**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

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

###### **FORM10-QSB**

| **x**                                             |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF  THE SECURITIES EXCHANGE ACT OF 1934**     |
|---------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
| ** **                                        |
| **For the  quarterly period ended June 30, 2007** |
| ** **                                        |   | ** **                                                                                    |
| **o**                                             |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                              |
| **Commission  File Number: 333-112325**           |

 

**TreatyOak Bancorp, Inc.**

(Exact name ofregistrant as specified in its charter)

| **Texas**                                                  |
|------------------------------------------------------------|
| (State or other  jurisdiction of                           |
| corporation or  organization)                              |
| ** **                                                 |
| **20-0413144**                                             |
| (I.R.S. Employer  Identification Number)                   |
| ** **                                                 |
| **101  Westlake Drive, Austin, Texas**                     |
| (Address of  Principal Executive Offices)                  |
| ** **                                                 |
| **78746**                                                  |
| (Zip Code)                                                 |
| ** **                                                 |
| **(512)  617-3600**                                        |
| (Registrant’s  telephone number, including area code) |

 

Indicate by check markwhether the issuer (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file****such reports), and (2) has been subject to such filingrequirements for the past 90 days.

| **Yes****x** |   | **No****o** |
|--------------|--------|-------------|

 

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

| **Yes****o** |   | **No****x** |
|--------------|--------|-------------|

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock as of theclose of business on August 9, 2007.

| $0.01 Par Value Common Stock |   |   | 2,902,393 shares |
|------------------------------|--------|--------|------------------|

 

Transitional SmallBusiness Disclosure Format (Check one):                      **Yes****o    No  ****x**

 

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**QUARTERLYREPORT ON FORM 10-QSB**

**FOR THEPERIOD ENDED JUNE 30, 2007**

**TABLE OFCONTENTS**
| **Part I.**  | **Financial Information** |
|--------------|---------------------------|
| ** **   | ** **                | * * |
| ** **   | **Item 1.**               | *Financial Statements* |
|         |                      |   |
|         |                      | Consolidated  Balance Sheets at June 30, 2007 (unaudited) and September 30, 2006 (audited) |
|         |                      |   |
|         |                      | Consolidated  Statements of Operations for the Three Months and Nine Months Ended   June 30, 2007, and 2006 (unaudited) |
|         |                      |   |
|         |                      | Consolidated  Statement of Changes in Shareholders’ Equity for the Nine Months Ended   June 30, 2007 (unaudited) |
|         |                      |   |
|         |                      | Consolidated  Statements of Cash Flows for the Nine Months Ended June 30, 2007 and  2006 (unaudited) |
|         |                      |   |
|         |                      | Notes to Consolidated Financial Statements  (unaudited) |
| ** **   | ** **                | * * |
| ** **   | **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* |
|         |                      |   |
|         |                      | Signatures |

 

This Form 10-QSBcontains forward-looking statements consisting of estimates with respect to thefinancial condition, results of operations, and other business of Treaty OakBancorp, Inc., that are subject to various factors which could cause actualresults to differ materially from those estimates.  Factors that could influence the estimatesinclude changes in the national, regional, and local market conditions,legislative and regulatory conditions, and an adverse interest rateenvironment.

i

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**TreatyOak Bancorp, Inc.**

**Consolidated Balance Sheets(unaudited)**

**June30, 2007 and September 30, 2006**

**(DollarsIn Thousands, Except Par Value and Share Amounts)**

 
| ** **                                                                                                   | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                                   | ** ** | **2007**          | ** ** | **2006(1)**            | ** ** |
| ASSETS                                                                                                       |       |              |       |                   |       |
|                                                                                                         |       |              |       |                   |       |
| Cash and cash items                                                                                          |       | $                 | 332        |                   | $          | 267 |   |
| Due from banks                                                                                               |       | 2,962             |       | 2,312                  |       |
| Federal funds sold                                                                                           |       | 21,443            |       | 23,775                 |       |
| Total cash and  cash equivalents                                                                             |       | 24,737            |       | 26,354                 |       |
|                                                                                                         |       |              |       |                   |       |
| Securities available  for sale                                                                               |       | 11                |       | 16                     |       |
| Securities held to  maturity, fair value of $1,450 and $2,001, respectively                                  |       | 1,451             |       | 2,006                  |       |
| Investment in Federal  Home Loan Bank stock, at cost                                                         |       | 224               |       | 224                    |       |
| Investment in  Independent Banker’s Financial Corporation stock, at cost                                |       | 102               |       | 102                    |       |
| Loans, net                                                                                                   |       | 78,001            |       | 59,620                 |       |
| Premises and equipment,  net                                                                                 |       | 5,627             |       | 5,593                  |       |
| Note receivable from  affiliate                                                                              |       | —            |       | 2,821                  |       |
| Accrued interest  receivable                                                                                 |       | 529               |       | 484                    |       |
| Due from affiliates                                                                                          |       | —            |       | 192                    |       |
| Goodwill and other  intangibles, net                                                                         |       | 1,199             |       | 1,205                  |       |
| Other assets                                                                                                 |       | 1,297             |       | 474                    |       |
| Total assets                                                                                                 |       | $                 | 113,178    |                   | $          | 99,091 |   |
|                                                                                                         |       |              |       |                   |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                   |       |              |       |                   |       |
|                                                                                                         |       |              |       |                   |       |
| Deposits:                                                                                                    |       |              |       |                   |       |
| Noninterest-bearing  demand                                                                                  |       | $                 | 27,134     |                   | $          | 28,091 |   |
| NOW, money  market and savings                                                                               |       | 35,893            |       | 32,401                 |       |
| Time deposits                                                                                                |       | 31,765            |       | 20,526                 |       |
| Total deposits                                                                                               |       | 94,792            |       | 81,018                 |       |
|                                                                                                         |       |              |       |                   |       |
| Accounts payable and  accrued expenses                                                                       |       | 342               |       | 352                    |       |
| Accrued interest payable                                                                                     |       | 284               |       | 160                    |       |
| Property mortgage                                                                                            |       | 2,619             |       | 2,667                  |       |
| Notes payable                                                                                                |       | —            |       | 2,483                  |       |
| Minority interest - PGI  Equity Partners, LP                                                                 |       | —            |       | 1,106                  |       |
| Other liabilities                                                                                            |       | 23                |       | 33                     |       |
| Total  liabilities                                                                                           |       | 98,060            |       | 87,819                 |       |
|                                                                                                         |       |              |       |                   |       |
| Shareholders’ equity:                                                                                   |       |              |       |                   |       |
| Preferred stock,  $0.01 par value; 1,000,000 shares authorized; none issued                                  |       | —            |       | —                 |       |
| Common stock,  $0.01 par value; 20,000,000 shares authorized; 2,908,396 and 2,640,226,  respectively, issued |       | 29                |       | 26                     |       |
| Paid-in capital                                                                                              |       | 18,651            |       | 14,989                 |       |
| Accumulated  deficit                                                                                         |       | (3,512            | )          | (3,693                 | )          |
| Less shares held  in treasury, at cost (6,003 shares)                                                        |       | (50               | )          | (50                    | )          |
| Total  shareholders’ equity                                                                             |       | 15,118            |       | 11,272                 |       |
| Total  liabilities and shareholders’ equity                                                             |       | $                 | 113,178    |                   | $          | 99,091 |   |

 

See Notes to ConsolidatedFinancial Statements (unaudited)

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(1) Derived from AuditedConsolidated Financial Statements

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**Treaty OakBancorp, Inc.**

**Consolidated Statements of Operations (unaudited)**

**Three Monthsand Nine Months Ended June 30, 2007 and 2006**

**(Dollars In Thousands, Except Share and Per ShareAmounts)**
| ** **                                           | ** ** | **Three Months** | ** ** | **Three Months** | ** ** | **Nine Months** | ** ** | **Nine Months** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                           | ** ** | **Ended June**   | ** ** | **Ended June**   | ** ** | **Ended June**  | ** ** | **Ended June**  | ** ** |
| ** **                                           | ** ** | **30, 2007**     | ** ** | **30, 2006**     | ** ** | **30, 2007**    | ** ** | **30, 2006**    | ** ** |
| Interest income:                                     |       |                  |       |                  |       |                 |       |                 |       |
| Loans, including fees                                |       | $                     | 1,738      |                  | $          | 1,104                |       | $                    | 4,882      |   | $ | 2,887 |   |
| Taxable securities                                   |       | 18                    |       | 22                    |       | 49                   |       | 76                   |       |
| Interest on deposits with other banks                |       | —                |       | 34                    |       | —               |       | 91                   |       |
| Federal funds sold                                   |       | 136                   |       | 73                    |       | 444                  |       | 181                  |       |
| Total interest income                                |       | 1,892                 |       | 1,233                 |       | 5,375                |       | 3,235                |       |
|                                                 |       |                  |       |                  |       |                 |       |                 |       |
| Interest  expense:                                   |       |                  |       |                  |       |                 |       |                 |       |
| Deposits                                             |       | 644                   |       | 252                   |       | 1,753                |       | 643                  |       |
| Other borrowings                                     |       | 42                    |       | 41                    |       | 149                  |       | 124                  |       |
| Total interest expense                               |       | 686                   |       | 293                   |       | 1,902                |       | 767                  |       |
|                                                 |       |                  |       |                  |       |                 |       |                 |       |
| Net interest  income                                 |       | 1,206                 |       | 940                   |       | 3,473                |       | 2,468                |       |
|                                                 |       |                  |       |                  |       |                 |       |                 |       |
| Provision for  loan losses                           |       | 75                    |       | 90                    |       | 220                  |       | 180                  |       |
| Net interest  income after provision for loan losses |       | 1,131                 |       | 850                   |       | 3,253                |       | 2,288                |       |
|                                                 |       |                  |       |                  |       |                 |       |                 |       |
| Noninterest  income:                                 |       |                  |       |                  |       |                 |       |                 |       |
| Service charges on deposit accounts                  |       | 57                    |       | 31                    |       | 129                  |       | 69                   |       |
| Other noninterest income                             |       | 47                    |       | 113                   |       | 180                  |       | 316                  |       |
| Total noninterest income                             |       | 104                   |       | 144                   |       | 309                  |       | 385                  |       |
|                                                 |       |                  |       |                  |       |                 |       |                 |       |
| Noninterest  expense:                                |       |                  |       |                  |       |                 |       |                 |       |
| Salaries and employee benefits                       |       | 691                   |       | 420                   |       | 1,832                |       | 1,253                |       |
| Occupancy and equipment expenses                     |       | 84                    |       | 109                   |       | 297                  |       | 331                  |       |
| Accounting and other professional fees               |       | 76                    |       | 63                    |       | 178                  |       | 255                  |       |
| Other noninterest expense                            |       | 367                   |       | 268                   |       | 1,074                |       | 750                  |       |
| Total noninterest expense                            |       | 1,218                 |       | 860                   |       | 3,381                |       | 2,589                |       |
|                                                 |       |                  |       |                  |       |                 |       |                 |       |
| Net income                                           |       | $                     | 17         |                  | $          | 134                  |       | $                    | 181        |   | $ | 84 |   |
|                                                 |       |                  |       |                  |       |                 |       |                 |       |
| Earnings per  common share - basic                   |       | $                     | 0.01       |                  | $          | 0.05                 |       | $                    | 0.07       |   | $ | 0.03 |   |
| Earnings per  common share - diluted                 |       | $                     | 0.01       |                  | $          | 0.05                 |       | $                    | 0.06       |   | $ | 0.03 |   |
|                                                 |       |                  |       |                  |       |                 |       |                 |       |
| Weighted average  shares outstanding - basic         |       | 2,783,192             |       | 2,630,018             |       | 2,726,174            |       | 2,629,548            |       |
| Weighted average shares  outstanding - diluted       |       | 3,043,770             |       | 2,631,074             |       | 2,927,716            |       | 2,631,702            |       |

 

See Notes to ConsolidatedFinancial Statements (unaudited)

4

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**TreatyOak Bancorp, Inc.**

**Consolidated Statement ofShareholders’ Equity (unaudited)**

**NineMonths Ended June 30, 2007**

**(Dollars In Thousands, ExceptShare Amounts)**
| ** **                                                   | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|--------------|------------|------------|------------|------------|------------|
| ** **                                                   | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Treasury** | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**  | ** ** |
|                                                         |       |                  |       |        |       |            |       |         |       |       |       |       |       |
| Balances at  October 1, 2006                                 |       | 2,640,226             |       | $           | 26         |            | $          | 14,989       |       | $          | (3,693     | )          | $          | (50 | ) | $ | 11,272 |   |
|                                                         |       |                  |       |        |       |            |       |         |       |       |       |       |       |
| Shares issued from Treaty Oak Holdings merger                |       | 1,094,163             |       | 11          |       | 9,082           |       | —       |       | —     |       | 9,093      |       |
| Shares retired from Treaty Oak Holdings merger               |       | (1,000,000            | )          | (10         | )          | (8,300          | )          | —       |       | —     |       | (8,310     | )          |
| Warrants and options from Treaty Oak Holdings merger         |       | —                |       | —      |       | 932             |       | —       |       | —     |       | 932        |       |
| Shares issued through the exercise of common stock  warrants |       | 171,606               |       | 2           |       | 1,714           |       | —       |       | —     |       | 1,716      |       |
| Non-cash stock based compensation                            |       | 2,401                 |       | —      |       | 234             |       | —       |       | —     |       | 234        |       |
| Net income                                                   |       | —                |       | —      |       | —          |       | 181          |       | —     |       | 181        |       |
|                                                         |       |                  |       |        |       |            |       |         |       |       |       |       |       |
| Balances at June  30, 2007                                   |       | 2,908,396             |       | $           | 29         |            | $          | 18,651       |       | $          | (3,512     | )          | $          | (50 | ) | $ | 15,118 |   |

