OVERVIEW

SWS Group, Inc. ("we," "us," "SWS" or the "company") is engaged in full-service securities brokerage and full-service commercial banking. While brokerage and banking revenues are dependent upon trading volumes and interest rates, which may fluctuate significantly, a large portion of our expenses remain fixed. Consequently, net operating results can vary significantly from period to period.

Our business is also subject to substantial governmental regulation and changes in legal, regulatory, accounting, tax and compliance requirements that may have a substantial impact on our business and results of operations. We also face substantial competition in each of our lines of business. See "Forward-Looking Statements" and "Risk Factors" in our Form 10-K filed with the Securities and Exchange Commission on September 5, 2008 and in this Form 10-Q.

We operate through four segments grouped primarily by products, services and customer base: clearing, retail, institutional and banking.

Clearing. We provide clearing and execution services (generally on a fully disclosed basis) for general securities broker/dealers and for firms specializing in high volume trading. Revenues in this segment are generated primarily through transaction charges to our correspondent firms for clearing their trades. Revenue is also earned from various fees and other processing charges as well as through net interest earnings on correspondent customer balances. We seek to grow our clearing business by expanding our correspondent base.

Retail. We offer retail securities products and services (equities, mutual funds and fixed income products), insurance products and managed accounts through the activities of our employee registered representatives and our independent contractors. This segment generates revenue primarily through commissions charged on securities transactions, fees from managed accounts and the sale of insurance products as well as net interest income from retail customer balances. We seek to grow our retail brokerage business by increasing our distribution capabilities through the recruitment of additional registered representatives. The retail segment includes M.L. Stern & Co., LLC and its wholly-owned subsidiary, Tower Asset Management, LLC, (collectively, "M.L. Stern") which purchases and sells municipal, federal and corporate bonds, mutual funds, unit trusts, closed ended funds, insurance, equities and other various investment securities at the retail level, as well as provides investment advisory services to high net worth individuals or families who require investment expertise and personal services.

Institutional. We serve institutional customers in securities lending, investment banking and public finance, fixed income sales and trading, proprietary trading and agency execution services. Revenues are derived from the net interest spread on stock loan transactions, commission and trading income from fixed income and equity products and investment banking fees from corporate and municipal securities transactions.

Banking. We offer traditional banking products and services and focus on several sectors of the residential housing market, including interim construction and short-term funding for mortgage bankers. The Bank earns substantially all of its income on the spread between the rates charged to customers on loans and the rates paid to depositors. We seek to grow our Bank by adding experienced bankers and through acquisition.

The "other" category includes SWS Group, corporate administration and SWS Capital Corporation. SWS Group is a holding company that owns various investments, including common stock of U.S. Home Systems, Inc. ("USHS") and NYSE Euronext, Inc. ("NYX").

Business Environment

Our business is sensitive to financial market conditions which, were very volatile during the first quarter of fiscal 2009 and became even more volatile subsequent to the end of the quarter. Equity market indices declined from a year ago with the Dow Jones Industrial Average (the "DJIA") decreasing 20%, the Standard & Poor's 500 Index down 21% and the NASDAQ Composite Index down 19%. Since the end of the first quarter, all indices have continued to decline. The DJIA has closed below 9,000 for the first time in five years. Volume remained active with average daily volume on the New York Stock Exchange increasing 20% over the same period last fiscal year.

The end of the first quarter of fiscal 2009 brought turmoil in the general economy and upheaval in the credit markets. These disruptions and developments have resulted in a range of actions by the U.S. and foreign governments to attempt to bring liquidity and order to the financial markets and to prevent a long recession in the world economy. The U.S. government has taken several actions to intervene in support of the credit markets, including the Troubled Asset Relief Program, through which the U.S. government is authorized to purchase up to $700 billion in whole loans and mortgage-related securities as well as to invest directly in financial institutions and commercial paper. Additional actions include the guarantee of certain money market mutual fund and bank borrowings and increased Federal Deposit Insurance Corporation ("FDIC") insurance for certain customer bank deposit accounts. Additionally, the government stepped in to take over the operations of Fannie Mae, Freddie Mac and American International Group, Inc. ("AIG") while allowing Lehman Brothers ("Lehman") to fail.

