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SWS > SEC Filings for SWS > Form 10-Q on 9-Nov-2011All 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. During the three-months ended September 30, 2011, 84% of our total revenues were generated by our full-service brokerage business and 16% of our 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 ("SEC") on September 2, 2011 (the "Fiscal 2011 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 advisors and institutional firms. In addition to clearing trades, we tailor our services to meet the specific business needs of our clearing clients ("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 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 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 in newly originated residential loans from various mortgage bankers nationwide. Southwest Securities, FSB (the "Bank") earns substantially all of its 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") with the Office of the Comptroller of the Currency ("OCC").

The "other" category includes SWS Group, Inc. ("SWS Group"), corporate administration and SWS Capital Corporation. SWS Capital Corporation 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 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, the Company completed the following transactions contemplated by the Funding Agreement:

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;

issuance of 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

granting 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 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 were elected as directors of SWS Group by our Board of Directors on July 29, 2011.

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.

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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 demand for investment banking services, as reflected by the number and size of equity and debt financings and merger and acquisition transactions, 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 30, 2011, equity market indices were flat from a year ago with the Dow Jones Industrial Average (the "DJIA") up 0.5%, the NASDAQ Composite Index ("NASDAQ") up 1.4% and the Standards & Poor's 500 Index ("S&P 500") down 1.5 %. The DJIA closed at 10,913.38 on September 30, 2011 up from 10,860.26 at September 24, 2010 and down from 11,934.58 at June 24, 2011. The average daily volume on the NYSE increased 3% during the three-months ended September 30, 2011 compared to the same period of our last fiscal year. The Standard and Poor's downgrade of the United States credit rating on August 5, 2011 and the continuing uncertainty of the economic environment in Europe increased risk and volatility during the three-months ended September 30, 2011.

Economic and regulatory uncertainty created a challenging operating environment for us in the three-months ended September 30, 2011. The national unemployment rate, which was approximately 9% at the end of June 2011, was down from a high of 10% at the end of December 2009, but remains at historically high levels. The FRB reduced the federal funds target rate to 0 - 0.25% in December 2008 and announced in August 2011 that rates were unlikely to increase before mid-2013.

The disruptions and developments in the general economy and the credit markets over the past three years have 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 2011 Form 10-K.

While economists believe the recession ended in June 2009, unemployment and tight credit markets continue to create a fragile economic environment, and there is no guarantee that conditions will not worsen again. In addition to the downgrade of the United States' credit rating for the first time in the history of the ratings, world markets, especially those focused on the European Union and Japan, have been volatile due to debt problems in Europe and the natural disaster in Japan. Texas, which was largely insulated from severe job loss and real estate market deterioration at the start of the recession, has experienced distress in residential and commercial real estate values as well as elevated unemployment since the last quarter of calendar 2010. These factors have had, and will continue to have, a negative impact on our banking and brokerage operations.

Impact of Economic Environment

Brokerage. On the brokerage side of the business, volatility in the credit and mortgage markets, low interest rates and reduced volume in the stock markets continue to have an adverse impact on several aspects of our business, including depressed net interest margins, reduced liquidity and lower securities valuations.

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Net Interest Margins

Historically, the profitability of the brokerage business has been 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 is reduced, primarily from the extremely low yields on our assets segregated for regulatory purposes portfolio. 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 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, in the past, our lenders have taken actions that indicate their concerns regarding liquidity in the marketplace. These actions included reduced advance rates for certain security types, more stringent requirements for collateral eligibility and higher interest rates. Should our lenders or investors 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 would 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. To the extent we are required to post cash or other collateral to meet these requirements, we will have less borrowing capacity to finance our other businesses.

In July 2011, we borrowed $100.0 million from Hilltop and Oak Hill to provide additional liquidity for the broker/dealer business lines and the Bank, which reduced our liquidity risk.

Valuation of Securities

We trade mortgage, asset-backed securities 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 price monthly to ensure reasonable valuation. At September 30, 2011, we held mortgage and asset-backed securities of approximately $47.4 million included in securities owned, at fair value on the Consolidated Statements of Financial Condition.

