Annual Report Lone Star National Bancshares-Texas, Inc

11 ANNUAL REPORT LONE STAR NATIONAL BANCSHARES-TEXAS, INC. Our Mission Statement The mission of Lone Star National Bank is to be the premier, independent community bank in South Texas by providing the following to our Stakeholders:

Customers: Value-added quality sales and service; Employees: Providing a rewarding work environment with opportunities for advancement; Community: Helping our communities to grow, and serving them with pride and integrity; Shareholders: Providing a high rate of return consistent with a high performing bank. 4 Letter to Shareholders, Customers & Friends 7 Financial Highlights 8 Management’s Discussion and Analysis of Financial Conditions and Results of Operations

12 Management’s Report on Responsibility for Financial Reporting

13 Independent Auditor’s Report

50 Board of Directors

52 Advisory Directors

54 Bank Officers 56 Banking Centers, Mortgage & ATM Locations 57 Our History We deeply value our personal relationship with you. We will never take it for granted.

A. Jabier Rodriguez Chief Executive Officer Le er to Our Shareholders, Customers and Friends

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

Per Share Data Shareholders’ Equity Book Value (Dollars in Millions) 07 07 $23.05 $120 08 08 $26.37 $145 09 09 $28.47 $161 10 10 $29.57 $184 11 11 $32.88 $208

4 l 2011 Annual Report these new guidelines. one dollar of revenue, improved to 62%, or $1.00 on the dollar for 2011, from The increased levels of Capital, now 63% in 2010. This compares very required, has caused bank returns to be favorably to a Peer Group Ratio of 71%. Stock Price lowered significantly. Our Return on Per Share Average Assets of .98% and Return on Net Income increased from $3.7 Million, 07 Average Equity of 11.02% for 2011, far at year-end 2010, to $21.5 Million, at $50.00 08 exceeded the Return on Average Assets year end 2011, after the net effect of the $40.00 09 of .61% and 6.16% Return on Average gain from the sale of bonds and Real $36.00 10 Equity for our Peer Group as of Decem- Estate Owned Property write-downs. This $35.50 11 ber 31, 2011. The lower volume of loans is another record level of Net Income, $37.50 creating higher levels of liquidity, toget- clearly evidencing a complete rebound her with low rates has also served to and stabilization, achieved through reduce shareholder returns. several executive initiatives implemented Total Assets by our Team. Our highest reported Net (Dollars in Millions) For the year ending December 31, 2011, Income had been $18.5 Million in 2007, 07 $1,577 Total Assets grew $92 Million to $2.2 the initial year of the most severe 08 Billion, Loans grew $28 Million to $1.3 recession in U.S. history. $1,776 09 Billion and Deposits grew $87 Million to $1,857 10 $1.8 Billion. The Board of Directors and our Team will $2,092 11 continue to work hard and create $2,184 The total number of banking centers solutions with reduced risk in order to grew to 31, including three (3) new maintain and improve our profitability centers in the Rio Grande Valley and two and Shareholder value. The Book Value Net Income (2) new centers in San Antonio, to bring of our Stock has increased every year (Dollars in ousands) the total in San Antonio to four (4) since our inception in 1983. Our vision 07 $18,489 centers, with at least two (2) more for the future is to continue expanding 08 planned for 2012. Total Assets in San our franchise in South Texas, primarily in $13,291 09 Antonio reached $73 Million, as of the Rio Grande Valley and San Antonio $9,219 10 December 31, 2011. markets. $3,711 11 $21,519 Revenue from Interest Income increased We deeply value our personal relation- from $94 Million to $98 Million and ship with you. We will never take it for Non-Interest Income increased from $18 granted. We appreciate your support and Per Share Data: Million to $28 Million, including an $8.6 look forward to working with you to Net Income-Diluted Million increase in gain from the sale of achieve our mutual success. 07 bonds, for the years ended December $3.23 08 31, 2010 to December 31, 2011. Non- $2.33 09 Interest Expense increased from $52 Yours very truly, $1.62 10 Million to $57 Million, including $3 Million $0.63 11 in write downs of foreclosed Real Estate $3.40 Owned Properties, due to falling real estate values, during this same period. A. Jabier Rodriguez Chief Executive Officer Return on Average Our efficiency ratio, the cost to produce Stockholders’ Equity 07 16.30% 08 9.82% 09 6.15% 10 2.14% Carta a Nuestros 11 Accionistas, 11.02% 5 Year Compound Clientes y Amigos Annual Growth Rate Assets 4.94% Shareholders’ Equity El sector financiero se ha recuperado compañía, medidas en los procesos de 14.52% Loans después de los cuatro (4) años más administración de riesgo en cada una de 5.91% Deposits difíciles que la industria bancaria haya nuestras decisiones. Nuestro enfoque es 3.71% experimentado. Nosotros hemos resur- de mantener el riesgo en niveles bajos a gido con más experiencia y con el com- moderados y los rendimientos a un nivel promiso de implementar, a lo largo de la de moderado a alto.

2011 Annual Report l 5 El modelo de negocios para un banco millones en capital contable y $31 en el 2011. Esto se compara favorable- regional seguro y sólido ha cambiado a millones en reservas para riesgos crediti- mente con el índice de nuestros competi- uno basado en menor medida en ingresos cios, lo cual representa un índice de dores del mismo nivel que fue del 71%. derivados por intereses de crédito y en capital propio sobre el total de activos del mayor medida en ingresos generados por 9.53% y un índice de reservas para El rendimiento neto aumentó de $3.7 tarifas y comisiones con un alto nivel de riesgos crediticios sobre el total de millones al fin del 2010 a $21.5 millones al eficiencia. Esto ha sido en parte por los préstamos del 2.48% lo cual cumple fin del 2011, después del efecto neto por efectos de la recesión y la lenta recuper- claramente con estos nuevos requisitos. la ganancia de la venta de bonos y los ación de la economía. La ley sobre la bienes raíces adjudicadas por el banco. Reforma financiera Dodd-Frank esta- Los incrementos en los niveles de capital Este es otro nivel récord de ingreso neto, blecida recientemente, ha restringido los actualmente requeridos, han causado evidenciando claramente una recuper- cargos de comisiones por los sobregiros que el rendimiento de los bancos haya ación y estabilización completa, obtenida de cuentas de cheques y tarjetas de disminuido considerablemente. Nuestras a través de varias iniciativas ejecutivas débito, causando que los bancos reduz- tasas de rentabilidad con respecto al implementadas por nuestro equipo. Nues- can el pago de aquellos cheques sin promedio de los activos fue del .98% y el tro mayor rendimiento reportado había fondos, impactando de manera negativa rendimiento sobre el promedio del capital sido de $18.5 millones en el 2007, el año el ingreso por comisiones. La ley de propio fue del 11.02% en el 2011, siendo en que inicio la recesión más severa en la Reforma financiera Dodd-Frank también superiores a los rendimiento de nuestros historia de los Estados Unidos. ha cambiado virtualmente todos los competidores del mismo nivel que fueron reglamentos correspondientes al consu- del .6% y el 6.16%, respectivamente al La mesa directiva y nuestro equipo midor, relacionados o no con las hipote- 31 de diciembre del 2011. La disminución continuarán trabajando arduamente en la cas. Solo el tiempo nos dirá si ésta ley, a en el volumen de créditos ha creado creación de soluciones innovadoras de través de la creación de la “Agencia de mayores niveles de liquidez que aunado a bajo riesgo para poder mantener y Protección Financiera al Consumidor” las bajas tasas de interés han contribuido mejorar nuestra rentabilidad y el valor de tendrá algún valor para los consumi- a la reducción en el rendimiento a los las participaciones de nuestros accionis- dores, sin embargo, tendrán que pasar accionistas. tas. El valor contable de nuestras ac- de una (1) a dos (2) generaciones para ciones ha aumentado cada año desde su determinar este impacto. Lo único que sí A diciembre 31 del 2011, el total de los inicio en 1983. Nuestra visión para el sabemos es que ésta no podría prevenir activos aumentó en $92 millones para futuro es de continuar expandiendo otra crisis financiera. llegar a la cantidad de $2.2 mil millones, nuestra franquicia en el Sur de Texas, los préstamos crecieron en $28 millones principalmente en el Valle del Rio Grande La ley de Reforma financiera Dodd-Frank alcanzando la cifra de $1.3 mil millones y y en San Antonio. ha introducido cambios profundos en la los depósitos aumentaron $87 millones forma en que el gobierno regula a la logrando llegar a $1.8 mil millones. Valoramos profúndame nuestra relación industria financiera. El aumento en la personal con ustedes, misma que nunca supervisión incluye un aumento en los El número total de sucursales aumentó a subestimaremos. Agradecemos su apoyo niveles de capital y reservas para riesgos 31, incluyendo tres (3) nuevas sucursales y esperamos trabajar con ustedes para crediticios para cumplir con los requisitos en el Valle del Rio Grande y dos (2) más lograr un éxito mutuo. regulatorios. El índice de capital para los en San Antonio, lo cúal hace un total de bancos ha aumentado de un 6% a un cuatro (4) sucursales en San Antonio, con Atentamente, índice general de 9.5%. Las reservas de al menos dos (2) nuevas sucursales pro- riesgos crediticios se han incrementado del gramadas para el 2012. Al 31 de diciem- 1% a un índice general del 2.5%. Estos bre del 2011, el total de activos en San nuevos niveles han dado como resultado Antonio alcanzó los $73 millones. A. Jabier Rodriguez un incremento del capital y reservas para Director General riesgos crediticios con un total para Lone Los ingresos por intereses devengados Star National Bank de $96.5 millones de aumentaron de $94 millones a $98 Valor Contable por Accion dólares. Como se ve a continuación. millones, y los ingresos por otros concep- 07 $23.05 tos aumentaron de $18 millones a $28 08 Capital: 6% al 9.5% = +3.5% millones, incluyendo un aumento de $8.6 $26.37 09 Provisiones: 1% al 2.5% = +1.5% millones en ganancias por la venta de $28.47 10 bonos correspondientes a los años 2010 $29.57 Total de Activos: y 2011. Los gastos operativos aumen- 11 $2.2 Mil millones x 3.5% = $32.88 taron de $52 millones a $57 millones, $77.0 millones incluyendo $3 millones en gastos relacio- Participaciones de Total de Préstamos: nados con propiedades de bienes raíces los Accionistas $1.3 Mil millones x 1.5% = adjudicadas al banco, debido a la caída (En Millones) $19.5 millones de los valores de los bienes raíces 07 $120 Aumento Total de Capital Requerido: durante este mismo periodo. 08 $145 $96.5 millones 09 Nuestro índice de eficiencia, el costo de $161 10 Al 31 de diciembre del 2011, Lone Star producir un dólar de ingresos, mejoró de $184 11 Bancshares-Texas, Inc. cuenta con $208 un 63% de un $1.00 en el 2010 a un 62% $208

6 l 2011 Annual Report Financial Highlights (Dollars in ousands, Except Per Share Data)

For the Year 2011 2010 Change %Change Net income $ 21,519 $ 3,711 $ 17,808 479.87% Return on average assets 0.98% 0.19% 0.79% 415.79% Return on average shareholders’equity 11.02% 2.14% 8.87% 414.49% Net interest margin 3.58% 3.67% -0.09% -2.45% Efficiency ratio 62.36% 63.47% -1.11% -1.75% Per share data: Net income - basic $ 3.41 $ 0.64 $ 2.77 432.81% Net income - diluted $ 3.40 $ 0.63 $ 2.77 439.68% Dividends declared - - - Book value at end of period $ 32.88 $ 29.57 $ 3.30 11.16% Weighted average shares outstanding (in thousands) - Basic 6,317 5,823 494 8.48% - Diluted 6,332 5,902 430 7.29% Shares outstanding at end of period 6,331 6,226 105 1.69% (in thousands)

Capital Ratios Tier 1 risk-based capital ratio 18.26% 16.12% 2.14% 13.28% Total risk-based capital ratio 19.53% 17.38% 2.15% 12.37% Leverage capital ratio 10.48% 10.00% 0.48% 4.80% Shareholders' equity to total assets 9.53% 8.80% 0.73% 8.30%

Balance Sheet Data Total assets $ 2,184,155 $ 2,091,672 $ 92,483 4.42% Loans 1,255,657 1,227,398 28,259 2.30% Allowance for loan losses 31,112 25,262 5,850 23.16% Investment securities 466,981 661,329 (194,348) -29.39% Deposits 1,805,942 1,718,509 87,433 5.09% Shareholders’ equity 208,129 184,109 24,020 13.05%

Asset Quality Ratios Allowance for Loan Losses to Loans 2.48% 2.06% 0.42% 20.39% Net Loan Charge-offs $ 5,250 $ 23,489 $ (18,239) -77.65% Net Loan Charge-offs to Average Loans 0.43% 1.95% -1.52% -77.95% Nonperforming Assets to Loans and 6.45% 7.37% -0.91% -12.35% Repossessed Assets Allowance for Loan Losses to 37.07% 26.90% 10.17% 37.81% Nonperforming Assets Provision for Loan Loss to Net 211.43% 113.46% 97.97% 86.29% Loan Charge-offs

Return on E ciency Per Share Data Average Assets Ratio Book Value 07 07 07 1.15% 53.57% $23.05 08 08 08 0.80% 57.73% $26.37 09 09 09 0.52% 64.14% $28.47 10 10 10 0.19% 63.47% $29.57 11 11 11 0.98% 62.36% $32.88

