UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549





FORM 10-Q








[ X ]  Quarterly Report Under Section 13 or 15 (d) of


the Securities Exchange Act of 1934


For the Quarterly Period Ended September 30, 2003








[    ] Transition Report Pursuant to Section 13 or 15 (d) of


the Securities Exchange Act of 1934


For the Transition Period from _________ to _________





Commission File Number: 0-24526





Coastal Bancorp, Inc.


(Exact name of Registrant as specified in its charter)








*Texas*
**
**

76-0428727*(State or other jurisdiction of*
**
*(I.R.S. Employer**incorporation or organization)*
**
*Identification No.)*







5718 Westheimer, Suite 600


Houston, Texas 77057


(Address of principal executive office)





(713) 435-5000


(Registrant's telephone number)





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





YES
X
NO





Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).    [ X ]





Indicate the number of shares outstanding of each of the issuer's classes of Common Stock, as of the latest practicable date.





Common Stock Outstanding: 5,235,099 as of October 31, 2003







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Coastal Bancorp, Inc. and Subsidiaries


Form 10-Q


Table of Contents











Part I.  Financial Information










|Item 1 | Financial Statements (unaudited)                                                                                             | 
|------ | ---------------------------------------------------------------------------------------------------------------------------- | 
|       |                                                                                                                              | 
|       | Consolidated Statements of Financial Condition at September 30, 2003 and December 31, 2002                                   | 
|       |                                                                                                                              | 
|       | Consolidated Statements of Income for the Nine-Month Periods Ended September 30, 2003 and 2002                               | 
|       |                                                                                                                              | 
|       | Consolidated Statements of Income for the Three-Month Periods Ended September 30, 2003 and 2002                              | 
|       |                                                                                                                              | 
|       | Consolidated Statements of Comprehensive Income for the Nine-Month and Three-Month Periods
Ended September 30, 2003 and 2002 | 
|       |                                                                                                                              | 
|       | Consolidated Statements of Cash Flows for the Nine-Month Periods Ended September 30, 2003 and 2002                           | 
|       |                                                                                                                              | 
|       | Notes to Consolidated Financial Statements                                                                                   | 
|       |                                                                                                                              | 
|Item 2 | Management's Discussion and Analysis of Financial Condition and Results of Operations                                        | 
|       |                                                                                                                              | 
|Item 3 | Quantitative and Qualitative Disclosures About Market Risk                                                                   | 
|       |                                                                                                                              | 
|Item 4 | Controls and Procedures                                                                                                      | 
















Part II.  Other Information













|       |                                                     | 
|------ | --------------------------------------------------- | 
|Item 1 | Legal Proceedings                                   | 
|       |                                                     | 
|Item 2 | Changes in 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











**Item 1. FINANCIAL STATEMENTS**
****
****
****
****
********
****
****
****
****
******COASTAL BANCORP, INC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION****(In Thousands, except share data)**September 30,
December 31,2003
2002(Unaudited)ASSETSCash and cash equivalents




$
35,347




$
39,766Federal funds sold





1,490





27,755Loans receivable held for sale





-





49,886Loans receivable, net (note 4)





1,951,987





1,812,785Mortgage-backed securities available-for-sale,at fair value
(note 3)

527,668





475,022Other securities available-for-sale, at fair value





2,271





1,788Accrued interest receivable





9,466





9,781Property and equipment





29,804





27,341Stock in the Federal Home Loan Bank of Dallas("FHLB")

45,243





41,221Goodwill





21,429





21,429Prepaid expenses and other assets





16,351





19,370$
2,641,056




$
2,526,144LIABILITIES AND STOCKHOLDERS' EQUITYLiabilities:Deposits (note 5)




$
1,638,914




$
1,614,368Advances from the FHLB (note 6)





792,031





696,085Company obligated mandatorily redeemable 9.0% trustpreferred securities of Coastal Capital Trust I(note 7)
50,000





50,000Company obligated mandatorily redeemable variable ratetrust preferred securities of Coastal Capital Trust II(note 7)

10,000





-Advances from borrowers for taxes and insurance

8,304





2,407Other liabilities and accrued expenses





10,514





10,399Total liabilities





2,509,763





2,373,259Commitments and contingencies (notes 4 and 9)Stockholders' equity (notes 1, 3, 10, 12 and 13):Preferred stock, no par value; authorized shares 5,000,000;9.12% Cumulative, Series A, 1,100,000 shares issuedandoutstanding
-





27,500Common stock, $.01 par value; authorized shares30,000,000; 7,929,485 shares issued and 5,182,610shares outstanding at September 30, 2003; 7,867,029shares issued and 5,141,010 outstanding atDecember 31, 2002
79





79Additional paid-in capital





36,475





35,736Retained earnings





148,699





141,986Accumulated other comprehensive income (loss) - netunrealized gain (loss) on securities available-for-sale


(315
)




619Treasury stock at cost (2,746,875 shares in 2003 and2,726,019shares in 2002)

(53,645
)




(53,035
)Total stockholders' equity





131,293





152,885$
2,641,056




$
2,526,144*See accompanying Notes to Consolidated Financial Statements*









**COASTAL BANCORP, INC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF INCOME****(In Thousands, except per share data)**Nine Months EndedSeptember 30,2003
2002(Unaudited)Interest income:Loans receivable

$
74,880

$
90,357Mortgage-backed securities


10,403


13,060FHLB stock, federal funds sold and other interest-earning assets


829


1,20386,112


104,620Interest expense:Deposits


22,934


30,859Advances from the FHLB


12,749


15,303Senior Notes payable (note 8)


-


378Company obligated mandatorily redeemable trust preferred securities


3,487


1,27539,170


47,815Net interest income


46,942


56,805Provision for loan losses (note 4)


2,700


2,700Net interest income after provision for loan losses


44,242


54,105Noninterest income:Service charges on deposit accounts


8,859


6,732Loan fees


681


888Gain on sale of loans receivable held for sale


798


40Gain (loss) on derivative instruments (note 9)


15


(18
)Gain (loss) on real estate owned


(23
)

207Gain on sale of mortgage-backed securities available-for-sale


302


-Other


748


66811,380


8,517Noninterest expense:Compensation, payroll taxes and other benefits


22,699


23,821Office occupancy


7,225


7,629Data processing


1,355


1,235Advertising


905


1,396Postage and delivery


1,163


1,206Other


7,343


6,12840,690


41,415Income before provision for Federal income taxes and minority interest


14,932


21,207Provision for Federal income taxes


4,735


6,289Income before minority interest


10,197


14,918Minority interest - preferred stock dividends of Coastal Banc ssb


-


1,507Net income

$
10,197

$
13,411Net income available to common stockholders

$
8,727

$
11,530Basic earnings per common share (note 10)

$
1.69

$
2.06Diluted earnings per common share (note 10)

$
1.62

$
1.97*See accompanying Notes to Consolidated Financial Statements*











**COASTAL BANCORP, INC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF INCOME****(In Thousands, except per share data)**Three Months EndedSeptember 30,2003
2002(Unaudited)Interest income:Loans receivable

$
24,049

$
29,649Mortgage-backed securities


3,251


4,034FHLB stock, federal funds sold and other interest-earning assets


250


34827,550


34,031Interest expense:Deposits


7,128


9,616Advances from the FHLB


4,291


4,944Company obligated mandatorily redeemable trust preferred securities


1,229


1,11212,648


15,672Net interest income


14,902


18,359Provision for loan losses (note 4)


900


900Net interest income after provision for loan losses


14,002


17,459Noninterest income:Service charges on deposit accounts


3,013


2,599Loan fees


259


266Gain on sale of loans receivable held for sale


6


-Gain on derivative instruments (note 9)


2


6Gain (loss) on real estate owned


73


(33
)Gain on sale of mortgage-backed securities available-for-sale


302


-Other


226


2163,881


3,054Noninterest expense:Compensation, payroll taxes and other benefits


7,245


7,968Office occupancy


2,505


2,408Data processing


461


413Advertising


336


546Postage and delivery


406


411Other


2,458


2,13413,411


13,880Income before provision for Federal income taxes and minority interest


4,472


6,633Provision for Federal income taxes


1,498


2,045Income before minority interest


2,974


4,588Minority interest - preferred stock dividends of Coastal Banc ssb


-


213Net income

$
2,974

$
4,375Net income available to common stockholders

$
2,758

$
3,748Basic earnings per common share (note 10)