Investment in Auction Rate Securities

At September 30, 2011, we held $21.7 million of auction rate municipal bonds which represented one security and 17.1% of our municipal portfolio. This security is an investment grade credit, was valued at 95.7% of par as of September 30, 2011 and was yielding less than 1% per year for the period. We currently have the ability to hold this investment until maturity. While we expect the issuer of this bond to refinance its debt when LIBOR interest rates rise, there can be no certainty that this refinancing will occur. We believe valuation of this bond at 95.7% of par at September 30, 2011 reflects an appropriate discount for the current lack of liquidity in this investment.

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Our customers also own $575,000 in auction rate bonds as well as approximately $1.1 million in auction rate preferred 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.

Bank. Management has implemented strategies to address asset quality and the requirements of the Order. Specifically, management has implemented balance sheet reduction strategies by aggressively selling classified assets. The liquidity provided by these actions has been carefully managed to allow reduction in the total balance sheet size while maintaining significant levels of balance sheet liquidity.

The Bank is also diligently working to reduce its exposure in commercial real estate, residential construction and land development loans. As a result of establishing concentration guidelines in fiscal 2011, the Bank has been able to reduce its concentration levels.

While the economic environment remains challenging, the Bank continued to reduce classified assets in the September 2011 quarter. Classified assets were $206.7 million at September 30, 2011, down $21.8 million from $228.5 million at June 30, 2011. Classified assets, as a percentage of total capital plus the allowance for loan losses, was 111.03% at September 30, 2011, 120.5% at June 30, 2011 and 127.1% at September 30, 2010. Non-performing assets (a subset of classified assets) decreased to $78.3 million at September 30, 2011 down from $89.5 million at June 30, 2011. Though we are working diligently to reduce classified assets and improve performance, the volatility of the economic environment remains a significant risk to this progress. Should the economic environment worsen, improvement in classified asset reduction could slow and additional migration of loans to problem status could increase.

The loan loss allowance at September 30, 2011 was $39.7 million, or 4.90% of loans held for investment, excluding purchased mortgage loans held for investment, as compared to $45.4 million, or 4.12% of loans held for investment, at September 30, 2010 and $44.4 million, or 4.99% of loans held for investment, excluding purchased mortgage loans held for investment, at June 30, 2011.

After obtaining the $100.0 million loan from Hilltop and Oak Hill, the Bank now has access to a significant amount of additional capital and is preparing a revised capital plan. We believe that access to this additional capital will provide substantial support for future earnings opportunities as well as provide added flexibility in resolving negatively classified assets. 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.



Net income for the three-months ended September 30, 2011 was $1.7 million as compared to a net loss of $20.7 million for the three-months ended September 24, 2010. The three-month periods ended September 30, 2011 and September 24, 2010 contained 68 and 63 trading days, respectively.

Southwest Securities was custodian for $26.8 billion and $27.8 billion in total customer assets at September 30, 2011 and September 24, 2010, respectively.

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The following is a summary of increases (decreases) in categories of net revenues and operating expenses for the three-months ended September 30, 2011 compared to the three-months ended September 24, 2010 (dollars in thousands):

                                                            Three-Months Ended
                                                           Amount         Change
  Net revenues:
  Net revenues from clearing operations                  $       224            9 %
  Commissions                                                 (3,133 )         (8 )
  Net interest                                                (9,297 )        (34 )
  Investment banking, advisory and administrative fees          (911 )         (8 )
  Net gains on principal transactions                         (5,924 )        (49 )
  Other                                                       (1,830 )        (29 )

                                                         $   (20,871 )        (21 )%

  Operating expenses:
  Commissions and other employee compensation            $    (5,845 )        (10 )%
  Occupancy, equipment and computer service costs               (616 )         (7 )
  Communications                                                (319 )        (10 )
  Floor brokerage and clearing organization charges              111           12
  Advertising and promotional                                   (105 )        (16 )
  Provision for loan loss                                    (39,511 )       (100 )
  Other                                                       (8,559 )        (53 )

                                                         $   (54,844 )        (43 )%

  Pre-tax income                                         $    33,973         >100 %

