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SWS > SEC Filings for SWS > Form 10-Q on 6-Nov-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 three-months ended September 30, 2013, 88% of our total revenues were generated by our full-service brokerage business and 12% 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, which 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 filed with the Securities and Exchange Commission (the "SEC") on September 6, 2013 (the "Fiscal 2013 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 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, registered investment advisors and institutional firms. In addition to clearing trades, we tailor our services to meet the specific needs of our clearing correspondents ("correspondents") and offer products and services such 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 income on correspondent customer balances.

Retail. We offer retail securities (such as equities, mutual funds and fixed income products), insurance products and managed accounts through the activities of our employees that are 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, trading and underwriting of taxable and tax-exempt fixed income securities and equity trading. Our securities borrowing and 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 fixed income sales and trading group specializes in trading and underwriting U.S. government and government agency bonds, corporate bonds, municipal 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 in a limited number of listed securities.

Revenues in the institutional segment are derived from the net interest spread on stock loan transactions, commissions, and trading income from fixed income and equity products and investment banking, and underwriting 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

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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.

The Bank earns substantially all of its net revenues on the spread between the rates charged to customers on loans and the interest rates paid to depositors as well as interest income from investments.

The Bank has committed to the Office of the Comptroller of the Currency ("OCC") that the Bank will, 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, 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 credit agreement with Hilltop and Oak Hill that accrues interest at 8% per annum (the "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 outstanding common stock of the company for each investor (assuming the warrants are exercised 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 our outstanding common stock. Mr. Gerald J. Ford and Mr. J. Taylor Crandall have been appointed and elected as directors of SWS Group on behalf of Hilltop and Oak Hill, respectively, pursuant to this right.

We entered into this transaction with Hilltop and Oak Hill to ensure that the Bank would maintain adequate capital ratios under an Order to Cease and Desist 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 advanced 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 the 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 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. 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 the approval of 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, 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 market areas and the current political environment.

As of September 30, 2013, equity market indices were up versus a year ago with the Dow Jones Industrial Average (the "DJIA") up 12.6%, the Standard & Poor's 500 Index ("S&P 500") up 16.7% and the NASDAQ Composite Index ("NASDAQ") up 21.0%. The DJIA closed at 15,129.67 on September 30, 2013 up from 13,437.13 and 14,909.60 on September 28, 2012 and June 30, 2013, respectively. While the indexes showed improvement and reached closing prices that have not been reached since 2008, the

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average daily trading volume on the NYSE decreased 10% as compared to the same period of our prior fiscal year. The continued uncertainty in the economic environment, with the federal government shutdown and the required implementation by businesses and individuals of the Affordable Care Act, continued low levels of workforce participation and high unemployment rates, contributed to volatility during the first three months of fiscal 2014. For our clearing, retail, and institutional segments, in particular our institutional segment, the uncertainty about the Federal Reserve's plans for monetary easing has added to the volatility in interest rates and fixed income inventory valuations. For our banking segment, this uncertainty creates issues in its approach and timing of mitigation of interest rate risk in a rising interest rate environment.

Continued economic and regulatory uncertainty also created a challenging operating environment for us during the three-months ended September 30, 2013. The national unemployment rate, which was approximately 7.2% at the end of September 30, 2013, was down from a high of 10.0% at the end of December 2009, and 7.6% at the end of June 2013, but remains at historically high levels. The Board of Governors of the Federal Reserve System ("FRB") reduced the federal funds target rate to 0 - 0.25% on December 16, 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 the U.S. and foreign governments to attempt to bring liquidity and order to the financial markets and to prevent an extended recession in the world economy. For more details regarding some of the actions taken by U.S. and foreign governments, see the discussion under Business-Regulation contained in our Fiscal 2013 Form 10-K.

Government intervention in the markets for the past several years has created artificially low short-term interest rates. Public announcements by the FRB regarding timing of reduced intervention or increased interest rates has led to substantial volatility in the fixed income markets. This volatility has produced and could continue to produce material changes in the value of our fixed income trading portfolio.

