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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the fiscal year ended June 29, 2012
For the transition period from to
Commission file number 000-19483
SWS GROUP, INC.
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code (214) 859-1800
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes No X
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act. Yes No X
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 X No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
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. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes No X
The aggregate market value of voting and non-voting common equity held by non-affiliates on December 30, 2011 was $250,923,672 based on the closing price of the registrants common stock, $6.87 per share, reported on the New York Stock Exchange on December 30, 2011. For purposes of this computation, all officers, directors and 10% beneficial owners of the registrant are deemed to be affiliates. Such determination should not be deemed an admission that such officers, directors or 10% beneficial owners are, in fact, affiliates of the registrant.
As of August 30, 2012, there were 32,877,467 shares of the registrants common stock, $0.10 par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement to be used in connection with the solicitation of proxies to be voted at the Registrants Annual Meeting of Stockholders to be held November 15, 2012 are incorporated by reference into Part III of this Annual Report on Form 10-K.
SWS GROUP, INC. AND SUBSIDIARIES
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:
Our future operating results also depend on our operating expenses, which are subject to fluctuation due to:
Other factors, risks and uncertainties that could cause actual results to differ materially from our expectations discussed in this report include those factors described in the sections titled Item 1. Business, Item 1A. Risk Factors, Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations - Overview, -Risk Management, and -Critical Accounting Policies and Estimates and those discussed in our other reports filed with and available from the Securities and Exchange Commission (the SEC). Our forward-looking statements are based on current beliefs, assumptions and expectations, 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 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 upon which any statement is based.
We are a diversified financial services holding company focused on delivering a broad range of investment banking, commercial banking and related financial services to individual, corporate and institutional investors, broker/dealers, governmental entities and financial intermediaries. We are the largest full-service brokerage firm headquartered in the Southwestern United States (based on the number of financial advisors).
For purposes of this report, references to we, us, our, SWS and the company mean SWS Group, Inc. collectively with all of our subsidiaries, and references to SWS Group mean solely SWS Group, Inc. as a single entity.
SWS Group is a Delaware corporation and was incorporated in 1972, and its common stock is listed on the New York Stock Exchange (NYSE). Our principal executive offices are located at 1201 Elm Street, Suite 3500, Dallas, Texas 75270. Our telephone number is (214) 859-1800 and our website is www.swsgroupinc.com. We do not intend for information contained on our website to be part of this Form 10-K. We file annual, quarterly and current reports, proxy statements and other information with the SEC. You may read and copy any document we file with the SEC at the SECs public reference room at 100 F Street, N.E., Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for information on the public reference room.
The SEC also maintains an Internet site that contains annual, quarterly and current reports, proxy and information statements and other information that we (together with other issuers) file electronically. The SECs Internet site is www.sec.gov. We make available free of charge on or through our website our annual, quarterly and current reports and amendments to those reports as soon as reasonably practicable after we electronically file such material with or furnish it to the SEC. Additionally, we will provide electronic or paper copies of our filings free of charge upon request.
Our principal brokerage subsidiary, Southwest Securities, Inc. (Southwest Securities), is a registered broker/dealer and a member of the NYSE. It is also a member of the Financial Industry Regulatory Authority (FINRA), Securities Investor Protection Corporation (SIPC), and other regulatory and trade organizations.
Southwest Securities provides integrated trade execution, clearing and client account processing to over 150 financial service organizations, which includes correspondent broker/dealers and registered investment advisors in 30 states and Canada. Southwest Securities serves individual investors through its private client group offices in Texas, California, Nevada and Oklahoma and institutional investors nationwide. Southwest Securities also extends margin credit and lends securities and manages and participates in underwriting equity and fixed income securities. For the fiscal year ended June 29, 2012, revenues from Southwest Securities accounted for approximately 74% of our consolidated revenues.
We also operate SWS Financial Services, Inc. (SWS Financial), a broker/dealer subsidiary that is also registered with FINRA. SWS Financial contracts with more than 300 individual registered representatives (who are FINRA licensed salespersons) for the administration of their securities business. While these registered representatives must conduct all of their securities business through SWS Financial, they may conduct insurance, real estate brokerage or other business for others or for their own accounts. The registered representatives are responsible for all of their direct expenses and are paid higher commission rates than Southwest Securities registered representatives to compensate them for their added expenses. SWS Financial is a correspondent of Southwest Securities.
We offer full-service, traditional and Internet banking through Southwest Securities, FSB (the Bank). The Bank is a federally chartered savings bank, organized and existing under the laws of the United States and regulated since July 21, 2011 by the OCC. Prior to July 21, 2011, the Bank was regulated by the OTS. As of July 21, 2011, the Federal Reserve Board (FRB) began supervising and regulating SWS Group and SWS Banc Holdings, Inc. (SWS Banc). The Bank conducts business from its main operating facilities and headquarters in Dallas, Texas and 12 banking center locations in Texas and New Mexico. In 2003, SWS Banc was incorporated as a wholly-owned subsidiary of SWS Group in the state of Delaware and became the sole stockholder of the Bank in 2004.
The annual consolidated financial statements of SWS are prepared as of the close of business on the last Friday in June. The Banks annual financial statements are prepared as of June 30th.
PRODUCTS AND SERVICES
In fiscal 2012, we operated through four business segments grouped primarily by products, services and customer base: clearing, retail, institutional and banking. The segments are managed separately based on the types of products and services offered and their related client bases and are consistent with how we manage our resources and assess our performance. For more information about each of these business segments, see Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, below. See also Note 24 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 included under Item 8. Financial Statements and Supplementary Data for information regarding the revenues, income (loss) and total assets of each of our business segments.
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.
In a fully disclosed clearing transaction, the identity of the clearing clients (correspondent) customer is known to us and we physically maintain the clients account and perform a variety of services as agent for the correspondent. Revenues in this segment are generated primarily through transaction charges to our correspondent firms for clearing their trades according to a contractual schedule.
In addition to clearing trades, we tailor our services to meet the specific needs of our clients 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.
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. High-volume trading firms trade actively on a proprietary basis or provide services to those customers who trade actively on a daily basis. As of June 29, 2012, Southwest Securities provided clearing services for three high-volume trading firms. The nature of services provided to the customers of high-volume trading firms and the internal costs necessary to support them are substantially lower than the standard correspondent costs and services. Accordingly, fees for services to these correspondents, on a per trade basis, are discounted substantially from the fees normally charged to other customers.
The terms of our agreements with our correspondents define the allocation of financial, operational and regulatory responsibility arising from the clearing relationship. To the extent that the correspondent has available financial resources, we are protected against claims by customers of the correspondent arising from actions by the correspondent; however, if the correspondent is unable to meet its financial obligations, dissatisfied customers may attempt to recover from us.
Retail. The Retail segment includes the sale of retail securities, insurance products and managed accounts. 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 account balances.
Retail Securities. We act as securities broker for retail investors in the purchase and sale of securities, options, commodities and futures contracts that are traded on various exchanges or in the over-the-counter market through our employee registered representatives or our independent contractor arrangements. As a securities broker, we extend margin credit on a secured basis to our retail customers in order to facilitate securities transactions. Through our insurance subsidiaries, we hold insurance licenses in 44 states in order to facilitate the sale of insurance and annuity products by our financial advisors to retail clients. In most cases, we charge commissions to our clients in accordance with our established commission schedule. In certain instances, discounts varying from the schedule are given, generally based upon the clients level of business, the trade size and other relevant factors. Some of our registered representatives also maintain licenses to sell certain insurance products. Southwest Securities is registered with the Commodity Futures Trading Commission (CFTC) as a non-guaranteed introducing broker and is a member of the National Futures Association (NFA). Southwest Securities is also a fully disclosed client of two of the largest futures commodity merchants in the United States.
Our financial advisors work with their individual clients to create investment portfolios based on the clients specific financial goals and tolerance for risk. We provide access to fee-based platforms and a wide array of products and services including access to investment management programs that can be tailored to the individual client relationship to enhance the financial advisors business and benefit his or her clients.
At June 29, 2012, Southwest Securities employed 166 registered representatives in 19 retail brokerage offices (two located in Houston and one located in each of Austin, Dallas, Georgetown, Longview, Lufkin, Plano, San Antonio and Southlake, Texas; one located in each of Oklahoma City and Norman, Oklahoma; one located in each of Beverly Hills, Monterey, Rancho Bernardo, Sacramento, San Diego and San Francisco, California and one located in Las Vegas, Nevada). (The employees located in the Rancho Bernardo office relocated to the San Diego office on June 29, 2012. The lease on the Rancho Bernardo office expired on June 30, 2012 and the lease was not renewed.) In addition, at June 29, 2012, SWS Financial had contracts with 310 independent retail representatives for the administration of their securities business.
Insurance. Southwest Financial Insurance Agency, Inc. and Southwest Insurance Agency, Inc., together with its subsidiary, Southwest Insurance Agency of Alabama, Inc., (collectively, SWS Insurance) hold insurance agency licenses in 44 states for the purpose of facilitating the sale of insurance and annuity products for our registered representatives to their retail customers. We retain no underwriting risk related to the insurance and annuity products that SWS Insurance sells.
Managed Accounts. Through the Investment Management Group of Southwest Securities, we provide seven advisory programs that offer advisors a wide array of products and services to enhance and grow their advisory business. Programs available include the following:
Margin Lending. We extend credit on a secured basis directly to our customers, the customers of correspondent firms and the correspondent firms themselves in order to facilitate securities transactions. This credit, which generates interest income, is known as margin lending and is conducted primarily in our clearing and retail segments. We extend margin credit to correspondent firms only to the extent that such firms pledge their own (proprietary) assets as collateral. Our correspondents indemnify us against margin losses in their customers accounts. Since we must rely on the guarantees and general creditworthiness of our correspondents, we may be exposed to significant risk of loss if they are unable to meet their financial commitments should there be a substantial adverse change in the value of margined securities.
In customer margin transactions, the client borrows money from us to purchase securities or for other purposes. The loan is collateralized by the securities purchased or by other securities owned by the client. Interest is charged to clients on the amount borrowed to finance margin transactions at a floating rate. The rate charged is dependent on the average net debit balance in the clients accounts, the activity level in the accounts and the applicable cost of funds. The amount of the loan is subject to the margin regulations (Regulation T) of the Board of Governors of the Federal Reserve System, FINRA margin requirements and our internal policies. In most transactions, Regulation T limits the amount loaned to a customer for the purchase of securities to 50% of the purchase price. Furthermore, in the event of a decline in the value of the collateral, FINRA requirements regulate the percentage of client cash or securities that must be on deposit as collateral for the loans.
In permitting clients to purchase on margin, we are subject to the risk that the value of our collateral could fall below the amount of that clients indebtedness. Agreements with margin account clients permit us to liquidate the clients securities with or without prior notice in the event of an insufficient amount of margin collateral. Despite those agreements, we may be unable to liquidate the clients securities for various reasons including, but not limited to, a thin trading market, an excessive concentration or the issuance of a trading halt.
The primary source of funds to finance client margin account balances is credit balances in the clients account. We generally pay interest to clients on these credit balances at a rate determined periodically. SEC regulations restrict the use of client funds to the financing of client activities including margin account balances. Excess customer credit balances, as defined by SEC regulations, are invested in short-term securities segregated for the exclusive benefit of customers as required by SEC regulations. We generate net interest income when there is a positive interest rate spread between the rate earned from margin lending and segregated short-term investments and the rate paid on customer credit balances.
Institutional. The Institutional segment is comprised of businesses serving institutional customers in the areas of securities borrowing and lending, municipal finance, investment banking, fixed income sales and equity trading. 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.
Securities Lending Activities. Our securities lending business includes borrowing and lending securities for other broker/dealers, lending institutions and our own clearing and retail operations. These activities involve borrowing securities to cover short sales and to complete transactions in which clients have failed to deliver securities by the required settlement date and lending securities to other broker/dealers for similar purposes.
When borrowing securities, we are required to deposit cash or other collateral or to post a letter of credit with the lender, and we generally receive a rebate (based on the amount of cash deposited) or a fee calculated to yield a negotiated rate of return. When lending securities, we receive cash or similar collateral and generally pay interest (based on the amount of cash deposited) to the other party to the transaction. Generally, we earn net interest income based on the spread between the interest rate on cash or similar collateral we deposit and the interest rate paid on cash or similar collateral we receive.
Securities borrowing and lending transactions are executed pursuant to written agreements with counterparties that generally require securities borrowed and loaned to be marked-to-market on a daily basis, excess collateral to be refunded, and deficit collateral to be furnished. Collateral adjustments are made on a daily basis through the facilities of various clearinghouses. We are a principal in these securities borrowing and lending transactions and are liable for losses in the event of a failure of any other party to honor its contractual obligation. Our management sets credit limits with each counterparty and reviews these limits regularly to monitor the risk level with each counterparty. The securities lending business is conducted primarily from Southwest Securities New Jersey office using a highly specialized sales force.
Investment Banking and Municipal Finance. Our investment banking and municipal finance businesses earn investment banking revenues by assisting corporate and public entity clients in meeting their financial needs and advising them on the most advantageous means of raising capital. Our municipal finance 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.
Our syndicate department coordinates the distribution of managed and co-managed corporate equity underwritings, accepts invitations to participate in competitive or negotiated underwritings managed by other investment banking firms and allocates and markets our selling allotments to institutional clients and to other broker/dealers.
Southwest Securities maintains a corporate finance branch office in Dallas, Texas and municipal finance branch offices in Austin, Dallas, Longview, Allen and San Antonio, Texas; Irvine and Cardiff, California; Hillsdale, New York; Albuquerque, New Mexico; Charlotte, North Carolina; Lexington, Kentucky; Columbia, South Carolina and Monroe, Louisiana.
Participation in firm commitment corporate and municipal underwritings can expose us to material risk due to the possibility that the securities we have committed to purchase may not be sold at the initial offering price. In addition, 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.
