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SWS > SEC Filings for SWS > Form 10-Q on 7-Nov-2012All Recent SEC Filings

Show all filings for SWS GROUP INC

Form 10-Q for SWS GROUP INC


Quarterly Report

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


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. For the three-months ended September 28, 2012, 85% of our total revenues were generated by our full-service brokerage business and 15% of our total revenues were generated by our commercial banking business. 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 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 (the "SEC") on September 7, 2012 (the "Fiscal 2012 Form 10-K").

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 for other broker/dealers (predominantly on a fully disclosed basis). Our clientele includes general securities broker/dealers and firms specializing in high volume trading. We currently support a wide range of clearing clients, including discount and full-service brokerage firms, direct access firms, registered investment advisers and institutional firms. In addition to clearing trades, we tailor our services to meet the specific business needs of our clearing correspondents ("correspondents") and offer such products and services as recordkeeping, trade reporting, accounting, general back-office support, securities and margin lending, reorganization assistance and custody of securities.

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.

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. As a securities broker, we extend margin credit on a secured basis to our retail customers in order to facilitate securities transactions. 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.

Institutional. We serve institutional customers in the areas of securities borrowing and lending, public finance, municipal sales and underwriting, investment banking, fixed income sales and equity trading. Our securities lending business includes borrowing and lending securities for other broker/dealers, lending institutions, and our own clearing and retail operations. Our municipal finance operations assist public bodies in originating, syndicating and distributing securities of municipalities and political subdivisions. Our corporate finance professionals arrange and evaluate mergers and acquisitions, conduct private placements and participate in public offerings of securities with institutional and individual investors, assist clients with raising capital, and provide other consulting and advisory services.

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Our fixed income sales and trading group specializes in trading and underwriting U.S. government and government agency bonds, corporate bonds, mortgage-backed, asset-backed and commercial mortgage-backed securities and structured products. The clients of our fixed income group include corporations, insurance companies, banks, mutual funds, money managers and other institutions. Our equity trading department focuses on providing the best execution for equity and option orders for clients. We also execute institutional portfolio trades and are a market maker in a limited number of listed securities.

Revenues in the institutional segment 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. We specialize in two primary areas, business banking and mortgage purchase. Our focus in business banking includes commercial and industrial lending along with small business lending. We originate the majority of our loans internally, and we believe this business model helps us build more valuable relationships with our customers. Our mortgage purchase division purchases participations and sub-participations in newly originated residential loans from various mortgage bankers nationwide.

Southwest Securities, FSB (the "Bank") earns substantially all of its net revenues on the spread between the rates charged to customers on loans and the rates paid to depositors. Our banking operations are currently restricted by and subject to the Order to Cease and Desist, Order No. WN-11-003, effective on February 4, 2011 (the "Order") originally issued by the Office of Thrift Supervision and now administered by the Office of the Comptroller of the Currency (the "OCC"). On March 16, 2012, the Bank was notified in a letter from the OCC that the OCC will allow relief from certain operating and growth restrictions required under the Order. Specifically, the OCC currently has no supervisory objection to any future extensions of Small Business Administration program 504 loans, commercial real estate owner-occupied loans, or mechanics lien residential 1-4 family construction loans so long as, prior to funding, the Bank's Board of Directors or a designated committee of the Bank approves and certifies that it complies with internal policies, accounting principles generally accepted in the United States ("GAAP"), regulatory guidance, and safe and sound association practices. In addition, the OCC currently has no supervisory objection to a future conservative growth plan for the Bank's balance sheet so long as the Bank maintains capital ratios above the requirements of the Order and concentration levels within policy guidelines.