2011 Annual Report l 7 and the proceeds were deposited into corre- each of these areas is a primary objective. loan losses has continually been enhanced to spondent banks in interest bearing accounts. Policies and procedures are developed to 2.48% of total loans at year end. ensure that loan commitments conform to Investment Securities: Total investment Management regularly reviews and monitors current strategies and guidelines. Manage- securities (available for sale and held to the loan portfolio to identify borrowers Management’s Discussion ment continues to refine the Company’s maturity) of $467.0 million at December 31, experiencing financial difficulties. Manage- credit policies and procedures to address 2011 decreased $194.3 million or 29.4% ment believes that at December 31, 2011 all risks in the current and prospective environ- compared to $661.3 million at December 31, such loans have been identified and included and Analysis of Financial ment and to reflect management’s current 2010. The mix of investment securities during in the nonaccrual, restructured or 90 days strategic focus. The credit process is contro- 2011 was changed to fortify the balance past due loan totals. Management continues lled with continuous credit review and analy- Condition and Results sheet by reducing its investment 30 year to emphasize maintaining a low level of non- sis, as well as reviewed by internal and mortgage-backed securities and shortening performing assets and returning nonperform- external auditors and regulatory authorities. the overall duration of the investment port- ing assets to an earning status. The Company’s loans are widely diversified by of Operations folio. Another strategic move included selling borrower and industry group. Allowance for Loan Losses: The allowance all private-label collateralized mortgage- for loan losses at December 31, 2011 of backed securities that were classified as The Company has lending policies in effect so The following discussion addresses informa- decision making. At December 31, 2011, the efficiency ratio equates to the cost of record- $31.1 million increased $5.9 million or 23.2% other-than-temporary impairment bonds. that lending of all types is approached, to the tion pertaining to the financial condition and Company had total assets of $2.2 billion, ing one dollar’s worth of revenue. The compared to $25.3 million at December 31, The rationale for selling the investment extent possible, including low-to-moderate results of operation of Lone Star National loans of $1.3 billion, deposits of $1.8 billion Company’s efficiency ratio remains very 2010. The allowance for loan losses at securities was due to anticipation of a future income neighborhoods and small business, on Bancshares-Texas, Inc. and subsidiaries (the and shareholders’ equity of $208.1 million. favorable when compared to the peer group December 31, 2011 was 2.48% of loans out- raising rate environment. This led to the a basis consistent with safe and sound “Company”) that may not be otherwise ratings of 71.2% for similar size bank holding standing, net of unearned discount. The Company’s primary goal is to provide a standards. Stress testing is utilized to take apparent from a review of the audited companies in the United States of America. desire to manage the possible unrealized higher quality service for its customers in the into consideration the potentially adverse Management analyzes the loan portfolio to consolidated financial statements and related losses (as a result of a rising rate environ- South Texas market by providing personal economic conditions under which liquidation determine the adequacy of the allowance for footnotes. It should be read in conjunction Analysis of Financial Condition ment) and to manage and thereby sell any service, relationship banking and innovative of the loan could occur. Generally, collateral loan losses and the appropriate provision with those statements as well as other Overview: The Rio Grande Valley economy is bond that was experiencing acceleration of technological solutions. In order to broaden accepted to secure the commercial loan required to maintain an adequate allowance. information presented throughout the report. improving slightly as reflected in a net growth prepayments due to refinancing of individual the customer base, primarily through portfolio is real estate, accounts receivable, In assessing the appropriateness of the allow- In addition to historical information, this in the labor market and an increase in mortgages within said investment securities. expanding the Company’s network of full- inventory, marketable securities and equip- ance, management reviews the size, quality discussion and other sections contained in commercial building permits. This is partially The fixed-rate mortgage-backed securities service banking offices, the Company opened ment. Autos, deeds of trust, life insurance and risks of loans in the portfolio and consid- this Annual Report include certain forward- offset by declines in residential building and collateralized mortgage obligations tota- five new banking centers during 2011 with and marketable securities are accepted as ers factors such as specific known risks, past looking statements regarding events and permits, airline boarding and vehicle and ling $394.0 million at December 31, 2011 three in the Rio Grande Valley: McAllen, Rio collateral for the installment loan portfolio. experience, the status and amount of nonper- trends which may affect the Company’s pedestrian bridge crossings to Mexico for reflects a decrease of $216.9 million when Grande City and Weslaco; and two in San forming assets and economic conditions. The future results. Such statements are subject to 2011 compared to 2010. The economy of the compared to $610.9 million at December 31, The Company’s policy on maturity extensions Antonio. Management constantly monitors allowance for loan losses is comprised of risk and uncertainties that could cause the Rio Grande Valley is based principally on 2010. and rollovers is based on management’s profitability of all banking centers in the three elements which include: 1) allowances retailing (including trade with Mexico), gove- assessment of individual loans. Approvals for Company’s actual results to differ materially. franchise and as such, a decision was made to Loans: Year 2011 has proven to be another rnment, agriculture, tourism, manufacturing, established on specific loans, 2) allowances Such factors include, but are not limited to, challenging year for the Company with the the extension or renewal of loans without close the Mercedes Mall banking center based on loss experience and trends in pools health care and education. The Company has reduction of principal for more than one those described in this discussion and during 2011. The Board of Directors is U.S. economy in recovery mode, reflecting expanded into the San Antonio area with four of or loans with similar characteristics and 3) analysis. modest expansion. The national and local twelve-month period are generally avoided, continuing its efforts to expand our banking unallocated allowances based on general banking centers operational in 2011 and a unless the loans are fully secured and prop- organization into the San Antonio market. economic growth was facing three headwinds The Company is a privately held bank holding fifth location to be operational in mid-2012. economic conditions and other internal and of unemployment, housing and government erly margined by cash or marketable secur- company headquartered in McAllen, Texas, The Company’s profitability is dependent on Additional locations in San Antonio are being external risk factors in our market. Loans debt. These headwinds continue to affect len- ities, or are revolving lines subject to annual offering a broad array of financial services managing interest rate spreads, other operat- selected for future banking centers. During identified as losses are charged off. In addi- ding as business owners have deleveraged analysis and renewal. through its wholly-owned banking subsidiary, ing income and expenses, and credit risk. Net 2011, San Antonio was ranked #1 Best- tion, the loan review committee of the and remained cautious about putting capital Nonperforming Assets: The Company has Company reviews the assessments of mana- Lone Star National Bank (the “Bank”). The interest income is the largest component of Performing Metropolitan Area in the United to work. Loans held for sale and held for procedures in place to assist in maintaining gement in determining the adequacy of the Bank operates from thirty-one banking revenue for the Company. The Company States per the Milken Institute, December investment of $1.26 billion at December 31, the overall quality of its loan portfolio. The Company’s allowance for loan losses. Based locations: twenty-seven (27) banking centers manages interest rate risks through a funds 2011, “Best- Performing Cities 2011.” 2011 increased $28.3 million or 2.3% compa- Company has established underwriting guide- in the Rio Grande Valley and four (4) banking management strategy which involves offering on total allocations, the provision is recorded Total assets of $2.2 billion at December 31, red to $1.23 billion at December 31, 2010. At lines to be followed by its officers and centers in San Antonio, Texas. The Bank deposit and/or loan structures that tend to to maintain the allowance at a level deemed 2011 increased $92.5 million or 4.4% comp- December 31, 2011, the loan portfolio consi- monitors its delinquency levels for any nega- engages in a wide range of commercial and counter the natural rate risk profile of the appropriate by management. While manage- ared to $2.1 billion at December 31, 2010. sted primarily of $3.5 million of real estate tive or adverse trends, particularly with resp- personal banking activities including the Company. The Company addresses loan and ment uses available information to recognize Total deposits of $1.8 billion at December 31, loans held for sale, $220.5 million of commer- ect to credits which have total exposures of usual acceptance of deposits for checking, deposit pricing, the asset and liability mix and losses on loans, there can be no assurance 2011 increased $87.4 million or 5.1% com- cial loans, $1.7 million of agriculture loans, $10,000 or more. savings and time deposit accounts; extension interest rate sensitivity on a periodic basis. that future additions to the allowance will not pared to $1.7 billion at December 31, 2010. $938.6 million of real estate loans and $88.0 of secured and unsecured loans to corpora- Yields on earning assets and rates paid on Nonperforming assets consist of nonaccrual be necessary. Future adjustments could be million of consumer and other loans. These tions, individuals and others; issuance of interest-bearing deposits within the Company Due from Banks-interest bearing: Due loans, loans for which the interest rate has necessary to the allowance for loan losses if loans were primarily originated within our letters of credit; rental of safe deposit boxes; declined during 2011. Through managem- from banks-interest bearing accounts of been renegotiated below originally contracted circumstances or economic conditions differ market area of the Rio Grande Valley and San brokerage services and insurance services. ent’s efforts, the net interest margin of $340.3 million at December 31, 2011 incre- rates and real estate or other assets that substantially from the assumptions used in Antonio, Texas and are generally secured by The Bank’s lending services include commer- 3.58% reflects a slight decline when com- ased $260.5 million or 326.6% compared to have been acquired in partial or full satisfac- making the initial determinations. The mod- residential or commercial real estate or cial, industrial, real estate, installment and pared to the net interest margin of 3.67% for $79.8 million at December 31, 2010. These tion of loan obligations. At December 31, est expansion in the national, state and local business or personal property. Despite the credit card loans and participation in loans 2010. The Company manages its credit risk funds represent excess funds deposited with 2011, nonperforming assets totaled $87.1 economy, as well as the high employment unprecedented contraction in the credit with other banks. The members of the Bank’s by establishing underwriting guidelines, whi- correspondent banks in interest bearing million or 6.5% of loans plus repossessed rates have resulted in increased levels of markets, we continued to lend to credit- management team have significant experi- ch address the characteristics of borrowers, accounts, primarily the Federal Reserve Bank. assets. Management has added seasoned nonperforming assets, increased loan loss worthy customers. ence and contacts from their service at the industries, geographic locations and risk Management’s strategy for 2011 was to personnel to assist in turning nonperforming provisions and reductions to income. Addit- Bank and their prior service with other succ- products. The credit process is controlled by fortify the balance sheet by reducing its The Company manages credit risk by assets into performing assets. Management ionally, as an internal part of the examination essful community banks that have operated continuous review and credit analysis. The investment 30 year mortgage-backed secu- establishing and implementing strategies and believes that it is unlikely that any material process, bank regulatory agencies periodi- in the same market. The Bank seeks to Company evaluates its management of oper- rities and shorten the overall duration of the guidelines appropriate to the characteristics loss will be incurred on disposition of the cally review our allowance for loan losses. provide its products and services through a ating expenses through the efficiency ratio, investment portfolio. As a result of this stra- of borrowers, industries, geographic locations collateral even though the volume of loan The banking regulatory agencies could requ- high quality experienced staff and local which is approximately 62.4% for 2011. The tegy, U.S. Government securities were sold and products. Diversification of risk within losses has increased, while the allowance for ire the recognition of additions to our loan

