment evaluation and financial condition or future results of operations.

Stock-Based Compensation—The Company accounts for stock-based employee compensation plans using the fair value-based method of accounting. The Company’s results of operations reflect compensation expense for all employee stock-based compensation, including the unvested portion of stock options granted prior to 2003. The fair value of stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. This model requires the input of subjective assumptions including stock price volatility and employee turnover that are utilized to measure compensation expense.

Other-Than-Temporarily Impaired Securities—When the fair value of a security is below its amortized cost, and depending on the length of time the condition exists and the extent the fair market value is below amortized cost, additional analysis is performed to determine whether an impairment exists. Available for sale and held to maturity securities are analyzed quarterly for possible other-than-temporary impairment. The analysis considers (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, (iii) whether the market decline was affected by macroeconomic conditions, and (iv) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. Often, the information available to conduct these assessments is limited and rapidly changing, making estimates of fair value subject to judgment. If actual information or conditions are different than estimated, the extent of the impairment of the security may be different than previously estimated, which could have a material effect on the Company’s results of operations and financial condition.

Fair Values of Financial Instruments—The Company determines the fair market values of financial instruments based on the fair value hierarchy established which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. There are three levels of inputs that may be used to measure fair value. Level 1 inputs include quoted market prices, where available. If such quoted market prices are not available Level 2 inputs are used. These inputs are based upon internally developed models that primarily use observable market-based parameters. Level 3 inputs are unobservable inputs which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

RECENT ACQUISITIONS

Acquisition of Coppermark Bancshares, Inc.—On April 1, 2013, the Company completed the acquisition of Coppermark Bancshares, Inc. and its wholly-owned subsidiary, Coppermark Bank (collectively “Coppermark”) headquartered in Oklahoma City, Oklahoma. Coppermark operated nine (9) full-service banking offices: six (6) in Oklahoma City, Oklahoma and surrounding areas and three (3) in the Dallas, Texas area. As of March 31, 2013, Coppermark reported, on a consolidated basis, total assets of $1.25 billion, total loans of $847.6 million and total deposits of $1.11 billion.

Acquisition of East Texas Financial Services, Inc.- On January 1, 2013, the Company completed the acquisition of East Texas Financial Services, Inc. (OTC BB: FFBT) and its wholly-owned subsidiary, First Federal Bank Texas. East Texas Financial Services operated four (4) banking offices in the Tyler MSA, including three locations in Tyler, Texas and one location in Gilmer, Texas. As of December 31, 2012, East Texas Financial Services reported, on a consolidated basis, total assets of $165.0 million, total loans of $129.3 million and total deposits of $112.3 million.

SUBSEQUENT EVENTS

Pending Acquisition of FVNB Corp. – On July 1, 2013, the Company announced the signing of a definitive merger agreement to acquire FVNB Corp. and its wholly-owned subsidiary First Victoria National Bank (collectively, “FVNB”) headquartered in Victoria, Texas. FVNB operates thirty-four (34) banking locations. As of June 30, 2013, FVNB Corp., on a consolidated basis, reported total assets of $2.4 billion, total loans of $1.6 billion and total deposits of $2.2 billion. Under the terms of the definitive agreement, the Company will issue approximately 5,570,818 shares of Company common stock plus $91.25 million in cash for all outstanding shares of FVNB Corp. capital stock, subject to certain conditions and potential adjustments. The transaction is subject to customary closing conditions, including the receipt of customary regulatory approvals and approval by FVNB’s shareholders.

RESULTS OF OPERATIONS

Net income available to common shareholders was $53.8 million ($0.89 per common share on a diluted basis) for the quarter ended June 30, 2013 compared with $37.0 million ($0.78 per common share on a diluted basis) for the quarter ended June 30, 2012, an increase in net income of $16.9 million or 45.6%. The Company posted returns on average common equity of 9.27% and 9.06%,

returns on average assets of 1.33% and 1.35% and efficiency ratios of 42.51% and 41.94% for the quarters ended June 30, 2013 and 2012, respectively. The efficiency ratio is calculated by dividing total non-interest expense, excluding credit loss provisions, by net interest income plus non-interest income, excluding net gains and losses on the sale of securities and assets. Additionally, taxes are not part of this calculation.

For the six months ended June 30, 2013, net income available to common shareholders was $103.1 million ($1.76 per common share on a diluted basis) compared with $73.5 million ($1.55 per common share on a diluted basis) for the same period in 2012, an increase in net income of $29.7 million or 40.4%. The Company posted returns on average common equity of 9.25% and 9.10%, returns on average assets of 1.33% and 1.37% and efficiency ratios of 42.46% and 42.09% for the six months ended June 30, 2013 and 2012, respectively.

