** **

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

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

###### ** **

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

###### ** **

**ý****                      ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended March 31, 2006**

 

**o****                        ****TRANSITION REPORT PURSUANT TOSECTION 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 otherjurisdiction ofcorporation or organization)

 

**20-0413144**

(I.R.S. EmployerIdentification Number)

 

**101Westlake Drive, Austin, Texas**

(Address ofPrincipal Executive Offices)

 

**78746**

(Zip Code)

 

**(512)617-3600**

(Registrant’stelephone 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 ****ý****   No ****o**

 

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

**Yes  ****o****   No ****ý**

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock asof the close of business on May 12, 2006.
|                          |   |             |
|-------------------------------|--------|------------------|
| $0.01 Par Value Common  Stock |   | 2,629,983 shares |

 

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

 

 

----

 

**QUARTERLYREPORT ON FORM 10-QSB**

**FOR THEPERIOD ENDED MARCH 31, 2006**

**TABLE OFCONTENTS**

 
| **Part  I.** | **Financial Information**                                                                                                    |   |
|--------------|------------------------------------------------------------------------------------------------------------------------------|--------|
|         |                                                                                                                         |   |
| **Item 1.**  | *Financial  Statements*                                                                                                      |   |
|         |                                                                                                                         |   |
|         | Consolidated  Balance Sheets at March 31, 2006 (unaudited) and September 30, 2005 (audited)                                  |   |
|         |                                                                                                                         |   |
|         | Consolidated  Statements of Operations for the Three-Month and Six-Month Periods ended  March 31, 2005, and 2006 (unaudited) |   |
|         |                                                                                                                         |   |
|         | Consolidated  Statements of Cash Flows for the Six-Month Periods ended March 31, 2005, 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  and Reports on Form 8-K*                                                                                          |   |
|         |                                                                                                                         |   |
|         | Signatures                                                                                                                   |   |

 

This Form 10-QSB containsforward-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 influencethe estimates include changes in the national, regional, and local marketconditions, legislative and regulatory conditions, and an adverse interest rateenvironment.

 

i

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**Treaty Oak Bancorp, Inc.**

**ConsolidatedBalance Sheets (Unaudited)**

**March 31, 2006, and September 30,2005**

**(Dollars In Thousands, Except ParValue Amounts)**

 
| ** **                                                                                                    | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|---------------|------------|-------------------|------------|
| ** **                                                                                                    | ** ** | **2006**      | ** ** | **2005****(1)**   | ** ** |
| ASSETS                                                                                                        |       |          |       |              |       |
|                                                                                                          |       |          |       |              |       |
| Cash and cash  items                                                                                          |       | $             | 238        |              | $          | 230 |   |
| Due from banks                                                                                                |       | 5,518         |       | 9,271             |       |
| Federal funds  sold                                                                                           |       | 5,850         |       | 3,606             |       |
|                                                                                                          |       |          |       |              |       |
| Total cash and  cash equivalents                                                                              |       | 11,606        |       | 13,107            |       |
|                                                                                                          |       |          |       |              |       |
| Securities  available for sale                                                                                |       | 418           |       | 427               |       |
| Securities held  to maturity, fair value of $2,478 and $3,472, respectively                                   |       | 2,504         |       | 3,501             |       |
| Investment in  Federal Home Loan Bank, at cost                                                                |       | 222           |       | 217               |       |
| Investment in  Independent Bankers Financial Corporation, at cost                                             |       | 102           |       | 100               |       |
| Loans, net                                                                                                    |       | 48,533        |       | 35,683            |       |
| Premises and  equipment, net                                                                                  |       | 5,733         |       | 5,819             |       |
| Note receivable  from affiliate                                                                               |       | 352           |       | —            |       |
| Accrued interest  receivable                                                                                  |       | 351           |       | 348               |       |
| Due from  affiliates                                                                                          |       | 93            |       | 34                |       |
| Goodwill and  other intangibles, net                                                                          |       | 1,161         |       | 1,161             |       |
| Core deposit  intangibles                                                                                     |       | 49            |       | 54                |       |
| Other                                                                                                         |       | 378           |       | 298               |       |
|                                                                                                          |       |          |       |              |       |
| Total assets                                                                                                  |       | $             | 71,502     |              | $          | 60,749 |   |
|                                                                                                          |       |          |       |              |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                    |       |          |       |              |       |
|                                                                                                          |       |          |       |              |       |
| Deposits:                                                                                                     |       |          |       |              |       |
| Noninterest-bearing  demand                                                                                   |       | $             | 23,432     |              | $          | 17,057 |   |
| NOW, money  market and savings                                                                                |       | 20,440        |       | 13,413            |       |
| Time deposits                                                                                                 |       | 12,442        |       | 15,076            |       |
|                                                                                                          |       |          |       |              |       |
| Total deposits                                                                                                |       | 56,314        |       | 45,546            |       |
|                                                                                                          |       |          |       |              |       |
| Accounts payable  and accrued expenses                                                                        |       | 204           |       | 109               |       |
| Accrued interest  payable                                                                                     |       | 111           |       | 116               |       |
| Notes payable                                                                                                 |       | 2,762         |       | 2,801             |       |
| Minority  interest - PGI Equity Partners, LP                                                                  |       | 1,089         |       | 1,109             |       |
| Other  liabilities                                                                                            |       | 36            |       | 35                |       |
| Total  liabilities                                                                                            |       | 60,516        |       | 49,716            |       |
|                                                                                                          |       |          |       |              |       |
| Shareholders’  equity:                                                                                   |       |          |       |              |       |
| Common stock,  $0.01 par value; 20,000,000 shares authorized;  2,635,986 and 2,635,746, respectively, issued. |       | 26            |       | 26                |       |
| Paid-in capital                                                                                               |       | 14,951        |       | 14,949            |       |
| Accumulated  deficit                                                                                          |       | (3,938        | )          | (3,888            | )          |
| Accumulated  other comprehensive income (loss)                                                                |       | (3            | )          | (4                | )          |
| Less shares held  in treasury, at cost (6,003 shares)                                                         |       | (50           | )          | (50               | )          |
| Total  shareholders’ equity                                                                              |       | 10,986        |       | 11,033            |       |
|                                                                                                          |       |          |       |              |       |
| Total  liabilities and shareholders’ equity                                                              |       | $             | 71,502     |              | $          | 60,749 |   |

 

----

(1)Derived from audited financial statements.

 

See accompanying notes to unaudited consolidatedfinancial statements.

 

2

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**Treaty Oak Bancorp, Inc.**

**Consolidated Statements of Operations (Unaudited)**

**(Dollars In Thousands, except per share amounts)**

 
| ** **                                           | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months Ended  March 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **2006**                          | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Interest income:                                     |       |                              |       |                            |       |   |   |   |   |
| Loans, including  fees                               |       | $                                 | 950        |                            | $          | 333 |   | $ | 1,772 |   | $ | 566 |   |
| Taxable  securities                                  |       | 25                                |       | 37                              |       | 57 |   | 57 |   |
| Interest on  deposits with other banks               |       | 20                                |       | 9                               |       | 56 |   | 15 |   |
| Federal funds  sold                                  |       | 71                                |       | 20                              |       | 107 |   | 86 |   |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Total interest  income                               |       | 1,066                             |       | 399                             |       | 1,992 |   | 724 |   |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Interest  expense:                                   |       |                              |       |                            |       |   |   |   |   |
| Deposits                                             |       | 207                               |       | 67                              |       | 381 |   | 153 |   |
| Interest on  other borrowings                        |       | 41                                |       | 59                              |       | 83 |   | 59 |   |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Total interest  expense                              |       | 248                               |       | 126                             |       | 464 |   | 212 |   |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Net interest  income                                 |       | 818                               |       | 273                             |       | 1,528 |   | 512 |   |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Provision for  loan losses                           |       | 45                                |       | 30                              |       | 90 |   | 30 |   |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Net interest  income after provision for loan losses |       | 773                               |       | 243                             |       | 1,438 |   | 482 |   |
| Noninterest  income:                                 |       |                              |       |                            |       |   |   |   |   |
| Service charges  on deposit accounts                 |       | 19                                |       | 17                              |       | 39 |   | 33 |   |
| Other  noninterest income                            |       | 102                               |       | 78                              |       | 197 |   | 78 |   |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Total  noninterest income                            |       | 121                               |       | 95                              |       | 236 |   | 111 |   |
| Noninterest  expense:                                |       |                              |       |                            |       |   |   |   |   |
| Salaries and  employee benefits                      |       | 442                               |       | 509                             |       | 833 |   | 1,092 |   |
| Occupancy and  equipment expenses                    |       | 114                               |       | 58                              |       | 175 |   | 169 |   |
| Other  noninterest expense                           |       | 308                               |       | 450                             |       | 707 |   | 711 |   |
| Minority  interests in partnership income (loss)     |       | 6                                 |       | (30                             | )          | 9 |   | (30 | ) |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Total  noninterest expense                           |       | 870                               |       | 987                             |       | 1,724 |   | 1,942 |   |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Net income  (loss)                                   |       | $                                 | 24         |                            | $          | (649 | ) | $ | (50 | ) | $ | (1,349 | ) |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Loss per common  share - basic                       |       | $                                 | 0.01       |                            | $          | (0.25 | ) | $ | (0.02 | ) | $ | (0.52 | ) |
| Loss per common  share - diluted                     |       | $                                 | 0.01       |                            | $          | (0.25 | ) | $ | (0.02 | ) | $ | (0.52 | ) |
|                                                 |       |                              |       |                            |       |   |   |   |   |
| Weighted average  shares outstanding - basic         |       | 2,635,887                         |       | 2,617,684                       |       | 2,635,816 |   | 2,602,365 |   |
| Weighted average  shares outstanding - diluted       |       | 2,637,882                         |       | 2,617,684                       |       | 2,660,599 |   | 2,602,365 |   |

 

See accompanying notes to unaudited consolidatedfinancial statements.