Texas, along with the rest of the country, has experienced distress in residential and commercial real estate values as well as elevated unemployment rates since the last calendar quarter of 2010. Real estate values, along with unemployment statistics, have improved; however, with the improvement, competition in the banking business has increased as loan demand is not yet robust.

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 effect 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 exposure to European sovereign debt or direct exposure 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 underlying securities, and the collateral is adjusted daily to maintain the 102% margin.

Net Interest Margins

Historically, the profitability of our brokerage business has been highly 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 this 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 remain substantially 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 lenders extending the credit. While we have not experienced any reductions in our uncommitted borrowing capacity, over the past three years, our lenders have taken actions that indicate their concerns about extending liquidity in the marketplace. These actions included reduced advance rates for certain security types, more stringent requirements for collateral eligibility, higher

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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 could 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 other business. We expect these margin requirements may increase over the next 12 months.

Valuation of Securities

We regularly trade mortgage, asset-backed and other types of fixed income securities. We monitor our trading limits daily to ensure that these securities are maintained at levels we consider 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 30, 2013, we held mortgage and asset-backed securities of approximately $21.6 million included in securities owned, at fair value on the Consolidated Statements of Financial Condition. Included in this balance are approximately $0.4 million of short inventory in to-be-announced ("TBA") securities, which are government agency mortgage-backed securities whose collateral remain unknown until just prior to the trade settlement.

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, Inc. provides the Bank with a sound foundation, as well as the flexibility to accelerate the reduction of classified assets.

The Bank continued to reduce classified assets in the quarter ended September 30, 2013. Classified assets were $58.7 million at September 30, 2013, down from $67.6 million at June 30, 2013. Classified assets as a percentage of total capital plus the allowance for loan losses was 32.6% at September 30, 2013 and 37.4% at June 30, 2013. Non-performing assets (a subset of classified assets) decreased to $29.3 million at September 30, 2013 from $38.0 million at June 30, 2013. The Bank has significantly reduced classified assets and improved performance over the past five quarters, but the reduction in classified assets could slow and additional loans could be moved to problem status should the economic environment worsen.

The Bank's loan loss allowance at September 30, 2013 was $12.2 million, or 2.85% of loans held for investment, excluding purchased mortgage loans held for investment and loans measured at fair value, as compared to $12.3 million, or 2.85% of loans held for investment, excluding purchased mortgage loans held for investment and loans measured at fair value, at June 30, 2013 and $20.9 million, or 4.28% at September 30, 2012.

The Tier I (core) capital ratio was 13.5% and the total risk-based capital ratio was 27.3% at September 30, 2013, as compared to 13.5% and 24.9%, respectively, at June 30, 2013 (without giving effect to the Basel III final rules). With the stability of these capital ratios and availability of capital from SWS Group, Inc., the Bank's management has focused on diversifying the balance sheet by reducing loan concentrations and building an investment portfolio. In conjunction with building the security investment portfolio, the Bank entered into $120.0 million of interest rate swaps, to reduce deposit cost variability by 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.

The Bank is focused on implementing and executing its business plan, which includes the continued diversification of the balance sheet and conservative growth strategies. The Bank's available for sale investment portfolio was $573.0 million and $503.1 million at September 30, 2013 and June 30, 2013, respectively. The Bank plans to continue to manage a tiered investment portfolio designed to provide cash flows for loan originations. At September 30, 2013 and June 30, 2013, the Bank's mortgage purchase program loan balance was $91.9 million and $174.0 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 September 30, 2013 and June 30, 2013, the Bank had $870.1 million and $878.4 million, respectively, in funds on deposit from customers of Southwest Securities, representing approximately 88.0% and 88.4%, respectively, of the Bank's total deposits.

Events and Transactions

A description of material events and transactions impacting our 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 30, 2013, the value of these warrants decreased primarily due to the decrease in the derived volatility of our common stock from 51% at June 30, 2013 to 49% at

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September 30, 2013 and the effect of the time to maturity. The decrease in value resulted in an unrealized pre-tax gain of $2.0 million for the first quarter of fiscal 2014. During the three-months ended September 28, 2012, the value of these warrants increased due to increased stock price volatility from 52.0% to 56.0% and an increase in the stock price from $5.33 at June 29, 2012 to $6.11 at September 28, 2012, partially offset by the passage of time. The increase in value resulted in an unrealized pre-tax loss of $8.2 million for the three-months ended September 28, 2012.

