UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10 - Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

Commission File Number 000-51548

STATE NATIONAL BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Texas		75-2641879
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

4500 Mercantile Plaza Drive
Suite 300
Fort Worth, Texas 76137
(Address of principal executive offices, including zip code)

(817) 547-1150
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer o Accelerated Filer o Non-Accelerated Filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)

Yes o No x

The number of shares outstanding of the issuer’s Common Stock as of November 10, 2006, was 12,051,846 shares.

STATE NATIONAL BANCSHARES, INC.

INDEX

		PAGE
PART I - FINANCIAL INFORMATION
ITEM 1.	FINANCIAL STATEMENTS
	Consolidated Balance Sheets	1
	Consolidated Statements of Operations	2
	Consolidated Statements of Changes in Shareholders' Equity	3
	Consolidated Statements of Cash Flows	4
	Notes to Interim Consolidated Financial Statements	5

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	10

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	27

ITEM 4.	CONTROLS AND PROCEDURES	27

PART II - OTHER INFORMATION
ITEM 1.	LEGAL PROCEEDINGS	27

ITEM 1A.	RISK FACTORS	27

ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	28

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	28

ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	29

ITEM 5.	OTHER INFOMATION	29

ITEM 6.	EXHIBITS	29

PART I -FINANCIAL INFORMATION

ITEM 1. Financial Statements

STATE NATIONAL BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

September 30, 2006 and December 31, 2005

(Unaudited)

	September 30,			December 31,
	2006			2005
Assets:	(Dollars in thousands, except share data)
Cash and cash equivalents:
Cash and due from banks	$	58,887		$	72,922
Federal funds sold		—			36,950
Interest-bearing deposits in other banks		3,155			44,763
Total cash and cash equivalents		62,042			154,635
Securities available-for-sale, at fair value (amortized cost of $237,455 and $208,797 at September 30, 2006 and December 31, 2005, respectively)		226,023			206,787
Federal Reserve Bank stock and other investments, at cost		9,126			8,094
Loans held-for-sale		4,318			11,584
Loans held for investment:
Total loans held for investment		1,130,655			1,074,611
Less allowance for loan losses		12,992			12,591
Net loans held for investment		1,117,663			1,062,020
Premises and equipment, net		54,529			48,769
Goodwill		99,354			100,486
Other intangible assets, net		15,334			17,936
Accrued interest receivable		10,038			8,919
Other real estate and other repossessed assets		1,019			935
Other assets		45,757			42,712
Total assets	$	1,645,203		$	1,662,877
Liabilities and shareholders' equity:
Deposits:
Noninterest bearing deposits	$	478,192		$	487,369
Interest-bearing demand deposits		494,829			523,857
Interest-bearing time deposits		344,182			345,852
Total deposits		1,317,203			1,357,078
Federal funds purchased and securities sold under agreement to repurchase		43,151			28,597
Accrued interest payable		1,957			1,645
Other liabilities		8,152			10,459
Junior subordinated debentures		47,000			47,000
Notes payable		1,226			5,841
Total liabilities		1,418,689			1,450,620

Minority interest in consolidated subsidiary		1,167			—

Shareholders' equity:
Common stock, $1 par value;
Authorized shares—40,000,000;
Issued and outstanding shares—12,047,513 and 11,971,107, respectively		12,047			11,971
Additional paid-in capital		179,399			177,428
Retained earnings		35,400			24,164
Accumulated other comprehensive loss		(1,499	)		(1,306	)
Total shareholders' equity		225,347			212,257
Total liabilities and shareholders' equity	$	1,645,203		$	1,662,877

See Accompanying Notes to Consolidated Financial Statements.

STATE NATIONAL BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

Three Months and Nine Months Ended September 30, 2006 and 2005

(Unaudited)

	Three Months						Nine Months
	Ended September 30,						Ended September 30,
	2006			2005			2006			2005
Interest income:	(In thousands, except per share data)
Loans, including fees	$	23,272		$	17,728		$	66,227		$	50,519
Securities		2,700			1,277			7,652			4,100
Deposits in other banks		51			127			588			237
Federal funds sold		84			457			789			740
Total interest income		26,107			19,589			75,256			55,596
Interest expense:
Deposits		5,064			2,862			13,910			7,267
Federal funds purchased and securities sold under agreement to repurchase		449			178			1,120			387
Subordinated notes payable		1,073			832			3,025			2,314
Notes payable		22			10			96			30
Total interest expense		6,608			3,882			18,151			9,998
Net interest income		19,499			15,707			57,105			45,598
Provision for loan losses		160			150			960			750
Net interest income after provision for loan losses		19,339			15,557			56,145			44,848
Non-interest income:
Service charges on deposit accounts		2,891			2,600			8,385			7,416
Gain on sale of loans		641			804			1,925			2,153
Bank owned life insurance		326			316			979			948
Net realized (loss)/gain on sale of investment securities		—			—			(79	)		1
Other		1,178			1,211			3,522			3,285
Total non-interest income		5,036			4,931			14,732			13,803
Non-interest expenses:
Salaries and employee benefits		8,108			7,297			24,413			21,614
Net occupancy and equipment expense		2,490			2,322			7,495			6,628
Amortization of intangibles		998			824			3,017			2,471
Communication expense		330			300			975			856
Data processing expense		238			203			694			622
Advertising		443			330			1,165			864
Professional fees		588			326			1,679			1,017
Supplies		148			166			528			587
Net (gain) costs applicable to other real estate and other repossessed assets		(8	)		(6	)		196			23
Merger expenses		126			19			884			59
Other		2,423			2,244			7,383			6,378
Total noninterest expenses		15,884			14,025			48,429			41,119
Income before income taxes and minority interest in consolidated subsidiary’s net loss		8,491			6,463			22,448			17,532
Income tax expense		2,811			2,085			7,677			5,857
Minority interest in consolidated subsidiary’s net loss		19			—			67			—
Net income	$	5,699		$	4,378			14,838		$	11,675
Basic income per share	$	0.47		$	0.43		$	1.24		$	1.16
Diluted income per share		0.46			0.42			1.21			1.14
Dividends per share		0.10			—			0.30			—

See Accompanying Notes to Consolidated Financial Statements.

STATE NATIONAL BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Change in Shareholders’ Equity

(Unaudited)

	Common Stock
	Shares		Amount		Additional Paid-In Capital		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total
	(Dollars in thousands, except number of shares)
Balance, January 1, 2005		10,054,582	$	10,055	$	133,519	$	7,482		$	304		$	151,360
Comprehensive income:
Net income		—		—		—		16,682			—			16,682
Change in unrealized gain on available-for-sale securities, net of deferred income taxes		—		—		—		—			(1,609	)		(1,609	)
Reclassification adjustment for gains included in net income		—		—		—		—			(1	)		(1	)
Total comprehensive income														15,072
Issuance of new stock		1,907,692		1,907		43,279		—			—			45,186
Stock option award expense		—		—		486		—			—			486
Stock options exercised		8,833		9		144		—			—			153
Balance, December 31, 2005		11,971,107		11,971		177,428		24,164			(1,306	)		212,257
Comprehensive income:
Net income		—		—		—		14,838			—			14,838
Change in unrealized gain on available-for-sale securities, net of deferred income taxes		—		—		—		—			(272	)		(272	)
Reclassification adjustment for losses included in net income		—		—		—		—			79			79
Total comprehensive income														14,645
Dividends - $0.30 per share		—		—		—		(3,602	)		—			(3,602	)
Stock option award expense		—		—		357		—			—			357
Stock issued for directors fees		7,576		7		183		—			—			190
Stock options exercised		68,830		69		1,431		—			—			1,500
Balance, September 30, 2006		12,047,513	$	12,047	$	179,399	$	35,400		$	(1,499	)	$	225,347

See Accompanying Notes to Consolidated Financial Statements.

STATE NATIONAL BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

	Nine Months Ended September 30,
	2006			2005
Operating Activities:	(Dollars in thousands)
Net income	$	14,838		$	11,675
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		960			750
Depreciation and amortization		5,725			4,744
Stock compensation expense		357			362
Stock issued for directors fees		190			—
Loans originated for sale		(78,991	)		(93,420	)
Proceeds from sales of loans held-for-sale		88,182			97,194
Gain on sale of loans		(1,925	)		(2,153	)
Gain on sale of premises and equipment		(24	)		—
Net loss (gain) on sale of investment securities		79			(1	)
Net loss (gain) on sale of other real estate and repossessed assets		5			(55	)
Deferred income tax benefit		(1,033	)		(862	)
Minority interest in consolidated subsidiary’s net loss		(67	)		—
Write-down of premises and equipment		11			80
Net amortization of premium on securities		7			492
Net change in other assets and liabilities		(5,028	)		1,597
Net cash provided by operating activities		23,286			20,403
Investing Activities:
Purchase Price adjustment for Heritage acquisition		717			—
Purchases of securities available-for-sale		(101,185	)		(7,966	)
Purchases of Federal Reserve Bank stock and other investments		(2,526	)		(91	)
Proceeds from sales, maturities and calls of securities available-for-sale		82,584			40,062
Proceeds from maturities and calls of Federal Reserve Bank Stock & other investments		476			413
Net increase in loans		(57,174	)		(30,393	)
Proceeds from sale of premises and equipment		374			312
Proceeds from sales of other real estate and other repossessed assets		482			1,259
Purchase of premises and equipment		(8,823	)		(4,435	)
Net cash used in investing activities		(85,075	)		(839	)
Financing Activities:
Net (decrease) increase in deposits		(39,875	)		24,382
Stock issued through exercise of stock options		1,500			153
Net increase in federal funds purchased and securities sold under agreement to repurchase		14,554			8,940
Principal payments on FHLB note		(4,726	)		(89	)
Proceeds from Note		111			—
Initial public offering issuance costs		—			(334	)
Proceeds from minority interest		1,234			—
Payment of cash dividends		(3,602	)		—
Net cash (used in) provided by financing activities		(30,804	)		33,052
Net (decrease) increase in cash and cash equivalents		(92,593	)		52,616
Cash and cash equivalents, beginning of period		154,635			89,467
Cash and cash equivalents, end of period	$	62,042		$	142,083

Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	17,839		$	9,631
Income taxes paid, net of refunds		8,746			5,248
Noncash transactions:
Transfer of loans to other real estate owned, net		672			1,120

See Accompanying Notes to Consolidated Financial Statements.