 

SeeNotes to Consolidated Financial Statements (unaudited)

5

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**Treaty Oak Bancorp, Inc.**

**ConsolidatedStatements of Cash Flows (unaudited)**

**Nine Months Ended June 30, 2007 and2006**

**(Dollars In Thousands)**

 
| ** **                                                                                | ** ** | **Nine Months** | ** ** | **Nine Months** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                                                | ** ** | **Ended June**  | ** ** | **Ended June**  | ** ** |
| ** **                                                                                | ** ** | **30, 2007**    | ** ** | **30, 2006**    | ** ** |
| Cash flows from  operating activities:                                                    |       |                 |       |                 |       |
| Net income                                                                                |       | $                    | 181        |                 | $          | 84 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                 |       |                 |       |
| Provision for loan losses                                                                 |       | 220                  |       | 180                  |       |
| Non-cash stock based compensation                                                         |       | 234                  |       | —               |       |
| Depreciation and amortization                                                             |       | 275                  |       | 264                  |       |
| Other                                                                                     |       | (7                   | )          | 15                   |       |
| Changes in other operating assets and liabilities:                                        |       |                 |       |                 |       |
| Accrued interest receivable                                                               |       | (2                   | )          | (5                   | )          |
| Other assets                                                                              |       | (760                 | )          | (177                 | )          |
| Accrued interest payable                                                                  |       | 123                  |       | 5                    |       |
| Other liabilities                                                                         |       | (100                 | )          | 156                  |       |
| **Net cash provided by operating activities**                                             |       | 164                  |       | 522                  |       |
|                                                                                      |       |                 |       |                 |       |
| Cash flows from  investing activities:                                                    |       |                 |       |                 |       |
| Proceeds from maturities and principal repayments on  securities - available for sale     |       | 5                    |       | 12                   |       |
| Proceeds from maturities and principal repayments on  securities - held to maturity       |       | 1,998                |       | 1,496                |       |
| Purchases of securities - held to maturity                                                |       | (1,443               | )          | —               |       |
| Acquistion of interest in PGI Equity Partners, LP                                         |       |                 |       | (80                  | )          |
| Purchases of correspondent bank stock                                                     |       | —               |       | (7                   | )          |
| Net increase in loans                                                                     |       | (18,534              | )          | (17,340              | )          |
| Cash received from the acquistion of Treaty Oak  Holdings, Inc.                           |       | 515                  |       | —               |       |
| (Advances to) repayments from affiliates                                                  |       | 192                  |       | (468                 | )          |
| Collection of notes receivable from affiliates                                            |       | 2,821                |       | —               |       |
| Purchases of premises and equipment                                                       |       | (294                 | )          | (58                  | )          |
| **Net cash used in investing activities**                                                 |       | (14,740              | )          | (16,445              | )          |
|                                                                                      |       |                 |       |                 |       |
| Cash flows from  financing activities:                                                    |       |                 |       |                 |       |
| Net increase in deposits                                                                  |       | 13,774               |       | 13,175               |       |
| Payments of principal on mortgage                                                         |       | (48                  | )          | (45                  | )          |
| Payments of principal on notes payable                                                    |       | (2,483               | )          | (12                  | )          |
| Proceeds from exercise of warrants                                                        |       | 1,716                |       | 11                   |       |
| **Net cash provided by financing activities**                                             |       | 12,959               |       | 13,129               |       |
|                                                                                      |       |                 |       |                 |       |
| Net decrease in  cash and cash equivalents                                                |       | (1,617               | )          | (2,794               | )          |
| Cash and cash  equivalents at beginning of period                                         |       | 26,354               |       | 13,107               |       |
| Cash and cash  equivalents at end of period                                               |       | $                    | 24,737     |                 | $          | 10,313 |   |

 

6

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**Treaty Oak Bancorp, Inc.**

**Consolidated Statements of Cash Flows(unaudited)**

**Nine Months Ended June 30, 2007 and2006**

**(DollarsIn Thousands)**
| ** **                                          | ** ** | **Nine Months** | ** ** | **Nine Months** | ** ** |
|-----------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                          | ** ** | **Ended June**  | ** ** | **Ended June**  | ** ** |
| ** **                                          | ** ** | **30, 2007**    | ** ** | **30, 2006**    | ** ** |
|                                                |       |                 |       |                 |       |
| Supplemental  disclosures of cash flow information: |       |                 |       |                 |       |
| Non-cash investing and financing information:       |       |                 |       |                 |       |
| Cash interest received                              |       | $                    | 5,330      |                 | $          | 3,230 |   |
| Cash interest paid                                  |       | $                    | 1,778      |                 | $          | 762 |   |
|                                                |       |                 |       |                 |       |
| Acquisition of  Treaty Oak Holdings, Inc.           |       |                 |       |                 |       |
| Assets acquired, excluding cash acquired            |       | $                    | 1,280      |                 |       |   |
| Liabilities assumed                                 |       | (80                  | )          |                 |       |
| Issuance of common stock                            |       | (9,093               | )          |                 |       |
| Retirement of comon stock                           |       | 8,310                |       |                 |       |
| Issuance of warrants and assumption of options      |       | (932                 | )          |                 |       |
| Net cash  acquired                                  |       | $                    | (515       | )                    |       |   |

 

SeeNotes to Consolidated Financial Statements (unaudited)

7

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**Note1.   Basis of Presentation**

Treaty Oak Bancorp, Inc.(the “Company”) is a bank holding company incorporated on November 18, 2003,and organized December 8, 2003 for the purpose of holding the common stock ofTreaty Oak Bank (formerly Texline State Bank, the “Bank”). The Company, through Treaty Oak Bank, provides afull range of commercial and consumer banking services to individuals andbusinesses in the commercial sector in Austin, Texas, and in the agriculture,cattle and commercial sectors in the community of Texline, Texas.

OnNovember 15, 2006, the Company completed its acquisition of Treaty OakHoldings, Inc. (“TOHI”) pursuant to the Agreement and Plan of Merger, datedOctober 3, 2006 (the “Merger Agreement”). The merger was approved by theCompany’s Board of Directors and also by the Company’s shareholders at aSpecial Meeting of Shareholders held on October 24, 2006. Prior to the merger,TOHI operated as a bank holding company and significant shareholder of theCompany, but otherwise had no active operations. As a result of the merger, theCompany now owns TOHI’s subsidiary companies, Treaty Oak Financial Holdings,Inc. (“TOFHI”) and PGI Capital, Inc. These entities have been consolidated inthe Company’s financial statements since the merger on November 15, 2006. TOFHIis an inactive corporate entity with assets of cash and a note receivable. PGICapital, Inc. is the general partner of PGI Equity Partners, LP, the entitywhich owns the Company’s corporate headquarters.

The Companyacquired a 47.5% interest in PGI Equity Partners, LP (the “Partnership”) onDecember 31, 2004. The Partnership owns and operates the building in which theCompany offices. On February 23, 2006, theCompany acquired additional 2.5% Class A and 1.25% Class B interests in the Partnershipfrom the sole remaining minority shareholder, bringing the Company’s totalownership interest in the Partnership to 51.25% at September 30, 2006. TOHIowned 43.25% of the limited partnership interests, while PGI Capital, Inc.owned the remaining 0.5% limited partnership interest. Thus, following theCompany’s merger with TOHI on November 15, 2006, the Company now owns 100.0% ofthe limited partnership interests in the Partnership as well as the 5.0%general partnership interest held by PGI Capital, Inc., the Partnership’sgeneral partner. The Partnership has been consolidated in the Company’sfinancial statements since December 31, 2004. TOHI and PGI Capital, Inc.’sinterests have been accounted for as minority interests until the merger onNovember 15, 2006.

The consolidatedfinancial statements include the accounts of Treaty Oak Bancorp, Inc., itswholly owned subsidiary Treaty Oak Bank, and PGI Equity Partners, LP. Theconsolidated financial statements also include the accounts of PGI Capital, Inc.and TOFHI subsequent to the merger on November 15, 2006.

The accompanying unaudited consolidated financial statements have beenprepared in accordance with the instructions to Form 10-QSB and, therefore, donot include all of the disclosures and notes required by accounting principlesgenerally accepted in the United States of America. In the opinion ofmanagement, all material adjustments (which are of a normal recurring nature)considered necessary for a fair presentation have been made. The results forthe interim period are not necessarily indicative of the results to be expectedfor the entire year or any other interim period.

New AccountingPronouncements

The Companyadopted Financial Accounting Standards Board Statement No. 123R, “Share-BasedPayment”, (“Statement 123R”) on October 1, 2006. Under Statement 123R, the costof employee services received in exchange for an award of equity instruments isbased on the grant-date fair value of the award (with limited exceptions). Thatcost is recognized over the period during which an employee is required toprovide service in exchange for the award – the requisite service period(usually the vesting period).

Prior to October 1, 2006,the Company accounted for stock-based compensation to employees using theintrinsic value method. Accordingly, compensation costs for employee stockoptions were measured as the excess, if any, of the fair value of the Company’scommon stock at date of grant over the exercise price.

The Companyaccounts for stock-based compensation to non-employees at fair value.

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes” (FIN 48). Fin 48 clarifies the accounting andreporting for income taxes recognized in accordance with SFAS No. 109,

8

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“Accounting for Income Taxes.” This Interpretation prescribes acomprehensive model for the financial statement recognition, measurement,presentation and disclosure of uncertain tax positions taken or expected to betaken in income tax returns. The Company is currently evaluating the impact ofFIN 48. The Company will adopt this Interpretation in the first quarter offiscal 2008.

In September 2006,the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements.” SAB 108 addresses the views of the SEC staffregarding the process of quantifying financial statement misstatements. SECregistrants are expected to reflect the effects of initially applying theguidance in SAB 108 in their annual financial statements covering the firstfiscal year ending after November 15, 2006. The cumulative effect of theinitial application should be reported in the carrying amounts of assets andliabilities as of the beginning of that fiscal year and the offsettingadjustment should be made to the opening balance of retained earnings for thatyear. The Company adopted SAB 108 on October 1, 2006. The adoption did not haveany impact on the financial statements.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements”. This Statement defines fair value, establishes aframework for measuring fair value and expands disclosures about fair valuemeasurements. It clarifies that fair value is the price that would be receivedto sell an asset or paid to transfer a liability in an orderly transactionbetween market participants in the market in which the reporting entitytransacts. This Statement does not require any new fair value measurements, butrather, it provides enhanced guidance to other pronouncements that require orpermit assets or liabilities to be measured at fair value. This Statement iseffective for fiscal years beginning after November 15, 2007, with earlieradoption permitted. The Company will adoptthis standard in the first quarter of fiscal 2008. The Company does not expect that the adoption ofthis Statement will have a material impact on its financial position, resultsof operations and cash flows.

InFebruary 2007, the FASB issued SFAS No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities”. This Statement permits entities tochoose to measure many financial assets and financial liabilities at fairvalue. Unrealized gains and losses on items for which the fair value option hasbeen elected will be reported in earnings. SFAS No. 159 is effective for fiscalyears beginning after November 15, 2007.  The Company will adopt thisstandard in the first quarter of fiscal 2008. The Company is currentlyevaluating the impact of SFAS No. 159 on its consolidated financial position,results of operations and cash flows.

**Note 2.   Merger with Organizing Shareholder**

OnNovember 15, 2006, the Company completed the acquisition of TOHI pursuantto the Agreement and Plan of Merger, dated October 3, 2006. TOHI was one of thefive organizing shareholders of the Company and operated as a bank holdingcompany and significant shareholder of the Company, but otherwise had no activeoperations. The primary purpose of the merger was to achieve certainoperational efficiencies for the Company and its affiliates. The merger wasapproved by the Company’s Board of Directors and also by the Company’sshareholders at a Special Meeting of Shareholders held on October 24, 2006. Priorto the consummation of the merger, TOHI held approximately 38% of the issuedand outstanding shares of the Company’s common stock. Pursuant to the MergerAgreement, (1) each issued and outstanding share of TOHI’s common stock, parvalue $0.01 per share was converted into the right to receive 0.8121 shares ofthe Company’s common stock, par value $0.01 per share, and (2) each issued andoutstanding share of TOHI’s preferred stock, par value $10.00 per share, wasconverted into the right to receive 1.2034 shares of the Company’s commonstock.