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

Loan from Hilltop and Oak Hill

In March 2011, we entered into a Funding Agreement (the "Funding Agreement") with Hilltop Holdings, Inc. ("Hilltop") and Oak Hill Capital Partners III, L.P. ("OHCP") and Oak Hill Capital Management Partners III, L.P. (collectively with OHCP, "Oak Hill"). On July 29, 2011, after receipt of stockholder and regulatory approval, we completed the following transactions contemplated by the Funding Agreement:

entered into a $100.0 million, five year, unsecured loan with an 8% interest rate from Hilltop and Oak Hill under the terms of a credit agreement;

issued warrants to Hilltop and Oak Hill allowing each to purchase up to 8,695,652 shares of our common stock at an exercise price of $5.75 per share (subject to anti-dilution adjustments), representing approximately 17% of the common stock of our company per warrant (assuming each exercises its warrant in full); and

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granted Hilltop and Oak Hill certain rights, including certain registration rights, preemptive rights, and the right for each to appoint one person to our Board of Directors for so long as each owns 9.9% or more of all of the outstanding shares of our common stock or securities convertible into at least 9.9% of our outstanding common stock. Mr. Gerald J. Ford and Mr. J. Taylor Crandall have been appointed and elected as directors of SWS Group pursuant to this right.

We entered into this transaction to ensure that the Bank would maintain adequate capital ratios under the Order and could continue to reduce classified assets in a strategic and efficient manner, as well as to ensure that the broker/dealer business lines would operate without disruption. See "Debt Issued with Stock Purchase Warrants" in the Notes to the Consolidated Financial Statements contained in this report for additional discussion on the loan from Hilltop and Oak Hill.

The funds received from Hilltop and Oak Hill upon completion of the transaction were recorded on our Consolidated Statements of Financial Condition as restricted cash. We are required to keep these funds in a restricted account until our Board of Directors, Hilltop and Oak Hill determine the amount(s) to be distributed to our subsidiaries. Upon approval of the Board of Directors, Hilltop and Oak Hill, SWS Group contributed $20.0 million of this cash to the Bank as capital in December 2011, loaned $20.0 million to Southwest Securities, Inc. ("Southwest Securities") in the third quarter of fiscal 2012 to use in general operations by reducing Southwest Securities' use of short-term borrowings for the financing of the company's day-to-day cash management needs, paid $20.0 million toward its intercompany payable to Southwest Securities and contributed $10.0 million in capital to Southwest Securities in the fourth quarter of fiscal 2012. The remaining $30.0 million remains in a restricted account at SWS Group to be used for general corporate purposes, subject to approval by the Board of Directors, Hilltop and Oak Hill.

Business Environment

Performance in the financial services industry in which we operate is highly correlated to the overall strength of the economy and financial market activity. Overall market conditions are a product of many factors which are beyond our control and can be unpredictable. These factors may affect the financial decisions made by investors, including their level of participation in the financial markets. In turn, these decisions may affect our business results. With respect to financial market activity, our profitability is sensitive to a variety of factors including the volatility of the equity and fixed income markets, the level and shape of various yield curves, the volume and value of trading in securities, the value of our customers' assets under management, the demand for loans and the value of real estate in our markets.

As of September 28, 2012, all equity market indices were up versus a year ago with the Dow Jones Industrial Average (the "DJIA") up 23.1%, the NASDAQ Composite Index (NASDAQ) up 29.0% and the Standards & Poor's 500 Index (S&P 500) up 27.3%. The DJIA closed at 13,437.13 on September 28, 2012, up from 10,913.38 at September 30, 2011 and 12,880.09 at June 29, 2012. While the indexes showed improvement and reached closing prices that haven't been reached since 2008, the average daily volume on the New York Stock Exchange (NYSE) decreased 36% during the three-months ended September 28, 2012 compared to the same period of our prior fiscal year. The continuing uncertainty in the economic environment domestically and in Europe, as well as continued high unemployment, contributed to uncertainty and volatility during the three-months ended September 28, 2012.