8 l 2011 Annual Report

loss allowance based on their judgment of pricing. The Company’s management belie- ings. In addition to these interest-bearing attributable to net charge-offs of $5.3 million, Other non-interest income for 2011 of $3.8 Legal and profession expense of $2.6 million information available to them at the time of ves that additional funds, if needed, can be funds, assets are also supported by interest- loan growth of $28.3 million, and an amount million increased $676,000 or 21.3% comp- for 2011 increased $484,000 or 22.9% their examination. attracted and deposit growth can be acceler- free funds, primarily demand deposits and to maintain the allowance for loan losses at a ared to $3.2 million for the prior year. The compared to $2.1 million for the prior year. ated through deposit pricing as the Company shareholder’s equity. Variations in the volume level deemed appropriate by management increase in other noninterest income is prim- The net increase in legal and professional Premises and Equipment: Premises and experiences increased loan demand or other and mix of assets and liabilities and their based on various factors discussed in the arily attributable to $569,000 increase in expense is primarily due to the added legal equipment of $64.5 million at December 31, liquidity needs. relative sensitivity to interest rate move- “Allowance for Loan Loss” section of this brokerage gross commissions, partially offset fees for loan related collections. 2011 increased $8.9 million or 16.0% comp- ments determine changes in net interest Report. by a decrease of $95,000 in gain on sale of ared to $55.6 million at December 31, 2010. Capital Resources: Shareholders’ equity of Advertising expense of $1.5 million for 2011 income. loans held for sale. The net increase in premises and equipment $208.1 million at December 31, 2011 signi- Non-interest Income: Non-interest income decreased $162,000 or 9.8% compared to for 2011 is primarily attributable to the ficantly increased $24.0 million or 13.1% Net interest income of $72.8 million for 2011, for 2011 of $27.9 million increased $10.0 Non-interest Expense: Non-interest expe- $1.7 million for the prior year. The net dec- addition of five new banking centers, inclu- compared to $184.1 million at December 31, reflects an increase of $6.6 million or 10.0% million or 55.6% compared to $17.9 million nse for 2011 of $56.8 million increased $5.0 rease is primarily attributable to television ding equipment, with three new banking 2010. The increase was primarily attributable compared to the prior year of $66.2 million. for prior year. The net increase in non-interest million or 9.8% compared to $51.7 million for and radio production (down $181,000). The centers in the Rio Grande Valley and two new to earnings of $21.5. Shareholders’ equity as The increase in net interest income was income for 2011 as compared to the prior prior year. The increase in non-interest expe- marketing focus is to continue to promote the banking centers in the San Antonio, Texas a percentage of total year-end assets was primarily attributable to management’s effo- year was primarily attributable to increases nse was primarily attributable to increased bank in the communities that we serve and to market and a second data center. 9.5% in 2011 and 8.8% in 2010. rts to control the cost of funds and build reflected in: gain on securities, other service employee compensation, net occupancy and promote product awareness. noninterest-bearing deposits. charges and fee income, and other non- equipment expenses, employee benefits, oth- Other Real Estate Owned: Other real Bank holding companies are required to The other real estate owned net expense of interest income partially offset by decreases er real estate owned, net expense, advertis- estate owned (“OREO”) of $44.7 million at maintain capital ratios in accordance with The net yield on total interest-earning assets, $4.3 million for 2011 increased $2.5 million guidelines adopted by the Federal Reserve in service charges on deposit accounts and ing expense and business development exp- December 31, 2011 decreased $2.3 million or also referred to as net interest margin, repre- or 136.2% compared to $1.8 million for the Board. The guidelines are commonly known real estate package fee income. ense, partially offset by a decrease in FDIC 4.9% compared to $47.0 million at December sents net interest income, on a tax equivalent prior year. This category includes direct exp- as Risk-Based Capital Guidelines. The mini- insurance premiums. 31, 2010. OREO assets represent property basis, divided by average interest-earning Service charges on deposit accounts for 2011 enses for foreclosed real estate including mum Total Risk-Based Capital, Tier 1 Risk- acquired as the result of borrower defaults on assets. Since a significant portion of the of $6.2 million decrease $522,000 or 7.8% The largest category of non-interest expense, property taxes, maintenance costs, write- Based Capital, and Tier 1 Leverage Capital downs, less rent income and net gains on the loans. Management actively manages the Company’s funding is derived from interest- compared to $6.7 million for the prior year. personnel expense of $27.7 million, which is ratios are 8.0%, 4.0% and 4.0%, respec- The net decrease for the year was attribut- sale of properties. The net increase in exp- OREO and records the value of each OREO at free sources, primarily demand deposits and comprised of employee compensation of tively. At December 31, 2011, the Company’s able to an $804,000 decrease in non- enses for 2011 compared to the prior year is either the lower of the fair market value less shareholders’ equity, the effective rate paid $22.8 million and employee benefits of $4.9 Total Risk-Based Capital, Tier 1 Risk-Based sufficient check income more commonly primarily attributable to write-downs of $2.8 estimated selling costs or at the cost of the for all funds is lower than the rate paid on million for 2011 increased $2.5 million or Capital and Tier 1 Leverage Capital ratios are referred to as overdraft charges. million reflecting a net increase of $2.5 mi- asset. Write-downs occurring at foreclosure interest-bearing liabilities alone. The net 10.0% compared to $25.2 million for the 19.53%, 18.26% and 10.48%, respectively. llion when compared to the prior year. are charged against the allowance for poss- interest margin of 3.58% for 2011 decreased Other service charge and fee income for 2011 prior year. Personnel expense increase was ible loan losses. On an ongoing basis, OREO is At December 31, 2011, the Company and the 9 basis points compared to 3.67% for the of $6.2 million increased $1.3 million or primarily a result of increases in headcount Business development of $702,000 for 2011 appraised as required by market indications Bank met the criteria for classification as a prior year. The Company continued to expe- 25.3% as compared to $5.0 million for the and increases in commissions and incentive decreased $237,000 or 25.2% compared to and applicable regulations. Any further write- “well-capitalized” institution under the pro- rience intense market competition for both prior year. The net increase in other service pay related to performance metrics. $939,000 for the prior year. The net decrease mpt corrective action rules promulgated loans and deposits during 2011. The yield on charge and fee income for 2011 was primarily is primarily attributable to a promotional pro- downs as a result of subsequent declines in Net occupancy and equipment expense of under the Federal Deposit Insurance Act. interest-earning assets of 4.84% for 2011 attributable to debit card interchange fee inc- gram designed to increase customer debit value are included in other noninterest exp- $8.0 million for 2011 increased $485,000 or Designation as a well-capitalized institution decreased 34 basis points compared to ome, international fees and merchant serv- card usage thereby increasing the Company’s ense along with other expenses related to 6.5% compared to $7.5 million for the prior under these regulations does not constitute a 5.18% for the prior year. The yield on ices income. Debit card interchange fee inco- debit card interchange fee income. See dis- maintaining the properties. year. The net increase in net occupancy and recommendation or endorsement of the Com- interest-bearing liabilities of 1.49% for 2011 me of $3.3 million for 2011 increasing cussion on “Other service charge and fee in- equipment expense for 2011 is primarily Deposits: Deposits at December 31, 2011 of pany or the Bank by federal bank regulators. decreased 29 basis points compared to $683,000 or 25.9% compared to $2.6 million come” above concerning increased debit card attributable to the addition of five new bank- $1.8 billion increased $87.4 million or 5.1% 1.78% for the prior year. for the prior year. The increase in debit card interchange fee income. The promotional Analysis of Results of Operations ing centers and a second data center which compared to $1.7 billion at December 31, fee income is attributable to management’s program rewards customers with redeemable Earnings Summary: Net income for 2011 Provision for Loan Losses: The amount of reflects a net increase in depreciation 2010. At December 31, 2011, noninterest- continuing efforts to increase the volume of points which are paid for by the Company. was $21.5 million or $3.40 per fully diluted provision for loan losses is based on periodic expense for property and equipment (up bearing deposits were 15.0% of total deposits debit card business. International fee income Total expenses for this program for 2011 of share, reflecting an increase of $17.8 million (not less than quarterly) evaluations of the and reflect of source of low cost funds for the of $721,000 for 2011 increasing $173,000 or $452,000), net building lease expenses (up $321,000 reflects a net decrease of $111,000 or $2.77 per fully diluted share, compared to loan portfolio, especially nonperforming and Company. Deposits are the Company’s prim- 31.7% compared to $547,000 for the prior $302,000), equipment lease expenses (down or 25.7% compared to the prior year. the net income of $3.7 million or $0.63 per other potential problem loans. During these ary source of funds. The Company offers a year and was attributable to an increase $67,000), utility expense (up $33,000), ins- fully diluted share for the year 2010. Earnings evaluations, management considers various Federal and State Income Taxes: Federal variety of products designed to attract and volume of business. Merchant services inco- urance expense (up $39,000), repairs and performance for 2011 as compared to the factors. For additional information concerning and state income taxes of $11.3 million for retain deposit customers, such as: checking me of $279,000 for 2011 increased $175,000 maintenance expense (down $413,000), ad prior year reflects an increase in net interest the factors in these evaluations, see the “Allo- the year 2011 increased $9.3 million comp- accounts, regular savings deposits, NOW acc- or 167.8% compared to $104,000 for the valorem taxes (up $125,000) and security income and noninterest income, a substantial wance for Loan Losses” section of this Report. ared to $2.0 million for the prior year. The ounts, money market accounts, select cert- prior year and was attributable to an (up $13,000). decrease in the provision for loan losses, increase in federal and state income taxes is ificates of deposit savings, an interest- The provision for loan losses is charged to increased volume of business. partially offset by increases in noninterest FDIC insurance expense of $2.2 million for attributable to an increased level of pretax bearing club account and certificates of earnings to bring the allowance for loan expense and income tax expense. A more Real estate package fee income for 2011 of 2011 decreased $479,000 or 17.7% comp- income during 2011. deposits. Deposits are obtained primarily losses to a level deemed appropriate by detailed description of the results of oper- ared to $2.7 million for the prior year. The net from individuals, partnerships and corpora- $279,000 decreased $19,000 or 6.4% comp- Net Income: Net income for 2011 was $21.5 ations is included in the material that follows. management based on factors such as ared to $298,000 for the prior year. The decrease in FDIC insurance expense for 2011 million or $3.40 per fully diluted share, refle- tions in our market areas. In addition, we historical experience, the volume and type of obtain deposits from state and local public decrease was primarily attributable to a compared to the prior year is primarily att- cting an increase of $17.8 million or $2.77 Net Interest Income: Net interest income lending conducted by the Company, the entities, commonly referred to as public fund decline in volume of business conducted. ributable to a change in the calculation of the per fully diluted share, compared to the net represents the largest source of income for amount of nonperforming assets, regulatory deposits. The Company’s policies also permit insurance being based on total assets versus income of $3.7 million or $0.63 per fully the Company. Net interest income is the policies, generally accepted accounting prin- Gain on securities for 2011 of $11.4 million the acceptance of brokered deposits. Gene- deposits. diluted share for the prior year. difference between interest earned on assets ciples, general economic conditions, particu- increased $8.6 million or 306.5% compared rally, both brokered certificates of deposit and and interest expense incurred for the funds larly as they relate to the Company’s lending to $2.8 million for the prior year. Gain on Data processing expense of $4.2 million for public funds are less expensive than retail supporting those assets. The largest category area, and other factors related to the collect- securities for year 2011 was partially decre- 2011 increased $554,000 or 15.2% comp- deposits and are easily managed. of earning assets consists of loans. The ibility of the Company’s loan portfolio. The ased by the $1.7 million loss on the sale of all ared to $3.6 million for the prior year. The net second largest category of earning assets is The interest rates paid are competitively provision for loan losses for the year 2011 of private-label collateralized mortgage-backed increase in data processing expense is pri- investments, followed by due from banks priced for each particular deposit product and $11.1 million compares very favorably to the securities bonds. For additional information marily due to the added expense of a second interest bearing. structured to meet our funding requirements. $26.7 million provision for loan losses for the concerning the factors in managing the inves- data center, which was operational June 2011 The Company’s management will continue to Earning assets are funded by consumer and prior year. The $11.1 million provision for tment portfolio, see the “Investment Secu- and volume of business conducted by the manage interest expense through deposit commercial deposits and short-term borrow- loan losses for year 2011 was primarily rities” section of this Report. Company. and the proceeds were deposited into corre- each of these areas is a primary objective. loan losses has continually been enhanced to spondent banks in interest bearing accounts. Policies and procedures are developed to 2.48% of total loans at year end. ensure that loan commitments conform to Investment Securities: Total investment Management regularly reviews and monitors current strategies and guidelines. Manage- securities (available for sale and held to the loan portfolio to identify borrowers ment continues to refine the Company’s maturity) of $467.0 million at December 31, experiencing financial difficulties. Manage- credit policies and procedures to address 2011 decreased $194.3 million or 29.4% ment believes that at December 31, 2011 all risks in the current and prospective environ- compared to $661.3 million at December 31, such loans have been identified and included ment and to reflect management’s current 2010. The mix of investment securities during in the nonaccrual, restructured or 90 days strategic focus. The credit process is contro- 2011 was changed to fortify the balance past due loan totals. Management continues lled with continuous credit review and analy- sheet by reducing its investment 30 year to emphasize maintaining a low level of non- sis, as well as reviewed by internal and mortgage-backed securities and shortening performing assets and returning nonperform- external auditors and regulatory authorities. the overall duration of the investment port- ing assets to an earning status. The Company’s loans are widely diversified by folio. Another strategic move included selling borrower and industry group. Allowance for Loan Losses: The allowance all private-label collateralized mortgage- for loan losses at December 31, 2011 of backed securities that were classified as The Company has lending policies in effect so The following discussion addresses informa- decision making. At December 31, 2011, the efficiency ratio equates to the cost of record- $31.1 million increased $5.9 million or 23.2% other-than-temporary impairment bonds. that lending of all types is approached, to the tion pertaining to the financial condition and Company had total assets of $2.2 billion, ing one dollar’s worth of revenue. The compared to $25.3 million at December 31, The rationale for selling the investment extent possible, including low-to-moderate results of operation of Lone Star National loans of $1.3 billion, deposits of $1.8 billion Company’s efficiency ratio remains very 2010. The allowance for loan losses at securities was due to anticipation of a future income neighborhoods and small business, on Bancshares-Texas, Inc. and subsidiaries (the and shareholders’ equity of $208.1 million. favorable when compared to the peer group December 31, 2011 was 2.48% of loans out- raising rate environment. This led to the a basis consistent with safe and sound “Company”) that may not be otherwise ratings of 71.2% for similar size bank holding standing, net of unearned discount. The Company’s primary goal is to provide a standards. Stress testing is utilized to take apparent from a review of the audited companies in the United States of America. desire to manage the possible unrealized higher quality service for its customers in the into consideration the potentially adverse Management analyzes the loan portfolio to consolidated financial statements and related losses (as a result of a rising rate environ- South Texas market by providing personal economic conditions under which liquidation determine the adequacy of the allowance for footnotes. It should be read in conjunction Analysis of Financial Condition ment) and to manage and thereby sell any service, relationship banking and innovative of the loan could occur. Generally, collateral loan losses and the appropriate provision with those statements as well as other Overview: The Rio Grande Valley economy is bond that was experiencing acceleration of technological solutions. In order to broaden accepted to secure the commercial loan required to maintain an adequate allowance. information presented throughout the report. improving slightly as reflected in a net growth prepayments due to refinancing of individual the customer base, primarily through portfolio is real estate, accounts receivable, In assessing the appropriateness of the allow- In addition to historical information, this in the labor market and an increase in mortgages within said investment securities. expanding the Company’s network of full- inventory, marketable securities and equip- ance, management reviews the size, quality discussion and other sections contained in commercial building permits. This is partially The fixed-rate mortgage-backed securities service banking offices, the Company opened ment. Autos, deeds of trust, life insurance and risks of loans in the portfolio and consid- this Annual Report include certain forward- offset by declines in residential building and collateralized mortgage obligations tota- five new banking centers during 2011 with and marketable securities are accepted as ers factors such as specific known risks, past looking statements regarding events and permits, airline boarding and vehicle and ling $394.0 million at December 31, 2011 three in the Rio Grande Valley: McAllen, Rio collateral for the installment loan portfolio. experience, the status and amount of nonper- trends which may affect the Company’s pedestrian bridge crossings to Mexico for reflects a decrease of $216.9 million when Grande City and Weslaco; and two in San forming assets and economic conditions. The future results. Such statements are subject to 2011 compared to 2010. The economy of the compared to $610.9 million at December 31, The Company’s policy on maturity extensions Antonio. Management constantly monitors allowance for loan losses is comprised of risk and uncertainties that could cause the Rio Grande Valley is based principally on 2010. and rollovers is based on management’s profitability of all banking centers in the three elements which include: 1) allowances retailing (including trade with Mexico), gove- assessment of individual loans. Approvals for Company’s actual results to differ materially. franchise and as such, a decision was made to Loans: Year 2011 has proven to be another rnment, agriculture, tourism, manufacturing, established on specific loans, 2) allowances Such factors include, but are not limited to, challenging year for the Company with the the extension or renewal of loans without close the Mercedes Mall banking center based on loss experience and trends in pools health care and education. The Company has reduction of principal for more than one those described in this discussion and during 2011. The Board of Directors is U.S. economy in recovery mode, reflecting expanded into the San Antonio area with four of or loans with similar characteristics and 3) analysis. modest expansion. The national and local twelve-month period are generally avoided, continuing its efforts to expand our banking unallocated allowances based on general banking centers operational in 2011 and a unless the loans are fully secured and prop- organization into the San Antonio market. economic growth was facing three headwinds The Company is a privately held bank holding fifth location to be operational in mid-2012. economic conditions and other internal and of unemployment, housing and government erly margined by cash or marketable secur- company headquartered in McAllen, Texas, The Company’s profitability is dependent on Additional locations in San Antonio are being external risk factors in our market. Loans debt. These headwinds continue to affect len- ities, or are revolving lines subject to annual offering a broad array of financial services managing interest rate spreads, other operat- selected for future banking centers. During identified as losses are charged off. In addi- ding as business owners have deleveraged analysis and renewal. through its wholly-owned banking subsidiary, ing income and expenses, and credit risk. Net 2011, San Antonio was ranked #1 Best- tion, the loan review committee of the and remained cautious about putting capital Nonperforming Assets: The Company has Company reviews the assessments of mana- Lone Star National Bank (the “Bank”). The interest income is the largest component of Performing Metropolitan Area in the United to work. Loans held for sale and held for procedures in place to assist in maintaining gement in determining the adequacy of the Bank operates from thirty-one banking revenue for the Company. The Company States per the Milken Institute, December investment of $1.26 billion at December 31, the overall quality of its loan portfolio. The Company’s allowance for loan losses. Based locations: twenty-seven (27) banking centers manages interest rate risks through a funds 2011, “Best- Performing Cities 2011.” 2011 increased $28.3 million or 2.3% compa- Company has established underwriting guide- in the Rio Grande Valley and four (4) banking management strategy which involves offering on total allocations, the provision is recorded Total assets of $2.2 billion at December 31, red to $1.23 billion at December 31, 2010. At lines to be followed by its officers and centers in San Antonio, Texas. The Bank deposit and/or loan structures that tend to to maintain the allowance at a level deemed 2011 increased $92.5 million or 4.4% comp- December 31, 2011, the loan portfolio consi- monitors its delinquency levels for any nega- engages in a wide range of commercial and counter the natural rate risk profile of the appropriate by management. While manage- ared to $2.1 billion at December 31, 2010. sted primarily of $3.5 million of real estate tive or adverse trends, particularly with resp- personal banking activities including the Company. The Company addresses loan and ment uses available information to recognize Total deposits of $1.8 billion at December 31, loans held for sale, $220.5 million of commer- ect to credits which have total exposures of usual acceptance of deposits for checking, deposit pricing, the asset and liability mix and losses on loans, there can be no assurance 2011 increased $87.4 million or 5.1% com- cial loans, $1.7 million of agriculture loans, $10,000 or more. savings and time deposit accounts; extension interest rate sensitivity on a periodic basis. that future additions to the allowance will not pared to $1.7 billion at December 31, 2010. $938.6 million of real estate loans and $88.0 of secured and unsecured loans to corpora- Yields on earning assets and rates paid on Nonperforming assets consist of nonaccrual be necessary. Future adjustments could be million of consumer and other loans. These tions, individuals and others; issuance of interest-bearing deposits within the Company Due from Banks-interest bearing: Due loans, loans for which the interest rate has necessary to the allowance for loan losses if loans were primarily originated within our letters of credit; rental of safe deposit boxes; declined during 2011. Through managem- from banks-interest bearing accounts of been renegotiated below originally contracted circumstances or economic conditions differ market area of the Rio Grande Valley and San brokerage services and insurance services. ent’s efforts, the net interest margin of $340.3 million at December 31, 2011 incre- rates and real estate or other assets that substantially from the assumptions used in Antonio, Texas and are generally secured by The Bank’s lending services include commer- 3.58% reflects a slight decline when com- ased $260.5 million or 326.6% compared to have been acquired in partial or full satisfac- making the initial determinations. The mod- residential or commercial real estate or cial, industrial, real estate, installment and pared to the net interest margin of 3.67% for $79.8 million at December 31, 2010. These tion of loan obligations. At December 31, est expansion in the national, state and local business or personal property. Despite the credit card loans and participation in loans 2010. The Company manages its credit risk funds represent excess funds deposited with 2011, nonperforming assets totaled $87.1 economy, as well as the high employment unprecedented contraction in the credit with other banks. The members of the Bank’s by establishing underwriting guidelines, whi- correspondent banks in interest bearing million or 6.5% of loans plus repossessed rates have resulted in increased levels of markets, we continued to lend to credit- management team have significant experi- ch address the characteristics of borrowers, accounts, primarily the Federal Reserve Bank. assets. Management has added seasoned nonperforming assets, increased loan loss worthy customers. ence and contacts from their service at the industries, geographic locations and risk Management’s strategy for 2011 was to personnel to assist in turning nonperforming provisions and reductions to income. Addit- Bank and their prior service with other succ- products. The credit process is controlled by fortify the balance sheet by reducing its The Company manages credit risk by assets into performing assets. Management ionally, as an internal part of the examination essful community banks that have operated continuous review and credit analysis. The investment 30 year mortgage-backed secu- establishing and implementing strategies and believes that it is unlikely that any material process, bank regulatory agencies periodi- in the same market. The Bank seeks to Company evaluates its management of oper- rities and shorten the overall duration of the guidelines appropriate to the characteristics loss will be incurred on disposition of the cally review our allowance for loan losses. provide its products and services through a ating expenses through the efficiency ratio, investment portfolio. As a result of this stra- of borrowers, industries, geographic locations collateral even though the volume of loan The banking regulatory agencies could requ- high quality experienced staff and local which is approximately 62.4% for 2011. The tegy, U.S. Government securities were sold and products. Diversification of risk within losses has increased, while the allowance for ire the recognition of additions to our loan

2011 Annual Report l 9

10 l 2011 Annual Report and the proceeds were deposited into corre- each of these areas is a primary objective. loan losses has continually been enhanced to spondent banks in interest bearing accounts. Policies and procedures are developed to 2.48% of total loans at year end. ensure that loan commitments conform to Investment Securities: Total investment Management regularly reviews and monitors current strategies and guidelines. Manage- securities (available for sale and held to the loan portfolio to identify borrowers ment continues to refine the Company’s maturity) of $467.0 million at December 31, experiencing financial difficulties. Manage- credit policies and procedures to address 2011 decreased $194.3 million or 29.4% ment believes that at December 31, 2011 all risks in the current and prospective environ- compared to $661.3 million at December 31, such loans have been identified and included ment and to reflect management’s current 2010. The mix of investment securities during in the nonaccrual, restructured or 90 days strategic focus. The credit process is contro- 2011 was changed to fortify the balance past due loan totals. Management continues lled with continuous credit review and analy- sheet by reducing its investment 30 year to emphasize maintaining a low level of non- sis, as well as reviewed by internal and mortgage-backed securities and shortening performing assets and returning nonperform- external auditors and regulatory authorities. the overall duration of the investment port- ing assets to an earning status. The Company’s loans are widely diversified by folio. Another strategic move included selling borrower and industry group. Allowance for Loan Losses: The allowance all private-label collateralized mortgage- for loan losses at December 31, 2011 of backed securities that were classified as The Company has lending policies in effect so The following discussion addresses informa- decision making. At December 31, 2011, the efficiency ratio equates to the cost of record- $31.1 million increased $5.9 million or 23.2% other-than-temporary impairment bonds. that lending of all types is approached, to the tion pertaining to the financial condition and Company had total assets of $2.2 billion, ing one dollar’s worth of revenue. The compared to $25.3 million at December 31, The rationale for selling the investment extent possible, including low-to-moderate results of operation of Lone Star National loans of $1.3 billion, deposits of $1.8 billion Company’s efficiency ratio remains very 2010. The allowance for loan losses at securities was due to anticipation of a future income neighborhoods and small business, on Bancshares-Texas, Inc. and subsidiaries (the and shareholders’ equity of $208.1 million. favorable when compared to the peer group December 31, 2011 was 2.48% of loans out- raising rate environment. This led to the a basis consistent with safe and sound “Company”) that may not be otherwise ratings of 71.2% for similar size bank holding standing, net of unearned discount. The Company’s primary goal is to provide a standards. Stress testing is utilized to take apparent from a review of the audited companies in the United States of America. desire to manage the possible unrealized higher quality service for its customers in the into consideration the potentially adverse Management analyzes the loan portfolio to consolidated financial statements and related losses (as a result of a rising rate environ- South Texas market by providing personal economic conditions under which liquidation determine the adequacy of the allowance for footnotes. It should be read in conjunction Analysis of Financial Condition ment) and to manage and thereby sell any service, relationship banking and innovative of the loan could occur. Generally, collateral loan losses and the appropriate provision with those statements as well as other Overview: The Rio Grande Valley economy is bond that was experiencing acceleration of technological solutions. In order to broaden accepted to secure the commercial loan required to maintain an adequate allowance. information presented throughout the report. improving slightly as reflected in a net growth prepayments due to refinancing of individual the customer base, primarily through portfolio is real estate, accounts receivable, In assessing the appropriateness of the allow- In addition to historical information, this in the labor market and an increase in mortgages within said investment securities. expanding the Company’s network of full- inventory, marketable securities and equip- ance, management reviews the size, quality discussion and other sections contained in commercial building permits. This is partially The fixed-rate mortgage-backed securities service banking offices, the Company opened ment. Autos, deeds of trust, life insurance and risks of loans in the portfolio and consid- this Annual Report include certain forward- offset by declines in residential building and collateralized mortgage obligations tota- five new banking centers during 2011 with and marketable securities are accepted as ers factors such as specific known risks, past looking statements regarding events and permits, airline boarding and vehicle and ling $394.0 million at December 31, 2011 three in the Rio Grande Valley: McAllen, Rio collateral for the installment loan portfolio. experience, the status and amount of nonper- trends which may affect the Company’s pedestrian bridge crossings to Mexico for reflects a decrease of $216.9 million when Grande City and Weslaco; and two in San forming assets and economic conditions. The future results. Such statements are subject to 2011 compared to 2010. The economy of the compared to $610.9 million at December 31, The Company’s policy on maturity extensions Antonio. Management constantly monitors allowance for loan losses is comprised of risk and uncertainties that could cause the Rio Grande Valley is based principally on 2010. and rollovers is based on management’s profitability of all banking centers in the three elements which include: 1) allowances retailing (including trade with Mexico), gove- assessment of individual loans. Approvals for Company’s actual results to differ materially. franchise and as such, a decision was made to Loans: Year 2011 has proven to be another rnment, agriculture, tourism, manufacturing, established on specific loans, 2) allowances Such factors include, but are not limited to, challenging year for the Company with the the extension or renewal of loans without close the Mercedes Mall banking center based on loss experience and trends in pools health care and education. The Company has reduction of principal for more than one those described in this discussion and during 2011. The Board of Directors is U.S. economy in recovery mode, reflecting expanded into the San Antonio area with four of or loans with similar characteristics and 3) analysis. modest expansion. The national and local twelve-month period are generally avoided, continuing its efforts to expand our banking unallocated allowances based on general banking centers operational in 2011 and a unless the loans are fully secured and prop- organization into the San Antonio market. economic growth was facing three headwinds The Company is a privately held bank holding fifth location to be operational in mid-2012. economic conditions and other internal and of unemployment, housing and government erly margined by cash or marketable secur- company headquartered in McAllen, Texas, The Company’s profitability is dependent on Additional locations in San Antonio are being external risk factors in our market. Loans debt. These headwinds continue to affect len- ities, or are revolving lines subject to annual offering a broad array of financial services managing interest rate spreads, other operat- selected for future banking centers. During identified as losses are charged off. In addi- ding as business owners have deleveraged analysis and renewal. through its wholly-owned banking subsidiary, ing income and expenses, and credit risk. Net 2011, San Antonio was ranked #1 Best- tion, the loan review committee of the and remained cautious about putting capital Nonperforming Assets: The Company has Company reviews the assessments of mana- Lone Star National Bank (the “Bank”). The interest income is the largest component of Performing Metropolitan Area in the United to work. Loans held for sale and held for procedures in place to assist in maintaining gement in determining the adequacy of the Bank operates from thirty-one banking revenue for the Company. The Company States per the Milken Institute, December investment of $1.26 billion at December 31, the overall quality of its loan portfolio. The Company’s allowance for loan losses. Based locations: twenty-seven (27) banking centers manages interest rate risks through a funds 2011, “Best- Performing Cities 2011.” 2011 increased $28.3 million or 2.3% compa- Company has established underwriting guide- in the Rio Grande Valley and four (4) banking management strategy which involves offering on total allocations, the provision is recorded Total assets of $2.2 billion at December 31, red to $1.23 billion at December 31, 2010. At lines to be followed by its officers and centers in San Antonio, Texas. The Bank deposit and/or loan structures that tend to to maintain the allowance at a level deemed 2011 increased $92.5 million or 4.4% comp- December 31, 2011, the loan portfolio consi- monitors its delinquency levels for any nega- engages in a wide range of commercial and counter the natural rate risk profile of the appropriate by management. While manage- ared to $2.1 billion at December 31, 2010. sted primarily of $3.5 million of real estate tive or adverse trends, particularly with resp- personal banking activities including the Company. The Company addresses loan and ment uses available information to recognize Total deposits of $1.8 billion at December 31, loans held for sale, $220.5 million of commer- ect to credits which have total exposures of usual acceptance of deposits for checking, deposit pricing, the asset and liability mix and losses on loans, there can be no assurance 2011 increased $87.4 million or 5.1% com- cial loans, $1.7 million of agriculture loans, $10,000 or more. savings and time deposit accounts; extension interest rate sensitivity on a periodic basis. that future additions to the allowance will not pared to $1.7 billion at December 31, 2010. $938.6 million of real estate loans and $88.0 of secured and unsecured loans to corpora- Yields on earning assets and rates paid on Nonperforming assets consist of nonaccrual be necessary. Future adjustments could be million of consumer and other loans. These tions, individuals and others; issuance of interest-bearing deposits within the Company Due from Banks-interest bearing: Due loans, loans for which the interest rate has necessary to the allowance for loan losses if loans were primarily originated within our letters of credit; rental of safe deposit boxes; declined during 2011. Through managem- from banks-interest bearing accounts of been renegotiated below originally contracted circumstances or economic conditions differ market area of the Rio Grande Valley and San brokerage services and insurance services. ent’s efforts, the net interest margin of $340.3 million at December 31, 2011 incre- rates and real estate or other assets that substantially from the assumptions used in Antonio, Texas and are generally secured by The Bank’s lending services include commer- 3.58% reflects a slight decline when com- ased $260.5 million or 326.6% compared to have been acquired in partial or full satisfac- making the initial determinations. The mod- residential or commercial real estate or cial, industrial, real estate, installment and pared to the net interest margin of 3.67% for $79.8 million at December 31, 2010. These tion of loan obligations. At December 31, est expansion in the national, state and local business or personal property. Despite the credit card loans and participation in loans 2010. The Company manages its credit risk funds represent excess funds deposited with 2011, nonperforming assets totaled $87.1 economy, as well as the high employment unprecedented contraction in the credit with other banks. The members of the Bank’s by establishing underwriting guidelines, whi- correspondent banks in interest bearing million or 6.5% of loans plus repossessed rates have resulted in increased levels of markets, we continued to lend to credit- management team have significant experi- ch address the characteristics of borrowers, accounts, primarily the Federal Reserve Bank. assets. Management has added seasoned nonperforming assets, increased loan loss worthy customers. ence and contacts from their service at the industries, geographic locations and risk Management’s strategy for 2011 was to personnel to assist in turning nonperforming provisions and reductions to income. Addit- Bank and their prior service with other succ- products. The credit process is controlled by fortify the balance sheet by reducing its The Company manages credit risk by assets into performing assets. Management ionally, as an internal part of the examination essful community banks that have operated continuous review and credit analysis. The investment 30 year mortgage-backed secu- establishing and implementing strategies and believes that it is unlikely that any material process, bank regulatory agencies periodi- in the same market. The Bank seeks to Company evaluates its management of oper- rities and shorten the overall duration of the guidelines appropriate to the characteristics loss will be incurred on disposition of the cally review our allowance for loan losses. provide its products and services through a ating expenses through the efficiency ratio, investment portfolio. As a result of this stra- of borrowers, industries, geographic locations collateral even though the volume of loan The banking regulatory agencies could requ- high quality experienced staff and local which is approximately 62.4% for 2011. The tegy, U.S. Government securities were sold and products. Diversification of risk within losses has increased, while the allowance for ire the recognition of additions to our loan