$
0.53

$
0.72Diluted earnings per common share (note 10)

$
0.51

$
0.68*See accompanying Notes to Consolidated Financial Statements*











**COASTAL BANCORP, INC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME****(In Thousands)**Nine Months EndedSeptember 30,2003
2002(Unaudited)Net income




$
10,197

$
13,411Other comprehensive income, net of tax:Unrealized gains (losses) on securities available-for-salearising during period

(1,130
)

1,626Reclassification adjustment for gains included in net income





196


-Total comprehensive income




$
9,263

$
15,037Three Months EndedSeptember 30,2003


2002(Unaudited)Net income




$
2,974

$
4,375Other comprehensive income, net of tax:Unrealized gains (losses) on securities available-for-salearising during period

(2,065
)

1,562Reclassification adjustment for gains included in net income





196


-Total comprehensive income




$
1,105

$
5,937*See accompanying Notes to Consolidated Financial Statements*












**COASTAL BANCORP, INC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF CASH FLOWS****(In Thousands)**Nine Months EndedSeptember 30,2003
2002(Unaudited)Cash flows from operating activities:Net income




$
10,197

$
13,411Adjustments to reconcile net income to net cash provided byoperating activities:Depreciation and amortization of property and equipmentand prepaid expenses and other assets





6,924


6,476Net amortization (accretion) of premiums, discounts and loan fees





7,211


3,558Provision for loan losses





2,700


2,700Originations and purchases of mortgage loans held for sale





(127,784
)

(8,592
)Sales of mortgage loans held for sale





153,443


11,758Gain on sale of mortgage loans held for sale





(798
)

(40
)Gain on sale of mortgage backed securities available-for-sale





(302
)

-Stock dividends from the FHLB





(731
)

(905
)(Gain) loss on derivative instruments





(15
)

18Decrease (increase) in:Accrued interest receivable





315


1,899Other, net





6,923


4,065Net cash provided by operating activities





58,083


34,348Cash flows from investing activities:Net decrease in federal funds sold





26,265


15,960Purchase of mortgage-backed securities available-for-sale





(242,998
)

(70,138
)Principal repayments on mortgage-backed securities available-for-sale

152,954


115,898Sales of mortgage-backed securities available-for-sale





33,078


-Purchase of other securities available-for-sale





(511
)

(243
)Proceeds from maturity of other securities available-for-sale





-


41,000Purchases of loans receivable





(452,670
)

(387,843
)Sales of loans receivable





-


10,111Net decrease in loans receivable





324,263


261,129Purchase of FHLB stock





(3,291
)

-Net purchases of property and equipment





(4,976
)

(2,861
)Net cash provided (used) by investing activities





(167,886
)

(16,987
)*(Table continued on next page)*











**COASTAL BANCORP, INC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED************************(In Thousands)**********Nine Months EndedSeptember 30,2003
2002(Unaudited)Cash flows from financing activities:Net increase (decrease) in deposits




$
24,546

$
(16,705
)Advances from the FHLB





12,606,474


15,601,400Principal payments on advances from the FHLB





(12,510,528
)

(15,559,494
)Proceeds from issuance of trust preferred securities





9,850


48,125Net increase in advances from borrowers for taxes and insurance


5,897


6,109Exercise of stock options for purchase of Common Stock, net


717


105Purchase of treasury stock





(652
)

(21,162
)Issuance of treasury shares





63


83Redemption of Senior Notes payable





-


(43,875
)Redemption of Coastal Banc ssb 9.0% Noncumulative Preferred Stock


-


(28,750
)Redemption of 9.12% Cumulative Series A Preferred Stock


(27,500
)

-Dividends paid





(3,483
)

(3,912
)Net cash provided (used) by financing activities





105,384


(18,076
)Net decrease in cash and cash equivalents





(4,419
)

(715
)Cash and cash equivalents at beginning of period





39,766


41,537Cash and cash equivalents at end of period




$
35,347

$
40,822Supplemental schedule of cash flows-interest paid




$
40,066

$
49,801Supplemental schedule of noncash investing and financing activities:Transfer of loans to the held for sale category




$
-

$
9,075Transfer of loans from held for sale to loans receivable





19,644


-Foreclosures of loans receivable





2,151


4,289*See accompanying Notes to Consolidated Financial Statements*
**
**
**









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Coastal Bancorp, Inc. and Subsidiaries


Notes to Consolidated Financial Statements








(1) Basis of Presentation





The accompanying unaudited Consolidated Financial Statements were prepared in accordance with the instructions for Form 10-Q and, therefore, do not include all disclosures necessary for a complete presentation of financial condition, results of operations, comprehensive income and cash flows in conformity with accounting principles generally accepted in the United States of America. All adjustments, which are, in the opinion of management, of a normal recurring nature and are necessary for a fair presentation of the interim financial statements, have been included. The results of operations for the period ended September 30, 2003 are not necessarily indicative of the results that may be expected for the entire fiscal year or any other interim period.





Recent Accounting Pronouncements


In November 2002, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 45 "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34" ("FIN 45"). This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. The Interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002 and did not have a material effect on Coastal's consolidated financial statements for the nine months ended September 30, 2003.





On January 17, 2003, the FASB issued FASB Interpretation No. 46 "Consolidation of Variable Interest Entities", which addresses consolidation by business enterprises of variable interest entities. FIN 46 clarifies the application of Accounting Research Bulletin No. 51 "Consolidated Financial Statements", to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after December 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. Coastal has two statutory and business trusts, one of which was formed subsequent to January 31, 2003, for the sole purpose of issuing trust preferred securities as further described in Note 7 to our accompanying consolidated financial statements.  Coastal currently believes the continued consolidation of these trusts is appropriate under Interpretation No. 46.  However, the application of Interpretation No. 46 to these types of trusts is an emerging issue and a possible unintended consequence of Interpretation No. 46 is the deconsolidation of these types of trusts.  Coastal is currently evaluating the impact that deconsolidation of these trusts would have on its consolidated financial statements.




In April 2003, the FASB issued Statement No. 149 ("Statement 149"), "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". Statement 149 amends FASB Statement No. 133 ("Statement 133"), "Accounting for Derivative Instruments and Hedging Activities" and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. Statement 149 improves financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, Statement 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative contains a financing component, amends the definition of underlying to conform to the language in FIN 45 and amends certain other existing pronouncements. Statement 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. However, the provisions of Statement 149 that related to Statement 133 implementation issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. The adoption of Statement 149 is not expected to have a material impact on Coastal's consolidated financial statements.





In May 2003, the FASB issued Statement No. 150 ("Statement 150"), "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity". Statement 150 requires certain financial instruments that have characteristics of both liabilities and equity to be classified as a liability on the consolidated statements of financial condition. Prior to the issuance of Statement 150, Coastal classified trust preferred securities as liabilities on the consolidated statements of financial condition and the related interest cost as interest expense on the consolidated statements of income, which is consistent with the requirements of Statement 150. Statement 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Statement 150 will be effected by reporting the cumulative effect of a change in accounting principle for contracts created before the issuance date and still existing at the beginning of that interim period. The adoption of Statement 150 did not have an impact on Coastal's consolidated financial statements.





Treasury Stock


On August 27, 1998, December 21, 1998, February 25, 1999, April 27, 2000, July 27, 2000 and April 25, 2002, the Board of Directors authorized six separate repurchase plans for up to 500,000 shares each of the outstanding shares of common stock through an open-market repurchase program and privately negotiated repurchases, if any. As of September 30, 2003, a total of 2,752,575 shares had been repurchased under all of the authorized repurchase plans.





As of September 30, 2003, 2,746,875 shares of common stock were held in treasury at an average price of $19.53 per share for a total cost of $53.6 million. Book value per common share at September 30, 2003 was $24.49.





Common Stock Dividends


On July 31, 2003, Coastal announced an increase in its quarterly common stock dividend from $0.12 to $0.15 per common share. Future dividend increases will be determined by the Board of Directors based upon Coastal's results of operations and financial condition, in addition to general economic and other factors.





Stock Options


Statement of Financial Accounting Standards No. 148 ("Statement 148") "Accounting for Stock-Based Compensation  Transition and Disclosure" was issued in December 2002. Statement 148 amends FASB Statement No. 123 "Accounting for Stock-Based Compensation" ("Statement 123") to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, Statement 148 amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Coastal has adopted the disclosure provisions included in Statement 148 in the notes to the consolidated financial statements for the three months and nine months ended September 30, 2003 and 2002 contained herein.





