** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

###### **WASHINGTON, DC 20549**

###### ** **

###### **FORM 10-QSB**

 
| **ý**                                                 | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF  1934**          |
|------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
|                                                       |
| **For the  quarterly period ended December 31, 2005** |
|                                                       |
| **o**                                                      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

# **Commission FileNumber: 333-112325**

# ** **

**Treaty Oak Bancorp, Inc.**

(Exact name of registrant asspecified in its charter)

 

**Texas**

(State or other jurisdiction of

corporation or organization)

 

**20-0413144**

(I.R.S. Employer IdentificationNumber)

 

**101Westlake Drive, Austin, Texas**

(Address of Principal ExecutiveOffices)

 

**78746**

(Zip Code)

 

**(512) 617-3600**

(Registrant’s telephone number,including area code)

 

Indicate by check mark whether the issuer (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file****such reports),and (2) has been subject to such filing requirements for the past 90 days.

 

**Yes  ****ý        No ****o**

 

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

 

**Yes  ****o     No ****ý**

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock as of the close of business on February 13, 2006.

 
| $0.01  Par Value Common Stock |   | 2,635,986 shares |
|-------------------------------|--------|------------------|

 

Transitional Small Business Disclosure Format (Checkone):         **Yes  ****o     No ****ý**

 

 

----

 

**QUARTERLYREPORT ON FORM 10-QSB**

**FOR THE PERIODENDED DECEMBER 31, 2005**

 

**TABLE OFCONTENTS**

 
| **Part I.**  | **Financial  Information**                                                                                                            |   |
|-------------------|---------------------------------------------------------------------------------------------------------------------------------------|--------|
|              |                                                                                                                                  |   |
| **Item 1.**       | *Financial  Statements*                                                                                                               |   |
|              |                                                                                                                                  |   |
|              | Consolidated Balance Sheets at September 30, 2005 and December 31,  2005 (unaudited)                                        |   |
|              |                                                                                                                                  |   |
|              | Consolidated Statements of Operations for the Three-Month Periods  ended December 31, 2005, and 2004 (unaudited)                 |   |
|              |                                                                                                                                  |   |
|              | Consolidated Statements of Changes in  Shareholders’ Equity for the Three-Month Period ended December 31, 2005  (unaudited) |   |
|              |                                                                                                                                  |   |
|              | Consolidated Statements of Cash Flows for the Three Month Periods  ended December 31, 2005, and 2004 (unaudited)                 |   |
|              |                                                                                                                                  |   |
|              | Notes to Consolidated Financial Statements                                                                                            |   |
|              |                                                                                                                                  |   |
| **Item 2.**       | *Management’s  Discussion and Analysis of Financial Condition and Results of Operations*                                         |   |
|              |                                                                                                                                  |   |
| **Item  3.**      | *Controls  and Procedures*                                                                                                            |   |
|              |                                                                                                                                  |   |
| **Part II.** | **Other Information**                                                                                                                 |   |
|              |                                                                                                                                  |   |
| **Item 1.**       | *Legal Proceedings*                                                                                                                   |   |
|              |                                                                                                                                  |   |
| **Item 2.**       | *Unregistered Sales of Equity Securities and Use of  Proceeds*                                                                        |   |
|              |                                                                                                                                  |   |
| **Item 3.**       | *Defaults Upon Senior Securities*                                                                                                     |   |
|              |                                                                                                                                  |   |
| **Item 4.**       | *Submission of Matters to a Vote of Security  Holders*                                                                                |   |
|              |                                                                                                                                  |   |
| **Item 5.**       | *Other Information*                                                                                                                   |   |
|              |                                                                                                                                  |   |
| **Item 6.**       | *Exhibits and Reports on Form 8-K*                                                                                               |   |
|              |                                                                                                                                  |   |
|              | Signatures                                                                                                                            |   |

 

This Form 10-QSB contains forward-looking statements consisting ofestimates with respect to the financial condition, results of operations, andother business of Treaty Oak Bancorp, Inc., that are subject to variousfactors which could cause actual results to differ materially from thoseestimates.  Factors that could influencethe estimates include changes in the national, regional, and local marketconditions, legislative and regulatory conditions, and an adverse interest rateenvironment.

 

2

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**Treaty Oak Bancorp, Inc.**

**Consolidated Balance Sheets**

**December 31, 2005, and September 30,2005**

**(Dollars In Thousands, Except Par ValueAmounts)**

 
| ** **                                                                              | ** ** | **December 31,****2005** | ** ** | **September 30,  2005 (1)** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------|------------|----------------------------------|------------|
|                                                                                    |       | ** **                    |       |                             |       |
| ASSETS                                                                                  |       |                          |       |                             |       |
| Cash and cash items                                                                     |       | $                             | 446        |                             | $          | 230 |   |
| Due from banks                                                                          |       | 1,238                         |       | 9,271                            |       |
| Federal funds sold                                                                      |       | 2,718                         |       | 3,606                            |       |
|                                                                                    |       |                          |       |                             |       |
| Total cash  and cash equivalents                                                        |       | 4,402                         |       | 13,107                           |       |
|                                                                                    |       |                          |       |                             |       |
| Securities available for sale                                                           |       | 424                           |       | 427                              |       |
| Securities held to maturity, fair value of  $2,970 and $3,472, respectively             |       | 3,003                         |       | 3,501                            |       |
| Loans, net                                                                              |       | 44,871                        |       | 35,683                           |       |
| Premises and equipment, net                                                             |       | 5,738                         |       | 5,819                            |       |
| Note receivable from affiliate                                                          |       | 337                           |       | -                                |       |
| Accrued interest receivable                                                             |       | 352                           |       | 348                              |       |
| Due from affiliates                                                                     |       | 54                            |       | 34                               |       |
| Goodwill                                                                                |       | 1,161                         |       | 1,161                            |       |
| Core deposit intangibles                                                                |       | 52                            |       | 54                               |       |
| Other                                                                                   |       | 673                           |       | 615                              |       |
|                                                                                    |       |                          |       |                             |       |
| Total assets                                                                            |       | $                             | 61,067     |                             | $          | 60,749 |   |
|                                                                                    |       |                          |       |                             |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                               |       |                          |       |                             |       |
|                                                                                    |       |                          |       |                             |       |
| Deposits:                                                                               |       |                          |       |                             |       |
| Noninterest-bearing  demand                                                             |       | $                             | 18,735     |                             | $          | 17,057 |   |
| NOW, money  market and savings                                                          |       | 15,052                        |       | 13,413                           |       |
| Time  deposits                                                                          |       | 12,114                        |       | 15,076                           |       |
|                                                                                    |       |                          |       |                             |       |
| Total  deposits                                                                         |       | 45,901                        |       | 45,546                           |       |
|                                                                                    |       |                          |       |                             |       |
| Accrued interest payable                                                                |       | 86                            |       | 116                              |       |
| Notes payable                                                                           |       | 2,782                         |       | 2,801                            |       |
| Minority interest - PGI Equity Partners, LP                                             |       | 1,112                         |       | 1,109                            |       |
| Other liabilities                                                                       |       | 227                           |       | 144                              |       |
|                                                                                    |       |                          |       |                             |       |
| Total  liabilities                                                                      |       | 50,108                        |       | 49,716                           |       |
|                                                                                    |       |                          |       |                             |       |
| Shareholders’ equity:                                                              |       |                          |       |                             |       |
| Common  stock, $0.01 par value; 20,000,000 shares authorized; 2,635,746 shares  issued. |       | 26                            |       | 26                               |       |
| Paid-in  capital                                                                        |       | 14,949                        |       | 14,949                           |       |
| Accumulated  deficit                                                                    |       | (3,962                        | )          | (3,888                           | )          |
| Accumulated  other comprehensive loss                                                   |       | (4                            | )          | (4                               | )          |
| Less shares  held in treasury, at cost (6,003 shares)                                   |       | (50                           | )          | (50                              | )          |
| Total  shareholders’ equity                                                        |       | 10,959                        |       | 11,033                           |       |
|                                                                                    |       |                          |       |                             |       |
| Total  liabilities and shareholders’ equity                                        |       | $                             | 61,067     |                             | $          | 60,749 |   |

 

----

(1) Derived from audited financial statements.

 

3

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**Treaty Oak Bancorp, Inc.**

**Consolidated Statements of Operations**

**Three Months Ended December 31, 2005,and 2004(Dollars In Thousands, Except Per Share Amounts)**

 
| ** **                                               | ** ** | **Three Months  December 31,  2005** | ** ** | **Three Months  December 31,  2004** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
|                                                     |       |                                      |       |                                      |       |
| Interest income:                                         |       |                                      |       |                                      |       |
| Loans,  including fees                                   |       | $                                         | 822        |                                      | $          | 233 |   |
| Taxable  securities                                      |       | 32                                        |       | 20                                        |       |
| Interest on  deposits with other banks                   |       | 36                                        |       | 6                                         |       |
| Federal  funds sold                                      |       | 36                                        |       | 66                                        |       |
|                                                     |       |                                      |       |                                      |       |
| Total  interest income                                   |       | 926                                       |       | 325                                       |       |
|                                                     |       |                                      |       |                                      |       |
| Interest expense:                                        |       |                                      |       |                                      |       |
| Deposits                                                 |       | 174                                       |       | 86                                        |       |
| Interest on  other borrowings                            |       | 42                                        |       | —                                    |       |
|                                                     |       |                                      |       |                                      |       |
| Total  interest expense                                  |       | 216                                       |       | 86                                        |       |
|                                                     |       |                                      |       |                                      |       |
| Net interest income                                      |       | 710                                       |       | 239                                       |       |
|                                                     |       |                                      |       |                                      |       |
| Provision for loan losses                                |       | 45                                        |       | —                                    |       |
|                                                     |       |                                      |       |                                      |       |
| Net interest income after provision for  loan losses     |       | 665                                       |       | 239                                       |       |
| Noninterest income:                                      |       |                                      |       |                                      |       |
| Service  charges on deposit accounts                     |       | 20                                        |       | 16                                        |       |
| Other  noninterest income                                |       | 95                                        |       | —                                    |       |
|                                                     |       |                                      |       |                                      |       |
| Total  noninterest income                                |       | 115                                       |       | 16                                        |       |
| Noninterest expense:                                     |       |                                      |       |                                      |       |
| Salaries and  employee benefits                          |       | 391                                       |       | 583                                       |       |
| Occupancy  and equipment expenses                        |       | 61                                        |       | 111                                       |       |
| Accounting  and other professional fees                  |       | 124                                       |       | 93                                        |       |
| Other  noninterest expense                               |       | 275                                       |       | 168                                       |       |
| Minority  interests in partnership income                |       | 3                                         |       | —                                    |       |
|                                                     |       |                                      |       |                                      |       |
| Total  noninterest expense                               |       | 854                                       |       | 955                                       |       |
| Net loss                                                 |       | $                                         | (74        | )                                         | $          | (700 | ) |
|                                                     |       |                                      |       |                                      |       |
| Loss per common share - basic and diluted                |       | $                                         | (0.03      | )                                         | $          | (0.27 | ) |
|                                                     |       |                                      |       |                                      |       |
| Weighted average shares outstanding - basic  and diluted |       | 2,635,746                                 |       | 2,584,246                                 |       |