TOHI had issuedoptions to acquire shares of common stock to various individuals, 40,000 ofwhich were outstanding as of the date of the merger. These options were assumedby the Company and, pursuant to the conversion ratio, now represent options toacquire 32,484 shares of the Company’s common stock. The options were fullyvested at the merger date. Also, at the closing of the merger, certain TOHIwarrantholders were issued new warrants to acquire, in the aggregate, 450,000shares of the Company’s common stock. The warrants were fully vested whenissued. The Company granted the TOHI shareholders certain limited registrationrights pursuant to a Registration Rights Agreement executed at the closing ofthe merger. Pursuant to the Registration Rights Agreement these former TOHIshareholders can request that the Company register their shares of the Company’scommon stock

9

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on a RegistrationStatement on Form S-3 if such form is available for use by the Company, butonly once during any 12-month period. The former TOHI warrantholders were alsogranted similar S-3 registration rights.

The TOHIshareholders contributed certain assets and liabilities to the Company inconnection with the merger. As of November 15, 2006, the assets and liabilitiescontributed by TOHI were as follows (in thousands):
|                                                        | ** ** | **As of November   15, 2006** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------|------------|
|                                                   |       |                                              |       |
| Cash                                                   |       | $                                                 | 441        |   |
| Subscriptions  receivable                              |       | 72                                                |       |
| Notes receivable                                       |       | 100                                               |       |
| Accrued interest  receivable                           |       | 5                                                 |       |
| Investment in  PGI Equity Partnership, LP              |       | 875                                               |       |
| Investment in  PGI Capital, Inc. (1)                   |       | 54                                                |       |
| Investment in  Treaty Oak Financial Holdings, Inc. (2) |       | 248                                               |       |
|                                                   |       | 1,795                                             |       |
| Accrued expenses                                       |       | (80                                               | )          |
|                                                   |       |                                              |       |
| Net assets  contributed by TOHI                        |       | $                                                 | 1,715      |   |

 

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(1)                PGI Capital, Inc.’sassets were comprised of $31,000 in cash and $224,000 of general and limitedpartnership interests in PGI Equity Partners LP. PGI Capital, Inc. liabilitiesincluded a note payable to the Bank of $200,000 plus accrued interest of$1,000.

(2)                Treaty OakFinancial Holdings’ assets were comprised of $43,000 in cash, a $166,500 notereceivable and related accrued interest of $38,000.

The Company and TOHI weredeemed to be under common control. A majority of the directors of the Companyalso served on TOHI’s board of directors and were shareholders of bothentities. TOHI also owned 1,000,000 shares of the Company’s common stock,representing approximately 38% of the Company shares then outstanding. Becausethe Company and TOHI were deemed to be under common control, purchaseaccounting was not applied to the merger. Instead the net assets contributed byTOHI were recorded at their predecessor basis. The 1,000,000 shares of Companycommon stock owned by TOHI were cancelled by the Company and recorded as areduction of its common stock accounts (par value and paid in capital) at theirfair market value, as determined by an independent appraisal, of $8.31 pershare, or $8,310,000 in the aggregate. The 1,094,163 new shares of Companystock issued to the TOHI shareholders were also recorded at the fair marketvalue price of $8.31 per share, or $9,093,000 in the aggregate. The warrantsissued by the Company in exchange for the TOHI warrants and the TOHI optionsassumed by the Company were valued and recorded at their fair value using aBlack-Scholes pricing model.****The net effectof the contribution of assets and the capital stock transactions was a$1,715,000 increase to the Company’s equity and a 94,163 net increase in thenumber of Company shares issued. Although the net assets contributed by TOHI tothe Company were not adjusted to their fair value, the assets were evaluatedfor collectibility and/or impairment according to generally accepted accountingprinciples prior to the merger and adjusted accordingly by TOHI prior to themerger.

**Note 3.   Earnings (Loss) Per Share**

Basic earnings pershare is computed by dividing net earnings by the weighted-average number ofcommon shares outstanding for the period.  Diluted earnings per share iscomputed using the weighted-average number of common shares outstanding plusthe number of additional common shares that would have been outstanding ifdilutive common shares had been issued.  For the three months ended June30, 2007, all potentially dilutive securities were

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dilutive. The902,079 of potentially dilutive securities included 418,950 of options topurchase common stock issued under the Company’s Stock Incentive Plan, 645options to purchase stock issued outside of the Plan, stock options to purchase32,484 shares of the Company’s common stock at an exercise price of $6.16 thatwere assumed in conjunction with the merger with TOHI and warrants to purchase450,000 of the Company’s common stock at an exercise price of the greater of$6.67 per share or the book value of the Company as defined by the warrantagreements. For the nine months ended June 30, 2007, all potentially dilutivesecurities except for 500 options to purchase common stock with an exerciseprice of $10.26 and 6,400 options to purchase common stock with an exerciseprice of $10.95, were dilutive. For the nine months ended June 30, 2007, the895,179 of potentially dilutive securities included 412,050 options to purchasecommon stock issued under the Company’s Stock Incentive Plan, 645 options topurchase stock issued outside of the Plan, stock options to purchase 32,484shares of the Company’s common stock at an exercise price of $6.16 that wereassumed in conjunction with the merger with TOHI and warrants to purchase450,000 of the Company’s common stock at an exercise price of the greater of$6.67 per share or the book value of the Company as defined by the warrantagreements.

For the three andnine months ended June 30, 2006, all potentially dilutive securities, exceptfor stock options to purchase 179,500 and 145,500 shares, respectively, of theCompany’s common stock at $8.33 per shares, were anti-dilutive.

Duringthe three months ended June 30, 2007, 168,265 of the Company’s warrants topurchase common stock at $10.00 per share which were issued in connection withthe Company’s initial public offering, were exercised. The remaining 140,000 ofwarrants 140,000 expired on June 30, 2007.

**Note 4.****          Securities**

Securities consisted of the following (in thousands):
|                                      | ** ** | **As of  June 30, 2007** | ** ** | **As of  September 30, 2006** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|----------------------------------------------|------------|
| ** **                           | ** ** | **Amortized  Cost**                     | ** ** | **Fair  Value**                              | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|                                 |       |                                    |       |                                         |       |   |   |   |   |
| Securities  Available for Sale:      |       |                                    |       |                                         |       |   |   |   |   |
| U.S. Government Agencies             |       | $                                       | 9          |                                         | $          | 9 |   | $ | 14 |   | $ | 14 |   |
| Other mortgage backed securities     |       | 2                                       |       | 2                                            |       | 2 |   | 2 |   |
|                                 |       |                                    |       |                                         |       |   |   |   |   |
| Total Securities  Available for Sale |       | $                                       | 11         |                                         | $          | 11 |   | $ | 16 |   | $ | 16 |   |
|                                 |       |                                    |       |                                         |       |   |   |   |   |
| Securities Held  to Maturity:        |       |                                    |       |                                         |       |   |   |   |   |
| U.S. Government Agencies             |       | $                                       | 1,446      |                                         | $          | 1,446 |   | $ | 2,000 |   | $ | 1,996 |   |
| Other mortgage backed securities     |       | 5                                       |       | 4                                            |       | 6 |   | 5 |   |
|                                 |       |                                    |       |                                         |       |   |   |   |   |
| Total Securities Held  to Maturity   |       | $                                       | 1,451      |                                         | $          | 1,450 |   | $ | 2,006 |   | $ | 2,001 |   |

 

AtJune 30, 2007, $512,000 of the Company’s securities were pledged to TexlineIndependent School District, $700,000 to the City of Texline and $250,000 tothe State of Texas.

**Note 5.****          Loans and Allowance for Loan Losses**

The Company grants real estate, commercial and agribusiness loans tocustomers primarily in the Austin and Northwest Texas markets. Loans at June30, 2007, and September 30, 2006 were as follows (in thousands):

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|                                  | ** ** | **As of June 30,  2007** | ** ** | **As of September  30, 2006** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|----------------------------------------------|------------|
|                             |       |                                    |       |                                         |       |
| Agriculture                      |       | $                                       | 2,758      |                                         | $          | 2,989 |   |
| Commercial                       |       | 28,451                                  |       | 19,068                                       |       |
| Commercial real  estate          |       | 18,129                                  |       | 18,582                                       |       |
| Residential real  estate         |       | 9,079                                   |       | 8,221                                        |       |
| Construction  real estate        |       | 13,940                                  |       | 4,329                                        |       |
| Consumer and  other              |       | 6,361                                   |       | 6,981                                        |       |
| Gross Loans                      |       | 78,718                                  |       | 60,170                                       |       |
| Less: allowance  for loan losses |       | (717                                    | )          | (550                                         | )          |
|                             |       |                                    |       |                                         |       |
| Net Loans                        |       | $                                       | 78,001     |                                         | $          | 59,620 |   |

 

Activity in the allowance for loan losses for the three months and ninemonths ended June 30, 2007, was as follows (in thousands):

 
| ** **                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|---------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                  | ** ** | **2007**                                        | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Balance at  beginning of period             |       | $                                               | 646        |                                           | $          | 358 |   | $ | 550 |   | $ | 277 |   |
| Provision for  loan losses                  |       | 75                                              |       | 90                                             |       | 220 |   | 180 |   |
| Loans charged  off                          |       | (7                                              | )          | (12                                            | )          | (58 | ) | (22 | ) |
| Recoveries on  loans previously charged off |       | 3                                               |       | 1                                              |       | 5 |   | 2 |   |
|                                        |       |                                            |       |                                           |       |   |   |   |   |
| Balance at end  of period                   |       | $                                               | 717        |                                           | $          | 437 |   | $ | 717 |   | $ | 437 |   |

 

At June 30, 2007and September 30, 2006, the Bank had approximately $95,000 and $123,000,respectively, in nonperforming loans and non accrual loans. At June 30, 2007and September 30, 2006 the Bank had approximately $800 and $5,000 inrepossessed assets, respectively, and approximately $76,000 and $41,000,respectively, in other real estate owned.

**Note 6.****          Premises and Equipment**

Premises and equipment at June 30, 2007, and September 30, 2006, wereas follows (in thousands):
|                                                 | ** ** | **As of June  30, 2007** | ** ** | **As of September   30, 2006** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------------------|------------|
|                                            |       |                                    |       |                                               |       |
| Land                                            |       | $                                       | 959        |                                               | $          | 959 |   |
| Building and  leasehold improvements            |       | 4,614                                   |       | 4,568                                              |       |
| Furniture,  fixtures and equipment              |       | 1,025                                   |       | 778                                                |       |
|                                            |       | 6,598                                   |       | 6,305                                              |       |
| Less accumulated  depreciation and amortization |       | (971                                    | )          | (712                                               | )          |
| Total                                           |       | $                                       | 5,627      |                                               | $          | 5,593 |   |

 

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Depreciation andamortization expense for the nine months ended June 30, 2007 and 2006 wasapproximately $260,000 and $257,000, respectively.

**Note 7.****          Deposits**

Time deposits of $100,000 or more totaled $16,713,000 and $8,989,000 atJune 30, 2007 and September 30, 2006, respectively. At June 30, 2007 andSeptember 30, 2006, the scheduled maturities of time deposits were as follows(in thousands):
| Years Ending September 30, | ** ** | **As of June  30, 2007** | ** ** | **As of September  30, 2006** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------------|------------|
|                                      |       |                                    |       |                                         |       |
| 2007                                      |       | $                                       | 15,927     |                                         | $          | 20,197 |   |
| 2008                                      |       | 15,076                                  |       | 329                                          |       |
| 2009                                      |       | 762                                     |       | —                                       |       |
|                                      |       |                                    |       |                                         |       |
|                                      |       | $                                       | 31,765     |                                         | $          | 20,526 |   |

 

**Note 8.****          Goodwill and Other Intangibles**

In conjunctionwith the acquisition of Texline State Bank, the Company recorded goodwill of$1,161,000 and core deposit intangibles of $70,000. Goodwill is periodically,but at least annually, reviewed to determinewhether a decline in value exists which requires a charge to earnings and areduction to the goodwill reflected on the statement of financial condition ofthe Company.

Core deposit intangiblesare amortized on a straight-line basis over seven years. The following tablereflects the net carrying amount of core deposit intangibles at June 30, 2007and September 30, 2006 (in thousands):
|                                 | ** ** | **As of June  30, 2007** | ** ** | **As of September   30, 2006** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|----------------------------------------------------|------------|
| Gross core  deposit intangibles |       | $                                       | 70         |                                               | $          | 70 |   |
| Less:  accumulated amortization |       | (32                                     | )          | (26                                                | )          |
|                            |       |                                    |       |                                               |       |
| Net core deposit  intangibles   |       | $                                       | 38         |                                               | $          | 44 |   |

 

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

The Companyadopted Financial Accounting Standards Board Statement No. 123R, “Share-BasedPayment”, (“Statement 123R”) on October 1, 2006. Under Statement 123R, the costof employee services received in exchange for an award of equity instruments isbased on the grant-date fair value of the award (with limited exceptions). Thatcost is recognized over the period during which an employee is required toprovide service in exchange for the award – the requisite service period(usually the vesting period). The Company adopted Statement 123R using themodified prospective application, which was required for public companies. Underthe modified prospective application, Statement 123R applies to new awards andto awards modified, repurchased, or cancelled after October 1, 2006. Additionally,compensation cost for the portion of awards for which the requisite service hadnot been

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rendered that areoutstanding as of October 1, 2006 will be recognized as the requisite serviceis rendered subsequent to October 1, 2006.