As provided by Statement 123, Coastal accounts for its stock compensation programs in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Under this method, no stock-based compensation expense is reflected in net income, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. The following tables illustrate the effects on net income and earnings per share as if Coastal had applied the fair value recognition provisions of Statement 123 as amended by Statement 148.


Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)





Nine Months EndedSeptember 30,2003
2002(In thousands, except per share data)Net income available to common stockholders, as reported

$
8,727

$
11,530Deduct: Total stock-based compensation expense determined under the fair valuebased method for all awards, net of related tax effects


(184
)

(319
)Proforma net income available to common stockholders

$
8,543

$
11,211Earnings per common share:Basic  as reported

$
1.69

$
2.06Basic  proforma

$
1.66

$
2.00Diluted  as reported

$
1.62

$
1.97Diluted  proforma

$
1.59

$
1.91







Three Months EndedSeptember 30,2003
2002(In thousands, except per share data)Net income available to common stockholders, as reported

$
2,758

$
3,748Deduct: Total stock-based compensation expense determined under the fair valuebased method for all awards, net of related tax effects


(61
)

(106
)Proforma net income available to common stockholders

$
2,697

$
3,642Earnings per common share:Basic  as reported

$
0.53

$
0.72Basic  proforma

$
0.52

$
0.70Diluted  as reported

$
0.51

$
0.68Diluted  proforma

$
0.50

$
0.67




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|Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

(2)  Principles of Consolidation





The accompanying unaudited Consolidated Financial Statements include the accounts of Coastal Bancorp, Inc. ("Bancorp") and its wholly-owned subsidiaries, Coastal Banc Holding Company, Inc., Coastal Capital Trust I and Coastal Capital Trust II (collectively "Coastal"). Coastal Banc Holding Company Inc.'s wholly-owned subsidiaries are Coastal Banc ssb, Coastal Banc Capital Corp. and Coastal Banc Mortgage Corp. Coastal Banc ssb's wholly-owned subsidiaries are CoastalBanc Financial Corp. and Coastal Banc Insurance Agency, Inc. (collectively, the "Bank"). All significant intercompany balances and transactions have been eliminated in consolidation.





(3) Mortgage-backed Securities





Mortgage-backed securities at September 30, 2003 were as follows (in thousands):




Amortized
Unrealized
Unrealized
FairCost
Gains
Losses
ValueAvailable-for-sale:Agency securities

$
445,018

$
1,132

$
(978
)
$
445,172CMOs  Non-agency


81,429


-


(672
)

80,757Non-agency securities


1,709


30


-


1,739$
528,156

$
1,162

$
(1,650
)
$
527,668





As overall interest rates increase, the fair value of Coastal's mortgage-backed securities could be negatively affected by decreasing any unrealized gains and possibly resulting in additional net unrealized losses in future periods.





Mortgage-backed securities at December 31, 2002 were as follows (in thousands):





Amortized
Unrealized
Unrealized
FairCost
Gains
Losses
ValueAvailable-for-sale:Agency securities

$
387,636

$
1,983

$
(470
)
$
389,149CMOs  Non-agency


84,376


67


(644
)

83,799Non-agency securities


2,060


14


-


2,074$
474,072

$
2,064

$
(1,114
)
$
475,022






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|Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

(4) Loans Receivable





Loans receivable at September 30, 2003 and December 31, 2002 were as follows (dollars in thousands):




September 30, 2003
December 31,2002Real estate mortgage loans:First-lien mortgage, primarily residential

$
968,608

$
855,633Commercial


373,921


317,692Multifamily


102,238


116,020Residential construction


125,116


123,085Acquisition and development


138,402


143,463Commercial construction


189,042


241,128Commercial, financial and industrial


176,226


135,209Loans secured by deposits


12,839


14,465Consumer and other loans


31,371


33,4302,117,763


1,980,125Loans in process


(150,223
)

(147,769
)Allowance for loan losses


(19,066
)

(18,118
)Unearned interest and loan fees


(3,055
)

(2,910
)Premium on purchased loans, net


6,568


1,457$
1,951,987

$
1,812,785Weighted average yield


4.73
%

5.52
%





At September 30, 2003, Coastal had outstanding commitments to originate or purchase $16.6 million of real estate mortgage and other loans and had commitments under lines of credit to originate primarily construction and other loans of approximately $187.3 million. In addition, at September 30, 2003, Coastal had $17.4 million of outstanding standby letters of credit. Management anticipates the funding of these commitments through normal operations.





Standby letters of credit are written for conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The Bank's policies generally require that letters of credit arrangements contain security and debt covenants similar to those contained in loan agreements. Under the standby letters of credit, the Bank is required to make payments to the beneficiary of the letters of credit upon request by the beneficiary so long as all performance criteria have been met. At September 30, 2003, the maximum potential amount of future payments under standby letters of credit was $17.4 million. As of September 30, 2003, the fair value of these guarantees, which is the liability recorded when fees are collected, was immaterial to the consolidated financial statements.





At September 30, 2003 and December 31, 2002, the carrying value of loans that were considered to be impaired totaled approximately $6.9 million and $8.5 million, respectively, and the related allowance for loan losses on those impaired loans totaled $1.9 million and $2.4 million at September 30, 2003 and December 31, 2002, respectively. Of the impaired loans outstanding, one loan with a balance of $32,000 at September 30, 2003 and eight loans with a balance of $551,000 at December 31, 2002 did not have specific portions of the allowance for loan losses allocated to them at each respective date. The average recorded investment in impaired loans during the nine months ended September 30, 2003 and 2002 was $7.8 million and $3.4 million, respectively.




Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)





An analysis of activity in the allowance for loan losses for the nine months ended September 30, 2003 and 2002 is as follows (in thousands):




Nine Months EndedSeptember 30,2003
2002Balance, beginning of period




$
18,118

$
15,385Provision for loan losses





2,700


2,700Charge-offs





(2,372
)

(2,785
)Recoveries





620


704Balance, end of period




$
19,066

$
16,004








Coastal services for others loans receivable which are not included in the Consolidated Financial Statements. The total amounts of such loans were $53.6 million and $68.8 million at September 30, 2003 and December 31, 2002, respectively.










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|                                                                                             
|                                                                                             
|Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

(5) Deposits





Deposits, their stated rates and the related weighted average interest rates, at September 30, 2003 and December 31, 2002, are summarized below (dollars in thousands). Effective January 1, 1998, Coastal implemented a program whereby a portion of the balances in noninterest-bearing and interest-bearing checking accounts is reclassified to money market demand accounts under Federal Reserve Regulation D. The amount of such reclassification, reflected in the following table, was approximately $247.4 million ($138.9 million from noninterest-bearing and $108.5 million from interest-bearing) at September 30, 2003 and $250.9 million ($131.3 million from noninterest-bearing and $119.6 million from interest-bearing) at December 31, 2002.





Stated Rate
September 30,
2003
December 31, 2002Noninterest-bearing checking


0.00
%
$
55,292

$
51,029Interest-bearing checking


0.00 - 1.00


13,990


14,353Savings accounts


0.25 - 1.24


44,730


44,603Money market demand accounts


0.00 - 2.13


594,795


530,659708,807


640,644Certificate accountsLess than 2.00


388,378


104,3582.00 - 2.99


328,875


558,3373.00 - 3.99


137,187


206,6454.00 - 4.99


47,641


63,2345.00 - 5.99


24,812


34,4476.00 - 6.99


3,194


6,5247.00 - 7.99


19


1068.00 - 8.99


1


73930,107


973,724$
1,638,914

$
1,614,368Weighted average interest rate





1.69
%

2.12
%




Prior to the reclassification as discussed above, noninterest-bearing checking accounts, interest-bearing checking accounts and money market demand accounts were as follows at September 30, 2003 and December 31, 2002 (in thousands):





September 30, 2003
December 31, 2002Noninterest-bearing checking

$
194,206

$
182,290Interest-bearing checking


122,444


134,034Money market demand accounts


347,427


279,717








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|                                                                                             
|                                                                                             
|Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

The scheduled maturities of certificate accounts outstanding at September 30, 2003 were as follows (in thousands):