Net Interest Income

The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “rate change.”

Net interest income before the provision for credit losses was $118.7 million for the quarter ended June 30, 2013 compared with $83.7 million for the quarter ended June 30, 2012, an increase of $35.1 million, or 41.9%. This increase includes $12.0 million related to purchase accounting accretion during the three months ended June 30, 2013. During the three months ended June 30, 2012, $756 thousand of purchase accounting accretion was recorded. The average rate paid on interest-bearing liabilities decreased 12 basis points from 0.52% for the quarter ended June 30, 2012 compared with 0.40% for the quarter ended June 30, 2013, while the average yield on interest-earning assets decreased 23 basis points from 3.90% for the quarter ended June 30, 2012 compared with 3.67% for the quarter ended June 30, 2013. The average volume of interest-bearing liabilities increased $3.32 billion and the average volume of interest-earning assets increased $4.54 billion for the same period as a result of the acquisitions over the past year. The net interest margin on a tax equivalent basis decreased 12 basis points from 3.55% for the quarter ended June 30, 2012 compared with 3.43% for the quarter ended June 30, 2013. The impact on net interest margin of the purchase accounting accretion was an increase of 34 basis points.

Net interest income before the provision for credit losses increased $61.3 million, or 37.0%, to $226.8 million for the six months ended June 30, 2013 compared with $165.5 million for the same period in 2012. This increase includes $26.3 million related to purchase accounting accretion during the six months ended June 30, 2013. During the six months ended June 30, 2012, $701 thousand of purchase accounting accretion was recorded. The increase in net interest income was primarily attributable to higher average interest-earning assets as a result of the acquisitions over the past year. The average volume of interest-earning assets increased $4.23 billion for the six months ended June 30, 2013 compared with the same period in 2012. The net interest margin on a tax equivalent basis decreased to 3.43% for the six months ended June 30, 2013 compared with 3.60% for the same period in 2012. The impact on the net interest margin of the purchase accounting accretion was an increase of 40 basis points.

The following tables set forth, for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest earned or paid on such amounts, and the average rate earned or paid for the three and the six month periods ended June 30, 2013 and 2012. The tables also set forth the average rate paid on total interest-bearing liabilities, and the net interest margin on average total interest-earning assets for the same periods. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield.


	Three Months Ended June 30,
	2013								2012
	Average Balance			Interest Earned/ Interest Paid		Average Yield/Rate (4)			Average Balance			Interest Earned/ Interest Paid		Average Yield/Rate (4)
	(Dollars in thousands)
Assets
Interest-Earning Assets:
Loans	$	6,114,598		$	89,842		5.89	%	$	3,914,352		$	54,793		5.63	%
Investment securities		7,964,157			39,384		1.98	%		5,635,810			38,072		2.70	%
Federal funds sold and other earning assets		35,113			76		0.87	%		20,916			9		0.17	%

Total interest-earning assets		14,113,868			129,302		3.67	%		9,571,078			92,874		3.90	%

Allowance for credit losses		(57,754	)							(50,746	)
Noninterest-earning assets		2,114,816								1,398,857

Total assets	$	16,170,930							$	10,919,189

Liabilities and Shareholders’ Equity
Interest-Bearing Liabilities:
Interest-bearing demand deposits	$	2,580,750			2,100		0.33	%	$	1,706,176			2,089		0.49	%
Savings and money market deposits		4,261,466			3,172		0.30	%		2,779,524			2,444		0.35	%
Certificates and other time deposits		2,543,895			3,898		0.61	%		1,880,096			3,550		0.76	%
Securities sold under repurchase agreements		471,430			312		0.27	%		98,968			59		0.24	%
Federal funds purchased and other borrowings		541,034			472		0.35	%		610,499			418		0.28	%
Junior subordinated debentures		85,055			606		2.86	%		85,055			648		3.06	%

Total interest-bearing liabilities		10,483,630			10,560		0.40	%		7,160,318			9,208		0.52	%

Noninterest-Bearing liabilities:
Noninterest-bearing demand deposits		3,295,211								2,069,965
Other liabilities		69,741								56,742

Total liabilities		13,848,582								9,287,025
Shareholders’ equity		2,322,348								1,632,164

Total liabilities and shareholders’ equity	$	16,170,930							$	10,919,189

Net interest rate spread							3.27	%							3.39	%
Net interest income and margin (1) (2)				$	118,742		3.37	%				$	83,666		3.52	%

Net interest income and margin (tax equivalent) (3)				$	120,805		3.43	%				$	84,498		3.55	%

(1)	Yield is based on amortized cost and does not include any component of unrealized gains or losses.

(2)	The net interest margin is equal to net interest income divided by average interest-earning assets.