 

4

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**Treaty Oak Bancorp, Inc.**

**Consolidated Statements of Changes inShareholders' Equity**

**Three Months Ended December 31, 2005,and 2004(Dollars In Thousands)**

 
| ** **                                                                       | ** ** | ** **       | ** ** | ** **  | ** ** | ** **      | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------|------------|-------------|------------|-----------------|------------|-------------------|------------|-----------------|------------|------------|------------|------------|------------|
| ** **                                                                       | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **        | ** ** | **other**       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                       | ** ** | **Common Stock** | ** ** | **paid-in** | ** ** | **Accumulated** | ** ** | **comprehensive** | ** ** | **Treasury**    | ** ** | ** ** | ** ** |
| ** **                                                                       | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **capital**     | ** ** | **Deficit**       | ** ** | **loss**        | ** ** | **Stock**  | ** ** | **Total**  | ** ** |
| ** **                                                                       | ** ** | ** **       | ** ** | ** **  | ** ** | ** **      | ** ** | ** **        | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balances at October 1,  2005                                                |       | 2,635,746        |       | $           | 26         |            | $          | 14,949            |       | $               | (3,888     | )          | $          | (4         | )          | $ | (50 | ) | $ | 11,033 |   |
|                                                                             |       |             |       |        |       |            |       |              |       |            |       |       |       | —     |       |
| Net loss - unaudited                                                             |       |             |       |        |       |            |       | (74               | )          | —          |       | —     |       | (74        | )          |
| Change in unrealized income (loss) on securities  available for sale - unaudited |       |             |       |        |       |            |       |              |       | —          |       | —     |       | —     |       |
|                                                                             |       |             |       |        |       |            |       |              |       |            |       |       |       |       |       |
| Total comprehensive loss - unaudited                                             |       |             |       |        |       |            |       | —            |       | —          |       | —     |       | (74        | )          |
|                                                                             |       |             |       |        |       |            |       |              |       |            |       |       |       |       |       |
| Balances at December 31, 2005 - unaudited                                   |       | 2,635,746        |       | $           | 26         |            | $          | 14,949            |       | $               | (3,962     | )          | $          | (4         | )          | $ | (50 | ) | $ | 10,959 |   |

 

5

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**Treaty OakBancorp, Inc.**

**Consolidated Statements of Cash Flows**

**ThreeMonths Ended December 31, 2005, and 2004**

**(DollarsIn Thousands)**

 
| ** **                                                                                 | ** ** | **Three Months Ended  December 31,  2005** | ** ** | **Three Months Ended  December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Cash flows from operating activities:                                                      |       |                                            |       |                                            |       |
| Net loss                                                                                   |       | (74                                             | )          | $                                               | (700       | ) |
| Adjustments  to reconcile net loss to net cash provided by (used in) operating activities: |       |                                            |       |                                            |       |
| Minority  interests in partnership income                                                  |       | 3                                               |       | —                                          |       |
| Provision  for loan losses                                                                 |       | 45                                              |       | —                                          |       |
| Non-cash  stock based compensation                                                         |       | 1                                               |       | —                                          |       |
| Depreciation  and amortization                                                             |       | 89                                              |       | 42                                              |       |
| Changes in  other operating assets and liabilities:                                        |       |                                            |       |                                            |       |
| Accrued  interest receivable                                                               |       | (4                                              | )          | (43                                             | )          |
| Other assets                                                                               |       | (25                                             | )          | (1                                              | )          |
| Accrued  interest payable                                                                  |       | (30                                             | )          | 2                                               |       |
| Other  liabilities                                                                         |       | 83                                              |       | (71                                             | )          |
| **Net cash  provided by (used in) operating activities**                                   |       | 88                                              |       | (771                                            | )          |
|                                                                                       |       |                                            |       |                                            |       |
| Cash flows from investing activities:                                                      |       |                                            |       |                                            |       |
| Proceeds  from maturities and principal repayments on securities - available for sale      |       | 3                                               |       | 6                                               |       |
| Proceeds  from maturities and principal repayments on securities - held to maturity        |       | 498                                             |       | —                                          |       |
| Acquisition  of interest in PGI Equity Partners, LP, net of cash received of $24           |       | —                                          |       | (926                                            | )          |
| Purchase of  securities - held to maturity                                                 |       | —                                          |       | (4,994                                          | )          |
| Purchase of  correspondent bank stock                                                      |       | (2                                              | )          | —                                          |       |
| Purchase of  equipment                                                                     |       | (6                                              | )          | (9                                              | )          |
| Net increase  in loans                                                                     |       | (9,265                                          | )          | (5,192                                          | )          |
| **Net cash  used in investing activities**                                                 |       | (8,772                                          | )          | (11,115                                         | )          |
|                                                                                       |       |                                            |       |                                            |       |
| Cash flows from financing activities:                                                      |       |                                            |       |                                            |       |
| Net increase  in deposits                                                                  |       | 355                                             |       | 13,575                                          |       |
| Proceeds  from the sale of common stock, net of issuance costs                             |       | —                                          |       | 3,701                                           |       |
| Advances to  affiliates                                                                    |       | (20                                             | )          | 69                                              |       |
| Loans to  affiliates                                                                       |       | (337                                            | )          | —                                          |       |
| Repurchase  of common stock                                                                |       | —                                          |       | (50                                             | )          |
| Payments of  principal on mortgage                                                         |       | (19                                             | )          | —                                          |       |
| **Net cash  provided by (used in) financing activities**                                   |       | (21                                             | )          | 17,295                                          |       |
|                                                                                       |       |                                            |       |                                            |       |
| Net increase (decrease) in cash and cash  equivalents                                      |       | (8,705                                          | )          | 5,409                                           |       |
|                                                                                       |       |                                            |       |                                            |       |
| Cash and cash equivalents at beginning of  period                                          |       | 13,107                                          |       | 9,284                                           |       |
| Cash and cash equivalents at end of period                                                 |       | 4,402                                           |       | 14,693                                          |       |
|                                                                                       |       |                                            |       |                                            |       |
| Supplemental disclosures of cash flow  information:                                        |       |                                            |       |                                            |       |
| Non-cash  investing and financing information                                              |       |                                            |       |                                            |       |
| Assets  acquired - investment in PGI equity Partners, LP                                   |       | $                                               | —     |                                            | $          | 4,943 |   |
| Liabilities  assumed - investment in PGI Equity partners, LP                               |       | —                                          |       | (3,015                                          | )          |
| Minority  interest - PGI Equity Partners, LP                                               |       | —                                          |       | (1,002                                          | )          |
| Cash paid,  net of cash acquired                                                           |       | $                                               | —     |                                            | $          | 926 |   |
| Cash  interest paid                                                                        |       | $                                               | 246        |                                            | $          | 62 |   |

 

6

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**Treaty Oak Bancorp, Inc.**

**Notes to Consolidated FinancialStatements - unaudited**

**Three Months Ended December 31, 2005, and2004**

 

**Note 1.  Basis of Presentation**

 

Treaty Oak Bancorp, Inc. (the “Company”) is a bank holding companyincorporated on November 18, 2003, and organized December 8, 2003 forthe purpose of holding the common stock of Treaty Oak Bank (formerly TexlineState Bank, the “Bank”).  The Companyacquired the Bank on March 9, 2004, and began conducting bankingoperations in Texline, Texas.  The Bankcommenced operations in Austin, Texas, on September 10, 2004, and prior tothe commencement of operations in Austin, the Company was considered to be inthe development stage.

 

The Company, through Treaty Oak Bank, provides a full range ofcommercial and consumer banking services to individuals and businesses in thecommercial sector in Austin, Texas, and in the agriculture, cattle andcommercial sectors in the community of Texline, Texas.

 

The Company acquired a 47.5% interest in PGI Equity Partners, LP (the “Partnership”)on December 31, 2004. The Partnership owns and operates the building inwhich the Company offices.

 

The Company (through its Bank subsidiary) acquired a 50% interest inTreaty Oak Mortgage, LLC on June 27, 2005 for a purchase price of $1,000which is accounted for on the equity method of accounting.

 

The consolidated financial statements include the accounts of TreatyOak Bancorp, Inc., its wholly owned subsidiary Treaty Oak Bank, and theaccounts of PGI Equity Partners, LP.

 

The accompanying unaudited consolidated financial statements have beenprepared in accordance with the instructions to Form 10-QSB and,therefore, do not include all of the disclosures and notes required bygenerally accepted accounting principles. In the opinion of management, all material adjustments (which are of anormal recurring nature) considered necessary for a fair presentation have beenmade.  The results for the interim periodare not necessarily indicative of the results to be expected for the entire yearor any other interim period.

 

Stock-Based Compensation

 

The Company accounts for stock-based compensation to employees usingthe intrinsic value method.  Accordingly,compensation costs for employee stock options is measured as the excess, ifany, of the fair value of the Company’s common stock at date of grant over theexercise price.

 

The Company accounts for stock-based compensation to non-employees atfair value.

 

As of December 31, 2005, there were outstanding options topurchase an aggregate of 286,550 shares of the Company’s common stock. Each option has an exercise price of between $8.33 and $8.83 per share and maybe exercised in three equal annual installments for each year of servicemeasured from the grant date.  During the three months ended December 31,2005, the Company granted stock options to purchase an aggregate of 82,750shares of its common stock with an exercise price of $8.50 per share.  There were no options granted during thethree months ended December 31, 2004.

 

Accordingly, the expense related to stock option compensation includedin the determination of net income for the three months ended December 31,2005 and 2004, is less than that which would have been recognized if the fairvalue method had been applied.  TheCompany’s net income and earnings per share would have been adjusted to theproforma amounts indicated below.

 

The Company anticipates implementing FASB Statement No. 123R, “Share-BasedPayment”, beginning on October 1, 2006. Statement 123R requires publicentities to measure the cost of employee services received in exchange for anaward of equity instruments based on the grant-date fair value of the award(with limited exceptions). That cost will be recognized over the period duringwhich an employee is required to provide service in exchange for the award –the requisite service period (usually the vesting period).