STATE NATIONAL BANCSHARES, INC. AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements

(Unaudited)

1. Nature of Operations and Basis of Presentation

State National Bancshares, Inc. (the “Company” or “SNBI”) is a bank holding company headquartered in Fort Worth, Texas, offering a broad range of financial products and services primarily through the Company’s main subsidiary, State National Bank (the “Bank”), a national banking association. As of September 30, 2006, the Bank operated 43 banking centers located in three distinct geographic markets throughout Texas and New Mexico: the greater Tarrant County area (Fort Worth, Texas); West Texas (Lubbock, Abilene and Odessa), and Rio Grande (El Paso, Texas and Southern New Mexico). As a bank holding company, the Company is subject to the provisions of the Bank Holding Company Act, and to supervision and regulation by the Board of Governors of the Federal Reserve System.

The unaudited consolidated financial statements include the accounts of the Company and its subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation. These statements are, in the opinion of management, a fair presentation of the financial position and results for the periods presented. These financial statements are unaudited but, in the opinion of management, reflect all necessary adjustments, including usual recurring adjustments, for a fair presentation of such financial statements.

The presentation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amount of revenue and expenses during the reporting periods. These estimates are based on information available as of the date of the consolidated financial statements. Therefore, actual results could differ from those estimates.

Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted from these statements pursuant to rules and regulations of the Securities and Exchange Commission (the “SEC”) and, accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the year ended December 31, 2005, which we included in our Annual Report on Form 10-K filed on March 29, 2006. The results of operations for the nine-month period ended September 30, 2006 are not necessarily indicative of the results to be expected for the full year.

2. Merger Announcement

On June 12, 2006, SNBI and Banco Bilbao Vizcaya Argentaria, S.A., a bank organized under the laws of Spain (“BBVA”), entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which, among other things, BBVA will acquire all of the issued and outstanding shares of capital stock of SNBI and all of the outstanding and unexercised options of SNBI by virtue of the merger of a wholly-owned subsidiary of BBVA, with and into SNBI, with SNBI as the surviving corporation (the “Merger”).

Under the terms and subject to the conditions of the Merger Agreement, which has been approved by the Board of Directors of SNBI and the appropriate corporate body of BBVA, at the effective time of the Merger (the “Effective Time”), all of the outstanding common stock of SNBI will be cancelled in exchange for $38.50 per share. All of the outstanding and unexercised options to acquire shares of common stock of SNBI will be cancelled at the Effective Time in exchange for an amount in cash per outstanding and unexercised option equal to the difference between (i) the mean between the highest and lowest selling prices quoted on The Nasdaq National Market for a share of SNBI’s common stock on the last trading day prior to the Effective Time and (ii) the per share exercise price of the stock option. The Merger Agreement contains representations, warranties and covenants of SNBI and BBVA. In addition, SNBI has agreed (i) to conduct its businesses in the ordinary course during the period between the execution of the Merger Agreement and consummation of the Merger and (ii) not to engage in certain kinds of transactions during such period without the consent of BBVA. The Board of Directors of SNBI has adopted a resolution recommending the approval and adoption of the Merger Agreement by SNBI’s shareholders, and has agreed to hold a shareholder meeting to put these matters before SNBI’s shareholders for their consideration. SNBI has further agreed not to (i) solicit proposals relating to alternative business combination transactions or (ii) subject to certain exceptions, enter into discussions or negotiations or provide confidential information in connection with any proposals for alternative business combination transactions.

All regulatory approvals required for consummation of the Merger have been obtained. However, consummation of the Merger remains subject to various conditions, including requisite approvals of the holders of SNBI common stock. In addition, each party’s obligation to consummate the Merger is subject to certain other conditions, including (i) the other party’s representations and warranties in the Merger Agreement being true and correct at the Effective Time, subject to the materiality standards contained in the Merger Agreement, (ii) material compliance of the other party with its covenants and (iii) the absence of any law or order prohibiting the consummation of the Merger.

On October 6, 2006, SNBI filed with the SEC a definitive proxy statement scheduling a special meeting of its shareholders to vote on the Merger on November 15, 2006. SNBI anticipates the Merger will be close on January 3, 2007, assuming that shareholder approval is obtained. For additional information, refer to the Form 8-K filed with the SEC on June 16, 2006 and the definitive proxy statement on Schedule 14A filed with SEC on October 6, 2006.

3. Earnings Per Share

Basic earnings per share represent income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method.

The computation of earnings per share is presented below:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(Dollars in thousands, except per share data)
Reported net income	$	5,699		$	4,378		$	14,838		$	11,675
Add: Stock-based employee compensation expense included in reported net income, net of tax		69			78			232			235
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of tax		(69	)		(81	)		(232	)		(247	)
Pro forma net income	$	5,699		$	4,375		$	14,838		$	11,663
Earnings per share:
Basic—as reported	$	0.47		$	0.43		$	1.24		$	1.16
Basic—pro forma		0.47			0.43			1.24			1.16
Diluted—as reported		0.46			0.42			1.21			1.14
Diluted—pro forma		0.46			0.42			1.21			1.14

4. Adoption of Accounting Standards

SFAS No. 123, "Share-Based Payment (Revised 2004)" ("SFAS 123R") establishes standards for the accounting for transactions in which an entity (i) exchanges its equity instruments for goods or services, or (ii) incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments or that may be settled by the issuance of the equity instruments. SFAS 123R eliminates the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the date of the grant. SFAS 123R is mandatory for all entities with fiscal periods starting after June 15, 2005. As a public entity we implemented SFAS 123R on January 1, 2006 and its adoption did not have a material impact on our consolidated financial position, results of operations or cash flows including our first quarter stock-based compensation expense.

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109”. FIN 48 clarifies the accounting for uncertainty in income taxes and provides greater consistency in criteria used to recognize, derecognize and measure benefits related to income taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on classification, interest and penalties, accounting in interim periods, disclosure and transition. The effective date of FIN 48 is for fiscal years beginning after December 15, 2006. We have not yet assessed the impact of the implementation of FIN 48 on our financial condition or results of operations.

In March 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 156, “Accounting for Servicing of Financial Assets” (“FAS 156”), an amendment of FASB Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” FAS 156 was issued to simplify the accounting for servicing assets and servicing liabilities and reduce the volatility that results from the use of different measurement attributes for servicing rights and the related financial instruments used to hedge risks associated with those servicing rights. SFAS 156 requires all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable, and permits for subsequent measurement using either fair value measurement with changes in fair value reflected in earnings or the amortization and impairment requirements of Statement No. 140. The subsequent measurement of separately recognized servicing assets and servicing liabilities at fair value eliminates the necessity for entities that manage the risks inherent in servicing assets and servicing liabilities with derivatives to qualify for hedge accounting treatment and eliminates the characterization of declines in fair value as impairments or direct write-downs. The effective date of FAS 156 is for fiscal years beginning after September 15, 2006. Early adoption is permitted in a period if financial statements have not yet been issued. We adopted SFAS 156 effective January 1, 2006 and elected to not apply the fair value method.

5. Initial Public Offering

On September 29, 2005, we completed an initial public offering of 1,907,692 shares of common stock at the initial offering price of $26 per share. The proceeds received after the underwriters’ discounts and commissions but before expenses related to the offering were $46.1 million. All of the proceeds from the offering, net of issuance costs of approximately $1.0 million, were used to fund a portion of the purchase price of Heritage Financial Corporation, which we acquired on October 6, 2005.

6. Recent Acquisitions

On October 6, 2005, SNBI acquired all of the outstanding common stock of Heritage Financial Corporation ("Heritage") for $53.5 million in cash in order to further expand in the Fort Worth Metroplex (Tarrant County) area. To fund the acquisition, SNBI issued, through an initial public offering, 1,907,692 shares of SNBI common stock at $26 per share. The acquisition was accounted for under the purchase method of accounting for business combinations. Core deposit intangibles related to this transaction amounted to $6.0 million and are amortized on an accelerated basis using a ten year life. Goodwill associated with the transaction originally amounted to approximately $29.7 million. During 2006, purchase price allocation adjustments of approximately $717,000 were recorded which reduced the balance of goodwill to $29.0 million. At the date of acquisition, SNBI acquired assets of $226.3 million, net loans of $103.4 million, and deposits of $197.3 million before purchase accounting adjustments.

7. Regulatory Matters

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. The Bank, as a national bank, is subject to the dividend restrictions set forth in the National Bank Act of 1864 and the regulations and policies of the Office of the Comptroller of the Currency, or the OCC. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 Capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 Capital (as defined) to average assets (Leverage) (as defined). Management believes, as of September 30, 2006, that the Company and the Bank met all capital adequacy requirements to which they are subject.

The most recent notification from the OCC categorized the Bank as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized,” an institution must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 Leverage ratios as set forth in the following tables. There are no conditions or events since the most recent notification that management believes have changed the institution’s capital category.

As of September 30, 2006 and December 31, 2005, required and actual regulatory capital amounts and ratios for SNBI were as follows:

	September 30,			December 31,			Minimum Capital			Well- Capitalized
	2006			2005			Ratios			Ratios
	(Dollars in thousands)
Tier 1 capital	$	158,695		$	142,690
Total capital		171,687			155,281
Total risk-weighted assets		1,251,397			1,191,030
Adjusted quarterly average assets		1,523,668			1,525,043
Capital ratios:
Leverage ratio		10.42	%		9.36	%		4.00	%		5.00	%
Tier 1 capital to risk-weighted assets		12.68			11.98			4.00			6.00
Total capital to risk-weighted assets		13.72			13.04			8.00			10.00

The minimum capital ratios as determined by the regulators for well-capitalized banks and the Bank’s actual capital ratios as of September 30, 2006 were as follows:

	Minimum Ratios for Well-Capitalized Banks			Actual Ratios as of September 30, 2006
Leverage ratio		5.00	%		9.12	%
Tier 1 capital to risk-weighted assets		6.00			11.12
Total capital to risk-weighted assets		10.00			12.16

8. Stock-Based Compensation

SNBI has a nonqualified stock option plan to provide an incentive for key employees to remain in service, to extend to them the opportunity to acquire a proprietary interest in SNBI so that they will apply their best efforts for the benefits of SNBI, and to aid SNBI in attracting and retaining key personnel. Prior to 2003, we had applied the recognition and measurement provisions of Accounting Principles Board No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations in accounting for our plan. APB 25 required compensation cost to be recognized only when the option exercise price is less than the fair market value of the underlying stock on the date of grant. Effective January 1, 2003, we adopted the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123") under the prospective transition method. At that time, SNBI began to recognize the cost of stock-based employee compensation calculated under the fair-value-based method of accounting. The compensation cost is calculated by using the Black-Scholes option-pricing model to value the options on the measurement date, which is generally the date of the grant. This model requires the input of assumptions such as volatility, expected terminations and expected forfeitures. Changes to the assumptions can materially affect the fair value estimate. Additionally, there may be other factors that would otherwise affect the value of the employee stock options granted but that are not considered by the model. Accordingly, while management believes that the Black-Scholes option-pricing model provides a reasonable estimate of fair value, the model does not necessarily provide the best single measure of fair value for the Company’s employee stock options. Under the prospective transition method, this cost was recognized only on awards granted after January 1, 2003.

