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EX-31.1 - CHIEF EXECUTIVE OFFICER CERTIFICATION FILED PURSUANT TO SECTION 302 - Hilltop Securities Holdings LLCdex311.htm
EX-32.2 - CHIEF FINANCIAL OFFICER CERTIFICATION FURNISHED PURSUANT TO SECTION 906 - Hilltop Securities Holdings LLCdex322.htm
EX-31.2 - CHIEF FINANCIAL OFFICER CERTIFICATION FILED PURSUANT TO SECTION 302 - Hilltop Securities Holdings LLCdex312.htm
EX-32.1 - CHIEF EXECUTIVE OFFICER CERTIFICATION FURNISHED PURSUANT TO SECTION 906 - Hilltop Securities Holdings LLCdex321.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

Form 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 25, 2011

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number 000-19483

 

 

SWS GROUP, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   75-2040825
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
1201 Elm Street, Suite 3500, Dallas, Texas   75270
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code (214) 859-1800

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of April 29, 2011, there were 32,568,359 shares of the registrant’s common stock, $.10 par value, outstanding.

 

 

 


Table of Contents

SWS GROUP, INC. AND SUBSIDIARIES

INDEX

 

PART I. FINANCIAL INFORMATION   

Item 1. Financial Statements

  

Consolidated Statements of Financial Condition March 25, 2011 (unaudited) and June  25, 2010

     1   

Consolidated Statements of Loss and Comprehensive Loss For the three and nine-months ended March  25, 2011 and March 26, 2010 (unaudited)

     2   

Consolidated Statements of Cash Flows For the nine-months ended March 25, 2011 and March  26, 2010 (unaudited)

     3   

Notes to Consolidated Financial Statements (unaudited)

     5   

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

     41   

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     79   

Item 4. Controls and Procedures

     79   
PART II. OTHER INFORMATION   

Item 1. Legal Proceedings

     79   

Item 1A. Risk Factors

     80   

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

     81   

Item 3. Defaults Upon Senior Securities

     81   

Item 4. (Removed and Reserved)

     81   

Item 5. Other Information

     81   

Item 6. Exhibits

     82   
SIGNATURES      83   
EXHIBIT INDEX      84   


Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SWS Group, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

March 25, 2011 and June 25, 2010

(In thousands, except par values and share amounts)

 

     March     June  
     (Unaudited)        
Assets     

Cash and cash equivalents

   $ 274,022      $ 27,190   

Assets segregated for regulatory purposes

     232,021        284,827   

Receivable from brokers, dealers and clearing organizations

     2,169,587        1,889,400   

Receivable from clients, net

     243,348        216,574   

Loans held for sale

     67,818        424,055   

Loans, net

     912,881        1,154,065   

Securities owned, at market value

     266,592        245,587   

Securities held to maturity

     35,525        87,140   

Securities purchased under agreements to resell

     57,974        30,507   

Goodwill

     7,552        7,552   

Securities available for sale

     1,813        1,388   

Other assets

     154,504        162,406   
                
   $ 4,423,637      $ 4,530,691   
                
Liabilities and Stockholders’ Equity     

Short-term borrowings

   $ 185,400      $ 110,000   

Payable to brokers, dealers and clearing organizations

     2,083,918        1,819,995   

Payable to clients

     390,089        420,672   

Deposits

     1,120,090        1,488,804   

Securities sold under agreements to repurchase

     7,217        12,389   

Securities sold, not yet purchased, at market value

     93,736        67,594   

Drafts payable

     27,233        27,346   

Advances from Federal Home Loan Bank

     96,809        132,821   

Other liabilities

     61,714        67,676   
                
     4,066,206        4,147,297   

Stockholders’ equity:

    

Preferred stock of $1.00 par value. Authorized 100,000 shares; none issued

     —          —     

Common stock of $0.10 par value. Authorized 60,000,000 shares; issued 33,312,140 and outstanding 32,324,008 shares at March 25, 2011; issued 33,312,140 and outstanding 32,342,190 shares at June 25, 2010

     3,331        3,331   

Additional paid-in capital

     326,525        326,462   

Retained earnings

     35,115        61,893   

Accumulated other comprehensive income – unrealized holding loss, net of tax of $255 at March 25, 2011 and $81 at June 25, 2010

     637        304   

Deferred compensation, net

     3,282        3,176   

Treasury stock (988,132 shares at March 25, 2011 and 969,950 shares at June 25, 2010, at cost)

     (11,459     (11,772
                

Total stockholders’ equity

     357,431        383,394   

Commitments and contingencies

    
                

Total liabilities and stockholders’ equity

   $ 4,423,637      $ 4,530,691   
                

See accompanying Notes to Consolidated Financial Statements.

 

1


Table of Contents

SWS Group, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF LOSS AND COMPREHENSIVE LOSS

For the three and nine-months ended March 25, 2011 and March 26, 2010

(In thousands, except per share and share amounts)

(Unaudited)

 

     For the Three-Months
Ended
    For the Nine-Months
Ended
 
     March 25,
2011
    March 26,
2010
    March 25,
2011
    March 26,
2010
 

Revenues:

        

Net revenues from clearing operations

   $ 2,805      $ 2,476      $ 8,065      $ 7,832   

Commissions

     32,915        35,215        110,010        119,979   

Interest

     31,606        36,224        107,180        118,397   

Investment banking, advisory and administrative

fees

     7,271        7,895        31,537        26,183   

Net gains on principal transactions

     10,544        7,776        30,386        32,251   

Other

     4,352        5,661        13,898        17,017   
                                

Total revenue

     89,493        95,247        301,076        321,659   

Interest expense

     11,566        12,246        35,196        44,028   
                                

Net revenues

     77,927        83,001        265,880        277,631   
                                

Non-interest expenses:

        

Commissions and other employee compensation

     52,841        53,032        168,884        174,860   

Occupancy, equipment and computer service costs

     8,375        8,607        25,320        25,696   

Communications

     3,254        3,370        9,811        9,925   

Floor brokerage and clearing organization charges

     1,112        1,008        3,296        2,939   

Advertising and promotional

     702        881        2,057        3,056   

Provision for loan loss

     4,727        25,000        50,967        34,420   

Other

     10,317        9,402        39,937        31,102   
                                

Total non-interest expenses

     81,328        101,300        300,272        281,998   
                                

Loss before income tax benefit

     (3,401     (18,299     (34,392     (4,367

Income tax benefit

     (1,254     (6,759     (11,167     (1,779
                                

Net loss

     (2,147     (11,540     (23,225     (2,588

Net gain/(loss) recognized in other comprehensive loss, net of tax of $(57) and $(3) for the three-months ended March 25, 2011 and March 26, 2010, respectively and $174 and $4 for the nine-months ended March 25, 2011 and March 26, 2010, respectively.

     (110     1        333        (22
                                

Comprehensive loss

   $ (2,257   $ (11,539   $ (22,892   $ (2,610
                                

Loss per share – basic

        

Net loss

   $ (0.07   $ (0.35   $ (0.71   $ (0.09
                                

Weighted average shares outstanding – basic

     32,501,344        32,544,021        32,510,570        29,489,035   
                                

Loss per share – diluted

        

Net loss

   $ (0.07   $ (0.35   $ (0.71   $ (0.09
                                

Weighted average shares outstanding – diluted

     32,501,344        32,544,021        32,510,570        29,489,035   
                                

See accompanying Notes to Consolidated Financial Statements.

 

2


Table of Contents

SWS Group, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the nine-months ended March 25, 2011 and March 26, 2010

(In thousands)

(Unaudited)

 

     For the Nine-Months Ended  
     March 25,
2011
    March 26,
2010
 

Cash flows from operating activities:

    

Net loss

   $ (23,225   $ (2,588

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

    

Depreciation and amortization

     5,477        5,232   

Amortization of premiums/discounts on loans purchased

     (106     (138

Amortization of premiums /discounts on investment securities

     146        4   

Provision for doubtful accounts on firm receivables

     405        720   

Provision for loan loss and write downs on real estate owned properties

     64,316        38,029   

Deferred income tax benefit

     (4,388     (5,251

Allowance for deferred tax asset

     844        —     

Deferred compensation for deferred compensation plan and restricted stock plan

     3,402        4,382   

Loss (gain) on sale of loans

     661        (902

Loss on disposition/sale of fixed assets

     6        5   

Loss on sale of real estate

     3,027        1,549   

Gain on the sale of investment securities

     (81     —     

Gain on issuer’s redemption of investment securities

     (1,078     —     

Equity in earnings of unconsolidated ventures

     (177     (1,687

Gain on the sale of securities available for sale

     —          (16

Dividend received on investment in Federal Home Loan Bank stock

     (19     (12

Shortfall for taxes on vesting of restricted stock

     314        120   

Change in operating assets and liabilities:

    

Decrease in assets segregated for regulatory purposes

     52,806        10,940   

Net change in broker, dealer and clearing organization accounts

     (16,264     (73,792

Net change in client accounts

     (57,762     (13,643

Net change in loans held for sale

     363,452        (59,320

Increase in securities owned

     (21,005     (59,110

Increase in securities purchased under agreements to resell

     (27,467     (12,044

Increase in other assets

     (11,385     (13,800

Increase (decrease) in drafts payable

     (113     3,137   

Increase in securities sold, not yet purchased

     26,142        15,436   

Decrease in other liabilities

     (8,818     (9,102
                

Net cash provided by (used in) operating activities

     349,110        (171,851
                

Cash flows from investing activities:

    

Purchase of fixed assets and capitalized improvements on real estate owned properties

     (2,399     (5,788

Proceeds from fixed asset transactions

     —          86   

Proceeds from the sale of real estate

     41,748        20,400   

Proceeds from the sale of loans

     40,895        —     

Loan originations and purchases

     (283,513     (304,379

Loan repayments

     384,976        215,277   

Cash paid on investments

     (35,525     (83,447

Proceeds from the sale of investment securities

     75,555        2,925   

Proceeds from the issuer’s redemption of investment securities

     7,347        —     

Proceeds from the cash received on investments

     5,557        650   

Proceeds from the sale of Federal Home Loan Bank stock

     2,886        267   

Purchases of Federal Home Loan Bank stock

     (1,460     —     
                

Net cash provided by (used in) investing activities

     236,067        (154,009
                

 

3


Table of Contents
     For the Nine-Months Ended  
     March 25,
2011
    March 26,
2010
 

Cash flows from financing activities:

    

Payments on short-term borrowings

   $ (4,278,782   $ (2,168,900

Cash proceeds from short-term borrowings

     4,349,782        2,265,900   

Cash proceeds from other financing activities

     4,400        —     

Increase (decrease) in deposits

     (368,714     146,102   

Advances from the Federal Home Loan Bank

     418,644        997   

Payments on advances from the Federal Home Loan Bank

     (454,656     (8,579

Payment of cash dividends on common stock

     (3,578     (8,285

Shortfall for taxes on vesting of restricted stock

     (314     (120

Cash receipts on securities sold under agreements to repurchase

     (5,172     3,411   

Net proceeds from secondary offering

     —          54,700   

Proceeds related to the deferred compensation plan

     385        499   

Purchase of treasury stock related to the deferred compensation plan

     (340     (228
                

Net cash (used in) provided by financing activities

     (338,345     285,497   
                

Net increase (decrease) in cash and cash equivalents

     246,832        (40,363

Cash and cash equivalents at beginning of period

     27,190        96,253   
                

Cash and cash equivalents at end of period

   $ 274,022      $ 55,890   
                

Supplemental schedule of non-cash investing and financing activities:

    

Granting of restricted stock

   $ 670      $ 1,461   
                

Foreclosures on loans

   $ 40,089      $ 41,485   
                

Transfer of securities from held to maturity to available for sale

   $ 42,519      $ —     
                

Supplemental disclosure of cash flow information:

    

Cash paid during the period for:

    

Interest

   $ 33,237      $ 46,718   
                

Income taxes

   $ 1,635      $ 7,055   
                

See accompanying Notes to Consolidated Financial Statements.

 

4


Table of Contents

SWS Group, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

Three and Nine-Months Ended March 25, 2011 and March 26, 2010

(Unaudited)

GENERAL AND BASIS OF PRESENTATION

The interim consolidated financial statements as of March 25, 2011, and for the three and nine-months ended March 25, 2011 and March 26, 2010, are unaudited; however, in the opinion of management, these interim statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial position, results of operations and cash flows. These financial statements should be read in conjunction with the audited consolidated financial statements and related notes as of and for the fiscal year ended June 25, 2010 filed on Form 10-K. Amounts included for June 25, 2010 are derived from the audited consolidated financial statements as filed on Form 10-K. All significant inter-company balances and transactions have been eliminated.

The consolidated financial statements include the accounts of SWS Group, Inc. (“SWS Group”) and the consolidated active subsidiaries listed below (collectively with SWS Group, “SWS” or the “Company”):

 

Southwest Securities, Inc.    “Southwest Securities”
SWS Financial Services, Inc.    “SWS Financial”
Southwest Financial Insurance Agency, Inc.   
Southwest Insurance Agency, Inc.   

Southwest Insurance Agency of Alabama, Inc.

   collectively, “SWS Insurance”
SWS Banc Holdings, Inc.    “SWS Banc”

Southwest Securities, FSB

   “Bank”

Southwest Securities is a New York Stock Exchange (“NYSE”) member broker/dealer and Southwest Securities and SWS Financial, both registered investment advisors, are members of the Financial Industry Regulatory Authority (“FINRA”). Each is registered with the Securities and Exchange Commission (the “SEC”) as a broker/dealer under the Securities Exchange Act of 1934 (“Exchange Act”) and as registered investment advisors under the Investment Advisors Act of 1940.

SWS Insurance holds insurance agency licenses in forty-six states for the purpose of facilitating the sale of insurance and annuities for Southwest Securities and its correspondents. The Company retains no underwriting risk related to the insurance and annuity products that SWS Insurance sells.

The Bank is a federally chartered savings bank regulated by the Office of Thrift Supervision (“OTS”). With the passage of the Dodd-Frank Wall Street Reform Consumer Protection Act, or the Dodd-Frank Act, effective July 21, 2011 (unless extended by up to six months), the OTS will be abolished and the Office of Comptroller of the Currency (“OCC”) will take over supervision and regulation of the Bank and the Federal Reserve Board (“FRB”) will take over supervision and regulation of SWS Group and SWS Banc, which was incorporated as a wholly owned subsidiary of SWS Group and became the sole stockholder of the Bank in 2004.

Consolidated Financial Statements. The quarterly consolidated financial statements of SWS are customarily closed on the last Friday of the month. The Bank’s third quarter financial statements are prepared as of March 31, 2011. Any individually material transactions are reviewed and recorded in the appropriate quarterly period. All significant inter-company balances and transactions have been eliminated.

 

5


Table of Contents

Change in Accounting Estimate. Prior to the third quarter of fiscal 2010, the Bank’s provision for loan loss computation used a three year rolling average of historical loan losses by product type to assess losses in the Bank’s loan portfolio. Product types consist of 1-4 family residential loans, 1-4 family residential construction loans, land and land development loans, commercial real estate loans, commercial loans and consumer loans. Due to accelerated deterioration in the Bank’s loan portfolio, depressed appraised values for collateral, continued high unemployment rates in Texas and deteriorating banking industry loss statistics, the Bank’s management reevaluated its use of historical loan losses in its provision for loan loss computation. As a result of this reevaluation, in the third quarter of fiscal 2010, management reduced the historical loan loss look back period from three years to four quarters.

Due to continued deterioration in the Bank’s loan portfolio, depressed appraised values for collateral, continued high unemployment rates in Texas and deteriorating banking industry loss statistics in the first quarter of fiscal 2011, the Bank’s management reevaluated its problem loan volume trend component in its provision for loan loss computation. The problem loan volume trend component now includes two separate calculations for criticized and classified loans. Prior to the first quarter of fiscal 2011, the Bank had one calculation for these loans. To more appropriately assess these loans, the Bank segregated these loans and applied two separate historical loss ratios, one being the regular historical loan loss ratio applied to criticized and classified loans and the other being based on distressed sale charge-off levels applied to criticized and classified loans. Also, due to the significant increase in classified loans and the Bank’s need to provide a heavier weighting for these types of loans in the Bank’s allowance calculation, the Bank segregated the assets and used the “distressed sell mark,” which is the fair value adjustment made on the loans placed in an auction, as a basis for the additional emphasis in the model.

Amortization Expense. The Company has recorded a customer relationship intangible which is amortized over a five year period at a rate based on the estimated future economic benefit of the customer relationships. See additional discussion in “Intangible Assets.”

Income Taxes. SWS and its subsidiaries file a consolidated federal income tax return. Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

The Company records net deferred tax assets to the extent the Company believes these assets will more likely than not be realized. In making such determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations. A valuation allowance is established against deferred tax assets that do not meet the criteria for recognition. In the event the Company were to determine that it would be able to realize deferred income tax assets in the future in excess of their net recorded amount, the Company would make an adjustment to the valuation allowance which would reduce the provision for income taxes.

The portion of deferred tax assets derived from operating losses are realized when the Company generates consolidated taxable income within the carry-back and carry-forward periods. Based on the Company’s history of generating taxable income and the Company’s projection for future taxable income over the carry-forward period, management believes that it is more likely than not that the Company will realize all of its deferred tax assets derived from operating losses. However, the amount of deferred tax assets considered realizable could be reduced if estimates of future taxable income during the carry-forward period are reduced.

 

6


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Certain deferred tax assets are derived from capital losses, which depend on having sufficient capital gain income within the carry-back and carry-forward period available under the tax law. The Company’s deferred tax assets include $844,000 which reflects the benefit of capital losses associated with its investments in certain partnership assets. In the first quarter of fiscal 2011, the Company established a valuation allowance in the amount of $844,000. As of March 25, 2011, the Company did not believe it was more likely than not that sufficient capital gain income would be generated to offset these capital losses.

At March 25, 2011, the Company had approximately $1,329,000 of unrecognized tax benefits. The Company’s net liability increased $208,000 from June 25, 2010 to March 25, 2011 due to unrecognized tax benefits related to tax positions taken on previously filed returns and returns expected to be filed in the current year. While the Company expects that the net liability for uncertain tax positions will change during the next twelve months, the Company does not believe that the change will have a significant impact on its consolidated financial position or results of operations.

The Company recognizes interest and penalties on income taxes in income tax expense. Included in the net liability was accrued interest and penalties, net of federal benefit, of $254,000 as of March 25, 2011 and $273,000 as of June 25, 2010. The total amount of unrecognized income tax benefits that, if recognized, would reduce income tax expense, net of federal benefit, was approximately $1,075,000 as of March 25, 2011 and $848,000 as of June 25, 2010.

With limited exceptions, the Company is no longer subject to U.S. federal, state or local tax audits by taxing authorities for tax years preceding 2006. The examination of the Company’s returns by a state agency for the tax years ended December 31, 2006 through 2008 was concluded with no material adjustments.

Income tax benefit for the three and nine-month periods ended March 25, 2011 and March 26, 2010 (effective rate of 36.9% and 36.9% in the three-month periods ended March 25, 2011 and March 26, 2010, respectively, and 32.5% and 40.7% in the nine-month periods ended March 25, 2011 and March 26, 2010, respectively) differs from the amount that would otherwise have been calculated by applying the federal corporate tax rate (35% in fiscal 2011 and 2010 ) to loss before income tax benefit and is comprised of the following (in thousands):

 

     Three-Months Ended     Nine-Months Ended  
     2011     2010     2011     2010  

Income tax benefit at the statutory rate

   $ (1,190   $ (6,404   $ (12,037   $ (1,528

Tax exempt interest

     (231     (184     (651     (558

Tax exempt income from company-owned life insurance (“COLI”)

     (148     (114     (614     (545

State income taxes, net of federal tax benefit

     24        (93     464        710   

Non-deductible meals and entertainment

     48        78        125        218   

Non-deductible compensation

     245        —          630        —     

Valuation allowance

     —          —          844        —     

Other, net

     (2     (42     72        (76
                                
   $ (1,254   $ (6,759   $ (11,167   $ (1,779
                                

 

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Table of Contents

The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities as of March 25, 2011 and June 25, 2010 are presented below (in thousands):

 

     March     June  
     2011     2010  

Deferred tax assets:

    

Employee compensation plans

   $ 11,380      $ 11,787   

Allowance for probable loan losses

     18,235        12,625   

Bad debt reserve

     1,724        1,847   

Deferred rent

     1,666        1,675   

Fixed assets, net

     —          202   

Gain on sale of loans deferred

     686        804   

Investment in unconsolidated ventures

     123        384   

State taxes

     1,446        1,155   

Other

     860        643   
                

Total gross deferred tax assets

   $ 36,120      $ 31,122   
                

Deferred tax liabilities:

    

Securities available for sale

   $ (319   $ (145

Extraordinary gain

     (239     (239

Fixed assets, net

     (639     —     

Other

     (70     (99
                

Total gross deferred tax liabilities

     (1,267     (483
                

Valuation allowance

     (844     —     
                

Net deferred tax assets – included in other assets on the consolidated statements of financial condition

   $ 34,009      $ 30,639   
                

FAIR VALUE OF FINANCIAL INSTRUMENTS

Fair value accounting establishes a framework for measuring fair value and expands disclosures about fair value measurements. Under fair value accounting, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the primary market in which the reporting entity transacts. The standard clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. Under the standard, fair value measurements are separately disclosed by level within the fair value hierarchy. The standard describes three levels of inputs that may be used to measure fair value:

 

   

Level 1 — Quoted prices in an active market for identical assets or liabilities. Assets and liabilities utilizing Level 1 inputs include the following: (a) the Company’s investment in U.S. Home Systems, Inc. (“USHS”) common stock; (b) the Company’s deferred compensation plan’s investment in Westwood Holdings Group, Inc. (“Westwood”) common stock; (c) the Company’s investment in government guaranteed bonds purchased under the Temporary Liquidity Guarantee Program (“TLGP”); and (d) certain inventories held in the Company’s securities owned and securities sold, not yet purchased portfolio. Valuation of these instruments does not require a high degree of judgment as the valuations are based on quoted prices in active markets that are readily available.

 

   

Level 2 — Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Assets and liabilities utilizing Level 2 inputs include certain inventories held in

 

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the Company’s securities owned and securities sold, not yet purchased portfolio. These financial instruments are valued using quoted prices that are less frequent than those in active markets or by models that use various assumptions that are derived from or supported by data that is generally observable in the marketplace. Valuations in this category are inherently less reliable than quoted market prices due to the degree of subjectivity involved in determining appropriate methodologies and the applicable underlying observable market assumptions.

 

   

Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets and liabilities. Assets and liabilities utilizing Level 3 inputs include certain inventories held in the Company’s securities owned portfolio. These financial instruments have significant inputs that cannot be validated by readily determinable market data and generally involve considerable judgment by management.

The following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Assets Segregated for Regulatory Purposes. Because quoted market prices are available in an active market, these securities are classified within Level 1 of the valuation hierarchy. These securities consist of government bonds purchased under the TLGP.

Securities Available for Sale. Because quoted market prices are available in an active market, the Company’s investment in USHS common stock and the Company’s deferred compensation plan’s investment in Westwood common stock are classified within Level 1 of the valuation hierarchy.

Securities Owned and Securities Sold, Not Yet Purchased Portfolio. Securities classified as Level 1 securities primarily consist of financial instruments whose value is based on quoted market prices such as corporate equity securities and U.S. government obligations.

Securities classified as Level 2 securities include financial instruments that are valued using models or other valuation methodologies. These models are primarily industry standard models that consider various assumptions, including time value, yield curve, volatility factors, current market and contractual prices for the underlying financial instruments, as well as other relevant economic measures. Substantially all of these assumptions are observable in the marketplace, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace. Securities in this category include corporate debt, certain U.S. government and government agency obligations and municipal obligations.

Securities classified as Level 3 securities are securities whose fair value is estimated based on internally developed models or methodologies, including discounted cash flow, utilizing significant inputs that are generally less readily observable. Included in this category are certain corporate equity securities and municipal auction rate securities.

