**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 ofincorporation or organization)
            
            (I.R.S.
                Employer Identification No.)4500
                Mercantile Plaza DriveSuite
                300Fort
                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
xNo
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
                STATEMENTSConsolidated
                Balance Sheets
            1Consolidated
                Statements of Operations
            2Consolidated
                Statements of Changes in Shareholders' Equity
            3Consolidated
                Statements of Cash Flows
            4Notes
                to Interim Consolidated Financial Statements
            5ITEM
                2.
            MANAGEMENT’S
                DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                OPERATIONS
            10ITEM
                3.
            QUANTITATIVE
                AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
            27ITEM
                4.
            CONTROLS
                AND PROCEDURES
            27**PART
                II -****OTHER INFORMATION**ITEM
                1.
            LEGAL
                PROCEEDINGS
            27ITEM
                1A.
            RISK
                FACTORS
            27ITEM
                2.
            UNREGISTERED
                SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
            28ITEM
                3.
            DEFAULTS
                UPON SENIOR SECURITIES
            28ITEM
                4.
            SUBMISSION
                OF MATTERS TO A VOTE OF SECURITY HOLDERS
            29ITEM
                5.
            OTHER
                INFOMATION
            29ITEM
                6.
            EXHIBITS
            29




i





**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
            
            $
            72,922Federal
                funds sold
            
            
            —
            
            
            36,950Interest-bearing
                deposits in other banks
            
            
            3,155
            
            
            44,763Total
                cash and cash equivalents
            
            
            62,042
            
            
            154,635Securities
                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
            
            
            206,787Federal
                Reserve Bank stock and other investments, at cost
            
            
            9,126
            
            
            8,094Loans
                held-for-sale
            
            
            4,318
            
            
            11,584Loans
                held for investment:Total
                loans held for investment
            
            
            1,130,655
            
            
            1,074,611Less
                allowance for loan losses
            
            
            12,992
            
            
            12,591Net
                loans held for investment
            
            
            1,117,663
            
            
            1,062,020Premises
                and equipment, net
            
            
            54,529
            
            
            48,769Goodwill
            
            
            99,354
            
            
            100,486Other
                intangible assets, net
            
            
            15,334
            
            
            17,936Accrued
                interest receivable
            
            
            10,038
            
            
            8,919Other
                real estate and other repossessed assets
            
            
            1,019
            
            
            935Other
                assets
            
            
            45,757
            
            
            42,712**Total
                assets**
            
            $
            1,645,203
            
            $
            1,662,877**Liabilities
                and shareholders' equity:**Deposits:Noninterest
                bearing deposits
            
            $
            478,192
            
            $
            487,369Interest-bearing
                demand deposits
            
            
            494,829
            
            
            523,857Interest-bearing
                time deposits
            
            
            344,182
            
            
            345,852Total
                deposits
            
            
            1,317,203
            
            
            1,357,078Federal
                funds purchased and securities sold under agreement to
                repurchase
            
            
            43,151
            
            
            28,597Accrued
                interest payable
            
            
            1,957
            
            
            1,645Other
                liabilities
            
            
            8,152
            
            
            10,459Junior
                subordinated debentures
            
            
            47,000
            
            
            47,000Notes
                payable
            
            
            1,226
            
            
            5,841**Total
                liabilities**
            
            
            1,418,689
            
            
            1,450,620Minority
                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
            
            
            11,971Additional
                paid-in capital
            
            
            179,399
            
            
            177,428Retained
                earnings
            
            
            35,400
            
            
            24,164Accumulated
                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.





1




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




See
      Accompanying Notes to Consolidated Financial Statements.