The Federal Reserve Board ("FRB") lowered the federal funds rate by 275 basis points from September 30, 2007 to September 30, 2008 and an additional 100 basis points since September 26, 2008. Additionally, the FRB lowered collateral requirements to increase liquidity in the financial markets.

Investors have responded to the volatile markets with a flight to quality which has, in turn, reduced yields on short-term treasury securities and has produced a dramatic reduction in commercial paper issuance.

Securities and banking regulators have been active in establishing temporary rules and regulations to respond to this crisis. Some of these actions have resulted in temporary or, in some cases, permanent, restrictions on certain types of securities transactions, most notably short sales of equity securities of certain financial institutions.

All of these factors have had an impact on our businesses. Additionally, any potential growth in the U.S. stock markets in the upcoming months will be tempered by investor uncertainty resulting from the outcome of the November 2008 presidential election, volatility in the cost of energy and commodities, unemployment and recession concerns, as well as the general state of the U.S. and world economies.

Impact of Credit Markets

Brokerage. On the brokerage side of the business, volatility in the credit and mortgage markets has had an impact on several aspects of our business primarily related to valuation of securities, liquidity and counterparty risk.

Valuation of Securities

While trading in sub-prime collateralized debt obligations, proprietary structured products, credit default swaps and other volatile investments are not primary activities for us, we do trade other debt and equity securities and we have seen deterioration in the marketability and valuation of some of these products as the market for some types of securities are not functioning at normal levels.

In order to take advantage of attractive tax-free yields for the company, we began investing in certain auction rate municipal bonds in the spring of 2008. We had an average of $96.1 million invested in these securities during the first quarter of fiscal 2009 and the balance at quarter end was $95.0 million. Subsequent to the end of the quarter, we sold $31.2 million of these bonds reducing our holdings to $63.8 million. These securities are investment grade credits, are valued at par and as of October 31, 2008 are yielding 7.19% per year. Auctions on the current holdings have substantially failed since shortly after quarter end. While management does not expect any reduction in the cash flow from these bonds, prolonged failure of these auctions could indicate an impairment in their value due to lack of liquidity. The company currently has the ability to hold these investments until the municipal market recovers.

These securities are currently financed through a combination of bank loans and our own capital. Should our lender determine that these securities are no longer eligible collateral or should they decide to reduce the advance rate for these securities, we could be required to finance substantially all of this portfolio from our existing capital. This could impact our ability to carry inventories of other securities to support our fixed income, equity and correspondent clearing businesses which, in turn, could reduce the volume and profitability of those businesses. Management monitors these investments daily and ensures that we have limited concentrations in any one issuer.

Customers of Southwest Securities, Inc. ("Southwest Securities"), SWS Financial Services, Inc. ("SWS Financial") and M.L. Stern also hold investments in auction rate securities. Our customers hold approximately $23.6 million in auction rate preferred securities which were generally purchased at other brokerage firms and transferred to Southwest Securities. We did not actively market these securities to our customers. Substantially all of these securities are subject to partial redemption and/or restructuring by the sponsors. We also hold $925,000 in proprietary positions in auction rate preferred securities. Our customers also hold $16.8 million in auction rate bonds held at our M.L. Stern subsidiary. A number of our competitors who sold or underwrote these securities have been required by regulators to repurchase these securities from their customers. Should we be required to take similar action, our liquidity could be negatively impacted.

We also trade mortgage and asset-backed securities on a regular basis. We monitor our trading limits daily to ensure that these securities are maintained at levels we consider to be prudent given current market conditions. Inventories of these securities are priced using a third-party pricing service and are reviewed monthly to ensure reasonable valuation. At September 26, 2008, we held mortgage and asset-backed securities of approximately $11.1 million included in "Securities owned, at market value" on the Consolidated Statements of Financial Condition.