As stated in Note 3 — Adoption of Accounting Standards, SNBI adopted the provisions of SFAS 123R on January 1, 2006. SFAS 123R requires stock-based compensation transactions to be recognized as compensation cost in the income statement based on their fair values on the measurement date, which is generally the date of the grant. We transitioned to SFAS 123R for stock-based compensation using the modified prospective application. Under the modified prospective application, SFAS 123R applies to new awards granted after the implementation date, as well as unvested awards granted prior to the implementation date. As of January 1, 2006, SNBI had no unvested awards for options granted prior to January 1, 2003. For the nine months ended September 30, 2006, we recorded stock option expense totaling $357,000.

In the fourth quarter of 2005, as a publicly traded company, we began measuring volatility in our stock when calculating stock option expense. As public trading of SNBI stock began on September 30, 2005, it was most appropriate to use implied volatility when calculating the fair value of the stock options. As we had been a privately held company prior to the IPO, our stock volatility had been minimal. This change increased our stock option expense on the options granted in 2005 by approximately 64.4%. In the nine months ended September 30, 2006, we granted 27,000 shares of new stock options.

9. Minority Interest

The Bank entered into a limited partnership with a third party to construct and own a four story building that will provide a permanent location for our downtown Fort Worth banking center and additional non-bank office space that will be available for lease. The Bank has a controlling interest in this entity and the third party is a significant tenant of the building and owns the remaining interest in the entity. This has created a minority interest in the consolidated subsidiary on our consolidated balance sheet of $1.2 million and a minority interest in the loss of the consolidated subsidiary on our consolidated income statement of operations of $67,000 as of and for the nine month period ending September 30, 2006.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis presents management’s analysis of our results of operations for the three months and nine months ended September 30, 2006 and 2005 and our financial condition as of September 30, 2006 and December 31, 2005. The discussion should be read in conjunction with our financial statements and the notes related thereto which appear elsewhere in this Quarterly Report on Form 10-Q.

Statements contained in this report that are not purely historical are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, including our expectations, intentions, beliefs, or strategies regarding the future. Any statements in this document about expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,” “would” and “outlook,” and similar expressions. Accordingly, these statements involve estimates, assumptions and uncertainties, which could cause actual results to differ materially from those expressed in them. Any forward-looking statements are qualified in their entirety by reference to the factors discussed throughout this document. All forward-looking statements concerning economic conditions, rates of growth, rates of income or values as may be included in this document are based on information available to us on the dates noted, and we assume no obligation to update any such forward-looking statements. It is important to note that our actual results may differ materially from those in such forward-looking statements due to fluctuations in interest rates, inflation, government regulations, economic conditions, customer disintermediation and competitive product and pricing pressures in the geographic and business areas in which we conduct operations, including our plans, objectives, expectations and intentions and other factors discussed in this report and our Annual Report on Form 10-K for the year ended December 31, 2005, including the following:

·	we may be unable to satisfy the shareholder approval and other conditions to closing the planned merger with BBVA;

·	contingencies related to the announcement and pendency of the BBVA merger may impact our employees and customers;

·	any termination of the Merger Agreement with BBVA may result in costs and disruptions to our business and relationships with employees and customers;

·	if a significant number of our customers fail to perform under their loans, our business, profitability, and financial condition would be adversely affected;

·	our current level of interest rate spread may decline in the future, and any material reduction in our interest spread could have a material impact on our business and profitability;

·	the modification of the Federal Reserve Board’s current position on the capital treatment of our junior subordinated debt and trust preferred securities could have a material adverse effect on our financial condition and results of operations;

·	adverse changes in domestic or global economic conditions could have a material adverse effect on our business, growth, and profitability;

·	we could be liable for breaches of security in our online banking services, and fear of security breaches could limit the growth of our online services;

·	maintaining or increasing our market share depends on market acceptance and regulatory approval of new products and services;

·	significant reliance on loans secured by real estate may increase our vulnerability to downturns in the real estate market and other variables impacting the value of real estate;

·	if we fail to retain our key employees, growth and profitability could be adversely affected;

·	we may be unable to manage our future growth;

·	increases in our allowance for loan and lease losses could materially adversely affect our earnings;

·	our directors and executive officers beneficially own a significant portion of our outstanding common stock; and

·	we face substantial competition in our primary market area.

These factors and the risk factors identified in this report and our Annual Report on Form 10-K for the year ended December 31, 2005, could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us, and you should not place undue reliance on any such forward-looking statements. Any forward-looking statement speaks only as of the date on which it is made and we do not undertake any obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict which will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

Executive Overview

Introduction

We are a registered bank holding company headquartered in Fort Worth, Texas, offering a broad array of financial services through our wholly owned banking subsidiary, State National Bank (“SNB” or the “Bank”). As of September 30, 2006, we had, on a consolidated basis, total assets of $1.6 billion, net loans of $1.1 billion, total deposits of $1.3 billion, and shareholders' equity of $225.3 million. We currently operate through a network of 43 banking centers located in three distinct geographic markets throughout Texas and New Mexico: the greater Tarrant County area (Fort Worth, Texas); West Texas (Lubbock, Abilene and Odessa); and Rio Grande (El Paso, Texas and Southern New Mexico). Our headquarters are located at 4500 Mercantile Plaza Drive, Suite 300, Fort Worth, TX 76137 and our telephone number is (817) 547-1150. Our website address is www.statenationalbank.com.

As a bank holding company, we generate most of our revenue from interest on loans and investments, service charges, and gains on the sale of loans. Our primary source of funding for our loans is deposits we hold in the Bank. Our largest expenses are interest on these deposits and salaries and related employee benefits. We usually measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk-based capital ratios. We also measure our performance by our efficiency ratio, which is calculated by dividing noninterest expense less amortization of core deposit intangibles by the sum of net interest income on a tax equivalent basis and noninterest income.

Our consolidated financial statements for the three and nine-month period ended September 30, 2006 and 2005 and the fiscal year ended December 31, 2005 include financial results for each of our wholly owned subsidiaries: State National Bank, TWOENC, Inc., State National Properties, LLC, and State National Bancshares of Delaware and in 2006 our majority owned subsidiary SNB-WP, LP. Our statutory trust subsidiaries which are special purpose vehicles that were used to issue trust preferred securities, are not consolidated with us or the Bank.

Merger Agreement

On June 12, 2006, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Banco Bilbao Vizcaya Argentaria, S.A., a bank organized under the laws of Spain (“BBVA”). Pursuant to the Merger Agreement, among other things, BBVA will acquire all of our issued and outstanding shares of capital stock and all of our outstanding and unexercised options by virtue of the merger of a wholly-owned subsidiary of BBVA, with and into the Company, with the Company as the surviving corporation (the “Merger”).

Under the terms and subject to the conditions of the Merger Agreement, which has been approved by our Board of Directors and the appropriate corporate body of BBVA, at the effective time of the Merger (the “Effective Time”), all of our outstanding common stock will be cancelled in exchange for $38.50 per share. All of the outstanding and unexercised options to acquire shares of our common stock will be cancelled at the Effective Time in exchange for an amount in cash per outstanding and unexercised option equal to the difference between (i) the mean between the highest and lowest selling prices quoted on The Nasdaq National Market for a share of our common stock on the last trading day prior to the Effective Time and (ii) the per share exercise price of the stock option.

The Merger Agreement contains representations, warranties and covenants of BBVA and us. In addition, we have agreed (i) to conduct its business in the ordinary course during the period between the execution of the Merger Agreement and consummation of the Merger and (ii) not to engage in certain kinds of transactions during such period without the consent of BBVA. Our Board of Directors has adopted a resolution recommending the approval and adoption of the Merger Agreement by our shareholders, and has agreed to hold a shareholder meeting to put these matters before our shareholders for their consideration. We have further agreed not to (i) solicit proposals relating to alternative business combination transactions or (ii) subject to certain exceptions, enter into discussions or negotiations or provide confidential information in connection with any proposals for alternative business combination transactions.

All regulatory approvals required for consummation of the Merger have been obtained. However, consummation of the Merger remains subject to various conditions, including requisite approvals of the holders of our common stock. In addition, each party’s obligation to consummate the Merger is subject to certain other conditions, including (i) the other party’s representations and warranties in the Merger Agreement being true and correct at the Effective Time, subject to the materiality standards contained in the Merger Agreement, (ii) material compliance of the other party with its covenants and (iii) the absence of any law or order prohibiting the consummation of the Merger.

On October 6, 2006, SNBI filed with the SEC a definitive proxy statement scheduling a special meeting of its shareholders to vote on the merger on November 15, 2006. SNBI anticipates the Merger will close on January 3, 2007, assuming that shareholder approval is obtained. For additional information, refer to the Form 8-K filed with the SEC on June 16, 2006 and the definitive proxy statement on Schedule 14A filed with SEC on October 6, 2006.

Critical Accounting Policies

We prepare our consolidated financial statements based on the selection of certain accounting policies, generally accepted accounting principles and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. Our accounting policies are described in detail in the notes to our consolidated financial statements included in our most recent Annual Report on Form 10-K.

We deem an accounting policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on our financial statements.