2


**STATE
      NATIONAL BANCSHARES, INC. AND SUBSIDIARIES**


**C** **onsolidated** **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
            
            $
            151,360Comprehensive
                income:Net
                income
            
            
            —
            
            
            —
            
            
            —
            
            
            16,682
            
            
            —
            
            
            16,682Change
                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
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            15,072Issuance
                of new stock
            
            
            1,907,692
            
            
            1,907
            
            
            43,279
            
            
            —
            
            
            —
            
            
            45,186Stock
                option award expense
            
            
            —
            
            
            —
            
            
            486
            
            
            —
            
            
            —
            
            
            486Stock
                options exercised
            
            
            8,833
            
            
            9
            
            
            144
            
            
            —
            
            
            —
            
            
            153**Balance,
                December 31, 2005**
            
            
            11,971,107
            
            
            11,971
            
            
            177,428
            
            
            24,164
            
            
            (1,306
            )
            
            212,257Comprehensive
                income:Net
                income
            
            
            —
            
            
            —
            
            
            —
            
            
            14,838
            
            
            —
            
            
            14,838Change
                in unrealized gain on available-for-sale securities, net of deferred
                income taxes
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (272
            )
            
            (272
            )Reclassification
                adjustment for losses included in net income
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            79
            
            
            79Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            14,645Dividends
                - $0.30 per share
            
            
            —
            
            
            —
            
            
            —
            
            
            (3,602
            )
            
            —
            
            
            (3,602
            )Stock
                option award expense
            
            
            —
            
            
            —
            
            
            357
            
            
            —
            
            
            —
            
            
            357Stock
                issued for directors fees
            
            
            7,576
            
            
            7
            
            
            183
            
            
            —
            
            
            —
            
            
            190Stock
                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.


3


**STATE
      NATIONAL BANCSHARES, INC. AND SUBSIDIARIES**


**C** **onsolidated** **Statements of Cash Flows**


**(Unaudited)**




**Nine
                Months Ended September 30,****2006**
            
            **2005**Operating
                Activities:
            
            **(Dollars
                in thousands****)**Net
                income
            
            $
            14,838
            
            $
            11,675Adjustments
                to reconcile net income to net cash provided by operating activities:Provision
                for loan losses
            
            
            960
            
            
            750Depreciation
                and amortization
            
            
            5,725
            
            
            4,744Stock
                compensation expense
            
            
            357
            
            
            362Stock
                issued for directors fees
            
            
            190
            
            
            —Loans
                originated for sale
            
            
            (78,991
            )
            
            (93,420
            )Proceeds
                from sales of loans held-for-sale
            
            
            88,182
            
            
            97,194Gain
                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
            
            
            80Net
                amortization of premium on securities
            
            
            7
            
            
            492Net
                change in other assets and liabilities
            
            
            (5,028
            )
            
            1,597Net
                cash provided by operating activities
            
            
            23,286
            
            
            20,403Investing
                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
            
            
            40,062Proceeds
                from maturities and calls of Federal Reserve Bank Stock & other
                investments
            
            
            476
            
            
            413Net
                increase in loans
            
            
            (57,174
            )
            
            (30,393
            )Proceeds
                from sale of premises and equipment
            
            
            374
            
            
            312Proceeds
                from sales of other real estate and other repossessed
                assets
            
            
            482
            
            
            1,259Purchase
                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
            )
            
            24,382Stock
                issued through exercise of stock options
            
            
            1,500
            
            
            153Net
                increase in federal funds purchased and securities sold under agreement
                to
                repurchase
            
            
            14,554
            
            
            8,940Principal
                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
            )
            
            33,052Net
                (decrease) increase in cash and cash equivalents
            
            
            (92,593
            )
            
            52,616Cash
                and cash equivalents, beginning of period
            
            
            154,635
            
            
            89,467Cash
                and cash equivalents, end of period
            
            $
            62,042
            
            $
            142,083Supplemental
                disclosures of cash flow information:Cash
                paid during the period for:Interest
            
            $
            17,839
            
            $
            9,631Income
                taxes paid, net of refunds
            
            
            8,746
            
            
            5,248Noncash
                transactions:Transfer
                of loans to other real estate owned, net
            
            
            672
            
            
            1,120




See
      Accompanying Notes to Consolidated Financial Statements.