The Company held one municipal auction rate bond with a par amount of $23,300,000 that was classified as a Level 3 security at both March 25, 2011 and June 25, 2010. This security is an investment grade credit, was valued at 95.7% of par, or $22,298,000, at both March 25, 2011 and June 25, 2010, and yielded less than 1% per year for both periods. The interest rate on the bond is based on the LIBOR rate. The discount on the value of the bond is due to a lack of marketability. While management does not expect any reduction in the cash flow from this bond, the disruption in the credit markets has led to auction failures. The Company currently

 

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has the ability to hold this investment until maturity. While the Company expects the issuer of this bond to refinance the debt when LIBOR interest rates rise, there can be no certainty that this refinancing will occur. The Company believes the valuation of this bond at 95.7% of par at March 25, 2011 reflected an appropriate discount for the current lack of liquidity in this investment.

The following tables summarize by level within the fair value hierarchy “Assets segregated for regulatory purposes,” “Securities available for sale,” “Securities owned, at market value” and “Securities sold, not yet purchased, at market value” as of March 25, 2011 and June 25, 2010.

 

March 25, 2011                            
(in thousands)                            
     Level 1      Level 2      Level 3      Total  

Assets segregated for regulatory purposes

           

U.S. government guaranteed obligations

   $ 55,879       $ —         $ —         $ 55,879   
                                   
   $ 55,879       $ —         $ —         $ 55,879   
                                   

Securities available for sale

           

USHS common stock

   $ 1,643       $ —         $ —         $ 1,643   

Westwood common stock

     170         —           —           170   
                                   
   $ 1,813       $ —         $ —         $ 1,813   
                                   

Securities owned, at market value

           

Corporate equity securities

   $ 5,038       $ —         $ 1,225       $ 6,263   

Municipal obligations

     —           95,288         22,298         117,586   

U.S. government agency obligations

     13,749         11,413         —           25,162   

Corporate obligations

     —           102,904         —           102,904   

Other

     877         13,800         —           14,677   
                                   
   $ 19,664       $ 223,405       $ 23,523       $ 266,592   
                                   

Securities sold, not yet purchased, at market value

           

Corporate equity securities

   $ 880       $ —         $ —         $ 880   

U.S. government agency obligations

     59,890         2,101         —           61,991   

Corporate obligations

     —           30,289         —           30,289   

Other

     32         544         —           576   
                                   
   $ 60,802       $ 32,934       $ —         $ 93,736   
                                   

Grand total

   $ 16,554       $ 190,471       $ 23,523       $ 230,548   
                                   
June 25, 2010                            
(in thousands)                            
     Level 1      Level 2      Level 3      Total  

Assets segregated for regulatory purposes

           

U.S. government guaranteed obligations

   $ 62,167       $ —         $ —         $ 62,167   
                                   
   $ 62,167       $ —         $ —         $ 62,167   
                                   

Securities available for sale

           

USHS stock

   $ 1,146       $ —         $ —         $ 1,146   

Westwood stock

     242         —           —           242   
                                   
   $ 1,388       $ —         $ —         $ 1,388   
                                   

 

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     Level 1      Level 2      Level 3      Total  

Securities owned, at market value

           

Corporate equity securities

   $ 10,893       $ —         $ 1,841       $ 12,734   

Municipal obligations

     —           109,844         22,298         132,142   

U.S. government agency obligations

     13,710         5,808         —           19,518   

Corporate obligations

     —           70,844         —           70,844   

Other

     994         9,355         —           10,349   
                                   
   $ 25,597       $ 195,851       $ 24,139       $ 245,587   
                                   

Securities sold, not yet purchased, at market value

           

Corporate equity securities

   $ 925       $ —         $ —         $ 925   

Municipal obligations

     —           17         —           17   

U.S. government agency obligations

     45,225         101         —           45,326   

Corporate obligations

     —           20,867         —           20,867   

Other

     31         428         —           459   
                                   
   $ 46,181       $ 21,413       $ —         $ 67,594   
                                   

Grand total

   $ 42,971       $ 174,438       $ 24,139       $ 241,548   
                                   

There were no transfers between Level 1 and Level 2 for the nine-months ended March 25, 2011.

The following table provides a reconciliation of the beginning and ending balances for the major classes of assets and liabilities measured at fair value using significant unobservable inputs (Level 3):

 

(in thousands)    Corporate
Equity
Securities
    Municipal
Obligations
     Total  

Beginning balance at June 25, 2010

   $ 1,841      $ 22,298       $ 24,139   

Unrealized gains

     2        —           2   
                         

Ending balance at September 24, 2010

     1,843        22,298         24,141   

Sales/redemption

     (18     —           (18
                         

Ending balance at December 31, 2010

     1,825        22,298         24,123   

Sales/redemption

     (600     —           (600
                         

Ending balance at March 25, 2011

   $ 1,225      $ 22,298       $ 23,523   
                         

Changes in unrealized gains (losses) and realized gains (losses) for corporate and municipal obligations and corporate equity securities are presented in “Net gains on principal transactions” on the consolidated statements of loss and comprehensive loss.

The total unrealized gain included in earnings that related to assets still held for the three and nine-month periods ended March 25, 2011 was $0 and $2,000, respectively.

Substantially all of SWS’s brokerage assets and liabilities are carried at market value or at amounts which, because of their short-term nature, approximate current fair value.

EMPLOYEE BENEFITS

Stock Option Plans. There were no active stock option plans at March 25, 2011. All outstanding options under the SWS Group, Inc. Stock Option Plan (the “1996 Plan”) may still be exercised until their contractual expiration date occurs. Options granted under the 1996 Plan have a maximum ten-year term, and all options are fully vested.

 

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Restricted Stock Plan. The Restricted Stock Plan allows for awards of up to 1,250,000 shares of SWS Group’s common stock to SWS’s directors, officers and employees. No more than 300,000 of the authorized shares may be newly issued shares of common stock. The Restricted Stock Plan terminates on August 21, 2013. The vesting period is determined on an individual basis by the Compensation Committee of the Board of Directors. In general, restricted stock granted to employees under the Restricted Stock Plan vests pro-rata over a three year period, and restricted stock granted to non-employee directors vests on the one year anniversary of the date of grant.

During the first nine months of fiscal 2011, the Board of Directors approved grants to various officers and employees totaling 64,151 shares with a weighted average market value of $6.16 per share. In the first nine months of fiscal 2010, the Board of Directors approved grants to various officers and employees totaling 146,844 shares with a weighted average market value of $14.76 per share. SWS recorded deferred compensation in “Additional paid-in capital” of approximately $395,000 in fiscal 2011 and $2,016,000 in fiscal 2010. For the three and nine-months ended March 25, 2011, SWS recognized compensation expense related to restricted stock grants of approximately $354,000 and $901,000, respectively. For the three and nine-months ended March 26, 2010, SWS recognized compensation expense related to restricted stock grants of approximately $530,000 and $2,151,000, respectively.

At March 25, 2011, the total number of unvested shares outstanding under the Restricted Stock Plan was 213,274 and the total number of shares available for future grants was 351,531.

CASH AND CASH EQUIVALENTS

For the purpose of the consolidated statements of cash flows, SWS considers cash to include cash on hand and in bank accounts. In addition, SWS considers funds due from banks and interest bearing deposits in other banks to be cash. Highly liquid debt instruments purchased with original maturities of three months or less, when acquired, are considered to be cash equivalents. The Federal Deposit Insurance Corporation (“FDIC”) insures accounts up to $250,000. In accordance with the Dodd-Frank Act, non-interest bearing transaction accounts are temporarily covered under FDIC insurance until December 31, 2012. At March 25, 2011 and June 25, 2010, cash balances included $751,000 and $13,988,000, respectively, that were not federally insured because they represented amounts in individual accounts above the federally insured limit for each such account. This at-risk amount is subject to fluctuation on a daily basis, but management does not believe there is significant risk with respect to such deposits.

The Bank is required to maintain balances on hand or with the Federal Reserve Bank. At March 31, 2011 and June 30, 2010, these reserve balances amounted to $4,099,000 and $10,776,000, respectively.

INVESTMENTS

SWS has interests in three investment partnerships that are accounted for under the equity method, which approximates fair value. One is a limited partnership venture capital fund to which SWS has committed $5,000,000. As of March 25, 2011, SWS had fulfilled its $5,000,000 commitment. Based on a review of the fair value of this limited partnership investment, SWS determined that its share of the investments made by the limited partnership should be valued at $2,114,000 as of March 25, 2011. SWS recorded a net gain on this investment for the three-months ended March 25, 2011 of $7,000 and a net loss on this investment for the nine-months ended March 25, 2011 of $180,000. In comparison, during the three and nine-months ended March 26, 2010, SWS recorded net gains of $885,000 and $1,263,000, respectively, on this investment.

 

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The other two investments are limited partnership equity funds to which the Bank committed $3,000,000 in fiscal 2007 and $2,000,000 in fiscal 2009 as a cost effective way of meeting its obligations under the Community Reinvestment Act of 1977 (“CRA”). As of March 31, 2011, the Bank had invested $3,000,000 of its aggregate $5,000,000 commitment to the two funds. During the three and nine-months ended March 31, 2011, the Bank recorded net gains of $493,000 and $357,000, respectively, related to these two investments. In comparison, during the three and nine-months ended March 31, 2010, the Bank recorded losses of $1,000 and gains of $334,000, respectively, related to these two investments. During the three and nine-months ended March 31, 2011, the Bank received a $306,000 distribution from one of these investments.

SECURITIES HELD TO MATURITY

Securities held to maturity consist of the following;

 

(in thousands)    March 31, 2011      June 30, 2010  
     Recorded
Value
     Fair Value      Recorded
Value
     Fair Value  

GNMA securities

   $ 35,525       $ 35,525       $ 80,875       $ 82,149   

Municipal bonds

     —           —           6,265         6,948   
                                   

Total

   $ 35,525       $ 35,525       $ 87,140       $ 89,097   
                                   

On March 31, 2011, the Bank purchased GNMA securities at a cost of $35,525,000 including a premium of $525,000. The premium is amortized over an average life of 15 years using the interest method. These securities are classified as held to maturity and are accounted for at amortized cost.

In the third quarter of fiscal 2010, the Bank purchased GNMA securities at a cost of $83,047,000 including a premium of $837,000. The premium was being amortized over an average life of four years using the interest method. The Bank recorded $0 and $151,000 in amortization of the premium during the three and nine-month periods ended March 31, 2011, respectively. During the three and nine-month periods ended March 31, 2011, the Bank received $26,000 and $6,234,000 of principal and interest payments, respectively, recording $26,000 and $983,000 in interest, respectively. In December 2010, the Bank sold $32,955,000 of the GNMA securities for $32,976,000, generating a realized gain of $21,000. The Bank sold these securities in order to increase the Bank’s capital ratios by reducing the Bank’s asset base. As a result of this sale, it was determined that the remaining balance of the GNMA securities was no longer held to maturity and was reclassed to securities available for sale. These securities were marked to market with any unrealized gain/loss being recorded to other comprehensive income. The remaining balance of the GNMA securities was sold in January 2011, yielding a gain of $60,000.

In addition, at June 30, 2010, the Bank held municipal bonds from state and political subdivisions. The Bank recorded amortization of the discount on these securities of $0 and $7,100 for the three-months ended March 31, 2011 and 2010, respectively. The Bank recorded amortization of the discount on these securities of $4,900 and $20,900 for the nine-months ended March 31, 2011 and 2010, respectively. During the first half of fiscal 2011, $6,004,000 of these securities were redeemed, resulting in a gain of $1,078,000. In February 2011, the remaining $265,000 of these securities were redeemed at no gain.

The amortized cost and estimated fair value of investments held to maturity at March 31, 2011, by contractual maturity, are shown below (in thousands). Expected maturities may differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties.

 

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     Securities Held to Maturity  
     Amortized
Cost
     Fair Value  

Due in one year or less

   $ —         $ —     

Due from one year to five years

     35,525         35,525   
                 
   $ 35,525       $ 35,525   
                 

ASSETS SEGREGATED FOR REGULATORY PURPOSES

At March 25, 2011, SWS held TLGP bonds with a market value of $55,879,000 and cash of approximately $176,142,000 segregated in special reserve bank accounts for the exclusive benefit of customers under Exchange Act Rule 15c3-3. SWS had no reserve deposits in special reserve bank accounts for the Proprietary Accounts of Introducing Brokers (“PAIB”) at March 25, 2011.

At June 25, 2010, SWS held TLGP bonds with a market value of $62,167,000 and cash of approximately $222,660,000 segregated in special reserve bank accounts for the exclusive benefit of customers under Exchange Act Rule 15c3-3. SWS had no reserve deposits in special reserve bank accounts for the PAIB at June 25, 2010.

SECURITIES AVAILABLE FOR SALE

SWS Group owns shares of common stock of USHS and Westwood, which are classified as securities available for sale. The unrealized holding gains (losses), net of tax, related to these securities are recorded as a separate component of stockholders’ equity on the consolidated statements of financial condition.

The following table summarizes the cost and market value of these investments at March 25, 2011 and June 25, 2010 (dollars in thousands):

 

     Shares      Original     

Gross

Unrealized

    

Gross

Unrealized

     Market  
     Held      Cost      Gains      Losses      Value  

March 25, 2011

              

USHS

     357,154       $ 914       $ 729       $ —         $ 1,643   

Westwood

     4,216         7         163         —           170   
                                      

Securities available for sale

      $ 921       $ 892       $ —         $ 1,813   
                                      

 

     Shares      Original     

Gross

Unrealized

    

Gross

Unrealized

     Market  
     Held      Cost      Gains      Losses      Value  

June 25, 2010

              

USHS

     357,154       $ 914       $ 232       $ —         $ 1,146   

Westwood

     6,383         89         153         —           242   
                                      

Securities available for sale

      $ 1,003       $ 385       $ —         $ 1,388   
                                      

 

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RECEIVABLE FROM AND PAYABLE TO BROKERS, DEALERS AND CLEARING ORGANIZATIONS

At March 25, 2011 and June 25, 2010, SWS had receivable from and payable to brokers, dealers and clearing organizations related to the following (in thousands):

 

     March      June  

Receivable

     

Securities failed to deliver

   $ 17,533       $ 11,096   

Securities borrowed

     2,066,510         1,798,910   

Correspondent broker/dealers

     40,849         44,998   

Clearing organizations

     30,618         20,958   

Other

     14,077         13,438   
                 
   $ 2,169,587       $ 1,889,400   
                 

Payable

     

Securities failed to receive

   $ 18,232       $ 17,705   

Securities loaned

     2,041,780         1,775,693   

Correspondent broker/dealers

     12,283         11,669   

Other

     11,623         14,928   
                 
   $ 2,083,918       $ 1,819,995   
                 

SWS participates in the securities borrowing and lending business by borrowing and lending securities other than those of its clients. SWS obtains or releases collateral as prices of the underlying securities fluctuate. At March 25, 2011, SWS had collateral of $2,066,404,000 under securities lending agreements, of which SWS had repledged $1,993,459,000. At June 25, 2010, SWS had collateral of $1,798,791,000 under securities lending agreements, of which SWS had repledged $1,732,411,000.

LOANS HELD FOR SALE

Loans held for sale consist of originated loans that were held for investment that management subsequently decided to sell as well as purchased loans held for sale.

Originated loans that are now available for sale (referred to as “other loans held for sale”) are valued at the lower of cost or market as determined by the negotiated sales price or if no sales price is yet determined, at an agreed upon acceptance price as determined by a third party valuation and management.

Other loans held for sale were transferred to the held for sale category in anticipation of immediate disposition. These were classified loans that were being marketed through an international marketing campaign. The fair value of these loans was determined using a discounted cash flow model to reflect the return required for immediate disposition of a distressed loan. These loans were valued using Level 3 valuation methodologies, see further discussion of Level 3 methodologies in “Fair Value of Financial Instruments.

Loans in the mortgage purchase program are valued at the lower of cost or market as determined by outstanding commitments from investors or current investor yield requirements calculated on the aggregate note basis. The purchased loans are pre-sold by the mortgage company to secondary investors who have been approved by the Bank. Purchased loans consist of first mortgage loans and home improvement loans, which have been purchased or originated but not yet sold in the secondary

 

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market. Gains and losses on the sale of loans held for sale in the mortgage purchase program are determined using the specific identification method.

The recorded and fair values of loans held for sale were as follows:

(in thousands)

      March 31, 2011      June 30, 2010  
     Recorded
Value
     Fair Value             Recorded
Value
     Fair Value  

Mortgage purchase program

   $ 60,603       $ 60,737          $ 424,055       $ 424,986   

Other loans held for sale

     7,215         7,215            —           —     
                                      

Total

   $ 67,818       $ 67,952          $ 424,055       $ 424,986   
                                      

LOANS AND ALLOWANCE FOR PROBABLE LOAN LOSSES

The Bank grants loans to customers primarily within Texas and New Mexico. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their loans is dependent upon the general economic conditions of Texas and New Mexico.

Loans receivable, excluding held for sale, at March 31, 2011 and June 30, 2010 are summarized as follows (in thousands):

 

     March     June  

Loans receivable:

    

Construction

   $ 79,420      $ 128,552   

Lot and land development

     70,602        121,214   

Residential mortgage

     127,525        153,031   

Commercial real estate

     431,294        515,274   

Multi-family

     55,344        75,481   

Commercial loans

     192,851        191,694   

Consumer loans

     3,673        4,692   
                
     960,709        1,189,938   

Unamortized premiums and discounts

     (514     (732
                
     960,195        1,189,206   

Allowance for probable loan losses

     (47,314     (35,141
                
   $ 912,881      $ 1,154,065   
                

In the second quarter of fiscal 2011, the Company adopted Accounting Standards Update (“ASU”) 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” The information requested by this ASU is included in the tables below.

The allowance for probable loan loss is increased by charges to income and decreased by charge-offs (net of recoveries). Management periodically evaluates the adequacy of the allowance on the Bank’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral and current economic conditions. In determining the appropriate balance at the balance sheet date, management evaluated the Bank’s historical loss percentage, concentrations of risk in the portfolio, estimated changes in the value of underlying collateral as well as changes in the volume and growth in the portfolio.

 

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The analysis of the allowance for loan losses for the three and nine-months ended March 31, 2011 and 2010 and the recorded investment in loans receivable at March 31, 2011 and 2010 was as follow (in thousands):

 

     Three-Months Ended
March 31, 2011
    Three-Months Ended
March 31, 2010
 
     Real-Estate     Non-Real
Estate
    Total     Real-Estate     Non-Real
Estate
    Total  

Allowance for credit losses:

            

Balance at beginning of period

   $ 43,141      $ 3,900      $ 47,041      $ 15,661      $ 1,940      $ 17,601   

Charge-offs

     (4,298     (298     (4,596     (12,094     (155     (12,249

Recoveries

     130        12        142        39        4        43   
                                                

Net charge-offs

     (4,168     (286     (4,454     (12,055     (151     (12,206

Additions charged to operations

     3,993        734        4,727        24,326        674        25,000   
                                                

Balance at end of period

   $ 42,966      $ 4,348      $ 47,314      $ 27,932      $ 2,463      $ 30,395   
                                                

Ending balance: individually evaluated for impairment

   $ 1,275      $ 209      $ 1,484      $ 36      $ 33      $ 69   
                                                

Ending balance: collectively evaluated for impairment

   $ 41,691      $ 4,139      $ 45,830      $ 27,896      $ 2,430      $ 30,326   
                                                

Financing receivables:

            

Balance at end of period

   $ 763,640      $ 196,555      $ 960,195      $ 990,958      $ 192,275      $ 1,183,233   
                                                

Ending balance: individually evaluated for impairment

   $ 82,278      $ 4,806      $ 87,084      $ 33,605      $ 384      $ 33,989   
                                                

Ending balance: collectively evaluated for impairment

   $ 681,362      $ 191,749      $ 873,111      $ 957,353      $ 191,891      $ 1,149,244   
                                                
     Nine-Months Ended
March 31, 2011
    Nine-Months Ended
March 31, 2010
 
     Real-Estate     Non-Real
Estate
    Total     Real-Estate     Non-Real
Estate
    Total  

Allowance for credit losses:

            

Balance at beginning of period

   $ 32,257      $ 2,884      $ 35,141      $ 13,412      $ 1,319      $ 14,731   

Charge-offs

     (37,299     (1,976     (39,275     (17,579     (1,271     (18,850

Recoveries

     425        56        481        61        33        94   
                                                

Net charge-offs

     (36,874     (1,920     (38,794     (17,518     (1,238     (18,756

Additions charged to operations

     47,583        3,384        50,967        32,038        2,382        34,420   
                                                

Balance at end of period

   $ 42,966      $ 4,348      $ 47,314      $ 27,932      $ 2,463      $ 30,395   
                                                

The allowance to ending loan balance ratio as of March 31, 2011 and March 31, 2010 was 4.93% and 2.57%, respectively.

 

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Loans receivable on non-accrual status as of March 31, 2011 and June 30, 2010 were as follows (in thousands):

 

     March 31,
2011
     June 30,
2010
 

Real estate:

     

1-4 family

   $ 3,334       $ 6,065   

Lot and land development

     20,261         8,776   

Multi-family

     16,633         2,394   

Residential construction

     7,345         3,809   

Commercial real estate

     24,607         16,911   

Non-real estate:

     

Commercial loans

     3,673         462   

Consumer loans

     81         11   
                 
   $ 75,934       $ 38,428   
                 

Loans are classified as non-performing when they are 90 days or more past due as to principal or interest or when reasonable doubt exists as to timely collectability. The Bank uses a standardized review process to determine which loans should be placed on non-accrual status. At the time a loan is placed on non-accrual status, previously accrued and uncollected interest is reversed against interest income. Interest income on non-accrual loans is subsequently recognized to the extent cash payments are received for loans where ultimate full collection is likely. For loans where ultimate collection is not likely, interest payments are applied to the outstanding principal and income is only recognized if full payment is made. The average recorded investment in non-accrual loans was approximately $61,633,000 during the nine-months ended March 31, 2011 and $29,653,000 during the nine-months ended March 31, 2010. The Bank did not recognize any income on non-accrual loans during the three and nine-months ended March 31, 2011 and March 31, 2010.

The following tables highlight the Bank’s recorded investment and unpaid principal balance for impaired loans by type as well as the related allowance, average recorded investment and interest income recognized as of March 31, 2011 and June 30, 2010 (in thousands):

 

     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Average
Recorded
Investment( *)
     Interest
Income
Recognized( #)
 

March 31, 2011 With no related allowance recorded:

              

1-4 family

   $ 3,181       $ 3,510       $  —         $ 6,933       $  —     

Lot and land development

     21,320         24,007         —           11,508         50   

Multi-family

     16,633         16,815         —           8,666         —     

Residential construction

     7,345         7,816         —           2,508         —     

Commercial real estate

     19,766         22,318         —           14,163         —     

Commercial loans

     3,359         4,136         —           1,428         —     

Consumer loans

     80         217         —           118         —     
                                            
     71,684         78,819         —           45,324         50   
                                            

 

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     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Average
Recorded
Investment( *)
     Interest
Income
Recognized( #)
 

With an allowance recorded:

              

1-4 family

   $ 2,372       $ 2,372       $ 387       $ 3,370       $ 115   

Lot and land development

     170         170         5         1,505         9   

Multi-family

     —           —           —           4,835         —     

Residential construction

     232         232         2         78         12   

Commercial real estate

     11,259         11,259         881         14,121         536   

Commercial loans

     1,367         1,366         209         414         61   
                                            
     15,400         15,399         1,484         24,323         733   
                                            

Total

              

1-4 family

     5,553         5,882         387         10,303         115   

Lot and land development

     21,490         24,177         5         13,013         59   

Multi-family

     16,633         16,815         —           13,501         —     

Residential construction

     7,577         8,048         2         2,586         12   

Commercial real estate

     31,025         33,577         881         28,284         536   

Commercial loans

     4,726         5,502         209         1,842         61   

Consumer loans

     80         217         —           118         —     
                                            
   $ 87,084       $ 94,218       $ 1,484       $ 69,647       $ 783   
                                            

 

(*) 

Represents the average of each month-end recorded investment for the nine-months ended March 31, 2011.

(#)

Represents interest income recognized on impaired loans for the nine-months ended March 31, 2011. No material amount of interest income was recognized on impaired loans for the nine-months ended March 31, 2010.