 

7

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123R applies to all awards granted after the required effective dateand to awards modified, repurchased, or cancelled after that date. The impactthat this statement will have on our consolidated financial statements isdependent upon the levels of share based payments granted in the future.

 

The weighted average fair value of the options granted during the threemonths ended December 31, 2005, and December 31, 2004 has beenestimated using the Black-Scholes option pricing model with the followingassumptions:

 
| ** **              | ** ** | **Three Months Ended  December 31, 2005** | ** ** | **Three Months Ended  December 31, 2004** | ** ** |
|-------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| Dividend yield          |       | 0                                              | %          | 0                                              | %          |
| Risk-free interest rate |       | 4.25                                           | %          | 4.75                                           | %          |
| Expected volatility     |       | 22                                             | %          | 22                                             | %          |
| Expected life in years  |       | 6.85 Years                                     |       | 10 Years                                       |       |

 

The table below presents the pro forma effecton the Company’s loss from operations assuming the Company had expensed thefair value of the options (in thousands, except per share amounts):

 
| ** **                   | ** ** | **Three Months Ended  December 31,  2005** | ** ** | **Three Months Ended  December 31,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
|                         |       |                                            |       |                                            |       |
| Net loss - as reported       |       | $                                               | (74        | )                                               | $          | (700 | ) |
| Net loss - pro forma         |       | (112                                            | )          | (752                                            | )          |
| Loss per share - as reported |       |                                            |       |                                            |       |
| basic                        |       | $                                               | (0.03      | )                                               | $          | (0.27 | ) |
| diluted                      |       | $                                               | (0.03      | )                                               | $          | (0.27 | ) |
| Loss per share - pro forma   |       |                                            |       |                                            |       |
| basic                        |       | $                                               | (0.04      | )                                               | $          | (0.29 | ) |
| diluted                      |       | $                                               | (0.04      | )                                               | $          | (0.29 | ) |

 

**Note 2.  Common Stock Offering**

 

Stock subscriptions outstanding at September 30, 2004 from theinitial offering were collected during the period from October 1, 2004 to December 31,2004, representing 405,663 shares of common stock or $3,379,000.  Proceedsfrom additional subscriptions were received and 39,408 shares of common stockissued. The company bought back 6,003 shares of common stock that were held astreasury stock at December 31, 2004. 6,302 stock subscriptions remainedoutstanding at December 31, 2004. The final stock subscription was paid infull on March 11, 2005. All of the stock subscriptions have now beenaccounted for and that activity has been closed.

 

**Note 3.  Earnings Per Share**

 

Basic earnings (loss) per share is computed by dividing net earnings(loss) by the weighted average number of common shares outstanding for theperiod.  Diluted earnings per share is computed using the weighted-averagenumber of common shares outstanding plus the number of additional common sharesthat would have been outstanding if dilutive common shares had beenissued.  For all periods presented all potentially dilutive securitiesoutstanding were anti-dilutive.

 

8

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**Note4.  Securities**

 

Securities consisted of the following (in thousands):

 
| ** **                          | ** ** | **As of  December 31, 2005:** | ** ** | **As of  September 30, 2005:** | ** ** |
|-------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|
| ** **                          | ** ** | **Amortized  Cost**                | ** ** | **Fair  Value**                     | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| Securities Held to Maturity:        |       |                               |       |                                |       |   |   |   |   |
|                                |       |                               |       |                                |       |   |   |   |   |
| U.S.  Government Agencies           |       | $                                  | 2,997      |                                | $          | 2,965 |   | $ | 3,495 |   | $ | 3,467 |   |
| Mortgage-backed  securities         |       | 6                                  |       | 5                                   |       | 6 |   | 5 |   |
| Total Securities Held to Maturity   |       | 3,003                              |       | 2,970                               |       | 3,501 |   | 3,472 |   |
|                                |       |                               |       |                                |       |   |   |   |   |
| Securities Available for Sale:      |       |                               |       |                                |       |   |   |   |   |
|                                |       |                               |       |                                |       |   |   |   |   |
| U.S.  Government Agencies           |       | 401                                |       | 396                                 |       | 401 |   | 396 |   |
| Mortgage-backed  securities         |       | 27                                 |       | 28                                  |       | 30 |   | 31 |   |
| Total Securities Available for Sale |       | 428                                |       | 424                                 |       | 431 |   | 427 |   |
|                                |       |                               |       |                                |       |   |   |   |   |
| Total                               |       | $                                  | 3,431      |                                | $          | 3,394 |   | $ | 3,932 |   | $ | 3,899 |   |

 

Mortgage-backed securities are backed by pools of mortgages most ofwhich are insured or guaranteed by the Federal Home Loan Mortgage Corporation(FHLMC), the Federal National Mortgage Association (FNMA) or the GovernmentNational Mortgage Association (GNMA).

 

Agency notes and bonds mature within one year. Expected maturities ofmortgage-backed securities may differ from contractual maturities becauseissuers may have the right to call or prepay obligations.  Therefore maturities of mortgage-backedsecurities are not presented.

 

At December 31,2005, $1,212,000 of the Company’s securities were pledged to TexlineIndependent School District ($1,011,000) and to the City of Texline ($201,000).

 

**Note5.  Loans and Allowance for Loan Losses**

 

The Company grants agribusiness, real estate, and commercial loans tocustomers primarily in the Austin and Northwest Texas markets.

 

Loans at December 31, 2005, and September 30, 2005 were asfollows (in thousands):

 
| ** **                      | ** ** | **December 31, 2005** | ** ** | **September 30, 2005** | ** ** |
|---------------------------------|------------|----------------------------|------------|-----------------------------|------------|
|                            |       |                       |       |                        |       |
| Agriculture                     |       | $                          | 3,025      |                        | $          | 3,261 |   |
| Commercial                      |       | 15,566                     |       | 12,887                      |       |
| Commerical real estate          |       | 11,055                     |       | 8,619                       |       |
| Residential real estate         |       | 6,848                      |       | 4,524                       |       |
| Construction real estate        |       | 5,629                      |       | 4,152                       |       |
| Consumer                        |       | 3,065                      |       | 2,517                       |       |
|                            |       | 45,188                     |       | 35,960                      |       |
| Less: allowance for loan losses |       | (317                       | )          | (277                        | )          |
|                            |       |                       |       |                        |       |
|                            |       | $                          | 44,871     |                        | $          | 35,683 |   |

 

9

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Activity in the allowance for loan losses for the three months ended December 31,2005 and the year ended September 30, 2005, was as follows (in thousands):

 
| ** **                                 | ** ** | **December 31, 2005** | ** ** | **September 30, 2005** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
|                                       |       |                       |       |                        |       |
| Balance at beginning of the period         |       | $                          | 277        |                        | $          | 217 |   |
| Provision for loan losses                  |       | 45                         |       | 130                         |       |
| Loans charged off                          |       | (6                         | )          | (85                         | )          |
| Recoveries on loans previously charged-off |       | 1                          |       | 15                          |       |
|                                       |       |                       |       |                        |       |
| Balance at the end of the period           |       | $                          | 317        |                        | $          | 277 |   |

 

The Company had no impaired loans at December 31, 2005, or September 30,2005.  At December 31, 2005 and September 30, 2005, the Bank hadapproximately $101,000 and $91,000, respectively, in nonperforming loansincluding non accrual loans of $101,000 and $85,000 respectively and loans pastdue over 90 days and still accruing interest of zero and $6,000 respectively.  At December 31, 2005 and September 30,2005 the Bank had $15,000 in repossessed assets, and $24,000 and zero,respectively, in other real estate owned.

 

**Note6.  Premises and Equipment**

 

Premises and equipment at December 31, 2005, and September 30,2005, were as follows (in thousands):

 
| ** **                                      | ** ** | **December 31, 2005** | ** ** | **September 30, 2005** | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
|                                            |       |                       |       |                        |       |
| Land                                            |       | $                          | 949        |                        | $          | 949 |   |
| Building and leasehold improvements             |       | 4,520                      |       | 4,520                       |       |
| Furniture, fixtures and equipment               |       | 724                        |       | 718                         |       |
|                                            |       | 6,193                      |       | 6,187                       |       |
| Less accumulated depreciation and  amortization |       | (455                       | )          | (368                        | )          |
|                                            |       | $                          | 5,738      |                        | $          | 5,819 |   |

 

Depreciation and amortization expense for the three months ended December 31,2005 was $87,000 and $42,000 for the three months ended December 31, 2004.

 

**Note7.  Deposits**

 

Time deposits of $100,000 or more totaled $6,095,000 and $7,797,000 at December 31,2005 and September 30, 2005, respectively. At December 31, 2005 and September 30,2005, the scheduled maturities of time deposits were as follows (in thousands):

 

10

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| ** **                                         | ** ** | **As of  December 31, 2005** | ** ** | **As of  September 30, 2005** | ** ** |
|----------------------------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|
| Time deposits maturing in the fiscal year  ending: |       |                              |       |                               |       |
|                                               |       |                              |       |                               |       |
| 2006                                               |       | $                                 | 9,082      |                               | $          | 12,685 |   |
| 2007                                               |       | 2,975                             |       | 2,391                              |       |
| 2008                                               |       | 57                                |       | —                             |       |
|                                               |       | $                                 | 12,114     |                               | $          | 15,076 |   |

 

**Note8.  Goodwill and Other Intangibles**

 

In conjunction with the acquisition of Texline State Bank, the Companyrecorded Goodwill of $1,161,000 and core deposit intangibles of $70,000.  Goodwill is periodically, but at leastannually, reviewed to determine whether a decline in value exists whichrequires a charge to earnings and a reduction to the goodwill reflected on thestatement of financial condition of the Company.

 

Core deposit intangibles are amortized on a straight-line basis overseven years.  The following tablereflects the net carrying amount of core deposit intangibles at December 31,2005 and September 30, 2005 (in thousands):

 
| ** **                     | ** ** | **December 31, 2005** | ** ** | **September 30, 2005** | ** ** |
|--------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| Gross core deposit intangibles |       | $                          | 70         |                        | $          | 70 |   |
| Less accumulated amortization  |       | (18                        | )          | (16                         | )          |
| Net core deposit intangibles   |       | $                          | 52         |                        | $          | 54 |   |

 

**Note 9.  Stock Based Compensation and 2004 StockIncentive Plan**

 

On January 19, 2004, the Company and its shareholders approved theCompany’s 2004 Stock Incentive Plan (the “Plan”).  The Plan authorizesincentive stock option grants, non-statutory stock option grants, direct stockissuances, stock appreciation rights, salary investment option grants, anddirector fee option grants.  Eligible participants are employees,non-employee board members, and independent consultants or advisors.  TheCompany has reserved 500,000 shares of common stock under the Plan, and theshare reserve increases on the 1st business day in January eachyear (beginning in 2005) by an amount equal to 2% of the number of outstandingshares of the Company on the last business day in December of thepreceding year, subject to a maximum annual increase of 100,000 shares. No person may receive stock option grants, stock issuances, or stockappreciation rights for more than 100,000 shares in the aggregate in anycalendar year under the Plan.