Economic and regulatory uncertainty created a challenging operating environment for us during the three-months ended September 28, 2012. The national unemployment rate, which was approximately 7.8% at the end of September 2012, was down from a high of 10.0% at the end of December 2009, and 8.2% at the end of June 2012, but remains at historically high levels. The Federal Reserve Board reduced the federal funds target rate to 0 - 0.25% in December 2008 and announced in January 2012 and reemphasized in its August 2012 meeting that rates were unlikely to increase at least through mid-2015.

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The disruptions and developments in the world economy and the credit markets over the past three years also resulted in a range of actions by 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. For more details regarding some of the actions taken by U.S. and foreign governments, see the discussion under the caption Item 1. Business-Regulation contained in the Fiscal 2012 Form 10-K.

Unemployment and tight credit markets continue to create a fragile economic environment. As indicated by the August 2011 downgrade of the United States' credit rating and the June 2012 Moody's Investor Services downgrade of the 15 largest U.S. financial institutions including Bank of America Corp., Citigroup Inc., The Goldman Sachs Group, Inc., and JP Morgan Chase & Co., global equity markets have been volatile primarily due to ongoing debt problems in Europe.

In addition, Texas experienced distress in residential and commercial real estate values as well as elevated unemployment rates since the last calendar quarter of 2010. These factors, while improving, have had, and will continue to have, a negative impact on our banking and brokerage operations.

Impact of Economic Environment

Brokerage. Volatility in the U.S. credit and mortgage markets, low interest rates and reduced volume in the U.S. stock markets continue to have an adverse impact on several aspects of our brokerage business, including depressed net interest margins, reduced liquidity and lower trading volumes.

Exposure to European Sovereign Debt

We have no direct exposure to European sovereign debt or to European banks. However, we do participate in securities lending with U.S. subsidiaries of several European banks. Receivables from securities lending are secured by collateral equal to 102% of the market value of the securities, and the collateral is adjusted daily to maintain the 102% margin.

Net Interest Margins

Historically, the profitability of the brokerage business has been primarily dependent upon net interest income. We earn net interest income on the spread between the rates earned and paid on customer and correspondent balances as well as from our securities lending business. With interest rates at historically low levels, the spread we are able to earn has been reduced, primarily from the extremely low yields on our portfolio of assets segregated for regulatory purposes. Additionally, the spread in our securities lending business has declined. Lastly, because the yields on money market funds have declined significantly, revenue sharing arrangements with our primary money market fund providers have been substantially reduced. We do not expect any significant changes in these dynamics until short-term interest rates rise.

We have taken actions to mitigate the impact of the margin contraction by renegotiating arrangements with our clearing customers, changing the mix of our assets segregated for regulatory purposes and developing new business in our securities lending portfolio. Despite these actions, profits from net interest income remain below historical levels.


Dislocation in the credit markets has led to increased liquidity risk. All but $45.0 million 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 any reductions in our uncommitted borrowing capacity, our lenders have taken actions that indicate their concerns regarding liquidity and risk in the marketplace. These actions include reduced advance rates for certain security types, more stringent requirements for collateral eligibility and higher interest rates. Should our lenders take any actions that could negatively impact the terms of our lending arrangements, the cost of conducting our business will increase and our volume of business could be limited.

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The volatility in the U.S. stock markets has also impacted our liquidity through increased margin requirements at our clearing houses. These margin requirements are determined by the clearing houses through a combination of risk formulas that are periodically adjusted to reflect perceived risk in the market. To the extent we are required to post cash or other collateral to meet these requirements, we will have less liquidity to finance our other businesses.

Valuation of Securities

We trade mortgage, asset-backed and other types of fixed income 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. We price these securities using a third-party pricing service, and we review the prices monthly to ensure reasonable valuations. At September 28, 2012, we held mortgage and asset-backed securities of approximately $33.0 million included in securities owned, at fair value on the Consolidated Statements of Financial Condition.