2011 Annual Report l 11 Management’s Report on Responsibility for Financial Reporting To Our Shareholders March 23, 2012

Financial Statements The management of Lone Star National actions to correct deficiencies identified. ctive internal control over financial rep- Bancshares-Texas, Inc. and its subsid- orting presented in conformity with There are inherent limitations in any iaries (the “Company”) has the respons- accounting principles generally accepted internal control, including the possibility ibility for preparing the consolidated in the United States of America and call of human error and the circumvention or financial statements and for their integ- report instructions. overriding of controls. Accordingly, even rity and objectivity. The consolidated fin- effective internal control can provide ancial statements were prepared in conf- Compliance with Laws only reasonable assurance with respect ormity with accounting principles gene- and Regulations to financial statement preparation. rally accepted in the United States of Management is responsible for comp- Further, because of changes in cond- America. The consolidated financial sta- liance with the federal and state laws and itions, the effectiveness of internal cont- tements include amounts that are based regulations concerning dividend rest- rol may vary over time. on management’s best estimates and riction and federal laws and regulations judgments. Management assessed the Company’s concerning loans to insiders designated internal control over financial reporting by the Federal Deposit Insurance Corp- Internal Control Over presented in conformity with both acc- oration as safety and soundness laws Financial Reporting ounting principles generally accepted in and regulations. Management is responsible for estab- the United States of America and call Management assessed compliance by lishing and maintaining effective internal report instructions as of December 31, the Bank with the designated laws and controls over financial reporting pre- 2011. This assessment was based on regulations relating to safety and sou- sented in conformity with both accou- criteria for effective internal control over ndness. Based on this assessment, man- nting principles generally accepted in the financial reporting described in Internal agement concludes that the Bank com- United States of America and the inst- Control-Integrated Framework issued by plied, in all significant respects, with the ructions of the Board of Governors of the the Committee of Sponsoring Orga- designated laws and regulations related Federal Reserve System for preparation nizations of the Tredway Commission. to safety and soundness for the year of Consolidated Financial Statements for Based on this assessment, management ended December 31, 2011. Bank Holding Companies (Reporting concludes that, as of December 31, 2011, Form FR Y-9C). This internal control Lone Star National Bancshares-Texas, contains monitoring mechanisms, and Inc. and subsidiaries maintained effe-

A. Jabier Rodriguez Chief Executive Officer

George R. Carruthers Executive Vice President & Chief Financial Officer

12 l 2011 Annual Report Certified Public Accountants 801 QUINCE AVENUE • P.O. BOX 3125 • McALLEN, TEXAS 78502-3125 (956) 682-6365 • FAX (956) 682-2995

2011 Annual Report l 13 LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31, 2011 and 2010 (Dollars in Thousands, Except Share Data)

2011 2010 Assets Cash and due from banks $ 36,416 $ 22,303 Due from banks-interest bearing 303,901 57,475 Total cash and cash equivalents 340,317 79,778 Certificates of deposit 2,533 - Securities available for sale 144,018 387,108 Securities to be held to maturity 322,963 274,221 Loans held for sale 3,469 1,413 Loans, less allowance for loan losses of $31,112 and $25,262 respectively 1,221,076 1,200,723 Properties and equipment, net 64,510 55,624 Net deferred tax asset 8,409 6,843 Overpayment of federal income tax 868 5,065 Accrued interest receivable 7,132 7,947 Other real estate 44,689 46,991 Other assets 24,171 25,959 Total assets $ 2,184,155 $ 2,091,672 Liabilities Deposits Demand $ 271,117 $ 248,913 NOW accounts 421,985 342,143 Savings and money market deposit accounts 230,442 202,528 Time $100 and over 711,520 711,899 Other time 170,878 213,026 Total deposits 1,805,942 1,718,509 Accrued interest payable 1,827 2,179 Allowance for off-balance-sheet losses 1,180 1,136 Other liabilities 4,139 1,468 Federal funds purchased and securities sold under repurchase agreements 21,748 25,872 Guaranteed preferred beneficial interest in Company's subordinated debentures 27,837 27,837 Other borrowed money 113,353 130,562 Total liabilities 1,976,026 1,907,563 Stockholders' equity Common stock, par value $5; authorized 50,000,000 shares; 6,330,918 and 6,225,588 shares issued and outstanding 31,655 31,128 Paid-in capital 58,748 56,700 Retained earnings 113,911 92,424 Accumulated other comprehensive income 3,815 3,857 Total st ockholders' equity 208,129 184,109 Total liabilities and stockholders' equity $ 2,184,155 $ 2,091,672

The accompanying notes are an integral part of the consolidated financial statements.

14 l 2011 Annual Report LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Consolidated Statements of Income Years Ended December 31, 2011 and 2010 (Dollars in Thousands)

2011 2010 Interest income Loans, including fees $ 77,045 $ 76,159 Securities available for sale 9,951 9,432 Securities to be held to maturity 11,035 7,774 Due from banks 460 265 98,491 93,630 Interest expense Deposits 20,483 21,901 Federal funds purchased and repurchase agreements 415 518 Subordinated debentures 761 770 Other borrowed money 4,070 4,276 25,729 27,465 Net interest income 72,762 66,165 Provision for loan losses 11,100 26,650 Net interest income after provision for loan losses 61,662 39,515 Noninterest income Service charges on deposit accounts 6,199 6,721 Other service charge and fee income 6,214 4,958 Real estate package fee income 279 298 Gain on securities 11,375 2,797 Other noninterest income 3,846 3,171 27,913 17,945 Noninterest expense Employee compensation 22,841 21,118 Net occupancy and equipment expenses 7,956 7,471 Employee benefits 4,872 4,080 FDIC insurance 2,221 2,700 Data processing expense 4,197 3,643 Legal and professional 2,598 2,114 Advertising expense 1,498 1,660 Telephone expense 1,363 1,594 Other real estate, net 4,344 1,839 Supplies 496 687 Business development 702 939 Provision for off-balance-sheet losses 44 286 Other noninterest expense 3,671 3,618 56,803 51,749 Income before income tax expense 32,772 5,711 Income tax expense 11,253 2,000 Net income $ 21,519 $ 3,711

The accompanying notes are an integral part of the consolidated financial statements.

2011 Annual Report l 15 LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Equity Years Ended December 31, 2011 and 2010 (Dollars in Thousands)

Comprehensive Common Paid-in income stock capital Balance at December 31, 2009 $ 28,328 $ 39,450

Comprehensive income Net income $ 3,711 - - Other comprehensive income, net of tax Unrealized holding gains arising during period 3,320 Reclassification adjustment for gains included in net income (4,276) Total other comprehensive income (loss) (956) - - Total comprehensive income $ 2,755 Sale of common stock, 555,555 shares 2,778 17,136 Exercise of stock options, 4,450 shares 22 52 Purchase of treasury stock, 34,953 shares - - Sale of treasury stock, 35,078 shares - - Share-based compensation - 54 Tax benefit from stock options exercised - 8

Balance at December 31, 2010 31,128 56,700

Comprehensive income Net income $ 21,519 - - Other comprehensive income, net of tax Unrealized holding gains arising during period 13,253 Reclassification adjustment for gains included in net income (13,295) Total other comprehensive income (loss) (42) - - Total comprehensive income $ 21,477 Exercise of stock options, 105,330 shares 527 734 Purchase of treasury stock, 139,312 shares - - Sale of treasury stock, 139,312 shares - - Loss on purchase of treasury stock - - Share-based compensation - 731 Tax benefit from stock options exercised - 583

Balance at December 31, 2011 $ 31,655 $ 58,748

The accompanying notes are an integral part of the consolidated financial statements.

16 l 2011 Annual Report Accumulated other Total Retained comprehensive Treasury stockholders' earnings income (loss) stock equity $ 88,713 $ 4,813 $ )5($ 161,299

3,711 - - 3,711

- (956) - (956)

- - - 19,914 - - - 74 - - ( )623,1 (1,326) - - 133,1 1,331 - - - 54 - - - 8

92,424 3,857 - 184,109

21,519 - - 21,519

- (42) - (42)

- - - 1,261 - - ( )879,4 (4,978) - - 649,4 4,946 (32) - 23 - - - - 731 - - - 583

$ 113,911 $ 3,815 $ -$ 208,129

2011 Annual Report l 17 LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Years Ended December 31, 2011 and 2010 (Dollars in Thousands) 2011 2010 Operating activities Net income $ 21,519 $ 3,711 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 4,586 4,201 Amortization (accretion) of investment security premiums and discounts, net 7,006 6,254 Share-based compensation 1,314 62 Gain on sale of other real estate (1,981) (506) Gain on sale of investment securities (11,375) (4,169) Gain on sale of properties and equipment (8) - Provision for loan losses 11,100 26,650 Other than temporary impairment of securities held to maturity - 1,372 Writedown of other real estate owned 4,137 287 Provision for off-balance-sheet losses 44 286 Decrease (increase) in overpayment of federal income tax 4,197 (3,496) Increase in deferred income tax benefit (1,546) (1,018) Decrease (increase) in accrued interest receivable 815 (870) Increase in loans held for sale (2,056) (837) Decrease in other assets 897 1,175 Decrease in accrued interest payable (352) (20) Increase (decrease) in other liabilities 2,671 (357) Net cash provided by operating activities 40,968 32,725 Investing activities Proceeds from sale of investment securities available for sale 479,870 151,383 Proceeds from sale of investment securities held to maturity 9,665 17,218 Proceeds from sale of trading securities - 113,318 Proceeds from maturities and principal reduction of securities available for sale 79,576 124,916 Proceeds from maturities and principal reduction of securities to be held to maturity 61,913 40,421 Proceeds from mandatory repurchase of FHLB stock 834 1,347 Proceeds from sale of properties and equipment 73 - Purchase of certificates of deposit (2,533) - Purchase of securities available for sale (307,736) (369,421) Purchase of securities to be held to maturity (125,467) (214,113) Purchase of trading securities - (112,892) Purchase of properties and equipment (12,646) (6,993) Net increase in loans (45,435) (74,371) Improvements to other real estate (1,260) (536) Net proceeds from sale of other real estate 15,388 4,930 Net cash provided (used) by investing activities 152,242 (324,793)

The accompanying notes are an integral part of the consolidated financial statements.

18 l 2011 Annual Report LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Continued) Years Ended December 31, 2011 and 2010 (Dollars in Thousands)

2011 2010 Financing activities Net increase in demand deposits, NOW accounts, savings and money market accounts 129,960 106,880 Proceeds from sale of common stock 1,261 19,988 Proceeds from sale of treasury stock 4,946 1,331 Repayment of other borrowed money (75,209) (197,207) Proceeds from other borrowed money 58,000 162,000 Net decrease in federal funds purchased and securities sold under repurchase agreements (4,124) (138) Net increase (decrease) in time deposits (42,527) 139,946 Purchase of treasury stock (4,978) (1,326) Net cash provided by financing activities 67,329 231,474

Increase (decrease) in cash and cash equivalents 260,539 (60,594) Cash and cash equivalents at beginning of year 79,778 140,372 Cash and cash equivalents at end of year $ 340,317 $ 79,778

The accompanying notes are an integral part of the consolidated financial statements.

2011 Annual Report l 19 LONE STAR NATIONAL BANCSHARES--TEXAS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2011 and 2010

Note 1 - Summary of Significant Accounting Policies

Lone Star National Bancshares--Texas, Inc. (the “Parent” or “Company”), its primary subsidiary, Lone Star National Bank (the “Bank”) and its other subsidiaries (collectively the “Company”) are headquartered in McAllen, Texas. The Company provides a broad array of customary banking services and operates 31 regulatory banking locations throughout the Rio Grande Valley of Texas and San Antonio, Texas. The accounting principles and reporting policies conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. A summary of the more significant accounting policies follows:

Basis of Presentation. The consolidated financial statements include the accounts of Lone Star National Bancshares--Texas, Inc. and its wholly-owned subsidiaries. The Company eliminates all significant intercompany transactions and balances in consolidation. The accounting and financial reporting policies the Company follows conform, in all material respects, to accounting principles generally accepted in the United States of America.

The Company determines whether it has a contro lling financial interest in an entity by first evaluating whether the entity is a voting interest entity or a variable interest entity under accounting principles generally accepted in the United States of America. Voting interest entities are entities in which the total equity investment at risk is sufficient to enable the entity to finance itself independently and provides the equity holders with the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity’s activities. The Company consolidates voting interest entities in which it has all, or at least a majority of, the voting interest. As defined in applicable accounting standards, variable interest entities (“VIEs”) are entities that lack one or more of the characteristics of a voting interest entity. A controlling finan cial interest in an entity is present when an enterprise has a variable interest, or a combination of variable interests, that will absorb a majority of the entity’s expected losses, receive a majority of the entity’s expected residual returns, or both. The enterprise with a controlling financial interest, known as the primary beneficiary, consolidates the VIE. The Company’s wholly- owned subsidiaries, Lone Star National Capital Trust II, Lone Star National Capital Trust III and Lone Star National Capital Trust IV are VIEs for which the Company is not the primary beneficiary. Accordingly, the accounts of these entities are not included in the Company’s consolidated financial statements.