Prior to October 1, 2006,the Company accounted for stock-based compensation to employees using theintrinsic value method. Accordingly, compensation costs for employee stockoptions was measured as the excess, if any, of the fair value of the Company’scommon stock at date of grant over the exercise price.

The Companyaccounts for stock-based compensation to non-employees at fair value.

OnJanuary 19, 2004, the Company and its shareholders approved the Company’s2004 Stock Incentive Plan (the “Plan”).  The Plan authorizes incentivestock option grants, non-statutory stock option grants, direct stock issuances,stock appreciation rights, salary investment option grants, and director feeoption grants.  Eligible participants are employees, non-employee boardmembers, and independent consultants or advisors.  The Company initiallyreserved 500,000 shares of common stock under the Plan, and the share reserveincreases on the 1st business day in January each year (beginningin 2005) by an amount equal to 2% of the number of outstanding shares of theCompany on the last business day in December of the preceding year,subject to a maximum annual increase of 100,000 shares.  No person mayreceive stock option grants, stock issuances, or stock appreciation rights formore than 100,000 shares in the aggregate in any calendar year under the Plan. Optionawards are generally granted with an exercise price equal to the market priceof the Company’s stock at the date of the grant; have 10-year contractual termsand vest based on three years of continuous service. Share awards generallyvest over four years.

The followingtable illustrates the stock compensation expense recognized during the threeand nine months ended June 30, 2007:
|                                            | ** ** | **Three Months  Ended June  30, 2007** | ** ** | **Nine Months  Ended June  30, 2007** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------------|------------|------------------------------------------------------|------------|
| Stock options  for employees and directors |       | $                                                     | 57         |                                                 | $          | 164 |   |
| Stock options  for services provided       |       | 11                                                    |       | 20                                                   |       |
| Restricted stock  grants                   |       | 24                                                    |       | 50                                                   |       |
|                                       |       | $                                                     | 92         |                                                 | $          | 234 |   |

 

For the threemonths and nine months ended June 30, 2006, the expense related to stock optioncompensation included in the determination of net income was less than thatwhich would have been recognized if the fair value method had been applied. TheCompany’s net income and earnings per share would have been adjusted to theproforma amounts indicated below for thethree months and nine months ended June 30, 2006, assuming the Company hadexpensed the fair value of the options (in thousands, except per shareamounts):
|                                           | ** ** | **Three Months Ended  June 30, 2006** | ** ** | **Nine Months Ended  June 30, 2006** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------------------|------------|
|                                      |       |                                                      |       |                                                     |       |
| Net income – as  reported            |       | $                                                         | 134        |                                                     | $          | 84 |   |
| Net income  (loss) – pro forma       |       | $                                                         | 95         |                                                     | $          | (28 | ) |
|                                      |       |                                                      |       |                                                     |       |
| Income per share  – as reported      |       |                                                      |       |                                                     |       |
| Basic                                     |       | $                                                         | 0.05       |                                                     | $          | 0.03 |   |
| Diluted                                   |       | $                                                         | 0.05       |                                                     | $          | 0.03 |   |
|                                      |       |                                                      |       |                                                     |       |
| Income (loss)  per share – pro forma |       |                                                      |       |                                                     |       |
| Basic                                     |       | $                                                         | 0.04       |                                                     | $          | (0.01 | ) |
| Diluted                                   |       | $                                                         | 0.04       |                                                     | $          | (0.01 | ) |

 

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The fair value ofeach option award is estimated on the date of grant using the Black-Scholesoption pricing model. The Black-Scholes option pricing model requires the inputof highly subjective assumptions. The Company continues to assess theassumptions and methodologies used to calculate the estimated fair value of thestock-based compensation. Circumstances may change and additional data maybecome available over time, which could result in changes to these assumptionsand methodologies. The risk-free rate for periods within the expected life ofthe options is based on the U.S. Treasury yield in effect at the time of thegrant. The expected life of the options is estimated based on the vesting lifeand contractual life of the options. Volatility in the Black-Scholes model isbased on historical volatility for comparable publicly-traded banks and theCompany’s historical stock prices since inception.

The fair value ofrestricted common stock granted under the Plan is estimated using the mostrecently traded market price of the Company’s common stock at the time of thegrant.

The weightedaverage fair value of the options granted during the three months ended June30, 2007 and 2006, has been estimated using the Black-Scholes option pricingmodel with the following assumptions:
|                          | ** ** | **Three Months Ended  June 30, 2007** | ** ** | **Three Months Ended  June 30, 2006** | ** ** |
|--------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Dividend yield           |       | 0                                                         | %          | 0                                                         | %          |
| Risk-free  interest rate |       | 4.96                                                      | %          | 4.73                                                      | %          |
| Expected  volatility     |       | 5.0                                                       | %          | 22.0                                                      | %          |
| Expected life in years   |       | 6.85 Years                                                |       | 6.85 Years                                                |       |

 

As of June 30,2007, there were outstanding options under the Company’s Stock Incentive Planto purchase an aggregate of 418,950 shares of the Company’s common stock. Each option has an exercise price of between $8.00 and $10.95 per share and maybe exercised in three equal annual installments for each year of servicemeasured from the grant date.

The table belowpresents the summary of stock option and restricted stock activity for the Planduring the nine months ended June 30, 2007.

 
| ** **                            | ** ** | **Nine Months Ended June 30, 2007** | ** ** |
|---------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                            | ** ** | **Restricted Stock**                                    | ** ** | **Options** | ** ** |
| ** **                            | ** ** | **Shares**                                                   | ** ** | **Weighted  Average  Remaining  Contractual  Term in  Years** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term in  Years** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|                                  |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Outstanding,  beginning of the period |       | —                                                       |       |   |   | 301,350 |   | $ | 8.38 |   |   |   |   |   |
| Granted                               |       | 54,207                                                       |       |   |   | 120,650 |   | 8.98 |   |   |   |   |   |
| Forfeited/expired                     |       | —                                                       |       |   |   | (3,050 | ) | 8.40 |   |   |   |   |   |
| Outstanding, end  of the period       |       | 52,407                                                       |       | 3.5 |   | 418,950 |   | $ | 8.62 |   | 8.2 |   | $ | 985,902 |   |
|                                  |       |                                                              |       |  |   |  |   |   |   |   |   |   |   |
| Exercisable at  the end of the period |       | 2,401                                                        |       | — |   | 198,067 |   | $ | 8.41 |   | 7.2 |   | $ | 506,249 |   |

 

A summary of shares ofour common stock subject to our nonvested shares and options as of June 30,2007 and changes during the nine months ended June 30, 2007 is presented below:

15

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|                                     | ** ** | **Nine Months Ended June 30, 2007** | ** ** |
|-------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                          | ** ** | **Restricted Stock**                                    | ** ** | **Options** | ** ** |
| ** **                          | ** ** | **Shares**                                                   | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|                                |       |                                                         |       |   |   |   |   |   |   |
| Nonvested,  beginning of the period |       | —                                                       |       | $ | — |   | 180,400 |   | $ | 1.84 |   |
| Granted                             |       | 52,407                                                       |       | 8.26 |   | 120,650 |   | 2.48 |   |
| Vested                              |       | (2,401                                                       | )          | (8.73 | ) | (77,117 | ) | 1.79 |   |
| Forfeited/expired                   |       | —                                                       |       | — |   | (3,050 | ) | 1.83 |   |
| Nonvested, end of the  period       |       | 50,006                                                       |       | $ | 8.24 |   | 220,883 |   | $ | 2.21 |   |

 

Asof June 30, 2007, there was $713,925 of total unrecognized compensation costsrelated to nonvested share-based compensation arrangements granted under thePlan. That cost is expected to be recognized over a weighted-average period of2.8 years. No options were exercised during the three months and nine monthsended June 30, 2007.

**Note10.****              ****Other Related PartyTransactions**

**Transactionswith Former Organizing Shareholder**

On August 30, 2006, TOHI, the Company’s largestshareholder at that time, repurchased shares of its stock owned by certainprincipals of our formerly affiliated services firms, including the Company’sformer CEO Terry W. Hamann. Concurrent with this stock redemption, thoseformerly affiliated firms relocated from the headquarters building. At thattime, Mr. Hamann resigned his remaining positions with the Company includingall committee assignments and his seat on the board of directors of both theCompany and the Bank. Mr. Hamann had previously resigned his role as Chairman,CEO and President of the Company in February 2006.

**Other Transactions**

On October 11, 2005, the Company made a $355,000 loan to TOHI withmonthly interest payments due on the first of each month beginning November 1,2005. The purpose of the loan was to enable TOHI to pay off certainobligations, and to provide sufficient liquidity to TOHI until the proposedmerger with the Company was completed. On April 26, 2006, the obligation wasrenewed and increased to $373,000 at the then current prime rate. The loan wasrenewed and increased to $400,000 on September 1, 2006. The principal balance($396,000 as of September 30, 2006), along with any accrued interest, was dueand payable in full on November 1, 2006. On November 15, 2006, in connectionwith the merger of TOHI and the Company, the loan was paid in full.

On August 24, 2006, the Companymade a $2,425,000 loan to TOHI with monthly interest payments at the currentprime rate (8.25% at September 30, 2006) due on the 24th day ofeach month. The purpose of the loan was to enable TOHI to redeem shares ofcommon and preferred stock from certain of its shareholders. The loan was dueand payable on February 24, 2007 but was paid-off in full on November 15, 2006in connection with the Company’s acquisition of TOHI.

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**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 instrumentsinvolve, to varying degrees, elements of credit and interest-rate risk inexcess of the amount recognized in the consolidated balance sheet. The contractor notional amounts of those instruments reflect the extent of the Company’sinvolvement 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 same credit policies in making commitmentsand conditional obligations as they do for on-balance sheet instruments.

The following table summarizes the Company’s off-balance sheetfinancial instruments as of June 30, 2007 and September 30, 2006 (inthousands):
|                               | ** ** | **As of June  30, 2007** | ** ** | **As of September  30, 2006** | ** ** |
|-------------------------------|------------|-----------------------------------------|------------|----------------------------------------------|------------|
|                          |       |                                    |       |                                         |       |
| Commitments to  extend credit |       | $                                       | 22,537     |                                         | $          | 21,277 |   |
| Standby letters of  credit    |       | 14                                      |       | 1,935                                        |       |
|                               |            |                                         |            |                                              |            |  |  |

 

Commitments to extendcredit are agreements to lend to a customer as long as there is no violation ofany condition established in the contract. Commitments generally have fixedexpiration dates or other termination clauses and may require payment of a fee.Since many of the commitments are expected to expire without being drawn upon,the total commitment amounts do not necessarily represent future cashrequirements. The Company evaluates each customer’s creditworthiness on acase-by-case basis. The amount of collateral obtained if deemed necessary bythe Company upon extension of credit is based on management’s credit evaluationof the counterparty. Collateral held varies but may include accountsreceivable, inventory, property, plant and equipment and income-producingcommercial properties.

Standby letters of credit are written conditionalcommitments used by the Company to guarantee the performance of a customer to athird party. The Company’s policies generally require that letter of creditarrangements contain security and debt covenants similar to those contained inloan arrangements. In the event the customer does not perform in accordancewith the terms of the agreement with the third party, the Company would berequired to fund the commitment. The maximum potential amount of futurepayments the Company could be required to make is represented by thecontractual amount shown in the table above. If the commitment is funded, theCompany would be entitled to seek recovery from the customer. As of June 30,2007, no amounts have been recorded as liabilities for the Company’s potentialobligations under these guarantees.

**Note 12.****               Dividend Restrictions and Regulatory Matters**

Banks and bankholding companies are subject to regulatory capital requirements administeredby state and federal banking regulatory agencies. Capital adequacy guidelinesand, additionally for banks, prompt corrective action 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 capital requirementscan initiate regulatory action. As of June 30, 2007, management believes theBank is in compliance with all regulatory capital requirements to which it issubject.