 

On October 25, 2005 the Company granted 82,750 options to purchaseshares of stock at an exercise price of $8.50 per share to fifteen (15)officers and directors.  The optionsbecome exercisable for the option shares in three equal annual installmentsupon completion of each year of service over the three-year period of servicemeasured from October 25, 2005.

 

The table below presents the weighted average number of options issuedand outstanding during the three months ended December 31, 2005 and 2004.

 

11

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| ** **                                                        | ** ** | **Three Months Ended  December 31, 2005** | ** ** | **Three Months Ended  December 31, 2004** | ** ** |
|-------------------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                        | ** ** | **Shares**                                     | ** ** | **Weighted  Average  Exercise Price**          | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                                              |       |                                           |       |                                           |       |   |   |   |   |
| Outstanding, beginning of the period                              |       | 203,800                                        |       | $                                              | 8.64       |   | 166,500 |   | $ | 8.33 |   |
| Granted                                                           |       | 82,750                                         |       | 8.50                                           |       | — |   | — |   |
| Exercised                                                         |       | —                                         |       | —                                         |       | — |   | — |   |
| Forfeited/expired                                                 |       | —                                         |       | —                                         |       | — |   | — |   |
| Outstanding, end of the period                                    |       | 286,550                                        |       | $                                              | 8.60       |   | 166,500 |   | $ | 8.33 |   |
|                                                              |       |                                           |       |                                           |       |   |   |   |   |
| Exercisable at the end of the period                              |       | —                                         |       |                                           |       | — |   |   |   |
| Weighted-average  fair value of options granted during the period |       |                                           |       | $                                              | 1.82       |   |   |   | $ | — |   |
| Weighted-average remaining contractural  life (months)            |       | 107                                            |       |                                           |       | 115 |   |   |   |

 

All options issued under the plan have anexercise prices ranging from $8.33 per share to $8.83 per share.

 

**Note 10.  Other Related Party Transactions**

 

**PGI Equity Partners, L.P.**

 

The Company has made an investment in the entity that owns the Company’spremises.  On November 18, 2004, theindependent, disinterested directors and members of the Company’s AuditCommittee, Mr. Watson and Mr. Coleman, approved the terms whereby theCompany would purchase a Class D limited partnership interest in PGIEquity Partners, L.P. of 47.5% for a cash investment of $950,000.  The Company paid $150,000 as an investmentdeposit on November 18, 2004, and paid the remaining $800,000 upon closingof the investment on December 31, 2004. Upon the closing of the investment, Treaty Oak Holdings owns acollective limited partnership interest of 43.75%.  As a result of this transaction and thepreviously existing lease of the premises, the Company is required toconsolidate the operations PGI Equity Partners, L.P., for financial reportingpurposes.

 

**Treaty Oak Holdings, Inc.**

 

On October 11, 2005, Treaty Oak Bancorp, Inc. made a $355,000loan to Treaty Oak Holdings, Inc. (“TOHI”) with interest at 6.75% perannum, payable on the first of each month beginning November 1, 2005.  The purpose of the loan was to enable TOHI topay off certain obligations, and to provide sufficient liquidity to TOHI untilthe proposed merger with the Company has been completed.  The principal balance, along with any accruedinterest, is due and payable in full on September 1, 2006.  On December 31, 2005, the outstandingprincipal balance of the loan was $337,000.

 

**Accounting and Tax Services**

 

The Company receives tax planning advice and general tax and accountingservices from Hamann, Ernstmeyer & Williamson, P.C. (formerly Hamann &Associates”, P.C.  “HEW”), a professionalcorporation of certified public accountants in which Mr. Hamann (the ChiefExecutive Officer of the Company) owned an 80% interest.  As of March 31, 2005, Mr. Hamann’sownership changed to a 5% interest in HEW, and as of November, 2005, he has noremaining ownership interest.  Mr. Hamannis no longer an officer or a director of the company, and has a limitedparticipation in the ongoing delivery of services to its clients in an advisorycapacity.  None of the fees paid to HEW for services during the threemonths ended December 31, 2005, and 2004 were related to the efforts of Mr. Hamann,and Mr. Hamann is not currently compensated by the firm.  HEW is afirm focused on tax planning and advisory work and does not provide auditingservices to clients.  For the threemonths ended December 31, 2005, and December 31, 2004, the Companypaid approximately $21,000 and $18,750, respectively, for these servicesprimarily with respect to assistance in the preparation of the Company’s annualand periodic reporting, tax planning and reporting, and other advisoryservices.

 

12

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**Other Transactions**

 

The Company has a $54,000 and $34,000 Due from Affiliate balance as of December 31,2005 and September 30, 2005 respectively, which represents amounts duefrom Treaty Oak Holdings, Inc. to PGI Equity Partners, LP for occupancycosts.

 

**Note 11. Financial Instruments with Off-Balance Sheet Risk**

 

In the normal course of business, the Company is a party to financialinstruments with off-balance sheet risk to meet the financing needs of itscustomers, through the use of commitments to extend credit.  Those instruments involve, to varyingdegrees, elements of credit and interest-rate risk in excess of the amountrecognized in the consolidated balance sheet. The contract or notional amounts of those instruments reflect the extentof the Company’s involvement in particular classes of financial instruments.

 

The Company’s exposure to credit loss in the event of nonperformance bythe other party to the financial instrument for commitments to extend creditand standby letters of credit is represented by the contractual amount of thoseinstruments.  The Company uses the samecredit policies in making commitments and conditional obligations as they dofor on-balance sheet instruments.

 

The following table summarizes the Company’s off-balance sheetfinancial instruments as of December 31, 2005 and September 30, 2005(in thousands):

 
| ** **                   | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** |
|------------------------------|------------|-----------------------------|------------|------------------------------|------------|
|                         |       |                        |       |                         |       |
| Commitments to extend credit |       | $                           | 13,314     |                         | $          | 14,043 |   |
| Standby letters of credit    |       | $                           | 1,703      |                         | $          | 269 |   |

 

Commitments to extend credit are agreements to lend to a customer aslong as there is no violation of any condition established in thecontract.  Commitments generally havefixed expiration dates or other termination clauses and may require payment ofa fee.  Since many of the commitments areexpected to expire without being drawn upon, the total commitment amounts donot necessarily represent future cash requirements.  The Company evaluates each customer’screditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Companyupon extension of credit is based on management’s credit evaluation of thecounterparty.  Collateral held varies butmay include accounts receivable, inventory, property, plant and equipment andincome-producing commercial properties.

 

Standby letters of credit are written conditional commitments used bythe Company to guarantee the performance of a customer to a third party.  The Company’s policies generally require thatletter of credit arrangements contain security and debt covenants similar tothose contained in loan arrangements.  Inthe event the customer does not perform in accordance with the terms of theagreement with the third party, the Company would be required to fund thecommitment.  The maximum potential amountof future payments the Company could be required to make is represented by thecontractual amount shown in the table above. If the commitment is funded, the Company would be entitled to seekrecovery from the customer.  As of December 31,2005, no amounts have been recorded as liabilities for the Company’s potentialobligations under these guarantees.

 

**Note12.  Dividend Restrictions and RegulatoryMatters**

 

Banks and bank holding companiesare subject to regulatory capital requirements administered by state andfederal banking regulatory agencies. Capital adequacy guidelines and, additionally for banks, prompt correctiveaction

 

13

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regulations involvequantitative measures of assets, liabilities, and certain off-balance sheetitems calculated under regulatory accounting practices. Capital amounts andclassifications are also subject to qualitative judgments by regulators aboutcomponents, risk weightings and other factors. Failure to meet capitalrequirements can initiate regulatory action. As of December 31, 2005,management believes the Bank is in compliance with all regulatory capitalrequirements to which it is subject.

 

The following table sets forth the bank only actual capital levels inaddition to the requirements under prompt corrective action regulations (inthousands):

 
| ** **                              | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|-----------------------------------------|------------|------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                       | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| (Bank Only)                             |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| December 31,  2005:                |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| Tier I  capital to average assets       |       | $          | 7,680      |                                         | 14.19      | %                                                                                                | $          | 2,165 |   | 4.0 | % | $ | 2,706 |   | 5.0 | % |
| Tier I  capital to risk weighted assets |       | 7,680      |       | 15.69                                        | %          | 1,958                                                                                            |       | 4.0 | % | 2,937 |   | 6.0 | % |
| Total  capital to risk weighted assets  |       | 7,997      |       | 16.34                                        | %          | 3,915                                                                                            |       | 8.0 | % | 4,894 |   | 10.0 | % |
| September 30,  2005:               |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| Tier I  capital to average assets       |       | $          | 7,617      |                                         | 14.71      | %                                                                                                | $          | 2,071 |   | 4.0 | % | $ | 2,589 |   | 5.0 | % |
| Tier I capital  to risk weighted assets |       | 7,617      |       | 18.12                                        | %          | 1,654                                                                                            |       | 4.0 | % | 2,481 |   | 6.0 | % |
| Total  capital to risk weighted assets  |       | 7,894      |       | 19.09                                        | %          | 3,307                                                                                            |       | 8.0 | % | 4,134 |   | 10.0 | % |

 

As of December 31, 2005,the Bank met the level of capital required to be categorized as “well capitalized”under prompt corrective action regulations. Management is not aware of anyconditions subsequent to December 31, 2005 that would change the Bank’scapital category.

 

The Bank is a state chartered banking association and is subject toregulation, supervision and examination by the Texas Department of Banking andthe Federal Deposit Insurance Corporation (FDIC). In addition, upon makingcertain determinations with respect to the condition of any insured bank, theFDIC may begin proceedings to terminate a bank’s federal deposit insurance.