 

3

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**Treaty Oak Bancorp, Inc.**

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

**Six Months Ended March 31, 2006, and 2005**

**(Dollars In Thousands)**

 
| ** **                                                                                 | ** ** | **Six Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                                                 | ** ** | **March 31,**        | ** ** | **March 31,**        | ** ** |
| ** **                                                                                 | ** ** | **2006**             | ** ** | **2005**             | ** ** |
| Cash flows from  operating activities:                                                     |       |                 |       |                 |       |
| Net loss                                                                                   |       | $                    | (50        | )                    | $          | (1,349 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                 |       |                 |       |
|                                                                                       |       |                 |       |                 |       |
| Minority  interests in partnership loss                                                    |       | 9                    |       | (30                  | )          |
| Provision for  loan losses                                                                 |       | 90                   |       | 30                   |       |
| Non-cash stock  based compensation                                                         |       | —               |       | 95                   |       |
| Loan acquisition  costs                                                                    |       | —               |       | 100                  |       |
| Depreciation and  amortization                                                             |       | 176                  |       | 143                  |       |
| Changes in other  operating assets and liabilities:                                        |       |                 |       |                 |       |
| Accrued interest  receivable                                                               |       | (3                   | )          | (79                  | )          |
| Other assets                                                                               |       | (80                  | )          | (96                  | )          |
| Accrued interest  payable                                                                  |       | (5                   | )          | (2                   | )          |
| Accounts  payable, accrued expenses and other liabilities                                  |       | 96                   |       | 27                   |       |
| **Net  cash provided by provided by (used in) operating activities**                       |       | 233                  |       | (1,161               | )          |
|                                                                                       |       |                 |       |                 |       |
| Cash flows from  investing activities:                                                     |       |                 |       |                 |       |
| Proceeds from  maturities and principal repayments on securities - available for sale      |       | 10                   |       | 16                   |       |
| Proceeds from  maturities and principal repayments on securities - held to maturity        |       | 997                  |       | 1,000                |       |
| Purchase of  securities - held to maturity                                                 |       | —               |       | (5,494               | )          |
| Acquisition of  interest in PGI Equity Partners, LP, net of cash received of $24 in 2005   |       | (80                  | )          | (926                 | )          |
| Deposit on  investment from PGI Capital, Inc.                                              |       | —               |       | 100                  |       |
| Purchase of  correspondent bank stock                                                      |       | (7                   | )          | (2                   | )          |
| Purchase of  equipment                                                                     |       | (34                  | )          | (565                 | )          |
| Net increase in  loans                                                                     |       | (12,940              | )          | (11,817              | )          |
| **Net  cash (used in) investing activities**                                               |       | (12,054              | )          | (17,688              | )          |
|                                                                                       |       |                 |       |                 |       |
| Cash flows from  financing activities:                                                     |       |                 |       |                 |       |
| Net increase in  deposits                                                                  |       | 10,768               |       | 8,468                |       |
| Increase in  borrowed funds                                                                |       | —               |       | 250                  |       |
| Deposits in  escrow                                                                        |       | —               |       | (28                  | )          |
| Proceeds from  the sale of common stock, net of issuance costs                             |       | —               |       | 3,772                |       |
| Advances to  affiliates                                                                    |       | (411                 | )          | (75                  | )          |
| Repayments of  advances to affiliates                                                      |       | —               |       | 126                  |       |
| Payments on  notes payable                                                                 |       | (39                  | )          | (5                   | )          |
| Net repayment of  mortgage through refinance, net of costs                                 |       | —               |       | (181                 | )          |
| Proceeds from  note payable - PGI Equity Partners, LP                                      |       | —               |       | 149                  |       |
| Proceeds from exercise  of warrants                                                        |       | 2                    |       | —               |       |
| Repurchase of  common stock                                                                |       | —               |       | (50                  | )          |
| **Net  cash provided by financing activities**                                             |       | 10,320               |       | 12,426               |       |
| ** **                                                                                 |       |                 |       |                 |       |
| Net decrease in  cash and cash equivalents                                                 |       | (1,501               | )          | (6,423               | )          |
|                                                                                       |       |                 |       |                 |       |
| Cash and cash  equivalents at beginning of period                                          |       | 13,107               |       | 9,284                |       |
|                                                                                       |       |                 |       |                 |       |
| Cash and cash  equivalents at end of period                                                |       | 11,606               |       | 2,861                |       |
|                                                                                       |       |                 |       |                 |       |
| Supplemental  disclosures of cash flow information:                                        |       |                 |       |                 |       |
| Non-cash  investing and financing information:                                             |       |                 |       |                 |       |
| Cash interest  paid                                                                        |       | $                    | 495        |                 | $          | 155 |   |
|                                                                                       |       |                 |       |                 |       |
| Acquisition of PGI Equity Partners, LP                                                     |       |                 |       |                 |       |
| Assets acquired                                                                            |       | $                    | —     |                 | $          | 4,943 |   |
| Liabilities  assumed                                                                       |       | —               |       | (3,015               | )          |
| Minority  interests                                                                        |       | 80                   |       | (1,002               | )          |
| Cash paid, net  of cash acquired                                                           |       | $                    | 80         |                 | $          | 926 |   |

 

See accompanying notes to unaudited consolidatedfinancial statements.

 

4

----

 

**Treaty Oak Bancorp, Inc.**

**Notes to Consolidated Financial Statements -unaudited**

 

**Note1. Basis of Presentation**

 

Treaty OakBancorp, Inc. (the “Company”) is a bank holding company incorporated onNovember 18, 2003, and organized December 8, 2003 for the purpose of holdingthe common stock of Treaty Oak Bank (formerly Texline State Bank, the “Bank”). TheCompany acquired the Bank on March 9, 2004, and began conducting bankingoperations in Texline, Texas. The Bank commenced operations in Austin, Texas,on September 10, 2004.

 

The Company, throughTreaty Oak Bank, provides a full range of commercial and consumer bankingservices to individuals and businesses in the commercial sector in Austin, Texas,and in the agriculture, cattle and commercial sectors in the community ofTexline, Texas.

 

The Company acquired a47.5% interest in PGI Equity Partners, LP (the “Partnership”) on December 31,2004. The Partnership owns and operates the building in which the Companyoffices. On February 23, 2006, the Company acquired additional 2.5% Class A and1.25% Class B interests in the Partnership from the sole remaining minorityshareholder for $80,000 cash, bringing the total ownership interest in thePartnership to 51.25% at March 31, 2006.

 

The Company (through itsBank subsidiary) acquired a 50% interest in Treaty Oak Mortgage, LLC on June27, 2005 for a purchase price of $1,000, which is accounted for on the equitymethod of accounting.

 

The consolidated financialstatements include the accounts of Treaty Oak Bancorp, Inc., its wholly ownedsubsidiary Treaty Oak Bank, and the accounts of PGI Equity Partners, LP.

 

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith the instructions to Form 10-QSB and, therefore, do not include all of thedisclosures and notes required by accounting principles generally accepted inthe United States of America. In the opinion of management, all materialadjustments (which are of a normal recurring nature) considered necessary for afair presentation have been made. The results for the interim period are notnecessarily indicative of the results to be expected for the entire year or anyother interim period.

 

Stock-BasedCompensation

 

The Companyaccounts for stock-based compensation to employees using the intrinsic valuemethod. Compensation costs for employee stock options is measured as theexcess, if any, of the fair value of the Company’s common stock at date ofgrant over the exercise price.

 

The Company accounts forstock-based compensation to non-employees at fair value.

 

The Company anticipatesimplementing FASB Statement No. 123R, “Share-Based Payments”, beginning onOctober 1, 2006. Statement 123R requires public entities to measure the cost ofemployee services received in exchange for an award of equity instruments basedon the grant-date fair value of the award (with limited exceptions). That costwill be recognized over the period during which an employee is required to provideservice in exchange for the award – the requisite service period (usually thevesting period).

 

123R applies to allawards granted after the required effective date and to awards modified,repurchased, or cancelled after that date. The impact that this statement willhave on our consolidated financial statements is dependent upon the levels ofshare based payments granted in the future.

 

The weighted average fairvalue of the options granted during the three months ended March 31, 2006 and March31, 2005 has been estimated using the Black-Scholes option pricing model withthe following assumptions:

 

5

----

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|--------------------------|------------|------------------------|------------|------------------------|------------|
| ** **               | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005**     | ** ** |
|                     |       |                   |       |                   |       |
| Dividend yield           |       | 0                      | %          | 0                      | %          |
| Risk-free  interest rate |       | 4.75                   | %          | 4.00% - 4.75           | %          |
| Expected  volatility     |       | 22                     | %          | 22                     | %          |
| Expected life in  years  |       | 6.85 Years             |       | 10 Years               |       |

 

Thetable below presents the pro forma effect on the Company’s operations assumingthe Company had accounted for its stock options issued to employees at fairvalue (in thousands, except per share amounts):

 
| ** **                              | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months Ended  March 31,** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **2006**                          | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                    |       |                              |       |                            |       |   |   |   |   |
| Net income (loss) - as reported         |       | $                                 | 24         |                            | $          | (649 | ) | $ | (50 | ) | $ | (1,349 | ) |
| Net (loss) - pro forma                  |       | $                                 | (15        | )                               | $          | (700 | ) | $ | (123 | ) | $ | (1,458 | ) |
|                                    |       |                              |       |                            |       |   |   |   |   |
| Earnings (loss) per share - as reported |       |                              |       |                            |       |   |   |   |   |
| basic                                   |       | $                                 | 0.01       |                            | $          | (0.25 | ) | $ | (0.02 | ) | $ | (0.52 | ) |
| diluted                                 |       | $                                 | 0.01       |                            | $          | (0.25 | ) | $ | (0.02 | ) | $ | (0.52 | ) |
|                                    |       |                              |       |                            |       |   |   |   |   |
| Loss per share - pro forma              |       |                              |       |                            |       |   |   |   |   |
| basic                                   |       | $                                 | (0.01      | )                               | $          | (0.27 | ) | $ | (0.05 | ) | $ | (0.56 | ) |
| diluted                                 |       | $                                 | (0.01      | )                               | $          | (0.27 | ) | $ | (0.05 | ) | $ | (0.56 | ) |

 

**Note 2. Earnings Per Share**

 

Basic earnings (loss) pershare is computed by dividing net earnings (loss) by the weighted averagenumber of common shares outstanding for the period.  Diluted earnings pershare is computed using the weighted-average number of common sharesoutstanding plus the number of additional common shares that would have beenoutstanding if dilutive common shares had been issued.  For the six monthsended March 31, 2006 and the three and six months ended March 31, 2005, allpotentially dilutive securities outstanding were anti-dilutive. For the threemonths ended March 31, 2006, all potentially dilutive securities, except forstock options to purchase 140,500 shares of the Company’s common stock at $8.33per share, were anti-dilutive.

