Summary of SOUTHSIDE BANCSHARES INC

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis provides a comparison of our results of operations for the years ended December 31, 2008, 2007, and 2006 and financial condition as of December 31, 2008 and 2007. This discussion should be read in conjunction with the financial statements and related notes included elsewhere in this report. All share data has been adjusted to give retroactive recognition to stock splits and stock dividends.

CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements of other than historical fact that are contained in this document and in written material, press releases and oral statements issued by or on behalf of Southside Bancshares, Inc., a bank holding company, may be considered to be "forward-looking statements" within the meaning of and subject to the protections of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management's views as of any subsequent date. These statements may include words such as "expect," "estimate," "project," "anticipate," "appear," "believe," "could," "should," "may," "intend," "probability," "risk," "target," "objective," "plans," "potential," and similar expressions. Forward-looking statements are statements with respect to our beliefs, plans, expectations, objectives, goals, anticipations, assumptions, estimates, intentions and future performance, and are subject to significant known and unknown risks and uncertainties, which could cause our actual results to differ materially from the results discussed in the forward-looking statements. For example, discussions of the effect of our expansion, trends in asset quality and earnings from growth, and certain market risk disclosures are based upon information presently available to management and are dependent on choices about key model characteristics and assumptions and are subject to various limitations. See "Item 1. Business" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future. As a result, actual income gains and losses could materially differ from those that have been estimated. Other factors that could cause actual results to differ materially from forward-looking statements include, but are not limited to, the following:

· general economic conditions, either globally, nationally, in the State of Texas, or in the specific markets in which we operate, including, without limitation, the recent deterioration of the subprime, mortgage, credit and liquidity markets, which could cause compression of the Company's net interest margin, or a decline in the value of the Company's assets, which could result in realized losses;

· legislation, regulatory changes or changes in monetary or fiscal policy that adversely affect the businesses in which we are engaged, including the Federal Reserve's actions with respect to interest rates and other regulatory responses to current economic conditions;

· adverse changes in the status or financial condition of the Government Sponsored Enterprises (the "GSEs") impacting the GSEs' guarantees or ability to pay or issue debt;

· adverse changes in the credit portfolio of other U. S. financial institutions relative to the performance of certain of our investment securities;

· impact of future legislation and increases in depositors insurance premiums due to FDIC regulation changes;

· economic or other disruptions caused by acts of terrorism in the United States, Europe or other areas;

· changes in the interest rate yield curve such as flat, inverted or steep yield curves, or changes in the interest rate environment that impact interest margins and may impact prepayments on the mortgage-backed securities portfolio;

· increases in the Company's nonperforming assets;

· the Company's ability to maintain adequate liquidity to fund its operations and growth;

· failure of assumptions underlying allowance for loan losses and other estimates;

· unexpected outcomes of, and the costs associated with, existing or new litigation involving us;

· changes impacting the leverage strategy;

· our ability to monitor interest rate risk;

· significant increases in competition in the banking and financial services industry;

· changes in consumer spending, borrowing and saving habits;

· technological changes;

· our ability to increase market share and control expenses;

· the effect of changes in federal or state tax laws;

· the effect of compliance with legislation or regulatory changes;

· the effect of changes in accounting policies and practices;

· risks of mergers and acquisitions including the related time and cost of implementing transactions and the potential failure to achieve expected gains, revenue growth or expense savings;

· credit risks of borrowers, including any increase in those risks due to changing economic conditions; and

· risks related to loans secured by real estate, including the risk that the value and marketability of collateral could decline.

All written or oral forward-looking statements made by us or attributable to us are expressly qualified by this cautionary notice. We disclaim any obligation to update any factors or to announce publicly the result of revisions to any of the forward-looking statements included herein to reflect future events or developments.