 

From its initial acquisition of Texline State Bank, the Company’sbanking operations had been subject to a Memorandum of Understanding (MOU) withthe FDIC. The MOU had been entered into for the purpose of ensuring that bankmanagement appropriately and adequately addressed certain deficienciesidentified by the FDIC and Texas Department of Banking (TDB) during previousregulatory examinations prior to the Company’s acquisition. Following the FDICexamination of Treaty Oak Bank in November, 2004, the FDIC terminated the MOUand proposed a new MOU that was more limited in scope. In February 2005,Treaty Oak Bank agreed to become subject to the new MOU, which was subsequentlyexecuted effective March 3, 2005 by the FDIC. Prior to March 31,2005, the Bank had addressed all of the issues identified in the new MOU. At asubsequent follow-up review of the Bank conducted jointly by the FDIC and TDB,the on-site examiners deemed the Bank’s actions to date with regard to the newMOU to be “satisfactory.”  The Bank waslater advised to discontinue the submission of quarterly responses to the MOUbased upon the Bank’s affirmative actions in a letter dated April 25, 2005from the FDIC.

 

The TDB and the FDIC conducted a joint safety and soundness examinationof the bank and holding companies during December, 2005 and reported theirfindings to the board of directors on January 10, 2006. The final writtenreport has not yet been received by management as of February 9, 2006.However, in a letter dated January 24, 2006 the TDB acknowledged the bank’sremedial efforts in complying with the MOU and has officially terminated itsparticipation. On February 9, 2005, the bank received telephonenotification from the regional director of the FDIC informing us of theofficial termination of the MOU.

 

Certain restrictions exist regarding the ability of the Bank to paycash dividends. Regulatory approval is required in order to pay dividends untilsuch time as the accumulated deficit is eliminated and certain other conditionsare met.

 

14

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Further, the Company has been notified by its banking regulators thatno approval will be received in the first three years of operations.

 

15

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**Item 2.****                                                           *Management’s Discussion and Analysis of FinancialCondition and Results Of Operations***

 

**Introduction**

 

We are a bank holdingcompany headquartered in Austin, Texas. We operate a state chartered bank,Treaty Oak Bank (“the Bank”) in Austin, Texas with a branch in Texline, Texas. Webegan operations in Austin, Texas on September 10, 2004, and as a result,our operating history, as it relates to the banking industry, is limited. Inthe course of preparing our consolidated financial statements, we use certainestimates with respect to loans, intangibles, the allowance for loan losses andother estimates necessary for financial reporting. We have made no significantchanges to the types of estimates and the manner in which they are determinedsince the filing of our annual report on Form 10-KSB, except as otherwisenoted within this discussion and analysis.

 

**Results of Operations**

 

***General***

 

The following discussionanalyzes the results of the Company for the three months ended December 31,2005, and December 31, 2004.

 

***Net Income—General***

 

The Company’s fiscal yearends on September 30. The net loss for the quarter ended December 31,2005, was $74,000, compared to a net loss of $700,000 for the quarter ended December 31,2004. General operating expenses accounted for the net loss for the quarterended December 31, 2005, while the expenses associated with the start-upof operations in Austin, Texas, and the high concentration of cash and cashequivalents earning at significantly lower rates than if a higher concentrationof these assets were in the form of loans, accounted for substantially all ofthe losses for the quarter ended December 31, 2004.

 

Our profitability dependsprimarily on net interest income, which is defined as the difference betweentotal interest earned on interest earning assets (investments and loans) andtotal interest paid on interest bearing liabilities (deposits, borrowed funds).The Company’s net income is affected by its provision for loan losses, as wellas other income and other expenses. The provision for loan losses reflects theamount considered to be adequate to cover probable credit losses in the loanportfolio. Non-interest income or other income consists of service charges ondeposits, gain on sale of loans, and other operating income. Other expensesinclude salaries and employee benefits, occupancy expenses, data processingexpenses, marketing, supplies, and other operating expenses.

 

Net interest income isaffected by changes in the volume and mix of interest earning assets, the levelof interest rates earned on those assets, the volume and mix of interestbearing liabilities, and the level of interest rates paid on those interestbearing liabilities. The provision for loan losses is dependent upon changes inthe loan portfolio and management’s assessment of the collectibility of theloan portfolio, as well as economic and market conditions. Other income andother expenses are impacted by growth of operations and growth in the number ofaccounts through both acquisitions and core banking business growth. Growth inoperations affects other expenses as a result of additional employees, branchfacilities, and promotional marketing expense. Growth in the number of accountsaffects other income including service fees, as well as other expenses such ascomputer services, supplies, postage, telecommunications, and othermiscellaneous expenses.

 

***Net Interest Income***

 

For the quarter ended December 31, 2005,our net interest income was $710,000 compared to $239,000 for quarter ended December 31,2004. Net interest income for the quarter ended December 31, 2005 wasreduced by the amortization of direct loan origination costs for the quarter ofapproximately $9,000.

 

16

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For the comparative periods of December 31,2005, and December 31, 2004, the average rate on interest-bearingliabilities increased 132 basis points, from 1.55% to 2.87%, while the averagerate on interest bearing assets improved 219 basis points from 4.99% to 7.18%during the same period.

 

The following table presents, for the periodsindicated, the total dollar amount of interest income from average interestearning assets, and the resultant yields, as well as the interest expense onaverage interest bearing liabilities, and the resultant costs, expressed bothin dollars and rates. The averages are computed using the daily averages foreach item noted. Yields are reflected on an annualized basis.

 
| ** **                                       | ** ** | **Three Months Ended  December 31,  2005** | ** ** | **Three Months Ended  December 31,  2004** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                       | ** ** | **Average**                                               | ** ** | ** **                                                | ** ** | **Yield /** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield /** | ** ** |
| ** **                                       | ** ** | **Balance**                                               | ** ** | **Interest (2)**                                     | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest (2)** | ** ** | **Rate** | ** ** |
| Interest  Earning Assets:                        |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Loans (1)                                        |       | $                                                         | 40,033     |                                                      | $          | 822 |   | 8.21 | % | $ | 11,307 |   | $ | 233 |   | 8.24 | % |
| Taxable  investment securities                   |       | 3,834                                                     |       | 29                                                        |       | 3.03 | % | 2,780 |   | 20 |   | 2.88 | % |
| Federal  funds sold                              |       | 3,787                                                     |       | 36                                                        |       | 3.80 | % | 11,763 |   | 66 |   | 2.24 | % |
| Interest  bearing deposits with other banks      |       | 3,619                                                     |       | 36                                                        |       | 3.98 | % | — |   | 6 |   | 0.00 | % |
| FHLB and  IBFC stock                             |       | 317                                                       |       | 3                                                         |       | 3.79 | % | 211 |   | — |   | 0.00 | % |
| Total  interest earning assets                   |       | 51,590                                                    |       | 926                                                       |       | 7.18 | % | 26,061 |   | 325 |   | 4.99 | % |
| Non-interesting  earning assets                  |       | 8,938                                                     |       |                                                      |       |   |   | 13,249 |   |   |   |   |   |
| Total Assets                                     |       | $                                                         | 60,528     |                                                      |       |   |   |   | $ | 39,310 |   |   |   |   |   |
|                                             |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Interest  Bearing Liabilities:                   |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Deposits:                                        |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| NOW and  money market deposits                   |       | $                                                         | 12,995     |                                                      | 70         |   | 2.15 | % | $ | 10,513 |   | 40 |   | 1.52 | % |
| Savings  deposits                                |       | 472                                                       |       | —                                                    |       | 0.00 | % | 438 |   | 1 |   | 0.91 | % |
| Time  Deposits                                   |       | 12,710                                                    |       | 104                                                       |       | 3.27 | % | 8,261 |   | 45 |   | 2.18 | % |
| Short-term  borrowings                           |       | 87                                                        |       | 1                                                         |       | 4.60 | % | — |   | — |   | 0.00 | % |
| Property  mortgage and long-term borrowings      |       | 2,717                                                     |       | 41                                                        |       | 6.04 | % | 2,919 |   | — |   | 0.00 | % |
| Total  interest bearing liabilities              |       | 28,981                                                    |       | 216                                                       |       | 2.98 | % | 22,131 |   | 86 |   | 1.55 | % |
| Demand  deposits - non-interest bearing          |       | 19,026                                                    |       |                                                      |       |   |   | 5,327 |   |   |   |   |   |
| Other non-interest  bearing liabilities          |       | 507                                                       |       |                                                      |       |   |   | 1,203 |   |   |   |   |   |
| Shareholders’  equity                       |       | 12,014                                                    |       |                                                      |       |   |   | 10,649 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity |       | $                                                         | 60,528     |                                                      |       |   |   |   | $ | 39,310 |   |   |   |   |   |
|                                             |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Net interest  income                             |       |                                                      |       | $                                                         | 710        |   |   |   |   |   | $ | 239 |   |   |   |
|                                             |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Interest  rate spread (3)                        |       |                                                      |       |                                                      |       | 4.20 | % |   |   |   |   | 3.44 | % |
| Net interest  margin (4)                         |       |                                                      |       |                                                      |       | 5.50 | % |   |   |   |   | 3.67 | % |

 

----

(1)           Non-accrual loans are included in averageloans.

 

(2)           Interest income includes loan fees of $30,000for the three months ended December 31, 2005 and $10,000 for the threemonths ended December 31, 2004.

 

(3)           Interest rate spread represents the differencebetween the average yield on interest earning assets and the average cost ofinterest bearing liabilities.

 

(4)           Net interest margin represents annualized netinterest income as a percentage of average interest earning assets.