Fixed Income Sales and Equity Trading. Our fixed income sales and trading group specializes in trading and underwriting U.S. government and agency bonds, corporate bonds, municipal bonds, mortgage-backed, asset-backed and commercial mortgage-backed securities and structured products. The clients of our fixed income group include corporations, insurance companies, banks, mutual funds, money managers and other institutions. Southwest Securities has fixed income offices in Austin and Dallas, Texas; Chicago, Illinois; Ft. Lauderdale and Palm Beach Gardens, Florida; Encino, Irvine and San Francisco, California; Canton and Westport, Connecticut; Evergreen, Colorado; Bloomfield, New Jersey; Memphis, Tennessee and New York, New York.
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.
Banking. We offer traditional banking products and services through 12 full-service banking centers with 10 banking centers located in Texas, two located in Arlington and one located in each of Austin, Benbrook, Dallas, El Paso, Granbury, Houston, Southlake and Waxahachie, and two located in New Mexico with one each located in Albuquerque and Ruidoso. We specialize in two primary areas: business banking and mortgage purchase. Our focus in business banking includes small business (SBA) 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 banking operations are currently restricted by, and subject to, the Order with the OCC. See additional discussion of the Order in Note 29 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 included under Item 8. Financial Statements and Supplementary Data.
The Bank offers a full array of deposit products, including checking, savings, money market and certificates of deposit. As a full-service lender, the Bank offers competitive rates and terms on business loans, as well as a full line of consumer loans. Customers have access to comprehensive Internet banking services and online bill payment. The Bank offers commercial and commercial real estate loans as well as residential mortgage loans, primarily in Texas and New Mexico. In prior years, the Bank also provided interim construction lending to builders throughout the North Texas market.
Our mortgage purchase division purchases participations and sub-participations in newly originated residential loans (1-4 family), from various mortgage bankers nationwide. In the fourth quarter of fiscal 2012, the Bank signed a sub-participation agreement with a non-affiliate bank to sub-participate in this banks mortgage purchase program. We have made a maximum total commitment of $50.0 million pursuant to this agreement. As of June 30, 2012, 12% of the $294.3 million purchased mortgage loans held for investment balance was from this sub-participation agreement. The loans are pre-committed for sale by the mortgage company to secondary investors. The purchased mortgage loans held for investment are held by the Bank on average for 25 days or less. Approximately 95% of the loans conform to the standards of Fannie Mae, Freddie Mac or Ginnie Mae, and the rest are A credit jumbo loans. As of the date of this report, the Bank had approximately 60 customer/originators across the nation. Although the Bank is exposed to credit risk before the loans are sold by the mortgage company, there is no recourse to the Bank after the mortgage company sells the loan to the secondary investor.
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.
Revenues by Source
The following table shows our revenues by source for the last three fiscal years (dollars in thousands):
We encounter intense competition in our businesses. We compete directly with securities firms and banks, many of which have substantially greater capital and other resources than we have. We also encounter competition from insurance companies and financial institutions in many elements of our businesses.
The brokerage entities compete principally on the basis of service, product selection, price, location and reputation. We operate at a price disadvantage to discount brokerage firms that do not offer equivalent services. We compete for the correspondent clearing business on the basis of service, reputation, financial strength, price, technology and product selection.
Competition for successful securities traders, stock loan professionals and investment bankers among securities firms and other competitors is intense, as is competition for experienced financial advisors. We recognize the importance of hiring and retaining skilled professionals so we invest heavily in the recruiting process. The failure to attract and retain skilled professionals could have a material adverse effect on our business and on our performance.
The Bank also operates in an intensely competitive environment. This environment includes other banks, credit unions, nonbank lenders and insurance companies. The competition ranges from small community banks to trillion dollar commercial banks. As with the securities industry, the ability to attract and retain skilled professionals is critical to the Banks success. To enhance these activities the Bank utilizes SWS for assistance in recruiting and educational programs. The Bank competes for community banking customers locally based on reputation, service, location and price. The Bank also competes nationally through its mortgage purchased division.
We operate in the financial services industry as, among other things, a securities broker/dealer, a registered investment advisor and a bank. As a result, our businesses are highly regulated by U.S. federal and state regulatory agencies, self-regulatory organizations and securities exchanges and, to a lesser extent, by foreign governmental agencies and financial regulatory bodies. As a matter of public policy, regulatory bodies in the U.S. are charged with, among other things, safeguarding the integrity of the securities and other financial markets and with protecting the interests of customers, including depositors, the Federal Deposit Insurance Fund (DIF), and the banking system as a whole, not with protecting the interests of creditors or the stockholders of regulated entities.
Significant elements of the laws and regulations applicable to us are described below. The description is qualified in its entirety by reference to the full text of the statutes, regulations and policies that are described. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies.
We are under the jurisdiction of the SEC and are subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended (the Exchange Act), as administered by the SEC. As a public company whose common stock is listed on the NYSE, we are subject to corporate governance requirements established by the SEC and NYSE, as well as federal and state law. Under the Sarbanes-Oxley Act, we are required to meet certain requirements regarding business dealings with members of our Board of Directors, the structure of our Audit Committee and ethical standards for our senior financial officers. Also, under Section 404 of the Sarbanes-Oxley Act, we are required to assess the effectiveness of our internal controls over financial reporting and to obtain an opinion from our independent auditors regarding the effectiveness of our internal controls over financial reporting. Under SEC and NYSE rules, we are required to comply with other standards of corporate governance, including having a majority of independent directors serve on our Board of Directors, and the establishment of independent audit, compensation and corporate governance committees.
We are a legal entity separate and distinct from our banking and non-banking subsidiaries. Our principal sources of funds are cash dividends paid by our subsidiaries, capital contributions from the sale of our securities, investment income, and borrowings. Normally, federal laws limit the amount of dividends or other capital distributions that a banking institution can pay, and the Bank must obtain prior approval from the OCC before it can pay dividends to us. On February 4, 2011, the Board of Directors of the Bank agreed to a Stipulation and Consent to Issuance of Order to Cease and Desist and the OTS issued the Order. The Order is now enforced by the OCC. The Order provides that, among other things, the Bank cannot declare or pay dividends or make any other capital
distributions without the prior approval of the OCC after 30 days prior notice to the OCC. See also Note 29 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 included under Item 8. Financial Statements and Supplementary Data.
Due to the recent financial economic crisis, many new regulations and statutes have been proposed or enacted over the past several years that contain wide-ranging proposals for altering the structures, regulations and competitive relationships of financial institutions operating and doing business in the United States. Most notably, on July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was enacted.
The Dodd-Frank Act seeks to restore responsibility and accountability to the U.S. financial system by significantly altering the regulation of financial institutions and the financial services industry. Most of the provisions contained in the Dodd-Frank Act have delayed effective dates, and full implementation will require many new rules to be issued by federal regulatory agencies over the next several years. While we continue to closely monitor the implementation of the Dodd-Frank Act, including new and proposed regulations, the full impact of the new rules on our business is still uncertain.
Among other things, the Dodd-Frank Act:
From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. These initiatives may include proposals to expand or contract the powers of holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking and brokerage statutes and our operating environment in substantial and unpredictable ways. If enacted, such legislation could increase or decrease our cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any such legislation will be enacted, and, if enacted, the impact that it, and any implementing regulations, would have on our financial condition or results of operations. Any change in statutes, regulations or regulatory policies applicable to us or any of our subsidiaries could have a material effect on our business.
Regulation of SWS Group. SWS Group is regulated under the Savings and Loan Holding Company Act, as amended (the SLHC Act), and its subsidiaries that are not functionally regulated are subject to inspection, examination and supervision by the FRB.
The FRB has the power to order any savings and loan holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when the FRB has reasonable grounds to believe that continuation of such activity or such ownership or control constitutes a serious risk to the financial soundness, safety or stability of any bank subsidiary of the holding company.
The Dodd-Frank Act requires the federal financial regulatory agencies to adopt rules that prohibit banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain unregistered investment companies (defined as hedge funds and private equity funds). This provision is commonly called the Volcker Rule. In October 2011, federal regulators proposed rules to implement the Volcker Rule. The proposed rules are highly complex, and many aspects of their application remain uncertain.
FRB policy has historically required bank holding companies to act as a source of financial and managerial strength to their subsidiary banks. The Dodd-Frank Act codified this policy as a statutory requirement for savings and loan holding companies, such as SWS Group. Under this requirement, we are expected to commit resources to support the Bank, including at times when we may not be in a financial position to provide such resources. Any capital loans by a holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks. In the event of a holding companys bankruptcy, any commitment by the holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.
Regulation of the Securities Business. The securities industry in the United States is subject to extensive regulation under federal and state laws and regulations. Our U.S. broker/dealer subsidiaries are registered as such with the SEC and FINRA. Self-regulatory organizations such as FINRA have also enacted rules (which are subject to approval by the SEC) for governing the industry. Securities firms are subject to regulation by state securities commissions in the states in which they conduct business. Southwest Securities and SWS Financial are registered in all 50 states and the District of Columbia. Southwest Securities is also registered in the U.S. Virgin Islands. Federal and state authorities, as well as state regulatory authorities, have the power to undertake periodic examinations of our securities broker/dealer operations for the purpose of assuring our compliance with the applicable rules and regulations.
The regulations to which broker/dealers are subject cover all aspects of the securities business, including the manner in which securities transactions are effected, net capital requirements, recordkeeping and reporting procedures, relationships and conflicts with customers, the handling of cash and margin accounts, sales methods and
conduct, experience and training requirements for certain employees, the conduct of investment banking and research activities and the manner in which we prevent and detect money-laundering activities. Legislation and changes in rules promulgated by the SEC and by self-regulatory organizations or changes in the interpretation or enforcement of existing laws and rules often directly affect the method of operation and profitability of broker/dealers. The SEC and self-regulatory organizations may conduct administrative proceedings that can result in censure, fine, suspension or expulsion of a broker/dealer firm, its officers or employees.
Our broker/dealer subsidiaries are subject to the SECs net capital rule (Exchange Act Rule 15c3-1). Generally, a broker/dealers net capital is equal to its net worth plus qualified subordinated debt less deductions for non-allowable (or non-liquid) assets and other operational charges. The SEC and FINRA impose rules that require notification when net capital falls below certain predefined criteria. These rules also dictate the ratio of debt-to-equity in the regulatory capital composition of a broker/dealer and constrain the ability of a broker/dealer to expand its business under certain circumstances. If a firm fails to maintain the required net capital, it may be subject to suspension or revocation of registration by the applicable regulatory agency, and suspension or expulsion by these regulators could ultimately lead to the firms liquidation.
Compliance with the net capital requirements may limit our operations, requiring the intensive use of capital. Such rules require that a certain percentage of our assets be maintained in relatively liquid form and therefore act to restrict our ability to withdraw capital from our broker/dealer subsidiaries, which in turn may limit our ability to pay dividends, repay debt or redeem or purchase shares of our outstanding common stock. Any change in such rules or the imposition of new rules affecting the scope, coverage, calculation or amount of capital requirements, or a significant operating loss or any unusually large charge against capital, could adversely affect our ability to pay dividends, meet our debt covenant requirements or to expand or maintain present business levels. In addition, such rules may require us to make substantial capital contributions into one or more of our broker/dealer subsidiaries in order for such subsidiaries to comply with such rules, either in the form of cash or subordinated loans made in accordance with the requirements of the SECs net capital rule. As of June 29, 2012, Southwest Securities had regulatory net capital, as defined by Exchange Act Rule 15c3-1, of $150.3 million, which exceeded the amounts required by $143.6 million. However, the amount of net excess capital can change dramatically within a short period of time.
Our broker/dealer subsidiaries are required by federal law to belong to the SIPC, whose primary function is to provide financial protection for the customers of failing brokerage firms. SIPC provides protection for clients cash and securities up to $500,000 per customer account, of which a maximum of $250,000 may be in cash.
Our broker/dealer subsidiaries must also comply with the USA PATRIOT Act and other rules and regulations designed to fight international money laundering and to block terrorist access to the U.S. financial system. We are required to have systems and procedures to ensure compliance with such laws and regulations.
Certain activities of some SWS subsidiaries are regulated by the CFTC and various commodity exchanges. The CFTC also has net capital regulations (CFTC Rule 1.17) that must be satisfied. Our futures business is also regulated by the NFA, a registered futures association. Violation of the rules of the CFTC, the NFA or the commodity exchanges could result in remedial actions including fines, registration restrictions or terminations, trading prohibitions or revocations of commodity exchange memberships.
Banking Regulations. We are subject to the extensive regulatory framework applicable to savings and loan holding companies as well as federal savings associations.
As a savings and loan holding company, we are subject to regulation and examination by the FRB. The Bank is subject to regulation and examination by the OCC (its primary federal regulator). The banking regulators, including the OCC, FDIC and FRB have broad and, in some cases, overlapping, authority to prohibit activities of holding companies, federal savings banks, their non-banking subsidiaries, directors, officers and other institution affiliated parties (such as attorneys and accountants) that represent unsafe and unsound banking practices or that constitute violations of laws or regulations. The OCC can assess civil money penalties for violations of law, OTS/OCC orders, written conditions or written agreements with the OCC, as well as certain activities conducted on a knowing and reckless basis, if those activities caused a substantial loss to a depository institution. The penalties can be as high as $1.375 million for each day the activities continue.
The Dodd-Frank Act transferred the functions of the OTS (other than consumer protection) as they relate to the Bank to the OCC, and as they relate to SWS Group, to the FRB on July 21, 2011 (Transfer Date). Eventually, we will be required to comply with capital and activity requirements similar to those currently applicable to bank holding companies. In addition, the Dodd-Frank Act enacted new minimum capital requirements for depository institution holding companies and the federal banking agencies have proposed rules implementing these statutory provisions. The OCC published a final rule on the Transfer Date clarifying the application of its rules to federal savings banks in certain areas, including assessments, preemption of state law, visitorial powers and other clarifying administrative matters.
