OVERVIEW

SWS Group, Inc. (together with its subsidiaries, "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 ("SEC") 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. Prior to December 31, 2008, the retail segment included M.L. Stern & Co., LLC and its wholly-owned subsidiary, Tower Asset Management, LLC, (collectively, "M.L. Stern"). Substantially all of the operations of the M.L. Stern broker/dealer were transferred to Southwest Securities, Inc. ("Southwest Securities") in December 2008 and are operating as a division of Southwest Securities, (references to M.L. Stern include the division). Effective April 4, 2009, M.L. Stern has withdrawn from registration with the Financial Industry Regulatory Authority ("FINRA"), the SEC and all states. The division and Tower Asset Management, LLC purchase and sell 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. These operations are included in our retail segment.

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. Southwest Securities, FSB (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, Inc. ("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 have been very volatile during fiscal 2009. As of March 27, 2009, equity market indices had declined from a year ago with the Dow Jones Industrial Average (the "DJIA") decreasing 36%, the Standard & Poor's 500 Index down 38% and the NASDAQ Composite Index down 32%. The DJIA has closed below 7,000 for the first time since May of 1997 and was 7,776 at the close of trading on March 27, 2009, a 19% gain from its lowest point in the third quarter, March 9, 2009. Volume remained active with average daily volume for the quarter on the New York Stock Exchange increasing 2% over the same period last fiscal year. Subsequent to the end of the quarter, equity market indices have rallied; however, it is unclear whether this is sustainable.

The turmoil in the general economy and upheaval in the credit markets continued through the third quarter of fiscal 2009. 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.

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. In addition, the new U.S. President signed into law on February 17, 2009 the American Recovery and Reinvestment Act of 2009 "(ARRA"). This new legislation was designed to help stabilize the U.S. stock markets. The U.S. President has also brought several new proposals to the legislature for consideration, including plans to help the struggling mortgage and banking industries. However, the EESA, the ARRA and the proposed new legislation will take time to show their impact on the U.S. economy.

The Federal Reserve Board ("FRB") lowered the federal funds rate by 200 basis points from March 28, 2008 to March 27, 2009 and lowered collateral requirements in the hopes of increasing 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 U.S. 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.

Through the end of March 2009, these activities have yet to reinvigorate the financial and credit markets. Credit standards have continued to tighten while unemployment rates and foreclosures have increased substantially. All of these factors have had an impact on our businesses at the Bank and the brokerage.

Impact of Credit Markets

Brokerage. On the brokerage side of the business, volatility in the credit and mortgage markets coupled with the declining stock markets has had an impact on several aspects of our business primarily related to valuation of securities, liquidity, counterparty risk and reduced investor interest in maintaining or originating margin loans.

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 normally.

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. At the end of the first, second and third quarters of fiscal 2009, we held $95.0 million, $39.4 million and $24.5 million, respectively of auction rate municipal bonds. In the second and third quarters of fiscal 2009, we sold $55.6 million and $14.9 million, respectively, of the auction rate municipal bonds, reducing our holdings to $24.5 million, which represents one security and 41.5% of our municipal obligations portfolio at March 27, 2009. This security is an investment grade credit, is valued at par and as of March 30, 2009 is yielding approximately 1% per year. While management does not expect any reduction in the cash flow from this bond, prolonged failure of this auction could indicate an impairment in the value due to lack of liquidity. The company currently has the ability to hold this investment. We expect the issuer of this bond to refinance their debt. See additional discussion under "Critical Accounting Policies-Fair Value."

Our customers also own $13.7 million in auction rate bonds substantially all of which are held by customers of our M.L. Stern division. Our customers also hold investments in auction rate preferred securities. Our customers hold approximately $27.0 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 or classify them as cash equivalents on our statements to our customers. We do not underwrite auction rate securities or serve as the remarketing agent for any of these securities.