 

***Volume, Mix and Rate Analysis of Net InterestIncome***

 

The following table presents the extent towhich changes in volume, changes in interest rates, and changes in the interestrates times the changes in volume of interest earning assets and interestbearing liabilities affected the Bank’s interest income and interest expenseduring the periods indicated. Information is provided on changes in each categorydue to (1) changes attributable to changes in volume (change in volumetimes the prior period interest rate), (2) changes attributable to changesin interest rate (changes in rate times the prior period volume), and (3) changesattributable to changes in rate/volume (changes in interest rate times changesin volume). Changes attributable to the combined impact of volume and rate havebeen allocated proportionally to the changes due to volume and the changes dueto rate:

 

17

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| ** **                                  | ** ** | **Three Months Ended December 31, 2005  Compared to  Three Months Ended December 31, 2004** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Change Due**                                                                                                                                | ** ** | **Change Due** | ** ** | **Total** | ** ** |
| ** **                                  | ** ** | **to Volume**                                                                                                                                 | ** ** | **to Rate** | ** ** | **Change** | ** ** |
| **Interest  Earning Assets:**               |       |                                                                                                                                               |       |   |   |   |   |
| Loans                                       |       | $                                                                                                                                                  | 2,358      |   | $ | (1,769 | ) | $ | 589 |   |
| Taxable investment  securities              |       | 32                                                                                                                                                 |       | (23 | ) | 9 |   |
| Federal  funds sold                         |       | (240                                                                                                                                               | )          | 210 |   | (30 | ) |
| Interest  bearing deposits in banks         |       | 15                                                                                                                                                 |       | 15 |   | 30 |   |
|                                        |       |                                                                                                                                               |       |   |   |   |   |
| Increase  (decrease) in interest income     |       | 2,165                                                                                                                                              |       | (1,564 | ) | 601 |   |
|                                        |       |                                                                                                                                               |       |   |   |   |   |
| **Interest  Bearing Liabilities:**          |       |                                                                                                                                               |       |   |   |   |   |
| NOW and  money market deposit accounts      |       | (2,724                                                                                                                                             | )          | 2,754 |   | 30 |   |
| Time  deposits                              |       | 419                                                                                                                                                |       | (360 | ) | 59 |   |
|                                        |       |                                                                                                                                               |       |   |   |   |   |
| Increase  (decrease) in interest expense    |       | (2,305                                                                                                                                             | )          | 2,435 |   | 130 |   |
|                                        |       |                                                                                                                                               |       |   |   |   |   |
| Increase  (decrease) in net interest income |       | $                                                                                                                                                  | 4,470      |   | $ | (3,999 | ) | $ | 471 |   |

 

***Provision for Loan Losses***

 

The provision for loanlosses is an expense determined by management as the amount necessary toincrease the allowance for loan losses after net charge-offs have been deductedto a level that, in management’s best estimate, is necessary to absorb probablelosses in the loan portfolio. The amount of the provision is based onmanagement’s review of the loan portfolio and consideration of such factors ashistorical loss experience, general prevailing economic conditions, changes inthe size and composition of the loan portfolio and specific borrowerconsiderations, including the ability of the borrower to repay the loan and theestimated value of the underlying collateral. The provision is calculatedmonthly and a charge or credit to expense is made, as required, to adjust theallowance to the calculated level.

 

For the three months ended December 31,2005, the Bank made $45,000 in provisions for loan losses, compared to zero forthe three months ended December 31, 2004. The Bank charged off $6,000 incommercial and consumer loans and had recoveries of loans previouslycharged-off of $1,000 for net charge-offs of $5,000. The factors combinedincreased the Allowance for Loan Losses to $317,000 or 0.70% of the portfolioat December 31, 2005. This amount represents management’s estimate ofprobable losses inherent in the portfolio.

 

***Income Taxes***

 

No federal tax benefit hasbeen recorded for the three months ended December 31, 2005, based upon netoperating losses incurred and carried forward in previous years. Based upon theCompany’s limited operating history, the federal tax benefit of these losseshas been fully reserved.

 

18

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**Financial Condition**

 

***Loan Portfolio***

 

Net loans increased $9,188,000(25.75%) to $44,871,000 from $35,683,000 between December 31, 2005 and September 30,2005. The concentration within the portfolio has shifted over time from theprevious concentration of agricultural loans to real estate and commercialloans.

 

***Loan Portfolio Mix***

 

The following tables setforth the composition of the loan portfolio:

 

| ** **                       | ** ** | **December 31, 2005** | ** ** | **September 30, 2005** | ** ** |
|----------------------------------|------------|---------------------------------|------------|----------------------------------|------------|
|                             |       |                            |       |                             |       |
| Agriculture                      |       | $                               | 2,729      |                             | $          | 3,261 |   |
| Commercial                       |       | 15,316                          |       | 12,887                           |       |
| Commercial  real estate          |       | 12,518                          |       | 8,619                            |       |
| Residential  real estate         |       | 5,916                           |       | 4,524                            |       |
| Construction  real estate        |       | 5,118                           |       | 4,152                            |       |
| Consumer                         |       | 3,591                           |       | 2,517                            |       |
| **Gross  Loans**                 |       | 45,188                          |       | 35,960                           |       |
| Less:  allowance for loan losses |       | (317                            | )          | (277                             | )          |
|                             |       |                            |       |                             |       |
| **Net  Loans**                   |       | $                               | 44,871     |                             | $          | 35,683 |   |

 

Loan concentrations areconsidered to exist when there are amounts loaned to a multiple number ofborrowers engaged in similar activities that would cause them to be similarlyimpacted by economic or other conditions.

 

Prior to its acquisition byus, the Bank operated a branch office in Houston, Texas (which was closed in2002), and a second portfolio concentration developed with loans of one-to-fourfamily residential real estate. Approximately $1,170,000 of the Bank’sresidential real estate portfolio is comprised of single family residences inHouston. The majority of these loans originated between 1996 and 1998 for 15-yearterms with fixed rates of 8.75% or greater. These loans additionally havefive-year call provisions exercisable at the Bank’s discretion.

 

These residential real estateloans are expected to decrease as the individual loans continue to pay down.The majority of new loan growth is expected to originate from the Austin market.As had been anticipated by management, loans originated from the Austin marketreflect a broader, more diverse mix of industries and borrowers than had beenthe case previously. As new loans continue to originate for non-agriculturaland non residential real estate purposes, the percentage of the total loanportfolio creating the concentrations described above will continue to declinethereby diminishing undue risk associated with industry concentration.

 

Management may renew loansat maturity when requested by a customer whose financial strength appears tosupport such a renewal or when such a renewal appears to be in the bestinterest of the Bank. The Bank requires payment of accrued interest in suchinstances and may adjust the rate of interest, require a principal reduction,or modify other terms of the loan at the time of renewal.

 

***Loan Maturities***

 

As of December 31,2005, 39.79% of the loan portfolio consisting of agricultural, commercial, realestate and consumer loans, or $17,983,000, mature or re-price within one yearor less. $36,048,000 of the loan portfolio, or

 

19

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79.77%, are variable rate loans. At September 30, 2005, 36.52% ofthe loan portfolio consisting of agricultural, commercial, real estate andconsumer loans, or $13,132,000, matured or re-priced within one year or less.$28,108,000 of the loan portfolio, or 78.16%, were variable rate loans. Thefollowing table presents the contractual maturity ranges for agricultural,commercial, real estate and consumer loans outstanding at December 31,2005, and at September 30, 2005, and also presents for each maturity rangethe portion of loans that have fixed interest rates or interest rates thatfluctuate over the life of the loan in accordance with changes in the interestrate environment as represented by the base rate:

 
| ** **                      | ** ** | **Due in One Year  or Less** | ** ** | **Due after One Year  Through  Five Years** | ** ** | **Due after  Five Years** | ** ** | ** **   | ** ** |
|---------------------------------|------------|--------------------------------------------------|------------|-----------------------------------------------------------------|------------|-------------------------------------|------------|--------------|------------|
| ** **                      | ** ** | **Fixed**                                        | ** ** | **Floating**                                                    | ** ** | **Fixed**                           | ** ** | **Floating** | ** ** | **Fixed** | ** ** | **Floating** | ** ** | ** ** | ** ** |
| **December 31, 2005** | ** ** | **Rate**                                         | ** ** | **Rate**                                                        | ** ** | **Rate**                            | ** ** | **Rate**     | ** ** | **Rate** | ** ** | **Rate** | ** ** | **Total** | ** ** |
| ** **                      | ** ** | ** **                                       | ** ** | ** **                                                      | ** ** | ** **                          | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Agricultural                    |       | $                                                | 61,000     |                                                            | $          | 1,455,000                           |       | $            | —     |   | $ | 609,000 |   | $ | — |   | $ | 604,000 |   | $ | 2,729,000 |   |
| Real Estate-residential         |       | 316,000                                          |       | 1,015,000                                                       |       | 1,743,000                           |       | 1,771,000    |       | 1,071,000 |   | — |   | 5,916,000 |   |
| Real Estate- commercial         |       | 230,000                                          |       | 3,936,000                                                       |       | 326,000                             |       | 5,290,000    |       | — |   | 2,736,000 |   | 12,518,000 |   |
| Real Estate - construction      |       | 524,000                                          |       | 589,000                                                         |       | —                              |       | 3,783,000    |       | 222,000 |   | — |   | 5,118,000 |   |
| Commercial                      |       | 324,000                                          |       | 8,305,000                                                       |       | 1,985,000                           |       | 4,582,000    |       | — |   | 120,000 |   | 15,316,000 |   |
| Consumer and Other              |       | 174,000                                          |       | 1,054,000                                                       |       | 2,131,000                           |       | 199,000      |       | 33,000 |   | — |   | 3,591,000 |   |
| **Total**                       |       | $                                                | 1,629,000  |                                                            | $          | 16,354,000                          |       | $            | 6,185,000  |   | $ | 16,234,000 |   | $ | 1,326,000 |   | $ | 3,460,000 |   | $ | 45,188,000 |   |
|                            |       |                                             |       |                                                            |       |                                |       |         |       |   |   |   |   |   |   |
| ** **                      | ** ** | **Due in One Year  or Less** | ** ** | **Due after One Year  Through  Five Years** | ** ** | **Due after  Five Years** | ** ** | ** **   | ** ** |
| ** **                      | ** ** | **Fixed**                                        | ** ** | **Floating**                                                    | ** ** | **Fixed**                           | ** ** | **Floating** | ** ** | **Fixed** | ** ** | **Floating** | ** ** | ** ** | ** ** |
| **September 30, 2005**     | ** ** | **Rate**                                         | ** ** | **Rate**                                                        | ** ** | **Rate**                            | ** ** | **Rate**     | ** ** | **Rate** | ** ** | **Rate** | ** ** | **Total** | ** ** |
|                            |       |                                             |       |                                                            |       |                                |       |         |       |   |   |   |   |   |   |
| Agricultural                    |       | $                                                | 16,000     |                                                            | $          | 1,873,000                           |       | $            | 2,000      |   | $ | 766,000 |   | $ | — |   | $ | 604,000 |   | $ | 3,261,000 |   |
| Real Estate-residential         |       | 706,000                                          |       | —                                                          |       | 1,063,000                           |       | 1,612,000    |       | 1,077,000 |   | 66,000 |   | 4,524,000 |   |
| Real Estate- commercial         |       | 233,000                                          |       | 1,059,000                                                       |       | 339,000                             |       | 4,975,000    |       | — |   | 2,013,000 |   | 8,619,000 |   |
| Real Estate - construction      |       | —                                           |       | 936,000                                                         |       | —                              |       | 2,988,000    |       | 228,000 |   | — |   | 4,152,000 |   |
| Commercial                      |       | 328,000                                          |       | 6,352,000                                                       |       | 2,149,000                           |       | 3,935,000    |       | — |   | 123,000 |   | 12,887,000 |   |
| Consumer and Other              |       | 1,156,000                                        |       | 473,000                                                         |       | 539,000                             |       | 333,000      |       | 16,000 |   | — |   | 2,517,000 |   |
| **Total**                       |       | $                                                | 2,439,000  |                                                            | $          | 10,693,000                          |       | $            | 4,092,000  |   | $ | 14,609,000 |   | $ | 1,321,000 |   | $ | 2,806,000 |   | $ | 35,960,000 |   |

 

***Investment Securities***

 

The primary purposes of theinvestment portfolio are to provide a source of earnings for liquiditymanagement purposes, to provide collateral to pledge against public deposits,and to control interest rate risk. In managing the portfolio, the Bank seeks toattain the objectives of safety of principal, liquidity, diversification, andmaximized return on investment.