 

**Note 3. Other Comprehensive Income (Loss)**

 
| ** **                                                         | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months ended  March 31,** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | **2006**                          | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                         | ** ** | **(In thousands)**                | ** ** |
|                                                               |       |                              |       |                            |       |   |   |   |   |
| Net income  (loss)                                                 |       | $                                 | 24         |                            | $          | (649 | ) | $ | (50 | ) | $ | (1,349 | ) |
|                                                               |       |                              |       |                            |       |   |   |   |   |
| Change in  unrealized gain (loss) on securities available for sale |       | 1                                 |       | (4                              | )          | 1 |   | (7 | ) |
|                                                               |       |                              |       |                            |       |   |   |   |   |
| Other  comprehensive income (loss)                                 |       | $                                 | 25         |                            | $          | (653 | ) | $ | (49 | ) | $ | (1,356 | ) |

 

6

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**Note 4. Securities**

 

Securities consisted ofthe following (in thousands):

 
| ** **                           | ** ** | **As of  March 31, 2006** | ** ** | **As of  September 30, 2005** | ** ** |
|--------------------------------------|------------|---------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | **Amortized**             | ** ** | **Fair**                      | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                           | ** ** | **Cost**                  | ** ** | **Value**                     | ** ** | **Cost** | ** ** | **Value** | ** ** |
| Securities Held  to Maturity:        |       |                      |       |                          |       |   |   |   |   |
|                                 |       |                      |       |                          |       |   |   |   |   |
| U.S. Government  Agencies            |       | $                         | 2,498      |                          | $          | 2,473 |   | $ | 3,495 |   | $ | 3,467 |   |
| Mortgage-backed  securities          |       | 6                         |       | 5                             |       | 6 |   | 5 |   |
| Total Securities  Held to Maturity   |       | 2,504                     |       | 2,478                         |       | 3,501 |   | 3,472 |   |
|                                 |       |                      |       |                          |       |   |   |   |   |
| Securities  Available for Sale:      |       |                      |       |                          |       |   |   |   |   |
|                                 |       |                      |       |                          |       |   |   |   |   |
| U.S. Government  Agencies            |       | 400                       |       | 397                           |       | 401 |   | 396 |   |
| Mortgage-backed  securities          |       | 21                        |       | 21                            |       | 30 |   | 31 |   |
| Total Securities  Available for Sale |       | 421                       |       | 418                           |       | 431 |   | 427 |   |
|                                 |       |                      |       |                          |       |   |   |   |   |
| Total                                |       | $                         | 2,925      |                          | $          | 2,896 |   | $ | 3,932 |   | $ | 3,899 |   |

 

Mortgage-backedsecurities are backed by pools of mortgages and are typically insured orguaranteed by the Federal Home Loan Mortgage Corporation (FHLMC), the FederalNational Mortgage Association (FNMA) or the Government National MortgageAssociation (GNMA).

 

At March 31, 2006, $1,603,000 of the Company’ssecurities at fair value were pledged to Texline Independent School District($1,006,000) and to the City of Texline ($597,000).

 

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

 

The Company grantsagribusiness, real estate, and commercial loans to customers primarily in theAustin are and the Texas Panhandle. Loans at March 31, 2006, and September 30,2005, were as follows (in thousands):

 
| ** **                      | ** ** | **March 31, 2006** | ** ** | **September 30, 2005** | ** ** |
|---------------------------------|------------|--------------------|------------|------------------------|------------|
|                            |       |               |       |                   |       |
| Agriculture                     |       | $                  | 2,828      |                   | $          | 3,261 |   |
| Commercial                      |       | 14,048             |       | 12,887                 |       |
| Commerical real estate          |       | 14,902             |       | 8,619                  |       |
| Residential real estate         |       | 7,287              |       | 4,524                  |       |
| Construction real estate        |       | 5,472              |       | 4,152                  |       |
| Consumer                        |       | 4,354              |       | 2,517                  |       |
|                            |       |               |       |                   |       |
|                            |       | 48,891             |       | 35,960                 |       |
| Less: allowance for loan losses |       | (358               | )          | (277                   | )          |
|                            |       |               |       |                   |       |
|                            |       | $                  | 48,533     |                   | $          | 35,683 |   |

 

Activity in the allowancefor loan losses for the six months ended March 31, 2006 and year endedSeptember 30, 2005 was as follows (in thousands):

 

7

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| ** **                                 | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months ended  March 31,** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **2006**                          | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                       |       |                              |       |                            |       |   |   |   |   |
| Balance at beginning of period             |       | $                                 | 317        |                            | $          | 228 |   | $ | 277 |   | $ | 217 |   |
| Provision for loan losses                  |       | 45                                |       | 30                              |       | 90 |   | 30 |   |
| Loans charged off                          |       | (4                                | )          | (1                              | )          | (10 | ) | (1 | ) |
| Recoveries on loans previously charged-off |       | —                            |       | 1                               |       | 1 |   | 12 |   |
|                                       |       |                              |       |                            |       |   |   |   |   |
| Balance at the end of the period           |       | $                                 | 358        |                            | $          | 258 |   | $ | 358 |   | $ | 258 |   |

 

The Company had noimpaired loans at March 31, 2006 or September 30, 2005. At March 31, 2006 and September30, 2005, the Bank had approximately $175,000 and $91,000, respectively, innonperforming loans including non-accrual loans and loans past due over 90 daysand still accruing interest.

 

**Note 6. Premises and Equipment**

 

Premises and equipment atMarch 31, 2006, and September 30, 2005, were as follows (in thousands):

 
| ** **                                     | ** ** | **March 31, 2006** | ** ** | **September 30, 2005** | ** ** |
|------------------------------------------------|------------|--------------------|------------|------------------------|------------|
|                                           |       |               |       |                   |       |
| Land                                           |       | $                  | 959        |                   | $          | 949 |   |
| Building and leasehold improvements            |       | 4,560              |       | 4,520                  |       |
| Furniture, fixtures and equipment              |       | 753                |       | 718                    |       |
| Subtotal                                       |       | 6,272              |       | 6,187                  |       |
| Less accumulated depreciation and amoritzation |       | (539               | )          | (368                   | )          |
| Total                                          |       | $                  | 5,733      |                   | $          | 5,819 |   |

 

Depreciation andamortization expense for the six months ended March 31, 2006 and 2005 was$171,000 and $139,000, respectively.

 

**Note 7. Deposits**

 

Time deposits of $100,000or more totaled $6,259,000 and $7,797,000 at March 31, 2006 and September 30,2005, respectively. At March 31, 2006 and September 30, 2005, the scheduledmaturities of time deposits were as follows (in thousands):

 
| **Time deposits maturing in the  fiscal year ending:** | ** ** | **As of  March 31, 2006** | ** ** | **As of  September 30, 2005** | ** ** |
|--------------------------------------------------------|------------|---------------------------|------------|-------------------------------|------------|
|                                                   |       |                      |       |                          |       |
| 2006                                                   |       | $                         | 8,415      |                          | $          | 12,885 |   |
| 2007                                                   |       | 3,828                     |       | 2,191                         |       |
| 2008                                                   |       | 199                       |       | —                        |       |
|                                                   |       |                      |       |                          |       |
| ** **                                             |       | $                         | 12,442     |                          | $          | 15,076 |   |

 

**Note 8. Goodwill and Other Intangibles**

 

In conjunction with theacquisition of Texline State Bank, the Company recorded Goodwill of $1,161,000and core deposit intangibles of $70,000. Goodwill is periodically reviewed, atleast annually, to determine whether a decline in value exists which requires acharge to earnings and a reduction to goodwill reflected on the statement offinancial condition of the Company.

 

8

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Core deposit intangiblesare amortized on a straight-line basis over seven years. The following tablereflects the net carrying amount of core deposit intangibles at March 31, 2006and September 30, 2005 (in thousands):

 
| ** **                     | ** ** | **March 31, 2006** | ** ** | **September 30, 2005** | ** ** |
|--------------------------------|------------|--------------------|------------|------------------------|------------|
|                           |       |               |       |                   |       |
| Gross core deposit intangibles |       | $                  | 70         |                   | $          | 70 |   |
| Less accumulated amortization  |       | (21                | )          | (16                    | )          |
|                           |       |               |       |                   |       |
| Net core deposit intangibles   |       | $                  | 49         |                   | $          | 54 |   |

 

**Note9. Stock Based Compensation and 2004 Stock Incentive Plan**

 

On January 19, 2004,the Company and its shareholders approved the Company’s 2004 Stock IncentivePlan (the “Plan”).  The Plan authorizes incentive stock option grants,non-statutory stock option grants, direct stock issuances, stock appreciationrights, salary investment option grants, and director fee option grants. Eligible participants are employees, non-employee board members, andindependent consultants or advisors.  The Company has reserved 500,000shares of common stock under the Plan, and the share reserve increases on the 1stbusiness day in January each year (beginning in 2005) by an amount equalto 2% of the number of outstanding shares of the Company on the last businessday in December of the preceding year, subject to a maximum annualincrease of 100,000 shares.  No person may receive stock option grants,stock issuances, or stock appreciation rights for more than 100,000 shares inthe aggregate in any calendar year under the Plan.

 

On October 25, 2005 theCompany granted 82,750 options to purchase shares of stock at an exercise priceof $8.50 per share to fifteen (15) officers and directors. The options becomeexercisable for the option shares in three equal annual installments uponcompletion of each year of service over the three-year period of servicemeasured from October 25, 2005. On January 24, 2006, the Company granted 750options to purchase shares of stock at an exercise price of $8.50 per share totwo (2) employees. The options become exercisable for the option shares inthree equal annual installments upon completion of each year of service overthe three-year period of service measured from January 24, 2006. On January 27,2006, 23,000 options to purchase shares that had been awarded to employees nolonger with the Company expired.

 

The table below presentsthe weighted average number of options issued and outstanding during the sixmonths ended March 31, 2006, and 2005.

 
| ** **                                                        | ** ** | **For the  Six Months Ended  March 31, 2006** | ** ** | **For the  Six Months Ended  March 31, 2005** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                        | ** ** | ** **                                    | ** ** | **Weighted**                                  | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                        | ** ** | ** **                                    | ** ** | **Average**                                   | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                        | ** ** | **Shares**                                    | ** ** | **Exercise Price**                            | ** ** | **Shares** | ** ** | **Exercise Price** | ** ** |
|                                                              |       |                                          |       |                                          |       |   |   |   |   |
| Outstanding,  beginning of the period                             |       | 203,800                                       |       | $                                             | 8.64       |   | 165,500 |   | $ | 8.33 |   |
| Granted                                                           |       | 83,500                                        |       | 8.50                                          |       | 27,000 |   | 8.83 |   |
| Exercised                                                         |       | —                                        |       | —                                        |       | — |   | — |   |
| Forfeited/expired                                                 |       | (23,000                                       | )          | 8.58                                          |       | — |   | — |   |
| Outstanding, end  of the period                                   |       | 264,300                                       |       | $                                             | 8.65       |   | 192,500 |   | $ | 8.40 |   |
|                                                              |       |                                          |       |                                          |       |   |   |   |   |
| Exercisable at  the end of the period                             |       | —                                        |       |                                          |       | — |   |   |   |
| Weighted-average  fair value of options granted during the period |       |                                          |       | $                                             | 1.85       |   |   |   | $ | 3.78 |   |
| Weighted-average  remaining contractural life (months)            |       | 105                                           |       |                                          |       | 111 |   |   |   |

 

9

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**Note10. Other Related Party Transactions**

 

**TreatyOak Holdings, Inc.**

 

On October 11, 2005,Treaty Oak Bancorp, Inc. made a $355,000 loan to Treaty Oak Holdings, Inc. (“TOHI”)with interest at 6.75% (WSJ Prime, floating) per annum, payable on the first ofeach month beginning November 1, 2005. The purpose of the loan was to enableTOHI to pay off certain obligations, and provide working capital. On April 26,2006, the obligation was renewed and increased to $373,000 at the then current WSJprime rate of 7.75%. The principal balance, along with any accrued interest, isdue and payable in full on September 1, 2006. On March 31, 2006, theoutstanding principal balance of the loan was $352,000.