At March 27, 2009, four customers of Southwest Securities and one customer of SWS Financial Services, Inc. ("SWS Financial") held approximately $6.0 million of auction rate preferred securities that were purchased through us. Substantially all of these securities are subject to partial redemption and/or restructuring by the sponsors. We also hold $1.3 million in proprietary positions in auction rate preferred securities. A number of our competitors who sold or underwrote these securities have been required by regulators to repurchase these securities from their customers. We have not been contacted by any of our regulators in regard to a requirement to repurchase these securities from our customers nor have there been any inquiries to review our customers' holdings of such securities. However, 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 March 27, 2009, we held mortgage and asset-backed securities of approximately $15.5 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 reduce the net interest we earn on customer accounts.

We have one investment in a venture capital investment partnership which we account for on the equity method of accounting, which approximates 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 nine-months of fiscal 2009, we recorded losses of $2.6 million on this joint venture. A prolonged downturn in the economy could lead to a continued decline in the fair value of this investment. At March 27, 2009, this investment was recorded at $1.1 million.

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 during the third quarter of fiscal 2009 have ranged as high as 13% greater than our highest margin requirement in the third 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. In the third quarter of fiscal 2009, one of our securities lending clearing houses changed the computation of its margin requirement by implementing new margin requirements for the stock loan business. Implementation of new risk management reports by our business unit limited the negative impact of this change. This increase in our margin requirement could impact the volume of stock loan business we conduct.

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. 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 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.

Bank. Credit quality at the Bank continues to be adversely impacted by the current economic downturn. The North Texas residential market continues to work through the oversupply of vacant housing. Finished vacant housing inventory currently stands at 3.4 month supply, while 2.5 month supply is considered optimal, according to Residential Strategies, Inc. The Bank also continues to experience deterioration in lot and land development loan portfolios as well as commercial real-estate. Non-performing assets increased $13.5 million in the third fiscal quarter of 2009. The most significant increases were commercial real estate, up $11.1 million, and other real estate owned, up $5.0 million. Net charge-offs for the third quarter of fiscal 2009 were $3.5 million compared to $410,000 in the second quarter of fiscal 2009 and $177,000 in the third quarter of fiscal 2008. Our loan loss provision for this quarter was $5.7 million compared to $1.8 million in the second quarter of fiscal 2009 and $676,000 in the third quarter of fiscal 2008. The allowance for loan losses increased to $11.1 million or 0.99% of loans, up from 0.84% in the second quarter of fiscal 2009 and 0.74% in the third quarter fiscal 2008. We anticipate charge-offs and provision expense to continue at elevated levels for the next few quarters.

As the economic downturn persists, we anticipate we will experience continued deterioration in our commercial real estate portfolio. Deterioration in this portfolio could extend over the next few quarters. Because we expect that losses associated with this portfolio will have a tendency to be individually larger than those experienced in the residential portfolio, we may experience more volatility in our earnings.

After aggressive rate reductions from the Federal Reserve in the second quarter of fiscal 2009, rates have stabilized and net interest spreads are improving, resulting in a positive impact on earnings. See "Results of Operation-Segment-Banking" for discussion of the banking segment's net interest income.

Passage of the EESA accelerated the FRB's authority to pay interest on depository institutions' required and excess reserve balances. This allowed the FRB to establish a floor for federal funds which has provided stability to this 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 February 27, 2009, the FDIC adopted an interim rule imposing a 20 basis point emergency special assessment on the industry's insured institutions' deposits as of June 30, 2009, which will be collected on September 30, 2009. The FDIC has subsequently stated it could reduce the special assessment to as low as 10 basis points if the U.S. Congress enacts legislation that would increase the FDIC's borrowing authority from the U.S. Treasury from $30.0 billion to $100.0 billion. The interim rule also provides for future special assessments, if needed. We continue to monitor developments for this special assessment.

On October 14, 2008, the U.S. Treasury announced a capital purchase program which would inject $250 billion of capital into the banking system. On October 30, 2008, we, through our banking subsidiary, made an initial application for the Capital Purchase Program under the Trouble Asset Relief Program, "TARP funds." Management believed it was prudent to apply and subsequently evaluate whether to proceed with the application process at a future date. In January 2009, management determined it was not in the best interest of the firm to pursue this form of funding and has discontinued its application process.

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 resulted in a $5.4 million deficit. We have made a claim to SIPC and are negotiating 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. Substantially all of the operations of the M.L. Stern broker/dealer were transferred to Southwest Securities in December 2008 and are operating as M.L. Stern, a division of Southwest Securities, Inc. These operations are included in our retail segment. Effective April 4, 2009, M.L. Stern has withdrawn its broker/dealer registration with FINRA, the SEC and all states.

