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SWS > SEC Filings for SWS > Form 10-Q on 8-May-2013All Recent SEC Filings

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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 nine-months ended March 29, 2013, 85% of our total revenues were generated by our full-service brokerage business and 15% of our total revenues were generated by our 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 Annual Report on Form 10-K that was 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, municipal finance, 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 securities offerings 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 executing equity and option orders for clients. We also execute institutional portfolio trades and are a market maker for 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 three primary areas, business banking, focusing on industrial and small business lending, commercial real estate lending and mortgage purchase. 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 interest rates charged to customers on loans and the interest rates paid to depositors as well as interest income from investments.

Until terminated on January 14, 2013, our banking operations were 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 then 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 allowed relief from certain operating and growth restrictions required under the Order. Specifically, the OCC had no supervisory objection to any future extensions of Small Business Administration ("SBA") 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 approved and certified that it complied with internal policies, accounting principles generally accepted in the United States ("GAAP"), regulatory guidance, and safe and sound association practices. In connection with the termination of the Order on January 14, 2013, the Bank committed to the OCC that the Bank would, among other things: (i) adhere to the Bank's written business and capital plan as amended from time to time; and (ii) maintain a Tier I capital ratio at least equal to nine percent (9%) of adjusted total assets and a total risk-based capital ratio of at least twelve percent (12%).

The "other" category includes SWS Group, Inc. ("SWS Group"), corporate administration and SWS Capital Corporation, which is a dormant entity.

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 (the "Credit Agreement");

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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 the company per warrant (assuming each exercises its warrant in full); and

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 the outstanding shares of our common stock or securities convertible into at least 9.9% of the outstanding shares of our common stock. Mr. Gerald J. Ford and Mr. J. Taylor Crandall have been appointed and elected as directors of SWS Group for Hilltop and Oak Hill, respectively, pursuant to this right.

We entered into the transaction with Hilltop and Oak Hill 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 information regarding the loan from Hilltop and Oak Hill.

The funds borrowed pursuant to the Credit Agreement with Hilltop and Oak Hill 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 the second quarter of fiscal 2012, 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 its 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. On March 28, 2013, the $20.0 million loan from SWS Group to Southwest Securities was repaid and the company's Board of Directors, Hilltop and Oak Hill approved and SWS Group contributed $20.0 million of cash as a capital contribution to Southwest Securities. The remaining $30.0 million is being held 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 are unpredictable. These factors may affect the financial decisions made by investors, including their level of participation in the financial markets, which may in turn, 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 of trading in securities, the value of our customers' assets under management, the demand for loans, the value of real estate in our markets and the current political environment.

As of March 29, 2013, equity market indices were up versus a year ago with the Dow Jones Industrial Average (the "DJIA") up 10.34%, the NASDAQ Composite Index (NASDAQ) up 5.69% and the Standards & Poor's 500 Index (S&P 500) up 11.41%. The DJIA closed at 14,578.54 on March 28, 2013, up from 13,212.04 at March 30, 2012 and 12,880.09 at June 29, 2012. While the indexes showed improvement and reached closing prices that have not been reached since 2008, the average daily trading volume on the New York Stock Exchange (NYSE) decreased 10.43% during the three-months ended March 29, 2013 as compared to the same period of our prior fiscal year. The continued uncertainty in the economic environment both domestically and in Europe and continued high unemployment rates, contributed to volatility during the three-months ended March 29, 2013.

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The continued economic and regulatory uncertainty created a challenging operating environment for us during the three and nine-months ended March 29, 2013. The national unemployment rate, which was approximately 7.6% at the end of March 2013, 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 2013 that it anticipated that rates were unlikely to increase as long as the unemployment rate remained above 6.5%, the short-term inflation rate was projected to be no more than 0.5% above the Federal Open Market Committee's 2% longer-run goal, and longer-term inflation expectations continue to be stable.

The disruptions and developments in the world economy and the credit markets over the past three years 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. Indications of this fragile economic environment include 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. and the volatility of global equity markets primarily due to ongoing debt problems in Europe.

In addition, Texas has 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 interest 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.

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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 lenders 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, higher interest rates and pre-funding of daily settlements. Should our lenders take any actions that negatively impact the terms of our lending arrangements, the cost of conducting our business may increase and our volume of business could be limited.

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 business. We expect these margin requirements to continue to increase over the next eighteen months.

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 March 29, 2013, we held mortgage and asset-backed securities of approximately $46.4 million included in securities owned, at fair value on the Consolidated Statements of Financial Condition.

Bank. Shortly after closing the Hilltop and Oak Hill transaction, we contributed $20.0 million in capital to the Bank. We believe the $20.0 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 continued to reduce classified assets in the third quarter of fiscal 2013. Classified assets were $78.5 million at March 31, 2013, down from $110.7 million at June 30, 2012 and $129.8 million at March 31, 2012. Classified assets as a percentage of total capital plus the allowance for loan losses was 41.4% at March 31, 2013, 58.0% at June 30, 2012 and 67.0% at March 31, 2012.
Non-performing assets (a subset of classified assets) decreased to $45.7 million at March 31, 2013, from $72.7 million at June 30, 2012 and $75.1 million at March 31, 2012. Though the Bank continues to work diligently to reduce classified assets and improve performance, the slow pace of economic recovery remains a risk. Should the economic environment worsen, the reduction in classified assets could slow and additional loans could be moved to problem status.

The Bank's loan loss allowance at March 31, 2013 was $18.8 million, or 4.07% 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 $26.2 million, or 4.13% of loans held for investment, at March 31, 2012.