 

**Accountingand Tax Services**

 

The Company receives taxplanning advice and general tax and accounting services from Hamann,Ernstmeyer & Williamson, P.C. (formerly Hamann & Associates, P.C. “HEW”),a professional corporation of certified public accountants in which Mr. Hamann(the former Chief Executive Officer of the Company) owned an 80% interest. Asof March 31, 2005, Mr. Hamann’s ownership changed to a 5% interest in HEW,and as of November, 2005, he had no remaining ownership interest. HEW is a firmfocused on tax planning and advisory work and does not provide auditingservices to clients. For the three months ended March 31, 2006, and March 31,2005, the Company paid approximately $9,000 and $20,000, respectively; and$30,000 and $67,000 respectively, for the six months ended March 31, 2006 andMarch 31, 2005, for these services primarily with respect to assistance in thepreparation of the Company’s annual and periodic reporting, tax planning andreporting, and other advisory services.

 

**OtherTransactions**

 

The Company has a $93,000and $34,000 Due from Affiliate balance as of March 31, 2006 and September 30,2005 respectively, which represents amounts due from Treaty Oak Holdings, Inc.to PGI Equity Partners, LP for occupancy costs.

 

**Note 11. FinancialInstruments with Off-Balance Sheet Risk**

 

In the normal course ofbusiness, the Company is a party to financial instruments with off-balancesheet risk to meet the financing needs of its customers, through the use ofcommitments to extend credit. Those instruments involve, to varying degrees,elements of credit and interest-rate risk in excess of the amount recognized inthe consolidated balance sheet. The contract or notional amounts of thoseinstruments reflect the extent of the Company’s involvement in particularclasses of financial instruments.

 

The Company’s exposure tocredit loss in the event of nonperformance by the other party to the financialinstrument for commitments to extend credit and standby letters of credit isrepresented by the contractual amount of those instruments. The Company usesthe same credit policies in making commitments and conditional obligations asthey do for on-balance sheet instruments.

 

The following tablesummarizes the Company’s off-balance sheet financial instruments as of March31, 2006 and September 30, 2005 (in thousands):

 
| ** **                   | ** ** | **March 31,  2006** | ** ** | **September 30,  2005** | ** ** |
|------------------------------|------------|---------------------|------------|-------------------------|------------|
|                         |       |                |       |                    |       |
| Commitments to extend credit |       | 15,648              |       | $                       | 14,043     |   |
| Standby letters of credit    |       | $                   | 1,703      |                    | $          | 269 |   |
|                              |            |                     |            |                         |            |  |  |

 

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

 

10

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customer’screditworthiness on a case-by-case basis. The amount of collateral obtained ifdeemed necessary by the Company upon extension of credit is based on management’scredit evaluation of the counterparty. Collateral held varies but may includeaccounts receivable, inventory, property, plant and equipment andincome-producing commercial properties.

 

Standby letters of creditare written conditional commitments used by the Company to guarantee theperformance of a customer to a third party. The Company’s policies generallyrequire that letter of credit arrangements contain security and debt covenantssimilar to those contained in loan arrangements. In the event the customer doesnot perform in accordance with the terms of the agreement with the third party,the Company would be required to fund the commitment. The maximum potentialamount of future payments the Company could be required to make is representedby the contractual amount shown in the table above. If the commitment isfunded, the Company would be entitled to seek recovery from the customer. As ofMarch 31, 2006, no amounts have been recorded as liabilities for the Company’spotential obligations under these guarantees.

 

**Note 12. Dividend Restrictions and RegulatoryMatters**

 

Banks and bank holding companies are subject toregulatory capital requirements administered by state and federal bankingregulatory agencies. Capital adequacy guidelines and, additionally for banks,prompt corrective action regulations involve quantitative measures of assets,liabilities, and certain off-balance sheet items calculated under regulatoryaccounting practices. Capital amounts and classifications are also subject toqualitative judgments by regulators about components, risk weightings and otherfactors. Failure to meet capital requirements can initiate regulatory action. Asof March 31, 2006, management believes the Bank is in compliance with allregulatory capital requirements to which it is subject.

 

The following table setsforth the Bank only actual capital levels in addition to the requirements underprompt corrective action regulations (in thousands):

 
| ** **                              | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|-----------------------------------------|------------|------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                              | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| (Bank Only)                             |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| March 31, 2006:                         |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Tier I capital  to average assets       |       | $          | 7,796      |                               | 12.93      | %                                                                       | $          | 2,411 |   | 4.0 | % | $ | 3,014 |   | 5.0 | % |
| Tier I capital  to risk weighted assets |       | 7,796      |       | 14.37                              | %          | 2,170                                                                   |       | 4.0 | % | 3,256 |   | 6.0 | % |
| Total capital to  risk weighted assets  |       | 8,154      |       | 15.03                              | %          | 4,341                                                                   |       | 8.0 | % | 5,426 |   | 10.0 | % |
| September 30, 2005:                     |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Tier I capital  to average assets       |       | $          | 7,617      |                               | 14.71      | %                                                                       | $          | 2,071 |   | 4.0 | % | $ | 2,589 |   | 5.0 | % |
| Tier I capital  to risk weighted assets |       | 7,617      |       | 18.12                              | %          | 1,654                                                                   |       | 4.0 | % | 2,481 |   | 6.0 | % |
| Total capital to  risk weighted assets  |       | 7,894      |       | 19.09                              | %          | 3,307                                                                   |       | 8.0 | % | 4,134 |   | 10.0 | % |

 

As of March 31, 2006, the Bank met the level ofcapital required to be categorized as “well capitalized” under promptcorrective action regulations. Management is not aware of any conditionssubsequent to March 31, 2006, that would change the Bank’s capital category.

 

The Bank is a statechartered banking association and is subject to regulation, supervision andexamination by the Texas Department of Banking and the Federal DepositInsurance Corporation (FDIC). In addition, upon making certain determinationswith respect to the condition of any insured bank, the FDIC may beginproceedings to terminate a bank’s federal deposit insurance.

 

From its initialacquisition of Texline State Bank, the Company’s banking operations had beensubject to a Memorandum of Understanding (MOU) with the FDIC. The MOU had beenentered into for the purpose of ensuring that bank management appropriately andadequately addressed certain deficiencies identified by the FDIC and TexasDepartment of Banking (TDB) during previous regulatory examinations prior tothe Company’s acquisition. Following the FDIC examination of Treaty Oak Bank inNovember, 2004, the FDIC terminated the MOU and proposed a new

 

11

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MOU that was morelimited in scope. In February 2005, Treaty Oak Bank agreed to become subject tothe new MOU, which was subsequently executed effective March 3, 2005 by theFDIC. Prior to March 31, 2005, the Bank had addressed all of the issuesidentified in the new MOU. At a subsequent follow-up review of the Bankconducted jointly by the FDIC and TDB, the on-site examiners deemed the Bank’sactions to date with regard to the new MOU to be “satisfactory.”  The Bank was later advised to discontinue thesubmission of quarterly responses to the MOU based upon the Bank’s affirmativeactions in a letter dated April 25, 2005 from the FDIC.

 

The TDB and theFDIC conducted a joint safety and soundness examination of the bank and holdingcompanies during December, 2005 and reported their findings to the board ofdirectors on January 10, 2006. The final written report was received bymanagement in March, 2006, at which time the bank was advised of the officialtermination of the MOU.

 

Certain restrictionsexist 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.

 

12

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

 

**Introduction**

 

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

 

**Resultsof Operations**

 

*General*

 

Thefollowing discussion analyzes the results of the Company for the three monthsand six months ended March 31, 2006, and March 31, 2005.

 

***Net Income—General***

 

Forthe three months ended March 31, 2006, the Company had net income of $24,000,compared to a net loss of $649,000 for the three months ended March 31,2005. The improvement in is attributable to the increase in net interestincome, as the Company grew its earning assets 117% from March 31, 2005 andincreased the yield on those assets 138 basis points from 6.00% to 7.38%. Forthe same comparative period, interest bearing liabilities grew 75.71%, and therates paid on those deposits increased only 31 basis points, resulting in asubstantial increase in net interest income.

 

 For the six months ended March 31, 2005, theCompany had a net loss of $50,000 compared to a net loss of $1,349,000 for thesix months ended March 31, 2005. Again, the improvement in operations isattributable to the increase in net interest income, as the Company grew itsearning assets at a faster pace and at a greater yield than its interestbearing liabilities. Salaries and employee benefits decreased $259,000 for thefirst two quarters of fiscal 2006 as compared to the first two quarters offiscal 2005, which also contributed to the improvement in earnings.

 

Ourprofitability depends primarily on net interest income, which is defined as thedifference between total interest earned on interest earning assets(investments and loans) and total interest paid on interest bearing liabilities(deposits, borrowed funds). The Company’s net income is affected by itsprovision for loan losses, as well as other income and other expenses. Theprovision for loan losses reflects the amount considered to be adequate tocover probable credit losses in the loan portfolio. Non-interest income orother income consists of service charges on deposits, gain on sale of loans,and other operating income. Other expenses include salaries and employeebenefits, occupancy expenses, data processing expenses, marketing, supplies, andother operating expenses.

 

Netinterest income is affected by changes in the volume and mix of interestearning assets, the level of interest rates earned on those assets, the volumeand mix of interest bearing liabilities, and the level of interest rates paidon those interest bearing liabilities. The provision for loan losses isdependent upon changes in the loan portfolio and management’s assessment of thecollectibility of the loan portfolio, as well as economic and marketconditions. Other income and other expenses are impacted by growth ofoperations and growth in the number of accounts through both acquisitions andcore banking business growth. Growth in operations affects other expenses as aresult of additional employees, branch facilities, and promotional marketingexpense. Growth in the number of accounts affects other income includingservice fees, as well as other expenses such as computer services, supplies,postage, telecommunications, and other miscellaneous expenses.

 

13

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***Net Interest Income***

 

Forthe three months ended March 31, 2006, our net interest income was $818,000compared to $273,000 for the three months ended March 31, 2005. For the sixmonths ended March 31, 2006, our net interest income was $1,528,000 compared to$512,000 for the six months ended March 31, 2005.

 

Forthe comparative three month periods of March 31, 2006, and March 31, 2005,the average rate on interest-bearing liabilities increased 31 basis points,from 2.61% to 2.92%, while the average rate on interest bearing assets improved138 basis points from 6.00% to 7.38% during the same period. For thecomparative six month periods of March 31, 2006 and March 31, 2005, the averagerate on interest-bearing liabilities increased 85 basis points, from 2.05% to2.90%, while the average rate on interest bearing assets improved 179 basispoints from 5.50% to 7.29% during the same period.