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 ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 141 "Business Combinations."

In the third quarter of fiscal 2009, we reduced our initial estimates of the liabilities for severance costs and contract cancellation costs as additional information indicated that the costs would be lower than initially expected. The reduction in the estimate for the severance costs was $290,000 and was due to voluntary employee terminations subsequent to the acquisition date. The reduction in the contract cancellation fee estimate was due to a change in the estimated date of cancellation of the contract, which reduced the fees estimated to be paid to the vendor by $385,000. As a result of these adjustments, we recognized other income of $675,000 on our Consolidated Statement of Income and Comprehensive Income in the third quarter of fiscal 2009.

RESULTS OF OPERATIONS

Consolidated

Net income for the three and nine-month periods ended March 27, 2009 was $4.0 million and $20.0 million, respectively, a decrease of $4.6 million and $3.5 million from net income for the comparable three and nine-month periods ended March 28, 2008, respectively. Net income for the nine-month period ending March 28, 2008 includes income of $17,000 from discontinued operations. The three and nine-month periods ended March 27, 2009 and March 28, 2008 contained 59 and 188 and 60 and 187 trading days, respectively.

The following is a summary of increases (decreases) in categories of net revenues and operating expenses for the three and nine-month periods ended March 27, 2009 compared to the three and nine-month periods ended March 28, 2008 (dollars in thousands):

                                                            Three-Months                Nine-Months
                                                               Ended                       Ended
                                                                        %                           %
                                                         Amount       Change        Amount        Change
Net revenues:
Net revenues from clearing operations                   $ (1,143 )       (32 )%    $  (1,858 )       (17 )%
Commissions                                               19,055          70          59,836          79
Net interest                                              (3,640 )       (13 )         5,700           7
Investment banking, advisory and administrative fees        (190 )        (3 )         1,304           5
Net gains on principal transactions                        9,410         458          16,195         273
Other                                                     (2,896 )       (47 )       (12,407 )       (67 )

                                                          20,596          28          68,770          32

Operating expenses:
Commissions and other employee compensation             $ 17,061          38 %     $  49,404          39 %
Occupancy, equipment and computer service costs            2,105          33           4,979          26
Communications                                               873          35           2,632          37
Floor brokerage and clearing organization charges          1,541         195           1,439         117
Advertising and promotional                                  259          28             684          28
Other                                                      5,855          90          14,198          80

                                                          27,694          46          73,336          42

Pre-tax income                                          $ (7,098 )       (51 )%    $  (4,566 )       (12 )%

Net revenues increased for the third quarter of fiscal 2009 by $20.6 million as compared to the same period of fiscal 2008. The largest components of the increase were in commissions, $19.1 million and net gains on principal transactions, $9.4 million. The increase in commissions is due primarily to a $12.5 million increase in the institutional segment primarily in the fixed income business as greater volatility and wider spreads along with increased client activity led to more transactions. Also contributing to the increase in commissions is the increase in our retail segment of $6.6 million. The increase in our retail segment is primarily due to the acquisition of M.L Stern. M.L. Stern recorded commission revenue of $8.2 million for the third quarter of fiscal 2009. These commission revenue increases were partially offset by a $754,000 decrease in commissions for SWS Financial and a $820,000 decrease in commissions for our Private Client Group. The increase in net gains on principal transactions is driven by activity in the fixed income business primarily from the volatility in the market and increased customer activity. These increases were offset by a decrease in other revenue of $2.9 million and net interest of $3.6 million. The decrease in net interest is due primarily to a $6.1 million decrease in net interest on our stock loan/borrowing activities, offset by increased net interest from the Bank. The decrease in other revenue for the third quarter of fiscal 2009 when compared to the third quarter of fiscal 2008 is due to a decrease in insurance product sales of $1.3 million and a decrease in the Bank's other revenue. In the third quarter of fiscal 2008, the Bank recognized a gain on the sale of its factoring assets.

Net revenues increased for the first nine months of fiscal 2009 by $68.8 million . . .