Use of estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of Ameri ca requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. The allowance for possible loan losses, the fair value of financial instruments and the statu s of contingencies are particularly subject to change.

Cash and cash equivalents. For the purpose of reporting cash flows, the Company considers cash on hand, amounts due from banks, deposits with other financial institutions that have an initial maturity less than 90 days when acquired by the Company and federal funds sold to be cash and cash equivalents. Generally, federal funds sold are purchased and sold for one-day period s. The Company has maintained balances in various operating and money market accounts in excess of federally insured limits.

Repurchase/Resell Agreements. The Company purchases certain securities under agreements to resell. The amounts advanced under these agreements represent short-term loans and are reflected as assets in the accompanying consolidated balance sheets. The securities underlying these agreements are book entry

20 l 2011 Annual Report securities. The Company also sells certain securities under agreements to repurchase. The agreements are treated as collateralized financing transactions and the obligations to repurchase securities sold are reflected as a liability in the accompanying consolidated balance sheets. The dollar amount of the securities underlying the agreements remain in the asset accounts.

Investments in securities. Securities that management has both the positive intent and ability to hold to maturity are classified as securities held to maturity and are carried at cost, adjusted for amortization of premium or accretion of discount, using the level-yield method. Amortization and accretion on mortgage- backed securities are adjusted for prepayments. Securities that may be sold prior to maturity for asset/liability management purposes, or that may be sold in response to changes in interest rates, to changes in prepayment risk, to increase regulatory capital or other similar factors, are classified as securities available for sale and carried at fair value with any adjustments to fair value reported in stockholders’ equity as a component of accumulated other comprehensive income (loss), net of tax. Declines in the fair value of individual held to maturity and available for sale securities belo w their cost that are other than temporary result in write-downs of the individual securities to their fair value. The related write-downs are included in net income as realized losses. Securities purchased for trading purposes are held in the trading portfolio at fair value, with changes in fair value included in noninterest income.

Interest and dividends on securities, including the amortization of premiums and the accretion of discounts, are reported in interest income on securities using the level-yield method. Gains and losses on the sale of securities are recorded on the trade date and are calculated using the specific identification method.

Loans. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans.

Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of interest is doubtful. Assets acquired through foreclosure are carried at the lower of the estimated net realizable value or the balance of the loan and are included in other assets. Revenues and expenses from operations and changes in the valuation allowance of foreclosed assets are included in noninterest expense.

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

Allowance for Possible Loan Losses. The allowance for possible loan losses is a reserve established through a provision for po ssible loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses inherent in the loan portfolio. The allowance for possible loan losses includes allowance allocations calculated in accordance with Accounting Standards Codification (“ASC”) Topic 310, Receivables and allowance allocations calculated in accordance with ASC Topic 450, Contingencies.

2011 Annual Report l 21 Loans held for sale. The Company originates mortgage loans primarily for sale in the secondary market. These loans are generally sold on a non-recourse basis and are carried at the lower of cost or market on an aggregate basis.

Properties and equipment. Land is carried at cost. Other premises and equipment are carried at cost net of accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Depreciation for tax purposes is computed by using the Accelerated Cost Recovery System and the Modified Accelerated Cost Recovery System required by the Internal Revenue Code.

Impairment of long-lived assets. Long-lived assets and certain identifiable intangibles are reviewed by the Company for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

Earnings per share of common stock. Basic earnings per share are computed by dividing earnings available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect per share amounts that would have resulted if dilutive potential common stock had been converted to common stock.

Loan origination fees and costs. Loan origination fees and costs are deferred and recognized over the life of the loan as an adjustment of yield using the interest method.

Interest income on loans. Interest income on loans is accrued and credited to income based on the principal amount outstanding. The accrual of interest on loans is discontinued when, in the opinion of management, there is an indication that the borrower may be unable to meet payments as they become due. Upon such discontinuance, all unpaid accrued interest is reversed. Subsequent interest payments received on loans in which accrual of interest has been discontinued are either applied against principal or reported as income, depending upon management’s assessment of the ultimate collectability of principal.

Advertising. Advertising costs are expensed as they are incurred.

Income tax expense. Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities (excluding deferred tax assets and liabilities related to components of other comprehensive income). Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the expected amount most likely to be realized. Realization of deferred tax assets is dependent upon the generation of a sufficient level of future taxable income and recoverable taxes paid in prior years. Although realization is not assured, management believes it is more likely than not that all of the deferred tax assets will be realized.

Off-balance-sheet instruments. In the ordinary course of business the Company has entered into off- balance-sheet financial instruments consisting of commitments to extend credit, commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.

Derivative financial instruments. FASB ASC 815 Derivatives and Hedging requires companies to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Changes in fair value of a derivative must be recognized currently in earnings unless specific hedge accounting criteria are met. The Company’s risk management activities do not presently include entering into derivative contracts to manage interest rate risk.

22 l 2011 Annual Report Share-based payments. The Company accounts for all stock-based compensation transactions in accordance with ASC 718, Compensation — Stock Compensation ("ASC 718"), which requires that stock compensation transactions be recognized as compensation expense in the statement of operations based on their fair values on the measurement date, which is the date of the grant. Cost of the unvested portion of options issued in prior years and the cost of options issued during 2011, is recognized using the Black- Scholes-Merton option pricing model and a single options award approach method to measure the compensation cost of stock options granted in 2011.

Subsequent events. The Company has evaluated subsequent events for potential recognition and/or disclosure through March 23, 2012, the date on which these consolidated financial statements were available to be issued.

Reclassifications. Certain amounts in the prior year’s presentation have been reclassified to conform to the current year’s presentation. These reclassifications have no effect on previously reported net income.

Note 2 - Restriction On Cash and Due From Banks

The Company is required to maintain reserve funds in cash or on deposit with the Federal Reserve Bank. The required reserve balance at December 31, 2011 and 2010 was $724,000 and $819,000, respectively.

Note 3 - Investment Securities

An analysis of securities available for sale as of December 31, 2011 follows:

Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in Thousands) Cost Gains Losses Value

U.S. government agency $ 30,336 $ 26 ( $ 8 ) $ 30,354 U.S. treasury -0- -0- -0- -0- Mortgage-backed 77,059 5,276 -0- 82,335 Collateralized mortgage obligations 30,842 487 -0- 31,329 Total $ 138,237 $ 5,789 ( $ 8 ) $ 144,018

The carrying amount and estimated fair value of securities to be held to maturity as of December 31, 2011 follow: Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in Thousands) Cost Gains Losses Value

U.S. treasury $ 15,056 $ 981 $ -0- $ 16,037 State and local governments 19,251 978 -0- 20,229 Mortgage-backed 218,148 10,800 -0- 228,948 Collateralized mortgage obligations 62,204 1,854 -0- 64,058 Other 8,304 -0- -0- 8,304 Total $ 322,963 $ 14,613 $ -0- $ 337,576

2011 Annual Report l 23 An analysis of securities available for sale as of December 31, 2010 follows:

Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in Thousands) Cost Gains Losses Value

U.S. government agency $ 500 $ 36 ( $ -0- ) $ 536 U.S. treasury 9,919 -0- ( 437 ) 9,482 Mortgage-backed 172,567 6,052 ( 217 ) 178,402 Collateralized mortgage obligations 198,279 1,806 ( 1,397 ) 198,688 Total $ 381,265 $ 7,894 ( $ 2,051 ) $ 387,108

The carrying amount and estimated fair value of securities to be held to maturity as of December 31, 2010 follow: Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in Thousands) Cost Gains Losses Value

U.S. treasury $ 15,070 $ -0- ( $ 555 ) $ 14,515 State and local governments 16,525 430 ( 110 ) 16,845 Mortgage-backed 129,295 3,204 ( 33 ) 132,466 Collateralized mortgage obligations 104,534 1,429 ( 2,720 ) 103,243 Other 8,797 -0- ( -0- ) 8,797 Total $ 274,221 $ 5,063 ( $ 3,418 ) $ 275,866

The net change in unrealized holding gains and losses on securities available for sale, net of related tax effect, of $42,000 and $956,000 net losses for 2011 and 2010, respectively, was included in a separate component of stockholders’ equity as accumulated other comprehensive income (loss).

Provided below is a summary of securities which were in an unrealized loss position at December 31, 2011. A total of one security had unrealized losses at December 31, 2011. The unrealized loss was a security in a continuous loss position for less than twelve months and was a U.S. government agency security. The Company believes the deterioration in value is attributable to changes in market interest rates and not the credit quality of the issuer.

Less than 12 Months More than 12 Months Total Estimated Estimated Estimated Fair Unrealized Fair Unrealized Fair Unrealized (Dollars in Thousands) Value Loss Value Loss Value Loss

U.S. government agency $ 20,006 $ (8) $ -0- $ -0- $ 20,006 $ (8) U.S. treasury -0- -0- -0- -0- -0- -0- State and local governments -0- -0- -0- -0- -0- -0- Mortgage-backed -0- -0- -0- -0- -0- -0- Collateralized mortgage obligations -0- -0- -0- -0- -0- -0- Other -0- -0- -0- -0- -0- -0- Total $ 20,006 $ (8) $ -0- $ -0- $ 20,006 $ (8)

The amortized cost and estimated market value of securities available for sale and to be held to maturity at December 31, 2011, by contractual maturity, is shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

24 l 2011 Annual Report Securities Available for Sale Securities Held to Maturity Estimated Estimated Amortized Fair Amortized Fair Cost Value Cost Value (Dollars in Thousands) Due within one year $ -0- $ -0- $ 535 $ 544 Due one to five years 30,336 30,354 4,804 5,014 Due five to ten years -0- -0- 19,684 21,031 Due after ten years -0- -0- 9,284 9,677 Subtotal 30,336 30,354 34,307 36,266 Mortgage-backed and collateralized mortgage obligations 107,901 113,664 280,352 293,006 Other -0- -0- 8,304 8,304 Total $ 138,237 $ 144,018 $ 322,963 $ 337,576

Securities not due at a single maturity date are included in scheduled maturities on the basis of coupon maturity.

Proceeds from sales of securities available for sale were $479,870,000 and $151,383,000, respectively, for the years ended December 31, 2011 and 2010. Gross realized gains on sales of securities available for sale were $13,295,000 in 2011 and $4,207,000 in 2010. Gross realized losses on sales of securities available for sale were $190,000 in 2010 and $0 in 2010.

Proceeds from sales of trading securities were $0 in 2011 and $113,318,000 in 2010. Gross realized gains on sales of trading securities were $0 in 2011 and $476,000 in 2010. Gross realized losses on sales of trading securities were $0 in 2011 and $50,000 in 2010.

Proceeds from sales of securities to be held to maturity were $9,665,000 and $17,218,000, respectively, for the years ended December 31, 2011 and 2010. Gross realized gains on sales of securities to be held to maturity were $76,000 in 2011 and $29,000 in 2010. Gross realized losses on sales of securities to be held to maturity were $1,806,000 in 2011 and $493,000 in 2010. The Company’s decision to sell securities to be held to maturity was to limit its loss exposure on collateralized mortgage obligations with ratings downgrades.

Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than- temporary impairment losses, management considers, among other things, (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer and (iii) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in cost. Realized losses included in earnings for 2011 and 2010 for other-than-temporary declines in the fair value of securities total $0 and $1,372,000, respectively.

Investment securities with a carrying amount of $393,481,000 and $351,948,000 at December 31, 2011 and 2010, respectively, were pledged to secure public funds and for other purposes required or permitted by law.

2011 Annual Report l 25 Note 4 - Loans

Loans consist of the following:

December 31, (Dollars in Thousands) 2011 2010 Commercial $ 202,565 $ 217,477 Commercial tax-exempt 17,013 9,014 Overdrafts 917 796 Total commercial 220,495 227,287

Agricultural 1,657 1,591

Real estate Construction 183,233 178,825 Agricultural mortgage 70,660 56,164 1-4 Family mortgage 222,613 205,881 Multifamily mortgage 34,305 26,821 Commercial mortgage 431,260 418,073 Total real estate 942,071 885,764

Consumer 89,577 112,951 Total principal amount of loans 1,253,800 1,227,593 Unearned discount and unamortized fees and costs ( 1,612 )( 1,608 ) Allowance for loan losses ( 31,112 )( 25,262 ) Total loans $ 1,221,076 $ 1,200,723

The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions. Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined that the borrower’s management possesses sound ethics and solid business judgment, the Company’s management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may b e substantially dependent on the ability of the borrower to collect amounts due from its customers.

26 l 2011 Annual Report Real estate loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the cash flows of the borrower. Real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Comp any’s real estate portfolio are diverse in terms of type and location. This diversity helps reduce the Company’s exposure to adverse economic events that affect any single market or industry. Management monitors and evaluates real estate loans based on collateral and risk grade criteria. The Company tracks the level of owner-occupied real estate loans versus non-owner-occupied loans. At December 31, 2011, approximately 42 per cent of the outstanding principal balance of the Company’s commercial real estate loans were secured by owner-occupied properties.

The Company originates consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified. This activity, coupled with relatively small loan amounts that are spread across many individu al borrowers, minimizes risk. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80 percent, collection remedies, the number of such loans a borrower can have at one time and documentation requirements.

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

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are place d on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. In determining whether or not a borrower may be unable to meet payment obligations for each class of loans, the Company considers the borrower’s debt service capacity through the analysis of current financial information, if available, and/or current information with regards to the Company’s collateral position. Regulatory provisions would typically require the placement of a loan on non-accrual status if (i) principal or interest has been in default for a period of 90 days or more unless the loan is both well secured and in the process of collection or (ii) full payment of principal and interest is not expected. Loans may be placed on non-accrual status regardless of w hether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income on non-accrual loans is recognized only to the extent that cash payments are received in excess of principal due. A loan may be returned to accrual status when all the principal and interest amounts contractually due are brought current and future principal and interest amounts con tractually due are reasonably assured, which is typically evidenced by a sustained period (at least six months) of repayment performance by the borrower.

Year-end non-accrual loans, segregated by class of loans, were as follows:

(Dollars in Thousands) 2011 2010 Commercial $ 2,163 $ 3,449 Agricultural -0- -0- Consumer 114 93 Real estate 36,633 42,533 Total $ 38,910 $ 46,075

2011 Annual Report l 27 As of December 31, 2011, non-accrual loans reported in the table above included $6,475,000 related to loans that were restructured as “troubled debt restructurings” during 2011.

Had non-accrual loans performed in accordance with their original contractual terms, interest income would have increased by $2,488,000 and $2,849,000 for the years ended December 31, 2011 and 2010, respectively.

An age analysis of past due loans (including both accruing and non-accruing loans), segregated by class of loans, as of December 31, 2011 follows:

Accruing Loans 90 Loans 30-89 Loans 90 or or More (Dollars in Days Past More Days Total Past Days Past Thousands) Due Past Due Due Loans Current Loans Total Loans Due

Commercial $ 7,629 $ 1,450 $ 9,079 $ 211,416 $ 220,495 $ 490 Agricultural 84 -0- 84 1,573 1,657 -0- Consumer 1,998 695 2,693 86,883 89,576 657 Real estate 38,286 12,727 51,013 891,059 942,072 2,257 Total $ 47,997 $ 14,872 $ 62,869 $ 1,190,931 $ 1,253,800 $ 3,404

Accruing loans 90 or more days past due totaled $3,396,000 at December 31, 2010.

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 individ ual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of the estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

Regulatory guidelines require the Company to reevaluate the fair value of collateral supporting impaired collateral dependent loans on at least an annual basis. While the Company’s policy is to comply with the regulatory guidelines, the Comp any’s general practice is to reevaluate the fair value of collateral supporting impaired collateral dependent loans on a quarterly basis.

Year-end impaired loans are set forth in the following table. Interest income recognized on impaired loans for the time they were impaired was $439,000 and $379,000 during 2011 and 2010, respectively.

Unpaid Recorded Recorded Contractual Investment Investment Total Average (Dollars in Principal With No With Recorded Related Recorded Thousands) Balance Allowance Allowance Investment Allowance Investment 2011 Commercial $ 2,612 $ 1,383 $ 779 $ 2,162 $ 238 $ 2,719 Agricultural -0- -0- -0- -0- -0- -0- Consumer 122 113 1 114 1 104 Real Estate 44,238 32,372 4,261 36,855 928 33,990 Total $ 46,972 $ 33,868 $ 5,041 $ 39,131 $ 1,167 $ 36,813

28 l 2011 Annual Report Unpaid Recorded Recorded Contractual Investment Investment Total Average (Dollars in Principal With No With Recorded Related Recorded Thousands) Balance Allowance Allowance Investment Allowance Investment 2010 Commercial $ 4,929 $ 3,276 $ 173 $ 3,833 $ 106 $ 4,772 Agricultural -0- -0- -0- -0- -0- -0- Consumer 138 93 -0- 93 -0- 59 Real Estate 50,753 31,349 11,184 42,533 986 39,358 Total $ 55,820 $ 34,718 $ 11,357 $ 46,459 $ 1,092 $ 44,189

The restructuring of a loan is considered a “troubled debt restructuring” if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. Troubled debt restructurings during 2011 and 2010 are set forth in the following tables.

Balance at Balance at Restructuring December 31, 2011 Date 2011 (Dollars in Thousands) Commercial $ 157 $ 103 Agricultural - - Consumer - - Real estate 7,305 6,593 Total $ 7,462 $ 6,696

Balance at Balance at Restructuring December 31, 2010 Date 2010 (Dollars in Thousands) Commercial $ 168 $ 158 Agricultural - - Consumer - - Real estate 1,863 1,757 Total $ 2,031 $ 1,915

Typically loans identified as troubled debt restructurings by the Company are previously on non-accrual status and reported as impaired loans prior to restructuring. The modifications primarily related to extending the amortization periods of the loans and the granting of interest-rate concessions. All loans restructured during 2011 that remain outstanding are on non-accrual status as of December 31, 2011, with the exception of one loan with a balance of $222,000. The modifications did not impact the Company’s determination of the allowance for loan losses. As of December 31, 2011, there were no loans restructured in 2011 that were in default.