The Dodd-Frank Act also requires the FRB to mandate that any bank holding company or savings and loan holding company serve as a source of financial strength for any subsidiary that is a depository institution. The Dodd-Frank Act gave the federal banking agencies one year after the Transfer Date to issue joint final rules related to the source of financial strength requirement, however, these rules have not been proposed. source of financial strength is defined as the ability of a company that directly or indirectly owns or controls an insured depository institution to provide financial assistance to such insured depository institution in the event of the financial distress of the insured depository institution. Once these rules are finalized, as a savings and loan holding company, we will be required to be a source of financial strength for the Bank.
In July 2010, the FDIC voted to revise its existing Memorandum of Understanding with the primary federal regulators to enhance the FDICs existing backup authorities over insured depository institutions that the FDIC does not directly supervise. As a result, the Bank may be subject to increased supervision by the FDIC.
With very limited exceptions, we may not be acquired by any company or by any individual without the approval of a governing bank regulatory agency. That agency must complete an application review, and generally the public must have an opportunity to comment on any proposed acquisition. Without prior approval from the FRB, we may not acquire more than five percent of the voting stock of any savings institution or bank. The Dodd-Frank Act restricts a bank that is the subject of a formal enforcement action or a memorandum of understanding with respect to a significant supervisory matter from converting its charter, subject to certain exceptions.
The Bank is currently subject to OCC capital requirements. Federal statutes and OCC regulations have established four ratios for measuring an institutions capital adequacy: a Tier I (core) capital ratio the ratio of an institutions Tier I capital to adjusted tangible assets; a Tier I risk-based capital ratio an institutions adjusted Tier I capital as a percentage of total risk-weighted assets; a total risk-based capital ratio the percentage of total risk-based capital to total risk-weighted assets; and a tangible equity ratio the ratio of tangible capital to total tangible assets.
Federal statutes and OCC 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 agreed to the Stipulation and Consent to Issuance of Order to Cease and Desist and the Order was issued. As a result of the issuance of the Order, effective February 4, 2011, the Bank was deemed to be adequately capitalized and no longer meets the definition of well capitalized under federal statutes and OCC regulations even though its capital ratios meet or exceed all applicable requirements under Federal law, OCC regulations and the Order. See also Note 29 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 included under Item 8. Financial Statements and Supplementary Data.
In December 2010, the Basel Committee on Banking Supervision (the Basel Committee) released in December 2010 revised final frameworks for the regulation of capital and liquidity of internationally active banking organizations. These new frameworks are generally referred to as Basel III. On August 30, 2012, the Federal Reserve, the FDIC and the OCC published three proposed rules that would substantially amend the regulatory risk-based capital rules applicable to SWS Group and the Bank. The proposed rules implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. Public comments on the proposed rules are requested by October 22, 2012. After the comment period closes, the bank regulators will review the comments and publish final rules, which may vary substantially from the proposed rules.
The Basel III capital framework as adopted in the United States in the future will apply to SWS on a consolidated basis and to the Bank and will establish substantially higher capital requirements than currently apply. The proposed rules would require the following in regard to capital ratios:
The proposed effective date for this new capital framework is January 1, 2013 with a six-year phase in period. Under the proposed rules, in order to avoid limitations on capital distributions (including dividend payments, discretionary payments on Tier 1 instruments and share buybacks) and certain discretionary bonus payments, a banking organization would need to hold a specific amount of Common Equity Tier 1 capital in excess of their minimum risk based capital ratios. The fully phased-in buffer amount would be equal to 2.5% of risk-weighted assets.
Bank regulators are required to take prompt corrective action to resolve problems associated with insured depository institutions whose capital declines below certain levels. Federal banking agencies are required to take various mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions that are undercapitalized, significantly undercapitalized or critically undercapitalized. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized.
In the event an institution becomes undercapitalized, it must submit an acceptable capital restoration plan. The capital restoration plan will not be accepted by the regulators unless, among other requirements, each company having control of the undercapitalized institution guarantees the subsidiarys compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institutions holding company is entitled to a priority of payment in bankruptcy.
The aggregate liability of the holding company of an undercapitalized depository institution is limited to the lesser of 5% of the institutions assets at the time it became undercapitalized or the amount necessary to cause the institution to be adequately capitalized. The bank regulators have greater power in situations where an institution becomes significantly or critically undercapitalized or fails to submit a capital restoration plan. However, the guarantee can be limited for a holding company that is a functionally regulated affiliate of the depository institution, such as a holding company that is a broker/dealer registered with the SEC, if the functional regulator of the affiliate objects. For example, the FRB could require an SEC registered broker/dealer holding company for an undercapitalized federal savings bank to guarantee the banks capital restoration plan, subject to the limitations summarized above and subject to an objection from the holding companys functional regulator, the SEC.
An undercapitalized institution is also generally prohibited from increasing its average total assets, making acquisitions, establishing branches or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval. The prompt corrective action regulations also establish procedures for downgrading an institution to a lower capital category based on supervisory factors other than capital.
The FDIC insures the deposits of the Bank up to the applicable maximum in each account, or up to $250,000 per account. FDIC deposit insurance is backed by the full faith and credit of the United States government. The Dodd-Frank Act, as amended, provided unlimited FDIC deposit insurance on noninterest-bearing transaction accounts held at all insured depository institutions for the period from January 1, 2011 through December 31, 2012. This temporary unlimited coverage is separate from, and in addition to, the coverage provided to depositors for other accounts at an insured depository institution. At this time, it is unclear whether this temporary unlimited coverage will be extended beyond December 31, 2012.
On November 12, 2009, the FDIC Board of Directors voted to require insured depository institutions to prepay their estimated quarterly risk-based insurance assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012. The prepaid assessment, along with the Banks regular third quarter assessment, was paid on
December 30, 2009. For the purposes of estimating the Banks assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, and calculating the amount that the Bank prepaid on December 30, 2009, the Banks assessment rate was its total base assessment rate in effect on September 30, 2009. The FDIC Board of Directors also increased the annual assessment rates uniformly by 3 basis points beginning in 2011. As a result, the Banks total assessment rate for purposes of estimating its assessments for 2011 and 2012 was increased by an annualized 3 basis points beginning in 2011. The Banks total base assessment rate in effect on September 30, 2009 was 15.54 basis points and its prepayment amount was $8.2 million. Unlike the special assessment, which the FDIC collected on September 30, 2009, the prepayment was recorded as a prepaid expense and did not immediately affect the Banks earnings. Finally, the FDIC Board of Directors also voted to extend the DIF restoration period from seven to eight years.
In addition, all FDIC insured institutions are required to pay assessments to the FDIC at an annual rate of approximately 1.14 basis points of insured deposits to fund interest payments on bonds issued by the Financing Corporation, an agency of the federal government established to recapitalize the predecessor to the Savings Association Insurance Fund. These assessments will continue until the Financing Corporation bonds mature in 2017 through 2019.
Under the Dodd-Frank Act, the FDIC was given much greater discretion to manage the DIF, including where to set the designated reserve ratio (DRR). The Dodd-Frank Act increased the DRR from 1.15 percent to 1.35 percent and left unchanged the requirement that the FDIC Board set the DRR annually. The FDIC Board must set the DRR according to the following factors: (i) risk of loss to the insurance fund; (ii) economic conditions affecting the banking industry; (iii) preventing sharp swings in the assessment rates and (iv) any other factors it deems important. Based on those factors, the FDIC Board decided to set the DRR at 2.00 percent based on a historical analysis of losses to the DIF. The analysis showed in order to maintain a positive fund balance and steady, predictable assessment rates, the DRR must be at least 2.00 percent as a long-term, minimum goal. The DRR increase may increase FDIC deposit insurance assessments in the future.
Numerous regulations promulgated by the federal banking agencies, including the Bureau, as amended from time to time, affect the business operations of the Bank. These include regulations relating to holding company regulation, equal credit opportunity, electronic fund transfers, fair credit reporting, fair debt collection, service members civil relief, collection of checks, insider lending, lending limits, truth in lending, truth in savings, home ownership and equity protection, transactions with affiliates and availability of funds. Under FRB regulations, the Bank is required to maintain a reserve against its transaction accounts (primarily interest-bearing and noninterest-bearing checking accounts). Because reserves must generally be maintained in cash or in noninterest-bearing accounts, the historical effect of the reserve requirements is to increase the Banks cost of funds. The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve banks to pay interest on reserves, subject to regulations of the FRB, effective October 1, 2011. However, the Emergency Economic Stabilization Act of 2008 changed the effective date for this authority to October 1, 2008.
The Bank is subject to regulation by the Bureau, established by the Dodd-Frank Act as an independent entity within the Federal Reserve, which has the authority to promulgate consumer protection regulations applicable to all entities offering consumer financial services or products, including banks. The Bureau has broad rule-making authority for a wide range of consumer protection laws, including but not limited to, laws relating to alternative mortgage transaction parity, consumer leasing, electronic fund transfers, equal credit opportunity, fair credit billing, fair credit reporting, home owners protection, fair debt collection practices, lack of deposit insurance, consumer financial privacy, home mortgage disclosure, home ownership and equity protection, real estate settlement procedures, mortgage licensing, truth in lending and truth in savings, among other laws. The Bureau also has the authority to prohibit unfair, deceptive or abusive acts and practices related to offering consumer financial services or products. Because the Bank has less than $10 billion in total assets, the primary federal regulator with examination authority over the Bank for compliance with consumer financial protection laws is the OCC.
The Gramm-Leach-Bliley Act (GLBA) includes provisions that give consumers protections regarding the transfer and use of their nonpublic personal information by financial institutions. In addition, states are permitted under the GLBA to have their own privacy laws, which may offer greater protection to consumers than the GLBA. Numerous states in which the Bank does business have enacted such laws.
The Bank Secrecy Act, the USA PATRIOT Act and rules and regulation of the Office of Foreign Assets Control (OFAC Rules) include numerous provisions designed to fight international money laundering and to block terrorist access to the U.S. financial system. We have established policies and procedures to ensure compliance with the provisions of the Bank Secrecy Act, the USA PATRIOT Act and the OFAC Rules.
The Community Reinvestment Act of 1977 (CRA) requires deposit institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities. Depository institutions are periodically examined for compliance with the CRA and are assigned ratings. The primary federal regulatory agency assigns one of four possible ratings to an institutions CRA performance and is required to make public an institutions rating and written evaluation. The four possible ratings of meeting community credit needs are outstanding, satisfactory, needs to improve and substantial non-compliance. In the most recent examination, we received a Satisfactory CRA rating from the OTS. In the future, the OCC will examine the Bank for CRA compliance. The Bank has committed $8.0 million to three investments in limited partnership equity funds as a cost effective way of meeting its obligations under the CRA. As of June 30, 2012, the Bank had invested $2.4 million of its aggregate commitment to the three funds. These investments are subject to the Volcker Rule provisions of the Dodd-Frank Act, which limits the Banks ownership interest to 3% in any private equity funds and the federal agencies that will enforce the rule guaranteed that it will become effective July 21, 2014. Thereafter, financial institutions can request up to three additional one year extensions from the FRB, and the FRB can grant up to a five year extension for investments in illiquid funds made on or before May 21, 2010, and funds that are designed primarily to promote the public welfare are not subject to the rule as proposed. The Banks ownership percentage in two of the limited partnership equity funds are greater than 3% and would qualify as illiquid funds. In addition, these limited partnership equity funds may qualify as designed primarily to promote the public welfare as the Bank invests in these funds as a cost effective way of meeting its obligations under the CRA. The Banks ownership percentage in the other limited partnership equity fund is less than 3%.
Transactions between the Bank and its nonbanking affiliates, including us, are subject to Section 23A of the Federal Reserve Act. In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties. Affiliate transactions are also subject to Section 23B of the Federal Reserve Act, which generally requires that certain transactions between the Bank and its affiliates be on terms substantially the same, or at least as favorable to the Bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons. The FRBs Regulation W implements Section 23A and 23B of the Federal Reserve Act and codifies prior interpretive guidance with respect to affiliate transactions. The Dodd-Frank Act amends the definition of affiliate in Section 23A of the Federal Reserve Act to include any investment fund with respect to which a member bank or an affiliate thereof is an investment advisor. This amendment became effective on July 21, 2012.
The restrictions on loans to directors, executive officers, principal stockholders and their related interests (collectively referred to herein as insiders) contained in the Federal Reserve Act and Regulation O apply to all insured depository institutions, their subsidiaries and holding companies. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. These loans cannot exceed the institutions total unimpaired capital and surplus, and the OCC may determine that a lesser amount is appropriate. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions. The Dodd-Frank Act amends the statutes placing limitations on loans to insiders by including credit exposures to the person arising from a derivatives transaction, repurchase agreement, reverse repurchase agreement, securities lending transaction or securities borrowing transaction between the member bank and the person within the definition of an extension of credit to an insider. This amendment became effective on July 21, 2012.
Subject to various exceptions, savings and loan holding companies and their affiliates are generally prohibited from tying the provision of certain services, such as extensions of credit, to certain other services offered by a holding company or its affiliates.
We are subject to the requirements of the Secure and Fair Enforcement for Mortgage Licensing Act of 2008, or SAFE Act. The SAFE Act requires mortgage loan originators who are employees of regulated institutions (including banks and certain of their subsidiaries) to be registered with the Nationwide Mortgage Licensing System and Registry (the Registry), a database established by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators to support the licensing of mortgage loan originators by each state. As part of this registration process, mortgage loan originators must furnish the Registry with background
information and fingerprints for a background check. The SAFE Act generally prohibits employees of a regulated financial institution from originating residential mortgage loans without first registering with the Registry and maintaining that registration. Financial institutions must also adopt policies and procedures to ensure compliance with the SAFE Act.