 

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     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Average
Recorded
Investment( *)
     Interest
Income
Recognized( #)
 

June 30, 2010 With no related allowance recorded:

              

1-4 family

   $ 6,177       $ 6,915       $ —         $ 4,091       $ —     

Lot and land development

     9,514         10,040         —           5,879         127   

Multi-family

     2,394         4,896         —           802         —     

Residential construction

     3,839         4,039         —           4,377         —     

Commercial real estate

     9,350         12,983         —           7,626         —     

Commercial loans

     462         997         —           1,297         —     

Consumer loans

     11         17         —           4         —     
                                            
     31,747         39,887         —           24,076         127   
                                            

With an allowance recorded:

              

1-4 family

     —           —           —           1,352         —     

Lot and land development

     1,626         1,626         450         2,082         —     

Multi-family

     —           —           —           1,207         —     

Residential construction

     —           —           —           1,543         —     

Commercial real estate

     7,561         7,574         2,761         3,130         —     

Commercial loans

     —           —           —           456         —     

Consumer loans

     —           —           —           5         —     
                                            
     9,187         9,200         3,211         9,775         —     
                                            

Total

              

1-4 family

     6,177         6,915         —           5,443         —     

Lot and land development

     11,140         11,666         450         7,961         127   

Multi-family

     2,394         4,896         —           2,009         —     

Residential construction

     3,839         4,039         —           5,920         —     

Commercial real estate

     16,911         20,557         2,761         10,756         —     

Commercial loans

     462         997         —           1,753         —     

Consumer loans

     11         17         —           9         —     
                                            
   $ 40,934       $ 49,087       $  3,211       $ 33,851       $  127   
                                            

 

(*) Represents the average recorded investment for the twelve-months ended June 30, 2010.

( # ) Represents interest income recognized on impaired loans for the twelve-months ended June 30, 2010.

In compliance with the Order to Cease and Desist, Order No. WN-11-003, effective on February 4, 2011 (the “Order”), the Bank implemented processes to continuously monitor the credit quality of the loan portfolio as well as compliance with both internal policies and regulatory guidance. These processes include an internal credit review department and the use of external credit review consultants. Reports provided by these groups to management and the Board assist in overall risk

 

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mitigation for the loan portfolio and with compliance with the Order. See “Cease and Desist Order with the Office of Thrift Supervision.”

The Bank prepares a criticized and classified loan report that it uses to assist in calculating an adequate allowance for loan losses. The following tables summarize this report and highlight the overall quality of the Bank’s financing receivables, excluding loans held for sale, as of March 31, 2011 and June 30, 2010 (in thousands):

 

     Pass      Special
Mention(*)
     Substandard(#)      Total  

March 31, 2011

           

1-4 family

   $ 106,619       $ 46       $ 20,684       $ 127,349   

Lot and land development

     31,209         —           39,310         70,519   

Multi-family

     33,163         6,255         15,907         55,325   

Residential construction

     31,618         1,565         16,467         49,650   

Commercial real estate

     342,307         3,321         115,169         460,797   

Commercial loans

     179,329         257         13,296         192,882   

Consumer loans

     3,665         —           8         3,673   
                                   
   $ 727,910       $ 11,444       $ 220,841       $ 960,195   
                                   
     Pass      Special
Mention(*)
     Substandard(#)      Total  

June 30, 2010

           

1-4 family

   $ 138,470       $ 876       $ 13,449       $ 152,795   

Lot and land development

     90,870         —           30,213         121,083   

Multi-family

     64,169         16,440         2,394         83,003   

Residential construction

     70,178         —           10,285         80,463   

Commercial real estate

     463,019         13,462         78,944         555,425   

Commercial loans

     187,344         —           4,401         191,745   

Consumer loans

     4,681         —           11         4,692   
                                   
   $ 1,018,731       $ 30,778       $ 139,697       $ 1,189,206   
                                   

 

(*) These loans are currently protected by the current sound worth and paying capacity of the obligor, but have a potential weakness that would create a higher credit risk.

(#) These loans exhibit well defined weaknesses that could jeopardize the ultimate collection of all or part of the debt. Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate for substandard assets, does not have to exist in individual assets classified as “Substandard”.

 

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The following tables highlight the age analysis of the Bank’s financing receivables as of March 31, 2011 and June 30, 2010 (in thousands):

Age Analysis of Past Due Financing Receivables

As of March 31, 2011

 

     30-59 Days
Past Due
     60-89 Days
Past Due
     90 Days
and
Greater
     Total Past
Due
     Current      Total
Financing
Receivables
     Recorded
Investment
>90 Days and
Accruing
 

March 31, 2011

                    

1-4 family

   $ 2,776       $ 866       $ 1,326       $ 4,968       $ 122,381       $ 127,349       $  —     

Lot and land development

     799         1,686         2,717         5,202         65,317         70,519         —     

Multi-family

     1,576         —           2,260         3,836         51,489         55,325         —     

Residential construction

     289         722         3,945         4,956         44,694         49,650         —     

Commercial real estate

     2,674         4,127         4,993         11,794         449,003         460,797         —     

Commercial loans

     2,773         295         700         3,768         189,114         192,882         —     

Consumer loans

     76         —           109         185         3,488         3,673         —     
                                                              

Total

   $ 10,963       $ 7,696       $ 16,050       $ 34,709       $ 925,486       $ 960,195       $  —     
                                                              

 

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Age Analysis of Past Due Financing Receivables

As of June 30, 2010

 

     30-59 Days
Past Due
     60-89 Days
Past Due
     90 Days
and
Greater
     Total
Past Due
     Current      Total
Financing
Receivables
     Recorded
Investment
>90 Days
and
Accruing
 

June 30, 2010

                    

1-4 family

   $ 2,384       $ 1,158       $ 3,302       $ 6,844       $ 145,951       $ 152,795       $ 29   

Lot and land development

     1,150         4,134         2,708         7,992         113,091         121,083         —     

Multi-family

     —           —           2,394         2,394         80,609         83,003         —     

Residential construction

     —           367         1,701         2,068         78,395         80,463         —     

Commercial real estate

     168         2,845         6,181         9,194         546,231         555,425         —     

Commercial Loans

     32         —           263         295         191,450         191,745         —     

Consumer loans

     1         —           —           1         4,691         4,692         —     
                                                              

Total

   $ 3,735       $ 8,504       $ 16,549       $ 28,788       $ 1,160,418       $ 1,189,206       $ 29   
                                                              

 

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Table of Contents

During the three-months ended March 31, 2011, the Bank sold $4,400,000 of participations in certain loans subject to small business administration (“SBA”) guarantees with a total unpaid principal balance of $4,563,000. The guaranteed portion of these loans are subject to a 90-day recourse period related to the borrower’s timely payments, and sale accounting for the participations has been deferred until this recourse period has expired. As such, included in the Bank’s loan and short-term borrowing balances at March 31, 2011, was $4,400,000 of loans sold prior to March 31, 2011. The amounts sold represent the guaranteed portion of the SBA loans. The non-guaranteed portion of the loans was retained by the Bank. Additionally, loan origination fees of $380,000 received by the Bank related to the guaranteed portion of these loans will be deferred until the 90-day recourse period has expired, at which time this amount will be recognized as income.

Fair values of loans receivable are estimated for portfolios of loans with similar characteristics. Loans are segregated by type, such as real estate, commercial and consumer, which are further segregated into fixed and adjustable rate interest terms. The fair value of loans receivable is calculated by discounting scheduled cash flows through the estimated maturity using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics. The fair value of loans receivable was $988,014,000 and $1,264,675,000 at March 31, 2011 and June 30, 2010, respectively.

REAL ESTATE OWNED (“REO”) AND OTHER REPOSSESSED ASSETS

REO and other repossessed assets are valued at the lower of cost or market, less a selling discount, and are included in other assets on the consolidated statement of financial condition. REO and other repossessed assets are valued using Level 3 valuation methodologies, see further discussion of Level 3 methodologies in “Fair Value of Financial Instruments.” For those investments where the REO is valued at market, the value is determined by third party appraisals, or if the REO is being sold in an auction, by accepted bid amount. For those REO assets that are in an auction and a bid has not been accepted, a fair value estimate is derived by utilizing market data including appraised value adjusted for distressed sales. In certain circumstances, the Company adjusts appraised values to more accurately reflect the economic conditions of the area at the time of valuation. These adjustments are largely based on the historical loss on sales of REO properties. Included in other repossessed assets are land leases which are valued using a discounted cash flow analysis. The fair value of REO and other repossessed assets was $28,144,000 and $46,194,000 at March 31, 2011 and June 30, 2010, respectively. The amount of additional write-downs required to reflect current fair value was $1,806,000 and $13,349,000 for the three and nine-months ended March 31, 2011, respectively, and $1,687,000 and $3,608,000 for the three and nine-months ended March 31, 2010, respectively.

SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED

Securities owned and securities sold, not yet purchased at March 25, 2011 and June 25, 2010, which are carried at market value, consist of the following (in thousands):

 

     March      June  

Securities owned

     

Corporate equity securities

   $ 6,263       $ 12,734   

Municipal obligations

     117,586         132,142   

U.S. government agency obligations

     25,162         19,518   

Corporate obligations

     102,904         70,844   

Other

     14,677         10,349   
                 
   $ 266,592       $ 245,587   
                 

 

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Table of Contents
      March      June  

Securities sold, not yet purchased

     

Corporate equity securities

   $ 880       $ 925   

Municipal obligations

     —           17   

U.S. government agency obligations

     61,991         45,326   

Corporate obligations

     30,289         20,867   

Other

     576         459   
                 
   $ 93,736       $ 67,594   
                 

Certain of the above securities were pledged to secure short-term borrowings and as security deposits at clearing organizations for SWS’s clearing business. See additional discussion in “Short-Term Borrowings.” Securities pledged as security deposits at clearing organizations were $2,749,000 and $2,899,000 at March 25, 2011 and June 25, 2010, respectively. Additionally, at March 25, 2011 and June 25, 2010, SWS had pledged firm securities valued at $914,000 and $1,089,000, respectively, in conjunction with securities lending activities.

SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL

Transactions involving purchases of securities under agreement to resell (“reverse repurchase agreements”) are accounted for as collateralized financings except where SWS does not have an agreement to sell the same or substantially the same securities before maturity at a fixed or determinable price. At March 25, 2011, SWS held reverse repurchase agreements totaling $57,974,000, collateralized by U.S. government and government agency obligations with a market value of approximately $57,531,000. At June 25, 2010, SWS held reverse repurchase agreements totaling $30,507,000, collateralized by U.S. government and government agency obligations with a market value of approximately $30,465,000.

GOODWILL

SWS performed its annual assessment of the fair value of goodwill during fiscal 2010 in June 2010 and, based on the results of the assessment, SWS’s goodwill balance was not impaired. SWS bases its assessment of the fair value of the business units with goodwill on a weighted average of a discounted cash flow model estimate of fair value and a market multiple approach to fair value.

There were no events in the nine-months ended March 25, 2011 that would trigger an interim assessment of the fair value of goodwill. SWS’s goodwill balance was $7,552,000 at March 25, 2011, of which $4,254,000 was in the clearing segment and $3,298,000 was in the institutional segment.

INTANGIBLE ASSETS

On March 22, 2006, the Company entered into an agreement with TD Ameritrade Holding Corporation (“Ameritrade”), to transfer its correspondent clients to the Company. This transaction closed in July 2006. Of the maximum agreed upon purchase price of $5,800,000, $2,382,000 was paid upon closing with the remainder paid on the one year anniversary of the closing date. SWS paid an additional $2,678,000 in July 2007 under the terms of the agreement. As a result of these transactions, the Company recorded a customer relationship intangible of $5,060,000. The intangible asset is amortized over a five year period at a rate based on the estimated future economic benefit of the customer relationships. SWS recognized approximately $196,000 and $589,000, respectively, and $236,000 and $707,000, respectively, of amortization expense for the three and nine-months ended March 25, 2011 and March 26, 2010. The net intangible asset of $203,000 is included in other assets on the consolidated statements of financial condition. SWS performed its annual analysis of the impairment of its intangible asset in June 2010 and, based on its analysis, SWS’s intangible asset balance was not impaired. Nothing came to SWS’s attention in the first nine-months of fiscal 2011 that would require SWS to reperform this analysis.

 

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Table of Contents

SHORT-TERM BORROWINGS

Brokerage. Southwest Securities has credit arrangements with commercial banks, which include broker loan lines up to $300,000,000. These lines of credit are used primarily to finance securities owned, securities held for correspondent broker/dealer accounts, receivables in customers’ margin accounts and underwriting activities. These lines may also be used to release pledged collateral against day loans. These credit arrangements are provided on an “as offered” basis and are not committed lines of credit. These arrangements can be terminated at any time by the lender. Any outstanding balance under these credit arrangements is due on demand and bears interest at rates indexed to the federal funds rate. At March 25, 2011, the amount outstanding under these secured arrangements was $136,000,000, which was collateralized by securities held for firm accounts valued at $167,949,000. At June 25, 2010, the amount outstanding under these secured arrangements was $110,000,000, which was collateralized by securities held for firm accounts valued at $167,564,000.

SWS had $250,000 outstanding under unsecured letters of credit at March 25, 2011 and June 25, 2010, pledged to support its open positions with securities clearing organizations. The letters of credit bear a 1% commitment fee and are renewable semi-annually.

At June 25, 2010, SWS had an additional unsecured letter of credit issued for a sub-lease of space previously occupied by Mydiscountbroker.com, a subsidiary of SWS that was dissolved in July 2004, in the amount $143,000. This letter of credit expired September 10, 2010.

SWS also had $500,000 outstanding under an unsecured letter of credit at March 25, 2011 and June 25, 2010, pledged to support its underwriting activities. The letter of credit bears a 1% commitment fee and is renewable annually at SWS’s option.

In addition to the broker loan lines, at March 25, 2011 and June 25, 2010, SWS had a $20,000,000 unsecured line of credit that is due on demand and bears interest at rates indexed to the federal funds rate. This credit arrangement is provided on an “as offered” basis and is not a committed line of credit. The total amount of borrowings available under this line of credit is reduced by the amount outstanding on the line and under any unsecured letters of credit at the time of borrowing. At March 25, 2011, there were no amounts outstanding on this line, other than the $750,000 under unsecured letters of credit referenced above. At June 25, 2010, there were no amounts outstanding on this line, other than the $893,000 under unsecured letters of credit referenced above. At March 25, 2011 and June 25, 2010, the total amount available for borrowing was $19,250,000 and $19,107,000, respectively.

At both March 25, 2011 and June 25, 2010, SWS had an irrevocable letter of credit agreement aggregating $55,000,000 pledged to support customer open options positions with an options clearing organization. The letter of credit bears interest at the brokers’ call rate (0.5% at March 25, 2011), if drawn, and is renewable semi-annually. The letter of credit is fully collateralized by marketable securities held in client and non-client margin accounts with a value of $80,535,000 and $80,946,000 at March 25, 2011 and June 25, 2010, respectively.

On January 29, 2010, Southwest Securities entered into an agreement with an unaffiliated bank for a $50,000,000 committed revolving credit facility. The facility includes up to $15,000,000 in unsecured credit. The commitment fee is 37.5 basis points and when drawn, the interest rate is equal to the federal funds rate plus 75 basis points. The agreement provides that Southwest Securities must maintain tangible net worth of $150,000,000. On January 28, 2011, Southwest Securities renewed this facility. The new facility provides up to $45,000,000 of secured borrowings. As of March 25, 2011, there was $45,000,000 outstanding under the committed revolving credit facility. The $45,000,000 of secured borrowings was collateralized by securities with a value of $72,652,000 at March 25, 2011.

In addition to using customer securities to collateralize bank loans, SWS also loans client securities as collateral in conjunction with SWS’s securities lending activities. At March 25, 2011,

 

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approximately $318,712,000 of client securities under customer margin loans was available to be pledged, of which SWS had pledged $48,321,000 under securities loan agreements. At June 25, 2010, approximately $275,260,000 of client securities under customer margin loans was available to be pledged, of which SWS had pledged $41,629,000 under securities loan agreements.

Banking. At June 30, 2010, the Bank had an agreement with an unaffiliated bank for a $30,000,000 unsecured line of credit for the purchase of federal funds with a floating interest rate. The unaffiliated bank was not obligated by this agreement to sell federal funds to the Bank. The proceeds from the line of credit were used by the Bank to support short-term liquidity needs. In December 2010, this agreement was cancelled. At June 30, 2010, there were no amounts outstanding on this line of credit.

In the second quarter of fiscal 2010, the Bank entered into a secured line of credit agreement with the Federal Reserve Bank of Dallas. This line of credit is secured by the Bank’s commercial loan portfolio. This line is due on demand and bears interest at a rate equal to the federal funds target rate plus 100 basis points. At March 31, 2011, the total amount available under this line was $83,767,000 and there was no amount outstanding.

The Bank sold $4,400,000 of participations in certain loans subject to SBA guarantees with a total unpaid principal balance of $4,563,000, during the three-months ended March 31, 2011. The guaranteed portion of these loans are subject to a 90-day recourse period related to the borrower’s timely payments, and sale accounting for the participations has been deferred until this recourse period has expired. As such, included in the Bank’s loan and short-term borrowing balances at March 31, 2011, was $4,400,000 of loans sold prior to March 31, 2011. The amounts sold represent the guaranteed portion of the SBA loans. The non-guaranteed portion of the loans was retained by the Bank. Additionally, loan origination fees of $380,000 received by the Bank related to the guaranteed portion of these loans will be deferred until the 90-day recourse period has expired, at which time this amount will be recognized as income.

DEPOSITS

Deposits at March 31, 2011 and June 30, 2010 are summarized as follows (dollars in thousands):

 

     March     June  
     Amount      Percent     Amount      Percent  

Non-interest bearing demand accounts

   $ 72,753         6.5   $ 80,590         5.4

Interest bearing demand accounts

     11,616         1.0        99,529         6.7   

Savings accounts

     956,014         85.4        1,197,659         80.5   

Limited access money market accounts

     26,911         2.4        37,929         2.5   

Certificates of deposit, less than $100,000

     29,052         2.6        38,861         2.6   

Certificates of deposit, $100,000 and greater

     23,744         2.1        34,236         2.3   
                                  
   $ 1,120,090         100.0   $ 1,488,804         100.0
                                  

The weighted average interest rate on deposits was approximately 0.13% at March 31, 2011 and 0.25% at June 30, 2010.

 

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At March 31, 2011, scheduled maturities of certificates of deposit were as follows (in thousands):

 

     1 Year or
Less
     > 1 Year
Through
2 Years
     > 2 Years
Through
3 Years
     > 3 Years
Through
4 Years
     Thereafter      Total  

Certificates of deposit, less than $100,000

   $ 20,625       $ 3,271       $ 1,078       $ 3,072       $ 1,006       $ 29,052   

Certificates of deposit, $100,000 and greater

     16,218         3,127         539         3,236         624         23,744   
                                                     
   $ 36,843       $ 6,398       $ 1,617       $ 6,308       $ 1,630       $ 52,796   
                                                     

The Bank is funded primarily by core deposits, with interest bearing checking accounts and savings accounts from Southwest Securities’ customers making up a significant source of these deposits.

The fair value of deposits with no stated maturity, such as interest-bearing checking accounts, passbook savings accounts and advance payments from borrowers for taxes and insurance, are equal to the amount payable on demand (carrying value), as these deposits are very liquid and can reprice immediately. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value of certificates of deposit was $53,447,000 and $74,155,000 at March 31, 2011 and June 30, 2010, respectively. The fair value of other deposits was $1,067,377,000 and $1,415,528,000 at March 31, 2011 and June 30, 2010, respectively.

SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Securities sold under repurchase agreements, which are secured borrowings, generally mature within one to four days from the transaction date. Securities sold under repurchase agreements are reflected at the amount of cash received in connection with the transactions. The Company may be required to provide additional collateral based on the fair value of the underlying securities. The Company monitors the fair value of the underlying securities on a daily basis. Securities sold under repurchase agreements at March 25, 2011 and June 25, 2010 were $7,217,000 and $12,389,000, respectively.

ADVANCES FROM THE FEDERAL HOME LOAN BANK

At March 31, 2011 and June 30, 2010, advances from the Federal Home Loan Bank (“FHLB”) were due as follows (in thousands):

 

     March      June  

Maturity:

     

Due within one year

   $ 4,872       $ 33,714   

Due within two years

     14,160         9,376   

Due within five years

     39,267         48,050   

Due within seven years

     3,224         6,274   

Due within ten years

     9,754         5,486   

Due within twenty years

     25,532         29,921   
                 
   $ 96,809       $ 132,821   
                 

At March 31, 2011 (calculated at December 31, 2010), the advances from the FHLB had interest rates ranging from 2% to 7% and were collateralized by approximately $370,000,000 of collateral value (as defined) in qualifying loans. At June 30, 2010 (calculated at March 31, 2010), the advances from the FHLB had interest rates from 0.1% to 7% and were collateralized by approximately $483,000,000 of collateral value in qualifying loans.

 

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The fair value of advances from the FHLB is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for borrowings of similar remaining maturities. The fair value of advances from the FHLB was $107,222,000 and $146,560,000 at March 31, 2011 and June 30, 2010, respectively.

REGULATORY CAPITAL REQUIREMENTS

Brokerage. The Company’s broker/dealer subsidiaries are subject to the SEC’s Uniform Net Capital Rule (the “Rule”), which requires the maintenance of minimum net capital. Southwest Securities has elected to use the alternative method, permitted by the Rule, which requires that it maintain minimum net capital, as defined in Rule 15c3-1 of the Exchange Act, equal to the greater of $1,000,000 or 2% of aggregate debit balances, as defined in Rule 15c3-3 of the Exchange Act. At March 25, 2011, Southwest Securities had net capital of $114,231,000, or approximately 35.5% of aggregate debit balances, which was $107,787,000 in excess of its minimum net capital requirement of $6,444,000 at that date. Additionally, the net capital rule of the NYSE provides that equity capital may not be withdrawn or cash dividends paid if resulting net capital would be less than 5% of aggregate debit items. At March 25, 2011, Southwest Securities had net capital of $98,122,000 in excess of 5% of aggregate debit items.

SWS Financial follows the primary (aggregate indebtedness) method under Exchange Act Rule 15c3-1, which requires the maintenance of the larger of minimum net capital of $250,000 or 1/15 of aggregate indebtedness. At March 25, 2011, the net capital and excess net capital of SWS Financial was $926,000 and $676,000, respectively.

Banking. The Bank is subject to various regulatory capital requirements administered by federal agencies. Quantitative measures, established by regulation to ensure capital adequacy, require maintaining minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in 12 CFR 565 and 12 CFR 567) to risk-weighted assets (as defined ) and of Tier I (core) capital (as defined) to adjusted assets (as defined). Federal statutes and OTS regulations have established five capital categories for federal savings banks: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The federal banking agencies have jointly specified by regulation the relevant capital level for each category. An institution is defined as well-capitalized when its total risk-based capital ratio is at least 10.00%, its Tier I risk-based capital ratio is at least 6.00%, its Tier I (core) capital ratio is at least 5.00%, and it is not subject to any federal supervisory order or directive to meet a specific capital level.

On February 4, 2011, the Board of Directors of the Bank signed a Stipulation and Consent to Issuance of Order to Cease and Desist (the “Stipulation”) and the OTS issued the Order. Accordingly, as a result of the issuance of the Order, effective February 4, 2011, the Bank was deemed to be “adequately capitalized” and no longer met the definition of “well capitalized” under federal statutes and OTS regulations even though its capital ratios met or exceeded all applicable requirements under Federal law, OTS regulations and the Order. See additional discussion in “Cease and Desist Order with the Office of Thrift Supervision.” As of June 30, 2010, the Bank met all capital requirements to which it was subject and satisfied the requirements to be defined as a well-capitalized institution. As of March 31, 2011, the Bank’s total risk-based capital ratio was 14.5%, resulting in $24,947,000 in excess capital over the Order’s total risk-based capital requirement of $117,517,000, and its Tier I risk-based capital ratio was 13.3% and its Tier I (core) capital ratio was 9.6%, resulting in $21,831,000 in excess capital over the Order’s Tier I (core) capital requirement of $108,391,000.