Customer margin balances have also been negatively impacted by the declining stock market values, which will reduce the net interest we earn on customer accounts.

The company has one investment in a venture capital investment partnership which we account for on the equity method of accounting, which is reflective of fair value. This venture capital fund invests in small businesses in various stages of development and operating in a variety of industries. During the first quarter of fiscal 2009, we recorded a $1.1 million loss

on this joint venture. A prolonged downturn in the economy could lead to a continued decline in the fair value of this investment. At September 26, 2008, this investment was recorded at $1.6 million. Additionally, the company has commitment to invest an additional $1 million under certain circumstances.

Liquidity

Dislocation in the credit markets has led to increased liquidity risk. Substantially all of our borrowing arrangements are uncommitted lines of credit and, as such, can be reduced or eliminated at any time by the banks extending the credit. While we have not experienced reductions in our borrowing capacity, our lenders have taken actions that indicate their concerns regarding liquidity in the marketplace. These actions have included reduced advance rates for certain security types, more stringent requirements for collateral eligibility and higher interest rates. All of these actions have had a negative impact on our liquidity. Should our lenders continue to take additional similar actions, the cost of conducting our business will increase and our volume of business could be limited.

The volatility in the U.S. stock markets is also impacting our liquidity through increased margin requirements at our clearing houses. These margin requirements are determined through a combination of risk factors including volume of business and volatility in the U.S. stock markets. Consequently, our margin requirements at our clearinghouses have ranged as high as 37% greater than our highest margin requirement in the first quarter of last fiscal year. To the extent we are required to post cash or other collateral to meet these requirements, we have less borrowing capacity to finance our other businesses.

Failure of Financial Institutions

On September 19, 2008, Lehman filed for protection from its creditors with the Securities Investor Protection Corporation ("SIPC"). Lehman was one of our counterparties in our securities lending business. We had been working for several weeks to reduce our exposure to Lehman prior to the bankruptcy filing. As of the bankruptcy filing date, we had $10.3 million of stock borrowed from Lehman with a value of $9.7 million. Subsequent sales and revaluation of the collateral since the bankruptcy filing have led to an expected shortfall in collateral value of $5.4 million. The company recorded this loss in the first quarter of fiscal 2009. The Company had no exposure resulting from the U.S. intervention in Fannie Mae, Freddie Mac or AIG.

In October 2008, the U.S. Congress passed and the U.S. President signed into law the Emergency Economic Stabilization Act of 2008 ("EESA"). This new law brought many changes to the economic landscape in the hope of helping the U.S. economy. We have seen some stabilization in the U.S. stock markets, but this law will take time to show its impact on the U.S. economy.

Bank. The dislocation of the credit and mortgage markets has also impacted the operating environment of our wholly-owned bank subsidiary, Southwest Securities, FSB (the "Bank"), directly through loan portfolio exposure and indirectly primarily from the actions of the U.S. government and banking regulators.

The Bank continues to manage the deterioration of its residential construction loan portfolio. Average outstanding loans in this portfolio have decreased $39.4 million or 17.9% from the first quarter of fiscal 2008. The market continues to work through the absorption of the oversupply of finished vacant housing. As published by Residential Strategies Inc., finished vacant inventory in North Texas represents a 3.13 month supply, where a 2.5 month supply is considered equilibrium. Mortgage rates remain attractive and employment in North Texas remains strong which we believe should help mitigate any continued deterioration. A prolonged economic downturn could exacerbate the deterioration in this portfolio.

Passage of the EESA accelerated the Federal Reserve's authority to pay interest on depository institutions' required and excess reserve balances. The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on reserves beginning October 1, 2011. This acceleration became effective October 9, 2008. The interest paid on required reserve balances will be the target Federal Funds rate less 10 basis points. The rate paid on excess reserves will initially be set at the target Federal Funds rate less 35 basis points. Establishing this floor for Federal Funds should provide some stability to the Federal Funds market. This should have a positive impact for the Bank as it is an active participant in the Federal Funds market.