The followingtable sets forth the bank only actual capital levels in addition to the requirementsunder prompt corrective action regulations (in thousands):

17

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|                                          | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action  Provisions** | ** ** |
|------------------------------------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                   | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                     |       |       |       |                                         |       |                                                                                         |       |   |   |   |   |   |   |
| As of June 30,  2007                     |       |       |       |                                         |       |                                                                                         |       |   |   |   |   |   |   |
| Tier 1 capital (to average assets)       |       | $          | 8,878      |                                         | 9.49       | %                                                                                            | $          | 3,742 |   | 4 | % | $ | 4,678 |   | 5 | % |
| Tier 1 capital (to risk-weighted assets) |       | 8,878      |       | 10.18                                        | %          | 3,490                                                                                        |       | 4 | % | 5,234 |   | 6 | % |
| Total Capital  (to risk-weighted assets) |       | 9,595      |       | 11.00                                        | %          | 6,979                                                                                        |       | 8 | % | 8,724 |   | 10 | % |
|                                          |            |            |            |                                              |            |                                                                                              |            |  |  |  |  |  |  |  |  |  |

 
|                                          | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action  Provisions** | ** ** |
|------------------------------------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **                                   | ** ** | ** **                                                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| As of September  30, 2006                |       |       |       |                                         |       |                                                                                         |       |   |   |   |   |   |   |
| Tier 1 capital (to average assets)       |       | $          | 8,213      |                                         | 11.07      | %                                                                                            | $          | 2,967 |   | 4 | % | $ | 3,709 |   | 5 | % |
| Tier 1 capital (to risk-weighted assets) |       | 8,213      |       | 11.39                                        | %          | 2,885                                                                                        |       | 4 | % | 4,328 |   | 6 | % |
| Total Capital  (to risk-weighted assets) |       | 8,763      |       | 12.15                                        | %          | 5,771                                                                                        |       | 8 | % | 7,213 |   | 10 | % |
|                                          |            |            |            |                                              |            |                                                                                              |            |  |  |  |  |  |  |  |  |  |

 

Asof June 30, 2007 and September 30, 2006, the Bank met the level of capitalrequired to be categorized as “well capitalized” under prompt corrective actionregulations. Management is not aware of any conditions subsequent to June 30,2007 that would change the Bank’s capital category.

TheBank is a state chartered banking association and is subject to regulation,supervision and examination by the Texas Department of Banking and the FederalDeposit Insurance Corporation (FDIC). In addition, upon making certaindeterminations with respect to the condition of any insured bank, the FDIC maybegin proceedings to terminate a bank’s federal deposit insurance.

Certainrestrictions exist regarding the ability of the Bank to pay cash dividends. Regulatoryapproval is required in order to pay dividends until such time as theaccumulated deficit is eliminated and certain other conditions are met. Further,the Company has been notified by its banking regulators that no approval willbe received in the first three years of operations.

18

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

**Introduction**

We are a bank holding company headquartered in Austin,Texas. We operate a state chartered bank, Treaty Oak Bank (the “Bank”) inAustin, Texas with a branch in Texline, Texas. We began operations in Austin,Texas on September 10, 2004. Given its greater growth potential, we arefocusing the majority of our efforts on growing a community-oriented bank outof our headquarters in Austin, Texas. In the course of preparing ourconsolidated financial statements, we use certain estimates with respect toloans, intangibles, the allowance for loan losses and other estimates necessaryfor financial reporting. We have made no significant changes to the types ofestimates and the manner in which they are determined since the filing of ourannual report on Form 10-KSB, except as otherwise noted within this discussionand analysis.

**Recent Developments**

Inconnection with the Company’s initial public offering on May 7, 2004, we issuedapproximately 315,000 of warrants to purchase registered common stock at anexercise price of $10 per share, with an expiration date of June 30, 2007. Atotal of approximately 175,000 warrants were exercised prior to the expirationdate resulting in a total increase in the Company’s capital of $1,750,000 as ofJune 30, 2007. The unexercised warrants expired as of June 30, 2007. Thecapital from the warrants will be used to support the continued growth of theBank.

On July 17, 2007, the Company’s branch in MarbleFalls, Texas opened for business. Theprimary focus of our Marble Falls branch is on medium and small commercialbusinesses, real estate lending (including interim construction and commercialreal estate loans) and agricultural lending. The Company expects to open itsnewest branch in the Barton Creek area of southwest Austin in January 2008. Theprimary focus of the Barton Creek branch will be to expand the community bankoperations of our Austin headquarters.

OnNovember 15, 2006, the Company completed the acquisition of Treaty OakHoldings, Inc. (“TOHI”) pursuant to the Agreement and Plan of Merger, datedOctober 3, 2006. TOHI was one of the five organizing shareholders of theCompany and operated as a bank holding company and significant shareholder, butotherwise had no active operations. The merger was approved by the Company’sBoard of Directors and also by the Company’s shareholders at a Special Meetingof Shareholders held on October 24, 2006. Prior to the consummation of themerger, TOHI held approximately 38% of the issued and outstanding shares of ourcommon stock.

Theprimary purpose of this merger was to achieve certain operational efficienciesfor the Company and its affiliates. The following factors were important toboth the Company and TOHI Board’s decisions to approve the merger and recommendapproval to their respective shareholders:
| (i)    | The merger would simplify the bookkeeping, financial  reporting, and corporate record keeping for the Treaty Oak affiliated  entities;                                                                                                                                                       |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                         |
| (ii)   | The merger would reduce the accounting and other  costs for the various Treaty Oak entities, including the costs associated  with the filing of multiple tax returns and regulatory reports;                                                                                                 |
|   |                                                                                                                                                                                                                                                                                         |
| (iii)  | The merger would eliminate the need to treat TOHI as  a separate “bank holding company” and make the various banking regulatory  filings;                                                                                                                                          |
|   |                                                                                                                                                                                                                                                                                         |
| (iv)   | The Company and TOHI Boards of Directors believed  that it was beneficial for the Company and TOHI shareholders to have all of  the shareholders associated with the Treaty Oak affiliated entities invested  in one organization (*i.e*., the  Company) rather than multiple organizations; |
|   | * *                                                                                                                                                                                                                                                                                     |
| (v)    | As part of the exchange, the Company would receive  net assets from TOHI, including cash and limited partnership interests in PGI  Equity Partners, LP, the entity that owns Treaty Oak Bank’s                                                                                          |

 

19

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|        | headquarters at 101 Westlake Drive, Austin, Texas,  which would increase the liquidity and financial strength of the Company;                                                                                    |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                             |
| (vi)   | The merger was anticipated to be accretive to the  Company’s tangible book value per share outstanding;                                                                                                     |
|   |                                                                                                                                                                                                             |
| (vii)  | Net operating losses incurred by TOHI may be  available to offset future earnings of the Company; and                                                                                                            |
|   |                                                                                                                                                                                                             |
| (viii) | The TOHI Board believed that the exchange of the  TOHI shares for the Company shares in connection with the merger would  improve the liquidity of such shares since the Company is a public reporting  company. |

 

The Company and TOHI were deemed to be under commoncontrol. A majority of the directors of the Company also served on TOHI’s boardof directors and were shareholders of both entities. TOHI also owned 1,000,000shares of the Company’s common stock, representing approximately 38% of theCompany shares then outstanding. Because the Company and TOHI were deemed to beunder common control, purchase accounting was not applied to the merger. Insteadthe net assets contributed by TOHI were recorded at their predecessor cost. The1,000,000 shares of Company common stock owned by TOHI were cancelled by theCompany and recorded as a reduction of its common stock accounts (par value andpaid in capital) at their fair market value, as determined by an independentappraisal, of $8.31 per share, or $8,310,000 in the aggregate. The 1,094,163new shares of Company stock issued to the TOHI shareholders were also recordedat the fair market value price of $8.31 per share, or $9,093,000 in theaggregate. The warrants issued by the Company in exchange for the TOHI warrantsand the TOHI options assumed by the Company were valued and recorded at theirfair value using a Black-Scholes pricing model.****Thenet effect of the contribution of assets and the capital stock transactions wasa $1,715,000 increase to the Company’s equity and a 94,163 net increase in thenumber of Company shares issued. Although the net assets contributed by TOHI tothe Company were not adjusted to their fair value, the assets were evaluatedfor collectibility and/or impairment according to generally accepted accountingprinciples prior to the merger and adjusted accordingly by TOHI prior to themerger.

**Results of Operations**

***General***

The following discussion analyzes the results of theCompany for the three months and nine months ended June 30, 2007, and June 30,2006.

***Net Income—General***

The Company’s fiscal year ends on September 30.Net income for the three months ended June 30, 2007, was $17,000, compared tonet income of $134,000 for the three months ended June 30, 2006. Despite anincrease in the net income of the Company’s primary subsidiary, the Bank, theCompany’s net income decreased for the three months ended June 30, 2007 ascompared to the three months ended June 30, 2006, due to the recognition ofnon-cash based stock compensation to directors and employees, increaseddirectors’ fees and decreased earnings by PGI Equity Partners, LP as a resultof reduced sublease income. The Bank’s increased net income was a result ofasset growth and increased net interest margin offset by an increase inpersonnel and related expenses to support the growth of the Company and thestart-up costs associated with the Company’s new branch in Marble Falls, Texas,which opened in July 2007.

For the nine months ended June 30, 2007 the Companyhad net income of $134,000 compared to net income of $84,000 for the ninemonths ended June 30, 2006. Again, the improvement in operations isattributable to the increase in net interest income, as the Company grew itsearnings assets at a faster pace and at a greater yield than its interestbearing liabilities, and the elimination of expenses associated with thestart-up of operations in Austin, Texas. The increase in net income was offset,in part, by increased personnel expense and by the recognition of non-cashbased stock compensation to directors and employees.

20

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Our profitability depends primarily on net interestincome, which is defined as the difference between total interest earned oninterest earning assets (investments and loans) and total interest paid oninterest bearing liabilities (deposits, borrowed funds) and non-interest income.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 is affected by changes in thevolume and mix of interest earning assets, the level of interest rates earnedon those assets, the volume and mix of interest bearing liabilities, and thelevel of interest rates paid on those interest bearing liabilities. Theprovision for loan losses is dependent upon changes in the loan portfolio andmanagement’s assessment of the collectibility of the loan portfolio, as well aseconomic and market conditions. Other income and other expenses are impacted bygrowth of operations and growth in the number of accounts through bothacquisitions and core banking business growth. Growth in operations affectsother expenses as a result of additional employees, branch facilities, andpromotional marketing expense. Growth in the number of accounts affects otherincome including service fees, as well as other expenses such as computerservices, supplies, postage, telecommunications, and other miscellaneousexpenses.

***Net Interest Income***

For the three months ended June30, 2007, our net interest income was $1,206,000 compared to $940,000 for threemonths ended June 30, 2006.  For the ninemonths ended June 30, 2007, our net interest income was $3,473,000 compared to$2,468,000 for the nine months ended June 30, 2006.

For the comparative three month periodsof June 30, 2007, and June 30, 2006, the average rate on interest-bearingliabilities increased 121 basis points, from 3.30% to 4.51%, while the averagerate on interest bearing assets increased 69 basis points from 7.87% to 8.56%during the same period.  For thecomparative nine month periods of June 30, 2007, and June 30, 2006, the averagerate on interest-bearing liabilities increased 130 basis points, from3.17% to 4.47%, while the average rate on interest bearing assets increased 81basis points from 7.71% to 8.52% during the same period. The increase in theaverage rate on interest-bearing assets and liabilities was due to a generalincrease in interest rates during the period.  Interest rates on deposits increased at afaster rate than assets as a result of increased competition for deposits andthe Company’s increased use of wholesale funding sources.

The following tables present, forthe periods indicated, the total dollar amount of interest income from averageinterest earning assets, and the resultant yields, as well as the interestexpense on average interest bearing liabilities, and the resultant costs,expressed both in dollars and rates. Yields are reflected on an annualizedbasis (in thousands except for yields).
|                                                  | ** ** | **Three Months Ended  June 30, 2007** | ** ** | **Three Months Ended  June 30, 2006** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                       | ** ** | **Average  Balance**                                      | ** ** | **Interest  (2)**                                         | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Interest  (2)** | ** ** | **Yield/  Rate** | ** ** |
| Interest Earning  Assets:                        |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Loans (1)                                        |       | $                                                         | 75,429     |                                                      | $          | 1,738 |   | 9.22 | % | $ | 50,780 |   | $ | 1,104 |   | 8.70 | % |
| Taxable investment securities                    |       | 1,461                                                     |       | 18                                                        |       | 4.93 | % | 2,856 |   | 22 |   | 3.08 | % |
| Federal funds sold                               |       | 11,196                                                    |       | 136                                                       |       | 4.86 | % | 6,030 |   | 73 |   | 4.84 | % |
| Interest bearing deposits with other banks       |       | —                                                    |       | —                                                    |       | 0.00 | % | 2,681 |   | 31 |   | 4.63 | % |
| Federal Home Loan Bank Stock                     |       | 326                                                       |       | —                                                    |       | 0.00 | % | 324 |   | 3 |   | 3.70 | % |
|                                             |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Total interest  earning assets                   |       | 88,412                                                    |       | 1,892                                                     |       | 8.56 | % | 62,671 |   | 1,233 |   | 7.87 | % |
| Non-interest  earning assets                     |       | 11,154                                                    |       |                                                      |       |   |   | 9,633 |   |   |   |   |   |
|                                             |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Total assets                                     |       | $                                                         | 99,566     |                                                      |       |   |   |   | $ | 72,304 |   |   |   |   |   |
|                                             |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Interest Bearing  Liabilities:                   |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Deposits:                                        |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| NOW and money market deposits                    |       | $                                                         | 26,527     |                                                      | $          | 245 |   | 3.69 | % | $ | 18,118 |   | $ | 105 |   | 2.32 | % |
| Savings deposits                                 |       | 525                                                       |       | 2                                                         |       | 1.45 | % | 424 |   | 1 |   | 0.94 | % |
| Time deposits                                    |       | 30,955                                                    |       | 397                                                       |       | 5.13 | % | 14,296 |   | 146 |   | 4.09 | % |
| Short-term borrowings                            |       | 167                                                       |       | 4                                                         |       | 8.47 | % | 4 |   | — |   | 0.00 | % |
| Property mortgage and long term borrowings       |       | 2,625                                                     |       | 39                                                        |       | 5.99 | % | 2,687 |   | 41 |   | 6.10 | % |
|                                             |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Total interest  bearing liabilities              |       | 60,799                                                    |       | 686                                                       |       | 4.51 | % | 35,529 |   | 293 |   | 3.30 | % |
| Demand  deposits—non-interest bearing       |       | 24,036                                                    |       |                                                      |       |   |   | 24,937 |   |   |   |   |   |
| Other non-interest  bearing liabilities          |       | 640                                                       |       |                                                      |       |   |   | 707 |   |   |   |   |   |
| Shareholders’  equity                       |       | 14,091                                                    |       |                                                      |       |   |   | 11,131 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity |       | $                                                         | 99,566     |                                                      |       |   |   |   | $ | 72,304 |   |   |   |   |   |
|                                             |       |                                                           |       |                                                      |       |   |   |   |   |   |   |   |   |
| Net interest  income                             |       |                                                      |       | $                                                         | 1,206      |   |   |   |   |   | $ | 940 |   |   |   |
|                                             |       |                                                           |       |                                                      |       |   |   |   |   |   |   |   |   |
| Interest rate  spread (3)                        |       |                                                      |       |                                                      |       | 4.05 | % |   |   |   |   | 4.57 | % |
| Net interest margin (4)                          |       |                                                      |       |                                                      |       | 5.46 | % |   |   |   |   | 6.00 | % |