 

The following tables setforth the amortized cost and fair value of the Bank’s securities portfolio byaccounting classification category and by type of security as indicated:

 

20

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| ** **                           | ** ** | **As of  December 31, 2005:** | ** ** | **As of  September 30, 2005:** | ** ** |
|--------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                           | ** ** | **Amortized**                                | ** ** | **Fair**                                      | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                           | ** ** | **Cost**                                     | ** ** | **Value**                                     | ** ** | **Cost** | ** ** | **Value** | ** ** |
| Securities  Held to Maturity:        |       |                                         |       |                                          |       |   |   |   |   |
|                                 |       |                                         |       |                                          |       |   |   |   |   |
| U.S.  Government Agencies            |       | $                                            | 2,997      |                                          | $          | 2,965 |   | $ | 3,495 |   | $ | 3,467 |   |
| Mortgage-backed  securities          |       | 6                                            |       | 5                                             |       | 6 |   | 5 |   |
| Total  Securities Held to Maturity   |       | 3,003                                        |       | 2,970                                         |       | 3,501 |   | 3,472 |   |
|                                 |       |                                         |       |                                          |       |   |   |   |   |
| Securities  Available for Sale:      |       |                                         |       |                                          |       |   |   |   |   |
|                                 |       |                                         |       |                                          |       |   |   |   |   |
| U.S.  Government Agencies            |       | 401                                          |       | 396                                           |       | 401 |   | 396 |   |
| Mortgage-backed  securities          |       | 27                                           |       | 28                                            |       | 30 |   | 31 |   |
| Total  Securities Available for Sale |       | 428                                          |       | 424                                           |       | 431 |   | 427 |   |
|                                 |       |                                         |       |                                          |       |   |   |   |   |
| Total                                |       | $                                            | 3,431      |                                          | $          | 3,394 |   | $ | 3,932 |   | $ | 3,899 |   |

 

U.S. Treasury securities andsecurities of U.S. Government agencies generally consist of fixed ratesecurities with maturities of three months to five years. Other mortgage backedsecurities consists of fixed rate mortgage pass-through securities with amaturity of five to fifteen years.

 

***Asset Quality***

 

The following table setsforth the amount of non-performing loans and non-performing assets as of December 31,2005, and September 30, 2005:

 
| ** **                                               | ** ** | **At December 31,** | ** ** | **At September 30,** | ** ** |
|----------------------------------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **                                               | ** ** | **2005**                      | ** ** | **2005**                       | ** ** |
|                                                     |       |                          |       |                           |       |
| Non-accruing  loans                                      |       | $                             | 101,000    |                           | $          | 85,000 |   |
| Loans 90  days or more past due, still accruing interest |       | —                        |       | 6,000                          |       |
|                                                     |       |                          |       |                           |       |
| Total  non-performing loans                              |       | 101,000                       |       | 91,000                         |       |
| Other real  estate owned                                 |       | 24,000                        |       | —                         |       |
| Other  repossessed assets                                |       | 15,000                        |       | 15,000                         |       |
|                                                     |       |                          |       |                           |       |
| Total non-performing  assets                             |       | $                             | 140,000    |                           | $          | 106,000 |   |
|                                                     |       |                          |       |                           |       |
| Total  non-performing loans to total loans               |       | 0.23                          | %          | 0.24                           | %          |
| Allowance  for loan losses to non-performing loans       |       | 314                           | %          | 304                            | %          |
| Total  non-performing loans to total assets              |       | 0.17                          | %          | 0.15                           | %          |

 

***Non-performing Loans***

 

Non-performing loans include(1) loans accounted for on a non-accrual basis, (2) accruing loanscontractually past due 90 days or more as to interest and principal, and (3) troubleddebt restructurings. Management reviews the loan portfolio for problem loans onan ongoing basis.

 

During the ordinary course of business,management becomes aware of borrowers that may not be able to meet thecontractual requirements of loan agreements. Such loans are placed under closesupervision with consideration given to placing the loan on a non-accrualstatus, increasing the allowance for loan losses, and (if appropriate) partialor full

 

21

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charge-off. After a loan is placed on non-accrual status, any currentyear interest previously accrued but not yet collected is reversed againstcurrent income. When payments are received on non-accrual loans, such paymentsare applied to principal and not taken into income. Loans are not placed backon accrual status unless all back interest and principal payments are made. Ifinterest on non-accrual loans had been accrued, such income would have amountedto approximately $ 1,400 for the three months ended December 31, 2005 and$3,000 for the three months ended December 31, 2004. This amount was notincluded in interest income during this period.

 

Under Federal and Texas law, any loan 90 or more days past due isrequired to be placed on non-accrual basis unless specifically identifiedmitigating circumstances exist. Our policy is to place loans 90 days pastdue on non-accrual status. An exception is made when management believes theloan is fully secured and in process of collection. Non-accrual loans arefurther classified as impaired when underlying collateral is not sufficient tocover the loan balance and it is probable that we will not fully collect allprincipal and interest. As of December 31, 2005 and September 30,2005, we had $101,000 and $85,000 in non-accrual loans respectively. Loanscontractually past due over 90 days which continued to accrue interesttotaled $0 on December 31, 2005 and $6,000 on September 30, 2005,based upon specific information available at that time to management. Incompliance with these statutes we have developed pro forma financial statementsassuming that no loans will continue to accrue interest if they become90 days past due, and instead transfer all such loans to non-accruingstatus.

 

A “troubled debt restructuring” is arestructured loan upon which interest accrues at a below market rate or uponwhich certain principal has been forgiven so as to aid the borrower in thefinal repayment of the loan, with any interest previously accrued, but not yetcollected, being reversed against current income. Interest is accrued basedupon the new loan terms. There were no troubled debt restructurings outstandingas of December 31, 2005 and September 30, 2005*.*

 

Non-performing assets also consist of otherrepossessed assets and other real estate owned (“OREO”). OREO representsproperties acquired through foreclosure or other proceedings and is recorded atthe lower of cost or fair market value less the estimated cost of disposal.OREO is evaluated regularly to ensure that the recorded amount is supported byits current fair market value. Valuation allowances to reduce the carryingamount to fair market value less estimated costs of disposal are recorded asnecessary. Revenues and expenses from the operations of OREO and changes in thevaluation are included in other income and other expenses on the income statement.As of December 31, 2005, we had $24,000 in other real estate owned. Theproperty consists of two single family dwellings located in Dalhart, Texas. At September 30,2005, we had no other real estate owned, and no acquisitions or dispositions ofOREO during the fiscal year. Repossessed assets totaled $15,000 at December 31,2005 and September 30, 2005.

 

***Sources of Funds***

 

*General*

 

Deposits, short-term and long-termborrowings, loan and investment security repayments and prepayments, proceedsfrom the sale of securities, and cash flows generated from operations are theprimary sources of our funds for lending, investing, and other generalpurposes. Loan repayments are a relatively predictable source of funds exceptduring periods of significant interest rate declines, while deposit flows tendto fluctuate with prevailing interests rates, money markets conditions, generaleconomic conditions, and competition.

 

*Deposits*

 

We offer a variety of deposit accounts with arange of interest rates and terms. Core deposits consist of checking accounts(non-interest bearing), “NOW” accounts, savings accounts, and non-publiccertificates of deposit. These deposits, along with public fund deposits andshort-term borrowings, are used to support our asset base. Deposits areobtained predominantly from the geographic trade areas surrounding our officelocations. We rely primarily on customer service and long-standingrelationships with customers to attract and retain deposits; however, marketinterest rates and rates offered by competing financial institutionssignificantly affect our ability to attract and retain deposits.

 

22

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The following table setsforth the maturities of time deposits $100,000 and over as of December 31,2005, and September 30, 2005:

 
| ** **                                | ** ** | **At December 31, 2005** | ** ** | **At September 30, 2005** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|------------------------------------------|------------|
| Time  deposits $100,000 and over:         |       |                                    |       |                                     |       |
| Matuiring  within three months            |       | $                                       | 1,306,000  |                                     | $          | 4,760,000 |   |
| After three  months but within six months |       | 3,364,000                               |       | 1,205,000                                |       |
| After six months  but within 12 months    |       | 1,116,000                               |       | 1,523,000                                |       |
| After 12  months                          |       | 309,000                                 |       | 309,000                                  |       |
|                                      |       |                                    |       |                                     |       |
| Total time  deposits $100,000 and over:   |       | $                                       | 6,095,000  |                                     | $          | 7,797,000 |   |

 

*Return onEquity and Assets*

 

The following table setsforth certain information regarding the Company’s return on equity and assetsfor the periods indicated:

 
| ** **              | ** ** | **For the**      | ** ** | **For the**      | ** ** |
|-------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **              | ** ** | **Three Months** | ** ** | **Three Months** | ** ** |
| ** **              | ** ** | **Ended**             | ** ** | **Ended**             | ** ** |
| ** **              | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **              | ** ** | **2005**              | ** ** | **2004**              | ** ** |
| Return on  assets       |       | -0.13                 | %          | -372.00               | %          |
| Return on  equity       |       | -0.68                 | %          | -14.57                | %          |
| Dividend  payout ratio  |       | 0                     | %          | 0                     | %          |
| Equity to  assets ratio |       | 17.92                 | %          | 25.40                 | %          |

 

**Capital Resources**

 

The risk-based capital regulationsestablished and administered by the banking regulatory agencies discussedpreviously are applicable to the Bank. Risk-based capital guidelines aredesigned to make regulatory capital requirements more sensitive to differencesin risk profiles among banks, to account for off-balance sheet exposure, and tominimize disincentives for holding liquid assets. Under the regulations, assetsand off-balance sheet items are assigned to broad risk categories, each withappropriate weights. The resulting capital ratios represent capital as apercentage of total risk weighted assets and off-balance sheet items. Under theprompt corrective action regulations, to be adequately capitalized a bank mustmaintain minimum ratios of total capital to risk-weighted assets of 8.00%, Tier1 capital to risk-weighted assets of 4.00%, and Tier 1 capital to total assetsof 4.00%. Failure to meet these capital requirements can initiate certainmandatory and possibly additional discretionary actions by regulators that, ifundertaken, could have a direct material effect on the Bank’s financialstatements.