As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the weighted-average risk grade of loans, (ii) the leve l of classified loans, (iii) the delinquency status of the loans, (iv) net charge-offs, (v) non-performing loans and (vi) the general economic conditions of South Texas.

2011 Annual Report l 29 The Company utilized a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 11. A description of the general characteristics of the 11 risk grades is as follows:

§ Risk Grade 1 – This category includes all obligors whose balance sheet, current position, capitalization, profitability and cash flow have been demonstrated to be consistently of such high quality that the potential for significantp disru tion in their financial performance is virtually nonexistent. Only financially strong and publicly traded companies would be rated in this category but all loans secured by the Company’s certificates of deposit would qualify for such an internal risk rating.

§ Risk Grade 2 – This internal risk rating is assigned to borrowers having a stable record of strong earnings, a substantial current position, sound capitalization, and solid cash flow, and whose management team has experience and depth within a sound and stable industry.

§ Risk Grade 3 – Borrowers assigned this internal rating are considered above average with higher than average credit standards based on leverage, liquidity and debt coverage ratios as well as having excellent management in critical areas.

§ Risk Grade 4 – This internal risk rating includes borrowers that have average leverage, liquid ity and debt service coverage ratios that compare favorably with industry standards.

§ Risk Grade 5 – This internal risk rating includes borrowers that have average leverage, liquidity and debt service coverage ratios and management that may be relatively inexperienced or untested. Overall financial ratios may not be as solid on a historical basis or may compare less favorably with industry standards but are still considered acceptable.

§ Risk Grade 6 – This internal risk rating exhibits the same characteristics as Risk Grade 5, but requiring added attention due to added factors such as (1) average or unfavorable earnings and cash flow coverage, (2) average or unfavorable debt service coverage ratio, (3) repayment is slow or repayment history is marginal, (4) reliant on liquidation of collateralized assets to repay debt, (5) substantial credit, collateral, or loan policy exceptions exist, and (6) no secondary sources of repayment are evident.

§ Risk Grade 7 – This risk grading includes borrowers that exhibit potential weaknesses/early warning signals that deserve close attention. If left uncorrected, these potential weaknesses may result in the borrower being unable to meet its financial obligations at some future date. Alternatively, operating performance has exhibi ted improvement, which, although not yet stabilized, is improving and provided such performance continues, will result in removal from problem account status.

§ Risk Grade 8 – This risk grading indicates that loans are in the category of performing loans which are classified substandard. A substandard credit is inadequately protected by the current sound worthiness and paying capacity of the obligor or of the collateral pledged, if any. Lo ans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. These credits are characterized by the distinct possibility that the Company will sustain some loss if deficiencies are not corrected. However, the distinct possibility of loss in these credits, while existing in the aggregate amount of substandard assets, does not necessarily exist in individual assets classified substandard.

§ Risk Grade 9 – This risk grading indicates that loans are in the category of substandard loans, which are similar in definition to substandard-performing. The only difference is that substandard-non-accrual loans are not performing or meeting principal and/or interest payments as agreed. Moreover, loans in this category (including situations where the obligor has filed for

30 l 2011 Annual Report bankruptcy or similar protection from creditors, as collection of principal or interest on a timely basis in these situations is unlikely) must be classified as non-accrual. Additionally, these loans generally have a specific valuation allowance.

§ Risk Grade 10 – This risk grading includes loans that have all the weaknesses inherent in a substandard classification with the added factor that the weaknesses are pronounced to the point whe re, on the basis of current facts, conditions and values, collection or liquidation in full is highly questionable or improbable. While the possibility of loss is extremely high, the existence of specific pending factors, which may work to the obligor’s advantage, warrants that the estimated loss be deferred until a more exact status is determined. Additionally, these loans generally have a specific valuation allowance.

§ Risk Grade 11 – This risk grading is reserved for charge-offs. A loan in this category is considered uncollectible and of such little value that its continuance as an active asset of the Bank is not warranted. This classification does not mean that an asset has absolutely no recovery or salvage value, but simply that it is not practical or desirable to defer writing off all (or sometimes a portion) of a basically worthless asset, even though partial recovery may be effected in the future. Losses should be taken in the period in which they surface as uncollectible. Additionally, these loans generally have a specific valuation allowance.

In monitoring credit quality trends in the context of assessing the appropriate level of the allowance for loan losses, the Company monitors portfolio credit quality by the weighted-average risk grade of each class of loan. Individual relationship managers review updated financial information for all loans risk graded 1 through 6 to recalculate the risk grade on at least an annual basis. When a loan has a calculated risk grade of 7, it is considered to be on management’s “watch list,” where a significant risk-modifying action is anticipated in the near term. When a loan has a calculated risk grade of 7 or higher, the loan is monitored on an on-going basis.

The following table presents weighted average risk grades for all loans by class.

December 31, 2011 December 31, 2010 Weighted Weighted Average Average (Dollars in Thousands) Risk Grade Loans Risk Grade Loans Commercial Risk grades 1-6 3.45 $ 209,696 3.32 $ 219,206 Risk grade 7 7.00 6,569 7.00 1,392 Risk grade 8 8.00 1,379 8.00 2,444 Risk grade 9 9.00 2,851 9.00 4,245 Risk grade 10 10.00 - 10.00 - Risk grade 11 11.00 - 11.00 - Total commercial $ 220,495 $ 227,287

2011 Annual Report l 31 December 31, 2011 December 31, 2010 Weighted Weighted Average Average (Dollars in Thousands) Risk Grade Loans Risk Grade Loans Risk grades 1-6 2.63 $ 1,562 2.78 $ 1,465 Risk grade 7 7.00 55 7.00 41 Risk grade 8 8.00 40 8.00 85 Risk grade 9 9.00 - 9.00 - Risk grade 10 10.00 - 10.00 - Risk grade 11 11.00 - 11.00 - Total agricultural $ 1,657 $ 1,591

Consumer Risk grades 1-6 2.86 $ 89,335 2.94 $ 112,552 Risk grade 7 7.00 56 7.00 79 Risk grade 8 8.00 72 8.00 227 Risk grade 9 9.00 114 9.00 93 Risk grade 10 10.00 - 10.00 - Risk grade 11 11.00 - 11.00 - Total consumer $ 89,577 $ 112,951

Real estate Risk grades 1-6 4.19 $ 833,885 4.09 $ 766,849 Risk grade 7 7.00 22,714 7.00 21,667 Risk grade 8 8.00 49,936 8.00 56,138 Risk grade 9 9.00 34,931 9.00 40,760 Risk grade 10 10.00 605 10.00 350 Risk grade 11 11.00 - 11.00 - Total real estate $ 942,071 $ 885,764

The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Company’s allowance for loan loss methodology follows the accounting guidance set forth in U.S. generally accepted accounting principles and the Interagency Policy Statement on the Allowance for Loan and Lease Losses, which was jointly issued by the Company’s regulatory agencies. In that regard, the Company’s allowance for loan losses includes allowance allocations calculated in accordance with ASC Topic 310 Receivables and allowance allocations calculated in accordance with ASC Topic 450 Contingencies. Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans or loan pools. The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss and recovery experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions

32 l 2011 Annual Report of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate determination of the appropriate level of the allowance is dependent upon a variety of factors beyond the Company’s control, including, among other things, the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. The Company monitors whether or not the allowance for loan loss allocation model, as a whole, calculates an appropriate level of allowance for loan losses that moves in direct correlation to the general macroeconomic and loan portfolio conditions the Company experiences over time.

The Company’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with ASC Topic 310 based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with ASC Topic 450 based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with ASC Topic 450 based on general economic conditions and other risk factors both internal and external to the Company. The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. When a loan has a calculated grade of 7 or higher, the loan is analyzed to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for loan losses to the loan. Specific valuation allowances are determin ed by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, the relative risk grade of the loan and economic conditions.

Historical valuation allowances are calculated based on the historical gross loss experience of specific types of loans and the internal risk grade of such loans at the time they were charged-off. The Company calculates historical gross loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool. The historical gross loss ratios are periodically updated based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical gross loss ratio and the total dollar amount of the loans in the pool. The Company’s pools of similar loans include similarly risk-graded groups of commercial loans, commercial real estate loans, consumer real estate loans and consumer and other loans.

The components of the general valuation allowance include the additional reserves allocated to specific loan portfolio segments as a result of applying an environmental risk adjustment factor to the base historical loss allocation. The environmental adjustment factor is based upon a more qualitative analysis of risk. The various risks that may be considered in the determination of the environmental adjustment factor include, among other things, (i) the effects of the national and local economy; (ii) the change in the nature and volume of the loan portfolio; (iii) changes in lending policies and underwriting compliance risk; (iv) management risk; (v) existence and change in credit concentrations; (vi) credit risk management; (vii) change in residential construction; and (viii) international risk.

The following table details activity in the allowance for loan losses by portfolio segment for the years ended December 31, 2011 and 2010. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

2011 Annual Report l 33 (Dollars in Thousands) Commercial Agricultural Consumer Real Estate Total 2011 Beginning balance $ 4,648 $ 31 $ 2,188 $ 18,395 $ 25,262 Provision for loan losses 1,498 41 1,067 8,494 11,100 Charge-offs (1,389) (38) (1,190) (4,002) (6,619) Recoveries 545 5 491 328 1,369 Net charge-offs (844) (33) (699) (3,674) (5,250) Ending balance $ 5,302 $ 39 $ 2,556 $ 23,215 $ 31,112 Year-end amount allocated to: Loans individually evaluated for impairment $ 238 $ -0- $ 1 $ 928 $ 1,167 Loans collectively evaluated for impairment 5,064 39 2,555 22,287 29,945 Ending balance $ 5,302 $ 39 $ 2,556 $ 23,215 $ 31,112

2010 Beginning balance $ 3,996 $ 41 $ 2,176 $ 15,888 $ 22,101 Provision for loan losses 10,978 (12) 1,351 14,333 26,650 Charge-offs (11,064) -0- (1,919) (12,087) (25,070) Recoveries 738 2 580 261 1,581 Net charge-offs (10,326) 2 1,339) (11,826) (23,489) Ending balance $ 4,648 $ 31 $ 2,188 $ 18,395 $ 25,262 Year-end amount allocated to: Loans individually evaluated for impairment $ 106 $ -0- $ -0- $ 986 $ 1,092 Loans collectively evaluated for impairment 4,542 31 2,188 17,409 24,170 Ending balance $ 4,648 $ 31 $ 2,188 $ 18,395 $ 25,262

The Company’s recorded investment in loans as of December 31, 2011 and 2010 related to each balance in the allowance for loan losses by portfolio segment and disaggregated on the basis of the Company’s impairment methodology follows:

(Dollars in Thousands) Commercial Agricultural Consumer Real Estate Total 2011 Loans individually evaluated for impairment $ 882 $ -0- $ 57 $ 27,186 $ 28,125 Loans collectively evaluated for impairment 219,613 1,657 89,520 914,885 1,225,675 Ending balance $ 220,495 $ 1,657 $ 89,577 $ 942,071 $ 1,253,800 2010 Loans individually evaluated for impairment $ 2,438 $ -0- $ 18 $ 32,443 $ 34,899 Loans collectively evaluated for impairment 224,849 1,591 112,933 853,321 1,192,694 Ending balance $ 227,287 $ 1,591 $ 112,951 $ 885,764 $ 1,227,593

Net gains realized on the sale of loans held for sale totaled $232,000 and $342,000 for the years ended December 31, 2011 and 2010, respectively.

34 l 2011 Annual Report Note 5 - Properties and equipment

The following is a summary of properties and equipment, at cost less accumulated depreciation at year end:

(Dollars in Thousands) 2011 2010 Land $ 18,492 $ 14,822 Buildings and improvements 37,603 35,729 Furniture and equipment 30,718 24,198 Construction in progress 1,327 884 88,140 75,633 Less accumulated depreciation ( 23,630 ) ( 20,009 ) $ 64,510 $ 55,624

Depreciation expense was $3,695,000 and $3,243,000 for the years ended December 31, 2011 and 2010, respectively. The Company capitalized $30,000 of interest costs as properties and equipment during 2011. There was no interest cost capitalized as properties and equipment during 2010.

Note 6 - Time Deposits

Time deposit accounts included in the balance sheet that have a remaining term of more than one year are as follows: Amount Years Ending (Dollars in December 31, Thousands) 2012 $ 575,672 2013 178,831 2014 80,901 2015 28,214 2016 18,744 Beyond 2016 36 $ 882,398

Note 7 – Other Liabilities

Major classifications of other liabilities at year end are as follows:

(Dollars in Thousands) 2011 2010 Accrued expenses $ 2,327 $ 1,070 Federal and state income taxes payable 147 107 Property taxes payable 1,665 291 $ 4,139 $ 1,468

Note 8 – Borrowed funds

Securities sold under agreements to repurchase are stated at the amount of cash received in connection with the transaction. The agreements have various interest rates ranging from 0.20 percent to 3.25 percent and repurchase dates to June 21, 2012. Securities sold under agreements to repurchase totaled $21,748,000 and $25,872,000 at December 31, 2011 and 2010 with accrued interest of $17,000 and $28,000 respectively. The securities sold under the agreements are collateralized by a security interest in securities available for sale.

2011 Annual Report l 35 The following are available lines of credit the Company has with other financial institutions:

Line of Financial Institution Credit Amount Interest Expiration (Dollars in Thousands) Amount Available Rate Date Federal Home Loan Bank of Dallas $ 423,939 $ 232,586 Variable None The Independent Bankers Bank 15,000 15,000 Variable None Frost National Bank 30,000 30,000 Variable None Federal Reserve Bank 157,975 157,975 Variable None $ 626,914 $ 435,561

The Company has received advances in the amount of $113,353,000 from Federal Home Loan Bank of Dallas (“FHLB”) under provisions of its line of credit facility. The advances mature September 13, 2012 through September 18, 2018 with interest due quarterly at rates of 0.627 percent through 4.349 percent.

The line of credit with FHLB is collateralized by a blanket floating lien on certain mortgage loans. The lines of credit with The Independent Bankers Bank and Frost National Bank are unsecured. The line of credit with the Federal Reserve Bank (“FRB”) is collateralized by a blanket floating lien on certain commercial and agriculture loans.

The Company, through a private placement, has issued a total of $27 million of Floating Rate Cumulative Trust Preferred Securities (27,000 shares with a liquidation amount of $1,000 per security) (the “Trust Preferred Securities”). The Trust Preferred Securities were issued through newly-formed, wholly-owned subsidiaries, Lone Star National Capital Trust II, Lone Star National Capital Trust III and Lone Star National Capital Trust IV, which are special purpose Delaware statutory business trusts (“Trusts”). Unamortized debt issuance costs related to the Trusts, which are included in other assets, totaled $837,000 at December 31, 2011 and 2010. The Trusts invested the total proceeds from the equity contributions and the securities sale in the Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Debentures”) issued by the Company. The net proceeds from the sale of the Debentures was used for general corporate purposes, including capital investments in the Bank.

The Trust Preferred Securities issued by the trusts rank senior to the common securities. The obligation of the Company under the trust agreements and the guarantees relating to the trusts constitute the full and unconditional guarantee by the Company of the obligations of the trusts with respect to the Trust Preferred Securities and rank subordinate and junior in right to payment to all other liabilities.

The Debentures are subject to mandatory redemption pursuant to the terms of the trust agreements. The Company has the option to redeem the deb entures, in whole or in part, on or after any interest payment date after September 30, 2008 for the 2003 issue, April 7, 2009 for the 2004 issue and June 30, 2012 for the 2007 issue. In the event the Debentures are redeemed, a like amount of Trust Preferred Securities will be redeemed at the redemption price of $1,000 per security, plus accrued interest to the date of redemption. The table below summarizes the outstanding preferred securities issued by the trusts as of December 31, 2011 and 2010.

Trust name: Lone Star National Capital Trust II Issuance date: September 26, 2003 Amount: $10,000,000 Stated maturity: September 30, 2033 Floating interest rate: 2.95% per annum over the Three-Month LIBOR Rate Interest payable/Distribution dates: Quarterly/March 30, June 30, September 30, and December 30

36 l 2011 Annual Report Trust name: Lone Star National Capital Trust III Issuance date: March 25, 2004 Amount: $7,000,000 Stated maturity: April 6, 2034 Floating interest rate: 2.75% per annum over the Three-Month LIBOR Rate Interest payable/Distribution dates: Quarterly/January 7, April 7, July 7, and October 7

Trust name: Lone Star National Capital Trust IV Issuance date: June 21, 2007 Amount: $10,000,000 Stated maturity: September 15, 2037 Floating interest rate: 1.57% per annum over the Three-Month LIBOR Rate Interest payable/Distribution dates: Quarterly/March 15, June 15, September 15, and December 15

Despite the fact that the accounts of the capital trusts are not included in the Company's consolidated financial statements, the trust preferred securities issued by these subsidiary trusts are included in the Tier 1 capital of Lone Star National Bancshares-Texas, Inc. for regulatory capital purposes. Federal Reserve Board rules limit the aggregate amount of restricted core capital elements (which includes trust preferred securities, among other things) that may be included in the Tier 1 capital of most bank holding companies to 25 percent of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability.