4


**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.


5




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
            
            $
            11,675Add:
                Stock-based employee compensation expense included in reported net
                income,
                net of tax
            
            
            69
            
            
            78
            
            
            232
            
            
            235Deduct:
                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
            
            $
            11,663Earnings
                per share:Basic—as
                reported
            
            $
            0.47
            
            $
            0.43
            
            $
            1.24
            
            $
            1.16Basic—pro
                forma
            
            
            0.47
            
            
            0.43
            
            
            1.24
            
            
            1.16Diluted—as
                reported
            
            
            0.46
            
            
            0.42
            
            
            1.21
            
            
            1.14Diluted—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.




6




**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.




7


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
            
            $
            142,690Total
                capital
            
            
            171,687
            
            
            155,281Total
                risk-weighted assets
            
            
            1,251,397
            
            
            1,191,030Adjusted
                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
            
            
            6.00Total
                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
            
            
            11.12Total
                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.




8






**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.




9





**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 lossescould
                materially adversely affect our earnings;




10




·
            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.


11




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.


12




*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 increase s
      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.




13




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
            
            
            3.96Time
                deposits in other banks
            
            
            3,938
            
            
            51
            
            
            5.18
            
            
            13,591
            
            
            127
            
            
            3.74Fed
                funds sold
            
            
            6,449
            
            
            84
            
            
            5.21
            
            
            54,786
            
            
            457
            
            
            3.34Total
                interest-earning assets
            
            
            1,364,073
            
            
            26,248
            
            
            7.70
            
            
            1,161,784
            
            
            19,600
            
            
            6.75Noninterest-earning
                assets:Cash
                and due from banks
            
            
            61,018
            
            
            
            
            
            
            
            
            62,622Intangible
                assets
            
            
            115,103
            
            
            
            
            
            
            
            
            84,175Premises
                and equipment, net
            
            
            53,288
            
            
            
            
            
            
            
            
            35,835Accrued
                interest receivable and other assets
            
            
            53,683
            
            
            
            
            
            
            
            
            46,713Allowance
                for loan losses
            
            
            (13,151
            )
            
            
            
            
            
            
            
            (11,627
            )Total
                noninterest-earning assets
            
            
            269,941
            
            
            
            
            
            
            
            
            217,718TOTAL
                ASSETS
            
            $
            1,634,014
            
            
            
            
            
            
            
            $
            1,379,502LIABILITIES
                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
            
            
            2.53Fed
                funds purchased and securities under
              agreement
                to repurchase
            
            
            37,301
            
            
            449
            
            
            4.81
            
            
            23,869
            
            
            178
            
            
            2.98Junior
                subordinated debentures
            
            
            47,000
            
            
            1,073
            
            
            9.13
            
            
            47,000
            
            
            832
            
            
            7.08Note
                payable
            
            
            1,982
            
            
            22
            
            
            4.44
            
            
            823
            
            
            10
            
            
            4.86Total
                interest-bearing liabilities
            
            
            921,523
            
            
            6,608
            
            
            2.87
            
            
            793,190
            
            
            3,882
            
            
            1.96Noninterest-bearing
                liabilities:Demand
                deposits
            
            
            476,793
            
            
            
            
            
            
            
            
            412,567Accrued
                interest payable and other liabilities
            
            
            11,119
            
            
            
            
            
            
            
            
            12,412Total
                noninterest-bearing liabilities, net
            
            
            487,912
            
            
            
            
            
            
            
            
            424,979TOTAL
                LIABILITIES
            
            
            1,409,435
            
            
            
            
            
            
            
            
            1,218,169Minority
                interest in unconsolidated subsidiary
            
            
            1,172
            
            
            
            
            
            
            
            
            —SHAREHOLDERS'
                EQUITY
            
            
            223,407
            
            
            
            
            
            
            
            
            161,333TOTAL
                LIABILITIES AND
              SHAREHOLDERS'
                EQUITY
            
            $
            1,634,014
            
            
            
            
            
            
            
            $
            1,379,502Net
                interest income
            
            
            
            
            $
            19,640
            
            
            
            
            
            
            
            $
            15,718Net
                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.