September 30, 20030 through 12 months

$
694,36913 through 24 months


163,84325 through 36 months


13,08037 through 48 months


29,52849 through 60 months


29,142Over 60 months


145$
930,107


(6) Advances from the FHLB





The weighted average interest rates on advances from the FHLB at September 30, 2003 and December 31, 2002 were 1.99% and 2.71%, respectively. The scheduled maturities and related weighted average interest rates on advances from the FHLB at September 30, 2003 are summarized as follows (dollars in thousands):




WeightedAverageDue during the year ending December 31,

Interest Rate
Amount2003


3.83
%
$
3,4522004


1.64


295,4002005


2.04


356,0252006


1.70


105,7542007


4.38


2,9992008


3.85


5,5622009


7.99


3,2442010


5.38


2,0552011


6.64


7292012


5.76


2922013


5.46


8,6712014


5.44


2,8692015


6.66


1,6012017


5.43


1,9732018


5.05


1,4051.99
%
$
792,031


Advances from the FHLB are secured by certain first-lien mortgage and multifamily loans and mortgage-backed securities owned by Coastal.






|                                                                                             
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|                                                                                             
|                                                                                             
|Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

(7) Company Obligated Mandatorily Redeemable Trust Preferred Securities





On June 23, 2003, Bancorp, through Coastal Capital Trust II (a consolidated trust subsidiary) ("CCTII"), issued to a private institutional investor, 10,000 floating rate pooled trust preferred securities ("Trust Preferred Securities II") with a liquidation preference of $1,000 per security. The Trust Preferred Securities II represent an interest in the related junior subordinated debentures of Bancorp, which were purchased by the CCTII and have substantially the same payment terms as these Trust Preferred Securities II. The junior subordinated notes are the only assets of the CCTII and interest payments from the notes finance the distributions paid on the Trust Preferred Securities II. Distributions on the securities are payable quarterly at a variable interest rate, reset quarterly, equal to LIBOR plus 3.05%, and are included in interest expense in the consolidated statements of income.  Interest was paid on the Trust Preferred Securities II at the rate of 4.0775% for the quarter ended September 30, 2003.  Effective October 1, 2003 the rate reset at 4.19% for the fourth quarter of 2003.





The Trust Preferred Securities II are subject to mandatory redemption at the liquidation preference, in whole or in part, upon repayment of the junior subordinated debentures at maturity or their earlier redemption. The junior subordinated debentures are redeemable prior to the maturity date of June 23, 2033, at the option of Bancorp on or after June 23, 2008, in whole at any time or in part from time to time. The junior subordinated debentures are also redeemable at any time, in whole, but not in part, upon the occurrence of specific events defined within the trust indenture. Bancorp has the option to defer distributions on the junior subordinated debentures from time to time for a period not to exceed 20 consecutive quarters.





The proceeds from the issuance of the Trust Preferred Securities II were used on July 31, 2003 in the redemption of all of Bancorp's 9.12% Series A Cumulative Preferred Stock (Nasdaq:CBSAO).





On June 18, 2002, Coastal, through Coastal Capital Trust I (a consolidated trust subsidiary) ("CCTI"), issued 2,000,000 trust preferred securities ("Trust Preferred Securities I") with a liquidation preference of $25 per security. The Trust Preferred Securities I represent an interest in Bancorp's junior subordinated debentures, which were purchased by the CCTI. The junior subordinated debentures are the only assets of the CCTI and interest payments from the debentures finance the distributions paid on the Trust Preferred Securities I. Distributions on the securities are payable quarterly at the annual rate of 9.0% and are included in interest expense in the consolidated statements of income.





The Trust Preferred Securities I are subject to mandatory redemption at the liquidation preference, in whole or in part, upon repayment of the junior subordinated debentures at maturity or their earlier redemption. The junior subordinated debentures are redeemable prior to the maturity date of June 30, 2032, at the option of Bancorp on or after June 30, 2007, in whole at any time or in part from time to time. The junior subordinated debentures are also redeemable at any time, in whole, but not in part, upon the occurrence of specific events defined within the trust indenture. Bancorp has the option to defer distributions on the junior subordinated debentures from time to time for a period not to exceed 20 consecutive quarters.





A portion of the proceeds from the issuance of the Trust Preferred Securities I were used to repurchase 500,000 shares of common stock for $15.0 million from a director of Bancorp in June 2002. In addition, $28.8 million of the proceeds were used on July 15, 2002, to redeem all of the Bank's 9.0% Series A Noncumulative Preferred Stock (Nasdaq:CBSAP) through a capital contribution to Coastal Banc ssb.






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|                                                                                             
|                                                                                             
|Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

(8) Senior Notes Payable





On June 30, 1995, Coastal issued $50.0 million of 10.0% Senior Notes due June 30, 2002. The Senior Notes became redeemable at Coastal's option, in whole or in part, on June 30, 2000, at par, plus accrued interest to the redemption date. Interest on the Senior Notes was payable quarterly. During 2001 and 1999, Coastal repurchased in the open market $3.0 and $3.1 million, respectively, of the Senior Notes outstanding at par. On February 1, 2002, Coastal redeemed all of the remaining Senior Notes outstanding ($43.9 million) at par plus accrued interest to the redemption date.





(9) Derivative Instruments





Coastal is a party to derivative instruments in the normal course of business to reduce its exposure to fluctuations in interest rates. These derivative instruments have included interest rate swap agreements where Coastal makes fixed interest payments and receives payments based on a floating index and interest rate cap agreements, as described below. For the nine months ended September 30, 2003 and 2002, Coastal recorded a fair value gain (loss) on these derivative instruments of $15,000 and ($18,000), respectively. As of September 30, 2003 and December 31, 2002, interest rate cap agreements were Coastal's only derivative instruments and were recorded at fair value.





Payments on the interest rate cap agreements are based on the notional principal amount of the agreements; no funds were actually borrowed or are to be repaid. No payments are required to be made upon the expiration of the agreements. The fair value of the interest rate cap agreements was zero at September 30, 2003 and December 31, 2002, which is the recorded book value of the agreements at such dates. The interest rate cap agreements are used to alter the interest rate sensitivity of a portion of Coastal's mortgage-backed securities and loans receivable portfolios. As such, the amortization of any purchase price and interest income from the interest rate cap agreements is recorded in interest income in the accompanying consolidated statements of income, as applicable. The net decrease in interest income related to the interest rate cap agreements for the nine months ended September 30, 2003 and 2002 was approximately $15,000 and $19,000, respectively. No payments were made to Coastal under the interest rate cap agreements during the nine months ended September 30, 2003 or 2002.  As of September 30, 2003, Coastal had one interest rate cap agreement with a third party with a notional amount totaling $4.3 million. The current agreement provides for the third party to make payments to Coastal whenever a defined floating rate exceeds 9.0%. This agreement expires in 2003.





Market risk, or the risk of loss due to movement in market prices or rates, is quantified by Coastal through a risk monitoring process of marking to market its assets and liabilities to expected market level changes in an instantaneous shock of plus and minus 200 basis points on a quarterly basis. This process discloses the effects on market values of the assets and liabilities, unrealized gains and losses, including off-balance sheet items, as well as potential changes in net interest income.





Coastal is exposed to credit loss in the event of nonperformance by the counterparty to the cap agreement and attempts to control this risk through credit monitoring procedures. The notional principal amount does not represent Coastal's exposure to credit loss.






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|                                                                                             
|Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

(10) Earnings Per Share





The following summarizes information related to the computation of basic and diluted earnings per share ("EPS") for the nine- and three-month periods ended September 30, 2003 and 2002 (dollars in thousands, except share and per share data):




Nine Months EndedSeptember 30,2003
2002Net income




$
10,197

$
13,411Preferred stock dividends





1,470


1,881Net income available to common stockholders




$
8,727

$
11,530Weighted average number of common shares outstanding used in basic EPS calculation


5,159,564


5,596,525Add assumed exercise of outstanding stock options as adjusted for dilutive securities


229,003


262,176Weighted average number of common sharesoutstanding used in diluted EPScalculation





5,388,567


5,858,701Basic EPS




$
1.69

$
2.06Diluted EPS




$
1.62

$
1.97Three Months EndedSeptember 30,2003


2002Net income




$
2,974

$
4,375Preferred stock dividends





216


627Net income available to common stockholders




$
2,758

$
3,748Weighted average number of common shares outstanding used in basic EPS calculation


5,168,964


5,226,334Add assumed exercise of outstanding stockoptions as adjusted for dilutive securities


218,383


248,101Weighted average number of common shares outstanding used in dilutedEPS calculation


5,387,347


5,474,435Basic EPS




$
0.53

$
0.72Diluted EPS




$
0.51

$
0.68




(11) Coastal Banc ssb Preferred Stock





On October 21, 1993, the Bank issued 1,150,000 shares of 9.0% Noncumulative Preferred Stock, no par value, Series A, at a price of $25 per share to the public (Nasdaq:CBSAP). Dividends on the Preferred Stock were payable quarterly at the annual rate of $2.25 per share, when, as and if declared by the Board of Directors of the Bank. At any time on or after December 15, 1998, the Preferred Stock could be redeemed in whole or in part only at the Bank's option at $25 per share plus unpaid dividends (whether or not earned or declared) for the then current dividend period to the date fixed for redemption.






Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)




With a portion of the proceeds from the issuance of the Trust Preferred Securities I, the Bank redeemed, from the stockholders of record, all of the 9.0% Series A Noncumulative Preferred Stock on July 15, 2002 (see note 7). The redemption price was $25.185 per share, which represented the stated value of the Preferred Stock, plus accrued and unpaid dividends to the date of redemption.





Pursuant to Coastal's tax benefit agreement with the FDIC, Coastal received a tax benefit for dividends paid on this Preferred Stock. This benefit ceased upon the redemption of this Preferred Stock.





(12) Coastal Bancorp, Inc. Preferred Stock





On May 11, 1999, Coastal Bancorp, Inc. ("Bancorp") issued 1,100,000 shares of 9.12% Series A Cumulative Preferred Stock, no par value, at a price of $25 per share (Nasdaq:CBSAO) to the public ("Bancorp Preferred Stock"). Dividends on the Bancorp Preferred Stock were payable quarterly at the annual rate of $2.28 per share. The preferred stock was callable on May 15, 2003 at Bancorp's option.





With the proceeds from the issuance of the Trust Preferred Securities II (see note 7) and a capital distribution of $17.9 million from the Bank, Bancorp redeemed from the stockholders of record all of the 9.12% Series A Noncumlative Preferred Stock on July 31, 2003. The redemption price was $25.19633 per share, which represented the stated value plus an amount equal to accrued but unpaid dividends to the date of redemption.





Pursuant to Coastal's tax benefit agreement with the FDIC, Coastal received a tax benefit for dividends paid on this Bancorp Preferred Stock.  This benefit ceased upon the redemption of the Bancorp Preferred Stock.  The benefit amounted to a reduction in Coastal's effective tax rate of approximately 3% for the nine months ended September 30, 2003 and 2002.  Excluding this tax benefit and the tax benefit for the minority interest expense in 2002, the effective tax rate for the nine months ended September 30, 2003 and 2002 was approximately 35%.





(13) Statutory Capital Requirements





The applicable regulations require federally insured institutions, which are not the highest rated, to have a minimum regulatory tier 1 (core) capital to total assets ratio equal to a minimum of 4.0%, a tier 1 risk-based capital to risk-weighted assets ratio of 4.0% and a total risk-based capital to risk-weighted assets ratio of 8.0%.





At September 30, 2003, the Bank's regulatory capital in relation to its existing regulatory capital requirements for capital adequacy purposes was as follows (dollars in thousands):





Minimum For Capital



Well-CapitalizedActual



Adequacy Purposes



RequirementsCapital Requirement

Amount
Ratio



Amount
Ratio



Amount
RatioTier 1 (core)
$
164,765
6.29
%

$
104,696
4.00
%

$
130,870
5.00
%Tier 1 risk-based

164,765
9.21



71,561
4.00



107,342
6.00Total risk-based

183,831
10.28



143,123
8.00



178,904
10.00





As of September 30, 2003, the most recent notification from the Federal Deposit Insurance Corporation ("FDIC") categorized the Bank as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum Tier 1 (core), Tier 1 risk-based and total risk-based ratios as set forth in the table above. There are no conditions or events since that notification that management believes have changed the institution's category.





Coastal Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)




Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations





Financial Condition





Total assets increased by $114.9 million from December 31, 2002 to September 30, 2003. The net increase was primarily due to increases of $139.2 million in loans receivable and $52.6 million in mortgage-backed securities available-for-sale, somewhat offset by decreases of $49.9 million in loans receivable held for sale and $26.3 million in federal funds sold when comparing the two periods. There were also small changes in other asset categories. The increase in loans receivable was primarily due to the purchase of $452.7 million in single-family mortgage loans, offset by principal payments received on mortgage and other types of loans. The increase in mortgage-backed securities was due to the purchase of $243.0 million of securities, offset by sales of $33.1 million and principal payments received. The decrease in loans receivable held for sale was due primarily to the sale to third party investors in January 2003 of a loan package purchased in November of 2002, the majority of which was intended to be sold.





From December 31, 2002 to September 30, 2003, total liabilities increased by $136.5 million primarily to fund asset purchases and due to the issuance of Trust Preferred Securities II to partially fund the redemption of the 9.12% Series A Preferred Stock. When comparing the two periods, advances from the FHLB increased $95.9 million and deposits increased $24.5 million. During the nine months ended September 30, 2003, Coastal issued $10.0 million in Trust Preferred Securities II through a consolidated trust subsidiary (see note 7 to the Consolidated Financial Statements). Stockholders' equity decreased 14.1% or $21.6 million from December 31, 2002 to September 30, 2003 primarily as a result of the redemption of the 9.12% Series A Cumulative Preferred Stock (see note 12 to the Consolidated Financial Statements). Other changes included net income, offset by dividends declared and increases of $934,000 and $610,000 in accumulated other comprehensive loss and Treasury Stock, respectively.





Results of Operations for the Nine Months Ended September 30, 2003 and 2002





General





For the nine months ended September 30, 2003, net income was $10.2 million compared to $13.4 million for the nine months ended September 30, 2002. The decrease was primarily due to a $9.9 million decrease in net interest income, as a result of a 0.56% decrease in net interest margin, to 2.54%, and a $9.6 million decrease in average net interest-earning assets when comparing the first nine months of 2003 to the same period in 2002. This decrease in net interest income was somewhat offset by a $2.9 million increase in noninterest income, a $725,000 decrease in noninterest expense, a $1.6 million decrease in the provision for Federal income taxes and a $1.5 million decrease in the expense for minority interest (related to preferred stock of Coastal Banc ssb which was redeemed on July 15, 2002).





Interest Income





Due primarily to principal paydowns, amortization of related premiums and the replacement of assets at lower yields (interest rates), interest income decreased $18.5 million to $86.1 million for the nine months ended September 30, 2003 from $104.6 million for the nine months ended September 30, 2002. The decrease was comprised of a $15.5 million decrease in interest income on loans receivable, a $2.7 million decrease in interest income on mortgage-backed securities and a $374,000 decrease in interest income on FHLB stock, federal funds sold and other interest-earning assets.





When comparing the two periods, average interest-earning assets increased $18.2 million while the average yield decreased 1.05% from 5.72% in 2002 to 4.67% in 2003. The $18.2 million increase in average interest-earning assets consisted primarily of a $23.8 million increase in the average balance of mortgage-backed securities available-for-sale, offset by an $8.4 million decrease in other securities available-for-sale. The 1.05% decrease in the average yield was primarily due to decreases of 1.11% and 0.90% in the average yield on loans receivable and mortgage-backed securities, respectively, due to significant principal paydowns and the replacement of assets at lower yields (interest rates) during the nine months ended September 30, 2003.





During 2003, Coastal has experienced significant principal paydowns on its mortgage-backed securities and single-family mortgage loans receivable portfolios due to the continuing low market rates of interest and the resulting refinancings of its mortgage assets. The paydowns, on an annualized basis, were approximately 43% on mortgage-backed securities and 50% on single-family mortgage loans during the nine months ended September 30, 2003. Because the majority of Coastal's single-family mortgage assets have been acquired through bulk purchases, the significant paydowns Coastal has experienced have resulted in greater premium amortization (and therefore a lower yield) on those purchased assets. In addition, due to the lower interest rate environment, Coastal is replacing these paid down assets with lower yielding assets, again with many being purchased at a premium.