 

21

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|                                                  | ** ** | **Nine Months Ended  June 30, 2007** | ** ** | **Nine Months Ended  June 30, 2006** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                       | ** ** | **Average  Balance**                                     | ** ** | **Interest  (2)**                                        | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Interest  (2)** | ** ** | **Yield/  Rate** | ** ** |
|                                             |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Interest Earning  Assets:                        |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Loans (1)                                        |       | $                                                        | 70,636     |                                                     | $          | 4,882 |   | 9.22 | % | $ | 44,334 |   | $ | 2,887 |   | 8.68 | % |
| Taxable investment securities                    |       | 1,528                                                    |       | 49                                                       |       | 4.28 | % | 3,463 |   | 76 |   | 2.93 | % |
| Federal funds sold                               |       | 11,583                                                   |       | 444                                                      |       | 5.11 | % | 5,006 |   | 181 |   | 4.82 | % |
| Interest bearing deposits with other banks       |       | —                                                   |       | —                                                   |       | 0.00 | % | 2,815 |   | 83 |   | 3.93 | % |
| Federal Home Loan Bank Stock                     |       | 326                                                      |       | —                                                   |       | 0.00 | % | 320 |   | 7 |   | 3.34 | % |
| Total interest  earning assets                   |       | 84,073                                                   |       | 5,375                                                    |       | 8.52 | % | 55,938 |   | 3,235 |   | 7.71 | % |
| Non-interest  earning assets                     |       | 11,163                                                   |       |                                                     |       |   |   | 18,173 |   |   |   |   |   |
| Total assets                                     |       | $                                                        | 95,236     |                                                     |       |   |   |   | $ | 74,111 |   |   |   |   |   |
|                                             |       |                                                          |       |                                                     |       |   |   |  |   |   |   |   |   |
| Interest Bearing  Liabilities:                   |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Deposits:                                        |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| NOW and money market deposits                    |       | $                                                        | 28,420     |                                                     | $          | 784 |   | 3.68 | % | $ | 15,557 |   | $ | 289 |   | 2.48 | % |
| Savings deposits                                 |       | 527                                                      |       | 6                                                        |       | 1.46 | % | 448 |   | 2 |   | 0.60 | % |
| Time deposits                                    |       | 24,778                                                   |       | 963                                                      |       | 5.18 | % | 123503 |   | 372 |   | 3.67 | % |
| Short-term borrowings                            |       | 574                                                      |       | 29                                                       |       | 6.74 | % | 46 |   | — |   | 0.00 | % |
| Property mortgage and long term borrowings       |       | 2,441                                                    |       | 119                                                      |       | 6.51 | % | 2,702 |   | 104 |   | 5.13 | % |
|                                             |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Total interest  bearing liabilities              |       | 56,740                                                   |       | 1,902                                                    |       | 4.47 | % | 32,256 |   | 767 |   | 3.17 | % |
| Demand  deposits—non-interest bearing       |       | 24,616                                                   |       |                                                     |       |   |   | 21,055 |   |   |   |   |   |
| Other non-interest  bearing liabilities          |       | 577                                                      |       |                                                     |       |   |   | 10,628 |   |   |   |   |   |
| Shareholders’  equity                       |       | 13,303                                                   |       |                                                     |       |   |   | 10,173 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity |       | $                                                        | 95,236     |                                                     |       |   |   |   | $ | 74,111 |   |   |   |   |   |
|                                             |       |                                                          |       |                                                     |       |   |   |   |   |   |   |   |   |
| Net interest  income                             |       |                                                     |       | $                                                        | 3,473      |   |   |   |   |   | $ | 2,468 |   |   |   |
|                                             |       |                                                     |       |                                                          |       |   |   |   |   |   |   |   |   |
| Interest rate  spread (3)                        |       |                                                     |       |                                                     |       | 4.05 | % |   |   |   |   | 4.54 | % |
| Net interest margin (4)                          |       |                                                     |       |                                                     |       | 5.51 | % |   |   |   |   | 5.88 | % |

 

----

(1)                                  Non-accrual loans areincluded in average loans.

(2)                                  Interest income includesloan fees of $73,000 and $178,000, for the three and nine months ended June 30,2007, respectively and $38,000 and $94,000 for the three and nine months ended June30, 2006.

(3)                                  Interest rate spreadrepresents the difference between the average yield on interest earning assetsand the average cost of interest bearing liabilities.

(4)                                  Net interest marginrepresents annualized net interest income as a percentage of average interestearning assets.

22

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***Volume,Mix and Rate Analysis of Net Interest Income***

The following table presents theextent to which changes in volume, changes in interest rates, and changes inthe interest rates times the changes in volume of interest earning assets andinterest bearing liabilities affected the Bank’s interest income and interestexpense during the period indicated. Information is provided on changes in eachcategory due to (1) changes attributable to changes in volume (change involume times the prior period interest rate), (2) changes attributable tochanges in interest rate (changes in rate times the prior period volume), and(3) changes attributable to changes in rate/volume (changes in interestrate times changes in volume). Changes attributable to the combined impact ofvolume and rate have been allocated proportionally to the changes due to volumeand the changes due to rate (in thousands):
|                                             | ** ** | **Three Months Ended June 30, 2007  Compared to  Three Months Ended June 30, 2006** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Change Due to  Volume**                                                                                                        | ** ** | **Change Due to  Rate** | ** ** | **Total Change** | ** ** |
|                                        |       |                                                                                                                                       |       |   |   |   |   |
| Interest Earning  Assets:                   |       |                                                                                                                                       |       |   |   |   |   |
| Loans                                       |       | $                                                                                                                                          | 568        |   | $ | 66 |   | $ | 634 |   |
| Taxable investment securities               |       | (17                                                                                                                                        | )          | 13 |   | (4 | ) |
| Federal funds sold                          |       | 63                                                                                                                                         |       | — |   | 63 |   |
| Interest bearing deposits with other banks  |       | (32                                                                                                                                        | )          | 1 |   | (31 | ) |
| Increase in  interest income                |       | $                                                                                                                                          | 582        |   | $ | 80 |   | $ | 662 |   |
|                                        |       |                                                                                                                                            |       |  |   |  |   |
| Interest Bearing  Liabilities:              |       |                                                                                                                                       |       |   |   |   |   |
| NOW and money market deposit accounts       |       | $                                                                                                                                          | 78         |   | $ | 62 |   | $ | 140 |   |
| Savings deposits                            |       | 1                                                                                                                                          |       | 1 |   | 2 |   |
| Time deposits                               |       | 214                                                                                                                                        |       | 37 |   | 251 |   |
| Short-term borrowings                       |       | 3                                                                                                                                          |       | 1 |   | 4 |   |
| Long term borrowings                        |       | (1                                                                                                                                         | )          | (1 | ) | (2 | ) |
| Increase in  interest expense               |       | 295                                                                                                                                        |       | 100 |   | 395 |   |
| Increase  (decrease) in net interest income |       | $                                                                                                                                          | 287        |   | $ | (20 | ) | $ | 267 |   |

 
|                                             | ** ** | **Nine Months Ended June 30, 2007  Compared to  Nine Months Ended June 30, 2006** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Change Due   to Volume**                                                                                                | ** ** | **Change Due to  Rate** | ** ** | **Total Change** | ** ** |
|                                        |       |                                                                                                                                     |       |   |   |   |   |
| Interest Earning  Assets:                   |       |                                                                                                                                     |       |   |   |   |   |
| Loans                                       |       | $                                                                                                                                        | 1,212      |   | $ | 119 |   | $ | 1,331 |   |
| Taxable investment securities               |       | (41                                                                                                                                      | )          | 23 |   | (18 | ) |
| Federal funds sold                          |       | 168                                                                                                                                      |       | 7 |   | 175 |   |
| Interest bearing deposits with other banks  |       | (59                                                                                                                                      | )          | 4 |   | (55 | ) |
| Increase in  interest income                |       | $                                                                                                                                        | 1,280      |   | $ | 153 |   | $ | 1,433 |   |
|                                        |       |                                                                                                                                          |       |  |   |  |   |
|  Interest Bearing Liabilities:         |       |                                                                                                                                     |       |   |   |   |   |
| NOW and money market deposit accounts       |       | $                                                                                                                                        | 237        |   | $ | 93 |   | $ | 330 |   |
| Savings deposits                            |       | 1                                                                                                                                        |       | 2 |   | 3 |   |
| Time deposits                               |       | 292                                                                                                                                      |       | 102 |   | 394 |   |
| Short-term borrowings                       |       | 18                                                                                                                                       |       | 2 |   | 20 |   |
| Long term borrowings                        |       | (8                                                                                                                                       | )          | 19 |   | 11 |   |
| Increase in  interest expense               |       | 540                                                                                                                                      |       | 218 |   | 758 |   |
| Increase  (decrease) in net interest income |       | $                                                                                                                                        | 740        |   | $ | (65 | ) | $ | 675 |   |

 

23

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***Provision for Loan Losses***

The provision for loan losses is an expense determinedby management as the amount necessary to increase the allowance for loan lossesafter net charge-offs have been deducted to a level that, in management’s bestestimate, is necessary to absorb probable losses in the loan portfolio. Theamount of the provision is based on management’s review of the loan portfolioand consideration of such factors as historical loss experience, generalprevailing economic conditions, changes in the size and composition of the loanportfolio and specific borrower considerations, including the ability of theborrower to repay the loan and the estimated value of the underlyingcollateral. The provision is calculated monthly and a charge or credit toexpense is made, as required, to adjust the allowance to the calculated level.

For the three months ended June 30, 2007, the Bankmade $75,000 in provisions for loan losses, compared to $90,000 for the threemonths ended June 30, 2006.  For thethree months ended June 30, 2007, the Bank charged off $7,000 in commercial andconsumer loans and had recoveries of loans previously charged-off of $3,000 fornet charge-offs of $4,000. For the three months ended June 30, 2006, the Bankcharged off $12,000 in commercial and consumer loans and had recoveries ofloans previously charged-off of $1,000 for net charge-offs of $11,000. Thefactors combined increased the Allowance for Loan Losses to $717,000 or 0.91%of the portfolio at June 30, 2007 as compared to 0.91% at September 30, 2006.This amount represents management’s estimate of probable losses inherent in theportfolio.  For the nine months ended June30, 2007 and June 30, 2006, the provision for loan losses was $220,000 and $180,000,respectively.  For the nine months ended June30, 2007, the Bank charged-off $58,000 in commercial and consumer loans and hadrecoveries of loans previously charged-off of 5,000 for a net charge-off of $53,000.  For the nine months ended June 30, 2006, theBank charged-off $22,000 in commercial and consumer loans and had recoveries ofloans previously charged-off of $2,000 for a net charge-off of $20,000.

***OtherIncome***

For the three months ended June30, 2007, other income decreased $40,000 from $144,000 during the three monthsended June 30, 2006, to $104,000. The majority of the decrease was related tothe decrease in sublease income in PGI Equity Partners, LP.  For the nine months ended June 30, 2007,other income decreased $76,000 from $385,000 during the nine months ended June30, 2006 to $309,000. The decrease also was due to the decrease in subleaseincome.