 

Thefollowing tables present, for the periods indicated, the total dollar amount ofinterest income from average interest earning assets, and the resultant yields,as well as the interest expense on average interest bearing liabilities, andthe resultant costs, expressed both in dollars and rates. The averages arecomputed using the daily averages for each item noted. Yields are reflected onan annualized basis.

 

14

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| ** **                                       | ** ** | **Three Months Ended  March 31,  2006** | ** ** | **Three Months Ended  March 31,  2005** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                       | ** ** | **Average**                             | ** ** | ** **                              | ** ** | **Yield /** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield /** | ** ** |
| ** **                                       | ** ** | **Balance**                             | ** ** | **Interest (2)**                        | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest (2)** | ** ** | **Rate** | ** ** |
| Interest Earning  Assets:                        |       |                                    |       |                                    |       |   |   |   |   |   |   |   |   |
| Loans (1)                                        |       | $                                       | 46,360     |                                    | $          | 950 |   | 8.20 | % | $ | 17,723 |   | $ | 333 |   | 7.52 | % |
| Taxable  investment securities                   |       | 3,328                                   |       | 25                                      |       | 3.00 | % | 5,253 |   | 37 |   | 2.82 | % |
| Federal funds  sold                              |       | 6,422                                   |       | 71                                      |       | 4.42 | % | 3,413 |   | 20 |   | 2.34 | % |
| Interest bearing  deposits with other banks      |       | 1,333                                   |       | 16                                      |       | 4.80 | % | — |   | 9 |   | 0.00 | % |
| FHLB and TIB  stock                              |       | 321                                     |       | 4                                       |       | 4.98 | % | 211 |   | — |   | 0.00 | % |
| Total interest  earning assets                   |       | 57,764                                  |       | 1,066                                   |       | 7.38 | % | 26,600 |   | 399 |   | 6.00 | % |
| Non-interesting  earning assets                  |       | 8,895                                   |       |                                    |       |   |   | 10,759 |   |   |   |   |   |
| Total Assets                                     |       | $                                       | 66,659     |                                    |       |   |   |   | $ | 37,359 |   |   |   |   |   |
|                                             |       |                                    |       |                                    |       |   |   |   |   |   |   |   |   |
| Interest Bearing  Liabilities:                   |       |                                    |       |                                    |       |   |   |   |   |   |   |   |   |
| Deposits:                                        |       |                                    |       |                                    |       |   |   |   |   |   |   |   |   |
| NOW and money  market deposits                   |       | $                                       | 18,161     |                                    | 94         |   | 2.07 | % | $ | 10,756 |   | 39 |   | 1.45 | % |
| Savings deposits                                 |       | 491                                     |       | 1                                       |       | 0.81 | % | 477 |   | 1 |   | 0.84 | % |
| Time Deposits                                    |       | 12,499                                  |       | 112                                     |       | 3.58 | % | 3,611 |   | 27 |   | 2.99 | % |
| Short-term  borrowings                           |       | 67                                      |       | —                                  |       | 0.00 | % | 1,608 |   | — |   | 0.00 | % |
| Property  mortgage and long-term borrowings      |       | 2,702                                   |       | 41                                      |       | 6.07 | % | 2,852 |   | 59 |   | 8.27 | % |
| Total interest  bearing liabilities              |       | 33,920                                  |       | 248                                     |       | 2.92 | % | 19,304 |   | 126 |   | 2.61 | % |
| Demand deposits  - non-interest bearing          |       | 21,208                                  |       |                                    |       |   |   | 4,825 |   |   |   |   |   |
| Other  non-interest bearing liabilities          |       | 314                                     |       |                                    |       |   |   | 384 |   |   |   |   |   |
| Shareholders’  equity                       |       | 11,217                                  |       |                                    |       |   |   | 12,846 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity |       | $                                       | 66,659     |                                    |       |   |   |   | $ | 37,359 |   |   |   |   |   |
|                                             |       |                                    |       |                                    |       |   |   |   |   |   |   |   |   |
| Net interest  income                             |       |                                    |       | $                                       | 818        |   |   |   |   |   | $ | 273 |   |   |   |
|                                             |       |                                    |       |                                    |       |   |   |   |   |   |   |   |   |
| Interest rate  spread (3)                        |       |                                    |       |                                    |       | 4.46 | % |   |   |   |   | 3.39 | % |
| Net interest  margin (4)                         |       |                                    |       |                                    |       | 5.66 | % |   |   |   |   | 4.11 | % |
|                                                  |            |                                         |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                       | ** ** | **Six  Months Ended  March 31,  2006** | ** ** | **Six  Months Ended  March 31,  2005** | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **Average**                            | ** ** | ** **                             | ** ** | **Yield /** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield /** | ** ** |
| ** **                                       | ** ** | **Balance**                            | ** ** | **Interest  (2)**                      | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest  (2)** | ** ** | **Rate** | ** ** |
| Interest Earning  Assets:                        |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| Loans (1)                                        |       | $                                      | 43,197     |                                   | $          | 1,772 |   | 8.20 | % | $ | 14,515 |   | $ | 566 |   | 7.80 | % |
| Taxable  investment securities                   |       | 3,581                                  |       | 54                                     |       | 3.02 | % | 4,017 |   | 57 |   | 2.84 | % |
| Federal funds  sold                              |       | 5,105                                  |       | 107                                    |       | 4.19 | % | 7,588 |   | 86 |   | 2.27 | % |
| Interest bearing  deposits with other banks      |       | 2,476                                  |       | 52                                     |       | 4.20 | % | — |   | 15 |   | 0.00 | % |
| FHLB and TIB  stock                              |       | 319                                    |       | 7                                      |       | 4.39 | % | 211 |   | — |   | 0.00 | % |
| Total interest  earning assets                   |       | 54,678                                 |       | 1,992                                  |       | 7.29 | % | 26,331 |   | 724 |   | 5.50 | % |
| Non-interesting  earning assets                  |       | 8,916                                  |       |                                   |       |   |   | 12,004 |   |   |   |   |   |
| Total Assets                                     |       | $                                      | 63,594     |                                   |       |   |   |   | $ | 38,335 |   |   |   |   |   |
|                                             |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| Interest Bearing  Liabilities:                   |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| Deposits:                                        |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| NOW and money  market deposits                   |       | $                                      | 16,031     |                                   | 164        |   | 2.05 | % | $ | 10,635 |   | 79 |   | 1.49 | % |
| Savings deposits                                 |       | 482                                    |       | 1                                      |       | 0.41 | % | 458 |   | 2 |   | 0.87 | % |
| Time Deposits                                    |       | 12,705                                 |       | 216                                    |       | 3.40 | % | 5,936 |   | 72 |   | 2.43 | % |
| Short-term  borrowings                           |       | 77                                     |       | 1                                      |       | 2.60 | % | 804 |   | — |   | 0.00 | % |
| Property  mortgage and long-term borrowings      |       | 2,710                                  |       | 82                                     |       | 6.05 | % | 2,886 |   | 59 |   | 4.09 | % |
| Total interest  bearing liabilities              |       | 32,005                                 |       | 464                                    |       | 2.90 | % | 20,719 |   | 212 |   | 2.05 | % |
| Demand deposits  - non-interest bearing          |       | 19,917                                 |       |                                   |       |   |   | 5,076 |   |   |   |   |   |
| Other  non-interest bearing liabilities          |       | 56                                     |       |                                   |       |   |   | 792 |   |   |   |   |   |
| Shareholders’  equity                       |       | 11,616                                 |       |                                   |       |   |   | 11,748 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity |       | $                                      | 63,594     |                                   |       |   |   |   | $ | 38,335 |   |   |   |   |   |
|                                             |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| Net interest  income                             |       |                                   |       | $                                      | 1,528      |   |   |   |   |   | $ | 512 |   |   |   |
|                                             |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| Interest rate  spread (3)                        |       |                                   |       |                                   |       | 4.39 | % |   |   |   |   | 3.45 | % |
| Net interest  margin (4)                         |       |                                   |       |                                   |       | 5.59 | % |   |   |   |   | 3.89 | % |
|                                                  |            |                                        |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

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

 

(2)                                  Interest income includes loan fees of $26,000and $56,000, respectively, for the three months and six months ended March 31,2006 and $19,000 and $29,000, respectively, for the three months and six monthsended March 31, 2005.

 

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

 

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

 

15

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***Volume, Mix andRate Analysis of Net Interest Income***

 

Thefollowing table presents the extent to which changes in volume, changes ininterest rates, and changes in the interest rates times the changes in volumeof interest earning assets and interest bearing liabilities affected the Bank’sinterest income and interest expense during the periods indicated. Informationis provided on changes in each category due to (1) changes attributable tochanges in volume (change in volume times the prior period interest rate),(2) changes attributable to changes in interest rate (changes in ratetimes the prior period volume), and (3) changes attributable to changes inrate/volume (changes in interest rate times changes in volume). Changesattributable to the combined impact of volume and rate have been allocatedproportionally to the changes due to volume and the changes due to rate: 

 
| ** **                                 | ** ** | **Three  Months Ended March 31, 2006  Compared to  Three Months Ended March 31, 2005** | ** ** | **Six  Months Ended March 31, 2006  Compared to  Six Months Ended March 31, 2005** | ** ** |
|--------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Change  Due**                                                                        | ** ** | **Change  Due**                                                                    | ** ** | **Total** | ** ** | **Change  Due** | ** ** | **Change  Due** | ** ** | **Total** | ** ** |
| ** **                                 | ** ** | **to  Volume**                                                                         | ** ** | **to Rate**                                                                        | ** ** | **Change** | ** ** | **to  Volume** | ** ** | **to Rate** | ** ** | **Change** | ** ** |
| **Interest Earning Assets:**               | ** ** | ** **                                                                             | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans                                      |       | 2,360                                                                                  |       | (1,743                                                                             | )          | 617 |   | 2,355 |   | (1,149 | ) | 1,206 |   |
| Taxable  investment securities             |       | (57                                                                                    | )          | 45                                                                                 |       | (12 | ) | (13 | ) | 10 |   | (3 | ) |
| Federal funds  sold                        |       | (7,530                                                                                 | )          | 7,581                                                                              |       | 51 |   | (68 | ) | 89 |   | 21 |   |
| Interest bearing  deposits in banks        |       | 4                                                                                      |       | 3                                                                                  |       | 7 |   | 18 |   | 19 |   | 37 |   |
| Federal Home Loan  Bank stock and other    |       | 2                                                                                      |       | 2                                                                                  |       | 4 |   | 4 |   | 3 |   | 7 |   |
|                                       |       |                                                                                   |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Increase (decrease) in interest income     |       | (5,221                                                                                 | )          | 5,888                                                                              |       | 667 |   | 2,296 |   | (1,028 | ) | 1,268 |   |
|                                       |       |                                                                                   |       |                                                                               |       |   |   |   |   |   |   |   |   |
| **Interest Bearing Liabilities:**          | ** ** | ** **                                                                             | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| NOW and money  market deposit accounts     |       | 229                                                                                    |       | (174                                                                               | )          | 55 |   | 155 |   | (70 | ) | 85 |   |
| Savings deposits                           |       | 11                                                                                     |       | (11                                                                                | )          | — |   | — |   | (1 | ) | (1 | ) |
| Time deposits                              |       | 323                                                                                    |       | (238                                                                               | )          | 85 |   | 269 |   | (125 | ) | 144 |   |
| Short term  borrowings                     |       | —                                                                                 |       | —                                                                             |       | — |   | — |   | 1 |   | 1 |   |
| Long term  borrowings                      |       | (13                                                                                    | )          | (5                                                                                 | )          | (18 | ) | — |   | 23 |   | 23 |   |
|                                       |       |                                                                                   |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Increase (decrease) in interest expense    |       | 550                                                                                    |       | (428                                                                               | )          | 122 |   | 424 |   | (172 | ) | 252 |   |
|                                       |       |                                                                                   |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Increase (decrease) in net interest income |       | (5,771                                                                                 | )          | 6,316                                                                              |       | 545 |   | 1,872 |   | (856 | ) | 1,016 |   |