Interest Expense





Interest expense on interest-bearing liabilities was $39.2 million for the nine months ended September 30, 2003, as compared to $47.8 million for the same period in 2002. The decrease in interest expense was again primarily due to the lower overall market rates of interest that declined throughout 2002 and have continued to decline during the first nine months of 2003, offset by the increase in interest expense due to the 9.0% Trust Preferred Securities I issued in June of 2002 and the floating rate Trust Preferred Securities II issued in June of 2003.





When comparing the two periods, the average rate paid on interest-bearing liabilities decreased to 2.38% for the nine months ended September 30, 2003 from 2.94% for the same period in 2002 and average interest-bearing liabilities increased by $27.8 million. The 0.56% decrease in the average rate paid on interest-bearing liabilities was due primarily to a 0.69% decrease in the average rates paid on advances from the FHLB and a 0.64% decrease in the average rate paid on interest-bearing deposits. The increase in average interest-bearing liabilities consisted primarily of a $50.4 million increase in advances from the FHLB and a $34.4 million increase in the average balance of Trust Preferred Securities due to the issuance of $50.0 million of the Trust Preferred Securities I on June 18, 2002 at 9.0% and $10.0 million of the Trust Preferred Securities II on June 23, 2003 at a floating rate (LIBOR plus 3.05). These increases were somewhat offset by a $52.1 million decrease in average interest-bearing deposits (primarily due to the sale of the Hill Country branches in December 2002) and a $5.0 million decrease in the average balance of Senior Notes due to their redemption on February 1, 2002.





Net Interest Income





Net interest income was $46.9 million for the nine months ended September 30, 2003 and $56.8 million for the same period in 2002. As discussed above, the decrease was due primarily to principal paydowns, amortization of related premiums and the replacement of assets at lower yields (interest rates). Net interest margin ("Margin") was 2.54% for the nine months ended September 30, 2003 compared to 3.10% for the nine months ended September 30, 2002. Margin represents net interest income as a percentage of average interest-earning assets. Net interest spread ("Spread"), defined to exclude noninterest-bearing deposits, decreased to 2.29% for the nine months ended September 30, 2003 from 2.78% for the nine months ended September 30, 2002. Management also calculates an alternative Spread which includes noninterest-bearing deposits. Under this calculation, the alternative Spreads for the nine months ended September 30, 2003 and 2002 were 2.47% and 2.99%, respectively. Margin and Spread are affected by the changes in the amount and composition of interest-earning assets and interest-bearing liabilities. When comparing the two periods, average interest-earning assets increased $18.2 million and average interest-bearing liabilities increased $27.8 million.





Management's overall goal is to continue to improve the asset/liability composition to be less vulnerable to market interest rate fluctuations, primarily through the addition of loans tied to variable rates such as LIBOR and local and regional prime rates. Management attempts to mitigate margin compression in a declining interest rate environment by requiring interest rate floors on certain variable rate loans.





Provision for Loan Losses and the Allowance for Loan Losses - Critical Accounting Policy





The provision for loan losses was $2.7 million for the nine months ended September 30, 2003 and for the nine months ended September 30, 2002. At September 30, 2003, Coastal had nonperforming loans totaling $15.4 million, which was a decrease of $3.1 million, or 17%, when compared to December 31, 2002. This decrease was primarily a result of the decrease in nonperforming first lien residential (single-family) mortgage loans due to management's increased focus on ongoing collection efforts. Nonperforming loans are those loans on nonaccrual status as well as those loans greater than ninety days delinquent and still accruing interest. The ratio of nonperforming assets to total assets was 0.70% at September 30, 2003, compared to 0.91% at December 31, 2002. At September 30, 2003 the allowance for loan losses as a percentage of nonperforming loans (excluding nonperforming loans held for sale which are recorded at the lower of cost or fair value) was 123.8% compared to 97.7% at December 31, 2002.





Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provision required to maintain an adequate allowance. Estimating the allowance for loan losses is a critical accounting policy. It is subjective in nature and requires material estimates that may be subject to revision as facts and circumstances warrant. In assessing the adequacy of the allowance, management reviews the type, size, quality and risk of loans in the portfolio and considers such factors as specific known risks, historical and peer group experience, the existing nonperforming loans and the underlying collateral value on those loans, general economic conditions, particularly as they relate to Coastal's lending areas and other factors related to the collectibility of Coastal's loan portfolio. Based on the ongoing assessment by management, provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level deemed appropriate by management based on probable losses in the loan portfolio. While management uses the best information available at the time to recognize losses on loans, there can be no assurance that future additions to the allowance will not be necessary.





Noninterest Income





For the nine months ended September 30, 2003, noninterest income increased $2.9 million to $11.4 million, compared to $8.5 million for the nine months ended September 30, 2002. The $2.9 million increase in noninterest income was primarily due to a $2.1 million increase in service charges on deposit accounts, a $758,000 gain on the sale of loans receivable held for sale and a $302,000 gain on the sale of mortgage-backed securities available-for-sale. The increased income from service charges on deposit accounts is due to Coastal's continued focus on increasing transaction-type accounts and the related fee income, including Coastal's Free Checking and Bounce Protection features on retail checking accounts introduced during August 2002. The increase in the gain on the sale of mortgage loans held for sale was due to routine sales transactions by Coastal Banc ssb (the "Bank"), which were facilitated by Coastal Banc Mortgage Corp. ("CBMC"), an affiliate of the Bank. The loans sold were purchased by the Bank in packages with the intention to resell all or part of the loans in the packages to third party investors. CBMC was formed during the third quarter of 2002 for the purpose of facilitating the purchase and sale of whole loans and participations to third parties. These increases in other noninterest income were somewhat offset by a $230,000 decrease in the gain on the sale of real estate owned and a $207,000 decrease in loan fees. The decrease in loan fees was due to decreased construction loan activity, no warehouse activity in 2003 and decreased single-family mortgage loan fees due to the fact that the number of Coastal's mortgage loans that are being serviced by Coastal has decreased.





Noninterest Expense





For the nine months ended September 30, 2003, noninterest expense decreased $725,000 from the nine months ended September 30, 2002. When comparing the nine months ended September 30, 2003 to the same period in 2002, the $725,000 net decrease in noninterest expense was comprised primarily of a decrease in compensation, payroll taxes and benefits of $1.1 million, a decrease of $404,000 in office occupancy and a $491,000 decrease in advertising, somewhat offset by a $1.2 million increase in other noninterest expense. The $1.1 million decrease in compensation related expense is primarily comprised of the following: a $555,000 decrease in incentive and bonus expense because of the overall lower net income results, a $444,000 decrease due to the sale of the five Hill Country branches in December 2002, a $373,000 decrease due to the outsourcing of the internal audit department in September of 2002, offset by a $281,000 increase in compensation paid to CBMC employees including brokerage commissions related to the loan sales mentioned previously. The decrease in office occupancy was due to various assets becoming fully depreciated in 2002 and in 2003 and to the sale of the five Hill Country branches in December of 2002. The decrease in advertising expense was due to management's decision to reduce this spending in 2003. The increase in other noninterest expense was primarily comprised of the following: a $349,000 increase in audit and accounting fees, a $353,000 increase in legal fees and insurance premiums, a $122,000 increase in the provision for losses on deposit accounts and a $379,000 increase in expenses related to loans, repossessed assets and real estate owned.





Provision for Federal Income Taxes





The provision for Federal income taxes for the nine months ended September 30, 2003 was $4.7 million compared to $6.3 million for the nine months ended September 30, 2002. The $1.6 million decrease was due to the lower amount of income before provision for Federal income taxes and minority interest, with the effective tax rate for the periods being approximately 32% for the nine months ended September 30, 2003 and 32% for the same period in 2002 (when taking into account the tax benefit for the minority interest expense in 2002). As discussed in the notes to the Consolidated Financial Statements, Coastal received a tax benefit for the dividends paid on the Bancorp Preferred Stock pursuant to an agreement with the FDIC. The provision for Federal income taxes includes benefits of $514,000 and $658,000 for the nine months ended September 30, 2003 and 2002, respectively. This benefit ceased upon redemption of the Bancorp Preferred Stock on July 31, 2003.