The scheduled maturities of borrowings at December 31, 2011, were as follows:

Within After One After Two After Three After One But Within But Within But Within Five (Dollars in Thousands) Year TwoYears Three Years Four years Years Total Federal Home Loan Bank borrowings $ 15,000 $ 8,353 $ 15,000 $ -0- $ 75,000 $ 113,353 Securities sold under agreements to repurchase 21,748 -0- -0- -0- -0- 21,748 Trust preferred subordinated debentures -0- -0- -0- -0- 27,837 27,837 Total borrowings $ 36,748 $ 8,353 $ 15,000 $ -0- $ 102,837 $ 162,938

Note 9 - Federal and State Income Taxes

The components of the provision for income taxes consist of the following:

(Dollars in Thousands) 2011 2010 Current income tax expense Federal $ 12,596 $ 2,923 State 202 95 Total current income tax expense 12,798 3,018

Federal deferred income tax benefit ( 1,545 ) ( 1,018 )

Total income tax expense $ 11,253 $ 2,000

2011 Annual Report l 37 The following is a reconciliation between the amount of reported income tax expense and the amount computed by multiplying the income before income tax expense by the federal statutory rate:

(Dollars in Thousands) 2011 2010 Tax at federal statutory rate $ 11,470 $ 1,909 Additions (reductions) Tax-exempt income ( 478 ) ( 437 ) Non-deductible expenses 389 176 Non-statutory stock options ( 583 ) ( 8 ) State income tax, net of federal income tax effect 131 63 Other, net 324 297 Total income tax expense $ 11,253 $ 2,000

The net deferred tax asset included in the accompanying consolidated balance sheets is comprised of the following deferred tax assets and liabilities:

(Dollars in Thousands) 2011 2010 Deferred tax liability Properties and equipment $ 3,258 $ 2,035 Net unrealized gain on securities available for sale 1,966 1,987 Total deferred tax liability 5,224 4,022

Deferred tax asset Deferred loan fees 565 550 Allowance for loan losses 10,889 8,589 Allowance for off balance sheet losses 413 386 Deferred compensation 78 70 Other real estate 1,688 168 Writedown of other than temporarily impaired securities -0- 1,102 Total deferred tax asset before valuation allowance 13,633 10,865 Valuation allowance -0- -0- Total deferred tax asset 13,633 10,865 Net deferred tax asset $ 8,409 $ 6,843

Note 10 - Concentrations of Credit Risk

Concentrations of credit risk arise when a number of customers are engaged in similar business activities or activities in the same geographic region, or have similar economic features that would cause their ability to meet contractual obligations to be affected similarly by changes in economic conditions.

A significant portion of the Company’s investments are in securities of the U.S. Government and its agencies and corporations. The Company’s lending activities are conducted primarily with customers in the Rio Grande Valley of Texas. The concentrations of credit by type of loan are set forth in Note 4. Based on the nature of the banking business, management does not consider any of these concentrations unusual.

38 l 2011 Annual Report Note 11 - Supplemental Disclosures

Supplemental disclosures of cash flow information Years Ended December 31, 2011 2010 (Dollars in Thousands) Federal and State income taxes paid $ 12,898 $ 6,439

Interest paid $ 26,081 $ 27,485

Supplemental schedule of non-cash investing and financing activities

(Dollars in Thousands) Foreclosures and repossession in satisfaction of loans receivable $ 21,142 $ 19,801 Financing provided for sales of foreclosed and repossessed assets $ 6,832 $ 10,269

Note 12 - Fair Value Measurements

ASC Topic 820 Fair Value Measurements and Disclosures defines fair value, establishes a framework for measuring fair value under GAAP and enhances disclosures about fair value measurements. Fair value is defined under ASC Topic 820 as the price that would be received for an asset or paid to transfer a liability (an exit price) in the principal market for the asset or liability in an orderly transaction between market participants on the measurement date. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability. ASC Topic 820 establishes a fair value hierarch y for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1 Inputs -Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 Inputs -Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

Level 3 Inputs -Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or

2011 Annual Report l 39 reflective of future fair values. While management believes the Company's valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalu ed since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value is set forth below. Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company's monthly and/or quarterly valuation process.

Financial assets and financial liabilities measured at fair value on a recurring basis include the following:

Securities Available for Sale. U.S. Treasury securities are reported at fair value utilizing Level 1 inputs. Other securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

Trading Securities. U.S. Treasury securities and exchange-listed common stock are reported at fair value utilizing Level 1 inputs. Other securities classified as trading are reported at fair value utilizing Level 2 inputs in the same manner as described above for securities available for sale.

Derivatives. Derivatives are reported at fair value utilizing Level 2 inputs. The Company’s risk management activities do not presently include entering into derivative contracts to manage interest rate risk. In connection with single family mortgage loan originations, the Company enters into commitments with customers to extend mortgage loans and forward sales commitments for individual loans. The Company has identified these as derivative financial instruments and accordingly records these loan origination and sales commitments at estimated fair market value. As of December 31, 2011, the Company has not identified any other financial instruments as derivatives.

The following table summarizes the securities available for sale which were the financial assets measured at fair value on a recurring basis at December 31, 2011, segregated by the level of valuation inputs within the fair value hierarchy utilized to measure fair value: Level 1 Inputs $ 18,386 Level 2 Inputs 125,632 Level 3 Inputs -0- Total fair value $ 144,018 Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). Financial assets and liabilities measured at fair value on a non-recurring basis include the following:

Impaired Loans. Certain i mpaired loans are reported at the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using Level 2 inputs based on observable market data or Level 3 inputs based on customized discounting criteria. During 2011, certain impaired loans were remeasured and reported at fair value through a specific valuation allowance allocation of the allowance for possible loan losses based upon the fair value of the underlying collateral. Impaired loans with a carrying value of $5.0 million were reduced by specific valuation allowance allocations totaling $1.2 million to a total reported fair value of $3.8 million based on collateral valuations utilizing Level 2 valuation inputs.

40 l 2011 Annual Report ASC Topic 825, “Financial Instruments,” requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or nonrecurring basis are discussed above. The estimated fair value approximates carrying value for cash and cash equivalents, accrued interest and the cash surrender value of life insurance policies. The methodologies for other financial assets and financial liabilities are discussed below:

Loans. The estimated fair value approximates carrying value for variable-rate loans that reprice frequently and with no significant change in credit risk. The fair value of fixed-rate loans and 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.

Deposits. The estimated fair value approximates carrying value for demand deposits. The fair value of fixed-rate deposit liabilities with defined maturities is estimated by discounting future cash flows using the interest rates currently offered for deposits of similar remaining maturities. The estimated fair value of deposits does not take into account the value of the Company’s long-term relationships with depositors, commonly known as core deposit intan gibles, which are separate intangible assets, and not considered financial instruments. Nonetheless, the Company would likely realize a core deposit premium if its deposit portfolio were sold in the principal market for such deposits.

Borrowed Funds. The estimated fair value approximates carrying value for short-term borrowings. The fair value of long-term fixed-rate borrowings is estimated using quoted market prices, if available, or by discounting future cash flows using current interest rates for similar financial instruments. The estimated fair value approximates carrying value for variable-rate junior subordinated deferrable interest debentures that reprice quarterly.

Loan Commitments, Standby and Commercial Letters of Credit. The Company’s lending commitments have variable interest rates and “escape” clauses if the customer’s credit qu ality deteriorates. Therefore, the fair values of these items are not significant and are not included in the following table.

The estimated fair values of the Company’s financial instruments at December 31, 2011 are as follows:

Carrying Fair (Dollars in Thousands) Amount Value Financial assets Cash and due from banks $ 36,416 $ 36,416 Due from banks-interest bearing 303,901 303,901 Certificates of deposit 2,533 2,533 Investment securities 466,981 491,535 Loans 1,221,076 1,261,491 Accrued interest receivable 7,132 7,132 Loans held for sale 3,469 3,469

Financial liabilities Deposits 1,805,942 1,743,124 Repurchase agreements/borrowed funds 135,101 144,986 Subordinated debentures 27,837 27,837 Accrued interest payable 1,827 1,827

2011 Annual Report l 41 ASC Topic 825 permits the Company to choose to measure eligible items at fair value at specified election dates. Unrealized gains and losses on items for which the fair value measurement option has been elected are reported in earnings at each subsequent reporting date. The fair value option (i) may be applied instrument by instrument, with certain exceptions, thus the Company may record identical financial assets and liabilities at fair value or by another measurement basis permitted under generally accepted accounting principles, (ii) is irrevocable (unless a new election date occurs) and (iii) is applied only to entire instruments and not to portions of instruments. Unrealized gains and losses on items for which the fair value measurement option has been elected must be reported in earnings at each subsequent reporting date. During the reported periods, the Comp any had no financial instruments measured at fair value under the fair value measurement option.

Note 13 - Related-Party Transactions

The Company has entered into transactions with its officers, directors and significant stockholders. Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present unfavorable features.

Activity in related party loans is presented in the following table:

(Dollars in Thousands) 2011 2010 Balance at beginning of year $ 46,317 $ 41,078 Additions Advances 15,460 14,183 Changes to related status 563 -0- Reductions Collections ( 14,348 ) ( 8,897 ) Changes to unrelated status ( 115 ) ( 47 ) Charge-offs -0- -0- Balance at end of year $ 47,877 $ 46,317

As of December 31, 2011 and 2010, the total amount of deposits of the Company’s officers, directors and significant stockholders were $22,988,000 and $28,459,000, respectively.

The Company has construction contracts with one of its principal stockholders. The outstanding contracts, totaling $3,477,000, of which $924,000 were entered into in years prior to 2011, are for the construction and improvements of branch facilities. Payments made under construction contracts to related parties during 2011 and 2010 totaled $2,311,000 and $2,182,000, respectively.

The Company leases various facilities under operating leases with related parties that expire at various dates through July 2015 with some containing provisions that allow renewal at similar terms. Total rental expense in 2011 and 2010 for all operating leases with related parties was approximately $281,000 and $271,000, respectively.

The following is a schedule by year of futu re minimum lease payments under operating leases with related parties as of December 31, 2011 that have initial or remaining lease terms in excess of one year:

42 l 2011 Annual Report Year ended December 31, 2012 $ 281,000 2013 281,000 2014 277,000 2015 268,000 2016 268,000

The Company engaged in other related party transactions with an aggregate amount of $489,000 during 2011. These transactions included payments to related parties for office supplies, printing, maintenance and repair of other real estate owned property and the Company’s marketing program.

Note 14 - Employee Benefits

Employee Stock Ownership Plan. The Company has an employee stock ownership plan containing Internal Revenue Code Section 401 (k) provisions in effect for substantially all full-time employees. An employee becomes a participant after completing three months of service provided he or she has attained age 18. The Company makes a discretionary matching contribution up to a certain percentage of contributions made by the participant. Additional contributions are made at the discretion of the Board of Directors. Employee benefits include $350,000 and $183,000 for the employee stock ownership plan for 2011 and 2010, respectively. Incentive Compensation Agreement. Effective January 1, 2010 the Board of Directors terminated an existing incentive compensation agreement with certain officers. This plan provided for additional compensation to the officers based upon the Bank achieving certain levels of Return on Average Equity. There was no compensation accrued under the plan in 2010. The Company did not enter into any incentive compensation plans in 2011.

Note 15 - Share-Based Payments

The Company has granted stock options providing for the purchase of common stock by certain key employees and directors under option plans approved by the stockholders.

The 2006 Stock Option Plan authorized the issuance of stock options for 150,000 shares at fair value on the date of grant. As of December 31, 2011, no shares were available for grantin g under this plan. During 2011, the Company terminated the plan except for outstanding awards. Any forfeiture will be terminated. The options have a vesting period of five years.

A summary of the status of the Company’s stock option plan as of December 31, 2011 and 2010, and changes during the years ended on those dates are presented below:

Years Ended December 31, 2011 2010 Weighted Weighted Shares Average Shares Average Underlying Exercise Underlying Exercise Options Price Options Price Outstanding at beginning of year 185,442 $ 21.98 190,892 $ 21.98 Granted 84,188 35.50 80,688 36.00 Rescinded -0- N/A ( 80,688 ) 36.00 Exercised ( 105,330 ) 11.96 ( 4,450 ) 16.70 Expired/forfeited ( 5,500 ) 37.64 ( 1,000 ) 45.00 Outstanding at end of year 158,800 $ 35.25 185,442 $ 21.98 Options exercisable at end of year 156,798 $ 35.01 169,337 $ 20.19

2011 Annual Report l 43 Years Ended December 31, 2011 2010 Range of exercise prices $13.00 - $45.00 $11.00 - $45.00 Weighted average remaining contractual life 0.50 years 0.76 years

The following table summarizes information about stock options outstanding at December 31, 2011 and 2010:

Years Ended December 31, 2011 2010 Weighted Average Shares Shares Exercise Underlying Underlying Price Options Options

$11.00 -0- 73,830 $13.00 3,600 31,600 $24.00 15,000 18,500 $35.00 2,000 2,000 $35.50 84,188 -0- $36.00 33,000 37,500 $43.50 1,000 1,000 $45.00 20,012 21,012 158,800 185,442

The Company recognizes the cost of the unvested portion of options issued in prior years and the cost of options issued during 2011, using the Black-Scholes-Merton option pricing model and a single options award approach method to measure the compensation cost of stock options granted in 2011. This option pricing model relies on highly subjective and variable assumptions, including the expected life of the options; the price volatility of the underlying stock; and the rate of return a prudent investor could expect in a stable market. The Company utilized the following assumptions, based on historical values and industry averages: risk-free interest rate (2.82 percent) based upon a U. S. Treasury instrument with a life similar to the expected life of the option grant at the grant date; a dividend payout rate of zero; and an expected option life of 60 months. The expected stock price volatility assumption of 12.51 was determined using a combination of historical and implied volatility of the Company’s common stock. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. The forfeiture rate utilized is based on the Company’s historical experience with respect to stock options issued in prior period s.

Total compensation cost for share-based payments was $475,000 in 2011 and $35,000 in 2010 net of taxes of $256,000 and $19,000, respectively.

Note 16 - Commitments and Contingent Liabilities

In the normal course of business, the Company makes various commitments and incurs certain contingent liabilities that are not presented in the accompanying financial statements. These commitments and contingent liabilities include commitments to extend credit, standby letters of credit and credit card guarantees.

Commitments under standby letters of credit aggregated $4,554,000 and $5,378,000 at December 31, 2011 and 2010, respectively. Commitments to fund loans were approximately $76,852,000 and $93,073,000 at December 31, 2011 and 2010, respectively. At December 31, 2011 and 2010, the Company had guarantees on credit cards to its customers totaling $10,000 and $520,000, respectively.

44 l 2011 Annual Report Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company evaluates each customer’s creditworthiness on a case by case basis. The amount of the collateral obtained, if it is deemed necessary by the Company upon extensio n of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include certificates of deposit, accounts receivable, inventory, equipment and real estate.

Standby letters of credit and financial guarantees written are a conditional commitment issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds various types of collateral supporting those commitments for which collateral is deemed necessary, which may include certificates of deposit, accounts receivable, inventory, equipment and real estate. The Company did not incur any loss on its commitments in 2011 or 2010. Management does not anticipate any material losses as a result of its commitments and contingent liabilities.

The Company has entered into long-term agreements for certain data processing and computer software products and services. The data processing and computer software contracts provide for minimum monthly payments and additional charges based upon volume. These agreements expire in various years through 2014 and contain provisions that allow renewal at similar terms. Total expen se from these agreements amounted to $1,596,000 and $1,106,000 in 2011 and 2010, respectively.

Aggregate minimum contractual payments under these agreements for the next five years are as follows:

Year ended December 31, 2012 $ 1,794,000 2013 1,462,000 2014 673,000 2015 -0- 2016 -0-

The Company leases various facilities under operating leases expiring at various dates through August 2020 with some containing provisions that allow renewal at similar terms. Total rental expense in 2011 and 2010 for all operating leases was approximately $934,000 and $682,000, respectively.

The following is a schedule by year of future minimum lease payments under operating leases as of December 31, 2011 that have initial or remaining lease terms in exce ss of one year:

Year ended December 31, 2012 $ 653,000 2013 641,000 2014 461,000 2015 370,000 2016 350,000

The Company is a defendant in legal actions arising in connection with its ordinary course of business that are in various stages of litigation and investigation by the Company and its legal counsel. After reviewing with counsel the actions pending involving the Company, management believes that the ultimate resolution of these matters will not materially affect the Company’s financial position.

2011 Annual Report l 45 Note 17 - Earnings Per Share

Basic net income per share (“EPS”) was computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the year.

Diluted net income per share was computed by dividing net income by the weighted average number of common shares and common stock equivalents outstanding during the year. The diluted net income per share computations inclu de the effects of common stock equivalents applicable to stock option contracts and are determined using the treasury stock method.

The table below presents a reconciliation of basic and diluted net income per share computations. Years ended December 31, (Dollars in Thousands, Except Per Share Data) 2011 2010

Net income available to common shareholders $ 21,519 $ 3,711 Weighted average number of common shares outstanding used in basic EPS calculation 6,317,240 5,823,291 Add assumed exercise of dilutive securities outstanding - stock options 15,227 78,629 Weighted average number of common shares outstanding used in diluted basic EPS calculation 6,332,467 5,901,920 Basic EPS $ 3.41 $ 0.64 Diluted EPS $ 3.40 $ 0.63

Note 18 - Regulatory Matters

The Bank, as a National Bank, is subject to the dividend restrictions set forth by the Comptroller of the Currency (the “OCC”). Under such restrictions, the Bank may not, without the prior approval of the OCC, declare dividends in excess of the current year’s earnings (as defined) plus the retained earnings (as defined) from the prior two years or pay any dividend which would cause the Bank to become undercapitalized.

The Company is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet the minimum regulatory capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that if undertaken, could have a direct material effect on the Company and the consolidated financial statements. Under the regulatory capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines involving quantitative measures of the Company’s assets, liabilities, and certain off- balance-sheet items as calculated under regulatory accounting practices. The Company’s capital amounts and classification under the prompt corrective action guidelines are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of total risk-based capital and Tier I capital to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined). Management believes, as of December 31, 2011, that the Company meets all the capital adequacy requirements to which it is subject.