CRITICAL ACCOUNTING ESTIMATES

Our accounting and reporting estimates conform with United States generally accepted accounting principles ("GAAP") and general practices within the financial services industry. The preparation of financial statements in conformity with GAAP not previously defined requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. We consider our critical accounting policies to include the following:

Allowance for Losses on Loans. The allowance for losses on loans represents our best estimate of probable losses inherent in the existing loan portfolio. The allowance for losses on loans is increased by the provision for losses on loans charged to expense and reduced by loans charged-off, net of recoveries. The provision for losses on loans is determined based on our assessment of several factors: reviews and evaluations of specific loans, changes in the nature and volume of the loan portfolio, and current economic conditions and the related impact on specific borrowers and industry groups, historical loan loss experience, the level of classified and nonperforming loans and the results of regulatory examinations.

The loan loss allowance is based on the most current review of the loan portfolio. The servicing officer has the primary responsibility for updating significant changes in a customer's financial position. Each officer prepares status updates on any credit deemed to be experiencing repayment difficulties which, in the officer's opinion, would place the collection of principal or interest in doubt. Our internal loan review department is responsible for an ongoing review of our loan portfolio with specific goals set for the loans to be reviewed on an annual basis.

At each review, a subjective analysis methodology is used to grade the respective loan. Categories of grading vary in severity from loans that do not appear to have a significant probability of loss at the time of review to loans that indicate a probability that the entire balance of the loan will be uncollectible. If full collection of the loan balance appears unlikely at the time of review, estimates of future expected cash flows or appraisals of the collateral securing the debt are used to allocate the necessary allowances. The internal loan review department maintains a list of all loans or loan relationships that are graded as having more than the normal degree of risk associated with them. In addition, a list of specifically reserved loans or loan relationships of $50,000 or more is updated on a periodic basis in order to properly allocate necessary allowance and keep management informed on the status of attempts to correct the deficiencies noted with respect to the loan.

Loans are considered impaired if, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. In measuring the fair value of the collateral, we use assumptions such as discount rates, and methodologies, such as comparison to the recent selling price of similar assets, consistent with those that would be utilized by unrelated third parties performing a valuation.

Changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the conditions of the various markets in which collateral may be sold all may affect the required level of the allowance for losses on loans and the associated provision for loan losses.

As of December 31, 2008, our review of the loan portfolio indicated that a loan loss allowance of $16.1 million was adequate to cover probable losses in the portfolio.

Refer to "Loan Loss Experience and Allowance for Loan Losses" and "Note 1 - Summary of Significant Accounting and Reporting Policies" to our consolidated financial statements included in this report for a detailed description of our estimation process and methodology related to the allowance for loan losses.

Estimation of Fair Value. On January 1, 2008, we adopted Statements of Financial Accounting Standards ("SFAS") 157, "Fair Value Measurements", as presented in "Note 15 - Fair Value Measurement" to our consolidated financial statements included in this report. We also adopted SFAS 157-3, which was released on October 10, 2008. The estimation of fair value is significant to a number of our assets and liabilities. GAAP requires disclosure of the fair value of financial instruments as a part of the notes to the consolidated financial statements. Fair values are volatile and may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates and the shape of yield curves. Fair values for most investment and mortgage-backed securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on the

quoted prices of similar instruments or our estimate of fair value by using a range of fair value estimates in the market place as a result of the illiquid market specific to the type of security.

At September 30, 2008 and continuing at December 31, 2008, the valuation inputs for our available for sale ("AFS") trust preferred securities ("TRUPs") became unobservable as a result of the significant market dislocation and illiquidity in the marketplace. Although we continue to rely on non-binding prices compiled by third party vendors, the visibility of the observable market data (Level 2) to determine the values of these securities has become less clear. SFAS 157 assumes that fair values of financial assets are determined in an orderly transaction and not a forced liquidation or distressed sale at the measurement date. While we feel the financial market conditions during the latter half of the year reflect the market illiquidity from forced liquidation or distressed sales for these TRUPs, we determined that the fair value provided by our pricing service continues to be an appropriate fair value for financial statement measurement and therefore, as we verified the reasonableness of that fair value, we have not otherwise adjusted the fair value provided by our vendor. However, the severe decline in estimated fair value caused by the significant illiquidity in this market contrasts sharply with our assessment of the fundamental performance of these securities. Therefore, we believe the estimated fair value is no longer clearly based on observable market data and is based on a range of fair value data points from the market place as a result of the illiquid market specific to this type of security. Accordingly, we have now determined that the TRUPs security valuation is based on Level 3 inputs in accordance with SFAS 157.