Investment in Auction Rate Securities

At September 28, 2012, we held $20.3 million of auction rate municipal bonds which represented one security and 20.3% of our municipal portfolio. This security is an investment grade credit, was valued at 92.5% of par as of September 28, 2012 and was yielding less than 1% per year for the three-months ended September 28, 2012. We currently have the ability to hold this investment until maturity. While we expect the issuer of this bond to refinance its debt when London Interbank Offered Rates (LIBOR) rise, there can be no certainty that this refinancing will occur. We review this position on a quarterly basis and believe valuation of this bond at 92.5% of par at September 28, 2012 reflects an appropriate discount for the current lack of liquidity in this investment.

Bank. Shortly after closing the Hilltop and Oak Hill transaction, we contributed $20.0 million in capital to the Bank and filed a revised capital plan with the Bank's regulator. We believe the $20 million capital contribution and access to additional capital from SWS Group provides the Bank with a sound foundation for future earnings, as well as the flexibility to accelerate the reduction of classified assets.

The Bank has maintained compliance with the terms of the Order since it was issued on February 4, 2011. The diligent efforts by the Bank's Board of Directors, management and employees to adhere to the terms of the Order and plans filed with our regulators have resulted in substantial improvements in credit quality, loan concentration levels and capital ratios. As a result, on March 16, 2012, the Bank was notified in a letter from the OCC that the OCC will allow relief from certain operating and growth restrictions required under the Order. See "Cease and Desist Order with the Office of the Comptroller of the Currency" in the Notes to the Consolidated Financial Statements contained in this report and discussion above under "Overview" regarding the OCC's grant of relief from certain operating and growth restrictions required under the Order.

The Bank continued to reduce classified assets in the September 2012 quarter. Classified assets were $100.7 million at September 30, 2012, down from $110.7 million at June 30, 2012 and $206.7 million at September 30, 2011. Classified assets as a percentage of total capital plus the allowance for loan losses was 52.7% at September 30, 2012, 58.0% at June 30, 2012 and 111.0% at September 30, 2011. Non-performing assets (a subset of classified assets) decreased to $67.8 million at September 30, 2012, down from $72.7 million at June 30, 2012 and $78.3 million at September 30, 2011. Though the Bank continues to work diligently to reduce classified assets and improve performance, the slow pace of economic recovery remains a significant risk. Should the economic environment worsen, improvement in classified assets could slow and additional migration of loans to problem status could increase.

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The Bank's loan loss allowance at September 30, 2012 was $20.9 million, or 4.28% of loans held for investment, excluding purchased mortgage loans held for investment, as compared to $22.4 million, or 3.99% of loans held for investment, at June 30, 2012 and $39.7 million, or 4.90% of loans held for investment, at September 30, 2011.

The Bank's capital ratios at September 30, 2012 were significantly stronger than those at September 30, 2011 and steady with our June 30, 2012 ratios. The Tier 1 core ratio was 12.7% and the total risk-based capital ratio was 19.2% at September 30, 2012, as compared to 12.6% and 19.2%, respectively, at June 30, 2012 and 10.4% and 15.4%, respectively, at September 30, 2011. With the stability of these capital ratios and the $20.0 million capital contribution from SWS Group, the Bank's management has focused on diversifying the balance sheet by reducing loan concentrations and building an investment portfolio.

With the relief granted by the OCC in March 2012, the Bank has been actively filling open lending positions in our market areas. New lenders have been added in Houston, Austin, Dallas and Arlington, Texas as well as in Albuquerque, New Mexico. Given the economic environment and the lag in the process of hiring lenders and actual production, the Bank anticipates loan balances to begin a modest growth rate through fiscal 2013. The Bank's available for sale investment portfolio was $352.1 million and $304.0 million at September 30, 2012 and June 30, 2012, respectively. The Bank also anticipates growth in its mortgage purchase program which continues to perform well despite the current economic environment. Though there is uncertainty in the market, we believe there are also opportunities. With mortgage rates at historical lows, finance and re-finance opportunities are significant for qualified borrowers. At September 30, 2012 and June 30, 2012, the Bank's mortgage purchase program loan balance was $329.3 million and $294.3 million, respectively. These loans are held for investment on average for 25 days or less, which substantially limits credit risk.