As of December 31, 2011, the most recent notification from the regulators categorized the Company and the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Company and the Bank have to maintain minimum or greater total risk-based, Tier I risk-based, and Tier I leverage ratios as disclosed in the table below.

46 l 2011 Annual Report There are no conditions or events since the most recent notification that management believes have changed the Bank’s prompt corrective action category.

To Be Well Capitalized For Capital Under Prompt Actual Adequacy Purposes Action Provisions (Dollars in Thousands) Amount Ratio Amount Ratio Amount Ratio

Lone Star National Bancshares-Texas, Inc. December 31, 2011 Total Capital (to Risk-Weighted Assets) $ 247,352 19.53% $ 101,343 8% $ 126,679 10% Tier 1 Capital (to Risk-Weighted Assets) $ 231,314 18.26% $ 50,672 4% $ 76,008 6% Tier 1 Capital (to Average Assets) $ 231,314 10.48% $ 88,325 4% $ 110,406 5%

December 31, 2010 Total Capital (to Risk-Weighted Assets) $ 223,454 17.38% $ 102,879 8% $ 128,599 10% Tier 1 Capital (to Risk-Weighted Assets) $ 207,252 16.12% $ 51,440 4% $ 77,160 6% Tier 1 Capital (to Average Assets) $ 207,252 10.00% $ 82,908 4% $ 103,635 5%

Lone Star National Bank December 31, 2011 Total Capital (to Risk-Weighted Assets) $ 231,077 18.39% $ 100,506 8% $ 125,632 10% Tier 1 Capital (to Risk-Weighted Assets) $ 215,168 17.13% $ 50,253 4% $ 75,379 6% Tier 1 Capital (to Average Assets) $ 215,168 9.78% $ 88,029 4% $ 110,036 5%

December 31, 2010 Total Capital (to Risk-Weighted Assets) $ 207,733 16.71% $ 102,783 8% $ 128,479 10% Tier 1 Capital (to Risk-Weighted Assets) $ 191,545 14.91% $ 51,392 4% $ 77,088 6% Tier 1 Capital (to Average Assets) $ 191,545 9.30% $ 82,411 4% $ 103,014 5%

Note 19 - Recent Accounting Pronouncements

FASB ASC Topic 810, “Consolidation” ("ASC 810") was amended to change how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity's purpose and design and a company's ability to direct the activities of the entity that most significantly impact the entity's economic performance. The new authoritative accounting guidance requires additional disclosures about the reporting entity's involvement with variable-interest entities and any significant changes in risk exposure due to that involvement as well as its effect on the entity's financial statements. The new authoritative accounting guidance under ASC 810 was effec tive January 1, 2010 and did not have a significant impact on the Company’s financial statements.

ASU No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures About Fair Value Measurements.” ASU 2010-06 requires expanded disclosures related to fair value measurements including (i) the amounts of significant transfers of assets or liabilities between Levels 1 and 2 of the fair value hierarchy and the reasons for the transfers, (ii) the reasons for transfers of assets or liabilities in or out of Level 3 of the fair value hierarchy, with significant transfers disclosed separately, (iii) the policy for determining when transfers between levels of the fair value hierarchy are recognized and (iv) for recurring fair value measurements of assets and liabilities in Level 3 of the fair value hierarchy, a gross presentation of information about purchases, sales, issuances and settlements. ASU 2010-06 further clarifies that (i) fair value measurement disclosures should be provided for each class of assets and liabilities (rather than major category), which would generally be a subset of assets or liabilities within a line item in the statement of financial position and (ii) companies should provide

2011 Annual Report l 47 disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements for each class of assets and liabilities included in Levels 2 and 3 of the fair value hierarchy. The disclosures related to the gross presentation of purchases, sales, issuances and settlements of assets and liabilities included in Level 3 of the fair value hierarchy were required for the Company beginning January 1, 2011. The remaining disclosure requirements and clarifications made by ASU 2010-06 became effective for the Company on January 1, 2010. The new authoritative accounting guidance under ASC 820 did not have a significant impact on the Company’s financial statements.

ASU No. 2011-02, “Receivables (Topic 310) – A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” ASU 2011-02 clarifies wh ich loan modifications constitute troubled debt restructurings and is intended to assist creditors in determining whether a modification of the terms of a receivable meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude, under the guidance clarified by ASU 2011-02, that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. ASU 2011-02 became effective for the Company on July 1, 2011, and applies retrospectively to restructurings occurring on or after January 1, 2011. The new authoritative accounting guidance under ASU 2011-02 did not have a significant impact on the Company’s financial statements.

ASU 2011-11, Balance Sheet (Topic 210) – “Disclosures about Offsetting Assets and Liabilities.” ASU 2011-11 amends Topic 210, “Balance Sheet,” to require an entity to disclose both gross and net information about financial instruments, such as sales and repurchase agreements and reverse sales and repurchase agreements and securities borrowing/lending arrangements, and derivative instruments that are eligible for offset in the statement of financial position and/or subject to a master netting arrangement or similar agreement. ASU 2011-11 is effective for annual and interim periods beginning on January 1, 2013, and is not expected to have a significant impact on the Company’s financial statements.

48 l 2011 Annual Report 2011 Annual Report l 49 Board of Directors

Alonzo Cantu Oscar R. Gonzalez Cruz Cantu III Chairman of the Board Vice Chairman of the Board Land Development Lone Star National Bank Lone Star National Bank Cantu Construction, Inc. Certified Public Accountant

George R. Carruthers S. David Deanda, Jr. Lazaro H. Fernandez, Jr. Executive Vice President & President & Dos Rios Textiles Corp. Chief Financial Officer Chief Operating Officer Lone Star National Lone Star National Bank Bancshares-Texas, Inc.

Abdala Kalifa Nolan E. Perez, M.D. A. Jabier Rodriguez Kalifa’s Western Wear Gastroenterology Chief Executive Officer Lone Star National Bank

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

Joe D. Zayas, D.D.S. Dentist

2011 Annual Report l 51 Advisory Directors

Hidalgo County

Rolando Ayala Raul C. Garza Jaime A. Gonzalez, Jr. Arturo E. Guerra, Jr. Alberto Gutierrez, Jr., M.D. Executive Vice President Spirit Truck Lines, Inc. Attorney at Law Attorney at Law/Rancher Family Practice Lone Star National Bank

Victor Haddad, M.D. Ambrosio Hernandez, M.D. Jorge Medina Jose F. Peña, M.D. David M. Penoli Surgeon Pediatric Surgeon Joe Brand Internal Medicine Executive Vice President & Chief Financial Officer

Sunil Wadhwani Richard Walsh Watchzone.com Healds Valley Farms Marketing Consultant Starr County

Arturo S. Perez Jose A. Vazquez, M.D. The Honorable Gilberto Perez Properties, LLC Internal Medicine Judge Eloy Vera Managing Partner

52 l 2011 Annual Report Cameron County

Rusty Brechot Raymond Cisneros Narciso Escareño Mike Garcia David G. Oliveira Senior Vice President Executive Vice President & Travel Agency Inc. El Devisadero Ranch Attorney at Law Corporate Sales Manager Chief Credit Officer

Jose L. Peña Rodolfo A. Saca, M.D. Aldon Williams, M.D. Asim Zamir, M.D., F.A.A.P. Educator/Rancher Pediatric Neonatologist Pain Medicine Specialist Pediatrician Bexar County

Ricardo Castillo, M.D. Edmundo O. Garcia, M.D. Eliot Garza Damaso A. Oliva, M.D. Dipen J. Parekh, M.D. Family Practice Heritage Medical Clinic NSIDE Magazine Alamo Psychiatric Care, P.A. Urologic Oncology, Robotic Surgery

Larry E. Safir Media/Health Care Executive

2011 Annual Report l 53 Bank O cers

Corporate Office A. Jabier Rodriguez Adan Garcia Betty Bran Chief Executive Officer Senior Vice President Vice President Director Abby G. Gonzalez Hope Cadenas S. David Deanda, Jr. Senior Vice President Vice President President & Chief Operating Officer Director Gloria Guerra Veronica Cantu Senior Vice President Vice President Angie Vera-Oliva Executive Vice President & Lawrence Kentz Enrique Espinoza Chief Operations Officer Senior Vice President & Vice President Director Compliance Officer Jose Leal Raymond Cisneros Olga Lee Hinojosa Vice President Executive Vice President & Senior Vice President Chief Credit Officer Cindy Lopez-Ybarra Advisory Director Efrain Martinez Vice President Senior Vice President & D. M. Penoli BSA Officer Marco Perez Executive Vice President & Vice President Chief Financial Officer Adam Pearson Advisory Director Senior Vice President & Ismael Rodriguez Information Security Officer Vice President Rolando Ayala Executive Vice President Pedro Salazar Gregory Shoultz Advisory Director Senior Vice President Vice President & Controller Edward Borges Sameer Saxena Executive Vice President Senior Vice President & Chief Risk Officer Lone Star National Ted P. Sunderland Bancshares-Texas, Inc. Lawrence DesPres Senior Vice President George R. Carruthers Executive Vice President & Executive Vice President & Chief Information Officer Christine M. Villaseñor Chief Financial Officer Senior Vice President Sam De La Garza Janie Sandoval Executive Vice President Desiraee Walker Executive Vice President & Senior Vice President Financial Analysis Manager Tony Gorman Executive Vice President & Celeste De La Garza Joe M. Araiza, Jr. Human Resources & Training Director First Vice President First Vice President

Roger G. Leblond Edna X. De Saro Executive Vice President & First Vice President McAllen Chief Technology Officer Arden Peterson Leticia E. Hinojosa Senior Vice President First Vice President Rusty Brechot Senior Vice President Armando Martinez, Jr. Jose X. Villescas Advisory Director First Vice President Senior Vice President

Rueben Cole Vipul Patel Dustin A. Wells Senior Vice President First Vice President Senior Vice President

Brian Disque J. Edgar Ruiz II Cristobal Escobedo, Jr. Senior Vice President First Vice President First Vice President

Fred Flores Veronica Vizcarra-Prinkey Paul Garcia Senior Vice President First Vice President First Vice President

54 l 2011 Annual Report Rafael Gonzalez Michael Trippel Michele Robinson First Vice President First Vice President First Vice President

Homer Guerra Nena Gutierrez Michael Alvarado First Vice President Vice President Vice President

Eva Markum Olga G. Lopez First Vice President Vice President San Antonio A. Jabier Rodriguez Carmen Raymundo Robyn Rodriguez Chief Executive Officer First Vice President Vice President Director

Ixchetl Romero Susan Trevino Ezequiel “Rick” Acevedo, Jr. First Vice President Vice President Executive Vice President

Edna Yaccarino Maria I. Villarreal Gustavo Parra First Vice President Vice President Executive Vice President

Daniel Algranatti Cynthia Gutierrez Vice President Rio Grande City & Roma Senior Vice President Ruben C. Chapa Magda Ramirez Senior Vice President Roland Luna Vice President First Vice President Alejandra Gonzalez Lydia Sandoval Vice President Ryan Parker Vice President First Vice President

Leticia Zavala Hidalgo, Mission & Palmview Anthony Trevino Vice President Juan J. Acosta First Vice President Senior Vice President Raymond Chan Pharr, Edinburg & Jesse A. Villarreal Vice President Weslaco Senior Vice President Joel A. Gonzalez Mary Guajardo Vice President Senior Vice President Harlingen, Brownsville Elias Longoria, Jr. Port Isabel & Lone Star Insurance Services* Senior Vice President South Padre Island Jim Hansen President Norma Quintanilla Eduardo Caso Executive Vice President Senior Vice President Ruben Garza Vice President Martin Volpe Jackie Russell Senior Vice President Senior Vice President LSNB Investment Services** Julia De Leon Norma P. Weaver Yvonne L. Silguero First Vice President Senior Vice President LPL Branch Manager/Financial Consultant

Erika Degollado Margarita Gonzalez Enrique Lopez First Vice President First Vice President Financial Consultant

*Insurance Products Offered by Lone Star Insurance Services, Inc. are not insured by the FDIC or Any Other Federal Government Agency, are not Deposits of or Guaranteed by the Bank or Any Affiliate, and May Lose Value. **Investment Products Offered by LSNB Investment Services are not insured by the FDIC or Any Other Federal Government Agency, are not Deposits of or Guaranteed by the Bank or Any Affiliate, and May Lose Value. Securities and Insurance products offered through LPL Financial and its affiliates, Member FINRA/SIPC.

2011 Annual Report l 55 Banking Centers,

Mortgage & ATM San Antonio

Rio Grande Locations Valley

Rio Grande Valley Locations Mortgage Centers Brownsville Pharr Brownsville 3300 N. Expressway 83 206 W. Ferguson Avenue 3300 N. Expressway 83 - Mortgage Center - ATM - ATM - Motor Bank McAllen 4500 N. 10th Street, Suite 305 - Motor Bank 1201 S. Cage Boulevard 2100 Boca Chica Boulevard (Motor Bank) San Antonio - ATM - ATM 930 Proton, Suite 106 - Motor Bank 118 South Cage Boulevard Edinburg (Located at the Pharr City Hall Building) Offsite ATM Locations Alto Bonito 117 S. 10th Avenue - ATM 760 FM 2360 N - ATM - Motor Bank (Located Inside Alto County Stop) - Motor Bank Port Isabel Edinburg Harlingen 202 E. Queen Isabella Boulevard 5502 S. McColl Road 1901 N. Ed Carey Drive, Suite 100 (Motor Bank) (Located Inside The Women’s Hospital at Renaissance) - ATM (2) - ATM 5501 S. McColl Road - Motor Bank Rio Grande City (Located Inside Doctors Hospital at Renaissance) 918 W. Harrison Avenue 2300 E. Highway 83 (Motor Bank) - ATM McAllen - ATM - Motor Bank 3700 Buddy Owens Avenue (Located at Burger King) Hidalgo 201 N. Texas Street 633 S. International Boulevard - ATM 114 S. Main Street - ATM - Motor Bank (Located Inside Colors Name Brand Clothing) - Motor Bank Roma Pharr McAllen 305 E. Grant Street 1210 W. Expressway 83, Suite 6 520 E. Nolana Avenue - ATM (Located Inside Mas Building) - Motor Bank (Corporate Office) 3000 N. Cage Boulevard 5515 N. 10th Street South Padre Island (Located Inside The Pharr Events Center) - ATM 601 Padre Boulevard Progreso - Motor Bank - ATM 251 S. International Boulevard - Motor Bank 200 Lindberg Avenue (Located at the Progreso International Bridge) - ATM Weslaco Rio Grande City - Motor Bank 214 S. Texas Boulevard 100 FM 3167 - ATM 1300 E. Ridge Road (Located Inside the Starr County - Motor Bank - ATM Court House-Annex Building) - Motor Bank 620 W. Expressway 83 600 E. Nolana Avenue - ATM Roma - ATM - Motor Bank 4996 E. Highway 83 - Motor Bank (Located at Pueblo Express Mart) 5537 N. McColl Road San Antonio Locations - ATM 7954 Fredericksburg Road Lone Star Insurance Services* 520 E. Nolana Avenue, Suite 110 - Motor Bank - ATM - Motor Bank McAllen, Texas 78504 800 N. Main Street, Suite 600 (Located at the Art Village on Main) 40 NE Loop 410, Suite 408 LSNB Investment Services** - ATM (Annex Corporate Office- 520 E. Nolana Avenue, Suite 120 2109 S. 10th Street The Mercantile Building) McAllen, Texas 78504 - ATM - Motor Bank - Motor Bank 10000 San Pedro Avenue Mission - ATM 2003 E. Griffin Parkway - Motor Bank - ATM 6986 S. Zarzamora Street - Motor Bank - ATM 1100 S. Bryan Road - Motor Bank - ATM - Motor Bank

Palmview *Insurance Products Offered by Lone Star Insurance Services, Inc. are not insured by the FDIC or Any Other Federal Government Agency, 720 E. Veterans Boulevard are not Deposits of or Guaranteed by the Bank or Any Affiliate, and May Lose Value. - ATM **Investment Products Offered by LSNB Investment Services are not insured by the FDIC or Any Other Federal Government Agency, are not Deposits of or Guaranteed by the Bank or Any Affiliate, and May Lose Value. Securities and Insurance products offered through - Motor Bank LPL Financial and its affiliates, Member FINRA/SIPC.

56 l 2011 Annual Report Our History

Lone Star National Bank opened for Cameron County market in July 2001, true to our mission of supporting business on January 23, 1983 in Pharr, with a banking center at 3300 N. individuals and small businesses who Texas. Conducting business in a small, Expressway 83 in Brownsville. In March contribute to the growth of their 3,000 square-foot, temporary building 2010, the bank opened the first banking communities. And staying at the and with only ten employees, the bank center in Bexar County at 40 NE Loop forefront of technological advances like opened its doors with the objective of 410, Suite 408, in San Antonio. By “LSNB Mobile™” (mobile banking) and making the future more prosperous for December 2011, the bank opened the “Office Banker™” (remote capture) the community. fourth banking center in San Antonio. which let us bring the bank to our customers. Over the next two decades, Lone Star Today, Lone Star National Bank is a National Bank expanded continuously technologically advanced, full-service, These factors, combined with the opening banking centers throughout the independent, community bank with over support of our stockholders, customers, Valley, beginning with its first banking 500 employees and 31 locations across neighbors and friends, have made Lone center in Hidalgo County on April 4, South Texas. Our rapid growth is Star National Bank a well-known 1994, at 200 Lindberg in McAllen. In attributable to several factors such as success, and a leader in financial August 2000, the bank opened the offering personal “value added” cust- services in South Texas. banking center outside Hidalgo County in omer service and providing a rewarding Rio Grande City and then entered the environment for our employees. Staying 520 E. Nolana Avenue • McAllen, Texas 78504 1.800.580.0322 www.lonestarnationalbank.com

Member FDIC, Federal Reserve System and Lone Star National Bancshares-Texas, Inc.