Impairment of Investment Securities and Mortgage-backed Securities. Investment and mortgage-backed securities classified as AFS are carried at fair value and the impact of changes in fair value are recorded on our consolidated balance sheet as an unrealized gain or loss in "Accumulated other comprehensive income
(loss)," a separate component of shareholders' equity. Securities classified as AFS or held to maturity ("HTM") are subject to our review to identify when a decline in value is other-than-temporary. Factors considered in determining whether a decline in value is other-than-temporary include: whether the decline is substantial; the duration of the decline; the reasons for the decline in value; whether the decline is related to a credit event, a change in interest rate or a change in the market discount rate; our ability and intent to hold the investment for a period of time that will allow for a recovery of value; and the financial condition and near-term prospects of the issuer. When it is determined that a decline in value is other-than-temporary, the carrying value of the security is reduced to its estimated fair value, with a corresponding charge to earnings. For certain assets we consider expected cash flows of the investment in determining if impairment exists. The turmoil in the capital markets had a significant impact on our estimate of fair value for certain of our securities. We believe the market values are reflective of illiquidity as opposed to credit impairment. At December 31, 2008, we have in AFS Other Stocks and Bonds, $6.0 million cost basis in pooled TRUPs. Those securities are structured products with cash flows dependent upon securities issued by U.S. financial institutions, including banks and insurance companies. Our estimate of fair value at December 31, 2008 is approximately $646,000 and reflects the market illiquidity. We performed detailed cash flow modeling for each TRUP using an industry accepted model. Prior to loading the required assumptions into the model we reviewed the financial condition of each of the issuing banks that had not deferred or defaulted as of December 31, 2008. In addition, a base deferral assumption and pessimistic deferral assumption was assigned to each issuing bank based on the category in which it fell. Our analysis of the underlying cash flows contemplated various default, deferral and recovery scenarios, and based on that detailed analysis, we have concluded that there is no other-than-temporary impairment at December 31, 2008. Management considered other qualitative factors, which included the credit rating and the severity and duration of the mark-to-market loss. After considering these qualitative factors, management believes the quantitative factors, including the detailed review of the collateral and cash flow modeling, outweigh the qualitative factors to support the impairment conclusion that there is no other-than-temporary impairment at December 31, 2008. We will continue to update our assumptions and the resulting analysis each reporting period, to reflect changing market conditions.

Goodwill. Goodwill represents the excess of cost over the fair value of the net assets of businesses acquired. Goodwill and intangible assets acquired in a business combination and determined to have an

indefinite useful life are tested for impairment annually, or if an event occurred or circumstances changed that more likely than not reduced the fair value of the reporting unit.

The annual impairment analysis of goodwill included identification of reporting units, the determination of the carrying value of each reporting unit and the estimation of the fair value of each reporting unit. We tested for impairment of goodwill as of December 31, 2008. Step one of the impairment test involves comparing the fair value of the reporting unit to the carrying value of the reporting unit. If the fair value of the reporting unit is greater than the carrying value of the reporting unit, no additional testing is required. If the carrying amount of the reporting unit exceeds its fair value, we are required to perform a second step to the impairment test to measure the extent of the impairment. At December 31, 2008, the fair value of the reporting unit exceeded the carrying value of the reporting unit. As a result, we did not record any goodwill impairment for the year ended December 31, 2008.

Defined Benefit Pension Plan. The plan obligations and related assets of our defined benefit pension plan (the "Plan") are presented in "Note 14 - Employee Benefits" to our consolidated financial statements included in this report. Entry into the Plan by new employees was frozen effective December 31, 2005. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using observable market quotations. Plan obligations and the annual pension expense are determined by independent actuaries and through the use of a number of assumptions. Key assumptions in measuring the plan obligations include the discount rate, the rate of salary increases and the estimated future return on plan assets. In determining the discount rate, we utilized a cash flow matching analysis to determine a range of appropriate discount rates for our defined benefit pension and restoration plans. In developing the cash flow matching analysis, we constructed a portfolio of high quality non-callable bonds (rated AA- or better) to match as close as possible the timing of future benefit payments of the plans at December 31, 2008. Based on this cash flow matching analysis, we were able to determine an appropriate discount rate.