Although our lending activities expose us to some risk of liability for environmental hazards, we do not currently have any significant liabilities for environmental matters.
Our broker/dealer subsidiaries are required by federal law to belong to the SIPC. SIPC provides protection for clients up to $500,000 each with a limitation of $250,000 for claims for cash balances for all of our broker/dealers. Southwest Securities purchases insurance which, when combined with the SIPC insurance, provides coverage for Southwest Securities and SWS Financial in certain circumstances for securities held in clients accounts with a $100 million aggregate limit.
The Banks deposits are insured by the DIF, which is administered by the FDIC, up to applicable limits for each depositor. The FDICs DIF is funded by assessments on insured depository institutions, which depend on the risk category of an institution and the amount of insured deposits that it holds. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis.
At June 29, 2012, we employed 1,065 individuals. Southwest Securities, SWS Financial and SWS Insurance employed 882 of these individuals, 166 of whom were full-time registered representatives, and the Bank employed 183 individuals. In addition, 310 registered representatives were affiliated with SWS Financial as independent contractors.
As of the date of this report, we provided full-service securities brokerage to approximately 35,000 client accounts and clearing services to approximately 130,000 additional client accounts. No single client accounts for a material percentage of our total business.
As of the date of this report, we provided deposit and loan services to approximately 93,000 customers through the Bank and its subsidiaries, which included approximately 89,000 Southwest Securities customer accounts. No single customer constitutes a material percentage of the Banks total business.
We own various registered trademarks and service marks, including Southwest Securities, SWS, SWS Financial, Southwest Securities, FSB, and SWS Group, which are not material to our business. We also own various design marks related to logos for various business segments.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table lists our executive officers and their respective ages and positions at September 6, 2012, followed by a brief description of their business experience over the past five years. Each listed person has been appointed to the indicated office by our Board of Directors.
James H. Ross was named President, Chief Executive Officer and a member of the Board of Directors of SWS Group on October 28, 2010. Prior to October 28, 2010, Mr. Ross had served as interim CEO and member of the Board since August 18, 2010. He previously served as Executive Vice President since November 2004 and, in September 2007, was elected President and Chief Executive Officer of Southwest Securities. Mr. Ross served as the Director of the Private Client Group at Southwest Securities from March 2004 to March 2008. He served as Chief Executive Officer of SWS Financial from September 2004 to April 2011. Mr. Ross came to Southwest Securities in 2004 to head the Private Client Groups brokerage office in Dallas, Texas. Prior to coming to Southwest Securities, Mr. Ross was with UBS Paine Webber, where, from April 1991 to December 2003, Mr. Ross held various positions from financial advisor to branch manager. He began his securities industry career in 1975.
Stacy M. Hodges was named Chief Financial Officer and Treasurer on August 25, 2011 and prior to August 25, 2011, had served as interim Chief Financial Officer and Treasurer since October 12, 2010. She has served as Executive Vice President since February 1999. She previously served as Treasurer and Chief Financial Officer from August 1998 to August 2002. Ms. Hodges was Controller from November 1994 to August 1998. Ms. Hodges served as Director of Southwest Securities from June 1997 to August 2002 and from January 2012 to the present and served as Chief Financial Officer of Southwest Securities from June 1997 to December 2011. Prior to joining Southwest Securities, Ms. Hodges was a Senior Audit Manager in the Financial Services division of KPMG LLP. Ms. Hodges serves as a trustee on the board of SIFMAs Securities Industry Institute as well as a member of the Baylor University Accounting Advisory Council. Ms. Hodges is a member of the American Institute of Certified Public Accountants and the Texas Society of CPAs.
Daniel R. Leland has served as Executive Vice President since May 2007. Mr. Leland was also Executive Vice President from February 1999 to September 2004. He served as President and Chief Executive Officer of Southwest Securities from August 2002 to September 2004. He also served as Executive Vice President of Southwest Securities from July 1995 to August 2002 and was re-elected in February 2006. Mr. Leland began his career at Barre & Company in June 1983 where he was employed in various capacities in fixed income sales and trading before becoming President of Barre & Company in 1993. Mr. Leland has been an arbitrator for the National Association of Securities Dealers (NASD) and is a past Vice Chairman of the District 6 Business Conduct Committee. He is a past board member of the Bond Dealers of America and currently serves as the chair of the Taxable Committee.
Richard H. Litton has served as Executive Vice President and Executive Vice President of Southwest Securities for the Public Finance Division since July 1995. Beginning in September 2006, he became primarily responsible for the entire municipal securities product area of Southwest Securities. Previously, Mr. Litton was President of a regional investment bank and headed the Municipal Group in the Southwest for Merrill Lynch. Mr. Litton served on various advisory committees for the Texas House of Representatives Financial Institutions Committee, is a past member and director of the Municipal Advisory Council of Texas and currently serves on the Municipal Executive Committee and the Municipal Legal Advisory Committee of the Securities Industry and Financial Markets Association (SIFMA).
Jeffrey J. Singer was elected Executive Vice President in November 2008. He is also an Executive Vice President of Southwest Securities and heads its corporate finance business. From 2005 to 2008, Mr. Singer was President of Levantina USA, Inc., the North American subsidiary of Spains Grupo Levantina, the largest global producer of granite and marble materials. Prior to joining Levantina USA, Inc. in 2005, Mr. Singer spent his entire career working in the corporate finance sector for major investment banking firms such as Donaldson, Lufkin & Jenrette, Citigroups investment bank and Dillon Read (now part of UBS, Inc.).
W. Norman Thompson has served as Executive Vice President and Chief Information Officer since January 1995. Mr. Thompson was associated with Kenneth Leventhal & Co. (now a part of Ernst & Young LLP) in various capacities ranging from Audit Manager to Senior Consulting Manager from 1987 to 1994. Previously, Mr. Thompson was an auditor with KPMG LLP from 1981 to 1987. In the capacities he held with both Kenneth Leventhal & Co. and KPMG LLP, he was heavily involved in information technology auditing and consulting.
Allen R. Tubb was elected Vice President, General Counsel and Secretary in August 2002 and Executive Vice President in November 2011. He joined SWS as Corporate Counsel and Secretary in October 1999. From 1979 to 1999, Mr. Tubb was employed with Oryx Energy Company and its predecessor Sun Exploration and Production Company in various capacities including Chief Counsel, Worldwide Exploration and Production. Mr. Tubb is a member of the Texas Bar Association.
Our business, reputation, financial condition, operating results and cash flows can be impacted by a number of factors. Many of these factors are beyond our control and may increase during periods of market volatility or reduced liquidity. The potential harm from any one of these risks, or others, could cause our actual results to vary materially from recent results or from anticipated future results. Some risks may adversely impact not only our own operations, but the banking or securities industry in general which could also produce marked swings in the trading price of our securities.
RISKS SPECIFIC TO OUR INDUSTRIES
Recently enacted regulatory reform legislation will impose additional regulatory requirements on us. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities. On July 21, 2010, the President of the United States signed into law the Dodd-Frank Act. The ultimate effect of the Dodd-Frank Act and its implementing regulations on the financial services industry in general, and on us in particular, is uncertain at this time. SWS Group and the Bank will be subject to significant additional regulatory requirements, which may have a material impact on each or both of them, or SWS as a whole. The key effects of the Dodd-Frank Act on our business include:
As a result of the Dodd-Frank Act, the OTS was abolished and, on July 21, 2011, the OCC took over supervision and regulation of federal thrifts, such as the Bank, and the FRB took over supervision and regulation of savings and loan holding companies, including SWS Group. As a result, we expect to become subject to regulatory capital and activity requirements similar to those currently imposed on bank holding companies regulated by the FRB. The Dodd-Frank Act requires that SWS Group serve as a source of strength for the Bank and will eventually result in new minimum capital requirements for depository institution holding companies.
The Dodd-Frank Act also created a new independent regulatory body, the Bureau, which has been given broad rulemaking authority to implement the consumer protection laws that apply to banks and thrifts and to prohibit unfair, deceptive or abusive acts and practices. The Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are stricter than those regulations promulgated by this new independent regulatory body.
Full implementation of the Dodd-Frank Act will require many new rules to be issued by numerous federal regulatory agencies over the next several years. Given the significance of the changes and the additional regulatory action required for many of the new provisions, we cannot predict all of the ways or the degree to which our business, financial condition and results of operations may be affected by the Dodd-Frank Act once it is fully implemented. We expect, at a minimum, that our compliance costs will increase.
We may be adversely affected by increased governmental and regulatory scrutiny or negative publicity. Governmental scrutiny from regulators, legislative bodies and law enforcement agencies with respect to matters relating to compensation, our business practices, our past actions and other matters has increased dramatically in the past several years. The financial crisis and the current political and public sentiment regarding financial institutions has resulted in a significant amount of adverse press coverage, as well as adverse statements or charges by regulators or other government officials. Press coverage and other public statements that assert some form of wrongdoing often result in some type of investigation by regulators, legislators and law enforcement officials or in lawsuits. Responding to these investigations and lawsuits, regardless of the ultimate outcome of the proceeding, is time consuming and expensive and can divert the time and effort of our senior management from our business. Penalties and fines sought by regulatory authorities have increased substantially over the last several years, and certain regulators have been more likely in recent years to commence enforcement actions or to advance or support legislation targeted at the financial services industry. Adverse publicity, governmental scrutiny and legal and enforcement proceedings can also have a negative impact on our reputation and on the morale and performance of our employees, which could adversely affect our businesses and results of operations.
Failure to comply with the extensive state and federal laws governing our securities and banking operations, or the regulations adopted by several self-regulatory agencies having jurisdiction over us, could have material adverse consequences for us. Broker/dealers and banks are subject to regulation in almost every facet of their operations. Our ability to comply with these regulations depends largely on the establishment and maintenance of an effective compliance system as well as our ability to attract and retain qualified compliance personnel. We could be subject to disciplinary or other actions due to claimed non-compliance with these laws or regulations or possibly for the claimed non-compliance of our correspondents. If a claim of non-compliance is made by a regulatory authority, the efforts of our management could be diverted to responding to such claim and we could be subject to a range of possible consequences, including the payment of fines and the suspension of one or more portions of our business. Our clearing contracts generally include automatic termination provisions that are triggered in the event we are suspended from any of the national exchanges of which we are a member for failure to comply with the rules or regulations thereof. Failure to comply with these laws and regulations could have a material adverse effect on our business, financial condition, results of operations and cash flow.
Our business has been and may continue to be materially and adversely affected by financial market conditions and economic conditions generally. Our business is affected by conditions in the financial markets and economic conditions generally around the world. The financial services industry and the securities markets generally are materially and adversely affected by recessionary environments which can cause significant declines in the values of nearly all asset classes. Concerns about financial institution profitability and solvency as a result of general market conditions, particularly in the credit markets, may cause our clients to reduce the level of business that they do with us. Declines in asset values, the lack of liquidity, general uncertainty about economic and market activity and a lack of consumer and investor confidence have negatively impacted, and may continue to negatively impact, our business.
Our financial performance is highly dependent on the business environment in which we operate. A favorable business environment is generally characterized by, among other factors, high global gross domestic product growth, stable geopolitical conditions, transparent and efficient capital markets, liquid markets with active investors, low inflation, high business and consumer confidence, active new issuance markets for fixed income and equity securities and strong business earnings. Slowing growth, contraction of credit, increasing energy prices, declines in business or investor confidence or risk tolerance, increases in inflation, higher unemployment, outbreaks of hostilities or other geopolitical instability, corporate, political or other scandals that reduce investor confidence in capital markets and natural disasters, among other things, can affect the global financial markets. In addition, economic or political pressures in a country or region may cause local market disruptions and currency devaluations, which may also affect markets generally. In the event of changes in market conditions, such as interest or foreign exchange rates, equity, fixed income, commodity or real estate valuations, liquidity, availability of credit or volatility, our business could be adversely affected in many ways.
Overall, the business environment since 2008 has been extremely adverse. While many economists believe the recession ended in June 2009, unemployment and tight credit markets along with problems in Europe continue to create a fragile economic environment, and there is no guarantee that conditions will not worsen again leading to further decline in economic and market conditions. On August 5, 2011, Standard & Poors lowered its long term sovereign credit rating on the United States of America from AAA to AA+. Credit agencies have also reduced the credit ratings of various sovereign nations in recent months. While the ultimate impact of such action is inherently unpredictable, these downgrades could have a material adverse impact on financial markets and economic conditions throughout the world, including, specifically, the United States. Moreover, the markets anticipation of these impacts could have a material adverse effect on our business, financial condition and liquidity. Although Texas was largely insulated from severe job loss and real estate market deterioration at the start of the recession, it has now experienced distress in residential and commercial real estate values as well as elevated unemployment. These conditions have had, and will continue to have, a direct and material impact on our results of operations and financial condition because performance in the financial services industry is heavily influenced by the overall strength of economic conditions and financial market activity.
Our ability to access capital markets is dependent on market conditions and our credit standing, which could change unfavorably. Factors that are significant to the determination of our credit worthiness or otherwise affect our ability to raise financing include the level and volatility of our earnings and whether we have net losses;
our relative competitive position in the markets in which we operate; our product diversification; our ability to retain key personnel; our risk profile; our risk management policies; our cash liquidity; our capital adequacy; our corporate lending credit risk and legal and regulatory developments. Additionally, market conditions can be unfavorable for our industry causing banks and other liquidity providers to reduce or limit credit to our industry. This could limit the availability of, and thus our access to, capital and/or increase the cost of funding new or existing businesses.
Our revenues may decrease if securities transaction volumes decline. Our securities business depends upon the general volume of trading in the U.S. securities markets. If the volume of securities transactions should decline, revenues from our securities brokerage, securities lending and clearing businesses would decrease and our business, financial condition, results of operations and cash flow would be materially and adversely impacted.