(3)	In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax-equivalent adjustment has been computed using a federal income tax rate of 35%.

(4)	Annualized and based on an actual/365 day basis for the three months ended June 30, 2013 and on an actual/366 day basis for the three months ended June 30, 2012.


	Six Months Ended June 30,
	2013								2012
	Average Balance			Interest Earned/ Interest Paid		Average Yield/Rate (4)			Average Balance			Interest Earned/ Interest Paid		Average Yield/Rate (4)
	(Dollars in thousands)
Assets
Interest-Earning Assets:
Loans	$	5,691,541		$	171,306		6.07	%	$	3,866,672		$	108,010		5.62	%
Investment securities		7,860,438			75,932		1.95	%		5,414,033			76,393		2.82	%
Federal funds sold and other earning assets		34,954			95		0.55	%		73,536			87		0.24	%

Total interest-earning assets		13,586,933			247,333		3.67	%		9,354,241			184,490		3.97	%

Allowance for credit losses		(55,513	)							(51,174	)
Noninterest-earning assets		1,982,871								1,403,182

Total assets	$	15,514,291							$	10,706,249

Liabilities and Shareholders’ Equity
Interest-Bearing Liabilities:
Interest-bearing demand deposits	$	2,619,902			4,309		0.33	%	$	1,700,208			4,152		0.49	%
Savings and money market deposits		4,027,242			6,001		0.30	%		2,785,936			5,033		0.36	%
Certificates and other time deposits		2,457,676			7,550		0.62	%		1,925,584			7,689		0.80	%
Securities sold under repurchase agreements		460,049			604		0.26	%		76,136			96		0.25	%
Federal funds purchased and other borrowings		450,082			834		0.37	%		441,630			697		0.32	%
Junior subordinated debentures		85,055			1,211		2.87	%		85,055			1,311		3.10	%

Total interest-bearing liabilities		10,100,006			20,509		0.41	%	$	7,014,549			18,978		0.54	%

Noninterest-Bearing liabilities:
Noninterest-bearing demand deposits		3,118,400								2,020,453
Other liabilities		66,251								57,523

Total liabilities		13,284,657								9,092,525
Shareholders’ equity		2,229,634								1,613,724

Total liabilities and shareholders’ equity	$	15,514,291							$	10,706,249

Net interest rate spread							3.26	%							3.42	%
Net interest income and margin (1) (2)				$	226,824		3.37	%				$	165,512		3.56	%

Net interest income and margin (tax equivalent) (3)				$	231,013		3.43	%				$	167,240		3.60	%

(1)	Yield is based on amortized cost and does not include any component of unrealized gains or losses.

(2)	The net interest margin is equal to net interest income divided by average interest-earning assets.

(3)	In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax-equivalent adjustment has been computed using a federal income tax rate of 35%.

(4)	Annualized and based on an actual/365 day basis for the six months ended June 30, 2013 and on an actual/366 day basis for the six months ended June 30, 2012.

The following tables present the dollar amount of changes in interest income and interest expense for the major components of interest-earning assets and interest-bearing liabilities and distinguishes between the increase (decrease) related to changes in outstanding balances and the volatility of interest rates. For purposes of these tables, changes attributable to both rate and volume that cannot be segregated have been allocated to rate.


	Three Months Ended June 30,									Six Months Ended June 30,
	2013 vs. 2012									2013 vs. 2012
	Increase (Decrease) Due to Change in									Increase (Decrease) Due to Change in
	Volume			Rate			Total			Volume			Rate			Total
	(Dollars in thousands)									(Dollars in thousands)
Interest-Earning assets:
Loans	$	31,035		$	4,014		$	35,049		$	50,607		$	12,689		$	63,296
Securities		15,538			(14,226	)		1,312			33,528			(33,989	)		(461	)
Federal funds sold and other temporary investments		6			61			67			(47	)		55			8

Total increase (decrease) in interest income		46,579			(10,151	)		36,428			84,088			(21,245	)		62,843

Interest-Bearing liabilities:
Interest-bearing demand deposits		1,063			(1,052	)		11			2,215			(2,058	)		157
Savings and money market accounts		1,274			(546	)		728			2,157			(1,189	)		968
Certificates of deposit		1,270			(922	)		348			2,061			(2,200	)		(139	)
Junior subordinated debentures		—			(42	)		(42	)		—			(100	)		(100	)
Securities sold under repurchase agreements		223			30			253			474			34			508
Other borrowings		(40	)		94			54			13			124			137

Total increase (decrease) in interest expense		3,790			(2,438	)		1,352			6,920			(5,389	)		1,531

Increase (decrease) in net interest income	$	42,789		$	(7,713	)	$	35,076		$	77,168		$	(15,856	)	$	61,312

Provision for Credit Losses

Management actively monitors the Company’s asset quality and provides specific loss provisions when necessary. Provisions for credit losses are charged to income to bring the total allowance for credit losses to a level deemed appropriate by management of the Company based on such factors as historical credit loss experience, industry diversification of the Company’s commercial loan portfolio, the amount of nonperforming loans and related collateral, the volume growth and composition of the loan portfolio, current economic conditions that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the loan portfolio through the internal loan review process and other relevant factors.

