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| SWS > SEC Filings for SWS > Form 10-K on 9-Sep-2009 | All Recent SEC Filings |
9-Sep-2009
Annual Report
OVERVIEW
We are 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. In addition, we face substantial competition in each of our lines of business. See "Forward-Looking Statements," "Item 1. Business-Competition," "-Regulation" and "Item 1A. Risk Factors."
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. in December 2008 and are operating as separate offices of our private client group (references to M.L. Stern include these operations). These operations are included in our retail segment. Effective April 4, 2009, M.L. Stern withdrew from registration with FINRA, the SEC and all states. Tower Asset Management, LLC provided investment advisory services to high net worth individuals or families who required investment expertise and personal services. Tower Asset Management, LLC ceased operations on June 30, 2009.
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 business banking including commercial lending, commercial real-estate lending, SBA lending and residential construction lending. 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 have been very volatile during fiscal 2009. As of June 26, 2009, equity market indices had declined from a year ago with the Dow Jones Industrial Average (the "DJIA") decreasing 26%, the Standard & Poor's 500 Index down 28% and the NASDAQ Composite Index down 21%. During fiscal 2009, the DJIA closed below 7,000 for the first time since May of 1997 and was 8,348 at the close of trading on June 26, 2009, a 29% 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 16% over fiscal 2008. In the past quarter, equity market indices have rallied; however, it is unclear whether this is sustainable.
The turmoil in the general economy and upheavals in the credit markets continued through the fourth quarter of fiscal 2009. The disruptions and developments over the past eighteen months 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 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 EESA. This new law brought many changes to the economic landscape in the hope of helping the U.S. economy. In addition, the 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 FRB lowered the federal funds rate by 175 basis points from June 30, 2008 to June 30, 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 certain types of short sales of equity securities.
The fourth quarter of fiscal 2009, brought some improvement and stabilization in the financial and credit markets. Credit standards, which tightened dramatically during early fiscal 2009, have started showing some signs of stability. Unemployment rates and foreclosures, which increased substantially during the year, are showing some signs of improvement. 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 market, impacted 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 these 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 fiscal 2009 and 2008, we held $23.9 million and $88.2 million, respectively of auction rate municipal bonds. In fiscal 2009, we purchased $17.9 million
and sold $82.3 million in auction rate municipal bonds, reducing our holdings to $23.9 million, which represents one security and 26.3% of our municipal obligations portfolio at June 26, 2009. This security is an investment grade credit, is valued at its par value and as of June 26, 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. We expect the issuer of this bond to refinance their debt within the next fiscal year. See additional discussion under "Critical Accounting Policies-Fair Value."
Our customers own $4.6 million in auction rate bonds. Our customers also hold approximately $25.5 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 June 26, 2009, four customers of Southwest Securities and one customer of 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 $1.7 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 June 26, 2009, we held mortgage and asset-backed securities of approximately $3.2 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 reduces the net interest we earn on customer accounts.
We have one investment in a venture capital partnership which we account for using the equity method of accounting, which approximates fair value. This venture capital fund invests in small businesses in various stages of development and that operate in a variety of industries. During fiscal 2009, we recorded losses of $2.7 million on this investment. A prolonged downturn in the economy could lead to a continued decline in the fair value of this investment. At June 26, 2009, this investment was recorded at $1.0 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 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 fiscal 2009 ranged as high as 37% greater than our highest margin requirement in fiscal 2008. 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. In response to this change, we implemented new risk management reports for this business unit which effectively limited any negative impact from 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 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: Deterioration in the residential construction loan portfolio showed some improvement over the past two quarters, with non-performing assets decreasing $1.8 million in the third quarter of fiscal 2009 and an additional $2.1 million in the fourth quarter of fiscal 2009. Though these non-performing assets continue at elevated levels, we are encouraged by the improvement and anticipate this to continue over the next few quarters. Residential Strategies, Inc. ("RSI"), a Dallas-Fort Worth based market research and consulting firm specializing in new home activity, reported Dallas-Fort Worth overall inventory of new housing including finished and under construction inventory at a total of 10,523 units, a 6.29 month supply. A 6.0 month supply is considered a balanced inventory.
As we move through this economic cycle, the improvement in residential markets has been offset by accelerated deterioration in the commercial real estate market. As commercial transactions are typically larger than residential, we expect that losses will tend to be larger than in the residential portfolio as we move through this phase of the cycle.
Non-performing assets decreased $1.6 million during the fourth quarter of fiscal 2009 but increased $22.9 million for the year. Provision for loan losses totaled $4.9 million for the fourth quarter and $13.3 million for fiscal year 2009 compared to $5.7 million for the third quarter of fiscal 2009 and $3.5 million for fiscal 2008. Net charge-offs for the fourth quarter were $1.2 million compared to $3.5 million in the third quarter. Net charge offs for fiscal 2009 were $5.5 million compared to $2.1 million for fiscal 2008. We anticipate losses and provision expense to remain at these levels for the next few quarters. The allowance for loan losses increased 112.0% to $14.7 million at June 30, 2009 compared to $6.9 million at June 30, 2008. The allowance represents 1.3% of loans not held for sale, up from 1.0% in the third quarter of fiscal 2009 and 0.74% at June 30, 2008.
On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each depository institution's assets minus Tier 1 capital as of June 30, 2009. This special assessment will be collected September 30, 2009. The Bank accrued this expense in June, which totaled approximately $700,000. The FDIC has indicated there may be additional special assessments in the future. With FDIC's current authority to impose these special assessments expiring on January 1, 2010, we anticipate an additional special assessment may be announced in the first or second quarter of 2010. The amount of any such additional special assessment is not currently estimable.