Results of Operations for the Three Months Ended September 30, 2003 and 2002





General





For the three months ended September 30, 2003, net income was $3.0 million compared to $4.4 million for the three months ended September 30, 2002. The decrease was primarily due to a $3.5 million decrease in net interest income, as a result of a 0.63% decrease in net interest margin when comparing the third quarter of 2003 to the same period in 2002. This decrease in net interest income was partially offset by an $827,000 increase in noninterest income, a $469,000 decrease in noninterest expense, a $547,000 decrease in the provision for Federal income taxes and a $213,000 decrease in the expense for minority interest (related to the preferred stock of Coastal Banc ssb which was redeemed on July 15, 2002).





Interest Income





Due primarily to principal paydowns, amortization of related premiums and the replacement of assets at lower yields (interest rates), interest income decreased $6.5 million to $27.6 million for the three months ended September 30, 2003 from $34.0 million for the three months ended September 30, 2002. The decrease was comprised of a $5.6 million decrease in interest income on loans receivable, a $783,000 decrease in interest income on mortgage-backed securities and a $98,000 decrease in interest income on FHLB stock, federal funds sold and other interest-earning assets.





When comparing the two periods, average interest-earning assets increased $78.0 million while the average yield decreased 1.19% from 5.49% in 2002 to 4.30% in 2003. The $78.0 million increase in average interest-earning assets consisted primarily of a $74.4 million increase in the average balance of mortgage-backed securities. The 1.19% decrease in the average yield was primarily due to decreases of 1.14% and 1.12% in the average yield on loans receivable and mortgage-backed securities, respectively, due to significant principal paydowns and the replacement of assets at lower yields (interest rates).





During 2003, Coastal has experienced significant principal paydowns on its mortgage-backed securities and single-family mortgage loans receivable portfolios due to the continuing low market rates of interest and the resulting refinancings of its mortgage assets. These paydowns, on an annualized basis, were approximately 49% on mortgage-backed securities and over 60% on single-family mortgage loans during the three months ended September 30, 2003. Because the majority of Coastals single-family mortgage assets have been acquired through bulk purchases, the significant paydowns Coastal has experienced have resulted in greater premium amortization (and therefore a lower yield) on those purchased assets. In addition, due to the lower interest rate environment, Coastal is replacing these paid down assets with lower yielding assets, again with many being purchased at a premium.





Interest Expense





Interest expense on interest-bearing liabilities was $12.6 million for the three months ended September 30, 2003, as compared to $15.7 million for the same period in 2002. The decrease in interest expense was again primarily due to the lower overall market rates of interest that declined throughout 2002 and have continued to decline during the first nine months of 2003, offset by the increase in interest expense due to the floating rate Trust Preferred Securities II issued in June of 2003.





When comparing the two periods, the average rate paid on interest-bearing liabilities decreased to 2.19% for the three months ended September 30, 2003 from 2.81% for the same period in 2002 and average interest-bearing liabilities increased $78.6 million. The 0.62% decrease in the average rate paid on interest-bearing liabilities was due primarily to a 0.75% decrease in the average rate paid on advances from the FHLB and a 0.59% decrease in the average rate paid on interest-bearing deposits. The increase in average interest-bearing liabilities consisted primarily of a $120.5 million increase in the average balance of FHLB advances and an increase in Trust Preferred Securities due to the issuance of $10.0 million of the Trust Preferred Securities II on June 23, 2003 at a floating rate (LIBOR plus 3.05%). These increases were somewhat offset by a $51.9 million decrease in average interest-bearing deposits, primarily due to the December 2002 branch sale.





Net Interest Income





Net interest income was $14.9 million for the three months ended September 30, 2003 and $18.4 million for the same period in 2002. As discussed above, the decrease was due primarily to principal paydowns, amortization of related premiums and the replacement of assets at lower yields (interest rates). Net interest margin ("Margin") was 2.34% for the three months ended September 30, 2003 compared to 2.97% for the three months ended September 30, 2002. Margin represents net interest income as a percentage of average interest-earning assets. Net interest spread ("Spread"), defined to exclude noninterest-bearing deposits, decreased to 2.11% for the three months ended September 30, 2003 from 2.68% for the three months ended September 30, 2002. Management also calculates an alternative Spread which includes noninterest-bearing deposits. Under this calculation, the alternative Spreads for the three months ended September 30, 2003 and 2002 were 2.27% and 2.88%, respectively. Margin and Spread are affected by the changes in the amount and composition of interest-earning assets and interest-bearing liabilities. When comparing the two periods, average interest-earning assets increased $78.0 million and average interest-bearing liabilities increased $78.6 million.





Management's overall goal is to continue to improve the asset/liability composition to be less vulnerable to market interest rate fluctuations, primarily through the addition of loans tied to variable rates such as LIBOR and local and regional prime rates. Management attempts to mitigate margin compression in a declining interest rate environment by requiring interest rate floors on certain variable rate loans.





Provision for Loan Losses and the Allowance for Loan Losses - Critical Accounting Policy





The provision for loan losses was $900,000 for the three months ended September 30, 2003 and for the three months ended September 30, 2002. At September 30, 2003, Coastal had nonperforming loans totaling $15.4 million, which was a decrease of $3.1 million, or 17%, when compared to December 31, 2002. This decrease was primarily a result of the decrease in nonperforming first lien residential (single-family) mortgage loans due to management's increased focus on ongoing collection efforts. Nonperforming loans are those loans on nonaccrual status as well as those loans greater than ninety days delinquent and still accruing interest. The ratio of nonperforming assets to total assets was 0.70% at September 30, 2003, compared to 0.91% at December 31, 2002. At September 30, 2003 the allowance for loan losses as a percentage of nonperforming loans (excluding nonperforming loans held for sale which are recorded at the lower of cost or fair value) was 123.8% compared to 97.7% at December 31, 2002.





Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provision required to maintain an adequate allowance. Estimating the allowance for loan losses is a critical accounting policy. It is subjective in nature and requires material estimates that may be subject to revision as facts and circumstances warrant. In assessing the adequacy of the allowance, management reviews the type, size, quality and risk of loans in the portfolio and considers such factors as specific known risks, historical and peer group experience, the existing nonperforming loans and the underlying collateral value on those loans, general economic conditions, particularly as they relate to Coastal's lending areas and other factors related to the collectibility of Coastal's loan portfolio. Based on the ongoing assessment by management, provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level deemed appropriate by management based on probable losses in the loan portfolio. While management uses the best information available at the time to recognize losses on loans, there can be no assurance that future additions to the allowance will not be necessary.





Noninterest Income





For the three months ended September 30, 2003, noninterest income increased $827,000 to $3.9 million, compared to $3.0 million for the three months ended September 30, 2002. The $827,000 increase in noninterest income was primarily due to a $414,000 increase in service charges on deposit accounts, a $302,000 gain on the sale of mortgage-backed securities available-for-sale and a $106,000 increase in the gain on the sale of real estate owned. The increased income from service charges on deposit accounts is due to Coastal's continued focus on increasing transaction-type accounts and the related fee income, including Coastal's Free Checking and Bounce Protection features on retail checking accounts introduced during August 2002.





Noninterest Expense





For the three months ended September 30, 2003, noninterest expense decreased $469,000 from the three months ended September 30, 2002. When comparing the third quarter of 2003 to the same period in 2002, the $469,000 net decrease in noninterest expense was comprised primarily of a decrease in compensation, payroll taxes and benefits of $723,000 and a decrease of $210,000 in advertising. These decreases were somewhat offset by a $324,000 increase in other noninterest expense, and increases of $97,000 and $48,000 in office occupancy and in data processing, respectively. The decrease in compensation related expenses was primarily comprised of the following: decreased incentive and bonus expense of $298,000 because of the overall lower net income results, a $121,000 decrease due to the outsourcing of the internal audit department in September of 2002, a $151,000 decrease due to the sale of the five Hill Country branches in December 2002, in addition to other overall staffing changes to gain efficiencies throughout Coastal. The decrease in advertising expense was due to management's decision to reduce this spending in 2003. The $324,000 increase in other noninterest expense was primarily comprised of a $114,000 increase in audit and accounting fees related to the outsourcing of the internal audit department and a $251,000 increase in expenses related to loans, repossessed assets and real estate owned.