Loans and Allowance for Loan Losses

Loans that management has the intent and ability to hold for the foreseeable future, or until maturity or payoff, are reported at their outstanding unpaid principal balances adjusted by any charge-offs, unearned finance charges, allowance for loan and lease losses, and net deferred nonrefundable fees or costs on origination. The allowance for loan and lease losses is an estimate to provide for probable collection losses in our loan portfolio. Losses are charged and recoveries are credited to the allowance account at the time a loss is incurred or a recovery is received. The allowance for loan losses amounted to $13.0 million and $12.6 million as of September 30, 2006 and December 31, 2005, respectively. Losses charged to the allowance amounted to $1.3 million for the nine months ended September 30, 2006 compared to $1.5 million for the same period in 2005. Recoveries were credited to the allowance in the amounts of $703,000 and $977,000 for those same periods, respectively.

We follow a consistent procedural discipline and account for loan loss contingencies in accordance with Statement of Financial Accounting Standards (SFAS) No. 5, “Accounting for Contingencies,” and SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS No. 118, ”Accounting by Creditors for Impairment of a Loan — Income Recognition and Disclosures.”

To mitigate any difference between estimates and actual results relative to the calculation of the allowance for loan losses, our loan review department is specifically charged with reviewing monthly delinquency reports to determine if additional reserves are necessary. Delinquency reports and analysis of the allowance for loan losses are also provided to senior management and the Board of Directors on a monthly basis.

The loan review department evaluates significant changes in delinquency with regard to a particular loan portfolio to determine the potential for continuing trends, and loss projections are estimated and adjustments are made to the historical loss factor applied to that portfolio in connection with the calculation of loss reserves. Portfolio performance is also monitored through the monthly calculation of the percentage of non-performing loans to the total portfolio outstanding. A significant change in this percentage may trigger a review of the portfolio and eventually lead to additional reserves. We also track the ratio of net charge-offs to total portfolio outstanding.

We classify loans as nonperforming when they become 90 days past due. Nonperforming loans amounted to $8.9 million as of September 30, 2006 and $8.7 million as of December 31, 2005.

Other Real Estate Owned and Repossessed Assets

Other real estate owned (“OREO”) and repossessed assets, normally obtained through foreclosure or other workout situations, are initially recorded at the lower of fair value or book value at the date of foreclosure, establishing a new cost basis. Any resulting loss is charged to the allowance for loan losses. An appraisal of other real estate properties and valuations of repossessed assets is made periodically after acquisition, and comparison between the appraised value and the carrying value is performed. Additional declines in value after acquisition, if any, are charged to current operations. OREO and repossessed assets amounted to $1.0 million and $935,000 as of September 30, 2006 and December 31, 2005, respectively.

Results of Operations for the Three Months and Nine Months Ended September 30, 2006 and 2005

Net Interest Income and Net Interest Margin

Net interest income is the difference between interest income, principally from loans and investment securities portfolio, and interest expense, principally on customer deposits and borrowings. Net interest income is our principal source of earnings. Changes in net interest income result from changes in volume, spread and margin. Volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities. Spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Margin refers to net interest income divided by average interest-earning assets, and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.

Net interest income increased 24.1%, or $3.8 million, to $19.5 million and by 25.2%, or $11.5 million, to $57.1 million in the third quarter and nine months ended September 30, 2006, respectively, from $15.7 million and $45.6 million in the same periods of 2005. These increases resulted primarily from higher volumes in our loan portfolio due to our acquisition of Heritage Financial Corporation, and, to a lesser extent, organic growth and the increase in market interest rates on the loan and security portfolios.

Total interest income for the third quarter of 2006 was $26.1 million, compared to $19.6 million for the same period in 2005, representing a 33.3% increase. Total interest income for the nine months ended September 30, 2006 was $75.3 million compared to total interest income of $55.6 million for the same period in 2005, representing a 35.4% increase. The increases were due to the combined effect of increases in average interest-earning assets due to the Heritage acquisition, organic growth and increased yields resulting from higher interest rates during 2006. Average interest-earning assets for the three months and nine months ended September 30, 2006 increased 17.4%, or $202.3 million, to $1.364 billion and 20.1%, or $229.2 million, to $1.370 billion, respectively, compared to $1.162 billion and $1.141 billion for the same periods in 2005.

Total interest expense was $6.6 million for the quarter ended September 30, 2006, compared to $3.9 million for the same quarter in 2005. Total interest expense for the nine months ended September 30, 2006 was $18.2 million, compared to total interest expense of $10.0 million for the same period in 2005. These increases resulted primarily from the combination of increased deposit balances due to our acquisition of Heritage, higher rates paid on interest-bearing deposits and higher rates on subordinated notes payable during 2006. Average interest-bearing liabilities for the quarter ended September 30, 2006 increased to $921.5 million compared to $793.2 million for the same period of 2005. Average interest-bearing liabilities increased to $936.3 million for the nine months ended September 30, 2006, as compared to $790.4 million for the same period in 2005.

Net interest margin on a fully taxable equivalent basis increased to 5.76% and 5.60% for the third quarter and nine months ended September 30, 2006, respectively, as compared to 5.41% and 5.33% for the same periods in 2005. Net interest spread on a fully taxable equivalent basis was 4.83% for the quarter ended September 30, 2006, as compared to 4.79% for the same period in 2005. For the nine months ended September 30, 2006, net interest spread on a fully taxable equivalent basis decreased to 4.79%, as compared to 4.81% for the same period in 2005.

The following tables, for the periods indicated, present our average balance sheets and indicate the interest earned or paid on each major category of interest-earning assets and interest-bearing liabilities on a fully taxable equivalent basis, and the average rates earned or paid on each major category. This analysis details the contribution of our interest-earning assets and the overall impact of the cost of funds on our net interest income.

	Three Months Ended September 30,
	2006								2005
	Average Balance			Interest Income/ Expense		Yield/ Rate⁽¹⁾			Average Balance			Interest Income/ Expense		Yield/ Rate⁽²⁾
	(Dollars in thousands)
ASSETS:
Interest earning assets:
Loans, net of unearned income	$	1,116,668		$	23,300		8.35	%	$	963,379		$	17,728		7.36	%
Securities		237,018			2,813		4.75			130,028			1,288		3.96
Time deposits in other banks		3,938			51		5.18			13,591			127		3.74
Fed funds sold		6,449			84		5.21			54,786			457		3.34
Total interest-earning assets		1,364,073			26,248		7.70			1,161,784			19,600		6.75
Noninterest-earning assets:
Cash and due from banks		61,018								62,622
Intangible assets		115,103								84,175
Premises and equipment, net		53,288								35,835
Accrued interest receivable and other assets		53,683								46,713
Allowance for loan losses		(13,151	)							(11,627	)
Total noninterest-earning assets		269,941								217,718
TOTAL ASSETS	$	1,634,014							$	1,379,502
LIABILITIES AND SHAREHOLDERS’ EQUITY:
Interest-bearing liabilities:
Demand, savings and money market deposits	$	494,032		$	1,884		1.53	%	$	443,542		$	1,104		1.00	%
Time deposits		341,208			3,180		3.73			277,956			1,758		2.53
Fed funds purchased and securities under agreement to repurchase		37,301			449		4.81			23,869			178		2.98
Junior subordinated debentures		47,000			1,073		9.13			47,000			832		7.08
Note payable		1,982			22		4.44			823			10		4.86
Total interest-bearing liabilities		921,523			6,608		2.87			793,190			3,882		1.96
Noninterest-bearing liabilities:
Demand deposits		476,793								412,567
Accrued interest payable and other liabilities		11,119								12,412
Total noninterest-bearing liabilities, net		487,912								424,979
TOTAL LIABILITIES		1,409,435								1,218,169
Minority interest in unconsolidated subsidiary		1,172								—
SHAREHOLDERS' EQUITY		223,407								161,333
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	1,634,014							$	1,379,502
Net interest income				$	19,640							$	15,718
Net interest spread ⁽²⁾							4.83	%							4.79	%
Net interest margin ⁽³⁾							5.76	%							5.41	%

(1)	Yields on tax-exempt loans and securities are calculated on a fully taxable equivalent basis assuming a 35% tax rate.

(2)	Represents the average rate earned on interest-earning assets less the average rate paid on interest-bearing liabilities.

(3)	Represents net interest income on a fully taxable equivalent basis as a percentage of average interest-earning assets.

	Nine Months Ended September 30,
	2006								2005
	Average Balance			Interest Income/ Expense		Yield/ Rate⁽¹⁾			Average Balance			Interest Income/ Expense		Yield/ Rate⁽¹⁾
	(Dollars in thousands)
ASSETS:
Interest earning assets:
Loans, net of unearned income	$	1,099,152		$	66,315		8.04	%	$	958,497		$	50,519		7.03	%
Securities		230,944			8,005		4.62			139,414			4,140		3.96
Time deposits in other banks		17,642			588		4.44			10,807			237		2.92
Fed funds sold		22,531			789		4.67			32,302			740		3.05
Total interest-earning assets		1,370,269			75,697		7.37			1,141,020			55,636		6.50
Noninterest-earning assets:
Cash and due from banks		66,176								61,594
Intangible assets		116,297								85,007
Premises and equipment, net		51,412								34,921
Accrued interest receivable and other assets		53,413								46,233
Allowance for loan losses		(13,089	)							(11,511	)
Total noninterest-earning assets		274,209								216,244
TOTAL ASSETS	$	1,644,478							$	1,357,264
LIABILITIES AND SHAREHOLDERS’ EQUITY:
Interest-bearing liabilities:
Demand, savings and money market deposits	$	512,193		$	5,249		1.37	%	$	444,520		$	2,768		0.83	%
Time deposits		340,610			8,661		3.39			277,072			4,499		2.17
Fed funds purchased and securities under agreement to repurchase		34,285			1,120		4.36			20,919			387		2.47
Junior subordinated debentures		47,000			3,025		8.58			47,000			2,314		6.56
Note payable		2,225			96		5.75			851			30		4.70
Total interest-bearing liabilities		936,313			18,151		2.58			790,362			9,998		1.69
Noninterest-bearing liabilities:
Demand deposits		476,477								399,425
Accrued interest payable and other liabilities		11,949								9,544
Total noninterest-bearing liabilities, net		488,426								408,969
TOTAL LIABILITIES		1,424,739								1,199,331
Minority interest in unconsolidated subsidiary		812								—
SHAREHOLDERS' EQUITY		218,927								157,933
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	1,644,478							$	1,357,264
Net interest income				$	57,546							$	45,638
Net interest spread ⁽²⁾							4.79	%							4.81	%
Net interest margin ⁽³⁾							5.60	%							5.33	%

(1)	Yields on tax-exempt loans and securities are calculated on a fully taxable equivalent basis assuming a 35% tax rate.