Market fluctuations could adversely impact our securities business. We are subject to risks as a result of fluctuations in the securities markets. Our securities trading, market-making and underwriting activities involve the purchase and sale of securities as a principal, which subjects our capital to significant risks. Market conditions could limit our ability to sell securities purchased or to purchase securities sold in such transactions. If price levels for equity securities decline generally, the market value of equity securities that we hold in our inventory could decrease and trading volumes could decline. In addition, if interest rates increase, the value of debt securities we hold in our inventory would decrease. Rapid or significant market fluctuations could adversely affect our business, financial condition, results of operations and cash flow.
In addition, during periods of market disruption, it may be difficult to value certain assets if comparable sales become less frequent or market data becomes less observable. Certain classes of assets or loan collateral that were in active markets with significant observable data may become illiquid due to the current financial environment. In such cases, asset valuations may require more estimation and subjective judgment. The rapidly changing real estate market conditions could materially impact the valuation of assets and loan collateral as reported within our financial statements and changes in estimated values could vary significantly from one period to the next. Decreases in value may have a material adverse impact on our future financial condition or operating results.
The soundness of other financial institutions could adversely affect us. Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different counterparties and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. As a result, defaults by, or even speculation about, one or more financial services institutions, or the financial services industry generally, have led to market wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the receivable due us. Any such losses could be material and could materially and adversely affect our business, financial condition, results of operations and cash flow.
RISKS RELATED TO OUR COMPANY
The Bank is currently subject to a Cease and Desist Order that may adversely affect our business. On February 4, 2011, the Bank entered into a Stipulation and Consent to Issuance of an Order to Cease and Desist with the OTS whereby the Bank consented to the issuance of the Order.
The Order and the March 16, 2012 modification (Modified Order) as discussed in Note 29 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 included under Item 8. Financial Statements and Supplementary Data, requires that the Bank maintain a Tier I (core) capital ratio equal to or greater than 8 percent and a total risk-based capital ratio equal to or greater than 12 percent. The Modified Order restricts lending by the Bank but allowed for relief from certain operating and growth restrictions required under the Order. These restrictions may reduce earnings and growth of the Bank. Depending on the decrease in total assets held by the Bank, if any, and satisfaction of other aspects of the Order, the OCC (as successor to the OTS) can institute other corrective measures and has broad enforcement powers to impose additional restrictions on our operations.
Deteriorating credit quality, particularly in commercial, construction and real estate loans, has adversely impacted the Bank and may continue to adversely impact the Bank. Beginning in fiscal 2009, the Bank began to experience a downturn in the overall credit performance of its real estate loans held for investment, as well as acceleration in the deterioration of general economic conditions in Texas and other areas of the United States. This deterioration, as well as increases in Texas unemployment levels, worsened in the third quarter of fiscal 2010. These conditions have caused increased financial stress on many of the Banks borrowers and have negatively impacted their ability to repay their loans. Classified and non-performing assets increased significantly in fiscal 2010 and 2011 and real estate collateral values continued to decline in both fiscal 2010 and 2011. Due to these factors, the Bank significantly increased its loan loss reserves in fiscal 2010 and 2011.
Although both classified and non-performing assets have improved throughout fiscal 2012, the Bank expects credit quality to remain challenging and at elevated levels of risk at least through June 30, 2013. Continued deterioration in the credit quality of the Banks real estate loan portfolio could significantly increase non-performing loans, require additional increases in loan loss reserves and elevate charge-off levels. The occurrence of any of these events could have a material adverse effect on the Banks capital, financial condition and results of operations and increase the risk of additional regulatory action.
The Bank is subject to regulatory capital requirements that may limit its operations and potential growth. The Bank is a federal savings bank that is subject to comprehensive supervision and regulation of the OCC, including risk-based, leverage and tangible capital ratio requirements. Capital requirements may rise above normal levels when the Bank experiences deteriorating earnings and credit quality, and the OCC may increase the Banks capital requirements based on general economic conditions and the Banks particular condition, risk profile and growth plans. Our Order with the OCC provides that the Bank will maintain a total Tier I (core) capital ratio of 8% and risk-based capital ratio of 12%. Compliance with capital requirements may limit the Banks operations that require the intensive use of capital and could adversely affect the Banks ability to expand or maintain present business levels.
Failure to achieve and maintain effective internal controls could result in a misstatement of our financial statements. Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to furnish an annual report by our management assessing the effectiveness of our internal control over financial reporting. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. A material weakness is a control deficiency, or a combination of deficiencies, that results in more than a remote likelihood that a material misstatement of our annual or interim financial statements will not be prevented or detected.
Ineffective internal controls could adversely impact our ability to provide timely and accurate financial information. If we are unsuccessful in maintaining effective internal controls, we may be unable to report financial information timely and accurately or to maintain effective disclosure controls and procedures. Any such failure in the future could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding disclosure controls and effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder. If we are unable to report financial information in a timely and accurate manner or to maintain effective disclosure controls and procedures, we could be in default under our Credit Agreement or be subject to, among other things, investigations or regulatory or enforcement actions by the SEC, the Federal Reserve, the FDIC, the OCC or other governmental authorities.
In addition, any failure to maintain effective internal controls could cause investors to lose confidence in the accuracy and completeness of our financial reports, which in turn could cause our stock price to decline.
Risk management processes may not fully mitigate exposure to the various risks that we face, including market, liquidity and credit risk. We continue to refine our risk management techniques, strategies and assessment methods on an ongoing basis. However, risk management techniques and strategies, both ours and those available to the market generally, may not be fully effective in mitigating our risk exposure in all economic market environments or against all types of risk. For example, we might fail to identify or anticipate particular risks that our systems are capable of identifying, or the systems that we use, and that are used within the industry generally, may not be capable of identifying certain risks. Some of our strategies for managing risk are based upon our use of observed historical market behavior. We apply statistical and other tools to these observations to quantify our risk exposure. Any failures in our risk management techniques and strategies to accurately quantify our risk exposure could limit our ability to manage risks. In addition, any risk management failures could cause our losses to be significantly greater than the historical measures indicate. Further, our quantified modeling does not take all risks into account. As a result, we also take a qualitative approach in reducing our risk. Our more qualitative approach to managing those risks could prove insufficient, exposing us to material unanticipated losses.
Our business is significantly dependent on net interest margins. The profitability of our margin and stock lending businesses depends to a great extent on the difference between interest income earned on loans and investments of customer cash balances and the interest expense paid on customer cash balances and borrowings. The earnings and cash flows of the Bank are also dependent upon the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds.
Interest rates are sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, could affect the interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings. Such changes could also affect our ability to originate loans and obtain deposits and the fair value of our financial assets and liabilities. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore our earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.
Our net interest margins may decrease based on the mix of assets in the Banks portfolio and our investment strategy. In recent years, interest rates have declined to levels that have negatively impacted the net interest margin at the Bank. Additionally, as we reposition the Banks balance sheet to include a portfolio of conservative investment securities, the net interest margin on these assets is likely to be less than we have historically earned on our loan portfolio. Our earnings and results of operations could be adversely affected by any reduction in our net interest margin due to our investment policies or market dynamics.
We may not be able to reduce our operating expenses as a way to reduce operating losses. To the extent our net interest income declines or we face other declines in revenues, we may look to reduce our operating expenses where possible. However, we have limited control over certain costs, and in particular, the cost of meeting regulatory requirements and our cost to access capital or financing, if needed. If we are unable to reduce our operating expenses, our results of operations could be adversely affected.
Our margin lending, stock lending, securities trading and execution, bank lending and mortgage purchase businesses are all subject to credit risk. Credit risk in all areas of our business increases if securities prices decline rapidly because the value of our collateral could fall below the amount of indebtedness it secures. In rapidly appreciating markets, credit risk increases due to short positions. Our securities lending business as well as our securities trading and execution businesses subject us to credit risk if a counterparty fails to perform or if collateral securing its obligations is insufficient. In securities transactions, we are subject to credit risk during the period between the execution of a trade and the settlement by the customer.
In addition, the Bank is exposed to the risk that its loan customers may not repay their loans in accordance with their terms, the collateral securing the loans may be insufficient, or its loan loss reserve may be inadequate to fully compensate the Bank for the outstanding balance of the loan plus the costs to dispose of the collateral. Our mortgage warehousing activities subject us to credit risk during the period between funding by the Bank and when the mortgage company sells the loan to a secondary investor.
Significant failures by our customers, including correspondents, or clients to honor their obligations, together with insufficient collateral and reserves, could have a material adverse affect on our business, financial condition, results of operations and cash flow.
The Banks allowance for loan losses may not be sufficient to cover actual loan losses. The Banks borrowers may fail to repay their loans according to the loan terms, and the collateral securing the payment of these loans may be insufficient to assure repayment. Such loan losses could have a material adverse effect on our operating results. We make various assumptions, estimates and judgments about the collectibility of the Banks loan portfolio, including the creditworthiness of the borrowers and the value of the real estate and other assets serving as collateral for the loans. In determining the amount of the allowance for loan losses, the Bank relies on a number of factors, including its experience and evaluation of economic conditions. If the Banks assumptions prove to be incorrect, its allowance for loan losses may not be sufficient to cover losses inherent in its loan portfolio, and adjustments may be necessary that would have a material adverse effect on our operating results.
The Banks commercial real estate, commercial and mortgage lending businesses are dependent on the general health of the Texas and New Mexico economies. The downturn in these economies has adversely affected these lines of business, and consequently our financial condition, results of operations and cash flow. Any further deterioration in the economies of Texas or New Mexico could have an adverse impact on our financial condition, results of operations and cash flow.
Our business and prospects, including our ability to attract and retain clients and employees, may be adversely affected if our reputation is harmed. Our business is subject to significant reputational risks. If we fail, or appear to fail, to deal appropriately with various legal, regulatory or business issues, our reputation, business and prospects, including our ability to attract and retain clients and employees, could be seriously harmed. This could be the case not only in situations involving actual violations of law but also in circumstances where no laws have been violated. Our reputation could be harmed in many different ways, including as a result of perceived or actual failure to address conflicts of interest or ethical issues; failure to comply with legal or regulatory requirements; allegations of money laundering; violation of privacy policies; failure to properly maintain client and employee personal information; failure to maintain adequate or accurate records; allegations of unfair sales and trading practices; and improper identification of the legal, reputational, credit, liquidity and market risks inherent in our products. Publicity of a failure to appropriately address these issues could result in litigation claims or subject us to enforcement actions, fines and penalties and cause us to incur related costs and expenses. Legal liability or regulatory actions as a result of negative publicity could in turn cause significant additional reputational harm.
We depend on the highly skilled, and often specialized, individuals we employ. Competition for the services of personnel in our loan production, private client group, securities lending and trading businesses is intense, and we may not be able to retain them. We generally do not enter into employment agreements or noncompetition agreements with our employees. Our business, financial condition, operating results and cash flow could be materially impacted if we were to lose the services of certain of our loan production, private client group, securities lending or trading professionals. In particular, in our retail and institutional securities brokerage business we depend on the brokers and financial advisors that advise our clients, certain of whom generate significant income for us.
We depend on our computer and communications systems and an interruption in service would negatively affect our business. Our businesses rely on electronic data processing and communications systems. The effective use of technology allows us to better serve clients, increases efficiency and enables firms to reduce costs. Our continued success will depend, in part, upon our ability to successfully maintain, secure and upgrade the capability of our systems, our ability to address the needs of our clients by using technology to provide products and services that satisfy their demands and our ability to retain skilled information technology employees. Significant malfunctions or failures of our computer systems, computer security or any other systems in the trading process (e.g., record retention and data processing functions performed by third parties, and third party software, such as Internet browsers) could cause delays in customer trading activity. Such delays could cause substantial losses for customers and could subject us to claims from customers for losses, including litigation claiming fraud or negligence. In addition, if our computer and communications systems fail to operate properly, regulations would restrict our ability to conduct business. Any such failure could prevent us from collecting funds relating to customer transactions, which would materially impact our cash flow. Any computer or communications system failure or decrease in computer system performance that causes interruptions in our operations could have a material adverse effect on our business, financial condition, results of operations and cash flow.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
Our computer systems and network infrastructure could be vulnerable to security problems. Hackers may attempt to penetrate our network security which could have a material adverse effect on our business. A party who is able to penetrate our network security could misappropriate proprietary information. We rely on encryption and authentication technology licensed from third parties to provide the security and authentication necessary to effect secure transmission of confidential information. Advances in computer capabilities, discoveries in the field of cryptography and other discoveries, events or developments could lead to a compromise or breach of the algorithms that our licensed encryption and authentication technology uses to protect such confidential information. We may be required to expend significant capital and resources and engage the services of third parties to protect against the threat of such security, encryption and authentication technology breaches or to alleviate problems caused by such breaches. Security breaches or the inadvertent transmission of computer viruses could expose us to a risk of loss or litigation and possible liability which could have a material adverse affect on our business, financial condition, results of operations and cash flow.
Our Credit Agreement contains restrictions and covenants that impact our business and expose us to risks that could adversely affect our liquidity and financial condition. On July 29, 2011, we entered into a $100.0 million Credit Agreement with Hilltop Holdings, Inc. (Hilltop) and Oak Hill Capital Partners III, L.P. (OHCP) and Oak Hill Capital Management Partners III, L.P. (collectively with OHCP, Oak Hill). The Credit Agreement contains customary covenants, which require us to, among other things:
In addition, certain of these covenants limit our and certain of our subsidiaries ability to, among other things:
If we are unable to generate sufficient cash flow or otherwise obtain the funds necessary to make required payments under the Credit Agreement, or we fail to comply with the requirements of our indebtedness, we could default under the Credit Agreement. Any default that is not cured or waived could result in the acceleration of the obligations under the Credit Agreement. Any such default which actually causes an acceleration of obligations could have a material adverse effect on our liquidity and financial condition. Additionally, the covenants in such agreement or future debt agreements may restrict the conduct of our business, which could adversely affect our business by, among other things, limiting our ability to take advantage of financings, mergers, acquisitions and other corporate opportunities that may be beneficial to our business.