Provision for Federal Income Taxes





The provision for Federal income taxes for the three months ended September 30, 2003 was $1.5 million compared to $2.0 million for the three months ended September 30, 2002. The $547,000 decrease was primarily due to the lower amount of income before provision for Federal income taxes and minority interest, with the effective tax rate for the periods being approximately 33% for the quarter ended September 30, 2003 and 32% for the same period in 2002 (when taking into account the tax benefit for the minority interest expense in 2002). As discussed in the notes to the Consolidated Financial Statements, Coastal received a tax benefit for the dividends paid on the Bancorp Preferred Stock pursuant to an agreement with the FDIC. The provision for Federal income taxes includes the tax benefit received from the dividends on the Series A Preferred Stock of Coastal Bancorp, Inc. of $76,000 and $219,000 for the quarters ended September 30, 2003 and 2002, respectively. This benefit ceased upon redemption of the Bancorp Preferred Stock on July 31, 2003.







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Liquidity and Capital Resources





Coastal's primary sources of funds consist of deposits bearing market rates of interest, advances from the FHLB, principal payments on loans receivable and mortgage-backed securities and other types of borrowings. Coastal uses its funding resources principally to meet its ongoing commitments to fund maturing deposits and deposit withdrawals, repay borrowings, purchase loans receivable and mortgage-backed securities, fund existing and continuing loan commitments, maintain its liquidity, meet operating expenses and fund dividends and stock purchases and acquisitions of other banks and thrifts, either on a branch office or whole bank acquisition basis. At September 30, 2003, Coastal had binding commitments to originate or purchase loans totaling approximately $16.6 million and had $150.2 million of undisbursed loans in process. Scheduled maturities of certificates of deposit during the 12 months following September 30, 2003, totaled $694.4 million at September 30, 2003. Management believes that Coastal has adequate resources to fund all of its commitments.





During the nine months ended September 30, 2003, Coastal opened a new branch in the City of Rosenberg, Texas. As of September 30, 2003, Coastal operated 44 retail banking offices in Texas cities, including Houston, Austin, Corpus Christi, the Rio Grande Valley and small cities in the southeast quadrant of Texas (including this new branch in Rosenberg).





Forward-Looking Information





The Management's Discussion and Analysis of Financial Condition and Results of Operations set forth in this Form 10-Q should be read in conjunction with the information contained in the Consolidated Financial Statements and the Notes thereto.





The statements contained in this Quarterly Report on Form 10-Q which are not historical facts contain forward looking information with respect to plans, projections or future performance of Coastal, the occurrence of which involve certain risks and uncertainties detailed in Coastal's filings with the Securities and Exchange Commission ("SEC"). Such discussion contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Reform Act"), and is subject to the safe harbor created by that Reform Act. The words "estimate," "project," "anticipate," "expect," "intend," "believe," "plans," and similar expressions are intended to identify forward-looking statements. Because such forward-looking statements involve risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. Factors, all of which are difficult to predict and many of which are beyond the control of Coastal, that could cause actual results to differ materially include, but are not limited to: risks related to changes in market rates of interest, changes in our loan portfolio, including the risks associated with our non-traditional lending (loans other than single-family residential mortgage loans such as multifamily, real estate acquisition and development, commercial real estate, commercial business and commercial construction loans), the possibility that Coastal's allowance for loan losses proves to be inadequate, Coastal's ability to attract core deposits, the concentration of Coastal's loan portfolio in Texas and California to the extent that the economies of those states experience problems, Coastal's acquisition strategy, including risks of adversely changing results of operations and factors affecting Coastal's ability to consummate further acquisitions; risks involved in Coastal's ability to quickly and efficiently integrate the operations of acquired entities with those of Coastal; changes in business strategies, changes in general economic and business conditions and changes in the laws and regulations applicable to Coastal; and other factors as discussed in Coastal's Annual Report on Form 10-K for the year ended December 31, 2002, as filed with the SEC on March 25, 2003.







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Item 3. Quantitative and Qualitative Disclosures About Market Risk





There have been no material changes in Coastal's interest rate risk position since December 31, 2002. Coastal's principal market risk exposure is to interest rates. See note 9 of the Notes to Consolidated Financial Statements.





Item 4. Controls and Procedures





Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, Coastal's management has reviewed the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) of Coastal or caused such disclosure controls and procedures to be designed under management's supervision, particularly during the period in which this quarterly report was being prepared. Disclosure controls and procedures are the controls and other procedures of Coastal that are designed to ensure that the information required to be disclosed by Coastal in its reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by Coastal in its reports filed under the Exchange Act is accumulated and communicated to Coastal's management, including the principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Management believes that such disclosure controls and procedures as of the end of the period covered by this report were adequate to ensure that material information relating to Coastal, including its consolidated subsidiaries, is made known to management by others within Coastal and its consolidated subsidiaries. To management's knowledge, there were no significant changes in internal control over financial reporting or in other factors that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting.





Coastal intends to continually review and evaluate the design and effectiveness of its disclosure controls and procedures and to improve its controls and procedures over time and to correct any deficiencies that it may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning Coastal's business. While Coastal believes that the present design of its disclosure controls and procedures is effective to achieve this goal, further events affecting its business may cause Coastal to modify its disclosure controls and procedures.







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PART II - OTHER INFORMATION





Item 1. Legal Proceedings





Coastal is, and has been involved, from time to time, in various claims, complaints, proceedings and litigation relating to activities arising from the normal course of its operations. Based on the facts currently available to management, management believes that the matters pending at September 30, 2003 are without merit, or will be covered by insurance and any other matters are of such amounts, which upon resolution, are not likely to have a material adverse effect on Coastal's consolidated financial condition, results of operations or cash flows.





Item 2. Changes in Securities and Use of Proceeds





On June 23, 2003, Bancorp, through the CCTII, issued to a private institutional investor, 10,000 floating rate Trust Preferred Securities II with a liquidation preference of $1,000 per security. The Trust Preferred Securities II represent an interest in the related junior subordinated debentures of Bancorp, which were purchased by the CCTII and have substantially the same payment terms as these Trust Preferred Securities II. The junior subordinated notes are the only assets of the CCTII and interest payments from the notes finance the distributions paid on the Trust Preferred Securities II. Distributions on the securities are payable quarterly at a variable interest rate, reset quarterly, equal to LIBOR plus 3.05%, and are included in interest expense in the consolidated statements of income.





The Trust Preferred Securities II are subject to mandatory redemption at the liquidation preference, in whole or in part, upon repayment of the junior subordinated debentures at maturity or their earlier redemption. The junior subordinated debentures are redeemable prior to the maturity date of June 23, 2033, at the option of Bancorp on or after June 23, 2008, in whole at any time or in part from time to time. The junior subordinated debentures are also redeemable at any time, in whole, but not in part, upon the occurrence of specific events defined within the trust indenture. Bancorp has the option to defer distributions on the junior subordinated debentures from time to time for a period not to exceed 20 consecutive quarters.





The proceeds from the issuance of the Trust Preferred Securities II were used on July 31, 2003 in the redemption of Bancorp's 9.12% Series A Cumulative Preferred Stock (Nasdaq:CBSAO).  All 1,100,000 shares were redeemed from stockholders of record on July 31, 2003 at par plus accrued but unpaid dividends to the redemption date.





Item 3. Defaults Upon Senior Securities





Not applicable.





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





Not applicable.





Item 5. Other Information





Not applicable.





Item 6. Exhibits and Reports on Form 8-K





Reports on Form 8-K.


1) Form 8-K filed with the SEC on July 3, 2003 concerning the announcement that Bancorp had


issued a press release regarding the redemption of all of its Series A Cumulative Preferred Stock on July 31, 2003.





2) Form 8-K filed with the SEC on July 17, 2003 concerning the announcement that Bancorp had issued a press release regarding the results of operations and financial condition for the quarterly period ended June 30, 2003.





3) Form 8-K filed with the SEC on August 1, 2003 concerning the announcement that Bancorp's Board of Directors voted to increase the second quarter of 2003 common stock dividend.





Exhibits.


31.1 Certification of the Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley Act of 2002.





31.2 Certification of the Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley Act of 2002.





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





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





99.1 Statement of Factors Under Private Securities Litigation Reform Act of 1995.










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Signatures








Pursuant to the requirement of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

















Dated: 11/14/03      By: /s/ Manuel J. Mehos


Manuel J. Mehos


Chairman of the Board


Chief Executive Officer


(Principal Executive Officer)





























Dated: 11/14/03     By: /s/ Catherine N. Wylie


Catherine N. Wylie


Chief Financial Officer


(Principal Financial and


Accounting Officer)







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