 

***Provision for Loan Losses***

 

Theprovision for loan losses is an expense determined by management as the amountnecessary to increase the allowance for loan losses after net charge-offs havebeen deducted to a level that, in management’s best estimate, is necessary toabsorb probable losses in the loan portfolio. The amount of the provision isbased on management’s review of the loan portfolio and consideration of suchfactors as historical loss experience, general prevailing economic conditions,changes in the size and composition of the loan portfolio and specific borrowerconsiderations, including the ability of the borrower to repay the loan and theestimated value of the underlying collateral. The provision is calculatedmonthly and a charge to expense is made, as required, to increase the allowanceto the calculated level. For any particular month, in the event the requiredallowance is less than or equal to the current allowance, no expense is chargedor reversed.

 

Forthe three months ended March 31, 2006, the provision for loan losses was$45,000 compared to $30,000 for the three months ended March 31, 2005. For thethree months ended March 31, 2005, the Bank charged off $1,000 in commercialand consumer loans and had recoveries of loans previously charged off of $1,000for net charge offs of $0. For the three months ended March 31, 2006, the Bankcharged off $4,000 in commercial and consumer loans and had zero recoveries ofloans previously charged off for net charge offs of $4,000. The factorscombined increased the Allowance for Loan Losses to $358,000 or 0.73% of theportfolio. This amount represents management’s estimate of potential lossesinherent in the portfolio. For the six month’s ended March 31, 2006 and March31, 2005, the provision for loan losses was $90,000 and $30,000 respectively.For the six months ended March 31, 2006, the Bank charged off $10,000 incommercial and consumer loans and had recoveries of loans

 

16

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previously charged off of $1,000 for a net charge offof $9,000. For the six months ended March 31, 2005, the Bank charged off $1,000in commercial and consumer loans and had recoveries of loans previously chargedoff of $12,000, for a net recovery of $11,000.

 

***Income Taxes***

 

Nofederal tax benefit has been recorded for the three and six months ended March31, 2006, and 2005, based upon net operating losses incurred and carriedforward in previous years. Based upon the Company’s limited operating history,the federal tax benefit of these losses has been fully reserved against, asmanagement believes their realization is not more likely than not to occur.

 

**FinancialCondition**

 

***Loan Portfolio***

 

Netloans increased $12,850,000 (36%) to $48,533,000 from $35,683,000 between March31, 2006 and September 30, 2005. The concentration within the portfolio hasshifted over time from the previous concentration of agricultural loans to realestate and commercial loans.

 

***Loan Portfolio Mix***

 

Thefollowing tables set forth the composition of the loan portfolio:

 
| ** **                      | ** ** | **March 31, 2006** | ** ** | **September 30, 2005** | ** ** |
|---------------------------------|------------|--------------------|------------|------------------------|------------|
|                            |       |               |       |                   |       |
| Agriculture                     |       | $                  | 2,828      |                   | $          | 3,261 |   |
| Commercial                      |       | 14,048             |       | 12,887                 |       |
| Commerical real estate          |       | 14,902             |       | 8,619                  |       |
| Residential real estate         |       | 7,287              |       | 4,524                  |       |
| Construction real estate        |       | 5,472              |       | 4,152                  |       |
| Consumer                        |       | 4,354              |       | 2,517                  |       |
|                            |       |               |       |                   |       |
|                            |       | 48,891             |       | 35,960                 |       |
| Less: allowance for loan losses |       | (358               | )          | (277                   | )          |
|                            |       |               |       |                   |       |
|                            |       | $                  | 48,533     |                   | $          | 35,683 |   |

 

Loanconcentrations are considered to exist when there are amounts loaned to amultiple number of borrowers engaged in similar activities that would causethem to be similarly impacted by economic or other conditions.

 

Priorto its acquisition by us, the Bank operated a branch office in Houston, Texas(which was closed in 2002), and a second portfolio concentration developed withloans of one-to-four family residential real estate. Approximately $1,137,000of the Bank’s residential real estate portfolio is comprised of single familyresidences in Houston. The majority of these loans originated between 1996 and1998 for 15-year terms with fixed rates of 8.75% or greater. These loansadditionally have five-year call provisions exercisable at the Bank’sdiscretion.

 

Theseresidential real estate loans are expected to decrease as the individual loanscontinue to pay down. The majority of new loan growth is expected to originatefrom the Austin market. As had been anticipated by management, loans originatedfrom the Austin market reflect a broader, more diverse mix of industries and

 

17

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borrowers than had been the case previously. As newloans continue to originate for non-agricultural and non residential realestate purposes, the percentage of the total loan portfolio creating theconcentrations described above will continue to decline thereby diminishingundue risk associated with industry concentration.

 

Managementmay renew loans at maturity when requested by a customer whose financialstrength appears to support such a renewal or when such a renewal appears to bein the best interest of the Bank. The Bank requires payment of accrued interestin such instances and may adjust the rate of interest, require a principalreduction, or modify other terms of the loan at the time of renewal.

 

*Loan Maturities*

 

As ofMarch 31, 2005, 46.49% of the loan portfolio consisting of agricultural,commercial, real estate  and consumerloans, or $22,729,000, mature or re-price within one year or less. $38,562,000of the loan portfolio, or 78.87%, are variable rate loans. At September 30,2005, 36.52% of the loan portfolio consisting of agricultural, commercial, realestate and consumer loans, or $13,132,000, matured or re-priced within one yearor less. $28,108,000 of the loan portfolio, or 78.16%, were variable rateloans. The following table presents the contractual maturity ranges for agricultural,commercial, real estate and consumer loans outstanding at March 31, 2006, andat September 30, 2005, and also presents for each maturity range the portion ofloans that have fixed interest rates or interest rates that fluctuate over thelife of the loan in accordance with changes in the interest rate environment asrepresented by the base rate:

 
| ** **                 | ** ** | **Due in  One Year  or Less** | ** ** | **Due  after One Year  Through  Five Years** | ** ** | **Due  after  Five Years** | ** ** | ** **         | ** ** |
|----------------------------|------------|-------------------------------|------------|----------------------------------------------|------------|----------------------------|------------|--------------------|------------|
| **March 31, 2006**         | ** ** | **Fixed  Rate**               | ** ** | **Floating  Rate**                           | ** ** | **Fixed  Rate**            | ** ** | **Floating  Rate** | ** ** | **Fixed  Rate** | ** ** | **Floating  Rate** | ** ** | **Total** | ** ** |
|                       |       |                          |       |                                         |       |                       |       |               |       |   |   |   |   |   |   |
| Agricultural               |       | $                             | 5,000      |                                         | $          | 1,794,000                  |       | $                  | —     |   | $ | 524,000 |   | $ | — |   | $ | 505,000 |   | $ | 2,828,000 |   |
| Real Estate-residential    |       | 1,156,000                     |       | 1,738,000                                    |       | 1,813,000                  |       | 1,300,000          |       | 1,214,000 |   | 66,000 |   | 7,287,000 |   |
| Real Estate- commercial    |       | 256,000                       |       | 4,799,000                                    |       | 287,000                    |       | 6,883,000          |       | 20,000 |   | 2,657,000 |   | 14,902,000 |   |
| Real Estate - construction |       | 573,000                       |       | 2,070,000                                    |       | 113,000                    |       | 2,716,000          |       | — |   | — |   | 5,472,000 |   |
| Commercial                 |       | 226,000                       |       | 6,915,000                                    |       | 1,844,000                  |       | 4,945,000          |       | — |   | 118,000 |   | 14,048,000 |   |
| Consumer and Other         |       | 2,163,000                     |       | 1,034,000                                    |       | 659,000                    |       | 498,000            |       | — |   | — |   | 4,354,000 |   |
| **Total**                  |       | $                             | 4,379,000  |                                         | $          | 18,350,000                 |       | $                  | 4,716,000  |   | $ | 16,866,000 |   | $ | 1,234,000 |   | $ | 3,346,000 |   | $ | 48,891,000 |   |
|                            |            |                               |            |                                              |            |                            |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                 | ** ** | **Due in  One Year  or Less** | ** ** | **Due after  One Year  Through  Five Years** | ** ** | **Due  after  Five Years** | ** ** | ** **         | ** ** |
|----------------------------|------------|-------------------------------|------------|----------------------------------------------|------------|----------------------------|------------|--------------------|------------|
| **September 30, 2005**     | ** ** | **Fixed  Rate**               | ** ** | **Floating  Rate**                           | ** ** | **Fixed  Rate**            | ** ** | **Floating  Rate** | ** ** | **Fixed  Rate** | ** ** | **Floating  Rate** | ** ** | **Total** | ** ** |
|                       |       |                          |       |                                         |       |                       |       |               |       |   |   |   |   |   |   |
| Agricultural               |       | $                             | 16,000     |                                         | $          | 1,873,000                  |       | $                  | 2,000      |   | $ | 766,000 |   | $ | — |   | $ | 604,000 |   | $ | 3,261,000 |   |
| Real Estate-residential    |       | 706,000                       |       | —                                       |       | 1,063,000                  |       | 1,612,000          |       | 1,077,000 |   | 66,000 |   | 4,524,000 |   |
| Real Estate- commercial    |       | 233,000                       |       | 1,059,000                                    |       | 339,000                    |       | 4,975,000          |       | — |   | 2,013,000 |   | 8,619,000 |   |
| Real Estate - construction |       | —                        |       | 936,000                                      |       | —                     |       | 2,988,000          |       | 228,000 |   | — |   | 4,152,000 |   |
| Commercial                 |       | 328,000                       |       | 6,352,000                                    |       | 2,149,000                  |       | 3,935,000          |       | — |   | 123,000 |   | 12,887,000 |   |
| Consumer and Other         |       | 1,156,000                     |       | 473,000                                      |       | 539,000                    |       | 333,000            |       | 16,000 |   | — |   | 2,517,000 |   |
| **Total**                  |       | $                             | 2,439,000  |                                         | $          | 10,693,000                 |       | $                  | 4,092,000  |   | $ | 14,609,000 |   | $ | 1,321,000 |   | $ | 2,806,000 |   | $ | 35,960,000 |   |
|                            |            |                               |            |                                              |            |                            |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Investment Securities***

 

Theprimary purposes of the investment portfolio are to provide a source ofearnings for liquidity management purposes, to provide collateral to pledgeagainst public deposits, and to control interest rate risk. In managing theportfolio, the Bank seeks to attain the objectives of safety of principal,liquidity, diversification, and maximized return on investment.