The primary funding source for the Bank's balance sheet growth are core deposits from Southwest Securities' brokerage customers. These core deposits provide the Bank with a stable and low cost funding source. At September 30, 2012 and June 30, 2012, the Bank had $930.9 million and $930.7 million, respectively, in funds on deposit from customers of Southwest Securities, representing approximately 87.9% and 87.6%, respectively, of the Bank's total deposits.

Events and Transactions

A description of the material events and transactions impacting the company's results of operations in the periods presented are discussed below.

Warrant valuation. The warrants issued to Hilltop and Oak Hill are presented as liabilities carried at fair value on the Consolidated Statement of Financial Condition. During the three-months ended September 28, 2012, the value of these warrants increased due to the increase in our stock price from $5.33 at June 29, 2012, to $6.11 at September 28, 2012. The increase in value resulted in an $8.2 million unrealized pre-tax loss for the three-months ended September 28, 2012 compared to a $171,000 unrealized pre-tax loss for the three-months ended September 30, 2011.

Auction rate security. We hold an auction rate municipal bond that has been held at 95.7% of par since fiscal 2010. As a result of a recent trade in a similar security at a value less than par and an increase in volatility, we determined that our security should be written down to a value at 92.5% of par as of September 28, 2012. The result was a write down of $702,000 at September 28, 2012. See additional discussion of our valuation of the auction rate security in "Fair Value of Financial Instruments" in the Notes to the Consolidated Financial Statements contained in this report.

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Net loss for the three-months ended September 28, 2012 was $5.6 million and net income for the three-months ended September 30, 2011 was $1.7 million. The three-month periods ended September 28, 2012 and September 30, 2011 contained 63 and 68 trading days, respectively.

Southwest Securities was custodian for $30.0 billion and $26.8 billion in total customer assets at September 28, 2012 and September 30, 2011, respectively.

The following is a summary of increases (decreases) in categories of net revenues and operating expenses for the three-months ended September 28, 2012 compared to the three-months ended September 30, 2011 (dollars in thousands):

                                                            Three-Months Ended
                                                           Amount         Change
  Net revenues:
  Net revenues from clearing operations                  $      (521 )        (20 )%
  Commissions                                                 (3,316 )         (9 )
  Net interest                                                (3,493 )        (20 )
  Investment banking, advisory and administrative fees           (82 )         (1 )
  Net gains on principal transactions                          3,087           49
  Other                                                        1,695           38

                                                         $    (2,630 )         (3 )%

  Operating expenses:
  Commissions and other employee compensation            $     1,101            2 %
  Occupancy, equipment and computer service costs               (180 )         (2 )
  Communications                                                 300           10
  Floor brokerage and clearing organization charges              (50 )         (5 )
  Advertising and promotional                                    119           22
  Unrealized net loss on warrant valuation                     8,014         >100
  Other                                                          794           11

                                                         $    10,098           14 %

  Pre-tax loss                                           $   (12,728 )       >100 %

Net revenues decreased $2.6 million for the three-months ended September 28, 2012 as compared to the same period of the prior fiscal year. The largest components of the decrease were in net interest and commissions. The $3.5 million decrease in net interest revenue was due primarily to a 16% decrease in the average loan balance and a 20 basis point decrease in the net yield at the Bank as compared to the same period of the prior fiscal year. Also, interest expense on the loan from Hilltop and Oak Hill reduced net interest revenue by $3.1 million in the three-months ended September 28, 2012 as compared to $2.0 million in the three-months ended September 30, 2011. Additionally, interest revenue in our institutional business decreased $1.2 million due to a 20% decrease in the average stock loan portfolio balances as well as the decreased volume of trades in our taxable fixed income business. The $3.3 million decrease in commission revenue was due primarily to a $1.5 million decrease in our . . .

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