The EESA also temporarily increased deposit insurance coverage from $100,000 per insured account to $250,000 per insured account through December 31, 2009.

On October 14, 2008, the U.S. Treasury Department announced a capital purchase program which would inject up to $250 billion of capital into the banking system. The Bank is actively reviewing this program and the growth opportunities it may support.

Also, on October 14, 2008, the U.S. Treasury Department invoked the systemic risk exception of the FDIC Improvement Act of 1991 which provides the FDIC with flexibility to provide a 100 percent guarantee of newly issued senior unsecured debt and non interest bearing transaction accounts. The Bank plans to participate in both components of this program. The additional FDIC coverage for our customers should provide greater confidence in our banking system and the debt guarantee should provide additional stability to our Federal Funds transactions with other financial institutions.

Events and Transactions

Several material events and transactions impacted the results of operations in the periods presented. A description of the circumstances surrounding these transactions and the impact on our results are discussed below.

Write-off of $5.4 million for stock loan. In the first quarter of fiscal 2009, we wrote-off $5.4 million related to a deficit in the collateral securing a counterparty obligation of Lehman. We experienced the counterparty deficit as a result of Lehman declaring bankruptcy on September 19, 2008. Lehman had an obligation to us for stock borrowed of approximately $10.3 million at the time of the bankruptcy filing, which was backed by approximately $9.7 million in collateral. Subsequent sales and revaluation of the remaining collateral is expected to result in a $5.4 million deficit. We plan to make a claim to SIPC and negotiate with other counterparties to mitigate the deficit. However, the potential for a successful recovery is unknown at this time. This write-off was recorded in "Other expenses" on the Consolidated Statements of Income and Comprehensive Income.

Acquisition of M.L. Stern. In February 2008, we entered into a definitive agreement to purchase M.L. Stern from a subsidiary of Pacific Life Insurance Company. The acquisition was structured as a purchase of all of the outstanding membership interests of M.L. Stern. The assets and liabilities acquired as well as the financial results of M.L. Stern were included in our consolidated financial statements after the close of business on March 31, 2008, the acquisition date. The transaction has doubled the size of our private client advisor network and re-established us in the asset management business. The M.L. Stern business is included in our retail segment.

The aggregate acquisition price was approximately $8.7 million, which consisted of cash in the amount of $5.5 million and direct expenses of $3.2 million in finder's fees, legal fees, valuation fees, severance costs and contract cancellation costs. We accounted for the acquisition of M.L. Stern under the provisions of Financial Accounting Standards Board Statement of Financial Accounting Standards ("SFAS") No. 141 "Business Combinations."

RESULTS OF OPERATIONS

Consolidated

Net income for the three-month period ended September 26, 2008 was $7.0 million, a decrease of $698,000 from net income for the comparable three-month period ended September 28, 2007. Net income for the three-month period ending September 28, 2007 includes income of $17,000 from discontinued operations. Both the three-month period ended September 26, 2008 and September 28, 2007 contained 63 trading days.

The following is a summary of increases (decreases) in categories of net revenues and operating expenses for the three-month period ended September 26, 2008 compared to the three-month period ended September 28, 2007 (dollars in thousands):

                                                                  Change
                                                              Amount       %
      Net revenues:
      Net revenues from clearing operations                  $    (55 )    (2 )%
      Commissions                                              13,573      61
      Net interest                                              8,589      36
      Investment banking, advisory and administrative fees        883       9
      Net gains on principal transactions                       1,361     101
      Other                                                    (3,529 )   (55 )

                                                               20,822      31

      Operating expenses:
      Commissions and other employee compensation            $ 12,187      30 %
      Occupancy, equipment and computer service costs           1,217      19
      Communications                                              935      42
      Floor brokerage and clearing organization charges          (210 )   (19 )
      Advertising and promotional                                 206      35
      Other                                                     7,640     177