(2)	Represents the average rate earned on interest-earning assets less the average rate paid on interest-bearing liabilities.

(3)	Represents net interest income on a fully taxable equivalent basis as a percentage of average interest-earning assets.

The following table sets forth, for the periods indicated, the dollar amount of changes in interest earned and paid for interest-earning assets and interest-bearing liabilities and the amount of change attributable to changes in average daily balances (volume) or changes in average daily interest rates (rate) on a fully taxable equivalent basis. All changes in interest owed and paid for interest-earning assets and interest-bearing liabilities are attributable to either volume or rate. The impact of changes in the mix of interest-earning assets and interest-bearing liabilities is reflected in our net interest income.

	Three Months Ended September 30,									Nine Months Ended September 30,
	2006 Over 2005									2006 Over 2005
	Increase Due To Changes In:									Increase Due To Changes In:
	Volume			Rate			Total			Volume			Rate		Total
	(In thousands)
Interest-earning assets:
Loans, net of unearned income	$	2,821		$	2,751		$	5,572		$	7,413		$	8,383	$	15,796
Securities		1,060			465			1,525			2,718			1,147		3,865
Time deposits in other banks		(90	)		14			(76	)		150			201		351
Federal funds sold		(403	)		30			(373	)		(224	)		273		49
Total interest income		3,388			3,260			6,648			10,057			10,004		20,061
Interest-bearing liabilities:
Demand, savings and money market deposits		126			654			780			421			2,060		2,481
Time deposits		400			1,022			1,422			1,032			3,130		4,162
Federal funds purchased and securities sold under agreement to repurchase		100			171			271			247			486		733
Junior subordinated debentures		—			241			241			—			711		711
Notes payable		14			(2	)		12			48			18		66
Total interest expense		640			2,086			2,726			1,748			6,405		8,153
Increase in net interest income	$	2,748		$	1,174		$	3,922		$	8,309		$	3,599	$	11,908

Provision for Loan Losses

The amount of our provision for loan losses is based on periodic (not less than quarterly) evaluations of the loan portfolio, especially nonperforming and other potential problem loans. As discussed above, during these evaluations, we consider various factors. For additional information concerning the factors considered in these evaluations, see “Critical Accounting Policies—Loans and Allowance for Loan Losses.”

Our provisions for loan losses for the nine months ended September 30, 2006 and 2005 were $960,000 and $750,000, respectively. The increase in the provision for loan losses is primarily related to the increase in the size of our loan portfolio.

Noninterest Income

Our noninterest income for the third quarter and nine months ended September 30, 2006 was $5.0 million and $14.7 million, respectively, representing a 2.1% and 6.7% increase, respectively, from $4.9 million and $13.8 million for the same periods in 2005. Annualized noninterest income for the nine months ended September 30, 2006 and 2005 represented approximately 1.2% and 1.4%, respectively, of our average assets for the same periods. Additionally, noninterest income represented approximately 16.4% and 19.9% of our total revenues for the nine months ended September 30, 2006 and 2005, respectively. The decrease in ratio of noninterest income to total revenues is primarily due to the acquisition of Heritage, which provided a greater portion of interest income than noninterest income, and higher market interest rates.

As a result of our efforts to diversify our revenue sources, we currently earn noninterest income from various sources. Our largest noninterest income source is service charges, primarily on deposit accounts, representing 57.4% and 52.7% of our total noninterest income for the third quarter of 2006 and 2005, respectively. This income source increased to $2.9 million in the third quarter of 2006 from $2.6 million in the third quarter of 2005 and to $8.4 million in the nine months ended September 30, 2006 from $7.4 million in the nine months ended September 30, 2005. These increases were primarily due to an increase in our number of transactional and savings accounts resulting from our acquisition of Heritage. We periodically review service charge rates in an effort to maximize service charge income while maintaining a competitive position.

Gain on sale of loans was the second largest source of our noninterest income for the nine months ended September 30, 2006 and 2005. For the third quarter and nine months ended September 30, 2006, gain on sale of loans was $641,000 and $1.9 million, respectively, as compared to $804,000 and $2.2 million for the same periods in 2005. Income from gain on sale of loans as a percentage of total noninterest income was 13.1% and 15.6% for the nine months ended September 30, 2006 and 2005, respectively. This source of noninterest income is derived primarily from the origination and subsequent sale of mortgage loans. The origination of these loans is primarily from two sources, the purchase of new homes as well as the refinancing of existing home loans. We hedge our interest rate risk by selling our mortgage loans on a "best efforts" basis to secondary mortgage buyers at the time the rate is locked, which in effect eliminates most of the risk at the time of the sale.

Other income for the third quarter and nine months ended September 30, 2006 was $1.2 million and $3.5 million, respectively, representing a 2.7% decrease and a 7.2% increase, respectively, from $1.2 million and $3.3 million for the same periods in 2005. The $237,000 increase for the nine month period ended September 30, 2006 compared to the same period in 2005 was primarily due to increases in factoring income and debit card income. Factoring income added an additional $275,000 and debit card income increased $259,000. These increases were offset by non-reoccurring items of $296,000 that were booked in the nine months of 2005. In the first quarter of 2005, we recorded a $241,475 gain due to the sale of Pulse Network to Discover Financial Services on January 31, 2005 in which we had a shared interest based on network usage.

The following tables set forth the various components of our noninterest income for the periods indicated:

	Three Months Ended September 30,										Nine Months Ended September 30,
	2006					2005					2006						2005
	Amount		%			Amount		%			Amount			%			Amount		%
	(Dollars in thousands)
Service charges on deposit accounts	$	2,891		57.4	%	$	2,600		52.7	%	$	8,385			56.9	%	$	7,416		53.7	%
Gain on sale of loans		641		12.7			804		16.3			1,925			13.1			2,153		15.6
Bank owned life insurance		326		6.5			316		6.4			979			6.6			948		6.9
Net realized gain on sale of securities		—		—			—		—			(79	)		(0.5	)		1		—
Other		1,178		23.4			1,211		24.6			3,522			23.9			3,285		23.8
Total noninterest income	$	5,036		100.0	%	$	4,931		100.0	%	$	14,732			100.0	%	$	13,803		100.0	%

Noninterest Expense

Our total noninterest expense increased to $15.9 million and $48.4 million in the third quarter and nine months ended September 30, 2006, compared to $14.0 million and $41.1 million for the same periods in 2005, representing an increase of 13.3% and 17.8%, respectively. Included in the 2006 third quarter expenses are $884,000 in transaction costs related to the pending merger with BBVA. The remaining increases can be attributed to expanded personnel, occupancy costs, and other operating expense associated with our acquisition of Heritage in October 2005. The efficiency ratio improved to 60.67% for the third quarter of 2006, as compared to 63.93% for the same quarter in 2005, and 63.22% for the nine months ended September 30, 2006, as compared to 65.02% for same period in 2005. The efficiency ratio is determined by dividing total noninterest expense, less amortization of intangibles, by an amount equal to net interest income (fully taxable equivalent) plus noninterest income.

Salaries and employee benefits totaled $8.1 million and $24.4 million for the third quarter and nine months ended September 30, 2006, compared to $7.3 million and $21.6 million for the same periods in 2005, representing an increase of $811,000, or 11.1%, and $2.8 million, or 12.9%, for the comparable periods. Of the increase in the nine months ended September 30, 2006, $1.8 million is attributable to the acquisition of Heritage and $1.3 million is attributable to increase in bonus accrual. These increases were offset by declines in salaries and employee benefits.

Occupancy and equipment expenses totaled $2.5 million and $7.5 million for the third quarter and nine months ended September 30, 2006, respectively, compared to $2.3 million and $6.6 million for the same periods in 2005. This represented an increase of $168,000, or 7.2%, and $867,000, or 13.1%, for the third quarter and nine months ended September 30, 2006, respectively, from the comparable prior year periods. Of the $867,000 increase for the nine months ended September 30, 2006, $808,000 was attributable to the acquisition of Heritage.

Professional fees were $588,000 and $326,000, or 3.7% and 2.3% of total noninterest expenses, for the third quarter of 2006 and 2005, respectively. For the nine months ended September 30, 2006, these expenses increased to $1.7 million from $1.0 million for the same period in 2005. The increase is attributable primarily to audit and legal fees associated with public company reporting.

Net costs applicable to OREO and other repossessed assets consist of expense associated with holding and maintaining repossessed assets, the net gain or loss on the sales of such assets and the write-down of the carrying value of the assets. We recorded net revenues of $8,000 for the third quarter in 2006 compared to $6,000 in net revenues for the same period in 2005. These expenses increased to $196,000 for the nine months ended September 30, 2006 from $23,000 for the comparable period in 2005. Repossessed assets are initially recorded at the lower of fair value or book value upon repossession and resulting losses are charged to the allowance for loan losses. These assets are then periodically evaluated and recorded at fair value. Any subsequent decline in the fair value is charged to current operations.

Other noninterest expenses increased to $2.4 million and $7.4 million for the third quarter and nine months ended September 30, 2006 compared to $1.8 million and $5.2 million for the same periods in 2005. This increase was due to our organic asset growth as well as to the Heritage acquisition.