14




**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
            
            
            3.96Time
                deposits in other banks
            
            
            17,642
            
            
            588
            
            
            4.44
            
            
            10,807
            
            
            237
            
            
            2.92Fed
                funds sold
            
            
            22,531
            
            
            789
            
            
            4.67
            
            
            32,302
            
            
            740
            
            
            3.05Total
                interest-earning assets
            
            
            1,370,269
            
            
            75,697
            
            
            7.37
            
            
            1,141,020
            
            
            55,636
            
            
            6.50Noninterest-earning
                assets:Cash
                and due from banks
            
            
            66,176
            
            
            
            
            
            
            
            
            61,594Intangible
                assets
            
            
            116,297
            
            
            
            
            
            
            
            
            85,007Premises
                and equipment, net
            
            
            51,412
            
            
            
            
            
            
            
            
            34,921Accrued
                interest receivable and other assets
            
            
            53,413
            
            
            
            
            
            
            
            
            46,233Allowance
                for loan losses
            
            
            (13,089
            )
            
            
            
            
            
            
            
            (11,511
            )Total
                noninterest-earning assets
            
            
            274,209
            
            
            
            
            
            
            
            
            216,244TOTAL
                ASSETS
            
            $
            1,644,478
            
            
            
            
            
            
            
            $
            1,357,264LIABILITIES
                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
            
            
            2.17Fed
                funds purchased and securities underagreement
                to repurchase
            
            
            34,285
            
            
            1,120
            
            
            4.36
            
            
            20,919
            
            
            387
            
            
            2.47Junior
                subordinated debentures
            
            
            47,000
            
            
            3,025
            
            
            8.58
            
            
            47,000
            
            
            2,314
            
            
            6.56Note
                payable
            
            
            2,225
            
            
            96
            
            
            5.75
            
            
            851
            
            
            30
            
            
            4.70Total
                interest-bearing liabilities
            
            
            936,313
            
            
            18,151
            
            
            2.58
            
            
            790,362
            
            
            9,998
            
            
            1.69Noninterest-bearing
                liabilities:Demand
                deposits
            
            
            476,477
            
            
            
            
            
            
            
            
            399,425Accrued
                interest payable and other liabilities
            
            
            11,949
            
            
            
            
            
            
            
            
            9,544Total
                noninterest-bearing liabilities, net
            
            
            488,426
            
            
            
            
            
            
            
            
            408,969TOTAL
                LIABILITIES
            
            
            1,424,739
            
            
            
            
            
            
            
            
            1,199,331Minority
                interest in unconsolidated subsidiary
            
            
            812
            
            
            
            
            
            
            
            
            —SHAREHOLDERS'
                EQUITY
            
            
            218,927
            
            
            
            
            
            
            
            
            157,933TOTAL
                LIABILITIES AND
              SHAREHOLDERS'
                EQUITY
            
            $
            1,644,478
            
            
            
            
            
            
            
            $
            1,357,264Net
                interest income
            
            
            
            
            $
            57,546
            
            
            
            
            
            
            
            $
            45,638Net
                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.


15





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
            
            $
            15,796Securities
            
            
            1,060
            
            
            465
            
            
            1,525
            
            
            2,718
            
            
            1,147
            
            
            3,865Time
                deposits in other banks
            
            
            (90
            )
            
            14
            
            
            (76
            )
            
            150
            
            
            201
            
            
            351Federal
                funds sold
            
            
            (403
            )
            
            30
            
            
            (373
            )
            
            (224
            )
            
            273
            
            
            49Total
                interest income
            
            
            3,388
            
            
            3,260
            
            
            6,648
            
            
            10,057
            
            
            10,004
            
            
            20,061Interest-bearing
                liabilities:Demand,
                savings and money market deposits
            