Misconduct or errors by our employees or entities with which we do business could harm us and are difficult to detect and prevent. There have been a number of highly publicized cases involving fraud or other misconduct by employees in the financial services industry in recent years, and we run the risk that employee misconduct or employee error could occur at our company. For example, misconduct could involve the improper use or disclosure of confidential information, and error could involve the failure to follow or implement procedures, either of which could result in regulatory sanctions and serious reputational or financial harm. It is not always possible to deter misconduct or errors and the precautions we take to detect and prevent this activity may not be effective in all cases. Our ability to detect and prevent misconduct or errors by entities with which we do business may be even more limited. We may suffer reputational harm for any misconduct or errors by our employees or those entities with which we do business.
We face liquidity risk, which is the potential inability to repay short-term borrowings with new borrowings or assets that can be quickly converted into cash while meeting other obligations and continuing to operate as a going concern. Our liquidity may be impaired due to circumstances that we may be unable to control, such as general market disruptions or an operational problem that affects our trading clients, depositors, third parties or ourselves. Our ability to sell assets may also be impaired by regulatory constraints or if other market participants are seeking to sell similar assets at the same time. Our inability to borrow funds or sell assets to meet maturing obligations would have an adverse effect on our business, financial condition, results of operations and cash flow.
In addition, if our customers decide not to invest with us, our liquidity could be adversely affected. If our retail banking and securities clients withdraw their deposits or our institutional customers withdraw their trading lines with us, our liquidity would be impaired. Furthermore, we currently have access to advances from the Federal Home Loan Bank (FHLB). If we become subject to regulatory actions, we may not have access to these advances and our liquidity could be impaired.
Our securities business is subject to numerous operational risks. Our securities business must be able to consistently and reliably obtain securities pricing information and accurately assess loan values, process transactions and provide reports and other customer service. Any failure to keep current and accurate books and records can render us liable to disciplinary action by governmental and self-regulatory authorities, as well as to claims by our clients. If any of our financial, portfolio accounting or other data processing systems do not operate properly or are disabled, or if there are other shortcomings or failures in our internal processes, people or systems, we could suffer an impairment to our liquidity, a financial loss, a disruption of our businesses, liability to our customers and clients, regulatory problems or damage to our reputation. These systems may fail to operate properly or become disabled as a result of events that are wholly or partially beyond our control, including a disruption of electrical or communications services or our inability to occupy one or more of our buildings. In addition, our operations are dependent upon information from, and communications with, third parties, and operational problems at third parties may adversely affect our ability to carry on our business.
We are subject to risks relating to litigation and potential securities law liabilities. Many aspects of our business involve substantial risks of liability. In the normal course of our business, we have been subject to claims by clients alleging unauthorized trading, churning, mismanagement, suitability of investments, breach of fiduciary duty or other alleged misconduct by our employees or brokers. We are sometimes brought into lawsuits based on allegations concerning our correspondents. As underwriters, we are subject to substantial potential liability for material misstatements and omissions in prospectuses and other communications with respect to underwritten offerings of securities. Prolonged litigation producing significant legal expenses or a substantial settlement or adverse judgment could have a material adverse effect on our business, financial condition, results of operations and cash flow.
We face strong competition from larger firms. The financial services business is intensely competitive and we expect it to remain so. We compete on the basis of a number of factors, including client relationships, reputation, the abilities of our professionals, market focus and the relative quality and price of our services and products. Many of our competitors have a broader range of products and services, greater financial and marketing resources, larger customer bases, greater name recognition, more professionals to serve their clients needs and better established relationships with clients than we have. These larger competitors may be better able to respond to industry change, compete for skilled professionals, finance acquisitions, fund internal growth and compete for market share generally.
Our portfolio trading business is highly price competitive and serves a very limited market. Our portfolio trading business serves one small component of the portfolio trading execution market with a small customer base and a high service model, charging competitive commission rates. Consequently, growing or maintaining market share is very price sensitive. We rely upon a high level of customer service and product customization to maintain our market share; however, should prevailing market prices fall, or the size of our market segment or customer base decline, our profitability would be adversely impacted. In addition, in our portfolio trading business, we purchase securities as principal, which subjects our capital to significant risks. Further, the business may be materially impacted. See Market fluctuations could adversely impact our securities business.
Our existing correspondents may choose to perform their own clearing services, move their clearing business to one of our competitors or exit the business. As our correspondents operations grow, they often consider the option of performing clearing functions themselves, in a process referred to as self-clearing. The option
to convert to self-clearing operations may be attractive due to the fact that as the transaction volume of a broker/dealer grows, the cost of implementing the necessary infrastructure for self-clearing may eventually be offset by the elimination of per transaction processing fees that would otherwise be paid to a clearing firm. Additionally, performing their own clearing services allows self-clearing broker/dealers to retain their customers margin balances, free credit balances and securities for use in margin lending activities. Furthermore, our correspondents may decide to use the clearing services of one of our competitors or exit the business. Significant losses to self-clearing could have a material adverse affect on our business, financial condition, results of operations and cash flow.
Several of our product lines rely on favorable tax treatment and changes in federal tax law could impact the attractiveness of these products to our customers. We offer a variety of services and products, such as Individual Retirement Accounts and municipal bonds that rely on favorable federal income tax treatment to be attractive to our customers. Should favorable tax treatment of these products be eliminated or reduced, sales of these products could be materially impacted, which could have a material adverse effect on our business, financial condition, results of operations and cash flow.
We may not be able to realize the value of our deferred tax asset. We recognize deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax basis of assets and liabilities. As of June 29, 2012, our net deferred tax assets were approximately $23.7 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.
Rising insurance costs and regulations could adversely affect our business. Our operations and financial results are subject to risks and uncertainties associated with the increasing costs and regulations related to our use of a combination of insurance, self-insured retention and self-insurance for a number of risks, including, without limitation, property and casualty, workers compensation, general liability, and the company-funded portion of employee-related health care benefits. While the nature and scope of increasing costs and regulatory changes cannot be predicted, they could have a material adverse effect on our business, financial condition, results of operations and cash flow.
Strategic investments or acquisitions may result in additional risks and uncertainties in our business. We intend to grow our core businesses through both internal expansion and through strategic investments and acquisitions. To the extent we make strategic investments or acquisitions, we face numerous risks and uncertainties combining or integrating the relevant businesses and systems, including the need to combine accounting and data processing systems and management controls, and to integrate relationships with clients, vendors, and business partners. Acquisitions pose the risk that any business we acquire may lose clients or employees or could under-perform relative to expectations.
Our executive offices and primary broker/dealer and banking operations are located in approximately 192,000 square-feet of leased space in an office building in Dallas, Texas. The lease expires in 2020. Our other office locations are leased and generally do not exceed 28,000 square feet of space. We conduct our clearing operations primarily at our Dallas headquarters, and our securities lending activities are conducted from our offices in Old Bridge, New Jersey and New York, New York.
We have 19 retail brokerage offices with 10 in Texas, six in California, two in Oklahoma and one in Nevada. The lease on the Rancho Bernardo, California office expired on June 30, 2012 and the lease was not renewed.
We have 13 municipal finance branches, with five offices in Texas, two in California and one in each of New Mexico, North Carolina and South Carolina. In addition, municipal finance has an additional branch in each of Kentucky, New York and Louisiana for which SWS does not maintain an office. We have 15 fixed income branch offices, three in California and Florida, two in Connecticut and Texas, and one branch in each of Illinois, Colorado, New Jersey, Tennessee and New York. Our corporate finance office is located in Dallas, Texas. We also have a disaster recovery site in Dallas, Texas covering our brokerage and banking operations.
The Bank leases branch offices in Arlington, Austin, Benbrook, Downtown Dallas, El Paso, Houston and Southlake, Texas, and Albuquerque and Ruidoso, New Mexico. The Bank also owns a non-operational drive-in facility located in central Arlington, Texas. The Bank owns its banking facilities in Granbury, Waxahachie and South Arlington, Texas.
The company has developed business continuity plans that are designed to permit continued operation of business critical functions in the event of disruptions to our Dallas, Texas headquarters facility as well as critical facilities used by our major subsidiaries. Our critical activities can be relocated among our normal operating facilities and our North Dallas business recovery and disaster recovery center. Our North Dallas facility houses redundant securities and bank processing facilities adequate to replace those found in our primary data center. Our disaster recovery plans are periodically tested, and we participate in industry-wide tests within the securities industry.
Management believes that our present facilities are adequate for the foreseeable future, exclusive of expansion opportunities.
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 and regulatory proceedings. These claims allege violations of various federal and state securities laws, among other matters. 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 a material adverse effect on our business, consolidated financial condition, results of operations or cash flows.
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market for Common Stock. Our common stock trades on the NYSE under the symbol SWS. At August 30, 2012, there were 116 holders of record of our common stock and approximately 5,700 beneficial holders of our common stock. The following table sets forth for the periods indicated the high and low market prices for the common stock and the cash dividend declared per common share:
Stock Repurchases. The following table provides information about purchases of common stock by SWS during the quarter ended June 29, 2012:
(1) The 4,445 shares of common stock repurchased during the three months ended June 29, 2012 were acquired from grantees in connection with income tax withholding obligations arising from vesting of restricted stock grants. These shares were not part of our publicly announced program to repurchase shares of common stock.
(2) On August 24, 2011, the Board of Directors approved and announced a plan authorizing us to repurchase up to 500,000 shares of our common stock from time to time in the open market for an 18-month period ending on February 28, 2013. The Company does not intend to repurchase any shares of common stock under this plan.
Dividend policy. On a quarterly basis, the board of directors will determine whether we will pay a cash dividend. The payment and rate of dividends on our common stock is subject to several factors including limitations imposed by the terms of our Credit Agreement with Hilltop and Oak Hill, regulatory approval, operating results, our financial requirements, and the availability of funds from our subsidiaries, including the broker/dealer subsidiaries, which may be subject to restrictions under the net capital rules of the SEC and FINRA, and the Bank, which may be subject to restrictions by federal banking agencies and the Order. Specifically, our Credit Agreement with Hilltop and Oak Hill limits our quarterly cash dividend to $0.01 per share and only so long as we are not in default of any terms of the Credit Agreement. We currently intend to retain earnings to fund growth and do not plan to pay dividends on our common stock in the near future.
Equity Compensation Plan Information
Restricted Stock Plan. On November 12, 2003, our stockholders approved the adoption of the SWS Group, Inc. 2003 Restricted Stock Plan (Restricted Stock Plan). In November 2007, the stockholders of SWS Group approved an amendment to the Restricted Stock Plan to increase the number of shares available thereunder by 500,000. The Restricted Stock Plan allows for awards of up to 1,250,000 shares of our common stock to our 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 for awards is determined on an individualized basis by the Compensation Committee of the Board of Directors. In general, restricted stock granted to employees under the Restricted Stock Plan is fully vested after three years or is subject to a four year cliff vesting schedule, and restricted stock granted to non-employee directors vests on the one year anniversary of the date of grant. At June 29, 2012, the total number of shares outstanding under the Restricted Stock Plan was 396,625 and the total number of shares available for future grants was 24,637.
Deferred Compensation Plan. On November 10, 2004, the stockholders of SWS Group approved the 2005 Deferred Compensation Plan, the effective date of which was January 1, 2005, for eligible officers and employees to defer a portion of their bonus compensation and commissions. The deferred compensation plan was designed to comply with the American Jobs Creation Act of 2004. Contributions to the deferred compensation plan consist of employee pre-tax contributions and SWS Groups matching contributions, in the form of SWS Group common stock, up to a specified limit.
The assets of the deferred compensation plan include investments in SWS Group common stock, Westwood Holdings Group, Inc. (Westwood) common stock and company-owned life insurance (COLI). Investments in SWS Group common stock are carried at cost and are held as treasury stock with an offsetting deferred compensation liability in the equity section of the consolidated statements of financial condition. The deferred compensation plan limited the number of shares of SWS Group common stock that may be issued to 375,000 shares. On November 17, 2009, the stockholders of SWS Group voted to increase the authorized number of shares of SWS Group common stock available for issuance under the deferred compensation plan from 375,000 shares to 675,000 shares. The number of shares of SWS Group common stock available for future issuance under the plan was 197,354 at June 29, 2012. Investments in Westwood common stock are carried at market value and recorded as securities available for sale. Investments in COLI are carried at the cash surrender value of the insurance policies and recorded in other assets in the consolidated statements of financial condition.
For the fiscal year ended June 29, 2012, we had approximately $18.9 million, with a market value of $17.7 million, in deferred compensation plan assets. At June 29, 2012, funds totaling $3.5 million were invested in 305,852 shares of our common stock. Approximately $1.6 million of compensation expense was recorded for participant contributions and employer matching contributions related to the deferred compensation plan in fiscal 2012.
The trustee of the deferred compensation plan is Wilmington Trust Company.
Stock Option Plans. We did not have any active stock option plans at June 29, 2012. All currently outstanding options under the SWS Group, Inc. Stock Option Plan (the 1996 Plan) may still be exercised until their contractual expiration dates. Options granted under the 1996 Plan have a maximum ten-year term, and all options are fully vested. See Note 1(v) in the Notes to the Consolidated Financial Statements for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 included under Item 8. Financial Statements and Supplementary Data.
The following table sets forth certain information concerning our equity compensation plans approved by our stockholders as of June 29, 2012.
EQUITY COMPENSATION PLAN INFORMATION
(1) Amount represents 98,325 shares issuable upon the exercise of options granted under the 1996 Plan and 305,852 stock units credited to participants accounts under the deferred compensation plan (see descriptions above).