The Tier I (core) capital ratio was 13.1% and the total risk-based capital ratio was 23.2% at March 31, 2013, as compared to 12.6% and 19.2%, respectively, at June 30, 2012 and 12.3% and 20.4%, respectively, at March 31, 2012. 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. In building the investment portfolio, in April 2013, the Bank entered into $50.0 million of interest rate swaps. The Bank entered into these swaps to reduce deposit cost variability, specifically focusing on protecting earnings in a rising interest rate environment. The Bank plans to continue implementing this strategy, along with other balance sheet considerations, to manage interest rate risk.

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The Bank is focused on implementing and executing its business plan. The Bank's business plan includes the continued diversification of the balance sheet and conservative growth strategies. The Bank's available for sale investment portfolio was $400.9 million and $304.0 million at March 31, 2013 and June 30, 2012, respectively. The Bank plans to continue to manage a tiered investment portfolio designed to provide cash flows for loan originations. During the third quarter of fiscal 2013, the Bank originated $37.1 million in loans held for investment. At March 31, 2013 and June 30, 2012, the Bank's mortgage purchase program loan balance was $200.0 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 is core deposits from Southwest Securities' brokerage customers. These core deposits provide the Bank with a stable and low cost funding source. At March 31, 2013 and June 30, 2012, the Bank had $927.4 million and $930.7 million, respectively, in funds on deposit from customers of Southwest Securities, representing approximately 88.6% 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 our Consolidated Statements of Financial Condition. During the three and nine-months ended March 29, 2013, the value of these warrants increased primarily due to the increase in our stock price from $5.33 at June 29, 2012 to $6.05 at March 28, 2013. The increase in value resulted in an unrealized pre-tax loss of $0.3 million for the nine-months ended March 29, 2013 as compared to an unrealized pre-tax loss of $6.9 million for the nine-months ended March 30, 2012. See additional discussion of our valuation of the warrants in "Fair Value of Financial Instruments" in the Notes to the Consolidated Financial Statements contained in this report.

Auction rate security. Since fiscal 2010, we had held an auction rate municipal bond at 95.7% of par. As a result of a recent trade in a similar security at a value less than par and related market conditions, in the first quarter of fiscal 2013, we determined that our security should be written down to 92.5% of par. The result was a $702,000 write down at September 28, 2012. During the third quarter of fiscal 2013, we sold this security with no gain or loss recognized on the transaction.

Recapture in allowance for loan loss. The quality of the Bank's assets continued to improve during fiscal 2013 resulting in a $1.5 million recapture of our provision for loan loss in the second quarter of fiscal 2013.



Net loss for the three and nine-months ended March 29, 2013 was $5.7 million and $1.0 million, respectively, as compared to net income of $8.3 million and a net loss of $4.4 million for the three and nine-months ended March 30, 2012, respectively. The three and nine-month periods ended March 29, 2013 and March 30, 2012 contained 60 and 185 trading days and 62 and 193 trading days, respectively.

Southwest Securities was custodian for $30.4 billion and $29.4 billion in total customer assets at March 29, 2013 and March 30, 2012, respectively.

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The following is a summary of increases (decreases) in categories of net revenues and operating expenses for the three and nine-months ended March 29, 2013 compared to the three and nine-months ended March 30, 2012 (dollars in thousands):

                                                               Three-Months                      Nine-Months
                                                                  Ended                             Ended
                                                         Amount          % Change          Amount         % Change
Net revenues:
Net revenues from clearing operations                   $    (289 )            (12 )%     $   (913 )            (12 )%
Commissions                                                (3,136 )             (9 )        (4,606 )             (5 )
Net interest                                               (2,703 )            (19 )        (8,639 )            (18 )
Investment banking, advisory and administrative fees         (301 )             (3 )         2,382                9
Net gains on principal transactions                        (2,292 )            (27 )         5,069               23
Other                                                        (285 )             (4 )         1,985               12

                                                        $  (9,006 )            (12 )%     $ (4,722 )             (2 )%

Operating expenses:
Commissions and other employee compensation             $  (1,996 )             (4 )%     $  1,826                1 %
Occupancy, equipment and computer service costs              (305 )             (4 )          (771 )             (3 )
Communications                                                180                6             709                8
Floor brokerage and clearing organization charges             (53 )             (5 )          (198 )             (6 )
Advertising and promotional                                  (127 )            (12 )            51                2
Provision for loan loss                                        -                -           (3,925 )          >(100 )
Other                                                        (743 )             (9 )           653                3

                                                           (3,044 )             (4 )%       (1,655 )             (1 )%

Other gains (losses):
Unrealized gain (loss) on Warrant valuation               (16,342 )          >(100 )         6,667               96

Pre-tax (loss) income                                   $ (22,304 )          >(100 )%     $  3,600               55 %

Net revenues decreased $9.0 million for the three-months ended March 29, 2013 as compared to the same period of the prior fiscal year. Commissions revenue generated $3.1 million of the decrease primarily due to decreased customer demand in our taxable fixed income business. Net interest revenue contributed $2.7 million of the decrease primarily driven by a $1.7 million decrease in our banking segment due to a 27% decrease in our average loan balance and a 50 basis point decrease in the net interest rate yield at the Bank as compared to the same period of the prior fiscal year. The institutional segment contributed an additional $0.8 million of the net interest revenue decrease primarily due to a 22 basis point decrease in our average net interest spread in our stock lending business. Net gains on principal transactions contributed $2.3 million of the decrease primarily driven by a $2.7 million decrease in our institutional . . .

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