| CULLEN FROST BANKERS INC ITEM 1A RISK FACTORS An investment in the Corporation’s common stock is subject to risks inherent to the Corporation’s business |
| The material risks and uncertainties that management believes affect the Corporation are described below |
| Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report |
| The risks and uncertainties described below are not the only ones facing the Corporation |
| Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Corporation’s business operations |
| This report is qualified in its entirety by these risk factors |
| If any of the following risks actually occur, the Corporation’s financial condition and results of operations could be materially and adversely affected |
| If this were to happen, the value of the Corporation’s common stock could decline significantly, and you could lose all or part of your investment |
| Risks Related To The Corporation’s Business The Corporation Is Subject To Interest Rate Risk The Corporation’s earnings and cash flows are largely dependent upon its net interest income |
| Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds |
| Interest rates are highly sensitive to many factors that are beyond the Corporation’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System |
| Changes in monetary policy, including changes in interest rates, could influence not only the interest the Corporation receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) the Corporation’s ability to originate loans and obtain deposits, (ii) the fair value of the Corporation’s financial assets and liabilities, and (iii) the average duration of the Corporation’s mortgage-backed securities portfolio |
| If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Corporation’s net interest income, and therefore earnings, could be adversely affected |
| Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings |
| Although management believes it has implemented effective asset and liability management strategies, including the use of derivatives as hedging instruments, to reduce the potential effects of changes in interest rates on the Corporation’s results of operations, any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on the Corporation’s financial condition and results of operations |
| See the section captioned “Net Interest Income” in Item 7 |
| Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the Corporation’s management of interest rate risk |
| The Corporation Is Subject To Lending Risk There are inherent risks associated with the Corporation’s lending activities |
| These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets 14 _________________________________________________________________ [66]Table of Contents where the Corporation operates as well as those across the State of Texas and the United States |
| Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans |
| The Corporation is also subject to various laws and regulations that affect its lending activities |
| Failure to comply with applicable laws and regulations could subject the Corporation to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Corporation |
| As of December 31, 2005, approximately 80prca of the Corporation’s loan portfolio consisted of commercial and industrial, construction and commercial real estate loans |
| These types of loans are generally viewed as having more risk of default than residential real estate loans or consumer loans |
| These types of loans are also typically larger than residential real estate loans and consumer loans |
| Because the Corporation’s loan portfolio contains a significant number of commercial and industrial, construction and commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans |
| An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Corporation’s financial condition and results of operations |
| Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to commercial and industrial, construction and commercial real estate loans |
| The Corporation’s Allowance For Possible Loan Losses May Be Insufficient The Corporation maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense, that represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans |
| The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio |
| The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio |
| The determination of the appropriate level of the allowance for possible loan losses inherently involves a high degree of subjectivity and requires the Corporation to make significant estimates of current credit risks and future trends, all of which may undergo material changes |
| Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Corporation’s control, may require an increase in the allowance for possible loan losses |
| In addition, bank regulatory agencies periodically review the Corporation’s allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management |
| In addition, if charge-offs in future periods exceed the allowance for possible loan losses, the Corporation will need additional provisions to increase the allowance for possible loan losses |
| Any increases in the allowance for possible loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Corporation’s financial condition and results of operations |
| See the section captioned “Allowance for Possible Loan Losses” in Item 7 |
| Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the Corporation’s process for determining the appropriate level of the allowance for possible loan losses |
| The Corporation Is Subject To Environmental Liability Risk Associated With Lending Activities A significant portion of the Corporation’s loan portfolio is secured by real property |
| During the ordinary course of business, the Corporation may foreclose on and take title to properties securing certain loans |
| In doing so, there is a risk that hazardous or toxic substances could be found on these properties |
| If hazardous or toxic substances are found, the Corporation may be liable for remediation costs, as well as for personal injury and property damage |
| Environmental laws may require the Corporation to incur substantial expenses and may materially reduce the affected property’s value or limit the Corporation’s ability to use or sell the affected property |