 

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The Bank’s actual capital amounts and ratios are presented in the following tables (dollars in thousands):

 

     Actual     For Capital
Adequacy
Purposes
    To Be Well
Capitalized Under
Prompt Corrective
Action Provisions
    Order’s Capital
Requirements
 
     Amount      Ratio     Amount      Ratio     Amount      Ratio     Amount      Ratio  

March 31, 2011:

                    

Total risk-based capital

   $ 142,464         14.5   $ 78,345         8.0   $ 97,931         10.0   $ 117,517         12.0

Tier I risk-based capital

     130,222         13.3        39,172         4.0        58,759         6.0        78,345         8.0   

Tier I (core) capital

     130,222         9.6        54,196         4.0        67,745         5.0        108,391         8.0   

June 30, 2010:

                    

Total risk-based capital

   $ 172,483         12.2   $ 113,015         8.0   $ 141,268         10.0     

Tier I risk-based capital

     154,824         11.0        56,507         4.0        84,761         6.0        

Tier I (core) capital

     154,824         8.7        71,958         4.0        89,948         5.0        

 

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LOSS PER SHARE (“EPS”)

A reconciliation between the weighted average shares outstanding used in the calculation of basic and diluted EPS is as follows for the three and nine-month periods ended March 25, 2011 and March 26, 2010 (in thousands, except share and per share amounts):

 

     Three-Months Ended     Nine-Months Ended  
     March 25,
2011
    March 26,
2010
    March 25,
2011
    March 26,
2010
 

Net loss

   $ (2,147   $ (11,540   $ (23,225   $ (2,588

Dividends on estimated forfeitures-restricted Stock

     —          3        2        8   
                                

Adjusted net loss

   $ (2,147   $ (11,537   $ (23,223   $ (2,580
                                

Weighted average shares outstanding – basic(*)

     32,501,344        32,544,021        32,510,570        29,489,035   

Effect of dilutive securities:

        

Assumed exercise of stock options

     —          —          —          —     
                                

Weighted average shares outstanding – Diluted

     32,501,344        32,544,021        32,510,570        29,489,035   
                                

Loss per share – basic

        

Net loss

   $ (0.07   $ (0.35   $ (0.71   $ (0.09
                                

Loss per share – diluted

        

Net loss

   $ (0.07   $ (0.35   $ (0.71   $ (0.09
                                

 

(*) Unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (paid or unpaid) are treated as participating securities and are factored into the calculation of EPS, except in periods with a net loss, when they are excluded.

At March 25, 2011, there were options to acquire approximately 198,000 shares of common stock outstanding under the 1996 Plan. At March 26, 2010, there were options to acquire 425,000 shares of common stock outstanding under the 1996 Plan and the SWS Group, Inc. 1997 Stock Option Plan. See “Employee Benefits.” As a result of the net loss in the three and nine-months ended March 25, 2011 and March 26, 2010, respectively, all options were anti-dilutive and were not included in the calculation of diluted weighted average shares outstanding and diluted earnings per share.

Dividends per share for the three-months ended March 25, 2011 and March 26, 2010 were $0.01 and $0.09, respectively.

OFFERING OF COMMON STOCK

On October 16, 2009, the Company filed a shelf registration statement with the SEC in the amount of $150,000,000. On December 9, 2009, the Company closed a public offering of 4,347,827 shares of its common stock at a price of $11.50 per share. On December 16, 2009, the underwriters for the public offering exercised their option to purchase an additional 652,174 shares of SWS Group common stock to cover over-allotments. The Company generated net proceeds from these common stock offerings, after deducting underwriting discounts and commissions, of approximately $54,354,000.

REPURCHASE OF TREASURY STOCK

Periodically, SWS repurchases common stock under a plan approved by the Board of Directors. Currently, SWS is authorized to repurchase 500,000 shares of common stock from time to time in the open market, expiring February 28, 2012. No shares were repurchased by SWS under this program during the nine-months ended March 25, 2011. As of March 26, 2010, no shares were repurchased by SWS under the program in place as of that date.

 

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Additionally, the trustee under SWS’s deferred compensation plan periodically purchases common stock in the open market in accordance with the terms of the plan. This stock is classified as treasury stock in the consolidated financial statements, but participates in future dividends declared by SWS. The plan purchased 53,000 shares in the nine-months ended March 25, 2011, at a cost of approximately $340,000, or $6.42 per share. The plan purchased 15,099 shares in the nine-months ended March 26, 2010, at a cost of approximately $228,000, or $15.09 per share. The plan distributed 20,560 shares to participants in the nine-months ended March 25, 2011.

Upon vesting of the shares granted under the Restricted Stock Plan, the grantees may choose to sell a portion of their vested shares to the Company to cover the tax liabilities arising from the vesting. As a result, 18,183 shares were repurchased with a market value of approximately $131,000, or an average price of $7.22 per share, in the nine-months ended March 25, 2011. In the nine-months ended March 26, 2010, 32,100 shares were repurchased with a market value of $459,383, or an average of $14.31 per share.

SEGMENT REPORTING

SWS operates four business segments:

 

   

Clearing: The clearing segment provides clearing and execution services (generally on a fully disclosed basis) for general securities broker/dealers, for bank affiliated firms and firms specializing in high volume trading.

 

   

Retail: The retail brokerage segment includes retail securities products and services (equities, mutual funds and fixed income products), insurance products and managed accounts and encompasses the activities of our employee registered representatives and our independent representatives who are under contract with SWS Financial.

 

   

Institutional: The institutional brokerage segment serves institutional customers in securities lending, investment banking and public finance, fixed income sales and trading, proprietary trading and agency execution services.

 

   

Banking: The Bank offers traditional banking products and services and focuses on small business lending and short-term funding for mortgage bankers.

Clearing and institutional brokerage services are offered exclusively through Southwest Securities. The Bank and its subsidiaries comprise the banking segment. Retail brokerage services are offered through Southwest Securities (the Private Client Group and the Managed Advisors Accounts department), SWS Insurance, and through SWS Financial (which contracts with independent representatives for the administration of their securities business).

SWS’s segments are managed separately based on types of products and services offered and their related client bases. The segments are consistent with how the Company manages its resources and assesses its performance. Management assesses performance based primarily on income before income taxes and net interest revenue (expense). As a result, SWS reports net interest revenue (expense) by segment. SWS’s business segment information is prepared using the following methodologies:

 

   

the financial results for each segment are determined using the same policies as those described in Note 1, “Significant Accounting Policies,” to the Company’s audited consolidated financial statements contained in the Company’s Form 10-K for the fiscal year ended June 25, 2010;

 

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segment financial information includes the allocation of interest based on each segment’s earned interest spreads;

 

   

information system and operational expenses are allocated based on each segment’s usage;

 

   

shared securities execution facilities expenses are allocated to the segments based on production levels;

 

   

money market fee revenue is allocated based on each segment’s average balances; and

 

   

clearing charges are allocated based on clearing levels from each segment.

Intersegment balances are eliminated upon consolidation and have been applied to the appropriate segment.

The “other” category includes SWS Group, corporate administration and SWS Capital. SWS Capital is a dormant entity which holds approximately $20,000 of assets. SWS Group is a holding company that owns various investments, including USHS common stock.

 

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The following table presents the Company’s operations by the segments outlined above for the three and nine-months ended March 25, 2011 and March 26, 2010:

UNAUDITED QUARTERLY FINANCIAL INFORMATION

 

(in thousands)

   Clearing     Retail     Institutional      Banking     Other     Consolidated
SWS Group, Inc.
 

Three-months ended March 25, 2011

             

Operating revenue

   $ 3,838      $ 24,928      $ 29,428       $ (355   $ 48      $ 57,887   

Net intersegment revenues

     (235     258        151         917        (1,091     —     

Net interest revenue

     1,441        668        3,363         14,226        342        20,040   

Net revenues

     5,279        25,596        32,791         13,871        390        77,927   

Operating expenses

     5,323        26,246        23,270         17,624        8,865        81,328   

Depreciation and amortization

     215        229        145         612        595        1,796   

Income (loss) before taxes

     (44     (650     9,521         (3,753     (8,475     (3,401

Three-months ended March 26, 2010

             

Operating revenue

   $ 3,539      $ 26,523      $ 28,802       $ (422   $ 581      $ 59,023   

Net intersegment revenues

     (207     235        78         939        (1,045     —     

Net interest revenue

     1,386        755        3,800         18,152        (115     23,978   

Net revenues

     4,925        27,278        32,602         17,730        466        83,001   

Operating expenses

     4,829        28,244        23,068         37,852        7,307        101,300   

Depreciation and amortization

     243        261        141         624        501        1,770   

Income (loss) before taxes

     96        (966     9,534         (20,122     (6,841     (18,299

 

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UNAUDITED QUARTERLY FINANCIAL INFORMATION

 

(in thousands)

   Clearing     Retail     Institutional      Banking     Other     Consolidated
SWS Group, Inc.
 

Nine-months ended March 25, 2011

             

Operating revenue

   $ 11,686      $ 80,998      $ 101,383       $ (1,275   $ 1,104      $ 193,896   

Net intersegment revenues

     (668     731        321         2,850        (3,234     —     

Net interest revenue

     4,415        2,223        12,269         52,319        758        71,984   

Net revenues

     16,101        83,221        113,652         51,044        1,862        265,880   

Operating expenses

     15,313        82,030        76,209         98,558        28,162        300,272   

Depreciation and amortization

     645        714        434         1,848        1,836        5,477   

Income (loss) before taxes

     788        1,191        37,443         (47,514     (26,300     (34,392

Assets(*)

     341,375        183,516        2,426,935         1,368,813        35,246        4,355,885   

Nine-months ended March 26, 2010

             

Operating revenue

   $ 11,020      $ 80,430      $ 109,388       $ 488      $ 1,936      $ 203,262   

Net intersegment revenues

     (664     906        900         2,755        (3,897     —     

Net interest revenue

     4,327        2,197        12,748         55,300        (203     74,369   

Net revenues

     15,347        82,627        122,136         55,788        1,733        277,631   

Operating expenses

     21,244        83,299        80,352         69,970        27,133        281,998   

Depreciation and amortization

     730        799        416         1,843        1,444        5,232   

Income (loss) before taxes

     (5,897     (672     41,784         (14,182     (25,400     (4,367

Assets(*)

     371,065        186,558        1,903,873         1,704,279        26,286        4,192,061   

  

 

(*) Assets are reconciled to total assets as presented in the March 25, 2011 and March 26, 2010 consolidated statements of financial condition as follows (in thousands):

 

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     March 25, 2011     March 26, 2010  

Amount as presented above

   $ 4,355,885      $ 4,192,061   

Reconciling items:

    

Unallocated assets:

    

Cash

     5,363        8,428   

Receivables from brokers, dealers and clearing organizations

     31,625        55,478   

Receivable from clients, net of allowances

     15,696        17,849   

Other assets

     27,829        17,172   

Unallocated eliminations

     (12,761     (2,582
                

Total assets

   $ 4,423,637      $ 4,288,406   
                

COMMITMENTS, CONTINGENCIES AND GUARANTEES

Commitment and Contingencies.

Litigation. In the general course of its brokerage business and the business of clearing for other brokerage firms, SWS Group and/or its subsidiaries have been named as defendants in various lawsuits and arbitration proceedings. These claims allege violations of various federal and state securities laws. The Bank is also involved in certain claims and legal actions arising in the ordinary course of business. Except as noted below, management believes that resolution of these claims will not result in any material adverse effect on SWS’s consolidated financial position, results of operations or cash flows.

The Company has been named in three lawsuits related to a bond offering that was underwritten by M.L. Stern & Co., LLC, a company purchased by SWS Group in 2008. The offering took place in November of 2005, prior to the SWS Group purchase. The lawsuit was filed in November of 2009. M.L. Stern & Co., LLC underwrote approximately 40% of the $35,000,000 offering.

The lawsuits are in the early stage of discovery and the ultimate amount of liability associated with this claim cannot currently be determined. However, the Company believes it is at least reasonably possible that a loss related to this matter will be incurred. During fiscal 2011, the Company recorded a liability of approximately $1,000,000 related to this matter.

 

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Venture Capital Funds. The Bank has committed to invest $5,000,000 in two limited partnership equity funds. As of March 31, 2011, the Bank had invested $3,000,000 of its commitment. This investment is subject to the Volcker rule provisions of the Dodd-Frank Act, which will be finalized prior to October 21, 2011.

Underwriting. Through its participation in underwriting securities, both corporate and municipal, SWS could expose itself to material risk, since the possibility exists that securities SWS has committed to purchase cannot be sold at the initial offering price. Federal and state securities laws and regulations also affect the activities of underwriters and impose substantial potential liabilities for violations in connection with sales of securities by underwriters to the public. Total potential commitments under outstanding underwriting arrangements at March 25, 2011 were $6,083,000.

Guarantees. As of March 31, 2011, the Bank had issued stand-by letters of credit. The maximum potential amount of future payments the Bank could be required to make under the letters of credit was $688,000. The recourse provision of the letters of credit allows the amount of the letters of credit to become part of the fully collateralized loans with total repayment as a first lien. The collateral on these letters of credit consists of real estate, certificates of deposit, equipment, accounts receivable or furniture and fixtures.

Subject to the operating limitations in the Order, in the ordinary course of business, the Bank enters into loan agreements where the Bank commits to lend a specified amount of money to a borrower. At any point in time, there could be amounts that have not been advanced on the loan to the borrower, representing unfunded commitments, as well as amounts that have been disbursed but repaid, which are available for re-borrowing under a revolving line of credit. As of March 31, 2011, the Bank had unfunded commitments of $69,112,000 relating to revolving lines of credit. In addition, as of March 31, 2011, the Bank had unfunded new loans in the amount of $28,053,000.

The Company provides representations and warranties to counterparties in connection with a variety of commercial transactions and occasionally indemnifies them against potential losses caused by the breach of those representations and warranties. These indemnification obligations generally are standard contractual indemnities and are entered into in the normal course of business. The maximum potential amount of future payments that the Company could be required to make under these indemnities cannot be estimated. However, the Company believes that it is unlikely it will have to make material payments under these arrangements and has not recorded any contingent liability in the consolidated financial statements for these indemnities.

Southwest Securities is a member of multiple exchanges and clearinghouses. Under the membership agreements, members are generally required to guarantee the performance of other members. Additionally, if a member becomes unable to satisfy its obligations to the clearinghouse, other members would be required to meet shortfalls. To mitigate these performance risks, the exchanges and clearinghouses often require members to post collateral. SWS’s maximum potential liability under these arrangements cannot be quantified. However, the potential for SWS to be required to make payments under these arrangements is unlikely. Accordingly, no contingent liability is recorded in the consolidated financial statements for these arrangements.

 

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ACCOUNTING PRONOUNCEMENTS

The FASB and the SEC have recently issued the following statement and interpretation, which is applicable to SWS. Any other new accounting pronouncements not specifically identified in our disclosures are not applicable to SWS or are not expected to have a material effect on our financial statements:

ASU 2011-02, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” In April, 2011, the FASB issued the ASU to enhance the disclosure requirements regarding receivables. The enhanced disclosures are designed to assist creditors in determining whether a modified receivable is to be considered a troubled debt restructuring, including the impact on impairment and disclosures. ASU 2011-02 is effective for the first interim or annual reporting period ending on or after June 15, 2011, which is the Company’s fiscal 2011 fourth quarter ending June 24, 2011. The Company is in the process of evaluating the disclosure requirements and any impact the new disclosures will have on its financial statements and processes.

AFFILIATE TRANSACTIONS

At June 30, 2010, two directors, together with certain members of such directors’ families, owned approximately 64% of the ownership interests of a holding company which owned a local bank and one of SWS’s executive officers owned less than 1% of the ownership interests in this bank. The Bank sold loan participations with outstanding balances of $1,862,000 and $3,400,000 at March 31, 2011 and June 30, 2010, respectively, to this local bank. The local bank and the Bank had participations in $1,404,000 of foreclosed property at both March 31, 2011 and June 30, 2010. The terms of the participation agreements resulted in payments of interest and fees to the other bank of $39,000 and $126,000 for the three and nine-months ended March 31, 2011, respectively, and $51,000 and $226,000 for the three and nine-months ended March 31, 2010. The interest rates on these participations were substantially the same as those participations sold by the Bank to unrelated banks. In December 2010, one loan was sold and the local bank was paid $720,762 for its participation share of the net sales price. On July 31, 2010, certain assets of the local bank, including loan participations and foreclosed property, were sold to the local bank’s holding company. Affiliate transactions are subject to limitations specified in the Order. See “Cease and Desist Order with the Office of Thrift Supervision.”

CEASE AND DESIST ORDER WITH THE OFFICE OF THRIFT SUPERVISION

On February 4, 2011 (the “Effective Date”), the Board of Directors of the Bank signed the Stipulation consenting to and agreeing to the issuance by the OTS of the Order without admitting or denying that grounds exist for the OTS to initiate an administrative proceeding against the Bank. The description of the Order and the corresponding Stipulation set forth in this section or elsewhere in this filing is qualified in its entirety by reference to the Order and Stipulation, copies of which were filed as exhibits to our Form10-Q for the quarter ended December 31, 2010, which was filed with the SEC on February 9, 2011. The Memorandum of Understanding with the Office of Thrift Supervision that was entered into by the Bank and the OTS on July 13, 2010 was terminated effective February 4, 2011. Among other things, the Order provides:

 

   

The Bank must maintain a Tier 1 (Core) Capital Ratio equal to or greater than eight percent (8%) after the funding of an adequate Allowance for Loan and Lease Losses (“ALLL”) and a Total Risk-Based Capital Ratio equal to or greater than twelve percent (12%) (the “Minimum Levels”). On March 31, 2011, the Bank complied with these requirements with a Total Risk-Based Capital Ratio of 14.5% and a Tier 1 (Core) Capital Ratio of 9.6%.

 

   

The Bank submitted to the OTS for review and comment a written capital plan to maintain the Bank’s capital at the Minimum Levels for the quarterly periods from January 1, 2011 through December 31, 2013. On a quarterly basis, the Board of Directors of the Bank must review a report prepared by management detailing deviations from the capital plan and related corrective actions (if any).

 

   

Within 15 days after the Bank fails to meet the Minimum Levels or the Bank fails to submit or comply with the capital plan, the Bank must submit a contingency plan that is acceptable to the OTS that details the actions to be taken to: (a) consummate a merger or acquisition by another federally insured depository institution, or (b) voluntarily liquidate by filing an

 

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appropriate application with the OTS. Upon written notification from the OTS, this contingency plan must be implemented immediately and the Bank must provide the OTS with written status reports no later than the 1st and 15th day of each month following implementation of the contingency plan.

 

   

The Bank must implement and adhere to the business plan previously submitted by the Bank to the OTS and any material modifications are subject to the prior written approval of the OTS after a 45 day review period. On a quarterly basis starting on March 31, 2011, the Board of Directors of the Bank must review a report prepared by management detailing deviations from the business plan and related corrective actions (if any). The Bank modified the business plan when it completed the capital plan. The OTS will review these modifications as part of its review of the capital plan.

 

   

The Bank must implement and adhere to the classified asset reduction plan previously submitted by the Bank to the OTS and develop individual written specific workout plans for each classified asset in excess of $500,000. On a quarterly basis starting on March 31, 2011, the Board of Directors of the Bank must review an asset status report prepared by management detailing changes to classified assets and the status of workout plans and any revisions to such plans (if any).

 

   

The Bank engaged a qualified, experienced, and independent third party, acceptable to the OTS, to perform a review of at least forty percent (40%) of the construction, multi-family, nonresidential and land loan portfolios that were not classified substandard and prepare a written report setting forth their findings, including a detailed analysis for the loan classifications of each asset over $500,000. The Board must review the report and submit it to the OTS no later than September 30, 2011

 

   

The Bank submitted to the OTS for review and comment its written program for identifying, monitoring and controlling risks associated with concentrations of credit. Once the Bank is notified that the revised program is acceptable, the Board of Directors of the Bank must adopt the revised program. On a quarterly basis starting on March 31, 2011, the Board of Directors of the Bank must review the appropriateness of the Bank’s concentration limits given current conditions and the Bank’s compliance with the revised program and document the review in the minutes.

 

   

The Bank must not, without the prior written non-objection of the OTS, originate or purchase, or commit to originate and purchase construction, nonresidential mortgage or land loans subject to certain exceptions, including: (a) construction loans to facilitate the sale of lots financed by the Bank and loans for the purpose of construction of homes that are pre-sold on lots financed by the Bank; (b) owner-occupied residential construction loans to qualified customers who have a prior existing banking relationship with the Bank; (c) loans guaranteed by the Small Business Administration; (d) loans to facilitate the sale of real estate owned; and (e) commercial real estate workouts. All lending subject to the exceptions must comply with the Bank’s loan policy and all applicable laws, regulations and regulatory guidance. The Bank provided the OTS with a schedule of all legally binding commitments as of January 27, 2011.

 

   

The Bank’s outside directors conducted a management study and submitted the study to the Board of Directors. By May 30, 2011, the Board must adopt a written plan to address any identified weaknesses or deficiencies noted in the management study and specific dates for completion of corrective actions and submit the written plan to the OTS within 10 days of the Board meeting to consider the management plan.

 

   

The Bank must comply with brokered deposit regulatory requirements.

 

   

The Bank cannot increase its total assets during any quarter in excess of an amount equal to net interest credited on deposit liabilities during the prior quarter without the prior written notice of non-objection from the OTS.

 

   

The Bank cannot declare or pay dividends or make any other capital distributions without the prior approval of the OTS after 30 days prior notice to the OTS.

 

   

The Bank must comply with the prior notification requirements for changes in directors and senior executive officers set forth in applicable regulations.

 

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The Bank cannot enter into, renew, extend or revise any contractual arrangement relating to compensation or benefits for any senior executive officer or director of the Bank without providing the OTS with 45 days prior written notice of the proposed transaction. The Bank cannot make any bonus payment or otherwise increase the compensation of any of its senior executive officers or directors without providing the OTS with 45 days prior written notice of the proposed bonus or increase and receiving a written notice of non-objection from the OTS.

 

   

The Bank cannot make any golden parachute payment or prohibited indemnification payment unless, with respect to each payment, the Bank complies with applicable regulations.

 

   

The Bank cannot enter into any arrangement or contract with a third party service provider that is significant to the overall operation or financial condition of the Bank or outside the Bank’s normal course of business without providing the OTS with 45 days prior written notice of the proposed arrangement including a written determination that the arrangement or contract complies with regulatory guidance and receiving a written notice of non-objection from the OTS.

 

   

The Bank cannot engage in new transactions with affiliates unless, with respect to each transaction the Bank complies with applicable regulations.

 

   

By April 30, 2011, the Bank must ensure that all violations of law and/or regulation are corrected and adequate policies, procedures and systems are established or revised and thereafter implemented to prevent future violations.

 

   

The Board of Directors of the Bank must monitor and coordinate the Bank’s compliance with the Order, review and adopt all policies and procedures required by this Order prior to submission to the OTS.

 

   

Within 30 days after the end of each calendar quarter beginning on March 31, 2011, the Bank must prepare a written compliance tracking report for the Board. Within 45 days after the end of each calendar quarter beginning on March 31, 2011, the Board must review the compliance tracking report and all other reports required to be prepared by the Order, adopt a resolution certifying that each director has reviewed the compliance tracking report and all required reports and documenting any corrective actions adopted by the Board.

The Order will remain effective until terminated, modified or suspended in writing by the OTS. As of March 31, 2011, the Bank was in compliance with the terms of the Order.

 

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

OVERVIEW

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 nine-months ended March 25, 2011, 81% of our total revenues were generated by our full-service brokerage business and 19% 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 August 31, 2010.

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 public finance and municipal sales and underwriting professionals 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 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 subject to limitations in the Order to Cease and Desist, Order No. WN-11-003, effective on February 4, 2011 (the “Order”). 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.

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”).

Business Environment

Our business is sensitive to financial market conditions, which have been volatile over the past three years. As of March 25, 2011, equity market indices reflected an average increase from a year ago with the Dow Jones Industrial Average (the “DJIA”) up 13%, the Standard & Poor’s 500 Index (“S&P 500”) up 13% and the NASDAQ Composite Index (“NASDAQ”) up 15%. The DJIA closed at 12,220.59 on March 25, 2011 up from 10,850.36 at March 26, 2010 and 10,143.81 at June 25, 2010. On the other hand, the average daily volume on the NYSE declined during the third quarter of our fiscal 2011, decreasing 6% over the same period of our last fiscal year and 12% for the first nine-months of fiscal 2011 compared to fiscal 2010.

Despite the current positive direction in the equity markets, the volumes in the markets and economic and regulatory uncertainty have created a challenging operating environment for us. The national unemployment rate, which was approximately 8.8% at the end of March 2011, is down from a high of 10% at the end of December 2009 but remains at historically high levels. The Federal Reserve Board (“FRB”) reduced the federal funds target rate to 0 - 0.25% on December 16, 2008 and has not yet begun increasing rates. Many economists do not expect the federal funds rate to increase significantly during the remainder of 2011.