(2) Calculation of weighted-average exercise price does not include stock units credited to participants accounts under the deferred compensation plan.
(3) Amount represents 197,354 shares available for future issuance under the deferred compensation plan and 24,637 shares available for future issuance under the Restricted Stock Plan. The 1996 Plan expired on February 1, 2006, and there are no longer any shares available for issuance thereunder. All options outstanding under the 1996 Plan may still be exercised until their contracted expiration date.
The selected financial data presented below for the five fiscal years ended June 29, 2012 have been derived from our Consolidated Financial Statements as audited by our independent registered public accounting firm. The historical financial data are qualified in their entirety by, and should be read in conjunction with, the Consolidated Financial Statements and the notes thereto, the other financial information contained in this report and Managements Discussion and Analysis of Financial Condition and Results of Operation Events and Transactions.
CONDITION AND RESULTS OF OPERATIONS
We are engaged in full-service securities brokerage and full-service commercial banking. During the twelve-months ended June 29, 2012, 85% of our total revenues were generated by our full-service brokerage business and 15% of our total revenues were generated by our commercial banking business. While brokerage and banking revenues are dependent upon trading volumes and interest rates, which may fluctuate significantly, a large portion of our expenses remain fixed. Consequently, net operating results can vary significantly from period to period.
Our business is also subject to substantial governmental regulation and changes in legal, regulatory, accounting, tax and compliance requirements, which may have a substantial impact on our business and results of operations. We also face substantial competition in each of our lines of business. See Forward-Looking Statements, Item 1. Business-Competition, Item 1. -Regulation and Item 1A. Risk Factors.
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 needs of our clearing clients (correspondents) and offer such products and services as recordkeeping, trade reporting, accounting, general back-office support, securities and margin lending, reorganization assistance and custody of securities.
Revenues in this segment are generated primarily through transaction charges to our correspondent firms for clearing their trades. Revenue is also earned from various fees and other processing charges as well as through net interest earnings on correspondent customer balances.
Retail. We offer retail securities products and services (equities, mutual funds and fixed income products), insurance products and managed accounts through the activities of our employee registered representatives and our independent contractors. As a securities broker, we extend margin credit on a secured basis to our retail customers in order to facilitate securities transactions. This segment generates revenue primarily through commissions charged on securities transactions, fees from managed accounts and the sale of insurance products as well as net interest income from retail customer balances.
Institutional. We serve institutional customers in the areas of securities borrowing and lending, public finance, municipal sales and underwriting, investment banking, fixed income sales and equity trading. Our securities lending business includes borrowing and lending securities for other broker/dealers, lending institutions, and our own clearing and retail operations. Our municipal finance operations assist public bodies in originating, syndicating and distributing securities of municipalities and political subdivisions. Our corporate finance professionals arrange and evaluate mergers and acquisitions, conduct private placements and participate in public offerings of securities with institutional and individual investors, assist clients with raising capital, and provide other consulting and advisory services.
Our fixed income sales and trading group specializes in trading and underwriting U.S. government and government agency bonds, corporate bonds, mortgage-backed, asset-backed and commercial mortgage-backed securities and structured products. The clients of our fixed income group include corporations, insurance companies, banks, mutual funds, money managers and other institutions. Our equity trading department focuses on providing the best execution for equity and option orders for clients. We also execute institutional portfolio trades and are a market maker in a limited number of listed securities.
Revenues in the institutional segment are derived from the net interest spread on stock loan transactions, commission and trading income from fixed income and equity products and investment banking fees from corporate and municipal securities transactions.
Banking. We offer traditional banking products and services. We specialize in two primary areas, business banking and mortgage purchase. Our focus in business banking includes small business lending. We originate the majority of our loans internally and we believe this business model helps us build more valuable relationships with our customers. Our mortgage purchase division purchases participations and sub-participations in newly originated residential loans from various mortgage bankers nationwide. In the fourth quarter of fiscal 2012, the Bank signed a sub-participation agreement with a non-affiliate bank to sub-participate in this banks mortgage purchase program. The Bank has made a maximum total commitment of $50.0 million pursuant to the agreement.
The Bank earns substantially all of its revenues on the spread between the rates charged to customers on loans and the rates paid to depositors. Our banking operations are currently restricted by and subject to the Order with the OCC. On March 16, 2012, the Bank was notified in a letter from the OCC that the OCC will allow relief from certain operating and growth restrictions required under the Order. The OCC stated that it has no supervisory objection to any future extensions of Small Business Administration program 504 loans, commercial real estate owner-occupied loans, or mechanics lien residential 1-4 family construction loans provided that prior to funding the Banks Board of Directors or designated committee approves and certifies it complies with internal policies, accounting principles generally accepted in the United States (GAAP), regulatory guidance, and safe and sound association practices. The OCC also stated that it has no supervisory objection to a future conservative growth plan for the Banks balance sheet provided the Bank maintains capital ratios above the requirements of the Order and concentration levels within policy guidelines.
The other category includes SWS Group, corporate administration and SWS Capital Corporation. SWS Capital Corporation is a dormant entity. SWS Group is a holding company that owns various investments, including common stock of U.S. Home Systems, Inc. (USHS).
Loan from Hilltop and Oak Hill
In March 2011, we entered into a Funding Agreement with Hilltop and Oak Hill. On July 29, 2011, after receipt of stockholder and regulatory approval, we completed the following transactions contemplated by the Funding Agreement:
We entered into this transaction to ensure that the Bank would maintain adequate capital ratios under the Order and could continue to reduce classified assets in a strategic and efficient manner, as well as to ensure that the broker/dealer business lines would operate without disruption. See also Note 16 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 included under Item 8. Financial Statements and Supplementary Data for additional discussion on the loan from Hilltop and Oak Hill.
The funds received from Hilltop and Oak Hill upon completion of the transaction were recorded on our consolidated statements of financial condition as restricted cash. We are required to keep these funds in a restricted account until our Board of Directors, Hilltop and Oak Hill determine the amount(s) to be distributed to our subsidiaries. Upon approval of the Board of Directors, Hilltop and Oak Hill, SWS Group contributed $20.0 million of this cash to the Bank in December 2011, loaned Southwest Securities $20.0 million to use in general operations by reducing Southwest Securities use of short-term borrowings for the financing of the Companys day-to-day cash management needs, paid $20.0 million toward its intercompany payable to Southwest Securities and contributed $10.0 million to Southwest Securities. The remaining $30.0 million remains at SWS Group to be used for general corporate purposes subject to approval by the Board of Directors, Hilltop and Oak Hill.
Performance in the financial services industry in which we operate is highly correlated to the overall strength of the economy and financial market activity. Overall market conditions are a product of many factors, which are beyond our control and can be unpredictable. These factors may affect the financial decisions made by investors, including their level of participation in the financial markets. In turn, these decisions may affect our business results. With respect to financial market activity, our profitability is sensitive to a variety of factors, including the demand for investment banking services, as reflected by the number and size of equity and debt financings and merger and acquisition transactions, the volatility of the equity and fixed income markets, the level and shape of various yield curves, the volume and value of trading in securities, the value of our customers assets under management, the demand for loans and the value of real estate in our markets.
As of June 29, 2012, equity market indices reflected an average increase from a year ago with the Dow Jones Industrial Average (the DJIA) up 8%, the Standard & Poors 500 Index (S&P 500) up 7% and the NASDAQ Composite Index (NASDAQ) up 11%. The DJIA closed at 12,880.09 on June 29, 2012 up from 11,934.58 and 10,143.81 on June 24, 2011 and June 25, 2010, respectively. The indexes showed improvement and reached closing prices that havent been seen since 2008. However, the market remains volatile due to the slow recovery in the United States and the uncertainty in Europe. The average daily volume on the NYSE declined during our fiscal 2012, decreasing 10% over the same period in fiscal 2011. The continuing uncertainty in the economic environment domestically and in Europe contributed to uncertainty and volatility during our fiscal 2012.
Economic and regulatory uncertainty created a challenging operating environment for us in fiscal 2012. The national unemployment rate, which was approximately 8.2% at the end of June 2012, was down from a high of 10.0% at the end of December 2009, and 9.0% at the end of June 2011, but remains at historically high levels. The FRB reduced the federal funds target rate to 0 - 0.25% on December 16, 2008 and announced in January 2012 and reemphasized in their July 2012 meeting that rates were unlikely to increase before late 2014.
The disruptions and developments in the world economy and the credit markets over the past three years have resulted in a range of actions by the U.S. and foreign governments to attempt to bring liquidity and order to the financial markets and to prevent 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 Item 1. Business-Regulation.
Unemployment and tight credit markets continue to create a fragile economic environment. In addition to the August 2011 downgrade of the United States credit rating and the June 2012 Moodys Investor Services downgrade of the 15 largest financial institutions including Bank of America Corp., Citigroup Inc. Goldman Sachs and JP Morgan Chase, global equity markets have been volatile primarily due to debt problems in Europe.
Texas has experienced distress in residential and commercial real estate values as well as elevated unemployment rates since the last quarter of calendar 2010. These factors, while improving, have had, and will continue to have, a negative impact on our banking and brokerage operations.
Impact of Economic Environment
Brokerage: On the brokerage side of the business, volatility in the U.S. credit and mortgage markets, low interest rates and reduced volume in the U.S. stock markets continue to have an adverse impact on several aspects of our business, including depressed net interest margins, reduced liquidity and lower securities valuations.
Exposure to European Sovereign Debt
We have no exposure to European sovereign debt or direct exposure to European banks. However, we do participate in securities lending with U.S. subsidiaries of several European banks. Receivables from securities lending are secured by collateral equal to 102% of the market value of the securities, and the collateral is adjusted daily to maintain the 102% margin.
Net Interest Margins
Historically, the profitability of our brokerage business has been dependent upon net interest income. We earn net interest income on the spread between the rates earned and paid on customer and correspondent balances as well as from our securities lending business. With interest rates at historically low levels, the spread we are able to earn is reduced, primarily from the extremely low yields on our assets segregated for regulatory purposes portfolio. Additionally, the spread in our securities lending business has declined. Lastly, because the yields on money market funds have declined significantly, revenue sharing arrangements with our primary money market fund providers have been substantially reduced. We do not expect any significant changes in these dynamics until short-term interest rates rise.
We have taken actions to mitigate the impact of this margin contraction by renegotiating arrangements with our clearing customers, changing the mix of our assets segregated for regulatory purposes and developing new business in our securities lending portfolio. Despite these actions, profits from net interest remain below historical levels.
Dislocation in the credit markets has led to increased liquidity risk. All but $45.0 million of our borrowing arrangements are uncommitted lines of credit and, as such, can be reduced or eliminated at any time by the banks extending the credit. While we have not experienced any reductions in our uncommitted borrowing capacity, our lenders have previously 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. Should our lenders or investors take any actions that could negatively impact the terms of our lending arrangements, the cost of conducting our business will increase and our volume of business would be limited.
The volatility in the U.S. stock markets is also impacting our liquidity through increased margin requirements at our clearing houses. These margin requirements are determined through a combination of risk factors including volume of business and volatility in the U.S. stock markets. To the extent we are required to post cash or other collateral to meet these requirements, we will have less borrowing capacity to finance our other businesses.
Valuation of Securities
We trade mortgage, asset-backed and other types of fixed income securities on a regular basis. We monitor our trading limits daily to ensure that these securities are maintained at levels we consider prudent given current market conditions. We price these securities using a third-party pricing service and we review the prices monthly to ensure reasonable valuations. At June 29, 2012, we held mortgage and asset-backed securities of approximately $32.9 million included in securities owned, at fair value on the consolidated statements of financial condition.
Investment in Auction Rate Securities
At June 29, 2012, we held $21.0 million of auction rate municipal bonds, which represented one security and 18% of our municipal portfolio. This security is an investment grade credit, was valued at 95.7% of par as of June 29, 2012 and was yielding less than 1% per year for the period. We currently have the ability to hold this investment until maturity. While we expect the issuer of this bond to refinance its debt when London Interbank Offered Rates (LIBOR) rise, there can be no certainty that this refinancing will occur. We review this position on a quarterly basis and believe valuation of this bond at 95.7% of par at June 29, 2012 reflects an appropriate discount for the current lack of liquidity in this investment.
Bank: With a $20.0 million capital contribution to the Bank in December 2011, the Bank prepared and filed a new capital plan with its regulator in June 2012. We believe the $20.0 million contribution and access to additional capital from SWS Group provides the Bank with a sound foundation for future earnings, as well as the flexibility to accelerate the reduction of classified assets.
The Bank has maintained compliance with the terms of the Order since the Bank signed it on February 4, 2011. The diligent efforts by the Banks Board of Directors, management and employees to adhere to the terms of the Order and plans filed with regulators have resulted in substantial improvements in credit quality, loan concentration levels and capital ratios. As a result, on March 16, 2012, the Bank was notified in a letter from the OCC that the OCC will allow relief from certain operating and growth restrictions required under the Order. See additional discussion in Note 29 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 included under Item 8. Financial Statements and Supplementary Data for additional information on the Order and discussion above under Overview regarding the relief from certain operating and growth restrictions required under the Order.
While the economic environment remains challenging, the Bank continued to make significant progress in addressing the issues that led to the issuance of the Order. Classified assets were $110.7 million at June 30, 2012, down $117.8 million from $228.5 million at June 30, 2011. Classified assets as a percentage of total capital plus the allowance for loan losses was 58.0% at June 30, 2012, 120.5% at June 30, 2011 and 100.9% at June 30, 2010. Non-performing assets (a subset of classified assets) decreased to $72.7 million at June 30, 2012 down from $89.5 million at June 30, 2011 and $93.7 million at June 30, 2010. Though the Bank continues to work diligently to reduce classified assets and improve performance, the volatility of the economic environment remains a significant risk. Should the economic environment worsen, improvement in classified asset reduction could slow and additional migration of loans to problem status could increase.