Loans are charged-off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the provision for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations.

The Company recorded a $2.6 million provision for credit losses for the quarter ended June 30, 2013 and a $600 thousand provision for the quarter ended June 30, 2012. Net charge-offs were $1.4 million for the quarter ended June 30, 2013 compared with net charge-offs of $1.9 million for the quarter ended June 30, 2012. The Company made a $5.4 million provision for credit losses for the six months ended June 30, 2013 and a $750 thousand provision for the six months ended June 30, 2012. Net charge-offs were $1.7 million for the six months ended June 30, 2013 compared with $2.0 million for the six months ended June 30, 2012.

Noninterest Income

The Company’s primary sources of recurring noninterest income are NSF fees, credit, debit and ATM card income and service charges on deposit accounts. Noninterest income does not include loan origination fees which are recognized over the life of the related loan as an adjustment to yield using the interest method. Noninterest income totaled $25.3 million for the three months ended June 30, 2013 compared with $13.7 million for the same period in 2012, an increase of $11.6 million or 85.1%. Noninterest income totaled $48.7 million for the six months ended June 30, 2013 compared with $27.6 million for the same period in 2012, an increase of $21.1 million or 76.5%. Both increases were primarily due to the increases in NSF fees, credit, debit and ATM card income and service charges on deposit accounts as a result of a larger customer base resulting from the acquisitions of ASB and Coppermark. Additionally, noninterest income includes income generated from several new products and services assumed in the ASB acquisition, including trust and mortgage.

In July 2013, the Company became subject to the Durbin Amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act. This Federal Reserve rule is applicable to financial institutions that have assets of $10 billion or more and imposes limits on the amount of interchange, or swipe, fees that can be collected. The rule provides that the maximum permissible interchange fee for an electronic debit transaction is limited to $0.24. The fee is calculated as the sum of $0.21 per transaction and 5 basis points multiplied by the value of the transaction. If the card issuer develops and implements certain fraud protection policies and procedures, it may increase its debit card interchange fee by up to an additional one cent.

The following table presents, for the periods indicated, the major categories of noninterest income:


	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(Dollars in thousands)						(Dollars in thousands)
Nonsufficient funds (NSF) fees	$	8,346		$	5,167		$	16,855		$	10,556
Credit card, debit card and ATM card income		7,007			4,292			13,494			8,128
Service charges on deposit accounts		3,304			2,432			6,235			4,873
Trust income		896			—			1,913			—
Mortgage income		1,567			65			2,558			124
Bank owned life insurance income		932			345			1,708			694
Net (loss) gain on sale of assets		(180	)		70			(179	)		63
Net gain (loss) on sale of other real estate		237			(165	)		132			253
Other		3,165			1,450			5,999			2,910

Total noninterest income	$	25,274		$	13,656		$	48,715		$	27,601

Noninterest Expense

Noninterest expense totaled $61.3 million for the quarter ended June 30, 2013 compared with $40.8 million for the quarter ended June 30, 2012, an increase of $20.5 million or 50.3%. Noninterest expense totaled $117.1 million for the six months ended June 30, 2013 compared with $81.2 million for the six months ended June 30, 2012, an increase of $35.8 million or 44.1%. Both increases are primarily due to increases in salaries and employee benefits and general and administrative expenses related to the recent acquisitions. The following table presents, for the periods indicated, the major categories of noninterest expense:


	Three Months Ended June 30,				Six Months Ended June 30,
	2013		2012		2013		2012
	(Dollars in thousands)				(Dollars in thousands)
Salaries and employee benefits⁽¹⁾	$	37,517	$	23,572	$	70,726	$	46,824
Non-staff expenses:
Net occupancy and equipment		4,669		3,492		8,947		7,049
Debit card, data processing and software amortization		3,249		1,906		5,819		3,438
Regulatory assessments and FDIC insurance		2,579		1,659		4,974		3,207
Core deposit intangibles amortization		1,341		1,595		3,096		3,290
Depreciation		2,464		2,028		4,842		4,063
Communications (including telephone, courier and postage)		2,410		1,802		4,606		3,550
Other real estate expense		237		383		460		1,074
Professional fees		815		835		1,744		1,545
Printing and supplies		345		483		1,021		944
Other		5,674		3,033		10,832		6,263

Total noninterest expense	$	61,300	$	40,788	$	117,067	$	81,247

(1)	Includes stock based compensation expense of $908 thousand and $946 thousand for the three months ended June 30, 2013 and 2012, respectively, and $2.1 million and $2.2 million for the six months ended June 30, 2013 and 2012, respectively.