 

Thefollowing tables set forth the amortized cost and fair value of the Bank’ssecurities portfolio by accounting classification category and by type ofsecurity as indicated:

 

18

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| ** **                           | ** ** | **As of  March 31, 2006** | ** ** | **As of  September 30, 2005** | ** ** |
|--------------------------------------|------------|---------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | **Amortized  Cost**       | ** ** | **Fair  Value**               | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| Securities Held  to Maturity:        |       |                      |       |                          |       |   |   |   |   |
|                                 |       |                      |       |                          |       |   |   |   |   |
| U.S. Government  Agencies            |       | $                         | 2,498      |                          | $          | 2,473 |   | $ | 3,495 |   | $ | 3,467 |   |
| Mortgage-backed  securities          |       | 6                         |       | 5                             |       | 6 |   | 5 |   |
| Total Securities  Held to Maturity   |       | 2,504                     |       | 2,478                         |       | 3,501 |   | 3,472 |   |
|                                 |       |                      |       |                          |       |   |   |   |   |
| Securities  Available for Sale:      |       |                      |       |                          |       |   |   |   |   |
|                                 |       |                      |       |                          |       |   |   |   |   |
| U.S. Government  Agencies            |       | 400                       |       | 397                           |       | 401 |   | 396 |   |
| Mortgage-backed  securities          |       | 21                        |       | 21                            |       | 30 |   | 31 |   |
| Total Securities  Available for Sale |       | 421                       |       | 418                           |       | 431 |   | 427 |   |
|                                 |       |                      |       |                          |       |   |   |   |   |
| Total                                |       | $                         | 2,925      |                          | $          | 2,896 |   | $ | 3,932 |   | $ | 3,899 |   |

 

U.S.Treasury securities and securities of U.S. Government agencies generallyconsist of fixed rate securities with maturities of three months to five years.Other mortgage backed securities consists of fixed rate mortgage pass-throughsecurities with a maturity of five to fifteen years.

 

***Asset Quality***

 

The following table sets forth the amount ofnon-performing loans and non-performing assets as of March 31, 2006, andSeptember 30, 2005: 

 
| ** **                                               | ** ** | **At March 31,  2006** | ** ** | **At September 30,  2005** | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
|                                                     |       |                   |       |                       |       |
| Non-accruing  loans                                      |       | $                      | 175,000    |                       | $          | 85,000 |   |
| Loans 90 days or  more past due, still accruing interest |       | —                 |       | 6,000                      |       |
|                                                     |       |                   |       |                       |       |
| Total  non-performing loans                              |       | 175,000                |       | 91,000                     |       |
| Other real  estate owned                                 |       | 36,000                 |       | —                     |       |
| Other  repossessed assets                                |       | 15,000                 |       | 15,000                     |       |
|                                                     |       |                   |       |                       |       |
| Total  non-performing assets                             |       | $                      | 226,000    |                       | $          | 106,000 |   |
|                                                     |       |                   |       |                       |       |
| Total  non-performing loans to total loans               |       | 0.36                   | %          | 0.25                       | %          |
| Allowance for  loan losses to non-performing loans       |       | 205                    | %          | 304                        | %          |
| Total  non-performing loans to total assets              |       | 0.34                   | %          | 0.17                       | %          |
|                                                          |            |                        |            |                            |            |  |  |  |

 

***Non-performing Loans***

 

Non-performingloans include (1) loans accounted for on a non-accrual basis,(2) accruing loans contractually past due 90 days or more as tointerest and principal, and (3) troubled debt restructurings. Managementreviews the loan portfolio for problem loans on an ongoing basis.

 

Duringthe ordinary course of business, management becomes aware of borrowers that maynot be able to meet the contractual requirements of loan agreements. Such loansare placed under close supervision with consideration given to placing the loanon a non-accrual status, increasing the allowance for loan losses, and (ifappropriate) partial or full charge-off. After a loan is placed on non-accrualstatus, any current year interest previously accrued but not yet collected isreversed against current income. When payments are received on non-accrualloans, such payments are applied to principal and not taken into income. Loansare not placed back on accrual status unless all back interest and principalpayments are made. If interest on non-accrual loans had been accrued, suchincome would have amounted to approximately $ 3,000 and $800 for the threemonths ended March 31, 2006 and March 31, 2005, respectively. For the

 

19

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six months ended March 31, 2006 and March 31, 2005 such income wouldhave amounted to approximately $4,400 and $3,800 respectively. These amounts werenot included in interest income during these periods.

 

UnderFederal and Texas law, any loan 90 or more days past due is required to beplaced on non-accrual basis unless specifically identified mitigatingcircumstances exist. Our policy is to place loans 90 days past due onnon-accrual status. An exception is made when management believes the loan isfully secured and in process of collection. Non-accrual loans are furtherclassified as impaired when underlying collateral is not sufficient to coverthe loan balance and it is probable that we will not fully collect allprincipal and interest. As of March 31, 2006 and September 30, 2005, we had $175,000and $85,000 in non-accrual loans, respectively. Loans contractually past dueover 90 days which continued to accrue interest totaled $0 on March 31, 2006and $6,000 on September 30, 2005, based upon specific informationavailable at that time to management. In compliance with these statutes we havedeveloped pro forma financial statements assuming that no loans will continueto accrue interest if they become 90 days past due, and instead transferall such loans to non-accruing status.

 

A “troubleddebt restructuring” is a restructured loan upon which interest accrues at abelow market rate or upon which certain principal has been forgiven so as toaid the borrower in the final repayment of the loan, with any interestpreviously accrued, but not yet collected, being reversed against currentincome. Interest is accrued based upon the new loan terms. There were notroubled debt restructurings outstanding as of March 31, 2006 or September30, 2005*.*

 

Non-performingassets also consist of other repossessed assets and other real estate owned (“OREO”).OREO represents properties acquired through foreclosure or other proceedingsand is recorded at the lower of cost or fair market value less the estimatedcost of disposal. OREO is evaluated regularly to ensure that the recordedamount is supported by its current fair market value. Valuation allowances toreduce the carrying amount to fair market value less estimated costs ofdisposal are recorded as necessary. Revenues and expenses from the operationsof OREO and changes in the valuation are included in other income and otherexpenses on the income statement. As of March 31, 2006, we had $36,000 in otherreal estate owned. The property consists of two single family dwellings locatedin Dalhart, Texas, and one single family dwelling located in Texline, Texas. AtSeptember 30, 2005, we had no other real estate owned, and no acquisitions ordispositions of OREO during the fiscal year. Repossessed assets totaled $15,000at March 31, 2006 and September 30, 2005.

 

***Sources of Funds***

 

*General*

 

Deposits,short-term and long-term borrowings, loan and investment security repaymentsand prepayments, proceeds from the sale of securities, and cash flows generatedfrom operations are the primary sources of our funds for lending, investing,and other general purposes. Loan repayments are a relatively predictable sourceof funds except during periods of significant interest rate declines, whiledeposit flows tend to fluctuate with prevailing interests rates, money marketsconditions, general economic conditions, and competition.

 

*Deposits*

 

Weoffer a variety of deposit accounts with a range of interest rates and terms.Core deposits consist of checking accounts (non-interest bearing), “NOW”accounts, 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 competing financialinstitutions significantly affect our ability to attract and retain deposits.

 

Thefollowing table sets forth the maturities of time deposits $100,000 and over asof March 31, 2006 and September 30, 2005:

 

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| ** **                                | ** ** | **At March 31, 2006** | ** ** | **At September 30, 2005** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|---------------------------|------------|
| Time deposits $100,000 and over:          |       |                  |       |                      |       |
| Matuiring within  three months            |       | $                     | 3,315,000  |                      | $          | 4,760,000 |   |
| After three  months but within six months |       | 1,724,000             |       | 1,205,000                 |       |
| After six months  but within 12 months    |       | 911,000               |       | 1,523,000                 |       |
| After 12 months                           |       | 309,000               |       | 309,000                   |       |
|                                      |       |                  |       |                      |       |
| Total time deposits $100,000 and over:    |       | $                     | 6,259,000  |                      | $          | 7,797,000 |   |

 

*Returnon Equity and Assets*

 

Thefollowing table sets forth certain information regarding the Company’s returnon equity and assets for the periods indicated:

 
| ** **             | ** ** | **For the  Three Months  Ended** | ** ** | **For the  Six Months  Ended** | ** ** |
|------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **             | ** ** | **March 31,  2006**              | ** ** | **March 31,  2005**            | ** ** | **March 31,  2006** | ** ** | **March 31,  2005** | ** ** |
|                   |       |                             |       |                           |       |   |   |   |   |
| Return on assets       |       | 0.03                             | %          | -3.59                          | %          | -0.07 | % | -4.03 | % |
| Return on equity       |       | 0.21                             | %          | -12.74                         | %          | -0.45 | % | -13.70 | % |
| Dividend payout ratio  |       | 0                                | %          | 0                              | %          | 0 | % | 0 | % |
| Equity to assets ratio |       | 15.36                            | %          | -29.07                         | %          | 15.36 | % | -29.43 | % |

 

**CapitalResources**

 

Therisk-based capital regulations established and administered by the bankingregulatory agencies discussed previously are applicable to the Bank. Risk-basedcapital guidelines are designed to make regulatory capital requirements moresensitive to differences in risk profiles among banks, to account foroff-balance sheet exposure, and to minimize disincentives for holding liquidassets. Under the regulations, assets and off-balance sheet items are assignedto broad risk categories, each with appropriate weights. The resulting capitalratios represent capital as a percentage of total risk weighted assets andoff-balance sheet items. Under the prompt corrective action regulations, to beadequately capitalized 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 materialadverse effect on the Bank’s financial statements.