The following tables set forth a summary of noninterest expenses for the periods indicated:

	Three Months Ended September 30,												Nine Months Ended September 30,
	2006						2005						2006					2005
	Amount			%			Amount			%			Amount		%			Amount		%
	(Dollars in thousands)
Salaries and employee benefits:
Salaries	$	6,943			43.7	%	$	6,066			43.3	%	$	20,363		42.0	%	$	17,834		43.4	%
Medical and other benefits		415			2.6			577			4.1			1,632		3.4			1,692		4.1
Pension		333			2.1			273			1.9			998		2.1			800		2.0
Payroll taxes		417			2.6			381			2.7			1,420		2.9			1,288		3.1
Total salaries and employee benefits		8,108			51.0			7,297			52.0			24,413		50.4			21,614		52.6
Net occupancy and equipment expense		2,490			15.7			2,322			16.6			7,495		15.5			6,628		16.1
Amortization of intangibles		998			6.3			824			5.9			3,017		6.2			2,471		6.0
Professional fees		588			3.7			326			2.3			1,679		3.5			1,017		2.5
Advertising		443			2.8			330			2.3			1,165		2.4			864		2.1
Communication expense		330			2.1			300			2.1			975		2.0			856		2.1
Data processing		238			1.5			203			1.5			694		1.4			622		1.5
Supplies		148			0.9			166			1.2			528		1.1			587		1.4
OREO		(8	)		(0.1	)		(6	)		0.0			196		0.4			23		0.1
Merger and one-time expenses		126			0.8			19			0.1			884		1.8			59		0.1
Other		2,423			15.3			2,244			16.0			7,383		15.3			6,378		15.5
Total noninterest expense	$	15,884			100.0	%	$	14,025			100.0	%	$	48,429		100.0	%	$	41,119		100.0	%

Provision for Income Taxes

Income tax expense increased $726,000 to $2.8 million for the quarter ended September 30, 2006 compared with $2.1 million for the same period in 2005. For the nine months ended September 30, 2006, income tax expense totaled $7.7 million, an increase of $1.8 million, or 31.1%, compared with $5.9 million for the same period in 2005. The increase was primarily attributable to higher pretax earnings for the quarter ended September 30, 2006 when compared to the respective period in 2005. Our effective tax rate for the nine months ended September 30, 2006 was 34.2% compared to 33.4% for the same period in 2005.

Financial Condition as of September 30, 2006 and December 31, 2005

Our total assets as of September 30, 2006 were $1.645 billion, a decrease of $17.7 million, or 1.1%, from $1.663 billion as of December 31, 2005. Total loans were $1.135 billion at September 30, 2006 compared to $1.086 billion as of December 31, 2005. Total deposits decreased to $1.317 billion as of September 30, 2006, compared to $1.357 billion as of December 31, 2005. As of September 30, 2006, our shareholders’ equity was $225.3 million, compared to $212.3 million as of December 31, 2005.

Investment Securities

Our investment portfolio primarily serves as a source of interest income and, secondarily, as a source of liquidity and a management tool for our interest rate sensitivity. We manage our investment portfolio according to a written investment policy implemented by our Asset/Liability Management Committee. Our investment policy is reviewed annually by our Board of Directors. Investment balances, including cash equivalents and interest-bearing deposits in other financial institutions, are subject to change over time based on our asset/liability funding needs and our interest rate risk management objectives. Our liquidity levels take into consideration anticipated future cash flows and all available sources of credits and are maintained at levels management believes are appropriate to assure future flexibility in meeting our anticipated funding needs.

Our investment portfolio consists of securities that are classified as “available-for-sale” and securities we intend to hold until maturity, or “held-to-maturity securities.” The carrying values of our available-for-sale securities are adjusted for unrealized gain or loss as a valuation allowance, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income (loss).

The following table presents the composition, book value and fair value of our investment portfolio by major category as of the dates indicated:

	Available-for-Sale				Held-to-Maturity				Total
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
	(In thousands)
September 30, 2006:
U.S. treasury securities	$	6,951	$	6,908	$	—	$	—	$	6,951	$	6,908
U.S. government agencies obligations		142,721		142,158		—		—		142,721		142,158
Collateralized mortgage obligations		138		137		—		—		138		137
Mortgage-backed securities		53,146		51,615		—		—		53,146		51,615
State and municipal obligations		22,897		22,740		—		—		22,897		22,740
Federal Reserve Bank stock and other investments		2,476		2,465		9,126		9,126		11,602		11,591
Total	$	228,329	$	226,023	$	9,126	$	9,126	$	237,455	$	235,149
December 31, 2005:
U.S. treasury securities	$	7,051	$	6,969	$	—	$	—	$	7,051	$	6,969
U.S. government agencies obligations		109,516		108,622		—		—		109,516		108,622
Collateralized mortgage obligations		165		166		—		—		165		166
Mortgage-backed securities		64,357		63,292		—		—		64,357		63,292
State and municipal obligations		26,294		26,348		—		—		26,294		26,348
Federal Reserve Bank stock and other investments		1,414		1,390		8,094		8,094		9,508		9,484
Total	$	208,797	$	206,787	$	8,094	$	8,094	$	216,891	$	214,881

Our investment portfolio increased by approximately $20.3 million to $235.1 million as of September 30, 2006 from $214.9 million as of December 31, 2005. This increase was primarily due to increased purchases in response to higher market yields on securities.

Investment Portfolio — Maturity and Yields

The estimated fair value of our securities portfolio as of September 30, 2006 is presented below by contractual maturity:

	As of September 30, 2006
	Within One Year					After One but Within Five Years					After Five but Within Ten Years					After Ten Years					Total
	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield
	(Dollars in thousands)
Investments available-for-sale ⁽¹⁾⁽²⁾:
U.S. treasury obligations	$	3,970		4.56	%	$	2,938		3.77	%	$	—		—	%	$	—		—	%	$	6,908		4.22	%
U.S. government agencies obligations		43,205		3.75			98,953		5.03			—		—			—		—			142,158		4.64
Mortgage backed securities and collateralized mortgage obligations ⁽³⁾		1,836		5.34			49,075		4.63			839		4.89			3		7.00			51,753		4.66
State and municipal obligations		3,348		3.35			13,212		3.52			5,422		4.02			757		5.28			22,739		3.67
Other securities		—		—			—		—			—		—			2,465		4.54			2,465		4.60
Total investments available-for-sale		52,359		3.84			164,178		4.77			6,261		4.14			3,225		4.71			226,023		4.54
Other investments:
FHLB stock and other investments		—		—			—		—			—		—			9,126		5.19			9,126		5.19
Total other investments		—		—			—		—			—		—			9,126		5.19			9,126		5.19
Total investments	$	52,359		3.84	%	$	164,178		4.77	%	$	6,261		4.14	%	$	12,351		5.07	%	$	235,149		4.56	%

(1) Based on estimated fair value.

(2)	The yields shown in the above table are not calculated on a fully taxable equivalent basis.

(3)	Maturities of mortgage-backed securities and collateralized mortgage obligations, or CMOs, are based on anticipated lives of the underlying mortgages, not contractual maturities. CMO maturities are based on cash flow (or payment) windows derived from broker market consensus.

Securities with carrying values of approximately $131.0 million and $133.6 million were pledged to secure certain deposits at September 30, 2006 and December 31, 2005, respectively.

The following table discloses gross unrealized losses and the related fair value of our investment category and length of time that individual available-for-sale securities have been in a continuous unrealized loss position at September 30, 2006:

	Available-For-Sale Securities
	Less than 12 months				12 months or longer				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(In thousands)
Treasury/Agency₍₁₎	$	47,827	$	344	$	51,236	$	608	$	99,063	$	952
Mortgage-backed securities ⁽²⁾		17,967		465		33,109		1,071		51,076		1,536
Other		19,857		192		2,808		34		22,665		226
Total temporarily impaired securities	$	85,651	$	1,001	$	87,153	$	1,713	$	172,804	$	2,714

(1)

U.S. Treasury/Agency Debt Securities - The unrealized losses on investments in U.S. treasury and agency debt securities were caused by interest rate increases. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Because we have the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.

(2)

Mortgage-Backed Securities - The unrealized losses on investments in mortgage-backed securities were caused by interest rate increases. The contractual cash flows of these securities are guaranteed by Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC). It is expected that the securities would not be settled at a price less than the amortized cost of the investment. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because we have the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.

Loans

Our loan portfolio consists of loans made to businesses, individuals, and farm and ranch operations located in our primary trade areas. Real estate loans represent loans primarily for residential construction, commercial non-owner-occupied and owner-occupied real estate.

The following table presents our loans held for investment by category as of the dates indicated:

	September 30, 2006						December 31, 2005
	Amount			Loan Category to Total Loans			Amount			Loan Category to Total Loans
	(Dollars in thousands)
Real estate—construction	$	201,090			17.8	%	$	144,721			13.5	%
Real estate—1-4 family		113,851			10.1			125,901			11.7
Real estate—other		425,418			37.6			415,047			38.6
Lease financing		2,122			0.2			—			—
Commercial		257,124			22.7			263,975			24.6
Agricultural and other		88,435			7.8			84,646			7.9
Consumer		42,615			3.8			40,321			3.7
Total loans held for investment	$	1,130,655			100.0	%	$	1,074,611			100.0	%
Allowance for loan losses		(12,992	)					(12,591	)
Loans held for investment, net	$	1,117,663					$	1,062,020

As of September 30, 2006 our total loans held for investment, net of unearned income, was $1.131 billion, an increase of $56.0 million, as compared to $1.075 billion as of December 31, 2005. As of September 30, 2006, our real estate loans increased $54.7 million, lease financing increased $2.1 million, consumer loans increased $2.3 million, agriculture and other loans increased $3.8 million, and commercial loans decreased $6.9 million as compared to December 31, 2005. Our total loans held for investment, net of unearned income as a percentage of total assets, was 68.7% as of September 30, 2006, compared with 64.6% as of December 31, 2005.

Real estate loans, the largest component of our loan portfolio, consist primarily of commercial real estate loans or commercial lines of credit that are extended to finance the purchase or improvement of commercial real estate. Real estate loans equaled $740.4 million and $685.7 million as of September 30, 2006 and December 31, 2005, respectively. The percentage of our real estate secured loans in relation to our total loan portfolio, increased to 65.5% as of September 30, 2006, as compared to 63.8% as of December 31, 2005.

Our commercial loans, the second largest component of our loan portfolio, typically have floating rates of interest, are for varying terms (generally not exceeding five years), are personally guaranteed by the principal owners and are collateralized by real estate, accounts receivable, inventory or other business assets. Commercial loans decreased to $257.1 million as of September 30, 2006 from $264.0 million as of December 31, 2005. Commercial loans as a percentage of total loans were 22.7% as of September 30, 2006, and 24.6% as of December 31, 2005.

Consumer loans have historically represented a small part of our total loan portfolio. Consumer loans increased to $42.6 million as of September 30, 2006 from $40.3 million as of December 31, 2005. Consumer loans as a percentage of total loans were 3.8% and 3.7% as of September 30, 2006 and December 31, 2005, respectively.