***Non-InterestExpenses***

For the three months ended June30, 2007, salaries and employee benefits were $691,000 compared to $420,000 forthe three months ended June 30, 2006.  Theincrease in salaries and employee benefits was due to the Bank’s continuedgrowth and new branch openings and the corresponding addition of newemployees.  Stock based compensationrecognized for the three months ended June 30, 2007 totaled $92,000. Occupancyand equipment expenses for the three months ended June 30, 2007 decreased from$109,000 for the three months ended June 30, 2006 to $84,000.  Professional fees paid for accounting andlegal services, including regulatory filings and audit services, totaled $76,000and $63,000, respectively, for the three months ended June 30, 2007 and 2006.  The increase was due to an increase inexpense for professional tax and consulting fees.  Other expenses increased from $268,000 forthe three months ended June 30, 2006, to $367,000 for the three months ended June30, 2007.  This increase in otherexpenses was also a result of the growth of the Bank and the increase inemployees and the start-up expenses for the opening of the branch in MarbleFalls.

***Income Taxes***

No federal tax benefit has been recorded for the threeand nine months ended June 30, 2007, based upon net operating losses incurredand carried forward in previous years. Because of the Company’s limitedoperating history, the federal tax benefit of the cumulative losses has beenfully reserved against.  The Company hasnow achieved profitability for the previous six quarters and therefore, theCompany continues to evaluate whether the trend of profitable operationssupports the recording of federal tax benefits in a subsequent quarter.  However, due to the uncertainties in thecurrent interest rate environment, the start-up costs associated with theCompany’s branch expansion and the costs necessary to implement Sarbanes-OxleySection 404 compliance in the next fiscal year, the 

24

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Companybelieves a valuation allowance is warranted and will continue to monitor andevaluate the need for a valuation allowance.

**Financial Condition**

***Loan Portfolio***

Net loans increased $18,381,000 (30.8%) to $78,001,000from $59,620,000 between June 30, 2007 and September 30, 2006. Theconcentration within the portfolio has shifted over time from the previousconcentration of agricultural loans to real estate and commercial loans.

***Loan Portfolio Mix***

The following tables set forth the composition of theloan portfolio (in thousands):
|                                  | ** ** | **As of June 30,  2007** | ** ** | **As of September 30,  2006** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|----------------------------------------------|------------|
|                             |       |                                    |       |                                         |       |
| Agriculture                      |       | $                                       | 2,758      |                                         | $          | 2,989 |   |
| Commercial                       |       | 28,451                                  |       | 19,068                                       |       |
| Commercial real  estate          |       | 18,129                                  |       | 18,582                                       |       |
| Residential real  estate         |       | 9,079                                   |       | 8,221                                        |       |
| Construction  real estate        |       | 13,940                                  |       | 4,329                                        |       |
| Consumer and  other              |       | 6,361                                   |       | 6,981                                        |       |
| Gross Loans                      |       | 78,718                                  |       | 60,170                                       |       |
| Less: allowance  for loan losses |       | (717                                    | )          | (550                                         | )          |
|                             |       |                                    |       |                                         |       |
| Net Loans                        |       | $                                       | 78,001     |                                         | $          | 59,620 |   |

 

Loan concentrations are considered to exist when thereare amounts loaned to a multiple number of borrowers engaged in similaractivities that would cause them to be similarly impacted by economic or otherconditions.

For the three month and nine month periods ended June30, 2007, the majority of new loan growth came from the Austin marketreflecting a broader, more diverse mix of industries and borrowers.

Management may renew loans at maturity when requestedby a customer whose financial strength appears to support such a renewal orwhen such a renewal appears to be in the best interest of the Bank. The Bankrequires payment of accrued interest in such instances and may adjust the rateof interest, require a principal reduction, or modify other terms of the loanat the time of renewal.

***Loan Maturities***

The following table presents the contractual maturityranges for agricultural, commercial, real estate and consumer loans outstandingat June 30, 2007, and at September 30, 2006, and also presents for eachmaturity range the portion of loans that have fixed interest rates or interestrates that fluctuate over the life of the loan in accordance with changes inthe interest rate environment as represented by the base rate (in thousands):

25

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| ** **                       | ** ** | **Due in One Year  or Less** | ** ** | **Due after One Year  Through  Five Years** | ** ** | **Due after  Five Years** | ** ** | ** **         | ** ** |
|----------------------------------|------------|--------------------------------------------------|------------|-----------------------------------------------------------------|------------|-------------------------------------|------------|--------------------|------------|
| **June 30, 2007**      | ** ** | **Fixed  Rate**                                  | ** ** | **Floating  Rate**                                              | ** ** | **Fixed  Rate**                     | ** ** | **Floating  Rate** | ** ** | **Fixed  Rate** | ** ** | **Floating  Rate** | ** ** | **Total** | ** ** |
|                             |       |                                             |       |                                                            |       |                                |       |               |       |   |   |   |   |   |   |
| Agricultural                     |       | $                                                | 33         |                                                            | $          | 1,687                               |       | $                  | —     |   | $ | 551 |   | $ | — |   | $ | 487 |   | $ | 2,758 |   |
| Real estate –  residential  |       | 1,470                                            |       | 2,205                                                           |       | 1,888                               |       | 2,312              |       | 1,204 |   | — |   | 9,079 |   |
| Real estate –  commercial   |       | 201                                              |       | 7,841                                                           |       | 284                                 |       | 8,819              |       | — |   | 984 |   | 18,129 |   |
| Real estate –  construction |       | 1,001                                            |       | 5,039                                                           |       | 181                                 |       | 6,251              |       | — |   | 1,468 |   | 13,940 |   |
| Commercial                       |       | 2,302                                            |       | 14,813                                                          |       | 1,114                               |       | 10,216             |       | — |   | 6 |   | 28,451 |   |
| Consumer and  other              |       | 421                                              |       | 4,510                                                           |       | 757                                 |       | 634                |       | 18 |   | 21 |   | 6,361 |   |
| **Total**                        |       | $                                                | 5,428      |                                                            | $          | 36,095                              |       | $                  | 4,224      |   | $ | 28,783 |   | $ | 1,222 |   | $ | 2,966 |   | $ | 78,718 |   |

 
| ** **                       | ** ** | **Due in One Year  or Less** | ** ** | **Due after One Year  Through  Five Years** | ** ** | **Due after  Five Years** | ** ** | ** **         | ** ** |
|----------------------------------|------------|--------------------------------------------------|------------|-----------------------------------------------------------------|------------|-------------------------------------|------------|--------------------|------------|
| **September 30, 2006** | ** ** | **Fixed  Rate**                                  | ** ** | **Floating  Rate**                                              | ** ** | **Fixed  Rate**                     | ** ** | **Floating  Rate** | ** ** | **Fixed  Rate** | ** ** | **Floating  Rate** | ** ** | **Total** | ** ** |
|                             |       |                                             |       |                                                            |       |                                |       |               |       |   |   |   |   |   |   |
| Agricultural                     |       | $                                                | 6          |                                                            | $          | 2,137                               |       | $                  | —     |   | $ | 342 |   | $ | — |   | $ | 504 |   | $ | 2,989 |   |
| Real estate –  residential  |       | 163                                              |       | 2,635                                                           |       | 1,976                               |       | 1,914              |       | 1,533 |   | — |   | 8,221 |   |
| Real estate –  commercial   |       | 323                                              |       | 3,335                                                           |       | 258                                 |       | 9,928              |       | — |   | 4,738 |   | 18,582 |   |
| Real estate –  construction |       | 1,049                                            |       | 202                                                             |       | 1,013                               |       | 2,065              |       | — |   | — |   | 4,329 |   |
| Commercial                       |       | 173                                              |       | 12,118                                                          |       | 1,589                               |       | 5,050              |       | 27 |   | 111 |   | 19,068 |   |
| Consumer and  other              |       | 559                                              |       | 5,166                                                           |       | 652                                 |       | 550                |       | 31 |   | 23 |   | 6,981 |   |
| **Total**                        |       | $                                                | 2,273      |                                                            | $          | 25,593                              |       | $                  | 5,488      |   | $ | 19,849 |   | $ | 1,591 |   | $ | 5,376 |   | $ | 60,170 |   |

 

As of June 30, 2007, 52.7% of the loan portfolio, or $41,523,000,matures within one year or less and $67,844,000 of the loan portfolio, or 86.2%,are variable rate loans.  At September 30,2006, 46.3% of the loan portfolio or $27,866,000, matured within one year or lessand $57,818,000 of these loans, or 84.5%, were variable rate loans.

***InvestmentSecurities***

The primary purposes of the investment portfolio areto provide a source of earnings for liquidity management purposes, to providecollateral to pledge against public deposits, and to control interest raterisk. In managing the portfolio, the Bank seeks to attain the objectives ofsafety of principal, liquidity, diversification, and maximized return oninvestment.

The following tables set forth the amortized cost andfair value of the Bank’s securities portfolio by accounting classificationcategory and by type of security as indicated (in thousands) as of June 30,2007 and September 30, 2006:
|                                      | ** ** | **As of  June 30, 2007** | ** ** | **As of  September 30, 2006** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|----------------------------------------------|------------|
| ** **                           | ** ** | **Amortized  Cost**                     | ** ** | **Fair  Value**                              | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| Securities  Available for Sale:      |       |                                    |       |                                         |       |   |   |   |   |
| U.S. Government Agencies             |       | $                                       | 9          |                                         | $          | 9 |   | $ | 14 |   | $ | 14 |   |
| Other mortgage backed securities     |       | 2                                       |       | 2                                            |       | 2 |   | 2 |   |
| Total Securities  Available for Sale |       | $                                       | 11         |                                         | $          | 11 |   | $ | 16 |   | $ | 16 |   |
|                                 |       |                                         |       |                                              |       |  |   |  |   |
| Securities Held  to Maturity:        |       |                                    |       |                                         |       |   |   |   |   |
| U.S. Government Agencies             |       | $                                       | 1,446      |                                         | $          | 1,446 |   | $ | 2,000 |   | $ | 1,996 |   |
| Other mortgage backed securities     |       | 5                                       |       | 4                                            |       | 6 |   | 5 |   |
|                                 |       |                                    |       |                                         |       |   |   |   |   |
| Total Securities  Held to Maturity   |       | $                                       | 1,451      |                                         | $          | 1,450 |   | $ | 2,006 |   | $ | 2,001 |   |

 

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U.S. Treasury securities and securities of U.S.Government agencies generally consist of fixed rate securities with maturitiesof three months to five years. Other mortgage backed securities consists offixed rate mortgage pass-through securities with a maturity of five to fifteenyears.

***Asset Quality***

The following table sets forth the amount ofnon-performing loans and non-performing assets as of June 30, 2007, andSeptember 30, 2006 (in thousands except for percentages):
|                                                          | ** ** | **As of  June 30,  2007** | ** ** | **As of   September 30,  2006** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------------------|------------|
| Non-accruing  loans                                      |       | $                                   | 95         |                                           | $          | 123 |   |
| Loans 90 days or  more past due, still accruing interest |       | —                              |       | —                                         |       |
|                                                     |       |                                |       |                                           |       |
| Total non-performing  loans                              |       | 95                                  |       | 123                                            |       |
| Other real  estate owned                                 |       | 76                                  |       | 41                                             |       |
| Other  repossessed assets                                |       | 1                                   |       | 5                                              |       |
|                                                     |       |                                |       |                                           |       |
| Total non-performing  assets                             |       | $                                   | 172        |                                           | $          | 169 |   |
|                                                     |       |                                     |       |                                                |       |
| Total non-performing  loans to total loans               |       | 0.22                                | %          | 0.20                                           | %          |
| Allowance for  loan losses to non-performing loans       |       | 417                                 | %          | 447                                            | %          |
| Total non-performing  assets to total assets             |       | 0.15                                | %          | 0.17                                           | %          |

 

***Non-performing Loans***

Non-performing loans include (1) loans accountedfor on a non-accrual basis, (2) accruing loans contractually past due90 days or more as to interest and principal, and (3) troubled debtrestructurings. Management reviews the loan portfolio for problem loans on anongoing basis.

During the ordinary course ofbusiness, management becomes aware of borrowers that may not be able to meetthe contractual requirements of loan agreements. Such loans are placed underclose supervision with consideration given to placing the loan on a non-accrualstatus, increasing the allowance for loan losses, and (if appropriate) partialor full 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 June 30, 2007 and $2,600 forthe three months ended June 30, 2006. This amount was not included in interestincome during this period.

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Under Federal and Texas law, anyloan 90 or more days past due is required to be placed on non-accrual basisunless specifically identified mitigating circumstances exist. Our policy is toplace loans 90 days past due on non-accrual status. An exception is madewhen management believes the loan is fully secured and in process ofcollection. Non-accrual loans are further classified as impaired whenunderlying collateral is not sufficient to cover the loan balance and it isprobable that we will not fully collect all principal and interest. As of June30, 2007 and September 30, 2006, we had $95,000 and $123,000 in non-accrualloans, respectively. There were no loans contractually past due over90 days which continued to accrue interest on June 30, 2007 and September 30,2006, based upon specific information available at that time tomanagement.  In compliance with thesestatutes, we have developed pro forma financial statements assuming that noloans will continue to accrue interest if they become 90 days past due,and instead transfer all such loans to non-accruing status.