Income Taxes

Income tax expense increased $7.4 million or 38.8% to $26.3 million for the quarter ended June 30, 2013 compared with $19.0 million for the same period in 2012. For the six months ended June 30, 2013, income tax expense totaled $50.0 million, an increase of $12.3 million or 32.7% compared with $37.7 million for the same period in 2012. The increase was primarily attributable to higher pretax net earnings for the three and six months ended June 30, 2013 compared with the same periods in 2012. The Company’s effective tax rate for the three months ended June 30, 2013 and 2012 was 32.8% and 33.9%, respectively. The Company’s effective tax rate for the six months ended June 30, 2013 and 2012 was 32.6% and 33.9%, respectively.

FINANCIAL CONDITION

Loan Portfolio

Total loans were $6.17 billion at June 30, 2013, an increase of $992.5 million or 19.2% compared with $5.18 billion at December 31, 2012. Outstanding loans at June 30, 2013 comprised 43.7% of average earning assets for the quarter ended June 30, 2013.

The following table summarizes the loan portfolio of the Company by type of loan as of June 30, 2013 and December 31, 2012:


	June 30,		December 31,
	2013		2012
	(Dollars in thousands)
Residential mortgage loans held for sale	$	6,186	$	10,433

Commercial and industrial		999,677		771,114
Real estate:
Construction and land development		694,585		550,768
1-4 family residential (including home equity)		1,654,821		1,432,133
Commercial real estate (including multi-family residential)		2,390,820		1,990,642
Farmland		230,389		211,156
Agriculture		84,556		74,481
Consumer and other (net of unearned discount)		111,449		139,213

Total loans held for investment		6,166,297		5,169,507

Total	$	6,172,483	$	5,179,940

Nonperforming Assets

The Company had $14.9 million in nonperforming assets at June 30, 2013 and $13.0 million in nonperforming assets at December 31, 2012, an increase of $1.8 million or 14.2%. The ratio of nonperforming assets to loans and other real estate was 0.24% at June 30, 2013 compared with 0.25% at December 31, 2012.

The following table presents information regarding nonperforming assets as of the dates indicated:


	June 30,			December 31,
	2013			2012
	(Dollars in thousands)
Nonaccrual loans	$	4,295		$	5,382
Accruing loans 90 or more days past due		325			331

Total nonperforming loans		4,620			5,713
Repossessed assets		—			68
Other real estate		10,244			7,234

Total nonperforming assets	$	14,864		$	13,015

Nonperforming assets to total loans and other real estate		0.24	%		0.25	%

Allowance for Credit Losses

Management actively monitors the Company’s asset quality and provides specific loss allowances when necessary. The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Loans are charged-off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the allowance for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations. As of June 30, 2013, the allowance for credit losses amounted to $56.2 million or 0.91% of total loans compared with $52.6 million or 1.01% of total loans at December 31, 2012.

Set forth below is an analysis of the allowance for credit losses as of the dates indicated below:


	As of and for the Six Months Ended June 30, 2013			As of and for the Six Months Ended June 30, 2012
	(Dollars in thousands)
Average loans outstanding	$	5,691,541		$	3,866,672

Gross loans outstanding at end of period	$	6,172,483		$	3,950,332

Allowance for credit losses at beginning of period	$	52,564		$	51,594
Provision for credit losses		5,350			750
Charge-offs:
Commercial and industrial		(413	)		(321	)
Real estate and agriculture		(1,327	)		(1,729	)
Consumer and other		(1,192	)		(438	)
Recoveries:
Commercial and industrial		206			156
Real estate and agriculture		372			77
Consumer and other		616			293

Net charge-offs		(1,738	)		(1,962	)

Allowance for credit losses at end of period	$	56,176		$	50,382

Ratio of allowance to end of period loans		0.91	%		1.28	%
Ratio of net charge-offs to average loans (annualized)		0.06	%		0.10	%
Ratio of allowance to end of period nonperforming loans		1215.9	%		3102.3	%

Securities

The carrying cost of securities totaled $8.02 billion at June 30, 2013 compared with $7.44 billion at December 31, 2012, an increase of $575.8 million or 7.7%. At June 30, 2013, securities represented 49.3% of total assets compared with 51.0% of total assets at December 31, 2012.