            
            126
            
            
            654
            
            
            780
            
            
            421
            
            
            2,060
            
            
            2,481Time
                deposits
            
            
            400
            
            
            1,022
            
            
            1,422
            
            
            1,032
            
            
            3,130
            
            
            4,162Federal
                funds purchased and securities sold under agreement to
                repurchase
            
            
            100
            
            
            171
            
            
            271
            
            
            247
            
            
            486
            
            
            733Junior
                subordinated debentures
            
            
            —
            
            
            241
            
            
            241
            
            
            —
            
            
            711
            
            
            711Notes
                payable
            
            
            14
            
            
            (2
            )
            
            12
            
            
            48
            
            
            18
            
            
            66Total
                interest expense
            
            
            640
            
            
            2,086
            
            
            2,726
            
            
            1,748
            
            
            6,405
            
            
            8,153Increase
                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.


16




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
            
            
            15.6Bank
                owned life insurance
            
            
            326
            
            
            6.5
            
            
            316
            
            
            6.4
            
            
            979
            
            
            6.6
            
            
            948
            
            
            6.9Net
                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
            
            
            23.8Total
                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.


17




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
            
            
            4.1Pension
            
            
            333
            
            
            2.1
            
            
            273
            
            
            1.9
            
            
            998
            
            
            2.1
            
            
            800
            
            
            2.0Payroll
                taxes
            
            
            417
            
            
            2.6
            
            
            381
            
            
            2.7
            
            
            1,420
            
            
            2.9
            
            
            1,288
            
            
            3.1Total
                salaries and employee benefits
            
            
            8,108
            
            
            51.0
            
            
            7,297
            
            
            52.0
            
            
            24,413
            
            
            50.4
            
            
            21,614
            
            
            52.6Net
                occupancy and equipment expense
            
            
            2,490
            
            
            15.7
            
            
            2,322
            
            
            16.6
            
            
            7,495
            
            
            15.5
            
            
            6,628
            
            
            16.1Amortization
                of intangibles
            
            
            998
            
            
            6.3
            
            
            824
            
            
            5.9
            
            
            3,017
            
            
            6.2
            
            
            2,471
            
            
            6.0Professional
                fees
            
            
            588
            
            
            3.7
            
            
            326
            
            
            2.3
            
            
            1,679
            
            
            3.5
            
            
            1,017
            
            
            2.5Advertising
            
            
            443
            
            
            2.8
            
            
            330
            
            
            2.3
            
            
            1,165
            
            
            2.4
            
            
            864
            
            
            2.1Communication
                expense
            
            
            330
            
            
            2.1
            
            
            300
            
            
            2.1
            
            
            975
            
            
            2.0
            
            
            856
            
            
            2.1Data
                processing
            
            
            238
            
            
            1.5
            
            
            203
            
            
            1.5
            
            
            694
            
            
            1.4
            
            
            622
            
            
            1.5Supplies
            
            
            148
            
            
            0.9
            
            
            166
            
            
            1.2
            
            
            528
            
            
            1.1
            
            
            587
            
            
            1.4OREO
            
            
            (8
            )
            
            (0.1
            )
            
            (6
            )
            
            0.0
            
            
            196
            
            
            0.4
            
            
            23
            
            
            0.1Merger
                and one-time expenses
            
            
            126
            
            
            0.8
            
            
            19
            
            
            0.1
            
            
            884
            
            
            1.8
            
            
            59
            
            
            0.1Other
            
            
            2,423
            
            
            15.3
            
            
            2,244
            
            
            16.0
            
            
            7,383
            
            
            15.3
            
            
            6,378
            
            
            15.5Total
                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).