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 our Form 10-K filed with the SEC on August 31, 2010 and “Recent Regulatory Changes”.

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. Texas, which was largely insulated from severe job loss and real estate market deterioration at the start of the recession, has now experienced distress in residential and commercial real estate values as well as elevated unemployment. These factors have had a negative impact on our banking and brokerage operations.

 

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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.

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 depressed, 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 sweep providers have been substantially reduced. We do not expect any significant changes in these dynamics until short-term interest rates begin to 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 depressed.

We have also implemented a new FDIC sweep product that will eventually allow our brokerage customers the ability to obtain additional FDIC insurance coverage for pending investment funds in their accounts. This product will contribute to increased revenue sharing as interest rates increase.

Liquidity

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 in the marketplace. These actions have included reduced advance rates for certain security types, more stringent requirements for collateral eligibility and higher interest rates. All of these actions have had a negative impact on our liquidity. Should our lenders take additional similar actions, the cost of conducting our business will increase and our volume of business could be limited. To address this liquidity risk, we entered into a committed credit facility with a national bank that provides for up to $45 million of secured borrowings. As of March 25, 2011, we had borrowed $45.0 million under this facility.

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.

 

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Valuation of Securities

We trade mortgage and asset-backed securities on a regular basis. We monitor our trading limits daily to ensure that these securities are maintained at levels we consider to be prudent given current market conditions. These securities are priced using a third-party pricing service and we review the price monthly to ensure reasonable valuation. At March 25, 2011, we held mortgage and asset-backed securities of approximately $52.8 million included in securities owned, at market value on the consolidated statements of financial condition.

Investment in Auction Rate Securities

At March 25, 2011, we held $22.3 million of auction rate municipal bonds which represented one security and 19.0% of our municipal portfolio. This security is an investment grade credit, was valued at 95.7% of par as of March 25, 2011 and was yielding less than 1% per year for the period. While management does not expect any reduction in the cash flow from this bond, the disruption in the credit markets has led to auction failures. 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 March 25, 2011 reflects an appropriate discount for the current lack of liquidity in this investment.

Our customers also own $2.6 million in auction rate bonds as well as approximately $5.5 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. The banking environment remains challenging and continues to have a negative impact on the Bank’s earnings. Asset quality at the Bank, while not declining as rapidly as a year ago, remains at unacceptable levels. Primarily due to these asset quality issues, the Bank signed the Order on February 4, 2011.

Classified assets were $255.3 million at March 31, 2011 compared to $273.4 million at December 31, 2010 and $191.8 million at June 30, 2010. Classified assets as a percentage of total capital plus the allowance for loan losses was 132.7% at March 31, 2011 versus a target ratio of 40%. Non-performing assets (a subset of classified assets) were $104.6 million, or 7.6% of the Bank’s assets, at March 31, 2011 compared to $103.0 million, or 6.7% of the Bank’s assets, at December 31, 2010 and $93.4 million, or 5.3% of the Bank’s assets, at June 30, 2010. The Bank’s Texas Ratio, defined as non-performing assets divided by the sum of capital plus the allowance for loan losses, was 54.1% at March 31, 2011, 51.2% at December 31, 2010 and 39.4% at March 31, 2010.

The loan loss allowance at March 31, 2011 was $47.3 million, or 4.93% of loans held for investment, as compared to $47.0 million, or 4.58% of loans held for investment, at December 31, 2010 and $35.1 million, or 2.96% of loans held for investment, at June 30, 2010.

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 and reducing the size of the mortgage purchase loan portfolio. 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.

In the first quarter of fiscal 2011, the Bank engaged a consultant to assist with an international marketing campaign to sell $68.9 million in classified assets including performing loans, non-performing loans and real estate. The loans included in this marketing campaign were reclassified to held for sale in the first quarter of fiscal 2011, contributing $17.8 million to the provision for loan loss in the September 2010 quarter. Of these assets, $57.8 million have been sold and closed through the third quarter of fiscal 2011. These sales allowed the Bank to reduce its exposure to real estate loans, reduce the total portfolio of classified assets and reduce the overall size of the Bank’s balance sheet.

 

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In addition to the sale strategy noted above, the Bank has increased staffing in its special assets department with qualified professionals to aggressively address the reduction of classified assets. Management’s goal is to reduce the level of classified assets to capital from the current level of 132.7% to below 40%. The Bank is aggressively reviewing all available strategies to achieve this objective and expects that it will take several quarters to reach the 40% level.

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.

During the third quarter of fiscal 2011, the Bank established an internal loan review department. This department along with external loan reviews assists management in the early identification of potential problem loans.

Recent Events

On March 20, 2011, we entered into an agreement with Hilltop Holdings, Inc. (“Hilltop”) and Oak Hill Capital Partners (“Oak Hill”). Pursuant to the agreement, and once all necessary regulatory and stockholder approvals are obtained, we will:

 

   

obtain a $100.0 million, five year, unsecured loan from the investors;

 

   

issue warrants to each investor allowing such investor 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 investor exercises its warrant); and

 

   

grant the investors certain rights, including certain registration rights, preemptive rights, and the right for each investor to appoint one person to our Board of Directors so long as such investor 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.

We entered into this transaction to ensure that the broker/dealer business lines would operate smoothly in the future, the Bank would maintain adequate capital ratios under the Order, and the Bank could continue to reduce classified assets in a strategic and efficient manner.

Upon funding of the transaction, we will contribute $80.0 million of the proceeds of the term loan to the Bank unless otherwise agreed by each of the investors. The remaining $20.0 million will be held in reserve at SWS Group and will be deployed in the future for capital needs at the Bank or, subject to the consent of the investors, for other corporate purposes. The transaction is subject to various closing conditions, including stockholder and regulatory approvals, and there is no assurance the transaction will close.

Recent Regulatory Changes

We are subject to the extensive regulatory framework applicable to savings and loan holding companies as well as federal savings associations and insurance agencies. This regulatory framework is primarily intended for the protection of depositors, the Federal Deposit Insurance Fund (“DIF”), and the banking system as a whole, rather than for the protection of stockholders and creditors. The discussion below is intended to provide an update on material regulatory changes described in our 10-K filing on August 31, 2010 and the 10-Q filings on November 3, 2010 and February 9, 2010.

Federal statutes and Office of Thrift Supervision (“OTS”) regulations have established five capital categories for federal savings banks: well-capitalized, adequately capitalized, undercapitalized,

 

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significantly undercapitalized, and critically undercapitalized. The federal banking agencies have jointly specified by regulation the relevant capital level for each category. An institution is defined as well-capitalized when its total risk-based capital ratio is at least 10.00%, its Tier I risk-based capital ratio is at least 6.00%, its Tier I (core) capital ratio is at least 5.00%, and it is not subject to any federal supervisory order or directive to meet a specific capital level. As of March 31, 2011, the Bank’s total risk-based capital ratio was 14.5%, its Tier I risk-based capital ratio was 13.3% and its Tier I (core) capital ratio was 9.6%.

On February 4, 2011, the Board of Directors of the Bank signed a Stipulation and Consent to Issuance of Order to Cease and Desist (the “Stipulation”) and the OTS issued the Order. Accordingly, as a result of the issuance of the Order, effective February 4, 2011, the Bank was deemed to be “adequately capitalized” and no longer met the definition of “well capitalized” under federal statutes and OTS regulations even though its capital ratios met or exceeded all applicable requirements under Federal law, OTS regulations and the Order. See additional discussion in “Cease and Desist Order with the Office of Thrift Supervision” in the Notes to the Consolidated Financial Statements contained in this report.

Events and Transactions

Several material events and transactions impacted our results of operations in the periods presented. A description of the transactions and the impact on our results are discussed below.

Increase in provision for loan losses. The provision for loan loss increased $16.5 million for the nine-months ended March 31, 2011 compared to the nine-months ended March 31, 2010. See discussion in “Overview—Business Environment—Impact of Economic Environment—Bank.”

Sale of 5,000,001 shares of our common stock. On October 16, 2009, we filed a shelf registration statement with the SEC providing for the sale of $150.0 million of securities. On December 9, 2009, we closed a public offering of 4,347,827 shares of common stock at a price of $11.50 per share. On December 16, 2009, the underwriters for the public offering exercised their option to purchase 652,174 additional shares of our common stock to cover over-allotments. We generated net proceeds, after deducting underwriting discounts and commissions, from the offerings of approximately $54.3 million. We invested $47.5 million of the net proceeds as a $20.0 million capital contribution to the Bank and a $27.5 million capital contribution to Southwest Securities. The remaining funds were used for general corporate purposes.

Write-off of $6.3 million for clearing. In the first quarter of fiscal 2010, we recorded a pre-tax loss of $6.3 million as a result of a clearing correspondent’s unauthorized short sale of more than 2 million shares of a stock. The short sale and the subsequent trades to cover the short position resulted in a $6.3 million receivable from the correspondent. We determined that collection of this receivable was doubtful and established an allowance for this receivable. The loss was recorded in other expenses on the consolidated statements of income and comprehensive income.

RESULTS OF OPERATIONS

Consolidated

Net loss for the three and nine-month periods ended March 25, 2011 was $2.1 million and $23.2 million, respectively, as compared to a net loss of $11.5 million and $2.6 million, respectively, for the three and nine-month periods ended March 26, 2010. The three and nine-month periods ended March 25, 2011 and March 26, 2010 contained 58 and 189 and 58 and 188 trading days, respectively.

Southwest Securities was a custodian for $28.1 billion and $26.7 billion in total customer assets at March 25, 2011 and March 26, 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 and nine-month periods ended March 25, 2011 compared to the three and nine-month periods ended March 26, 2010 (dollars in thousands):

 

     Three-Months
Ended
    Nine-Months
Ended
 
     Amount     % Change     Amount     % Change  

Net revenues:

        

Net revenues from clearing operations

   $ 329        13   $ 233        3

Commissions

     (2,300     (7     (9,969     (8

Net interest

     (3,938     (16     (2,385     (3

Investment banking, advisory and administrative fees

     (624     (8     5,354        20   

Net gains on principal transactions

     2,768        36        (1,865     (6

Other

     (1,309     (23     (3,119     (18
                                
   $ (5,074     (6 )%    $ (11,751     (4 )% 
                                

Operating expenses:

        

Commissions and other employee compensation

   $ (191     —        $ (5,976     (3 )% 

Occupancy, equipment and

computer service costs

     (232     (3     (376     (1

Communications

     (116     (3     (114     (1

Floor brokerage and clearing

organization charges

     104        10        357        12   

Advertising and promotional

     (179     (20     (999     (33

Provision for loan loss

     (20,273     (81     16,547        48   

Other

     915        10        8,835        28   
                                
   $ (19,972     (20 )%    $ 18,274        6
                                

Pre-tax income

   $ 14,898        81   $ (30,025     (688 )% 
                                

Net revenues decreased for the third quarter of fiscal 2011 by $5.1 million as compared to the same period of fiscal 2010. The largest components of the decrease were in commissions, other revenue and net interest revenue. The $2.3 million decrease in commissions was due primarily to a $1.0 million decrease in commissions in the institutional segment, primarily in the taxable fixed income business due to reduced market volatility, and a $1.3 million decrease in commissions in the retail segment due to the closing of a Private Client Group (“PCG”) office in December 2010 and reduced advisor count in PCG. The decrease in other revenue was due primarily to a decrease in the gains on our investment in a limited partnership venture capital fund. The decrease in net interest revenue was primarily due to a decrease in the average balance of total loans at the Bank as compared to the same quarter in the prior fiscal year. These decreases were partially offset by an increase in net gains on principal transactions of $2.8 million. This gain was primarily in the institutional segment and resulted from an increase in trading profits as the market traded up for the third quarter of fiscal 2011 when compared to the third quarter of fiscal 2010.

Net revenues decreased for the first nine-months of fiscal 2011 by $11.8 million as compared to the same period of fiscal 2010. The largest components of the decrease were in commissions, net gains on principal transactions, other revenue and net interest revenue. The $10.0 million decrease in commissions was due primarily to a $9.7 million decrease in commissions in the institutional segment, primarily in the taxable fixed income business, as a result of reduced market volatility. The decrease in net gains on principal transactions was driven primarily by a decrease in taxable fixed income gains due to reduced spreads compared to the first half of the prior fiscal year. The decrease in other revenue was primarily due to an increase in net losses on the sale of real estate owned (“REO”) property and loans held for sale offset by a gain on the sale of securities at the Bank.

 

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The decrease in net interest revenue was primarily due to a decrease in the average balance of loans held for investment at the Bank as compared to the same period in the prior fiscal year. These revenue declines were partially offset by a $5.4 million increase in investment banking and advisory fees. The increase in investment banking and advisory fees was due to an increase the number of deals closed in our public finance business unit, an increase in underwritings in the taxable fixed income business as well as an increase in fees generated from advisory services in our corporate finance business unit.

Operating expenses decreased $20.0 million for the three-months ended March 25, 2011 as compared to the same period of fiscal 2010 substantially all from reductions in the provision for loan loss. The decrease for the Bank’s loan loss provision is discussed in “Overview—Business Environment—Impact of Economic Environment—Bank.”

Operating expenses increased $18.3 million for the nine-months ended March 25, 2011 as compared to the same period of fiscal 2010. The largest increase was the provision for loan loss of $16.5 million and other expenses of $8.8 million partially offset by a decrease of $6.0 million in commission and other employee compensation and a $1.0 million decrease in advertising and promotional expenses. The increase for the Bank’s loan loss provision is discussed in “Overview—Business Environment—Impact of Economic Environment—Bank.” The increase in other expenses was due to a $9.7 million increase in the Bank’s REO write-downs and a $4.9 million increase in professional services and fees. In addition, in fiscal 2010, there was a one time $875,000 reversal of an accrual from the purchase of M.L. Stern & Co., LLC. These increases were offset by the $6.3 million loss incurred in the first quarter of fiscal 2010 on a correspondent’s short sale of securities. Commission and other employee compensation expense declined primarily due to a decrease in variable compensation and a decrease in deferred compensation expenses related to our restricted stock plan. The decrease in advertising and promotional expense was due to a decrease in travel and entertainment expenses.

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 with the Federal Home Loan Bank (“FHLB”). Net interest income from our brokerage and banking segment were as follows for the three and nine-month periods ended March 25, 2011 and March 26, 2010 (in thousands):

 

     Three-Months Ended      Nine-Months Ended  
     March 25,
2011
     March 26,
2010
     March 25,
2011
     March 26,
2010
 

Brokerage

   $ 5,814       $ 5,826       $ 19,665       $ 19,069   

Bank(1)

     14,226         18,152         52,319         55,300   
                                   

Net interest

   $ 20,040       $ 23,978       $ 71,984       $ 74,369   
                                   

 

  (1)

The net interest reported for the Bank is for the periods ended March 31, 2011 and 2010.

 

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

 

     Three-Months Ended      Nine-Months Ended  
     March 25,
2011
     March 26,
2010
     March 25,
2011
     March 26,
2010
 

Daily average interest-earning assets:

           

Customer margin balances

   $ 228,000       $ 175,000       $ 212,000       $ 165,000   

Assets segregated for regulatory purposes

     238,000         311,000         260,000         311,000   

Stock borrowed

     2,157,000         1,826,000         2,027,000         1,893,000   

Daily average interest-bearing liabilities:

           

Customer funds on deposit, including short credits

     342,000         386,000         351,000         383,000   

Stock loaned

     2,129,000         1,753,000         2,000,000         1,831,000   

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

Income Tax Benefit

For the three-months ended March 25, 2011, income tax benefit (effective rate of 36.9%) 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, meals and entertainment and increases in the value of company-owned life insurance.

For the nine-months ended March 25, 2011, income tax benefit (effective rate of 32.5%) differed from the amount that would have otherwise been calculated by applying the federal corporate tax rate (35.0%) to loss before income taxes due to state income taxes and other permanently excluded items, such as tax exempt interest, meals and entertainment, increases in the value of company-owned life insurance and the valuation allowance.

Certain deferred tax assets are derived from capital losses, which depend on having sufficient capital gain income within the carry-back and carry-forward period available under the tax law. Our deferred tax assets include $844,000 which reflects the benefit of capital losses associated with our investments in certain partnership assets. In the first quarter of fiscal 2011, we established a valuation allowance in the amount of $844,000. We did not believe it was more likely than not that sufficient capital gain income would be generated to offset these capital losses. See additional discussion in “Income Taxes” in the Notes to the Consolidated Financial Statements contained in this report.

 

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Segment Information

The following is a summary of net revenues and pre-tax income (loss) by segment for the three and nine-months ended March 25, 2011 as compared to the three and nine-months ended March 26, 2010 (dollars in thousands):

 

     Three-Months Ended              
     March 25,
2011
    March 26,
2010
    Increase/
(Decrease)
    % Change  

Net revenues:

        

Clearing

   $ 5,279      $ 4,925      $ 354        7

Retail

     25,596        27,278        (1,682     (6

Institutional

     32,791        32,602        189        1   

Banking

     13,871        17,730        (3,859     (22

Other

     390        466        (76     (16
                                

Total

   $ 77,927      $ 83,001      $ (5,074     (6 )% 
                                

Pre-tax income (loss):

        

Clearing

   $ (44   $ 96      $ (140     >(100 )% 

Retail

     (650     (966     316        33   

Institutional

     9,521        9,534        (13     —     

Banking

     (3,753     (20,122     16,369        81   

Other

     (8,475     (6,841     (1,634     (24
                                

Total

   $ (3,401   $ (18,299   $ 14,898        81
                                

 

     Nine-Months Ended              
     March 25,
2011
    March 26,
2010
    Increase/
(Decrease)
    % Change  

Net revenues:

        

Clearing

   $ 16,101      $ 15,347      $ 754        5

Retail

     83,221        82,627        594        1   

Institutional

     113,652        122,136        (8,484     (7

Banking

     51,044        55,788        (4,744     (9

Other

     1,862        1,733        129        7   
                                

Total

   $ 265,880      $ 277,631      $ (11,751     (4 )% 
                                

Pre-tax income (loss):

        

Clearing

   $ 788      $ (5,897   $ 6,685        >100

Retail

     1,191        (672     1,863        >100   

Institutional

     37,443        41,784        (4,341     (10

Banking

     (47,514     (14,182     (33,332     >(100

Other

     (26,300     (25,400     (900     (4
                                

Total

   $ (34,392   $ (4,367   $ (30,025     >(100 )% 
                                

 

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Clearing

Three-months Ended:

The following is a summary of the results for the clearing segment for the three-months ended March 25, 2011 as compared to the three-months ended March 26, 2010 (dollars in thousands):

 

     Three-Months Ended               
     March 25,
2011
    March 26,
2010
     Increase/
(Decrease)
    % Change  

Net revenue from clearing services

   $ 2,805      $ 2,475       $ 330        13

Net interest

     1,441        1,386         55        4   

Other

     1,033        1,064         (31     (3
                                 

Net revenues

     5,279        4,925         354        7   

Operating expenses

     5,323        4,829         494        10   
                                 

Pre-tax income (loss)

   $ (44   $ 96       $ (140     >(100 )% 
                                 

Daily average customer margin

balance

   $ 114,000      $ 97,000       $ 17,000        18
                                 

Daily average customer funds on deposit

   $ 186,000      $ 222,000       $ (36,000     (16 )% 
                                 

Total correspondent clearing customer assets under custody were $14.5 billion and $13.5 billion at March 25, 2011 and March 26, 2010, respectively.

The following table reflects the number of client transactions processed for the three-months ended March 25, 2011 and March 26, 2010 and the number of correspondents at the end of each period.

 

     Three-Months Ended  
     March 25,
2011
     March 26,
2010
 

Tickets for high-volume trading firms

     420,784         252,360   

Tickets for general securities broker/dealers

     207,394         225,609   
                 

Total tickets

     628,178         477,969   
                 

Correspondents

     165         183   
                 

For the three-months ended March 25, 2011 as compared to the three-months ended March 26, 2010, tickets processed for high-volume trading firms increased 67% while tickets processed for general securities broker/dealers decreased by 8%. In addition, revenue per ticket decreased approximately 14% from $5.18 for the third quarter of fiscal 2010 to $4.47 for the third quarter of fiscal 2011. The increase in tickets processed for high-volume trading firms offset by the slight decrease in tickets for general securities broker/dealers led to a 13% increase in clearing fee revenue.

Other revenue, which includes fees from money market funds, decreased 3% for the three-months ended March 25, 2011 as compared to the same period last fiscal year. This decrease was due to a 12% decrease in the administrative fee income earned by the clearing segment from the money market providers. This fee income decreased due to a decrease in the average amount invested in money market funds as well as an increase in fee waivers from the money market providers.

Operating expenses increased for the three-months ended March 25, 2011 as compared to the same period last fiscal year primarily due to a $120,000 increase in occupancy, equipment and computer service costs, in particular software licenses, and a $280,000 increase in other expenses. The increase in software licenses was due to the Company’s expenses incurred to develop a new investor web product for our correspondent clients. The increase in other expense was due to an increase in

 

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operations and information technology expenses of $384,000, partially offset by a decrease in legal expenses of $117,000.

Nine-months Ended:

The following is a summary of the results for the clearing segment for the nine-months ended March 25, 2011 as compared to the nine-months ended March 26, 2010 (dollars in thousands):

 

     Nine-Months Ended              
     March 25,
2011
     March 26,
2010
    Increase/
(Decrease)
    % Change  

Net revenue from clearing services

   $ 8,064       $ 7,830      $ 234        3

Net interest

     4,415         4,327        88        2   

Other

     3,622         3,190        432        14   
                                 

Net revenues

     16,101         15,347        754        5   

Operating expenses

     15,313         21,244        (5,931     (28
                                 

Pre-tax income (loss)

   $ 788       $ (5,897   $ 6,685        >100
                                 

Daily average customer margin

balance

   $ 112,000       $ 95,000      $ 17,000        18
                                 

Daily average customer funds on deposit

   $ 202,000       $ 223,000      $ (21,000     (9 )% 
                                 

The following table reflects the number of client transactions processed for the nine-months ended March 25, 2011 and March 26, 2010.

 

     Nine-Months Ended  
     March 25,
2011
     March 26,
2010
 

Tickets for high-volume trading firms

     1,231,505         1,036,849   

Tickets for general securities broker/dealers

     648,267         695,228   
                 

Total tickets

     1,879,772         1,732,077   
                 

For the nine-months ended March 25, 2011 as compared to the nine-months ended March 26, 2010, tickets processed for high-volume trading firms increased 19% while tickets processed for general securities broker/dealers decreased by 7%. In addition, revenue per ticket decreased approximately 5% from $4.52 for the nine-months ended March 26, 2010 to $4.29 for the nine-months ended March 25, 2011.

Other revenue, which includes fees from money market funds, increased 14% for the nine-months ended March 25, 2011 as compared to the same period last fiscal year. This improvement was due to a 15% increase in the administrative fee income earned by the clearing segment from the money market providers on higher revenue sharing with various money market funds.

Operating expenses decreased $5.9 million for the nine-months ended March 25, 2011 as compared to the same period last fiscal year. This decrease was primarily related to other expenses which included a $6.3 million loss incurred on a correspondent’s short sale of securities in the first quarter of fiscal 2010 as well as a decrease in legal expenses of $704,000. These decreases were partially offset by an increase in operations and information technology expenses of $747,000 and an increase in professional services of $142,000 from the nine-months ended March 26, 2010.