 

As ofMarch 31, 2006 and as of September 30, 2005, the most recent notifications fromthe federal banking regulators categorized the Bank as well-capitalized. Awell-capitalized institution must maintain a minimum ratio of total capital torisk-weighted assets of at least 10.00%, a minimum ratio of Tier 1 capital torisk weighted assets of at least 6.00%, and a minimum ratio of Tier 1 capitalto total assets 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.

 

TheBank was in full compliance with all applicable capital adequacy requirementsas of March 31, 2006 and September 30, 2005. The required and actual amountsand ratios for the Bank as of March 31, 2006 and September 30, 2005, arepresented below:

 

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| ** **                              | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|-----------------------------------------|------------|------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                              | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| (Bank Only)                             |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| March 31, 2006:                         |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Tier I capital  to average assets       |       | $          | 7,796      |                               | 12.93      | %                                                                       | $          | 2,411 |   | 4.0 | % | $ | 3,014 |   | 5.0 | % |
| Tier I capital  to risk weighted assets |       | 7,796      |       | 14.37                              | %          | 2,170                                                                   |       | 4.0 | % | 3,256 |   | 6.0 | % |
| Total capital to  risk weighted assets  |       | 8,154      |       | 15.03                              | %          | 4,341                                                                   |       | 8.0 | % | 5,426 |   | 10.0 | % |
| September 30, 2005:                     |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Tier I capital to  average assets       |       | $          | 7,617      |                               | 14.71      | %                                                                       | $          | 2,071 |   | 4.0 | % | $ | 2,589 |   | 5.0 | % |
| Tier I capital  to risk weighted assets |       | 7,617      |       | 18.12                              | %          | 1,654                                                                   |       | 4.0 | % | 2,481 |   | 6.0 | % |
| Total capital to  risk weighted assets  |       | 7,894      |       | 19.09                              | %          | 3,307                                                                   |       | 8.0 | % | 4,134 |   | 10.0 | % |
|                                         |            |            |            |                                    |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |

 

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

 

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 chiefexecutive officer and chief financial officer concluded that the disclosurecontrols and procedures are effective to ensure that the information requiredto be disclosed by the Company in reports that it files or submits under theExchange Act is recorded, processed, summarized and reported to the Company’smanagement within the time periods specified in the Securities and ExchangeCommission’s rules and forms.

 

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 thenew rules, the Company is currently in the process of further reviewing anddocumenting its disclosure controls and procedures, including its internal accountingcontrols, and may from time to time make changes aimed at enhancing theireffectiveness and ensuring that the Company’s systems evolve with its business.

 

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

 

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

 

None

 

**Item 2.****                    *Changes in Securities and Use of Proceeds***

 

On May 7, 2004, theSecurities and Exchange Commission declared our Registration Statement on FormSB-2 (File No. 333-112325) related to our initial public offering effective. Inaddition, on October 22, 2004, we filed a Form SB-2MEF under Rule 462registering additional shares of common stock and warrants to purchase ourcommon stock under our public offering. We registered a total of 1,944,000shares of our common stock, of which 324,000 shares are issuable underregistered common stock warrants. We accepted subscriptions for 1,589,602shares of our common stock under the offering and have received net offeringproceeds (after deducting offering expenses) of approximately $11.9 million.

 

22

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As of March 31, 2006, wehad paid our organizing shareholder and affiliate, Treaty Oak Holdings forreimbursement of expenses and advances on our behalf in connection with ouroffering and repayment of the amount due under a convertible promissory note. TreatyOak Holdings owns approximately 39% of our common stock. We contributed to thecapital of the Bank and paid operating expenses including repayment of certaincosts previously paid by Treaty Oak Holdings. We also repaid principal andinterest under unsecured promissory notes issued in connection with thepurchase price of the Bank. The table below summarizes the use of net offeringproceeds through March 31, 2006:

 

| ** **                                                                                                                                                                                | ** ** | **As of  03/31/06** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|
| Gross proceeds  from sale of shares                                                                                                                                                       |       | 13,276,271          |       |
| Amounts receivable  as of December 31, 2004                                                                                                                                               |       | —              |       |
|                                                                                                                                                                                      |       |                |       |
| Repayment of  offering and start-up costs under Expense Reimbursement Agreement to Treaty  Oak Holdings, Inc., including offering costs of $500,000 and pre-opening  expenses of $275,000 |       | (775,000            | )          |
| Repayment of  note payable to Treaty Oak Holdings, Inc., including accrued interest of  approximately $7,000                                                                              |       | (507,302            | )          |
|                                                                                                                                                                                      |       |                |       |
| Repayment of  notes payable for the acquisition of Texline State Bank including accrued  interest of approximately $29,000                                                                |       | (1,015,332          | )          |
| Contribution to  the capital of the Bank                                                                                                                                                  |       | (7,500,000          | )          |
|                                                                                                                                                                                      |       |                |       |
| Payments to  directors and officers (bonuses and directors’ fees)                                                                                                                    |       | (172,687            | )          |
| Payments to  officers (salary and benefits)                                                                                                                                               |       | (298,320            | )          |
| Other payments  to affiliates for services                                                                                                                                                |       | (146,057            | )          |
|                                                                                                                                                                                      |       |                |       |
| Limited  partnership investment in affiliated limited partnership                                                                                                                         |       | (1,030,000          | )          |
| Loan to  affiliated company                                                                                                                                                               |       | (352,397            | )          |
| Repurchase of  shares issued                                                                                                                                                              |       | (50,005             | )          |
| Payment of  additional operating expenses (estimated)                                                                                                                                     |       | (779,906            | )          |
| Remaining net  proceeds                                                                                                                                                                   |       | 649,265             |       |

 

$679,691of the amount referenced as “Repayment of notes payable for the acquisition ofTexline State Bank was paid to Charles T. Meeks, a member of our Board ofDirectors and Chairman of the Board of the Bank. An additional amount of$18,783 due to Mr. Meeks from the acquisition of the Bank previously held inescrow is also included in this amount. On November 18, 2004, we approved thepurchase of a 47.5% preferential limited partnership interest in PGI EquityPartners, L.P., which owns and operates the building premises we lease, for$950,000. A deposit of $150,000 was paid on November 18, 2004 and the balanceof the purchase price of $800,000 was paid on December 30, 2004, at closing. OnFebruary 23, 2006, we purchased the remaining 3.75% minority interests in PGIEquity Partners, LP for $80,000 bringing the Company’s percentage ownership to51.25%. We had originally anticipated these funds would be used to capitalizethe Bank, but we believe the investment in premises will allow us theopportunity to realize more value from appreciation in the real property ratherthan over-capitalizing the Bank. On October 11, 2005, Treaty Oak Bancorp, Inc.made a $355,000 loan to Treaty Oak Holdings, Inc. (“TOHI”) with monthlyinterest payments due on the first of each month beginning November 1, 2005. OnApril 10, 2006, the loan was renewed and increased to $373,000. The totalprincipal advanced under this loan through March 31, 2006, was $352,000. Thepurpose of the loan was to enable TOHI to pay off certain obligations, and toprovide sufficient liquidity to TOHI until the proposed merger with the Companyhas been completed. The principal balance, along with any accrued interest, isdue and payable in full on September 1, 2006.

 

The remaining netproceeds have been invested in short-term interest bearing, money marketaccounts.

 

## **Item 3.**                    *Defaults upon Senior Securities*

 

## **None.**

 

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

## ** **

On February 28, 2006, weheld our annual meeting of shareholders. Holders of 1,483,370 of the 2,634,986outstanding shares of our common stock as of December 31, 2005, were present atthe meeting in person or by proxy. The following matters were approved at themeeting as indicated below.

 

1. Election of Class II Directors (to serve terms until 2009 annual meeting):

 
| **Nominee**                     | ** ** | **Votes** | ** ** | **Votes Withheld** | ** ** |
|---------------------------------|------------|-----------|------------|--------------------|------------|
| Hayden D. Watson                |       | 1,483,370 |       | —             |       |
| Jeffrey L. Nash                 |       | 1,483,370 |       | —             |       |
| Elias F. “Lee” Urbina |       | 1,483,010 |       | —             |       |

 

2.               Ratification ofMcGladrey & Pullen, LLP as auditors. 1,470,973 shares voted in favor, 600shares voted against, and 11,794 shares abstained.

 

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

 

On February 28, 2006, Terry W. Hamann resigned as Chairman, President and Chief Executive Officer of the Company. Mr. Hamann was subsequently elected “Chairman Emeritus” by the Company’s board of directors. Charles T. Meeks was elected Chairman of the Company’s Board of Directors and Jeffrey L. Nash was elected President and Chief Executive Officer of the Company. Mr. Meeks also serves as Chairman of the Board of Directors of the Company’s principal subsidiary, Treaty Oak Bank. Mr. Nash currently serves as the Company’s Chief Financial Officer and as a director, and also serves as a director as well as President and Chief Executive Officer of the Company’s principal subsidiary, Treaty Oak Bank. (See the Company’s Form 8-K filed with the S.E.C. on March 3, 2006).

 

## **Item 6.**                    *Exhibits*

 

a.               Exhibits

 
| 3      | .1     |   | Amended and  Restated Articles of Incorporation (filed as Exhibit 4.1 to Registration Statement  on Form S-8 filed with the Commission on October 22, 2004 (File No.  333-119914, which exhibit is incorporated herein by reference) |
|--------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                 |
| 3      | .2*    |   | By-laws                                                                                                                                                                                                                              |
|   |   |   |                                                                                                                                                                                                                                 |
| 4      | .1*    |   | Specimen Common  Stock Certificate, $.01 par value per share                                                                                                                                                                         |
|   |   |   |                                                                                                                                                                                                                                 |
| 4      | .2*    |   | See Exhibits 3.1  and 3.2 for provisions of the Articles of Incorporation and By-laws defining  rights of holders of Common Stock                                                                                                    |
|   |   |   |                                                                                                                                                                                                                                 |
| 31     | .1     |   | Certification of  Chief Executive Officer required by Rule 13a-14(a)/15d-14(a) under the  Exchange Act                                                                                                                               |
|   |   |   |                                                                                                                                                                                                                                 |
| 31     | .2     |   | Certification of  Chief Financial Officer required by Rule 13a-14(a)/15d-14(a) under the  Exchange Act                                                                                                                               |
|   |   |   |                                                                                                                                                                                                                                 |
| 32     | .1     |   | Certification of  Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of Sarbanes-Oxley Act of 2002                                                                                      |
|   |   |   |                                                                                                                                                                                                                                 |
| 32     | .2     |   | Certification of  Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of Sarbanes-Oxley Act of 2002                                                                                      |

 

24

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

 

25

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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: May 15, 2006 | By:                          | /s/ Jeffrey L. Nash |   |
|                |                         | Jeffrey L. Nash,  President and Chief Executive Officer |
|                |                         |   |
|                |                         |   |
|                | By:                          | /s/ Jeffrey L. Nash |   |
|                |                         | Jeffrey L. Nash, Chief  Financial Officer |

 

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