| In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Corporation’s exposure to environmental liability |
| Although the Corporation 15 _________________________________________________________________ [67]Table of Contents has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards |
| The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Corporation’s financial condition and results of operations |
| The Corporation’s Profitability Depends Significantly On Economic Conditions In The State Of Texas The Corporation’s success depends primarily on the general economic conditions of the State of Texas and the specific local markets in which the Corporation operates |
| Unlike larger national or other regional banks that are more geographically diversified, the Corporation provides banking and financial services to customers primarily in the Texas metropolitan areas of Austin, Boerne, Corpus Christi, Dallas, Fort Worth, Galveston, Harlingen, Houston, McAllen, New Braunfels, San Antonio and San Marcos |
| The local economic conditions in these areas have a significant impact on the demand for the Corporation’s products and services as well as the ability of the Corporation’s customers to repay loans, the value of the collateral securing loans and the stability of the Corporation’s deposit funding sources |
| A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Corporation’s financial condition and results of operations |
| The Corporation Operates In A Highly Competitive Industry and Market Area The Corporation faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources |
| Such competitors primarily include national, regional, and community banks within the various markets the Corporation operates |
| Additionally, various out-of-state banks have begun to enter or have announced plans to enter the market areas in which the Corporation currently operates |
| The Corporation also faces competition from many other types of financial institutions, including, without limitation, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, factoring companies and other financial intermediaries |
| The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation |
| Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking |
| Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems |
| Many of the Corporation’s competitors have fewer regulatory constraints and may have lower cost structures |
| Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Corporation can |
| The Corporation’s ability to compete successfully depends on a number of factors, including, among other things: • The ability to develop, maintain and build upon long-term customer relationships based on top quality service, high ethical standards and safe, sound assets |
| • The ability to expand the Corporation’s market position |
| • The scope, relevance and pricing of products and services offered to meet customer needs and demands |
| • The rate at which the Corporation introduces new products and services relative to its competitors |
| • Customer satisfaction with the Corporation’s level of service |
| • Industry and general economic trends |
| 16 _________________________________________________________________ [68]Table of Contents Failure to perform in any of these areas could significantly weaken the Corporation’s competitive position, which could adversely affect the Corporation’s growth and profitability, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations |
| The Corporation Is Subject To Extensive Government Regulation and Supervision The Corporation, primarily through Cullen/Frost, Frost Bank and certain non-bank subsidiaries, is subject to extensive federal and state regulation and supervision |
| Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not shareholders |
| These regulations affect the Corporation’s lending practices, capital structure, investment practices, dividend policy and growth, among other things |
| Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes |
| Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Corporation in substantial and unpredictable ways |
| Such changes could subject the Corporation to additional costs, limit the types of financial services and products the Corporation may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things |
| Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Corporation’s business, financial condition and results of operations |
| While the Corporation has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur |
| See the section captioned “Supervision and Regulation” in Item 1 |
| Business and Note 12 — Regulatory Matters in the notes to consolidated financial statements included in Item 8 |
| Financial Statements and Supplementary Data, which are located elsewhere in this report |
| The Corporation’s Controls and Procedures May Fail or Be Circumvented Management regularly reviews and updates the Corporation’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures |
| Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met |
| Any failure or circumvention of the Corporation’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Corporation’s business, results of operations and financial condition |
| New Lines of Business or New Products and Services May Subject The Corporation to Additional Risks From time to time, the Corporation may implement new lines of business or offer new products and services within existing lines of business |
| There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed |
| In developing and marketing new lines of business and/or new products and services the Corporation may invest significant time and resources |
| Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible |
| External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service |
| Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of the Corporation’s system of internal controls |
| Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on the Corporation’s business, results of operations and financial condition |
| Cullen/Frost Relies On Dividends From Its Subsidiaries For Most Of Its Revenue Cullen/Frost is a separate and distinct legal entity from its subsidiaries |
| It receives substantially all of its revenue from dividends from its subsidiaries |