Net revenues decreased for the three-months ended September 30, 2011 by $20.9 million as compared to the same period of the prior fiscal year. The largest components of the decrease were in net interest, net gains on principal transactions, commissions, and other revenue. The $9.3 million decrease in net interest revenue was due primarily to a 36% decrease in the average loan balance at the Bank as compared to the same quarter in the prior fiscal year. Also, interest expense on the loan from Hilltop and Oak Hill reduced net interest revenue by $2.0 million in the three-months ended September 30, 2011. The $5.9 million decrease in net gains on principal transactions was due primarily to reduced customer trading activity in the taxable fixed income business and reduced underwriting activity in the municipal finance business. The $3.1 million decrease in commissions was due primarily to a $3.0 million decrease in commissions primarily in the taxable fixed income business resulting from reduced customer activity due to increased economic uncertainty. The $1.8 million decrease in other revenue was due primarily to a decline in the value of investments in our deferred compensation plan, as well as a decrease in gains on the sale of the Bank's investment securities. This decrease was partially offset by an increase in the sale of insurance products in the retail segment.

Operating expenses decreased $54.8 million for the three-months ended September 30, 2011 as compared to the same period of the prior fiscal year primarily from reductions in the provision for loan loss. The decrease in the Bank's loan loss provision is discussed in "Overview-Business Environment-Impact of Economic Environment-Bank." Additionally, other expenses decreased $8.6 million due primarily to decreases in the Bank's REO loss provision, outside services related to the review of loan files and real-estate related expenses, as well as a decrease in legal expenses.

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Net Interest Income

We generate net interest income from our brokerage and banking segments. Net interest income from the brokerage segments is dependent upon the level of customer and stock loan balances as well as the spread between the rates we earn on those assets compared with the cost of funds. Net interest is the primary source of income for the Bank and represents the amount by which interest and fees generated by earning assets exceed the cost of funds. The Bank's cost of funds consists primarily of interest paid to the Bank's depositors on interest-bearing accounts and long-term borrowings from the Federal Home Loan Bank ("FHLB"). Net interest income from our brokerage, corporate and banking segment were as follows for the three-months ended September 30, 2011 and September 24, 2010 (in thousands):

                                         Three-Months Ended
                                 September 30,        September 24,
                                     2011                 2010
              Brokerage         $         7,104      $         6,924
              SWS Group, Inc.            (1,975 )                 -
              Bank                       12,674               20,176 (1)

              Net interest      $        17,803      $        27,100

(1) The net interest reported for the Bank is for the period ended September 30, 2010.

Average balances of interest-earning assets and interest-bearing liabilities in our brokerage operations were as follows (in thousands):

                                                                  Three-Months Ended
                                                         September 30,          September 24,
                                                             2011                   2010
Daily average interest-earning assets:
Customer margin balances                                $       228,000        $       200,000
Assets segregated for regulatory purposes                       243,000                273,000
Stock borrowed                                                1,830,000              2,047,000

Daily average interest-bearing liabilities:
Customer funds on deposit, including short credits              368,000                360,000
Stock loaned                                                  1,813,000              2,017,000

Net interest revenue generated by each segment is reviewed in detail in the segment analysis below.

Income Tax Benefit

For the three-months ended September 30, 2011, income tax expense (effective rate of 55.3%) differed from the amount that would have otherwise been calculated by applying the federal corporate tax rate (35.0%) to income before income taxes due to state income taxes and other permanently excluded items, such as tax exempt interest, compensation and increases in the value of company-owned life insurance.

Certain deferred tax assets are derived from capital losses. To use the deferred tax assets, we must have sufficient capital gain income within the carry-back and carry-forward period available under the tax law. Our deferred tax assets as of September 30, 2011 included $705,000 which reflected the benefit of capital losses associated with our investments in certain partnership assets. As of

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September 30, 2011, we did not believe it was more likely than not that we would generate sufficient capital gain income to offset these capital losses. Accordingly, we have a valuation allowance of $579,000 to reflect the amount of deferred tax assets that will more likely than not, in the opinion of management, not be recognized. The valuation allowance decreased $265,000 from the three-months ended September 24, 2010 as a result of recognizing $265,000 of capital gains during the most recent tax filing period and additional valuation information received with respect to our investments in these partnership assets. See additional discussion in "Income Taxes."

Segment Information

The following is a summary of net revenues and pre-tax income (loss) by segment
for the three-months ended September 30, 2011 as compared to the three-months
ended September 24, 2010 (dollars in thousands):

                                                Three-Months Ended
. . .
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