18




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
            
            $
            6,908U.S.
                government agencies obligations
            
            
            142,721
            
            
            142,158
            
            
            —
            
            
            —
            
            
            142,721
            
            
            142,158Collateralized
                mortgage obligations
            
            
            138
            
            
            137
            
            
            —
            
            
            —
            
            
            138
            
            
            137Mortgage-backed
                securities
            
            
            53,146
            
            
            51,615
            
            
            —
            
            
            —
            
            
            53,146
            
            
            51,615State
                and municipal obligations
            
            
            22,897
            
            
            22,740
            
            
            —
            
            
            —
            
            
            22,897
            
            
            22,740Federal
                Reserve Bank stock and other investments
            
            
            2,476
            
            
            2,465
            
            
            9,126
            
            
            9,126
            
            
            11,602
            
            
            11,591Total
            
            $
            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
            
            $
            6,969U.S.
                government agencies obligations
            
            
            109,516
            
            
            108,622
            
            
            —
            
            
            —
            
            
            109,516
            
            
            108,622Collateralized
                mortgage obligations
            
            
            165
            
            
            166
            
            
            —
            
            
            —
            
            
            165
            
            
            166Mortgage-backed
                securities
            
            
            64,357
            
            
            63,292
            
            
            —
            
            
            —
            
            
            64,357
            
            
            63,292State
                and municipal obligations
            
            
            26,294
            
            
            26,348
            
            
            —
            
            
            —
            
            
            26,294
            
            
            26,348Federal
                Reserve Bank stock and other investments
            
            
            1,414
            
            
            1,390
            
            
            8,094
            
            
            8,094
            
            
            9,508
            
            
            9,484Total
            
            $
            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.


19


*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
            
            
            4.64Mortgage
                backed securities and collateralized mortgage obligations
                (3)
            
            
            1,836
            
            
            5.34
            
            
            49,075
            
            
            4.63
            
            
            839
            
            
            4.89
            
            
            3
            
            
            7.00
            
            
            51,753
            
            
            4.66State
                and municipal obligations
            
            
            3,348
            
            
            3.35
            
            
            13,212
            
            
            3.52
            
            
            5,422
            
            
            4.02
            
            
            757
            
            
            5.28
            
            
            22,739
            
            
            3.67Other
                securities
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            2,465
            
            
            4.54
            
            
            2,465
            
            
            4.60Total
                investments available-for-sale
            
            
            52,359
            
            
            3.84
            
            
            164,178
            
            
            4.77
            
            
            6,261
            
            
            4.14
            
            
            3,225
            
            
            4.71
            
            
            226,023
            
            
            4.54Other
                investments:FHLB
                stock and other investments
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            9,126
            
            
            5.19
            
            
            9,126
            
            
            5.19Total
                other investments
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            9,126
            
            
            5.19
            
            
            9,126
            
            
            5.19Total
                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
            
            $
            952Mortgage-backed
                securities (2)
            
            
            17,967
            
            
            465
            
            
            33,109
            
            
            1,071
            
            
            51,076
            
            
            1,536Other
            
            
            19,857
            
            
            192
            
            
            2,808
            
            
            34
            
            
            22,665
            
            
            226Total
                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.




20




***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
              
              
              11.7Real
                  estate—other
              
              
              425,418
              
              
              37.6
              
              
              415,047
              
              
              38.6Lease
                  financing
              
              
              2,122
              
              
              0.2
              
              
              —
              
              
              —Commercial
              
              
              257,124
              
              
              22.7
              
              
              263,975
              
              
              24.6Agricultural
                  and other
              
              
              88,435
              
              
              7.8
              
              
              84,646
              
              
              7.9Consumer
              
              
              42,615
              
              
              3.8
              
              
              40,321
              
              
              3.7Total
                  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.