Passage of the EESA temporarily increased deposit insurance coverage from $100,000 per insured depositor to $250,000 per insured depositor. This increase is currently expected to expire December 31, 2013. On October 14, 2008, the U.S. Treasury 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 transaction account guarantee program is set to expire December 31, 2009. On June 23, 2009, the FDIC posted a notice of proposed rulemaking seeking comment on the potential extension of the transaction account guarantee program. The Bank and SWS Group are participating in this program and anticipate continued participation if the program is extended. No senior unsecured debt has been issued by SWS Group or the Bank.
Also on October 14, 2008, the U.S. Treasury announced a capital purchase program which would inject $250 billion of capital into the banking system primarily through the TARP. In January 2009, management determined it was not in the best interest of the company to participate in this form of funding.
In June 2009, the U.S. Treasury announced its proposed Financial Regulatory Reform. These proposals offer sweeping changes to the regulatory environment of the Bank, which could lead to significant changes in our business model if passed into law. Included in these proposals is the desire to eliminate the federal thrift charter and the creation of a new federal government agency, the National Bank Supervisor ("NBS") which would take over responsibilities of the Office of the Comptroller of the Currency and Office of Thrift Supervision. Bank management is actively analyzing the potential impact of such legislation.
To strengthen the balance sheet and provide support for additional growth, SWS Group injected $25.0 million of capital in the Bank, $15.0 million during the third quarter of fiscal 2009 and $10.0 million during the fourth quarter of fiscal 2009. This injection improved the Bank's capital position resulting in improved risk based and core capital ratios. The additional capital also allows the Bank to continue to take advantage of good lending opportunities in the markets it serves.
Events and Transactions
Several material events and transactions impacted the results of operations in the periods presented. A description of the facts and circumstances surrounding these transactions and the impact on our results is presented below:
NYSE/Archipelago.We owned 23,721 shares of Archipelago Holdings, LLC ("Archipelago") common stock prior to the merger of Archipelago and the NYSE in March 2006, for which we received 23,721 unrestricted shares of the new entity NYX. As part of the merger, we also surrendered our NYSE seat (carried at a cost of $230,000) in return for $300,000 in cash and 80,177 restricted shares of NYX common stock. On October 1, 2008, the NYX removed the restrictions on the remaining 26,725 shares that were set to lapse in March 2009. As of June 26, 2009, all of the NYX shares were unrestricted.
In July 2007, ownership of the NYX stock was transferred from Southwest Securities to SWS Group. These shares are now recorded as marketable equity securities available for sale and changes in valuation appear in the other comprehensive income line in the consolidated statements of income and comprehensive income. At June 27, 2008, we recorded a loss in other comprehensive income of $1.9 million, $1.3 million net of tax, on the NYX shares that we own. In fiscal 2007, we recorded gains of $1.2 million, in net gains (losses) on principal transactions, from the market appreciation of our shares of NYX.
As a result of the depressed price of NYX, SWS determined that it must review this security to evaluate whether such security was other than temporarily impaired. The review of this security was conducted in the fourth quarter of fiscal 2009.
To evaluate whether the decline in value for NYX was other than temporary, SWS reviewed the following factors:
• The length of time and the extent to which the market value has been less than cost;
• The financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer, such as changes in technology that may impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential;
• The intent and ability of SWS to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value; and
• The cyclicality and volatility of the investment.
Based on this review, it was determined that the decline in value for NYX was other than temporary. Consequently, realized losses of $4.3 million were recorded in other expenses. The new cost basis of the NYX investment is $2,909,000, the market value of the NYX shares at June 26, 2009.
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. Substantially all of the operations of the M.L. Stern broker/dealer were transferred to Southwest Securities in December 2008 and are operating as separate offices in our private client group. These operations are included in our retail segment. Effective April 4, 2009, M.L. Stern withdrew its broker/dealer registration with FINRA, the SEC and all states. Tower Asset Management, LLC ceased business operations on June 30, 2009.
The aggregate acquisition price for M.L. Stern 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 Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations."
The cost to acquire M.L. Stern was less than the fair values assigned to the acquired assets and liabilities, and as such, the excess was allocated as a pro-rata reduction of the amounts assigned to the acquired assets bringing all valued intangible assets to an adjusted fair value of zero. Depreciable fixed assets were also reduced to zero through the allocation process. After the allocation of the excess, $1.6 million of excess fair value over cost remained. We recognized this amount as an extraordinary gain.
In 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 fiscal 2009.
Payments to the Deferred Compensation Plan. We purchase COLI as a component of the company's deferred compensation plan. The life insurance policies are valued at the cash surrender values as of the balance sheet date and are included in other assets in the consolidated statement of financial condition. During the second quarter of fiscal 2007, we received proceeds of $2.3 million from COLI which were recorded in other revenue in the consolidated statements of income and comprehensive income.
TD Ameritrade Transaction. On March 22, 2006, the company entered into an agreement with TD Ameritrade Holding Corporation ("Ameritrade") to transfer 15 correspondent clients to the company. This transaction closed in July 2006, with 12 of the 15 correspondents agreeing to transfer to our clearing platform. As an inducement to transfer, we generally provided substantial clearing fee discounts for a transition period. As a result of this transaction, we have recorded a customer relationship intangible of $5.1 million, which is being amortized over a five year period at a rate based on the expected future economic benefit of the customer relationships. We recognized approximately $1.1 million, $1.3 million and $849,000 of amortization expense related to this intangible for the years ended June 26, 2009, June 27, 2008 and June 29, 2007, respectively. See additional discussion in Note 10 in the Notes to the Consolidated Financial Statements contained in this report.
Discontinued Operations/FSB Financial. In March 2006, the Bank sold the assets of its subsidiary, FSB Financial. The sales price of the transaction was $35.9 . . .
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