The amortized cost and fair value of investment securities were as follows:


	June 30, 2013
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
	(Dollars in thousands)
Available for Sale
States and political subdivisions	$	33,591	$	1,172	$	—		$	34,763
Collateralized mortgage obligations		547		10		(1	)		556
Mortgage-backed securities		133,199		8,438		(24	)		141,613
Other securities		7,289		141		(13	)		7,417

Total	$	174,626	$	9,761	$	(38	)	$	184,349

Held to Maturity
U.S. Treasury securities and obligations of U.S. Government agencies	$	5,772	$	51	$	—		$	5,823
States and political subdivisions		362,590		2,089		(1,839	)		362,840
Corporate debt securities		522		8		—			530
Collateralized mortgage obligations		75,235		1,530		(60	)		76,705
Mortgage-backed securities		7,376,516		106,996		(124,376	)		7,359,136
Qualified School Construction Bonds (QSCB)		12,900		2,332		—			15,232

Total	$	7,833,535	$	113,006	$	(126,275	)	$	7,820,266


	December 31, 2012
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
	(Dollars in thousands)
Available for Sale
States and political subdivisions	$	34,743	$	1,691	$	—		$	36,434
Collateralized mortgage obligations		616		—		(12	)		604
Mortgage-backed securities		168,701		11,742		(27	)		180,416
Other securities		8,786		430		—			9,216

Total	$	212,846	$	13,863	$	(39	)	$	226,670

Held to Maturity
U.S. Treasury securities and obligations of U.S. Government agencies	$	7,061	$	160	$	—		$	7,221
States and political subdivisions		391,510		7,074		(354	)		398,230
Corporate debt securities		1,500		28		—			1,528
Collateralized mortgage obligations		125,912		2,304		(50	)		128,166
Mortgage-backed securities		6,676,512		196,206		(4,517	)		6,868,201
Qualified School Construction Bonds (QSCB)		12,900		2,449		—			15,349

Total	$	7,215,395	$	208,221	$	(4,921	)	$	7,418,695

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

When OTTI occurs under either model, the amount of the other-than-temporary impairment recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its

amortized cost basis less any current-period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit-related portion of the impairment loss (“credit loss”) and the noncredit portion of the impairment loss (“noncredit portion”). The amount of the total OTTI related to the credit loss is determined based on the difference between the present value of cash flows expected to be collected and the amortized cost basis and such difference is recognized in earnings. The amount of the total OTTI related to the noncredit portion is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

As of June 30, 2013, the Company does not intend to sell any debt securities and management believes that the Company more likely than not will not be required to sell any debt securities before their anticipated recovery, at which time the Company will receive full value for the securities. Furthermore, as of June 30, 2013, management does not have the intent to sell any of its securities and believes that it is more likely than not that the Company will not have to sell any such securities before a recovery of cost. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe any of the securities are impaired due to reasons of credit quality. Accordingly, as of June 30, 2013, management believes any impairment in the Company’s securities are temporary and no impairment loss has been realized in the Company’s consolidated statements of income.

Deposits

Total deposits were $12.51 billion at June 30, 2013 compared with $11.64 billion at December 31, 2012, an increase of $866.8 million or 7.4%. At June 30, 2013, noninterest-bearing deposits totaled $3.28 billion and accounted for 26.2% of total deposits compared with 25.9% of total deposits at December 31, 2012. Interest-bearing deposits totaled $9.23 billion or 73.8% of total deposits at June 30, 2013 compared with $8.63 billion or 74.1% of total deposits at December 31, 2012.

The following table summarizes the daily average balances and weighted average rates paid on deposits for the periods indicated below:


	Six Months Ended June 30,
	2013					2012
	Average		Average			Average		Average
	Balance		Rate			Balance		Rate
	(Dollars in thousands)
Interest-bearing demand deposits	$	2,619,902		0.33	%	$	1,700,208		0.49	%
Regular savings		1,338,718		0.21	%		547,774		0.20	%
Money market savings		2,688,524		0.35	%		2,238,162		0.73	%
Certificates and other time deposits		2,457,676		0.62	%		1,925,584		0.80	%

Total interest-bearing deposits		9,104,820		0.41	%		6,411,728		0.64	%
Noninterest-bearing deposits		3,118,400					2,020,453

Total deposits	$	12,223,220		0.29	%	$	8,432,181		0.49	%

Other Borrowings

The following table presents the Company’s borrowings as of the dates indicated:


	June 30,		December 31,
	2013		2012
	(Dollars in thousands)
FHLB advances	$	770,000	$	245,000
FHLB long-term notes payable		11,215		11,753

Total other borrowings		781,215		256,753
Securities sold under repurchase agreements		481,170		454,502