Agriculture and other loans increased to $88.4 million as of September 30, 2006 from $84.7 million as of December 31, 2005. Agriculture and other loans as a percentage of total loans were 7.8% and 7.9% as of September 30, 2006 and December 31, 2005, respectively.

The following table presents the distribution of the maturity of our loans as of September 30, 2006. The table also presents the portion of our loans that have fixed interest rates or interest rates that fluctuate over the life of the loans in accordance with changes in the interest rate environment as represented by the prime rate.

	As of September 30, 2006
	One Year and Less		One to Five Years		Over Five Years		Total Carrying Value
			(In thousands)
Real estate—construction	$	147,355	$	38,363	$	15,372	$	201,090
Real estate—1-4 family		22,110		46,630		45,111		113,851
Real estate—other		54,593		234,212		136,613		425,418
Lease financing		—		—		2,122		2,122
Commercial loans		134,847		87,875		34,402		257,124
Consumer loans		20,503		17,706		4,406		42,615
Agriculture and other loans		77,307		7,630		3,498		88,435
Total loans held for investment	$	456,715	$	432,416	$	241,524	$	1,130,655
With fixed interest rates	$	109,749	$	226,300	$	80,971	$	417,020
With variable interest rates		346,966		206,116		160,553		713,635
Total loans held for investment	$	456,715	$	432,416	$	241,524	$	1,130,655

Nonperforming Assets

Nonperforming assets consist of loans on nonaccrual status, loans 90 days or more past due and still accruing interest, loans that have been restructured resulting in a reduction or deferral of interest or principal, OREO, and other repossessed assets.

The following table lists nonaccrual, past due and restructured loans, OREO and other repossessed assets as of the dates indicated:

	September 30,			December 31,
	2006			2005
	(Dollars in thousands)
Nonaccrual loans	$	8,806		$	8,654
Accruing loans past due over 90 days		—			—
Restructured loans		73			88
OREO		1,003			927
Other repossessed assets		16			8
Total nonperforming assets	$	9,898		$	9,677
Total nonperforming assets to total loans and other real estate		0.87	%		0.90	%

The nonperforming assets increased $221,000 to $9.9 million as of September 30, 2006 from $9.7 million as of December 31, 2005. The ratio of nonperforming assets over total loans and OREO decreased to 0.87% as of September 30, 2006, from 0.89% as of December 31, 2005.

At September 30, 2006, loans identified as being impaired consisted of nonhomogeneous loans placed on nonaccrual status. We generally place a loan on nonaccrual status and cease accruing interest when the payment of principal or interest is delinquent for 90 days, or earlier in some cases, unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan.

As of September 30, 2006 and December 31, 2005, the average investment in loans that are considered to be impaired under SFAS No. 114 was approximately $8.8 million and $7.8 million, respectively. Included in these amounts at September 30, 2006 and December 31, 2005 was $8.8 million and $8.6 million, respectively, of impaired loans for which our related specific reserve for loan losses was approximately $1.8 million and $2.0 million, respectively. We had $28,000 of impaired loans as of December 31, 2005 that did not have a specific related reserve for loan losses.

Allowance for Loan Losses

Management actively monitors the Company’s asset quality and provides specific loss allowances when necessary. Loans are charged-off against the allowance for loan losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the allowance for loan losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the adequacy of our allowance for loan and lease losses. Such agencies may recommend us to make additional provisions to the allowance based upon their judgments about information available to them at the time of their examinations. As of September 30, 2006, the allowance for loan losses amounted to $13.0 million, or 1.14% of total loans held for investment, compared with $12.6 million, or 1.17% of total loans held for investment, as of December 31, 2005.

The following table presents the activity in our allowance for loan losses for the nine months ended September 30, 2006 and the year ended December 31, 2005. The table also presents our average loan balances and certain pertinent ratios for the nine months ended September 30, 2006 and the year ended December 31, 2005.

	Nine months ended September 30,			Year Ended December 31,
	2006			2005
	(Dollars in thousands)
Analysis of allowance for loan losses:
Balance, beginning of period	$	12,591		$	11,383
Provision for loan losses		960			900
Loan loss reserves of acquired banks		—			1,670
Loans charged-off:
Real estate—construction		106			72
Real estate—1-4 family		113			96
Real estate—other		53			—
Commercial loans		552			1,067
Consumer loans		438			820
Agriculture and other loans		—			500
Total charge-offs		1,262			2,555
Recoveries of loans previously charged-off:
Real estate—construction		—			45
Real estate—1-4 family		5			18
Real estate—other		9			12
Commercial loans		463			535
Consumer loans		169			573
Agriculture and other loans		57			10
Total recoveries		703			1,193
Net loans charged-off		559			1,362
Balance, end of period	$	12,992		$	12,591
Average loans outstanding, net of unearned income, for the period ended	$	1,099,152		$	989,406
Ratio of net loan charge-offs to average loans, net of unearned income ₍₁₎		0.07	%		0.14	%
Ratio of allowance for loan losses to total loans, net of unearned income		1.14	%		1.17	%

(1) Annualized as of September 30, 2006.

Nonearning Assets

Premises, leasehold improvements and equipment, net of accumulated depreciation and amortization, totaled $54.5 million as of September 30, 2006 and $48.8 million as of December 31, 2005, an increase of $5.7 million. This increase is primarily attributable to our new Downtown Fort Worth banking center and the new Whisperwood banking center in Lubbock, Texas as well as the purchase of a building for an expansion of our back office operations that was planned before the Company was approached by BBVA.

Deposits

Deposits are our primary source of funds. The following table sets forth, for the periods indicated, the distribution of our average deposit account balances and average cost of funds on each category of deposits:

	Nine Months Ended								Year Ended
	September 30, 2006								December 31, 2005
	Average Balance		Percent of Deposits			Average Rate			Average Balance		Percent of Deposits			Average Rate
	(Dollars in thousands)
Noninterest-bearing demand deposits	$	476,477		35.9	%		—	%	$	416,168		35.4	%		—	%
Interest-bearing demand, savings and money market deposits		512,193		38.5			1.37			463,836		39.4			0.91
Time deposits of less than $100,000		187,924		14.1			3.17			167,646		14.3			2.18
Time deposits of $100,000 or more		152,686		11.5			3.66			127,973		10.9			2.65
Total deposits	$	1,329,280		100.0	%		1.40	%	$	1,175,623		100.0	%		0.96	%

Total deposits as of September 30, 2006 and December 31, 2005 were $1.317 billion and $1.357 billion, respectively, representing a decrease of $39.9 million, or 2.9%, for the nine months ended September 30, 2006. The decline in deposits is due to increased competition within our markets and seasonality within our deposit base. Average deposits for the nine months ended September 30, 2006 were $1.329 billion, as compared to $1.121 billion for the same period in 2005. The increase in average deposits during the nine months ended September 30, 2006 as compared with the nine months ended September 30, 2005 was primarily attributable to the acquisition of Heritage.

Total deposits as of September 30, 2006 and December 31, 2005 consisted of the following:

	September 30, 2006		December 31, 2005
	(In thousands)
Noninterest-bearing demand deposits	$	478,192	$	487,369
Interest-bearing deposits:
NOW and Money Market		420,845		448,762
Savings		73,984		75,095
Time deposits		344,182		345,852
Total interest-bearing deposits:		839,011		869,709
Total deposits	$	1,317,203	$	1,357,078

The following table sets forth the amount and maturities of the time deposits of $100,000 or more as of the dates indicated:

	September 30, 2006		December 31, 2005
	(In thousands)
Three months or less	$	22,621	$	37,958
Over three through six months		30,611		24,918
Over six through 12 months		48,992		36,452
Over 12 months		62,236		55,266
Total time deposits of $100,000 or more	$	164,460	$	154,594

Borrowings

Long-Term Debt

Deposits are the primary source of funds for our lending and investment activities. Occasionally, we obtain funding from the Federal Home Loan Bank (“FHLB”). As of September 30, 2006, we had $1.2 million in FHLB borrowings, compared to $5.8 million at December 31, 2005. The decrease in FHLB borrowings is due to two notes that matured in February with a combined balance of $4.6 million. The maturity dates on our outstanding FHLB notes range from 2008 to 2018 and have interest rates from 2.65% to 5.45%.

Other Borrowings

Borrowings, including funds purchased and securities sold under agreement to repurchase, totaled $43.2 million as of September 30, 2006, an increase of $14.6 million from December 31, 2005. Securities sold under agreement to repurchase totaled $38.7 million at September 30, 2006, an increase of $10.1 million from December 31, 2005. Federal funds purchased at September 30, 2006 totaled $4.5 million. We did not purchase federal funds as of December 31, 2005. The increase in borrowings was due to a higher level of funds purchased to satisfy liquidity needs as a result of growth in loans, additional purchases of investment securities and lower deposit balances.

Junior Subordinated Debentures

As of September 30, 2006 and December 31, 2005, we had $48.5 million (amount net of investments in trusts is $47.0 million) in outstanding junior subordinated debentures. See our Annual Report on Form 10-K, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations- Borrowings” which was filed on March 29, 2006, for further discussion.

Capital Resources and Capital Adequacy Requirements

Total shareholders’ equity was $225.3 million as of September 30, 2006 compared with $212.3 million as of December 31, 2005, an increase of $13.1 million, or 6.2%. The increase was due primarily to our net earnings of $14.8 million, offset by our dividend payment of $3.6 million.

Both the Board of Governors of the Federal Reserve System, with respect to the Company, and the OCC, with respect to the Bank, has established certain minimum risk-based capital standards that apply to bank holding companies and national banks. As of September 30, 2006, our Tier 1 risk based capital, total risk-based capital and leverage capital ratios were 12.68%, 13.72% and 10.42%, respectively. As of September 30, 2006, the Bank’s risk-based capital ratios were above the levels required for the Bank to be designated as “well capitalized” by the FDIC, with Tier 1 risk-based capital, total risk-based capital and leverage capital ratios of 9.12%, 11.12% and 12.16%, respectively.

Liquidity Management

Liquidity involves our ability to raise funds to support asset growth or reduce assets to meet deposit withdrawals and other payment obligations, to maintain reserve requirements and otherwise to operate on an ongoing basis. Our liquidity needs have primarily been met by growth in core deposits and the issuance of junior subordinated debentures. Although access to purchased funds from correspondent banks is available, we do not generally rely on these external funding sources. The cash and federal funds sold position, supplemented by amortizing investment and loan portfolios, have generally created an adequate liquidity position.

Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. As of September 30, 2006, our cash and due from bank balance was $58.9 million compared with $72.9 million as of December 31, 2005.

Aggregate Contractual Obligations

The following table represents our on and off-balance sheet aggregate contractual obligations, other than deposit liabilities, to make future payments to third parties as of the date specified:

	As of September 30, 2006
	Less than One Year		One Year to Three Years		Over Three Years to Five Years		Over Five Years		Total
	(In thousands)
FHLB advances	$	212	$	357	$	420	$	237	$	1,226
Junior subordinated debentures		—		—		—		47,000		47,000
Operating leases		1,453		2,625		1,431		471		5,980
Total	$	1,665	$	2,982	$	1,851	$	47,708	$	54,206

Aggregate contractual obligations above exclude the interest on our Federal Home Loan Bank advances and guaranteed preferred beneficial interests in our junior subordinated debentures. See footnote 7, “Borrowing Arrangements,” and footnote 8, “Guaranteed Preferred Beneficial Interest in the Company’s Subordinated Debentures,” to our audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, for additional information.

Off-Balance Sheet Arrangements

We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters-of-credit, which involve varying degrees of credit risk in excess of the amount recognized in the consolidated statement of financial position. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments.

	As of September 30, 2006
	Total Notional Amounts Committed		Less than 1 year		1-3 years		4-5 years		Over 5 years
	(In thousands)
Commitments to extend credit	$	308,459	$	236,159	$	65,928	$	2,229	$	4,143
Standby letters of credit		19,419		12,341		7,078		—		—
Total commercial commitments	$	327,878	$	248,500	$	73,006	$	2,229	$	4,143

As of September 30, 2006 and December 31, 2005, we had commitments to extend credit of $308.5 million and $253.9 million, respectively. We also had standby letters of credit of $19.4 million and $15.7 million as of September 30, 2006 and December 31, 2005, respectively.

The effect on our revenues, expenses, cash flows and liquidity of the unused portions of these commitments cannot reasonably be predicted because there is no guarantee that the lines of credit will be used.

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

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

The Company uses shock and simulation analysis to examine the potential effects of market changes on net interest income and market value. We consider macroeconomic variables, Company strategy, liquidity and other factors as it quantifies market risk. See our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations- Quantitative and Qualitative Disclosure about Market Risks,” for further discussion.

ITEM 4. Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q for the quarter ended September 30, 2006, we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our “disclosure controls and procedures,” as such term is defined under Exchange Act Rule 13a-15(e).

Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of the end of the fiscal quarter covered by this report, such disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is: (a) recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and (b) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

There were no changes in our internal controls over financial reporting during the quarter ended September 30, 2006 that materially affected, or were reasonably likely to materially affect, our internal controls over financial reporting.

PART II - OTHER INFORMATION

ITEM 1. Legal Proceedings

On July 28, 2006, a suit was filed against the Bank by Monte Hasie in the 72^nd District Court of Lubbock County, Texas alleging malicious prosecution, abuse of legal process, negligence and intentional infliction of emotional distress in connection with the criminal prosecution of the Plaintiff by the U.S. Government beginning in 2004. Subsequently, Hasie Financial Group joined as a plaintiff, and the Company was added as a defendant. The suit seeks compensatory or actual damages in excess of $10 million related to, among other things, loss of earnings, emotional distress, damage to reputation, and costs to defend the criminal prosecution. The suit also seeks exemplary damages and attorneys’ fees and costs. Our management, after discussion with legal counsel, believes the ultimate result of this litigation will not have a material adverse effect on the Company's financial position, results of operations or cash flows. The Bank and the Company deny all of plaintiffs’ allegations, and they plan to vigorously defend themselves against plaintiffs’ claims. However, events could occur that could cause any estimate of ultimate loss to differ materially.

Following the filing of the lawsuit, the Bank and the Company notified their insurance carrier, the Hartford Fire Insurance Company (“Hartford”) of the lawsuit in order to obtain coverage under its existing commercial general liability policies. Hartford notified the Bank and the Company it was denying coverage contending that the events in question, as alleged by Plaintiffs, occurred outside the applicable policy periods. As a result of Hartford’s denial of coverage, the Bank and the Company filed suit in the United States District Court, Northern District of Texas against Hartford seeking, amount other things, a declaratory judgment that coverage exists under the policies. That action is currently pending.

In addition to the foregoing, the Company is involved as plaintiff or defendant in a variety of routine litigation incidental to the normal course of business. Management believes, based on the opinion of legal counsel, that it has adequate defense or insurance protection with respect to such litigation and that any losses there from, whether or not insured, would not have a material adverse effect on the results of operations, financial position, or cash flows of the Company.

ITEM 1A. Risk Factors

Risks Related to the Proposed Merger

In connection with our proposed Merger with BBVA, on October 6, 2006 we filed a definitive proxy statement on Schedule 14A with the SEC. The proxy statement contains important information about the Company, the proposed Merger and other related matters. We urge all of our shareholders to read the proxy statement.

In relation to the proposed Merger, we are subject to certain risks including, but not limited to, those set forth below.

Failure to consummate the Merger could negatively impact our stock price and our future business and financial results.

Consummation of the Merger is subject to various conditions, including requisite approvals of the holders of our common stock. In addition, each party’s obligation to consummate the Merger is subject to certain other conditions, including (i) the other party’s representations and warranties in the Merger Agreement being true and correct at the Effective Time, subject to the materiality standards contained in the Merger Agreement, (ii) material compliance of the other party with its covenants and (iii) the absence of any law or order prohibiting the consummation of the Merger. There is no assurance that all of the various conditions will be satisfied or waived. If the proposed merger is not completed for any reason, we will be subject to several risks, including the following:

·	being required, under certain circumstances, including if the Merger Agreement is terminated in favor of an alternative offer from another potential buyer, to pay a termination fee of $19.2 million;

being required, under certain circumstances, including if our Board does not recommend in the proxy statement that our shareholders vote in favor of the merger or if an alternative proposal has been announced and the Merger Agreement is not approved by our shareholders, to reimburse BBVA for its costs and expenses in connection with the Merger Agreement;

·	having incurred certain costs relating to the proposed Merger that are payable whether or not the Merger is completed, including legal, accounting, financial advisor and printing fees;

·	having had the focus of management directed toward the proposed Merger and integration planning instead of on our core business and other opportunities that could have been beneficial to us; and

·	the market price of our common stock may decline to the extent that the current market price reflects a market belief that the Merger will be completed.

In addition, we will not realize any of the expected benefits of having completed the proposed Merger. If the proposed Merger is not completed, we cannot assure our shareholders that these risks will not materialize or materially adversely affect our business, financial results, financial condition and stock price.

Provisions of the Merger Agreement may deter alternative business combinations that could be more advantageous to our shareholders than the Proposed Merger.

Restrictions in the Merger Agreement on solicitation generally prohibit us from soliciting any acquisition proposal or offer for a merger or business combination with any other party, including a proposal that might be advantageous to our shareholders when compared to the terms and conditions of the proposed Merger. If the Merger is not completed, we may not be able to conclude another merger, sale or combination on as favorable terms, in a timely manner, or at all. If the Merger Agreement is terminated, we, in certain specified circumstances, may be required to pay a termination fee of $19.2 million to BBVA. In addition, under certain circumstances, we may be required to pay BBVA’s costs and expenses in connection with the Merger Agreement. These provisions may deter third parties from proposing or pursuing alternative business combinations that might result in greater value to our shareholders than the proposed Merger.

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

ITEM 3. Defaults Upon Senior Securities

Not applicable.

ITEM 4. Submission of Matters to a vote of Security Holders

Not applicable.

ITEM 5. Other Information

Not applicable.

ITEM 6. Exhibits

Exhibit Number		Description of Exhibit
2.1		Agreement and Plan of Merger, dated as of June 12, 2006, by and between Banco Bilbao Vizcaya Argentania, S.A. and State National Bancshares, Inc. is incorporated by reference from Exhibit 2.1 to the Registrant’s Form 8-K filed with the SEC on June 16, 2006.⁽¹⁾

10.1		Employment Agreement for Tom C. Nichols, dated as of June 12, 2006, with State National Bancshares, Inc. is incorporated by reference from Exhibit 10.1 to the Registrant’s Form 8-K filed with the SEC on June 16, 2006.

10.2		Employment Agreement for Don E. Cosby, dated as of June 12, 2006, with State National Bancshares, Inc. is incorporated by reference from Exhibit 10.2 to the Registrant’s Form 8-K filed with the SEC on June 16, 2006.

10.3		Employment Agreement for F. James Volk, dated as of June 12, 2006, with State National Bancshares, Inc. is incorporated by reference from Exhibit 10.3 to the Registrant’s Form 8-K filed with the SEC on June 16, 2006.

10.4		Tax Gross Up Agreement for Tom C. Nichols, dated as of June 12, 2006, with State National Bancshares, Inc. is incorporated by reference from Exhibit 10.4 to the Registrant’s Form 8-K filed with the SEC on June 16, 2006.

10.5		Tax Gross Up Agreement for Don E. Cosby, dated as of June 12, 2006, with State National Bancshares, Inc. is incorporated by reference from Exhibit 10.5 to the Registrant’s Form 8-K filed with the SEC on June 16, 2006.

10.6		Tax Gross Up Agreement for F. James Volk, dated as of June 12, 2006, with State National Bancshares, Inc. is incorporated by reference from Exhibit 10.6 to the Registrant’s Form 8-K filed with the SEC on June 16, 2006.

31.1		Rule 13a-14(a) Certification of Chief Executive Officer.

31.2		Rule 13a-14(a) Certification of Chief Financial Officer.

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

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

(1) Pursuant to Regulation S-K Item 601(b)(2), the Registrant will furnish supplementally to the SEC a copy of any omitted schedule to this exhibit upon request.

SIGNATURES

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


	STATE NATIONAL BANCSHARES, INC.

Date: November 10, 2006	By:	/s/ Don E. Cosby
		Don E. Cosby Executive Vice President, Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)

State National Bancshares, Inc. 10-Q