21


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
            
            $
            201,090Real
                estate—1-4 family
            
            
            22,110
            
            
            46,630
            
            
            45,111
            
            
            113,851Real
                estate—other
            
            
            54,593
            
            
            234,212
            
            
            136,613
            
            
            425,418Lease
                financing
            
            
            —
            
            
            —
            
            
            2,122
            
            
            2,122Commercial
                loans
            
            
            134,847
            
            
            87,875
            
            
            34,402
            
            
            257,124Consumer
                loans
            
            
            20,503
            
            
            17,706
            
            
            4,406
            
            
            42,615Agriculture
                and other loans
            
            
            77,307
            
            
            7,630
            
            
            3,498
            
            
            88,435Total
                loans held for investment
            
            $
            456,715
            
            $
            432,416
            
            $
            241,524
            
            $
            1,130,655With
                fixed interest rates
            
            $
            109,749
            
            $
            226,300
            
            $
            80,971
            
            $
            417,020With
                variable interest rates
            
            
            346,966
            
            
            206,116
            
            
            160,553
            
            
            713,635Total
                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
                
                $
                8,654Accruing
                    loans past due over 90 days
                
                
                —
                
                
                —Restructured
                    loans
                
                
                73
                
                
                88OREO
                
                
                1,003
                
                
                927Other
                    repossessed assets
                
                
                16
                
                
                8Total
                    nonperforming assets
                
                $
                9,898
                
                $
                9,677Total
                    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.


22




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
              
              $
              11,383Provision
                  for loan losses
              
              
              960
              
              
              900Loan
                  loss reserves of acquired banks
              
              
              —
              
              
              1,670Loans
                  charged-off:Real
                  estate—construction
              
              
              106
              
              
              72Real
                  estate—1-4 family
              
              
              113
              
              
              96Real
                  estate—other
              
              
              53
              
              
              —Commercial
                  loans
              
              
              552
              
              
              1,067Consumer
                  loans
              
              
              438
              
              
              820Agriculture
                  and other loans
              
              
              —
              
              
              500Total
                  charge-offs
              
              
              1,262
              
              
              2,555Recoveries
                  of loans previously charged-off:Real
                  estate—construction
              
              
              —
              
              
              45Real
                  estate—1-4 family
              
              
              5
              
              
              18Real
                  estate—other
              
              
              9
              
              
              12Commercial
                  loans
              
              
              463
              
              
              535Consumer
                  loans
              
              
              169
              
              
              573Agriculture
                  and other loans
              
              
              57
              
              
              10Total
                  recoveries
              
              
              703
              
              
              1,193Net
                  loans charged-off
              
              
              559
              
              
              1,362Balance,
                  end of period
              
              $
              12,992
              
              $
              12,591Average
                  loans outstanding, net of unearned income, for the period
                  ended
              
              $
              1,099,152
              
              $
              989,406Ratio
                  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.


23


***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
            
            
            0.91Time
                deposits of less than $100,000
            
            
            187,924
            
            
            14.1
            
            
            3.17
            
            
            167,646
            
            
            14.3
            
            
            2.18Time
                deposits of $100,000 or more
            
            
            152,686
            
            
            11.5
            
            
            3.66
            
            
            127,973
            
            
            10.9
            
            
            2.65Total
                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
            
            $
            487,369Interest-bearing
                deposits:NOW
                and Money Market
            
            
            420,845
            
            
            448,762Savings
            
            
            73,984
            
            
            75,095Time
                deposits
            
            
            344,182
            
            
            345,852Total
                interest-bearing deposits:
            
            
            839,011
            
            
            869,709Total
                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
            
            $
            37,958Over
                three through six months
            
            
            30,611
            
            
            24,918Over
                six through 12 months
            
            
            48,992
            
            
            36,452Over
                12 months
            
            
            62,236
            
            
            55,266Total
                time deposits of $100,000 or more
            
            $
            164,460
            
            $
            154,594




24




***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.


25


***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
            
            $
            1,226Junior
                subordinated debentures
            
            
            —
            
            
            —
            
            
            —
            
            
            47,000
            
            
            47,000Operating
                leases
            
            
            1,453
            
            
            2,625
            
            
            1,431
            
            
            471
            
            
            5,980Total
            
            $
            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
            
            $
            4,143Standby
                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.


26




**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.




27




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.


28




**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.


29


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. CosbyDon
                E. Cosby
              Executive
                Vice President, Chief Financial
              Officer,
                Secretary and Treasurer (Principal
              Financial
                and Accounting Officer)




30