Total	$	1,262,385	$	711,255

FHLB advances and long-term notes payable—The Company has an available line of credit with the FHLB of Dallas, which allows the Company to borrow on a collateralized basis. FHLB advances are considered short-term, overnight borrowings and used to manage liquidity as needed. Additionally, the Company utilizes long-term FHLB notes. Maturing advances are replaced by drawing on available cash, making additional borrowings or through increased customer deposits. At June 30, 2013, the Company had total funds of $3.78 billion available under this agreement, of which $781.2 million was outstanding. Short-term overnight FHLB advances of $770.0 million were outstanding at June 30, 2013, at a weighted average rate of rate of 0.16%. Long-term notes payable were $11.2 million at June 30, 2013, with a weighted average rate of 5.22%. The maturity dates on the FHLB notes payable range from the years 2013 to 2028 and have interest rates ranging from 4.08% to 6.10%.

Securities sold under repurchase agreements— At June 30, 2013, the Company had $481.2 million in securities sold under repurchase agreements compared with $454.5 million at December 31, 2012, an increase of $26.7 million or 5.9%. Repurchase agreements with banking customers are generally settled on the following business day. Approximately $63.6 million of the repurchase agreements outstanding at June 30, 2013 have maturity dates ranging from one to eighteen months. All securities sold under agreements to repurchase are collateralized by certain pledged securities.

Junior Subordinated Debentures

At June 30, 2013 and December 31, 2012, the Company had outstanding $85.1 million in junior subordinated debentures issued to the Company’s unconsolidated subsidiary trusts.

A summary of pertinent information related to the Company’s seven issues of junior subordinated debentures outstanding at June 30, 2013 is set forth in the table below (dollars in thousands):

Description

Issuance Date

Trust
Preferred
Securities
Outstanding

Interest Rate (1)

Junior
Subordinated
Debt Owed
to Trusts

Maturity Date (2)

Prosperity Statutory Trust II

July 31, 2001

15,000

3 month LIBOR +
3.58%, not to exceed
12.50%

15,464

July 31, 2031

Prosperity Statutory Trust III

August 13, 2003

12,500

3 month LIBOR + 3.00%

12,887

September 17, 2033

Prosperity Statutory Trust IV

December 30, 2003

12,500

3 month LIBOR + 2.85%

12,887

December 30, 2033

SNB Capital Trust IV

September 25, 2003

10,000

3 month LIBOR + 3.00%

10,310

September 25, 2033

TXUI Statutory Trust II

December 19, 2003

5,000

3 month LIBOR + 2.85%

5,155

December 19, 2033

TXUI Statutory Trust III

November 30, 2003

15,500

3 month LIBOR + 1.39%

15,980

December 15, 2035

TXUI Statutory Trust IV

March 31, 2006

12,000

3 month LIBOR + 1.39%

12,372

June 30, 2036

85,055

(1)	The 3-month LIBOR in effect as of June 30, 2013 was 0.274%.

(2)	All debentures are callable five years from issuance date.

Liquidity

Liquidity involves the Company’s ability to raise funds to support asset growth or reduce assets to meet deposit withdrawals and other payment obligations, to maintain reserve requirements and otherwise to operate the Company on an ongoing basis. The Company’s largest source of funds is deposits and its largest use of funds is loans. The Company does not expect a change in the source or use of its funds in the future. Although access to purchased funds from correspondent banks is available and has been utilized on occasion to take advantage of investment opportunities, the Company does not generally rely on these external funding sources. The cash and federal funds sold position, supplemented by amortizing investment and loan portfolios, has generally created an adequate liquidity position.

As of June 30, 2013, the Company had outstanding $1.16 billion in commitments to extend credit and $40.4 million in commitments associated with outstanding standby letters of credit. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the total outstanding may not necessarily reflect the actual future cash funding requirements.

The Company has no exposure to future cash requirements associated with known uncertainties or capital expenditures of a material nature.

Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. As of June 30, 2013, the Company had cash and cash equivalents of $251.1 million compared with $326.3 million at December 31, 2012, a decrease of $75.2 million. The decrease was primarily due to purchases of securities of $3.48 billion, a decrease in deposits of $363.3 million, an increase in loans of $50.1 million, repayments of other long-term borrowings of $40.8 million and dividends paid of $25.2 million, partially offset by proceeds from the maturities and repayments of securities of $2.87 billion, net proceeds from short-term debt of $524.6 million, net earnings of $103.1 million, an increase in securities sold under repurchase agreements of $26.7 million and cash received from acquisitions of $292.3 million.