A “troubled debt restructuring”is a restructured loan upon which interest accrues at a below market rate orupon which 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 notroubled debt restructurings outstanding as of June 30, 2007 andSeptember 30, 2006*.*

Non-performing assets alsoconsist of other repossessed assets and other real estate owned (“OREO”). OREOrepresents properties acquired through foreclosure or other proceedings and isrecorded at the lower of cost or fair market value less the estimated cost ofdisposal. OREO is evaluated regularly to ensure that the recorded amount issupported by its current fair market value. Valuation allowances to reduce thecarrying amount to fair market value less estimated costs of disposal arerecorded as necessary. Revenues and expenses from the operations of OREO andchanges in the valuation are included in other income and other expenses on theincome statement. As of June 30, 2007, and September 30, 2006, we had $76,000 and$41,000, respectively, in other real estate owned.  The property consists of three single familydwellings located in Texline and Dalhart, Texas.  Repossessed assets totaled $1,000 and $5,000,respectively, at June 30, 2007 and September 30, 2006.

***Sources of Funds***

*General*

Deposits, short-term andlong-term borrowings, loan and investment security repayments and prepayments,proceeds from the sale of securities, and cash flows generated from operationsare the primary 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 depositaccounts with a range of interest rates and terms. Core deposits consist ofchecking accounts (non-interest bearing), “NOW” accounts, money marketaccounts, savings accounts, and non-public certificates of deposit. Thesedeposits, along with public fund deposits and short-term borrowings, are usedto support our asset base. Deposits are obtained predominantly from thegeographic trade areas surrounding our office locations. We rely primarily oncustomer service and long-standing relationships with customers to attract andretain deposits; however, market interest rates and rates offered by competingfinancial institutions significantly affect our ability to attract and retaindeposits.  As the competition fordeposits has increased, we have continued to expand and diversify the Bank’sfunding sources.  For the three months andnine months ended June 30, 2007, we have increased institutional deposits toensure adequate funding of our loan growth.

The following table sets forth the maturities of timedeposits $100,000 and over as of June 30, 2007, and September 30, 2006 (inthousands):

28

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|                                          | ** ** | **As of  June 30,  2007** | ** ** | **As of   September 30,  2006** | ** ** |
|------------------------------------------|------------|-------------------------------------|------------|------------------------------------------------|------------|
| Time deposits  $100,000 and over:        |       |                                |       |                                           |       |
| Maturing within three months             |       | $                                   | 9,822      |                                           | $          | 1,949 |   |
| After three months but within six months |       | 2,281                               |       | 3,982                                          |       |
| After six months but within 12 months    |       | 3,198                               |       | 3,058                                          |       |
| After 12 months                          |       | 1,412                               |       | —                                         |       |
|                                     |       |                                |       |                                           |       |
| Total time  deposits $100,000 and over   |       | $                                   | 16,713     |                                           | $          | 8,989 |   |

 

*Return on Equity and Assets*

The following table sets forth certain informationregarding the Company’s return on equity and assets for the periods indicated:
|                        | ** ** | **For the Three Months  Ended** | ** ** | **For the Nine Months  Ended** | ** ** |
|------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **             | ** ** | **June 30,  2007**                        | ** ** | **June 30,  2006**                       | ** ** | **June 30,  2007** | ** ** | **June 30,  2006** | ** ** |
|                   |       |                                           |       |                                          |       |   |   |   |   |
| Return on assets       |       | 0.06                                           | %          | 0.18                                          | %          | 0.21 | % | 0.11 | % |
| Return on equity       |       | 0.45                                           | %          | 1.20                                          | %          | 1.60 | % | 0.75 | % |
| Dividend payout  ratio |       | 0                                              | %          | 0                                             | %          | 0 | % | 0 | % |
| Equity to assets ratio |       | 13.36                                          | %          | 15.02                                         | %          | 13.36 | % | 15.02 | % |

 

**Capital Resources**

In connection with theCompany’s initial public offering on May 7, 2004, we issued approximately315,000 of warrants to purchase registered common stock at an exercise price of$10 per share, with an expiration date of June 30, 2007.  A total of approximately 175,000 warrantswere exercised prior to the expiration date resulting in an increase in theCompany’s capital of $1,750,000.  Duringthe three months ended June 30, 2007, 168,265 warrants were exercised, therebyincreasing the Company’s capital by $1,682,650. The unexercised warrants expired as of June 30, 2007.  The capital from the warrants will be used tosupport the continued growth of the Bank.

The risk-based capitalregulations established and administered by the banking regulatory agenciesdiscussed previously are applicable to the Bank. Risk-based capital guidelinesare designed to make regulatory capital requirements more sensitive todifferences in risk profiles among banks, to account for off-balance sheetexposure, and to minimize disincentives for holding liquid assets. Under theregulations, assets and off-balance sheet items are assigned to broad riskcategories, each with appropriate weights. The resulting capital ratiosrepresent capital as a percentage of total risk weighted assets and off-balancesheet items. Under the prompt corrective action regulations, to be adequatelycapitalized a bank must maintain minimum ratios of total capital torisk-weighted assets of 8.00%, Tier 1 capital to risk-weighted assets of 4.00%,and Tier 1 capital to total assets of 4.00%. Failure to meet these capitalrequirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial effect on the Bank’s financial statements.

As of June 30, 2007 and as ofSeptember 30, 2006, the most recent notifications from the federal Bankingregulators categorized the Bank as well-capitalized. A well-capitalizedinstitution must maintain a minimum ratio of total capital to risk-weightedassets of at least 10.00%, a minimum ratio of Tier 1 capital to risk weightedassets of at least

29

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6.00%, and a minimum ratio of Tier 1 capital to totalassets of at least 5.00% and must not be subject to any written order,agreement, or directive requiring it to meet or maintain a specific capitallevel. There are no conditions or events since that notification that the Bank’smanagement believes have changed the capital classification.

The Bank was in full compliancewith all applicable capital adequacy requirements as of June 30, 2007 andSeptember 30, 2006. The required and actual amounts and ratios for the Bank asof June 30, 2007 and September 30, 2006, are presented below:
| ** **                               | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action  Provisions** | ** ** |
|------------------------------------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                   | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| As of June 30,  2007                     |       |       |       |                                         |       |                                                                                         |       |   |   |   |   |   |   |
| Tier 1 capital (to average assets)       |       | $          | 8,878      |                                         | 9.49       | %                                                                                            | $          | 3,742 |   | 4 | % | $ | 4,678 |   | 5 | % |
| Tier 1 capital (to risk-weighted assets) |       | 8,878      |       | 10.18                                        | %          | 3,490                                                                                        |       | 4 | % | 5,234 |   | 6 | % |
| Total Capital  (to risk-weighted assets) |       | 9,595      |       | 11.00                                        | %          | 6,979                                                                                        |       | 8 | % | 8,724 |   | 10 | % |
|                                          |            |            |            |                                              |            |                                                                                              |            |  |  |  |  |  |  |  |  |  |

 
| ** **                               | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action  Provisions** | ** ** |
|------------------------------------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| As of September  30, 2006                |       |       |       |                                         |       |                                                                                         |       |   |   |   |   |   |   |
| Tier 1 capital (to average assets)       |       | $          | 8,213      |                                         | 11.07      | %                                                                                            | $          | 2,967 |   | 4 | % | $ | 3,709 |   | 5 | % |
| Tier 1 capital (to risk-weighted assets) |       | 8,213      |       | 11.39                                        | %          | 2,885                                                                                        |       | 4 | % | 4,328 |   | 6 | % |
| Total Capital  (to risk-weighted assets) |       | 8,763      |       | 12.15                                        | %          | 5,771                                                                                        |       | 8 | % | 7,213 |   | 10 | % |
|                                          |            |            |            |                                              |            |                                                                                              |            |  |  |  |  |  |  |  |  |  |

 

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

Withthe participation of management, the Company’s chief executive officer andchief financial officer reviewed and evaluated the Company’s disclosurecontrols and procedures 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 chief executive officer and chieffinancial officer concluded that the disclosure controls and procedures areeffective to ensure that the information required to be disclosed by theCompany in reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported to the Company’s management within the timeperiods specified in the Securities and Exchange Commission’s rules and forms.

Therehave been no significant changes in the Company’s internal controls forfinancial reporting or in other factors that could significantly affect thesecontrols, including any significant deficiencies or material weaknesses ofinternal controls that would require corrective action.  In connection with the new rules, the Companyis currently in the process of further reviewing and documenting its disclosurecontrols and procedures, including its internal accounting controls, and mayfrom time to time make changes aimed at enhancing their effectiveness and ensuringthat the Company’s systems evolve with its business.

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**PART II.                OtherInformation**

**Item 1.                    *LegalProceedings***

None

**Item 2.                    *Unregistered Sales of Equity Securities and Use of Proceeds***

OnMay 7, 2004, the Securities and Exchange Commission declared our RegistrationStatement on Form SB-2 (File No. 333-112325) related to our initial publicoffering effective.  In addition, onOctober 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 totalof 1,944,000 shares of our common stock, of which 324,000 shares are issuableunder registered common stock warrants. We accepted subscriptions for 1,589,602 shares of our common stock underthe offering and have received net offering proceeds (after deducting offeringexpenses) of approximately $11.9 million.

From the offering proceeds, we paidour organizing shareholder and affiliate, Treaty Oak Holdings, Inc. (“TOHI”)for reimbursement of expenses and advances on our behalf in connection with ouroffering and repayment of the amount due under a convertible promissory note. TOHIowned approximately 39% of our common stock, but was acquired by us in atransaction that closed on November 15, 2006. We contributed to the capital ofthe Bank and paid operating expenses including repayment of certain costspreviously paid by TOHI. We also repaid principal and interest under unsecuredpromissory notes issued in connection with the purchase price of the Bank, andhave paid ongoing operating expenses. These payments are summarized in thetable below:
|                                                                                                                                                                                           | ** ** | **As of**              | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                | ** ** | **June 30, 2007** | ** ** |
| Gross proceeds  from sale of shares                                                                                                                                                       |       | $                           | 13,276,271 |   |
| Gross proceeds  from exercise of warrants                                                                                                                                                 |       | 1,522,600                   |       |
| 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)                                                                                                                    |       | (202,368                    | )          |
| Payments to  officers (salary and benefits)                                                                                                                                               |       | (337,108                    | )          |
| Other payments  to affiliates for services                                                                                                                                                |       | (149,057                    | )          |
| Limited  partnership investment in affiliated limited partnership                                                                                                                         |       | (1,030,000                  | )          |
| Loan to  affiliated company                                                                                                                                                               |       | (46,037                     | )          |
| Repurchase of  shares issued                                                                                                                                                              |       | (50,005                     | )          |
| Payment of additional  operating expenses (estimated)                                                                                                                                     |       | (1,030,200                  | )          |
| Remaining net proceeds                                                                                                                                                                    |       | $                           | 2,156,462  |   |

 

In connection with theCompany’s initial registered public offering on May 7, 2004, we issued warrantsto purchase approximately 315,000 shares common stock at an exercise price of$10 per share, with an expiration date of June 30, 2007.  A total of approximately 175,000 warrantswere exercised prior to the expiration date resulting in a total increase inthe Company’s capital of $1,750,000.  Ofthe total warrants exercised, $1,522,600 of the proceeds

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 had been received in cash by June 30,2007.  The unexercised warrants expiredas of June 30, 2007.  The capital fromthe warrants will be used to support the continued growth of the Bank.

## **Item3.                    *Defaults Upon Senior Securities***

## **None.**

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

None.

**Item 5.                    *Other Information***

None.

**Item 6.                    *Exhibits***
| Exhibit   Number | ** ** | **Exhibit Title**                                                                                                                                 |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(1)           |       | Agreement and Plan of Merger, dated October 3, 2006,  between Treaty Oak Holdings, Inc. and the Company                                           |
|             |       |                                                                                                                                              |
| 3.1(2)           |       | Amended and Restated Articles of Incorporation                                                                                                    |
|             |       |                                                                                                                                              |
| 3.2(3)           |       | By-laws                                                                                                                                           |
|             |       |                                                                                                                                              |
| 4.1(3)           |       | Specimen Common Stock Certificate, $.01 par value  per share                                                                                      |
|             |       |                                                                                                                                              |
| 4.2(3)           |       | 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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(1)    Incorporatedby reference to the Company’s Current Report on Form 8-K filed October 10,2006.

(2)    Incorporatedby reference to the Company’s Registration Statement on Form S-8 filed October22, 2004.

(3)    Incorporatedby reference to the same numbered exhibit to the Company’s RegistrationStatement on Form SB-2.

**     Filed herewith.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                         | **TREATY OAK BANCORP, INC.** |
|-------------------------|------------------------------|
|                    |                         |   |
|                    |                         |   |
| Dated: August  13, 2007 | By:                          | /s/ Jeffrey L. Nash |
|                    |                         | Jeffrey L. Nash,  President and Chief Executive Officer |
|                    |                         |   |
|                    |                         |   |
|                    | By:                          | /s/ Coralie S.  Pledger |
|                    |                         | Coralie S.  Pledger, Chief Financial Officer |

 

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