| These dividends are the principal source of funds to pay dividends on the Corporation’s common stock and interest and principal on Cullen/Frost’s debt |
| Various federal and/or state laws and regulations limit the amount of dividends that Frost Bank and certain non-bank subsidiaries may pay to Cullen/Frost |
| Also, Cullen/Frost’s right to participate in a distribution of assets upon 17 _________________________________________________________________ [69]Table of Contents a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors |
| In the event Frost Bank is unable to pay dividends to Cullen/Frost, Cullen/Frost may not be able to service debt, pay obligations or pay dividends on the Corporation’s common stock |
| The inability to receive dividends from Frost Bank could have a material adverse effect on the Corporation’s business, financial condition and results of operations |
| See the section captioned “Supervision and Regulation” in Item 1 |
| Business and Note 12 — Regulatory Matters in the notes to consolidated financial statements included in Item 8 |
| Financial Statements and Supplementary Data, which are located elsewhere in this report |
| Potential Acquisitions May Disrupt The Corporation’s Business and Dilute Stockholder Value The Corporation seeks merger or acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale or expanded services |
| Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things: • Potential exposure to unknown or contingent liabilities of the target company |
| • Exposure to potential asset quality issues of the target company |
| • Difficulty and expense of integrating the operations and personnel of the target company |
| • Potential disruption to the Corporation’s business |
| • Potential diversion of the Corporation’s management’s time and attention |
| • The possible loss of key employees and customers of the target company |
| • Difficulty in estimating the value of the target company |
| • Potential changes in banking or tax laws or regulations that may affect the target company |
| The Corporation regularly evaluates merger and acquisition opportunities and conducts due diligence activities related to possible transactions with other financial institutions and financial services companies |
| As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur at any time |
| Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of the Corporation’s tangible book value and net income per common share may occur in connection with any future transaction |
| Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on the Corporation’s financial condition and results of operations |
| During 2005, the Corporation acquired Horizon Capital Bank (Houston market area) and announced definitive agreements to acquire Texas Community Bancshares, Inc |
| (Dallas market area) and Alamo Corporation of Texas (Rio Grande Valley market area) |
| Details of these transactions are presented in Note 2 — Mergers and Acquisitions in the notes to consolidated financial statements included in Item 8 |
| Financial Statements and Supplementary Data, which is located elsewhere in this report |
| The Corporation May Not Be Able To Attract and Retain Skilled People The Corporation’s success depends, in large part, on its ability to attract and retain key people |
| Competition for the best people in most activities engaged in by the Corporation can be intense and the Corporation may not be able to hire people or to retain them |
| The unexpected loss of services of one or more of the Corporation’s key personnel could have a material adverse impact on the Corporation’s business because of their skills, knowledge of the Corporation’s market, years of industry experience and the difficulty of promptly finding qualified replacement personnel |
| The Corporation does not currently have employment agreements or non-competition agreements with any of its senior officers |
| 18 _________________________________________________________________ [70]Table of Contents The Corporation’s Information Systems May Experience An Interruption Or Breach In Security The Corporation relies heavily on communications and information systems to conduct its business |
| Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Corporation’s customer relationship management, general ledger, deposit, loan and other systems |
| While the Corporation has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed |
| The occurrence of any failures, interruptions or security breaches of the Corporation’s information systems could damage the Corporation’s reputation, result in a loss of customer business, subject the Corporation to additional regulatory scrutiny, or expose the Corporation to civil litigation and possible financial liability, any of which could have a material adverse effect on the Corporation’s financial condition and results of operations |
| The Corporation Continually Encounters Technological Change The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services |
| The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs |
| The Corporation’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Corporation’s operations |
| Many of the Corporation’s competitors have substantially greater resources to invest in technological improvements |
| The Corporation may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers |
| Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations |
| The Corporation Is Subject To Claims and Litigation Pertaining To Fiduciary Responsibility From time to time, customers make claims and take legal action pertaining to the Corporation’s performance of its fiduciary responsibilities |
| Whether customer claims and legal action related to the Corporation’s performance of its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Corporation they may result in significant financial liability and/or adversely affect the market perception of the Corporation and its products and services as well as impact customer demand for those products and services |
| Any financial liability or reputation damage could have a material adverse effect on the Corporation’s business, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations |
| Severe Weather, Natural Disasters, Acts Of War Or Terrorism and Other External Events Could Significantly Impact The Corporation’s Business Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on the Corporation’s ability to conduct business |
| Such events could affect the stability of the Corporation’s deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the Corporation to incur additional expenses |
| For example, during 2005, hurricanes Katrina and Rita made landfall and subsequently caused extensive flooding and destruction along the coastal areas of the Gulf of Mexico, including communities where the Corporation conducts business |
| Operations in several of the Company’s markets were disrupted by both the evacuation of large portions of the population as well as damage and or lack of access to the Company’s banking and operation facilities |
| While the impact of these hurricanes did not significantly affect the Corporation, other severe weather or natural disasters, acts of war or terrorism or other adverse external events may occur in the future |
| Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on the Corporation’s business, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations |
| 19 _________________________________________________________________ [71]Table of Contents Risks Associated With The Corporation’s Common Stock The Corporation’s Stock Price Can Be Volatile Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive |
| The Corporation’s stock price can fluctuate significantly in response to a variety of factors including, among other things: • Actual or anticipated variations in quarterly results of operations |
| • Recommendations by securities analysts |
| • Operating and stock price performance of other companies that investors deem comparable to the Corporation |
| • News reports relating to trends, concerns and other issues in the financial services industry |
| • Perceptions in the marketplace regarding the Corporation and/or its competitors |
| • New technology used, or services offered, by competitors |
| • Significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving the Corporation or its competitors |
| • Failure to integrate acquisitions or realize anticipated benefits from acquisitions |
| • Changes in government regulations |
| • Geopolitical conditions such as acts or threats of terrorism or military conflicts |
| General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause the Corporation’s stock price to decrease regardless of operating results |
| The Trading Volume In The Corporation’s Common Stock Is Less Than That Of Other Larger Financial Services Companies Although the Corporation’s common stock is listed for trading on the New York Stock Exchange (NYSE), the trading volume in its common stock is less than that of other larger financial services companies |
| A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Corporation’s common stock at any given time |
| This presence depends on the individual decisions of investors and general economic and market conditions over which the Corporation has no control |
| Given the lower trading volume of the Corporation’s common stock, significant sales of the Corporation’s common stock, or the expectation of these sales, could cause the Corporation’s stock price to fall |
| An Investment In The Corporation’s Common Stock Is Not An Insured Deposit The Corporation’s common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation (FDIC), any other deposit insurance fund or by any other public or private entity |
| Investment in the Corporation’s common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company |
| As a result, if you acquire the Corporation’s common stock, you may lose some or all of your investment |
| The Corporation’s Articles Of Incorporation, By-Laws and Shareholders Rights Plan As Well As Certain Banking Laws May Have An Anti-Takeover Effect Provisions of the Corporation’s articles of incorporation and by-laws, federal banking laws, including regulatory approval requirements, and the Corporation’s stock purchase rights plan could make it more 20 _________________________________________________________________ [72]Table of Contents difficult for a third party to acquire the Corporation, even if doing so would be perceived to be beneficial to the Corporation’s shareholders |
| The combination of these provisions effectively inhibits a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of the Corporation’s common stock |
| Risks Associated With The Corporation’s Industry The Earnings Of Financial Services Companies Are Significantly Affected By General Business And Economic Conditions The Corporation’s operations and profitability are impacted by general business and economic conditions in the United States and abroad |
| These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, and the strength of the US economy and the local economies in which the Corporation operates, all of which are beyond the Corporation’s control |
| A deterioration in economic conditions could result in an increase in loan delinquencies and non-performing assets, decreases in loan collateral values and a decrease in demand for the Corporation’s products and services, among other things, any of which could have a material adverse impact on the Corporation’s financial condition and results of operations |
| Financial Services Companies Depend On The Accuracy And Completeness Of Information About Customers And Counterparties In deciding whether to extend credit or enter into other transactions, the Corporation may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information |
| The Corporation may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information |
| Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations |
| Consumers May Decide Not To Use Banks To Complete Their Financial Transactions Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods |
| For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds |
| Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks |
| The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits |
| The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on the Corporation’s financial condition and results of operations |