                                                               21,975      40

      Pretax income                                          $ (1,153 )   (10 )%

Net revenues increased for the first quarter of fiscal 2009 by $20.8 million as compared to the same period of fiscal 2008. The largest components of the increase were in commissions, $13.6 million and net interest, $8.6 million. The increase in commissions is due to the acquisition of M.L Stern, which is in our retail segment. M.L. Stern recorded commission revenue of $9.7 million for the first quarter of fiscal 2009. Commission revenue also increased $4.5 million in the institutional segment primarily in the fixed income business as greater volatility and increased client activity led to wider spreads and more transactions. These commission revenue increases were partially offset by a $453,000 decrease in commissions for SWS Financial. The increase in net interest is due primarily to a 107 basis point increase in the spread in the stock loan business as well as an increase in the average loan balance at the Bank of 38%.

Operating expenses increased $22.0 million for the three-months ended September 26, 2008 as compared to the same period of fiscal 2008. The largest increases were in commissions and other employee compensation, $12.2 million and other expenses, $7.6 million. The increase in commissions and other employee compensation is due primarily to the addition of M.L. Stern. M.L. Stern's commission and other employee expenses were $8.3 million for the quarter ended September 26, 2008. The remainder of the increase is due to variable compensation in the institutional segment, additional headcount at the Bank and an increase in incentive compensation of $1.3 million from fiscal 2008 to fiscal 2009. The increase in other expenses is primarily due to the $5.4 million write-off

of the Lehman counterparty exposure, an increase in the provision for loan losses of $883,000, increases in licenses and legal fees of $628,000 and increases in purchased mortgage loan losses, real estate expenses and Savings Association Insurance Fund ("SAIF") assessments of $882,000.

Net Interest Income

Net interest income from the brokerage segments is dependent upon the level of customer and stock loan balances as well as the spread between the rates we earn on those assets compared with the cost of funds. Net interest is the primary source of income for the Bank and represents the amount by which interest and fees generated by earning assets exceed the cost of funds, primarily interest paid to the Bank's depositors on interest-bearing accounts. The components of interest earnings are as follows for the three-month period ended September 26, 2008 and September 28, 2007 (in thousands):

                                         Three-Months Ended
                                   September 26,     September 28,
                                       2008              2007
                   Brokerage      $        17,536   $        11,720
                   Bank                    14,664            11,891

                   Net interest   $        32,200   $        23,611

For the three-months ended September 26, 2008, net interest income from our brokerage entities accounted for approximately 20% of our net revenues. For the three-months ended September 28, 2007, net interest income generated by our brokerage entities accounted for approximately 18% of our net revenue. Net interest for the Bank is discussed in the Banking segment discussion below.

Average balances of interest-earning assets and interest-bearing liabilities are as follows (in thousands):

                                                       Three-Months Ended
                                                 September 26,     September 28,
                                                     2008              2007
    Average interest-earning assets:
    Customer margin balances                    $       231,000   $       292,000
    Assets segregated for regulatory purposes           334,000           312,000
    Stock borrowed                                    2,825,000         3,069,000

    Average interest-bearing liabilities:
    Customer funds on deposit                           483,000           503,000
    Stock loaned                                      2,784,000         3,030,000

Net interest revenue generated by each segment is reviewed in detail in the segment analysis below.

Income Tax Expense

For the three-months ended September 26, 2008, income tax expense (effective rate of 34.9%) did not differ materially from the amount that would have otherwise been calculated by applying the federal corporate tax rate (35%) to income from continuing operations before income taxes.

Segment Information

The following is a summary of the increases (decreases) in categories of net
revenues and pre-tax income by segment for the three-month period ended
September 26, 2008 compared to the three-month period ended September 28, 2007
(dollars in thousands):



                              Three-Months Ended
                       September 26,       September 28,       Increase/
                           2008                2007            (Decrease)      % Change
    Net revenues:
    Clearing          $         8,176     $        10,278     $     (2,102 )        (20 )%
    Retail                     29,997              19,639           10,358           53
    Institutional              36,812              23,953           12,859           54
    Banking                    15,327              12,491            2,836           23
    Other                      (2,544 )               585           (3,129 )       (535 )
. . .