 

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Retail

Three-months Ended:

The following is a summary of the results for the retail segment for the three-months ended March 25, 2011 as compared to the three-months ended March 26, 2010 (dollars in thousands):

 

     Three-Months Ended        
     March 25,
2011
    March 26,
2010
    % Change  

PCG

      

Commissions

   $ 12,259      $ 14,290        (14 )% 

Advisory fees

     1,275        1,316        (3

Insurance products

     728        1,488        (51

Other

     89        103        (14

Net interest revenue

     458        552        (17
                        
     14,809        17,749        (17
                        

Independent registered representatives (“SWS Financial”)

      

Commissions

     6,697        6,026        11   

Advisory fees

     731        622        18   

Insurance products

     1,850        1,470        26   

Other

     269        217        24   

Net interest revenue

     210        203        3   
                        
     9,757        8,538        14   
                        

Other

      

Commissions

     104        60        73   

Advisory fees

     614        599        3   

Insurance products

     282        276        2   

Other

     30        56        (46

Net interest revenue

     —          —          —     
                        
     1,030        991        4   
                        

Total net revenues

     25,596        27,278        (6

Operating expenses

     26,246        28,244        (7
                        

Pre-tax income (loss)

   $ (650   $ (966     33
                        

Daily average customer margin balances

   $ 82,000      $ 65,000        26
                        

Daily average customer funds on deposit

   $ 86,000      $ 120,000        (28 )% 
                        

PCG representatives

     175        207        (15 )% 
                        

SWS Financial representatives

     303        308        (2 )% 
                        

Net revenues in the retail segment decreased 6% for the three-months ended March 25, 2011 as compared to the same period last fiscal year due primarily to a decrease in commission revenue from closing one PCG office during the December 2010 quarter and a 15% decrease in the number of PCG representatives. This decline was partially offset by an increase in commission revenue in the independent registered representative sales force. Total customer assets were $12.3 billion at March 25, 2011 as compared to $13.2 billon at March 26, 2010. Assets under management were $669 million at March 25, 2011 as compared to $564 million at March 26, 2010.

Operating expenses decreased 7% for the three-months ended March 25, 2011 as compared to the same period last fiscal year. This decrease was primarily due to an 8% decrease in commission and other employee compensation expense, the primary component of operating expenses in the retail segment.

 

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Nine-months Ended:

The following is a summary of the results for the retail segment for the nine-months ended March 25, 2011 as compared to the nine-months ended March 26, 2010 (dollars in thousands):

 

     Nine-Months Ended        
     March 25,
2011
     March 26,
2010
    % Change  

PCG

       

Commissions

   $ 40,421       $ 44,169        (8 )% 

Advisory fees

     3,925         4,025        (2

Insurance products

     2,785         3,789        (26

Other

     271         119        >100   

Net interest revenue

     1,600         1,628        (2
                         
     49,002         53,730        (9
                         

Independent registered representatives

       

Commissions

     22,028         18,666        18   

Advisory fees

     2,232         1,724        29   

Insurance products

     5,482         4,463        23   

Other

     822         636        29   

Net interest revenue

     623         573        9   
                         
     31,187         26,062        20   
                         

Other

       

Commissions

     289         158        83   

Advisory fees

     1,748         1,655        6   

Insurance products

     866         855        1   

Other

     129         170        (24

Net interest revenue

     —           (3     —     
                         
     3,032         2,835        7   
                         

Total net revenues

     83,221         82,627        1   

Operating expenses

     82,030         83,299        (2
                         

Pre-tax income (loss)

   $ 1,191       $ (672     >100
                         

Daily average customer margin balances

   $ 79,000       $ 59,000        34
                         

Daily average customer funds on deposit

   $ 98,000       $ 127,000        (23 )% 
                         

Net revenues in the retail segment increased 1% for the nine-months ended March 25, 2011 as compared to the same period last fiscal year due to an increase in management advisory fee income of $501,000 and other revenue of $297,000, partially offset by a decrease in commission revenue of $255,000. The increase in other revenue was primarily due to a decrease in the fees paid on opening new accounts. PCG commission revenues decreased due primarily to the closing of one PCG office during the December 2010 quarter and a 15% decrease in the number of PCG representatives.

Operating expenses decreased 2% for the nine-months ended March 25, 2011 as compared to the same period last fiscal year. This decrease was primarily due to a $267,000 decrease in commission and employee compensation expense, the primary component of operating expenses in the retail segment, a $258,000 decrease in occupancy, equipment and computer service costs, a $423,000 decrease in communication expenses and a $255,000 decrease in advertising and promotional expenses.

 

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Institutional

Three-months Ended:

The following is a summary of the results for the institutional segment for the three-months ended March 25, 2011 as compared to the three-months ended March 26, 2010 (dollars in thousands):

 

     Three-Months Ended         
     March 25,
2011
     March 26,
2010
     % Change  

Commissions

        

Taxable fixed income

   $ 6,871       $ 7,655         (10 )% 

Municipal distribution

     3,270         3,231         1   

Portfolio trading

     3,647         3,906         (7

Other

     8         5         60   
                          
     13,796         14,797         (7
                          

Investment banking fees

     4,781         5,429         (12

Net gains on principal transactions

     10,751         8,340         29   

Other

     100         236         (58

Net interest revenue

        

Stock loan

     1,984         3,158         (37)   

Other

     1,379         642         115   
                          

Total

     32,791         32,602         1   

Operating expenses

     23,270         23,068         1   
                          

Pre-tax income

   $ 9,521       $ 9,534         —  
                          

Taxable fixed income representatives

     33         31         6
                          

Municipal distribution representatives

     24         24         —  
                          

Average balances of interest-earning assets and interest-bearing liabilities for the three-months ended March 25, 2011 as compared to the three-months ended March 26, 2010 were as follows (in thousands):

 

     Three-Months Ended  
     March 25,
2011
     March 26,
2010
 

Daily average interest-earning assets:

     

Stock borrowed

   $ 2,157,000       $ 1,826,000   

Daily average interest-bearing liabilities:

     

Stock loaned

     2,129,000         1,753,000   

The following table sets forth the number and aggregate dollar amount of new municipal bond underwritings conducted by Southwest Securities, as reported to the Municipal Securities Rulemaking Board, for the three-month periods ended March 25, 2011 and March 26, 2010:

 

     Three-Months Ended  
     March 25,
2011
     March 26,
2010
 

Number of Issues

     72         150   

Aggregate Amount of Offerings

   $ 5,076,406,000       $ 9,910,318,000   

Net revenues from the institutional segment increased 1% in the three-months ended March 25, 2011 as compared to the three-months ended March 26, 2010, while pre-tax income was even when comparing the same periods. Decreased commissions of $1.0 million was due to tighter spreads and reduced volatility primarily in taxable fixed income.

 

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Investment banking fees were down 12% in the three-months ended March 25, 2011 as compared to the same period in the last fiscal year. Corporate finance represented $1.1 million of this decrease while public finance was down $265,000 as a result of fewer transactions year-over-year. These decreases were partially offset by a $765,000 increase in taxable fixed income fees due to increased underwriting activity.

Net gains on principal transactions were up 29% in the three-months ended March 25, 2011 as compared to the same period last fiscal year. Municipal distribution represented $1.4 million and taxable fixed income represented $1.1 million of the increase. These increases were due to higher trading profits as the securities markets traded up for the third quarter of fiscal 2011 when compared to the third quarter of fiscal 2010.

In the three-months ended March 25, 2011, net interest revenue in the institutional segment decreased 12% over the same period of last fiscal year. The decrease was due to a 28 basis point decline in the average stock lending spread. This decrease was partially offset by an increase in interest earned in our taxable and non-taxable inventories of $964,000.

Operating expenses were up 1% for the three-months ended March 25, 2011 as compared to the same period last fiscal year primarily due to increased commissions and other employee compensation expense related to the increased operating revenues.

Nine-months Ended:

The following is a summary of the results for the institutional segment for the nine-months ended March 25, 2011 as compared to the nine-months ended March 26, 2010 (dollars in thousands):

 

     Nine-Months Ended         
     March 25,
2011
     March 26,
2010
     % Change  

Commissions

        

Taxable fixed income

   $ 25,477       $ 34,921         (27 )% 

Municipal distribution

     11,673         11,787         (1

Portfolio trading

     9,976         10,157         (2

Other

     16         14         14   
                          
     47,142         56,879         (17
                          

Investment banking fees

     23,612         18,951         25   

Net gains on principal transactions

     30,176         32,786         (8

Other

     453         772         (41

Net interest revenue

        

Stock loan

     8,631         11,461         (25

Other

     3,638         1,287         >100   
                          

Total

     113,652         122,136         (7

Operating expenses

     76,209         80,352         (5)   
                          

Pre-tax income

   $ 37,443       $ 41,784         (10 )% 
                          

 

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Average balances of interest-earning assets and interest-bearing liabilities for the nine-months ended March 25, 2011 as compared to the nine-months ended March 26, 2010 were as follows (in thousands):

 

     Nine-Months Ended  
     March 25,
2011
     March 26,
2010
 

Daily average interest-earning assets:

     

Stock borrowed

   $ 2,027,000       $ 1,893,000   

Daily average interest-bearing liabilities:

     

Stock loaned

     2,000,000         1,831,000   

The following table sets forth the number and aggregate dollar amount of new municipal bond underwritings conducted by Southwest Securities, as reported to the Municipal Securities Rulemaking Board, for the nine-month periods ended March 25, 2011 and March 26, 2010:

 

     Nine-Months Ended  
     March 25,
2011
     March 26,
2010
 

Number of Issues

     444         446   

Aggregate Amount of Offerings

   $ 40,093,950,000       $ 49,321,645,000   

Net revenues from the institutional segment decreased 7% while pre-tax income was down 10% in the nine-months ended March 25, 2011 as compared to the nine-months ended March 26, 2010. Tighter spreads and reduced volatility, primarily in taxable fixed income, led to a $9.7 million decline in commission revenue.

Investment banking fees were up 25% in the nine-months ended March 25, 2011 as compared to the same period in the last fiscal year. Public finance represented $2.2 million of this increase while corporate finance represented $1.1 million of the increase and taxable fixed income contributed $1.8 million to the increase due to increased underwriting activity. The increase in public finance and corporate finance was due to an increase in the number of transactions in the nine-months ended March 2011 as compared to the nine-months ended March 2010.

Net gains on principal transactions were down 8% in the nine-months ended March 25, 2011 as compared to the same period last fiscal year. Taxable fixed income represented $2.1 million of this decrease.

In the nine-months ended March 25, 2011, net interest revenue in the institutional segment was down 4% over the same period of the last fiscal year. The decrease was due to a 21 basis point decline in the average stock lending spread. This decrease was partially offset by an increase in interest earned in our taxable and tax exempt inventories of $2.8 million.

Operating expenses were down 5% for the nine-months ended March 25, 2011 as compared to the same period last fiscal year, primarily due to decreases in commissions and other employee compensation on lower net revenues.

 

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Banking

Three-months Ended:

The following is a summary of the results for the banking segment for the three-months ended March 31, 2011 and as compared to the three-months ended March 31, 2010 (dollars in thousands):

 

     Three-Months Ended        
     March 31,
2011
    March 31,
2010
    % Change  

Net interest revenue

   $ 14,226      $ 18,152        (22 )% 

Other

     (355     (422     16   
                        

Total net revenues

     13,871        17,730        (22

Operating expenses

     17,624        37,852        (53)   
                        

Pre-tax loss

     $(3,753)        $(20,122)        81%   
                        

Net interest revenue generated by the Bank accounted for approximately 18.3% of our consolidated net revenue for the three-months ended March 31, 2011 and 21.9% for the three-months ended March 31, 2010. The decrease in net interest revenue at the Bank for the three-months ended March 31, 2011 was due primarily to a 22% decrease in the average balance of loans held for investment and sale at March 31, 2011 as compared to March 31, 2010, as well as a decrease in the net yield on earning assets of 40 basis points. Other revenue for the Bank increased 16% for the three-months ended March 31, 2011 as compared to the same period last fiscal year. This increase was primarily due to a $493,000 increase in the gains earned on our limited partnership equity fund investment and a $61,000 increase in gains on the sale of securities, partially offset by a $169,000 loss on loans held for sale as well as a $317,000 decrease in gains on the sale of Small Business Administration (“SBA”) loans.

The Bank’s operating expenses were down 53% for the three-months ended March 31, 2011 as compared to the same period last fiscal year. This decrease was due primarily to a $20.3 million decrease in the Bank’s loan loss provision. The decrease in the Bank’s loan loss provision was due to some stability in the rate of decline of commercial real-estate values and a reduction in size of the Bank’s loan portfolio. The allowance computation is discussed in detail in “Loans and Allowance for Probable Loan Loss” below. The earnings at the Bank are expected to be volatile as we continue to manage the level of classified assets and as a result of the operating restrictions set forth in the Order.

The following table sets forth an analysis of the Bank’s net interest income by each major category of interest-earning assets and interest-bearing liabilities for the three-month periods ended March 31, 2011 and 2010 (dollars in thousands):

 

     Three-Months Ended  
     March 31, 2011     March 31, 2010  
     Average
Balance
     Interest
Income/
Expense (*)
     Yield/
Rate
    Average
Balance
     Interest
Income/
Expense (*)
     Yield/
Rate
 

Assets:

                

Interest-earning assets:

                

Loans:

                

Residential – mortgage

   $ 213,051       $ 3,384         6.4   $ 362,219       $ 5,984         6.7

Residential – construction

     46,529         720         6.3        105,883         1,313         5.0   

Commercial – real estate

     551,159         7,709         5.7        621,129         8,420         5.5   

Commercial – loans

     195,500         2,628         5.5        173,752         2,517         5.9   

Individual

     3,953         62         6.4        4,544         83         7.4   

Land

     80,435         1,011         5.1        135,887         1,628         4.9   

Money market

     1,097         —           —          88,867         15         0.1   

Federal funds sold

     2,441         1         0.2        16,128         4         0.1   

Interest bearing deposits in banks

     2,140         —           —          5,806         —           —     

Federal reserve funds

     281,527         151         0.2        49,115         13         0.1   

Investments – other

     8,846         15         0.7     47,198         280         2.4
                                        
     1,386,678       $ 15,681         4.6     1,610,528       $ 20,257         5.1

Non-interest-earning assets:

                

Cash and due from banks

     1,979              6,776         

Other assets

     32,317              59,046         
                            
   $ 1,420,974            $ 1,676,350         
                            

 

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Table of Contents
     Three-Months Ended  
     March 31, 2011     March 31, 2010  
     Average
Balance
    Interest
Income/
Expense (*)
     Yield/
Rate
    Average
Balance
     Interest
Income/
Expense (*)
     Yield/
Rate
 

Liabilities and Stockholders’ Equity:

               

Interest-bearing liabilities:

               

Certificates of deposit

   $ 55,665      $ 179         1.3   $ 70,406       $ 293         1.7

Money market accounts

     29,196        4         0.1        40,187         14         0.1   

Interest-bearing demand accounts

     10,646        2         0.1        92,301         35         0.2   

Savings accounts

     998,935        123         0.1        1,128,346         454         0.2   

Federal Home Loan Bank advances

     99,381        1,147         4.7        110,958         1,309         4.8   

Other financed borrowings

     2,933        —           —          28         —           —     
                                       
     1,196,756        1,455         0.5     1,442,226         2,105         0.6

Non-interest-bearing liabilities:

               

Non interest-bearing demand accounts

     76,344             63,810         

Other liabilities

     (2,087          5,380         
                           
     1,271,013             1,511,416         

Stockholders’ equity

     149,961             164,934         
                           
   $ 1,420,974           $ 1,676,350         
                           

Net interest income

     $ 14,226            $ 18,152      
                           

Net yield on interest-earning assets

          4.2           4.6
                           

 

(*) Loan fees included in interest income for the three-months ended March 31, 2011 and 2010 were $951 and $1,079, respectively.

Interest rate trends, changes in the U.S. economy, competition and the scheduled maturities and interest rate sensitivity of the loan portfolios and deposits affect the spreads earned by the Bank.

The following table sets forth a summary of the changes in the Bank’s interest earned and interest paid resulting from changes in volume and rate (in thousands):

 

     Three-Months Ended  
     March 31, 2011 as compared to March 31, 2010  
     Total
Change
    Attributed to  
       Volume     Rate     Mix  

Interest income:

        

Loans:

        

Real estate - mortgage

   $ (2,600   $ (2,464   $ (231   $ 95   

Real estate - construction

     (593     (736     324        (181

Commercial - real estate

     (711     (948     267        (30

Commercial - loans

     111        315        (181     (23

Individual

     (21     (11     (12     2   

Land

     (617     (665     81        (33

Money markets

     (15     (15     23        (23

Federal funds sold

     (3     (3     1        (1

Federal reserve funds

     138        61        14        63   

Investments - other

     (265     (257     (131     123   
                                
   $ (4,576   $ (4,723   $ 155      $ (8
                                

 

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     Three-Months Ended  
     March 31, 2011 as compared to March 31, 2010  
     Total
Change
    Attributed to  
       Volume     Rate     Mix  

Interest expense:

        

Certificates of deposit

   $ (114   $ (62   $ (66   $ 14   

Money market accounts

     (10     (4     (9     3   

Interest-bearing demand accounts

     (33     (30     (21     18   

Savings accounts

     (331     (52     (315     36   

Federal Home Loan Bank advances

     (162     (137     (28     3   
                                
     (650     (285     (439     74   
                                

Net interest income

     $(3,926)        $(4,438)        $594        $(82)   
                                

Nine-months Ended:

The following is a summary of the results for the banking segment for the nine-months ended March 31, 2011 and as compared to the nine-months ended March 31, 2010 (dollars in thousands):

 

     Nine-Months Ended         
     March 31,
2011
    March 31,
2010
     %
Change
 

Net interest revenue

   $ 52,319      $ 55,300         (5 )% 

Other

     (1,275     488         >(100
                         

Total net revenues

     51,044        55,788         (9

Operating expenses

     98,558        69,970         41   
                         

Pre-tax loss

     $(47,514)        $(14,182)         >(100 )% 
                         

For the nine-months ended March 31, 2011 as compared to the nine-months ended March 31, 2010, the Bank’s net revenues decreased 9%. The Bank posted a pre-tax loss of $47.5 million for the nine-months ended March 31, 2011, up from a $14.2 million pre-tax loss reported in the same period of the last fiscal year.

The decrease in net interest revenue at the Bank was due primarily to a decrease in the net yield on earning assets from 4.7% at March 31, 2010 to 4.4% at March 31, 2011. Other revenue for the Bank decreased more than 100% for the nine-months ended March 31, 2011 as compared to the same period last fiscal year. This decrease was primarily due to a $1.5 million increase in net losses on the sale of REO property, a $1.1 million increase on the loss of loans held for sale and a $401,000 decrease in gains on the sale of SBA loans. These decreases were partially offset by a $1.2 million gain on the sale of securities.

The Bank’s operating expenses were up 41% for the nine-months ended March 31, 2011 over the same period last fiscal year. This increase was due primarily to a $16.5 million increase in the Bank’s loan loss provision, a $9.7 million increase in the Bank’s REO write-downs, a $1.4 million increase in outside loan and real-estate related services and fees, a $544,000 increase in legal fees, and a $507,000 increase in fee assessments from regulatory agencies. The increase in the Bank’s loan loss provision was due to continued deterioration in the real estate market and the Bank’s commercial real estate loan portfolio as well as the continuing uncertainty in the U.S. economy. The allowance computation is discussed in detail in “Loans and Allowance for Probable Loan Loss” below.

 

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The following table sets forth an analysis of the Bank’s net interest income by each major category of interest-earning assets and interest-bearing liabilities for the nine-month periods ended March 31, 2011 and 2010 (dollars in thousands):

 

     Nine-Months Ended  
     March 31, 2011     March 31, 2010  
     Average
Balance
     Interest
Income/
Expense (*)
     Yield/
Rate
    Average
Balance
     Interest
Income/
Expense(*)
     Yield/
Rate
 

Assets:

                

Interest-earning assets:

                

Loans:

                

Residential – mortgage

   $ 359,407       $ 16,797         6.2   $ 365,465       $ 18,833         6.9

Residential – construction

     60,935         2,705         5.9        121,307         4,629         5.1   

Commercial – real estate

     599,615         24,454         5.4        607,232         25,236         5.5   

Commercial – loans

     201,903         8,306         5.5        159,986         7,007         5.8   

Individual

     4,250         221         6.9        4,608         255         7.4   

Land

     98,622         3,627         4.9        145,642         5,398         4.9   

Money market

     730         1         0.2        54,050         56         0.1   

Federal funds sold

     4,840         5         0.1        56,572         52         0.1   

Interest bearing deposits in banks

     4,403         1         —          11,925         1         —     

Federal reserve funds

     193,235         325         0.2        21,198         22         0.1   

Investments - other

     61,999         931         2.0        24,453         502         2.7   
                                        
     1,589,939       $ 57,373         4.8     1,572,438       $ 61,991         5.3

Non-interest-earning assets:

                

Cash and due from banks

     4,200              6,450         

Other assets

     40,083              49,601         
                            
   $ 1,634,222            $ 1,628,489         
                            

Liabilities and Stockholders’ Equity:

                

Interest-bearing liabilities:

                

Certificates of deposit

   $ 62,759       $ 690         1.5   $ 70,423       $ 987         1.9

Money market accounts

     34,329         16         0.1        42,706         50         0.2   

Interest-bearing demand accounts

     61,629         49         0.1        88,275         117         0.2   

Savings accounts

     1,132,462         617         0.1        1,093,996         1,513         0.2   

Federal Home Loan Bank advances

     108,085         3,682         4.5        113,598         4,024         4.7   

Federal funds purchased

     22         —           —          9         —           —     

Other financed borrowings

     2,831         —           —          —           —           —     
                                        
     1,402,117         5,054         0.5     1,409,007         6,691         0.6

Non-interest-bearing liabilities:

                

Non interest-bearing demand accounts

     76,314              60,014         

Other liabilities

     2,028              7,020         
                            
     1,480,459              1,476,041         

Stockholders’ equity

     153,763              152,448         
                            
   $ 1,634,222            $ 1,628,489         
                            

Net interest income

      $ 52,319            $ 55,300      
                            

Net yield on interest-earning assets

           4.4           4.7
                            

 

(*) Loan fees included in interest income for the nine-months ended March 31, 2011 and 2010 were $2,880 and $3,558, respectively.

 

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The following table sets forth a summary of the changes in the Bank’s interest earned and interest paid resulting from changes in volume and rate (in thousands):

 

     Nine-Months Ended  
     March 31, 2011 as compared to March 31, 2010  
     Total
Change
    Attributed to  
       Volume     Rate     Mix  

Interest income:

        

Loans:

        

Real estate - mortgage

   $ (2,036   $ (312   $ (1,753   $ 29   

Real estate - construction

     (1,924     (2,304     756        (376

Commercial - real estate

     (782     (317     (471     6   

Commercial - loans

     1,299        1,835        (425     (111

Individual

     (34     (20     (15     1   

Land

     (1,771     (1,743     (41     13   

Money markets

     (55     (55     19        (19

Federal funds sold

     (47     (47     2        (2

Federal reserve funds

     303        182        14        107   

Investments - other

     429        391        (14     52   
                                
   $ (4,618   $ (2,390   $ (1,928   $ (300
                                

Interest expense:

        

Certificates of deposit

   $ (297   $ (108   $ (212   $ 23   

Money market accounts

     (34     (10     (30     6   

Interest-bearing demand accounts

     (68     (35     (47     14   

Savings accounts

     (896     53        (917     (32

Federal Home Loan Bank advances

     (342     (285     (66     9   
                                
     (1,637     (385     (1,272     20   
                                

Net interest income

   $ (2,981   $ (2,005   $ (656   $ (320
                                

Other Segment

Three-months Ended:

Overall other segment net revenues were flat primarily due to a decrease of $878,000 in the gains on our limited partnership venture capital fund investment, which was partially offset by a $457,000 increase in net interest revenue and a $354,000 decrease in losses on firm inventory.

Pre-tax loss from the other segment was $8.5 million for the three-months ended March 25, 2011 as compared to $6.8 million for the same period last fiscal year. This was related to an increase in legal expenses of $1.4 million and a $1.1 million increase in employee benefits. These increases were partially offset by a decrease in corporate salaries of $471,000, reduced occupancy, equipment and computer services costs of $257,000 and a $240,000 reduction in bad debt expense on firm receivables.

Nine-months Ended:

Overall other segment net revenues were flat as net interest revenue increased by $961,000 from the same period last year. Net gains on principal transactions increased $687,000 due to gains on firm inventory. These improvements were substantially offset by a $1.4 million decrease in income earned on our limited partnership venture capital fund investment.

Pre-tax loss from the other segment was $26.3 million for the nine-months ended March 25, 2011 as compared to $25.4 million for the same period last fiscal year. The change was primarily due to a $2.2 million increase in legal expenses and a $524,000 increase in trading expenses. In addition, in fiscal 2010, there was a one time $875,000 reversal of an accrual from the purchase of M.L. Stern & Co., LLC. These expense increases were partially offset by decreases in commissions and employee compensation expense of $2.1 million, occupancy, equipment and computer service expenses of $393,000 and promotional expenses of $383,000. In addition, bad debt expenses were $315,000 lower.