Auction rate security. Since fiscal 2010, we held an auction rate municipal bond at 95.7% of par. As a result of a trade in a similar security at a value less than par and related market conditions, we determined that our security should be written down to 92.5% of par in the first quarter of fiscal 2013. This resulted in 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.

Employee reduction. Due to the revenue environment over the last three years, management determined that expense reductions were needed in order to improve operating results and execute our strategic business plan. As a result, we reduced the number of our employees by approximately 7% during the three-months ended September 30, 2013 and recorded approximately $1.2 million in severance expense for three-months ended September 30, 2013 in commissions and other employee compensation on the Consolidated Statements of Comprehensive Loss.



Net income for the three-months ended September 30, 2013 was $0.3 million and net loss for the three-months ended September 28, 2012 was $5.6 million. The three-months ended September 30, 2013 and September 28, 2012 contained 64 and 63 trading days, respectively.

Southwest Securities was custodian for $31.2 billion and $30.0 billion in total customer assets at September 30, 2013 and September 28, 2012, respectively.

The following is a summary of increases (decreases) in categories of net revenues and operating expenses for the three-months ended September 30, 2013 compared to the three-months ended September 28, 2012 (dollars in thousands):

                                                          Three- Months
                                                         Amount   Percent
Net revenues:
Net revenues from clearing operations                   $    154      7  %
Commissions                                               (1,800)    (6)
Net interest                                              (4,184)   (29)
Investment banking, advisory and administrative fees         645      6
Net gains on principal transactions                         (307)    (4)
Other                                                        378      6

$ (5,114) (7) %

                                                       Three- Months
                                                      Amount   Percent
Operating expenses:
Commissions and other employee compensation         $  (1,696)    (3) %
Occupancy, equipment and computer service costs            55      1
Communications                                            129      4
Floor brokerage and clearing organization charges          89      9
Advertising and promotional                               (18)    (3)
Provision for loan loss                                  (466)  (100)
Unrealized net gain/loss on warrant valuation         (10,152) >(100)
Other                                                  (2,242)   (28)
                                                      (14,301)   (17)
Pre-tax income                                      $   9,187    >100 %

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Net revenues decreased $5.1 million for the three-months ended September 30, 2013 as compared to the same period of the prior fiscal year. The largest components of the decrease were a $4.2 million decrease in net interest revenue and a $1.8 million decrease in commissions revenue. The $4.2 million decrease in net interest revenue was primarily driven by a $2.8 million decrease in net interest revenue in our banking segment due to a 32% decrease in our average loan balance and an 80 basis point decrease in net interest yield at the Bank as compared to the same period of the prior fiscal year. The institutional segment contributed an additional $1.1 million of the decrease in net interest revenue primarily due to a 29 basis point decrease in our average net interest spread in our stock lending business. The decrease in our average net interest spread was slightly offset by a 17% increase in our average stock lending portfolio balances.

The $1.8 million decrease in commissions revenue was due primarily to $2.6 million decrease in the institutional segment, which was offset by a $0.8 million increase in commissions revenue in the retail segment. The decrease in commissions in the institutional segment was due to a lower portfolio trading transaction volume in the first quarter of fiscal 2014 compared to the first quarter of fiscal 2013. The increase in commissions revenue in the retail segment was generated primarily by our private client group ("PCG").

Operating expenses decreased $14.3 million for the three-months ended September 30, 3013 as compared to the same period of the prior fiscal year. The largest components of this decrease were a $10.2 million decrease in the unrealized value of the warrants, a $2.2 million decrease in other expenses and a $1.7 million decrease in commissions and other employee compensation expense. We recognized a $2.0 million gain on the warrant valuation for the three-months ended September 30, 2013 and an $8.2 million loss on the warrant valuation for the three-months ended September 28, 2012. The $2.2 million decrease in other expenses for the three-months ended September 30, 2013 as compared to the same period of the prior fiscal year was primarily due to a $0.8 million decrease in . . .

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