 

As of December 31, 2005 and as of September 30,2005, the most recent notifications from the federal Banking regulatorscategorized the Bank as well-capitalized. A well-capitalized institution mustmaintain a minimum ratio of total capital to risk-weighted assets of at least10.00%, a minimum ratio of Tier 1 capital to risk weighted assets of at least6.00%, and a minimum ratio of Tier 1 capital to total assets of at least 5.00%and must not be subject to any written order, agreement, or directive requiringit to meet or maintain a specific capital level. There are no conditions orevents since that notification that the Bank’s management believes have changedthe capital classification.

 

The Bank was in full compliance with all applicable capital adequacyrequirements as of December 31, 2005 and September 30, 2005. Therequired and actual amounts and ratios for the Bank as of December 31,2005 and September 30, 2005, are presented below:

 

23

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| ** **                             | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|----------------------------------------|------------|------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                             | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                              | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| (Bank Only)                            |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| December 31,  2005:               |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Tier I capital to average assets       |       | $          | 7,680      |                               | 14.19      | %                                                                       | $          | 2,165 |   | 4.0 | % | $ | 2,706 |   | 5.0 | % |
| Tier I capital to risk weighted assets |       | 7,680      |       | 15.69                              | %          | 1,958                                                                   |       | 4.0 | % | 2,937 |   | 6.0 | % |
| Total capital to risk weighted assets  |       | 7,997      |       | 16.34                              | %          | 3,915                                                                   |       | 8.0 | % | 4,894 |   | 10.0 | % |
| September 30,  2005:              |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Tier I capital to average assets       |       | $          | 7,617      |                               | 14.71      | %                                                                       | $          | 2,071 |   | 4.0 | % | $ | 2,589 |   | 5.0 | % |
| Tier I capital to risk weighted assets |       | 7,617      |       | 18.12                              | %          | 1,654                                                                   |       | 4.0 | % | 2,481 |   | 6.0 | % |
| Total capital to risk weighted assets  |       | 7,894      |       | 19.09                              | %          | 3,307                                                                   |       | 8.0 | % | 4,134 |   | 10.0 | % |

 

**Item 3.****                                                           *Controls and Procedures***

 

With theparticipation of management, the Company’s chief executive officer and chieffinancial officer reviewed and evaluated the Company’s disclosure controls andprocedures as defined in Rules 13a-14(c) and 15d-14(c) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”), as of the endof the period covered by this report. Based on this evaluation, the chiefexecutive officer and chief financial officer concluded that the disclosurecontrols and procedures are effective to ensure that the information requiredto be disclosed by the Company in reports that it files or submits under theExchange Act is recorded, processed, summarized and reported to the Company’smanagement within the time periods specified in the Securities and ExchangeCommission’s rules and forms.

 

There havebeen no significant changes in the Company’s internal controls for financialreporting or in other factors that could significantly affect these controls,including any significant deficiencies or material weaknesses of internalcontrols that would require corrective action. In connection with the newrules, the Company is currently in the process of further reviewing anddocumenting its disclosure controls and procedures, including its internalaccounting controls, and may from time to time make changes aimed at enhancingtheir effectiveness and ensuring that the Company’s systems evolve with itsbusiness.

 

**PART II.****                                                OtherInformation**

 

**Item 1.****                                                           *Legal Proceedings***

 

None

 

**Item 2.****                                                           *Changes inSecurities and Use of Proceeds***

 

On May 7, 2004, the Securities andExchange Commission declared our Registration Statement on Form SB-2 (FileNo.333-112325) related to our initial public offering effective. In addition, on October 22,2004, we filed a Form SB-2MEF under Rule 462 registering additionalshares of common stock and warrants to purchase our common stock under ourpublic offering. We registered a total of 1,944,000 shares of our common stock,of which 324,000 shares are issuable under registered common stock warrants. Weaccepted subscriptions for 1,589,602 shares of our common stock under theoffering and have received net offering proceeds (after deducting offeringexpenses) of approximately $11.9 million.

 

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As of December 31, 2005, we had paid ourorganizing shareholder and affiliate, Treaty Oak Holdings for reimbursement ofexpenses and advances on our behalf in connection with our offering andrepayment of the amount due under a convertible promissory note. Treaty OakHoldings owns approximately 39% of our common stock. We contributed to thecapital of the Bank and paid operating expenses including repayment of certaincosts previously paid by Treaty Oak Holdings. We also repaid principal andinterest under unsecured promissory notes issued in connection with thepurchase price of the Bank. The table below summarizes the use of net offeringproceeds through December 31, 2005:

 

| ** **                                                                                                                                                                                     | ** ** | **As of  12/31/05** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|
| Gross proceeds from sale of shares                                                                                                                                                             |       | 13,276,271          |       |
| Amounts receivable as of December 31,  2004                                                                                                                                               |       | —              |       |
| Repayment of  offering and start-up costs under Expense Reimbursement Agreement to Treaty  Oak Holdings, Inc., including offering costs of $500,000 and pre-opening  expenses of $275,000 |       | (775,000            | )          |
| Repayment of  note payable to Treaty Oak Holdings, Inc., including accrued interest of  approximately $7,000                                                                              |       | (507,302            | )          |
| Repayment of  notes payable for the acquisition of Texline State Bank including accrued  interest of approximately $29,000                                                                     |       | (1,015,332          | )          |
| Contribution to the capital of the Bank                                                                                                                                                        |       | (7,500,000          | )          |
| Payments to directors and officers (bonuses  and directors’ fees)                                                                                                                         |       | (166,937            | )          |
| Payments to officers (salary and benefits)                                                                                                                                                     |       | (266,613            | )          |
| Other payments to affiliates for services                                                                                                                                                      |       | (143,057            | )          |
| Limited partnership investment in  affiliated limited partnership                                                                                                                              |       | (950,000            | )          |
| Loan to affiliated company                                                                                                                                                                     |       | (336,814            | )          |
| Repurchase of shares issued                                                                                                                                                                    |       | (50,005             | )          |
| Payment of additional operating expenses  (estimated)                                                                                                                                          |       | (719,934            | )          |
| Remaining net proceeds                                                                                                                                                                         |       | 845,277             |       |

 

$679,691 of the amount referenced as “Repayment of notes payable forthe acquisition of Texline State Bank was paid toCharles T. Meeks, a member of our Board of Directors and Chairman of the Boardof the Bank. An additional amount due to Mr. Meeks from the acquisition ofthe Bank in the amount of $18,783 previously held in escrow is also included inthis amount. On November 18, 2004, we approved the purchase of a 47.5%preferential limited partnership interest in PGI Equity Partners, L.P., whichowns and operates the building premises we lease, for $950,000. A deposit of$150,000 was paid on November 18, 2004 and the balance of the purchaseprice of $800,000 was paid on December 30, 2004, at closing. We hadoriginally anticipated these funds would be used for capital of the Bank, butwe believe the investment in premises will allow us the opportunity to realizemore value from appreciation in the real property rather than over-capitalizingthe Bank. On October 11, 2005, Treaty Oak Bancorp, Inc. made a$355,000 loan to Treaty Oak Holdings, Inc. with monthly interest paymentsdue on the first of each month beginning November 1, 2005. The totalprincipal advanced under this loan through December 31, 2005, was $336,814.The purpose of the loan was to enable TOHI to pay off certain obligations, andto provide sufficient liquidity to TOHI until the proposed merger with theCompany has been completed. The principal balance, along with any accruedinterest, is due and payable in full on September 1, 2006.

 

The remaining net proceeds have been invested in short-term interestbearing, money market accounts.

 

## **Item 3.**                                                           *DefaultsUpon Senior Securities*

## ** **

## **None.**

## ** **

## **Item 4.**                                                           *Submissionof Matters to a Vote of Security Holders*

## ** **

None.

 

25

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**Item 5.****                                                           *Other Information***

 

**Item 6.****                                                           *Exhibits andReports on Form 8-K***

 

a.               Exhibits

 
| 3.1    |   | Amended and Restated Articles of  Incorporation (filed as Exhibit 4.1 to Registration Statement on Form S-8  filed with the Commission on October 22, 2004 (File No. 333-119914,  which exhibit is incorporated herein by reference) |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                     |
| 3.2*   |   | By-laws                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                     |
| 4.1*   |   | Specimen Common Stock Certificate, $.01 par  value per share                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                     |
| 4.2*   |   | See Exhibits 3.1 and 3.2 for provisions of  the Articles of Incorporation and By-laws defining rights of holders of  Common Stock                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                     |
| 31.1   |   | Certification of Chief Executive Officer  required by Rule 13a-14(a)/15d-14(a) under the Exchange Act                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                     |
| 31.2   |   | Certification of Chief Financial Officer  required by Rule 13a-14(a)/15d-14(a) under the Exchange Act                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                     |
| 32.1   |   | Certification of Chief Executive Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of 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 Sarbanes-Oxley Act of 2002                                                                                                |

 

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*                                         Incorporatedby reference to the same numbered exhibit filed with the Company’s RegistrationStatement on Form SB-2 (File No. 333-112325).

 

b.              Current Reports on Form 8-K

 

We filed two current reports on Form 8-Kduring the reporting period. On October 6, 2004, we reported the close ofour public offering and acceptance of subscriptions for an aggregate of1,593,094 shares at a price of $8.33 per share for a total offering of$13,270,473.02. On December 28, 2004, we reported the resignation ofSandra Ellsworth as our chief financial officer and the appointment of JeffreyL. Nash as our new chief financial officer.

 

26

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

 
|                          | **TREATY OAK BANCORP, INC.** |
|-------------------------------|------------------------------|
|                          |                         |
|                          |                         |
| Dated: February 14, 2005 | By:                          | /s/ Terry W. Hamann |   |
|                          |                         | Terry W. Hamann, President and Chief  Executive Officer |
|                          |                         |
|                          |                         |
|                          | By:                          | /s/ Jeffrey L. Nash |   |
|                          |                         | Jeffrey L. Nash, Chief Financial Officer |
|                               |                              |  |  |  |  |

 

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