 

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FINANCIAL CONDITION

Investments

The reported value of the Bank’s investment portfolio at March 31, 2011 and June 30, 2010 is summarized as follows (in thousands):

 

     March 31,
2011
     June 30,
2010
 

Government-sponsored enterprises

   $ 35,525       $ 87,685   

States of the U.S. and political subdivisions

     —           6,265   
                 
   $ 35,525       $ 93,950   
                 

The Bank sold $75.5 million of securities in fiscal 2011. See additional discussion in “Securities Held to Maturity” in the Notes to the Consolidated Financial Statements contained in this report.

Loans and Allowance for Probable Loan Losses

The Bank grants loans to customers primarily within Texas and New Mexico. In the ordinary course of business, the Bank also purchases mortgage loans which have been originated in various areas of the United States. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their loan terms is dependent upon the general economic conditions in Texas and New Mexico. Substantially all of the Bank’s loans are collateralized with real estate.

The allowance for probable loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Management periodically evaluates the adequacy of the allowance based on the Bank’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral and current economic conditions. In determining the appropriate allowance at the balance sheet date, management evaluates the Bank’s historical loss percentage, concentrations of risk in the portfolio, estimated changes in the value of underlying collateral as well as changes in the volume and growth in the portfolio.

Prior to the third quarter of fiscal 2010, the Bank’s provision for loan loss computation used a three year rolling average of historical loan losses by product type to assess losses in the Bank’s loan portfolio. Product types consist of 1-4 family residential loans, 1-4 family residential construction loans, land and land development loans, commercial real estate loans, commercial loans and consumer loans. Due to accelerated deterioration in the Bank’s loan portfolio, depressed appraised values for collateral, continued high unemployment rates in Texas and deteriorating banking industry loss statistics, the Bank’s management reevaluated its use of historical loan losses in its provision for loan loss computation. As a result of this reevaluation, in the third quarter of fiscal 2010, management reduced the historical loan loss look back period from three years to four quarters.

Due to continued deterioration in the Bank’s loan portfolio, depressed appraised values for collateral, continued high unemployment rates in Texas and deteriorating banking industry loss statistics in the first quarter of fiscal 2011, the Bank’s management reevaluated its problem loan volume trend component in its provision for loan loss computation. The problem loan volume trend component now includes two separate calculations for criticized and classified loans. Prior to the first quarter of fiscal 2011, the Bank had one calculation for these loans. To more appropriately assess these loans, the Bank segregated these loans and applied two separate historical loss ratios, one being the regular historical loan loss ratio applied to criticized and classified loans and the other being based on distressed sale charge-off levels applied to criticized and classified loans. Also, due to the

 

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significant increase in classified loans and the Bank’s need to provide a heavier weighting for these types of loans in the Bank’s allowance calculation, the Bank segregated the assets and used the “distressed sell mark,” which is the fair value mark made on the loans placed in an auction, as a basis for the additional emphasis in the model.

With the implementation of a new internal loan review department and the continued implementation of enhanced credit administration procedures, the Bank management evaluated the timing of full implementation and the potential impact on the loan portfolio in the third quarter of fiscal 2011. As a result a new component was added to the allowance computation based on internal loan review downgrade statistics and applied to loans that have not been reviewed either internally or externally. Management also reassessed the second historical loss ratio applied to criticized and classified loans based on “distressed sell mark”. With the passage of time and no additional auction sales anticipated, management determined a new basis was required to establish a current effective sustainable factor. To achieve this, industry statistics obtained from the FDIC related to charge-offs were utilized.

The historical loss ratios are adjusted by an analysis of real estate market deterioration that is derived from industry data for the markets we serve, as well as information from our bank-specific losses related to real estate transactions. We also revise the historic loss ratios upward for concentrations of capital greater than 100% for the product types defined above. At March 31, 2011, our most significant concentration was in commercial real estate. Lastly, we adjust the loss ratios based on growth in the product types. Consideration of these factors resulted in an upward adjustment of our historical loss ratios over the past twelve months. Our calculation also includes specific allocations arising from our loan impairment analysis.

Certain types of loans, such as option ARM products, junior lien mortgages, high loan-to-value ratio mortgages, single family interest only loans, sub-prime loans, and loans with initial “teaser” rates, can have a greater risk of non-collection than other loans. At March 31, 2011, the Bank had $6.1 million in junior lien mortgages. These loans represented less than 1% of total loans at March 31, 2011. At March 31, 2011, the Bank did not have any exposure to sub-prime loans and loans with initial teaser rates. At March 31, 2011, the Bank had $10.0 million of single family interest only loans.

At March 31, 2011, the Bank’s loan portfolio included a total of $20.2 million in loans with a high loan-to-value ratio. High loan-to-value ratios are defined by OTS regulation and range from 75%-90% depending on the type of loan. At March 31, 2011, approximately 23% of these loans were 1-4 single family or lot loans to home builders in North Texas. We addressed the additional risk in these loans in our allowance calculation primarily through our review of the real estate market deterioration adjustment to the historical loss ratio. Additionally, at March 31, 2011, the Bank had two loans with high loan-to-value ratios that were deemed impaired. The impairment analysis on these loans resulted in a partial charge-off of $332,000 on one loan and no impairment allocation or loss on the remaining loan. Regulatory guidelines suggest that high loan-to-value ratio loans should not exceed 100% of total capital. At March 31, 2011, the Bank’s high loan-to-value ratio loans represented 14% of total capital.

We obtain appraisals on real estate loans at the time of origination from third party appraisers approved by the Bank’s board of directors. We may also obtain additional appraisals when the borrower’s performance indicates it may default. After a loan default and foreclosure, we obtain new appraisals to determine the fair value of the foreclosed asset. We obtain updated appraisals on foreclosed properties on an annual basis until we sell the property

Management reviews the loan loss computation methodology on a quarterly basis to determine if the factors used in the calculation are appropriate. Because our problem loans and losses are concentrated in real estate-related loans, we pay particular attention to real estate market deterioration and the concentration of capital in our real estate-related loans. Improvement or additional deterioration in the residential and commercial real estate market may have an impact on these factors in future quarters. To the extent we underestimate the impact of these risks, our allowance account could be materially understated.

 

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Loans receivable, including loans held for sale, at March 31, 2011 and June 30, 2010 are summarized as follows (in thousands):

 

     March 31,
2011
    June 30,
2010
 

Residential

    

Mortgage loans held for sale

   $ 60,603      $ 424,055   

Mortgage 1-4 first liens

     121,228        143,755   

Mortgage 1-4 junior liens

     6,121        9,040   
                
     187,952        576,850   
                

Construction

    

Residential construction

     41,677        80,463   

Multi-family construction

     7,973        7,595   

Commercial construction

     29,770        40,495   
                
     79,420        128,553   
                

Lot and land development

    

Residential land

     49,054        84,669   

Commercial land

     21,465        36,414   
                
     70,519        121,083   
                

Commercial real estate

     431,027        514,930   

Multi-family

     55,325        75,408   

Commercial loans

     192,882        191,745   

Consumer loans

     3,673        4,692   

Loans held for immediate sale:

    

Commercial real estate

     6,779        —     

Commercial loans

     330        —     

Mortgage 1-4

     106        —     

Residential construction

     —          —     

Multi-family

     —          —     
                
     7,215        —     
                
     1,028,013        1,613,261   

Allowance for probable loan loss

     (47,314     (35,141
                
   $ 980,699      $ 1,578,120   
                

The following table shows the scheduled maturities of certain loan categories at March 31, 2011 and segregates those loans with fixed interest rates from those with floating or adjustable rates (in thousands):

 

     1 year
or less
     1-5
years
     Over 5
Years
     Total  

Commercial real estate and multi-family

   $ 98,577       $ 266,698       $ 121,077       $ 486,352   

Commercial loans

     97,268         79,616         15,998         192,882   

Construction loans

     62,812         11,541         5,067         79,420   
                                   

Total

   $ 258,657       $ 357,855       $ 142,142       $ 758,654   
                                   

 

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     1 year
or less
     1-5
years
     Over 5
Years
     Total  

Amount of loans based upon:

           

Floating or adjustable interest rates

   $ 244,825       $ 265,197       $ 95,402       $ 605,424   

Fixed interest rates

     13,832         92,658         46,740         153,230   
                                   

Total

   $ 258,657       $ 357,855       $ 142,142       $ 758,654   
                                   

We maintain an internally classified loan list that helps us assess the overall quality of the loan portfolio and the adequacy of the allowance for loan losses. Loans on this list are classified as substandard, doubtful or loss based on the probability of repayment, collateral valuation and related collectability. This list is used to identify loans that are considered non-performing.

We classify loans as non-performing when they are 90 days or more past due as to principal or interest or when reasonable doubt exists as to timely collectability. The Bank uses a standardized review process to determine which non-performing loans should be placed on non-accrual status. At the time a loan is placed on non-accrual status, we reverse previously accrued and uncollected interest against interest income. We recognize interest income on non-accrual loans to the extent we receive cash payments for the loans with respect to which ultimate full collections is likely. For loans where ultimate collection is not likely, we apply interest payments to the outstanding principal and we recognize income only if full payment is made.

Non-performing assets and classified loans as of March 31, 2011 and June 30, 2010 are as follows (dollars in thousands):

 

     March 31,
2011
    June 30,
2010
 

Loans accounted for on a non-accrual basis

    

1-4 family

   $ 3,334      $ 6,065   

Lot and land development

     20,261        8,776   

Multi-family

     16,633        2,394   

Residential construction

     7,345        3,809   

Commercial real estate

     24,607        16,911   

Commercial loans

     3,673        462   

Consumer loans

     81        11   
                
     75,934        38,428   
                

Non-performing loans as a percentage of total loans

     7.4     2.4

Loans past due 90 days or more, not included above 1-4 family

     —          29   
                
     —          29   
                

REO

    

1-4 family

     939        5,862   

Lot and land development

     19,380        19,565   

Residential construction

     1,334        7,673   

Commercial real estate

     5,181        11,150   

Commercial loans

     218        612   
                
     27,052        44,862   
                

Other repossessed assets (“ORA”)

     1,092        1,332   

Troubled debt restructuring

     491        9,009   
                

Non-performing assets

   $ 104,569      $ 93,660   
                

 

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     March 31,
2011
    June 30,
2010
 

Non-performing assets as a percentage of Bank assets

     7.6     5.3
                

Current classified assets

    

1-4 family

   $ 17,365      $ 7,355   

Lot and land development

     18,669        22,802   

Multifamily

     (692     __   

Residential construction

     9,164        6,886   

Commercial real estate

     95,499        57,127   

Commercial loans

     10,688        3,926   
                
     150,693        98,096   
                

Total classified assets

    

1-4 family

     21,638        19,311   

Lot and land development

     58,801        51,143   

Multifamily

     15,941        2,394   

Residential construction

     17,843        18,368   

Commercial real estate

     125,287        93,724   

Commercial loans

     15,671        6,805   

Consumer loans

     81        11   
                
   $ 255,262      $ 191,756   
                

In fiscal 2011, Bank management hired and allocated additional resources to manage the growth in REO and non-performing assets. Management has prepared an asset-by-asset plan for these asset categories to reduce these loans and properties expeditiously. Specifically, the Bank began conducting an auction of classified assets totaling $68.9 million in September 2010. This strategy included the engagement of a consultant to assist in the disposition of certain classified assets through a national and international marketing campaign. Management’s focus on the continued reduction of these asset classes may have a material impact on future results of operations.

Total classified assets to Bank capital plus allowance for loan loss was 132.7% at March 31, 2011. Classified assets increased $63.5 million from the June 2010 quarter and 97% of total classified loans by collateral location are in Texas. Bank management is focused on expeditiously reducing this ratio through the disposal of these assets. Depending on the method of disposal, the Bank may be required to record additional write-downs to the fair values of these assets. Management estimates that losses on the ultimate disposal of these assets could range from 0% to 50% of the recorded value. While management is diligently working to dispose of these assets quickly, lack of demand for certain property types, length of sales cycle and manpower limitations will impact the time required to ultimately reduce the classified assets to a more acceptable level.

 

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The following table presents an analysis of REO for the three and nine-month periods ended March 31, 2011 and 2010 (dollars in thousands):

 

     Three-Months Ended
March 31,
    Nine-Months Ended
March 31,
 
     2011     2010     2011     2010  

Balance at beginning of period

   $ 38,201      $ 37,610      $ 44,862      $ 25,301   

Foreclosures

     3,365        12,449        40,089        41,485   

Sales

     (12,691     (6,956     (44,739     (21,949

Write-downs

     (1,806     (1,687     (13,349     (3,608

Other

     (17     21        189        208   
                                

Balance at end of period

   $ 27,052      $ 41,437      $ 27,052      $ 41,437   
                                

The following table presents non-performing assets as of March 31, 2011 by year of origination (in thousands):

 

Year

Originated

   Non-
Performing
Loans
     REO      ORA     Troubled Debt
Restructuring
     Current
Classified
Assets
     Total  

Fiscal 2006 or prior

   $ 10,607       $ 6,304       $ —        $ —         $ 30,812       $ 47,723   

Fiscal 2007

     4,644         5,748         980 (#)      —           19,555         30,927   

Fiscal 2008

     39,112         12,736         —          491         29,464         81,803   

Fiscal 2009

     13,458         2,057         112        —           53,260         68,887   

Fiscal 2010

     6,564         207         —          —           14,714         21,485   

Fiscal 2011

     1,549         —           —          —           2,888         4,437   
                                                    
   $ 75,934       $ 27,052       $ 1,092      $ 491       $ 150,693       $ 255,262   
                                                    

 

(#) 

Amount is classified as “special mention” on the Bank’s Thrift Financial Report (“TFR”) filed with the OTS.

An analysis of the allowance for probable loan losses for the three and nine-month periods ended March 31, 2011 and 2010 is as follows (dollars in thousands):

 

     Three-Months Ended
March 31,
    Nine-Months Ended
March 31,
 
     2011     2010     2011     2010  

Balance at beginning of period

   $ 47,041      $ 17,601      $ 35,141      $ 14,731   

Charge-offs:

        

Residential construction

     —          (1,913     (1,999     (2,999

Lot and land development

     (2,690     (4,074     (5,350     (5,487

Residential mortgage

     (588     (1,110     (4,225     (1,798

Commercial real estate

     (1,020     (2,606     (25,163     (4,904

Multi-family

     —          (2,391     (562     (2,391

Commercial loans

     (297     (149     (1,975     (1,253

Consumer loans

     (1     (6     (1     (18
                                

Total charge-offs

     (4,596     (12,249     (39,275     (18,850

 

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     Three-Months Ended
March 31,
    Three-Months Ended
March 31,
 
     2011     2010     2011     2010  

Recoveries:

        

Residential construction

   $ 59      $ 1      $ 216      $ 1   

Lot and land development

     57        37        153        37   

Residential mortgage

     13        1        27        18   

Commercial real estate

     1        —          29        5   

Commercial loans

     12        3        55        29   

Consumer loans

     —          1        1        4   
                                

Total recoveries

     142        43        481        94   
                                

Net charge-offs

     (4,454     (12,206     (38,794     (18,756

Additions charged to operations

     4,727        25,000        50,967        34,420   
                                

Balance at end of period

   $ 47,314      $ 30,395      $ 47,314      $ 30,395   
                                

Ratio of net charge-offs during the period to average loans outstanding during the period

     0.41     0.87     2.94     1.34%   
                                

With the continued challenging economic environment and persistent high unemployment rate, the Bank frequently reviews and updates its processes and procedures for the extension of credit, allowance for loan loss computation and internal asset review and classification. Recent changes include more stringent underwriting guidelines for loan-to-value ratios, guarantor’s financial condition, owner-occupied versus investor loans and speculative versus custom construction. The Bank currently requires more extensive documentation and data than it did in prior years in order to classify existing loans as performing loans. The Bank is also updating appraisals more frequently, even on performing loans, and such appraisals serve as an early indicator of loan deterioration. These actions led to increases in non-performing assets and the loan loss allowance in fiscal 2010 and have continued to lead to increases in non-performing assets and the loan loss allowance during the nine-months ended March 31, 2011.

As a result of the current economic environment and the Order, the Bank has significantly limited the growth of its loan portfolio in fiscal 2011 in order to allocate the time, resources and capital necessary to support the existing loan portfolio.

The allowance for probable loan losses is applicable to the following types of loans as of March 31, 2011 and June 30, 2010 (dollars in thousands):

 

     March 31, 2011     June 30, 2010  
     Amount      Percent
of loans
to total
loans
    Percent
of the
allowance
for loan
loss
    Amount      Percent
of loans
to total
loans
    Percent
of the
allowance
for loan
loss
 

Residential construction

   $ 1,087         7.7     2.3   $ 3,362         8.0     9.6

Lot and land development

     7,079         6.9        15.0        4,808         7.5        13.7   

Residential mortgage

     5,206         18.3        11.0        3,542         35.8        10.1   

Commercial real estate

     28,541         42.6        60.3        19,733         31.9        56.2   

Multi-family

     1,053         5.4        2.2        812         4.6        2.3   

Commercial loans

     4,310         18.8        9.1        2,853         11.9        8.1   

Consumer loans

     38         0.3        0.1        31         0.3        —     
                                                  
   $ 47,314         100.0     100.0   $ 35,141         100.0     100.0
                                                  

 

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At March 31, 2011, approximately 60% of the Bank’s loan loss allowance was allocated to its commercial real estate loan portfolio while the Bank’s commercial real estate loan portfolio represented approximately 43% of its total loan portfolio. Because commercial real estate loans tend to be individually larger than residential loans, deterioration in this portfolio leads to more volatility in our earnings.

The Bank’s written loan policies address specific underwriting standards for commercial real estate loans. These policies include loan to value requirements, cash flow requirements, acceptable amortization periods and appraisal guidelines. In addition, specific covenants, unique to each relationship, may be used where deemed appropriate to further protect the lending relationship. Collateral in the commercial real estate portfolio varies from owner-occupied properties to investor properties. We periodically review the portfolio for concentrations by industry as well as geography. All commercial relationships are stress tested at the time of origination and major relationships are then stress tested on an annual basis.

Deposits

Average deposits and the average interest rate paid on the deposits for the three and nine-months ended March 31, 2011 can be found in the discussion of the banking segment’s net interest income under the caption “Results of Operations-Segment-Banking.”

The Bank had $23.7 million and $34.2 million of certificates of deposit of $100,000 or greater at March 31, 2011 and June 30, 2010, respectively. The Bank is funded primarily by deposits from SWS’s brokerage customers. These core deposits provide the Bank with a stable and low cost funding source. The Bank also utilizes short-and long-term FHLB borrowings to match long-term fixed rate loan funding. At March 31, 2011, the Bank had $951.3 million in funds on deposit from customers of Southwest Securities, representing approximately 85% of the Bank’s total deposits and $96.8 million of FHLB borrowings. Core deposits have reduced the Bank’s reliance on short-term borrowings from the FHLB and brokered certificates of deposit. The Bank does not use brokered deposits to provide liquidity; consequently, the Bank is in compliance with the Order’s prohibition on the use of brokered deposits.

Short Term Borrowings and Advances from Federal Home Loan Bank

The table below presents short term borrowings and advances from the FHLB which were due within one year during the three and nine-month periods ended March 31, 2011 and 2010 (dollars in thousands):

 

     Three-Months Ended March 31,     Nine-Months Ended March 31,  
     2011     2010     2011     2010  
     Amount      Interest
Rate
    Amount      Interest
Rate
    Amount      Interest
Rate
    Amount      Interest
Rate
 

At end of period

   $ 4,872         5.1   $ 10,075         5.1   $ 4,872         5.1   $ 10,075         5.1

Average balance during period

     5,612         5.1     9,818         5.0     11,018         3.9     6,777         4.9

Maximum balance during period

     10,291         —          12,400         —          79,570         —          12,400         —     

LIQUIDITY AND CAPITAL RESOURCES

Management believes that our current assets and available liquidity are adequate to meet our liquidity needs over the next twelve months. However, there is no assurance our forecast will prove to be accurate or that we will not be required to raise additional capital. As a result, from time to time, management evaluates various opportunities to supplement the Company’s sources of liquidity and capital. This evaluation led to signing the funding agreement with Hilltop and Oakhill.

 

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Funding Agreement

On March 20, 2011, we entered into an agreement with Hilltop and Oak Hill pursuant to which we would obtain a $100.0 million, five year, unsecured loan from these investors. In addition, we agreed to issue warrants to each investor allowing such investor to purchase up to 8,695,652 shares of 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. The closing of this transaction remains subject to obtaining all necessary regulatory and stockholder approvals.

Secondary Offering

On October 16, 2009, we filed a shelf registration statement with the SEC providing for the sale of $150.0 million of our securities. On December 9, 2009, we closed a public offering of 4,347,827 shares of common stock at a price of $11.50 per share. On December 16, 2009, the underwriters for the public offering exercised their option to purchase 652,174 additional shares of our common stock to cover over-allotments. We generated net proceeds, after deducting underwriting discounts and commissions, of approximately $54.4 million from these offerings.

Brokerage

A substantial portion of our assets are highly liquid in nature and consist mainly of cash or assets readily convertible into cash. Our equity capital, short-term bank borrowings, interest bearing and non-interest bearing client credit balances, correspondent deposits and other payables finance these assets. We maintain an allowance for doubtful accounts that represent amounts that are necessary, in the judgment of management, to adequately absorb losses from known and inherent risks in receivables from clients, clients of correspondents and correspondents. The highly liquid nature of our assets provides us with flexibility in financing and managing our anticipated operating needs. Management believes that the brokerage business’ present liquidity position is adequate to meet its needs over the next twelve months.

Short-Term Borrowings. We have credit arrangements with commercial banks, which include broker loan lines up to $300.0 million. These lines of credit are used primarily to finance securities owned, securities held for correspondent broker/dealer accounts and receivables in customers’ margin accounts. These lines may also be used to release pledged collateral against day loans. These credit arrangements are provided on an “as offered” basis and are not committed lines of credit. These arrangements can be terminated at any time by the lender. Any outstanding balances under these credit arrangements are due on demand and bear interest at rates indexed to the federal funds rate. At March 25, 2011, the amount outstanding under these secured arrangements was $136.0 million, which was collateralized by securities held for firm accounts valued at $167.9 million. Our ability to borrow additional funds is limited by our eligible collateral. See additional discussion under “Risk Factors” in our Form 10-K filed with the SEC on August 31, 2010.

At March 25, 2011, we had $250,000 outstanding under unsecured letters of credit pledged to support our open positions with securities clearing organizations. These letters have a 1% commitment fee and are renewable semi-annually at our option.

At March 25, 2011, we had $500,000 under an outstanding unsecured letter of credit pledged to support our underwriting activities. This letter bears a 1% commitment fee and is renewable annually at our option.

We also have a $20.0 million unsecured line of credit that is due on demand and bears interest at rates indexed to the federal funds rate. This credit arrangement is provided on an “as offered” basis and is not a committed line of credit. The total amount of borrowings available under this line of

 

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credit is reduced by the amount outstanding under any unsecured letters of credit at the time of borrowing. At March 25, 2011, there were no amounts outstanding on this line other than the $750,000 under unsecured letters of credit referenced above. At March 25, 2011, we had $19.3 million available for borrowing under this line of credit.

At March 25, 2011, we had an irrevocable letter of credit agreement aggregating $55.0 million pledged to support our open options positions with an options clearing organization. The letter of credit bears interest at the brokers’ call rate (0.5% at March 25, 2011), if drawn, and is renewable semi-annually. This letter of credit is fully collateralized by marketable securities held in client and non-client margin accounts with a value of $80.5 million at March 25, 2011.

On January 28, 2011, Southwest Securities entered into an agreement with an unaffiliated bank for a $45.0 million committed revolving credit facility. The commitment fee is 37.5 basis points per annum and, when drawn, the interest rate is equal to the federal funds rate plus 75 basis points. The agreement requires Southwest Securities to maintain tangible net worth of $150.0 million. As of March 25, 2011, there was $45.0 million outstanding under the committed revolving credit facility. The $45.0 million of secured borrowings was collateralized by securities with a value of $72.7 million at March 25, 2011.

Net Capital Requirements. Our broker/dealer subsidiaries are subject to the requirements of the SEC relating to liquidity, capital standards and the use of client funds and securities. The amount of broker/dealer subsidiaries’ net assets that may be distributed to the parent of the broker/dealer is subject to restrictions under applicable net capital rules. Historically, we have operated in excess of the minimum net capital requirements. See “Regulatory Capital Requirements” in the Notes to the Consolidated Financial Statements contained in this report.