Salary increase assumptions are based upon historical experience and our anticipated future actions. The expected long-term rate of return assumption reflects the average return expected based on the investment strategies and asset allocation on the assets invested to provide for the Plan's liabilities. We considered broad equity and bond indices, long-term return projections, and actual long-term historical Plan performance when evaluating the expected long-term rate of return assumption. At December 31, 2008, the weighted-average actuarial assumptions of the Plan were: a discount rate of 6.10%; a long-term rate of return on Plan assets of 7.50%; and assumed salary increases of 4.50%. Material changes in pension benefit costs may occur in the future due to changes in these assumptions. Future annual amounts could be impacted by changes in the number of Plan participants, changes in the level of benefits provided, changes in the discount rates, changes in the expected long-term rate of return, changes in the level of contributions to the Plan and other factors.

OVERVIEW

OPERATING RESULTS

During the year ended December 31, 2008, our net income increased $14.0 million, or 84.0%, to $30.7 million, from $16.7 million for the same period in 2007. The increase in net income was primarily attributable to the increase in net interest income and noninterest income partially offset by an increase in the provision for loan losses and noninterest expense. The increase in noninterest income driven primarily by gain on sale of AFS securities that are non-recurring was offset by an increase in noninterest expense due primarily to increases in salaries and employee benefits due to the acquisition of FWBS during the fourth quarter of 2007 and an interest in SFG in the third quarter of 2007 as well as normal salary increases and new employees. Earnings per diluted share increased $0.98, or 83.1% to $2.16, for the year ended December 31, 2008, from $1.18 for the same period in 2007.

During the year ended December 31, 2007, our net income increased $1.7 million, or 11.2%, to $16.7 million, from $15.0 million for the same period in 2006. The increase in net income was primarily attributable to the increase in net interest income and noninterest income partially offset by an increase in

the provision for loan losses and noninterest expense. The increase in noninterest income was offset by an increase in noninterest expense due primarily to increases in salaries and employee benefits due to the acquisition of FWBS during the fourth quarter of 2007 and an interest in SFG in the third quarter of 2007. Earnings per diluted share were $1.18 and $1.07, respectively, for the years ended December 31, 2007 and 2006.

FINANCIAL CONDITION

Our total assets increased $503.9 million, or 22.9%, to $2.70 billion at December 31, 2008 from $2.20 billion at December 31, 2007. The increase was attributable to growth in our investment and mortgage-backed securities as well as loan growth. At December 31, 2008, loans were $1.02 billion compared to $961.2 million at December 31, 2007. Our securities portfolio increased by $434.7 million, or 42.3%, to $1.46 billion as compared to $1.03 billion at December 31, 2007. The increase in our securities were comprised entirely of U.S. Agency debentures, U.S. Agency mortgage-backed and related securities and municipal securities. Our increase in loans and securities was funded by increases in deposits and FHLB advances.

Our nonperforming assets at December 31, 2008 increased to $15.8 million, and represented 0.58% of total assets, compared to $3.9 million, or 0.18%, of total assets at December 31, 2007. Nonaccruing loans increased to $14.3 million and the ratio of nonaccruing loans to total loans increased to 1.40% at December 31, 2008 as compared to $2.9 million and 0.30% at December 31, 2007. Other Real Estate Owned ("OREO") increased to $318,000 at December 31, 2008 from $153,000 at December 31, 2007. Loans 90 days past due at December 31, 2008 increased to $593,000 compared to $400,000 at December 31, 2007. Repossessed assets increased to $433,000 at December 31, 2008 from $255,000 at December 31, 2007. Restructured performing loans at December 31, 2008 decreased to $148,000 compared to $225,000 at December 31, 2007.