Contractual Obligations


	1 year or less		More than 1 year but less than 3 years		3 years or more but less than 5 years		5 years or more		Total
	(Dollars in thousands)
Junior subordinated debentures	$	1,169	$	4,676	$	4,675	$	121,870	$	132,390
Federal Home Loan Bank notes payable and other borrowings		770,683		3,836		2,312		6,899		783,730
Operating leases		2,650		7,785		3,264		380		14,079

Total	$	774,502	$	16,297	$	10,251	$	129,149	$	930,199

Off-Balance Sheet Items


	1 year or less		More than 1 year but less than 3 years		3 years or more but less than 5 years		5 years or more		Total
	(Dollars in thousands)
Standby letters of credit	$	37,788	$	2,612	$	30	$	—	$	40,430
Commitments to extend credit		299,677		495,644		76,598		286,697		1,158,616

Total	$	337,465	$	498,256	$	76,628	$	286,697	$	1,199,046

Capital Resources

Total shareholders’ equity was $2.35 billion at June 30, 2013 compared with $2.09 billion at December 31, 2012, an increase of $255.9 million or 12.2%. The increase was due primarily to net earnings of $103.1 million, the issuance of common stock in connection with the exercise of stock options and restricted stock awards of $1.8 million and the issuance of common stock in connection with the acquisitions of East Texas Financial Services and Coppermark Bancshares, Inc. of $176.7 million, which was partially offset by dividends paid of $25.2 million for the six months ended June 30, 2013.

Both the Board of Governors of the Federal Reserve System with respect to the Company, and the Federal Deposit Insurance Corporation (“FDIC”) with respect to the Bank, have established certain minimum risk-based capital standards that apply to bank holding companies and federally insured banks. The following table sets forth the Company’s total risk-based capital, Tier 1 risk-based capital and Tier 1 to average assets (leverage) ratios as of June 30, 2013:


Consolidated Capital Ratios
Total capital (to risk weighted assets)	14.91	%
Tier 1 capital (to risk weighted assets)	14.15	%
Tier 1 capital (to average assets)	7.07	%

As of June 30, 2013, the Bank’s risk-based capital ratios were above the levels required for the Bank to be designated as “well capitalized” by the FDIC. To be designated as “well capitalized”, the minimum ratio requirements for the Bank’s total risk-based capital, Tier 1 risk-based capital, and Tier 1 to average assets (leverage) capital ratios must be 10.0%, 6.0% and 5.0%, respectively. The following table sets forth the Bank’s total risk-based capital, Tier 1 risk-based capital and Tier 1 to average assets (leverage) ratios as of June 30, 2013:


Consolidated Capital Ratios
Total capital (to risk weighted assets)	14.69	%
Tier 1 capital (to risk weighted assets)	13.93	%
Tier 1 capital (to average assets)	6.96	%

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company manages market risk, which for the Company is primarily interest rate risk, through its Asset Liability Committee which is composed of senior officers of the Company, in accordance with policies approved by the Company’s Board of Directors.

The Company uses simulation analysis to examine the potential effects of market changes on net interest income and market value. The Company considers macroeconomic variables, Company strategy, liquidity and other factors as it quantifies market risk. See the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Interest Rate Sensitivity and Liquidity” which was filed on February 28, 2013 for further discussion.

ITEM 4.

CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply judgment in evaluating its controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) were effective as of the end of the period covered by this report.

Changes in internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended June 30, 2013 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II—OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

The Company and the Bank are defendants, from time to time, in legal actions arising from transactions conducted in the ordinary course of business. The Company and Bank believe, after consultations with legal counsel, that the ultimate liability, if any, arising from such actions will not have a material adverse effect on their financial statements.

ITEM 1A.

RISK FACTORS

There have been no material changes in the Company’s risk factors from those disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

a. Not applicable

b. Not applicable

c. Not applicable

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

Not applicable

ITEM 4.

MINE SAFETY DISCLOSURES

None.

ITEM 5.

OTHER INFORMATION

Not applicable

ITEM 6.

EXHIBITS


Exhibit Number		Description of Exhibit

3.1		Amended and Restated Articles of Incorporation of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267) (the “Registration Statement”))

3.2		Articles of Amendment to Amended and Restated Articles of Incorporation of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006)

3.3		Amended and Restated Bylaws of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on October 19, 2007)

4.1		Form of certificate representing shares of the Company’s common stock (incorporated by reference to Exhibit 4 to the Registration Statement)

31.1*		Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended

31.2*		Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended

32.1**		Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2**		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101*		Interactive Financial Data

*	Filed with this Quarterly Report on Form 10-Q.

**	Furnished with this Quarterly Report on Form 10-Q.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


				PROSPERITY BANCSHARES, INC. ^® (Registrant)

Date: 08/07/13				/S/ DAVID ZALMAN
				David Zalman
				Chairman and Chief Executive Officer

Date: 08/07/13				/S/ DAVID HOLLAWAY
				David Hollaway
				Chief Financial Officer