Banking

Liquidity is monitored daily to ensure the Bank’s ability to support asset growth, meet deposit withdrawals, maintain reserve requirements and otherwise sustain operations. The Bank’s liquidity is maintained in the form of readily marketable loans and investment securities, balances with the FHLB, federal funds sold to correspondent banks and vault cash. At March 31, 2011, the Bank had net borrowing capacity with the FHLB of $318.4 million. In addition, at March 31, 2011, the Bank had the ability to borrow up to $83.8 million in funds from the Federal Reserve Bank of Dallas.

In the second quarter of fiscal 2010, the Bank entered into a secured line of credit agreement with the Federal Reserve Bank of Dallas. This line of credit is secured by the Bank’s commercial loan portfolio. This line is due on demand and bears interest at a rate 100 basis points over the federal funds target rate. This line is used to support short-term liquidity needs and, at March 31, 2011, there were no amounts outstanding.

The Bank’s asset and liability management policy is intended to manage interest rate risk. The Bank accomplishes this through management of the periodic repricing of its interest-earning assets and its interest-bearing liabilities. Overall interest rate risk is monitored through reports showing both sensitivity ratios, a simulation model and existing “GAP” data. (See the Bank’s GAP analysis in “Risk Management-Market Risk-Interest Rate Risk/Banking.”) At March 31, 2011, $951.3 million of the Bank’s deposits were from brokerage customers of Southwest Securities. Current events in the securities markets could impact the amount of these funds available to the Bank.

Capital Requirements. The Bank is subject to various regulatory capital requirements administered by federal agencies. Quantitative measures, established by regulation to ensure capital adequacy, require maintaining minimum amounts and ratios of total and Tier I capital (as defined in 12 CFR 565 and 12 CFR 567) to risk-weighted assets (as defined) and of Tier I (core) capital (as defined) to adjusted assets (as defined). At March 25, 2011, this resulted in excess capital of $24.9 million over the Order’s total risk-based capital requirement of $117.5 million and $21.8 million over the Order’s Tier I (core) capital requirement of $108.4 million. Under federal law, the OTS may require the Bank to apply another measure of risk-weight or capital ratio that the OTS deems appropriate.

 

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The Bank has historically met all capital adequacy requirements and, as of March 31, 2011, the Bank met all capital requirements to which it was subject and satisfied the requirements to be defined as a “well-capitalized institution.” However, on February 4, 2011, the Board of Directors of the Bank signed a Stipulation and Consent to Issuance of the Order. Accordingly, as a result of the issuance of the Order, effective February 4, 2011, the Bank is deemed to be “adequately capitalized” and no longer meets the definition of “well capitalized” under federal statutes and OTS regulations even though its capital ratios meet or exceed all applicable requirements under Federal law, OTS regulations and the Order. See additional discussion in “Cease and Desist Order with the Office of Thrift Supervision” in the Notes to the Consolidated Financial Statements contained in this report. Should the Bank not meet these minimums or should the OTS determine that the levels in excess of the minimum are necessary, certain mandatory and discretionary supervisory actions (as defined in 12 CFR 565.6) could be applicable. At March 31, 2011, the Bank’s total risk-based capital ratio was 14.5%, its Tier I risk-based capital ratio was 13.3% and its Tier I (core) capital ratio was 9.6%.

SWS Group contributed $23.0 million of capital to the Bank during the first quarter of fiscal 2011. This contribution allowed the Bank to meet its capital requirements and improved the Bank’s capital position.

Off-Balance Sheet Arrangements

We generally do not enter into off-balance sheet arrangements, as defined by the SEC. However, our broker/dealer subsidiaries enter into transactions in the normal course of business that expose us to off-balance sheet risk. See Note 24 of the Notes to Consolidated Financial Statements in our Form 10-K for the fiscal year ended June 25, 2010.

Cash Flow

Net cash provided by operating activities was $349.1 million and net cash used in operating activities was $171.9 million for the nine-months ended March 25, 2011 and March 26, 2010, respectively. The increase from fiscal 2010 to fiscal 2011 in net cash provided by operating activities was primarily due to the decrease in the Bank’s investment in purchased mortgage loans held for sale.

Net cash provided by investing activities for the nine-months ended March 25, 2011 was $236.1 million and net cash used in investing activities for the nine-months ended March 26, 2010 was $154.0 million. The primary reason for the increase in cash provided by investing activities was a $190.6 million decrease in the net amount invested in loans at the Bank, as well as the receipt of $75.6 million from the sale of investments, the receipt of $40.9 million from the sale of loans, $5.6 million from cash received on investments at the Bank and a $47.9 million decrease in cash paid on investments.

Net cash used in financing activities totaled $338.3 million for the nine-month period ended March 25, 2011 as compared to net cash provided by financing activities of $285.5 million in the same period of fiscal 2010. The primary reason for the decrease in the cash provided by financing activities was a decrease in deposits at the Bank and the receipt of funds from our public common stock offering in fiscal 2010.

We expect that cash flows provided by operating activities and short-term borrowings will be the primary source of working capital for the next twelve months.

 

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Treasury Stock

Periodically, we repurchase our shares of common stock under a plan approved by our Board of Directors. In August 2010, the Board of Directors of SWS Group approved a plan authorizing us to purchase up to 500,000 shares of common stock from time to time in the open market for an 18-month time period ending on February 28, 2012. During the nine-months ended March 25, 2011, no shares were purchased under this program.

On November 27, 2009, the stockholders of the SWS Group voted to increase the authorized number of shares of common stock available for issuance under the deferred compensation plan from 375,000 shares to 675,000 shares. The trustee under our deferred compensation plan periodically purchases shares of our common stock in the open market in accordance with the terms of the plan. This stock is classified as treasury stock in our consolidated financial statements, but participates in future dividends declared by us. During the nine-months ended March 25, 2011, the plan purchased 53,000 shares of our common stock at a cost of approximately $340,000, or $6.42 per share, and 20,560 shares were distributed to participants pursuant to the plan.

As restricted stock grants vest, grantees may sell a portion of their vested shares to us to cover the tax liabilities arising from vesting. As a result, in the nine-months ended March 25, 2011, we purchased 18,183 shares of common stock with a market value of $131,000, or an average of $7.22 per share, to cover tax liabilities.

RISK MANAGEMENT

We manage risk exposure through the involvement of various levels of management. We establish, maintain and regularly monitor maximum positions by industry and issuer in both trading and inventory accounts. Current and proposed underwriting, banking and other commitments are subject to due diligence reviews by senior management, as well as professionals in the appropriate business and support units involved. The Bank seeks to reduce the risk of significant adverse effects of market rate fluctuations by minimizing the difference between rate-sensitive assets and liabilities, referred to as “GAP”, and maintaining an interest rate sensitivity position within a particular timeframe. Credit risk related to various financing activities is reduced by the industry practice of obtaining and maintaining collateral. We monitor our exposure to counterparty risk through the use of credit information, the monitoring of collateral values and the establishment of credit limits. We have established various risk management committees that are responsible for reviewing and managing risk related to interest rates, trading positions, margin and other credit risk and risks from capital market transactions.

Credit Risk

Brokerage. Credit risk arises from the potential nonperformance by counterparties, customers or debt security issuers. We are exposed to credit risk as a trading counterparty and as a stock loan counterparty to dealers and customers, as a holder of securities and as a member of clearing organizations. We have established credit risk committees to review our credit exposure in our various business units. These committees are composed of senior management of the company. Credit exposure is also associated with customer margin accounts, which are monitored daily. We monitor exposure to individual securities and perform sensitivity analysis on a regular basis in connection with our margin lending activities. We adjust our margin requirements if we believe our risk exposure is not appropriate based on market conditions.

Banking. Credit risk is the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms and is inherent in all types of lending. The Bank has developed and continues to enhance its policies and procedures to provide a process for managing credit risk. These policies and procedures include underwriting guidelines, credit and collateral

 

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tracking, and detailed loan approval procedures which include officer and director loan committees. The Bank also maintains a detailed loan review process to monitor the quality of the loan portfolio. The Bank grants loans to customers primarily within Texas and New Mexico. The Bank also purchases mortgage loans which have been originated in other areas of the United States. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon the general economic conditions in Texas and New Mexico. Policies and procedures, which are in place to manage credit risk, are designed to be responsive to changes in these economic conditions.

Operational Risk

Operational risk refers generally to risk of loss resulting from our operations, including but not limited to, improper or unauthorized execution and processing of transactions, deficiencies in our operating systems, and inadequacies or breaches in our control processes. We operate in diverse markets and are reliant on the ability of our employees and systems to process large numbers of transactions. In order to mitigate and control operational risk, we have developed and continue to enhance specific policies and procedures that are designed to identify and manage operational risk at appropriate levels. We also use periodic self-assessments and internal audit examinations as further review of the effectiveness of our controls and procedures in mitigating our operational risk.

Legal Risk

Legal risk includes the risk of non-compliance with applicable legal and regulatory requirements. We are subject to extensive regulation in the different jurisdictions in which we conduct business. We have established procedures based on legal and regulatory requirements that are designed to reasonably ensure compliance with all applicable statutory and regulatory requirements. We also have established procedures that are designed to ensure that executive management’s policies relating to conduct, ethics and business practices are followed. In connection with our business, we have various procedures addressing significant issues such as regulatory capital requirements, sales and trading practices, new products, use and safekeeping of customer funds and securities, granting credit, collection activities, money laundering, privacy and record keeping.

Market Risk

Market risk generally represents the risk of loss that may result from the potential change in value of a financial instrument as a result of fluctuations in interest rates, market prices, investor expectations and changes in credit ratings of the issuer. Our exposure to market risk is directly related to our role as a financial intermediary in customer-related transactions and to our proprietary trading and securities lending activities.

Interest Rate Risk. A description of the interest rate risk for the brokerage and banking units are as follows:

Brokerage. Interest rate risk is a consequence of maintaining inventory positions, trading in interest rate sensitive financial instruments and maintaining a matched stock loan book. Our fixed income activities also expose us to the risk of loss related to changes in credit spreads. Credit spread risk arises from the potential that changes in an issuer’s credit rating or credit perception could affect the value of financial instruments.

Banking. Our primary emphasis in interest rate risk management for the Bank is the matching of assets and liabilities of similar cash flow and re-pricing time frames. This matching of assets and liabilities reduces exposure to rate movements and aids in stabilizing positive interest spreads. We strive to structure our balance sheet as a natural hedge by matching floating rate assets with variable short term funding and by matching fixed rate liabilities with similar longer term fixed rate assets. The Bank has established percentage change limits in both interest margin and net portfolio value. To verify that the Bank is within the limits established for interest margin, the Bank

 

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prepares an analysis of net interest margin based on various shifts in interest rates. To verify that the Bank is within the limits established for net portfolio value, the Bank analyzes data prepared by the OTS for interest rate sensitivity of the Bank’s net portfolio. These analyses are conducted on a quarterly basis for the Bank’s Board of Directors.

The following table illustrates the estimated change in net interest margin based on shifts in interest rates of positive 300 basis points and negative 100 basis points:

 

Hypothetical Change in Interest Rates   Projected Change in Net Interest Margin  
+300     12.51
+200     7.21
+100     1.82
0     0
-50     -4.00
-100     -7.96

The following GAP analysis table indicates the Bank’s interest rate sensitivity position at March 31, 2011 (in thousands):

 

     Repricing Opportunities  
     0-6 months      7-12 months      1-3 years      3+ years  

Earning assets:

           

Loans

   $ 830,609       $ 21,585       $ 54,585       $ 121,234   

Securities and FHLB stock

     5,403         —           —           35,525   

Interest bearing deposits

     267,803         —           —           —     
                                   

Total earning assets

     1,103,815         21,585         54,585         156,759   
                                   

Interest bearing liabilities:

           

Transaction accounts and savings

     994,541         —           —           —     

Certificates of deposit

     21,773         15,069         8,016         7,938   

Borrowings

     5,525         3,747         37,988         53,949   
                                   

Total interest bearing liabilities

     1,021,839         18,816         46,004         61,887   
                                   

GAP

   $ 81,976       $ 2,769       $ 8,581       $ 94,872   
                                   

Cumulative GAP

   $ 81,976       $ 84,745       $ 93,326       $ 188,198   
                                   

Market Price Risk. We are exposed to market price risk as a result of making markets and taking proprietary positions in securities. Market price risk results from changes in the level or volatility of prices, which affect the value of securities or instruments that derive their value from a particular stock or bond, a basket of stocks or bonds or an index.

 

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The following table categorizes “Securities owned, at market value” net of “Securities sold, not yet purchased, at market value,” which are in our securities owned and securities sold, not yet purchased, portfolios and “Securities available for sale” in our available-for-sale portfolio, which are subject to interest rate and market price risk at March 25, 2011 (dollars in thousands):

 

     Years to Maturity  
     1 or less     1 to 5     5 to 10     Over 10     Total  

Trading securities, at fair value

          

Municipal obligations

   $ 302      $ 8,395      $ 20,492      $ 66,099      $ 95,288   

Auction rate municipal bonds

     —          —          —          22,298        22,298   

U.S. government agency obligations

     3,844        (12,392     (17,317     (10,964     (36,829

Corporate obligations

     7        9,687        16,450        46,471        72,615   
                                        

Total debt securities

     4,153        5,690        19,625        123,904        153,372   

Corporate equity

     —          —          —          5,383        5,383   

Other

     14,101        —          —          —          14,101   
                                        
   $ 18,254      $ 5,690      $ 19,625      $ 129,287      $ 172,856   
                                        

Assets segregated for regulatory purposes

   $ —        $ 55,879      $ —        $ —        $ 55,879   
                                        

Weighted average yield

          

Municipal obligations

     3.2     3.1     4.2     6.1     5.4

Auction rate municipal bonds

     0.7     —          —          —          0.7

U.S. government agency obligations

     0.2     0.1     3.2     4.4     1.9

Corporate obligations

     2.8     3.5     5.1     4.9     4.4

Assets segregated for regulatory purposes

     —          0.4     —          —          0.4

Available-for-sale securities, at fair value

          

Securities available for sale

   $ 1,813      $ —        $ —        $ —        $ 1,813   
                                        

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in accordance with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect reported amounts and disclosures. Actual results may differ from these estimates under different assumptions or conditions. Except for our policies and methodology related to our loan loss reserve calculation, our accounting policies and methodology used in establishing estimates have not changed materially since June 25, 2010. See our annual report on Form 10-K for the fiscal year then ended.

FORWARD-LOOKING STATEMENTS

From time to time, we make statements (including some contained in this report) that predict or forecast future events, depend on future events for their accuracy, or otherwise contain “forward-looking” information and constitute “forward-looking statements” within the meaning of applicable U.S. securities legislation. Such statements are generally identifiable by the terminology used such as “plans,” “expects,” “estimates,” “budgets,” “intends,” “anticipates,” “believes,” “projects,” “indicates,” “targets,” “objective,” “could,” “should,” “may” or other similar words. By their very nature, forward-looking statements require us to make assumptions that may not materialize or that may not be accurate. Readers should not place undue reliance on any forward-looking statement and should recognize that the statements are predictions of future results, which may not occur as anticipated. Actual results may differ materially as a result of various factors, some of which are outside of our control, including:

 

   

the interest rate environment;

 

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the volume of trading in securities;

 

   

the liquidity in capital markets;

 

   

the volatility and general level of securities prices and interest rates;

 

   

the ability to meet regulatory capital requirements administered by federal agencies, including without limitation, those established by the Order with the OTS;

 

   

the level of customer margin loan activity and the size of customer account balances;

 

   

the demand for housing in Texas, New Mexico and the national market;

 

   

the credit-worthiness of our correspondents, counterparties in securities lending transactions and of our banking and margin customers;

 

   

the demand for investment banking services;

 

   

general economic conditions, especially in Texas and New Mexico and investor sentiment and confidence;

 

   

the value of collateral securing the loans we hold;

 

   

competitive conditions in each of our business segments;

 

   

changes in accounting, tax and regulatory compliance requirements;

 

   

the ability to attract and retain key personnel;

 

   

the availability of credit lines;

 

   

the potential misconduct or errors on the part of employees or entities with whom business is done;

 

   

the ability of borrowers to meet their contractual obligations and the adequacy of our allowance for loan losses; and

 

   

the potential of litigation and other regulatory liability.

Our future operating results also depend on our operating expenses, which are subject to fluctuation due to:

 

   

variations in the level of compensation expense incurred as a result of changes in the number of total employees, competitive factors, or other market variables;

 

   

variations in expenses and capital costs, including depreciation, amortization and other non-cash charges incurred to maintain our infrastructure; and

 

   

unanticipated costs which may be incurred from time to time in connection with litigation, regulation and compliance, loan analysis and modifications or other contingencies.

Other factors, risks and uncertainties that could cause actual results to differ materially from our expectations discussed in this report are described under the headings “Overview,” “Risk Management”, “Risk Factors” and “Critical Accounting Policies and Estimates” and in “Risk Factors” in our annual report on Form 10-K filed with the SEC, and our other reports filed with and available from the SEC. Our forward-looking statements are based on our current beliefs, assumptions and expectation, taking into account information that we reasonably believe to be reliable. All forward-looking statements we make speak only as of the date on which they are made,

 

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and except, as required by law, we expressly disclaim any obligation or undertaking to disseminate any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any statement is based.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The information required by this item is incorporated from “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the caption “Risk Management.”

 

Item 4. Controls and Procedures

The management of SWS, including the principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) pursuant to the Exchange Act) as of March 25, 2011. Based on such evaluation, the principal executive officer and principal financial officer have concluded that, as of March 25, 2011, our disclosure controls and procedures were effective for the purpose of ensuring that information required to be disclosed by SWS in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

There have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) pursuant to the Exchange Act) during the three-months ended March 25, 2011 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

In the general course of our brokerage business and the business of clearing for other brokerage firms, we have been named as defendants in various pending lawsuits and arbitration proceedings. These claims allege violations of various federal and state securities laws, including, specifically, certain Municipal Securities Rulemaking Board violations, an examination of political contributions and the use of consultants in connection with the firm’s municipal securities business. The Bank is also involved in certain claims and legal actions arising in the ordinary course of business. We believe that resolution of these claims will not result in any material adverse effect on our business, consolidated financial condition, results of operations or cash flows.

 

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Item 1A. Risk Factors

Except for the addition of the risk factors below, there have been no material changes from the risk factors disclosed in our Form 10-K for the fiscal year ended June 25, 2010 and in our quarterly reports on Form 10-Q filed after this Form 10-K.

Our assets as of March 25, 2011 include a deferred tax asset, the full value of which we may not be able to realize.

We recognize deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax bases of assets and liabilities. As of March 25, 2011, our deferred tax assets were approximately $34.0 million. We regularly review our deferred tax assets for recoverability based on our history of earnings, expectations for future earnings and expected timing of reversals of temporary differences. Realization of deferred tax assets ultimately depends on the existence of sufficient taxable income, including taxable income in prior carry-back years, as well as future taxable income.

The transaction contemplated by the Funding Agreement with Oak Hill and Hilltop remains subject to regulatory and stockholder approval, and our failure to obtain such approvals and close the transaction may adversely affect our future business, financial condition and results of operations.

The proposed transaction with Hilltop and Oak Hill, as contemplated under the Funding Agreement, is subject to regulatory and stockholder approval, which may not be obtained. Specifically, the Funding Agreement requires approval by the OTS or, if after July 21, 2011, the Board of Governors of the Federal Reserve System, of a rebuttal of control submission under the Savings and Loan Holding Company Act, and the investors are not required to complete the transaction if the Office of Thrift Supervision or the Board of Governors of the Federal Reserve System, whether in connection with the foregoing determinations or otherwise, imposes any condition or takes any action which would result in either investor being deemed to control the company under the Savings and Loan Holding Company Act or its implementing regulations or other applicable law or regulation, or that would materially adversely affect, in an investor’s good faith judgment, the economic or other benefits expected of the transactions contemplated by the Funding Agreement to either investor. In addition, pursuant to certain NYSE rules and regulations, stockholder approval is required prior to the issuance of common stock, or securities convertible into or exercisable for common stock, in any transaction or series of related transactions where, in general, the issuance involves more than 20% of our outstanding common stock or voting rights. The issuance of warrants and shares of common stock issuable upon exercise of the warrants (subject to anti-dilution adjustments) or, in certain circumstances, non-voting perpetual participating preferred stock issuable upon exercise of the warrants (which may be convertible into common stock in certain circumstances), if fully exercised, would represent approximately a 34% equity interest in our company in the aggregate. On April 14, 2011, we submitted a proposal to our stockholders to, among other things, approve the issuance of the warrants and the securities exercisable upon exercise of the warrants at a special meeting of stockholders to be held on May 18, 2011.

 

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If we do not receive the necessary regulatory and stockholder approval for this transaction, we will be unable to complete the transactions contemplated by the Funding Agreement and will not receive the $100 million loan. Further, we will be contractually obligated to reimburse the investors $250,000 upon termination of the Funding Agreement. We will also be contractually obligated, under certain circumstances, to pay the investors a termination fee of $3.5 million if, within twelve months of the termination of the Funding Agreement, we enter into an agreement with respect to, or complete a similar transaction with, another party and certain other requirements are met.

Any failure to consummate the proposed transaction with Hilltop and Oak Hill may impair our ability to raise additional capital, substantially limit our ability to implement our current business strategies and cause the market price of our common stock to decline. In addition, such failure may limit our ability to effectively sustain our operations, especially in the event of any future economic downturn, and could negatively affect our future business, financial condition or results of operations.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

 

Item 3. Defaults upon Senior Securities

None.

 

Item 4. (Removed and Reserved)

 

Item 5. Other Information

The table set forth below presents the amount awarded under our restricted stock plan for fiscal 2011 to each of the following Board of Directors. The Compensation Committee of the Board of Directors approved the awards on March 17, 2011.

 

     Restricted Stock Plan  

Name and Position

   Dollar
Value ($)
     Number
of Shares
Granted(1)
 

Robert A. Buchholz

Director

   $ 75,000         12,255   

I.D. Flores, III

Director

     75,000         12,255   

 

  (1) 

These shares are based on the last reported sales price of our common stock on the NYSE on March 17, 2011, which was $6.12 per share.

 

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On April 28, 2011, the Board of Directors approved the payment of a one time retention bonus to be made to certain executive officers. The retention bonus compensation is payable in four annual installments beginning in August of 2011. At the discretion of the Board of Directors, up to one-half of the full amount may be paid in common stock of the Company. Each installment of the retention bonus is subject to the current employment of the executive officer by the Company at the payment date. The table set forth below presents the amount awarded under the retention bonus plan to each of the following executive officers:

 

Name and Position

   Amount
Paid Under
the
Retention
Bonus Plan
 

James H. Ross

Director, President and Chief

Executive Officer

   $ 400,000   

Stacy M. Hodges

Executive Vice President and Chief

Financial Officer

     345,000   

Daniel R. Leland

Executive Vice President

     1,300,000   

Richard H. Litton

Executive Vice President

     1,300,000   

All executive officers as a group (8 persons)

   $ 4,050,000   

 

Item 6. Exhibits

The exhibits required to be furnished pursuant to Item 6 are listed in the Exhibit Index filed herewith, which Exhibit Index is incorporated herein by reference.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

   

SWS Group, Inc.

    (Registrant)

May 4, 2011

   

/S/ James H. Ross

Date     (Signature)
    James H. Ross
    Director and Chief Executive Officer
    (Principal Executive Officer)

May 4, 2011

   

/S/ Stacy M. Hodges

Date     (Signature)
    Stacy M. Hodges
    Chief Financial Officer
    (Principal Financial Officer)
    (Principal Accounting Officer)

 

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SWS GROUP, INC. AND SUBSIDIARIES

INDEX TO EXHIBITS

 

Exhibit
Number

 

Description

  3.1

  Restated Certificate of Incorporation of the Registrant incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K filed October 15, 2009

  3.2

  Restated By-laws of the Registrant incorporated by reference to Exhibit 3.2 to the Registrant’s Current Report on Form 8-K filed March 21, 2011

31.1*

  Chief Executive Officer Certification filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2*

  Chief Financial Officer Certification filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1*

  Chief Executive Officer Certification furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2*

  Chief Financial Officer Certification furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

* Filed herewith

 

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