Our deposits increased $25.6 million to $1.56 billion at December 31, 2008 from $1.53 billion at December 31, 2007. The increase was primarily due to branch expansion and increased market penetration. During 2008 brokered deposits decreased $92.9 million. As a result our deposits, net of brokered deposits, increased $118.6 million. Due to the increase in securities and loans and the decrease in brokered deposits during 2008, FHLB advances increased $444.8 million to $884.9 million at December 31, 2008, from $440.0 million at December 31, 2007. Short-term FHLB advances decreased $124.4 million to $229.4 million at December 31, 2008 from $353.8 million at December 31, 2007. Long-term FHLB advances increased $569.2 million to $655.5 million at December 31, 2008 from $86.2 million at December 31, 2007. Other borrowings at December 31, 2008 and 2007 totaled $72.8 million and $69.8 million, respectively, and at December 31, 2008 consisted of $12.5 million of short-term borrowings and $60.3 million of long-term debt.

Assets under management in our trust department decreased during 2008 and were approximately $628 million at December 31, 2008 compared to $718 million at December 31, 2007. The decrease is a result of a decrease in money market funds managed by the trust department.

Shareholders' equity at December 31, 2008 totaled $160.6 million compared to $132.3 million at December 31, 2007. The increase primarily reflects the net income of $30.7 million recorded for the year ended December 31, 2008, and the common stock issued of $2.1 million as a result of our incentive stock option and dividend reinvestment plans, a decrease in the accumulated other comprehensive loss of $3.6 million, all of which were partially offset by the payment of cash dividends to our shareholders of $8.3 million. The decrease in accumulated other comprehensive loss is comprised of a $10.7 million, net of tax, unrealized gain on securities, net of reclassification adjustment which was partially offset by a decrease of $7.1 million, net of tax, related to the change in the unfunded status of our defined benefit plan. See "Note 4 - Comprehensive Income (Loss)" to our consolidated financial statements included in this report.

During the first nine months of 2008 the economy in our market area began to reflect the effects of the housing led economic slowdown impacting other regions of the United States. During the fourth quarter as oil prices declined significantly and consumers all across the United States were impacted more severely by

the economic slowdown, our market areas began to experience a greater slowdown in economic activity. We cannot predict whether current economic conditions will improve, remain the same or decline.

Key financial indicators management follows include, but are not limited to, numerous interest rate sensitivity and interest rate risk indicators, credit risk, operations risk, liquidity risk, capital risk, regulatory risk, competition risk, yield curve risk, and economic risk.

LEVERAGE STRATEGY

We utilize wholesale funding and securities to enhance our profitability and balance sheet composition by determining acceptable levels of credit, interest rate and liquidity risk consistent with prudent capital management. This balance sheet strategy consists of borrowing a combination of long and short-term funds from the FHLB and, when determined appropriate, issuing brokered CDs. These funds are invested primarily in U.S. Agency mortgage-backed securities, and to a lesser extent, long-term municipal securities. Although U.S. Agency mortgage-backed securities often carry lower yields than traditional mortgage loans and other types of loans we make, these securities generally increase the overall quality of our assets because of either the implicit or explicit guarantees of the U.S. Government, are more liquid than individual loans and may be used to collateralize our borrowings or other obligations. While the strategy of investing a substantial portion of our assets in U.S. Agency mortgage-backed securities and to a lesser extent municipal securities has resulted in lower interest rate spreads and margins, we believe that the lower operating expenses and reduced credit risk combined with the managed interest rate risk of this strategy have enhanced our overall profitability over the last several years. At this time, we utilize this balance sheet strategy with the goal of enhancing overall profitability by maximizing the use of our capital.

Risks associated with the asset structure we maintain include a lower net interest rate spread and margin when compared to our peers, changes in the slope of the yield curve, which can reduce our net interest rate spread and margin, increased interest rate risk, the length of interest rate cycles, changes in volatility spreads associated with the mortgage-backed securities and municipal securities, and the unpredictable nature of mortgage-backed securities . . .