The Banks loan loss allowance at June 30, 2012 was $22.4 million, or 4.0% of loans held for investment, excluding purchased mortgage loans held for investment, as compared to $44.4 million, or 5.0% of loans held for investment, excluding purchased mortgage loans held for investment, at June 30, 2011.
The Banks capital ratios have strengthened significantly and remain well above the Orders required levels with a Tier 1 core ratio of 12.6% and a total risk-based capital ratio of 19.2% at June 30, 2012 compared to 9.9% and 15.6%, respectively, at June 30, 2011. With the stability of these capital ratios and the $20.0 million capital contribution from SWS Group, the Banks management has focused on diversifying the balance sheet by reducing loan concentrations and building an investment portfolio.
With the relief granted by the OCC in March 2012, the Bank has been actively filling open lending positions in our market areas. New lenders have been added in Houston, Austin, Dallas and Arlington, Texas as well as in Albuquerque, New Mexico. Additionally, the Bank has hired a Chief Credit Officer, a manager of Special Assets, a manager of Credit Administration, a new Credit Manager for Commercial and Industrial Lending and a new Credit Manager for mortgage purchase lending. Given the economic environment and the lag in the process of hiring lenders and actual production, the Bank anticipates loan balances to begin a modest growth rate through fiscal 2013. The Bank anticipates that additional growth will come from building out its investment portfolio. The Banks available for sale portfolio was $304.0 million at June 30, 2012. The Bank also anticipates growth in its mortgage purchase program which continues to perform well despite the current economic environment. Though there is uncertainty in the market, there are also opportunities. With mortgage rates at historical lows, finance and re-finance opportunities are significant for qualified borrowers. At June 30, 2012, the balance of the mortgage purchase program loans was $294.3 million. These loans are held for investment on average for 25 days or less, which substantially limits credit risk. We believe the funding for the Banks balance sheet growth will come from deposits, primarily from Southwest Securities brokerage customers. These core deposits provide the Bank with a stable and low cost funding source. At June 30, 2012, the Bank had $930.7 million in funds on deposit from customers of Southwest Securities, representing approximately 87.6% of the Banks total deposits.
Events and Transactions
A description of material events and transactions impacting our results of operations in the periods presented are discussed below:
Transaction with Hilltop and Oak Hill. On March 20, 2011, we entered into a Funding Agreement with Hilltop and Oak Hill. On July 29, 2011, after receipt of stockholder and regulatory approval, the Company completed the following transactions contemplated by the Funding Agreement:
Total interest expense recorded on this loan for fiscal 2012 was $11.0 million.
Warrant valuation. The warrants issued to Hilltop and Oak Hill are presented as liabilities carried at fair value on the consolidated statement of financial condition. During fiscal 2012, the value of these warrants increased due to increased stock price volatility from our initial valuation from 39.9% to 52.4%, partially offset by the passage of time and a decrease in our stock price from $5.45 at July 29, 2011, the issuance date of the warrants, to $5.33 at June 29, 2012. The increase in value resulted in an unrealized pre-tax loss of $3.7 million for fiscal 2012.
Change in provision for loan losses. The provision for loan loss decreased $48.5 million during fiscal 2012 and increased $5.8 million during fiscal 2011, resulting in an allowance for loan loss of $22.4 million at June 30, 2012 and $44.4 million at June 30, 2011. See discussion above under OverviewBusiness EnvironmentImpact of Economic EnvironmentBank, Financial Condition Loan and Allowance for Probable Loan Losses and Note 6 in the Notes to the Consolidated Financial Statements for fiscal years June 29, 2012, June 24, 2011, and June 25, 2010 included in Item 8 Financial Statements and Supplementary Data.
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 up to $150.0 million of securities. On December 9, 2009, we closed a public offering of 4,347,827 shares of our 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 $54.4 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 correspondents 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 loss and comprehensive loss.
RESULTS OF OPERATIONS
Net losses for the fiscal years ended June 29, 2012, June 24, 2011 and June 26, 2009 were $4.7 million, $23.2 million and $2.9 million, respectively. Fiscal years 2012, 2011 and 2010 contained 256, 252 and 251 trading days, respectively.
Southwest Securities was custodian for $29.0 billion, $28.0 billion and $25.6 billion in total customer assets at June 29, 2012, June 24, 2011 and June 25, 2010, respectively.
The following is a summary of fiscal year to fiscal year increases (decreases) in categories of net revenues and operating expenses (dollars in thousands):
Fiscal 2012 versus 2011
Net revenues decreased $48.6 million from fiscal 2011 to fiscal 2012. The largest components of the decrease were a $29.3 million decrease in net interest, a $10.8 million decrease in commissions, a $9.2 million decrease in net gains on principal transactions and a $1.3 million decrease in net revenues from clearing operations. The $29.3 million decrease in net interest revenue was due primarily to a 27% decrease in the average loan balance at the Bank compared to fiscal 2011. Also, interest expense on the loan from Hilltop and Oak Hill reduced net interest revenue by $11.0 million for fiscal 2012. The decrease in commissions was due primarily to a $6.7 million decrease in commissions in the institutional segment, primarily in the taxable fixed income business resulting from reduced customer activity due to increased economic uncertainty. In addition, we also experienced a $4.1 million decrease in commissions in the retail segment. This decrease was primarily due to a decrease in retail representative headcount, difficulty in recruiting representatives and reduced activity overall. The $9.2 million decrease in net gains on principal transactions was due to reduced customer trading activity in the taxable fixed income and municipal finance businesses. The decrease in net revenues from clearing operations was due primarily to changes in market conditions. In addition, the loss of 12 correspondents to broker withdrawals in fiscal 2012 also contributed to the decrease in clearing revenue. These revenue declines were partially offset by a $2.4 million increase in other revenue. This increase was made up of a $3.1 million decrease in net losses on the sale of real estate owned (REO) from the prior fiscal year, a $0.8 million increase in earnings on equity investments, a $0.6 million increase in insurance product sales and a $0.5 million decrease on losses on the sale of loans offset by a $1.6 million decrease in the value of the investments in our deferred compensation plan and a $0.6 million decrease in the gain on sale of securities.
Operating expenses decreased $76.2 million for fiscal 2012 as compared to fiscal 2011. The largest decreases were the $48.5 million decrease in the provision for loan loss, the $17.0 million decrease in other expense, the $11.8 million decrease in commissions and other employee compensation and the $2.2 million decrease in occupancy, equipment and computer service costs. The decrease in the Banks loan loss provision is discussed above under Overview-Business Environment-Impact of Economic Environment-Bank. The decrease in other expenses was due primarily to a $13.0 million decrease in the Banks REO loss provision, a $1.4 million decrease in third-party loan services, a $1.1 million decrease in the Banks fee assessments from regulatory agencies, a $1.1 million decrease in the Banks real estate related expenses and a $0.7 million decrease in legal expenses. The $11.8 million decrease in commissions and other employee compensation was primarily due to an $8.4 million decrease in commission expense related to a decrease in production revenues, commissions and investment banking, advisory and administrative fees and a $3.5 million decrease in salaries expense primarily related to the decrease in our headcount. The decrease in occupancy, equipment and computer service costs was due to a $0.8 million decrease in amortization expense related to a customer relationship intangible that was fully amortized in July 2011, a $0.6 million decrease in depreciation expense for equipment that became fully depreciated in fiscal 2012 that has not been replaced and a $0.6 million decrease in rental expense due to closing three banking center locations during fiscal 2012. These decreases in other expenses were offset by the $3.7 million unrealized loss on Warrant valuation as discussed above under Overview-Events and Transactions-Warrant Valuation.
Fiscal 2011 versus 2010
Net revenues decreased $24.9 million from fiscal 2010 to fiscal 2011. The largest components of the decrease were a $14.8 million decrease in commissions, a $2.7 million decrease in net gains on principal transactions and a $9.7 million decrease in net interest. The decrease in commissions and net gains on principal transactions was due primarily to reduced commissions and trading profits in the taxable fixed income business, as a result of tighter spreads and reduced volatility. 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 $3.9 million increase in investment banking and advisory fees due to an increase in unit investment trust 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 increased $4.0 million for fiscal 2011 as compared to fiscal 2010. The largest increases were the $5.8 million increase in the provision for loan loss and the $8.5 million increase in other expense. The increase in the Banks loan loss provision is discussed in Overview-Business Environment-Impact of Economic Environment-Bank. The increase in other expenses was due to an $8.7 million increase in the Banks REO write-downs, a $2.4 million increase in professional services and fees at the Bank and an increase in legal expenses of $3.2 million. 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 in other expenses were offset by the $6.3 million loss incurred in the first quarter of fiscal 2010 on a correspondents short sale of securities.
These increases in other expenses and the provision for loan loss were partially offset by a $9.0 million decrease in commission and other employee compensation and a $1.3 million decrease in advertising and promotional expenses. Commissions and other employee compensation expense declined primarily due to a decrease in variable compensation and a $2.4 million decrease in salaries and deferred compensation expenses related to our restricted stock plan offset by a $1.5 million increase in health insurance expense.
Net Interest Income
We generate net interest income from our brokerage segments and our banking segment. 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 Banks cost of funds consists primarily of interest paid to the Banks depositors on interest-bearing accounts and long-term borrowings with the FHLB. Net interest income from our brokerage, corporate and banking segments were as follows for the fiscal years 2012, 2011 and 2010 (in thousands):
Average balances of interest earning assets and interest-bearing liabilities in our brokerage operations were as follows for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 (in thousands):
Net interest revenue generated by each segment is reviewed in detail in the segment analysis below.
Income Tax Expense
For fiscal 2012, income tax benefit (effective rate of 20.4%) differed from the amount that would have otherwise been calculated by applying the federal corporate tax rate (35%) to loss before income tax benefit due to state income taxes and other permanently excluded items, such as tax exempt interest and compensation. See further discussion regarding reconciliation of the effective tax rate and the federal corporate tax rate in Note 17 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 included under Item 8. Financial Statements and Supplementary Data
For fiscal 2011, income tax benefit (effective rate of 30.6%) differed from the amount that would have otherwise been calculated by applying the federal corporate tax rate (35%) to loss before income tax benefit due to state income taxes and other permanently excluded items, such as tax exempt interest, meals and entertainment, compensation and increases in the value of company-owned life insurance (COLI).
For fiscal 2010, income tax benefit (effective rate of 36.4%) differed from the amount that would otherwise have been calculated by applying the federal corporate tax rate (35%) to loss before income tax benefit due to state income taxes and other permanently excluded items, such as tax exempt interest, meals and entertainment and increases in the value of COLI.
We have certain deferred tax assets that were derived from capital losses. To use the deferred tax assets, we must have sufficient capital gain income within the carry-back and carry-forward period available under the tax law. Our deferred tax assets as of June 29, 2012 and June 24, 2011 included $872,000 and $844,000, respectively, which reflected the benefit of capital losses associated with our investments in certain partnership assets. In the first quarter of fiscal 2011, we established an $844,000 valuation allowance against these deferred tax assets because we did not believe it was more likely than not that sufficient capital gain income would be generated to offset these capital losses during the applicable carry-back and carry-forward period. In fiscal year 2012, we increased the valuation allowance by $28,000 to $872,000 as a result of receiving additional valuation information about these investments. See also Note 17 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 29, 2012, June 24, 2011 and June 25, 2010 included under Item 8. Financial Statements and Supplementary Data.
The following is a summary of net revenues and pre-tax income (loss) by segment for fiscal 2012, 2011 and 2010 (dollars in thousands):
(1) The net revenues and pre-tax income reported for the banking segment is for the periods ended June 30, 2012, 2011 and 2010.
Clearing. The following is a summary of the results for the clearing segment for fiscal 2012, 2011 and 2010 (dollars in thousands):
Total correspondent clearing customer assets under custody were $14.7 billion, $14.4 billion and $13.0 billion at June 29, 2012, June 24, 2011 and June 25, 2010, respectively.
The following table reflects the number of client transactions processed for each of the last three fiscal years and the number of correspondents at the end of each fiscal year:
Fiscal 2012 versus 2011
For fiscal 2012, net revenues and clearing fee revenue in the clearing segment both decreased 12% from fiscal 2011. In addition, other revenue decreased 21% from fiscal 2011 to fiscal 2012 primarily due to a 25% decline in administrative fee income from revenue sharing with money market fund providers.
The decrease in clearing revenue was due primarily to changes in market conditions. In addition, the loss of 12 correspondents to broker withdrawals in fiscal 2012 also contributed to the decrease in clearing revenue.
Also, for fiscal 2012 as compared to fiscal 2011, tickets processed for high-volume trading firms decreased 38% while tickets processed for general securities broker/dealers decreased by 8%. Revenue per ticket increased approximately 29% from $4.35 for fiscal 2011 to $5.61 for fiscal 2012. The change in the mix of tickets processed led to an increase in revenue per ticket as fees charged to high-volume trading firms are discounted substantially from the fees charged to general securities broker/dealers. A four day increase in the number of trading days in fiscal 2012 compared to the prior fiscal year partially offset the decrease in ticket volume. There were 256 trading days in fiscal 2012 and 252 in fiscal 2011.
Operating expenses for fiscal 2012 decreased $0.3 million, or 2%, from fiscal 2011 due primarily to a $0.4 million decrease in occupancy, equipment and computer service costs, primarily due to a $0.8 million decrease in amortization expense related to a customer relationship intangible that was fully amortized in July 2011. This decrease was offset by a $0.3 million increase in information technology costs.
Fiscal 2011 versus 2010
The clearing segment posted a 1% increase in net revenues and a 109% increase in pre-tax income for fiscal 2011 as compared to fiscal 2010.
Other revenue decreased 15% for fiscal 2011 as compared to fiscal 2010. The decrease was due to a decrease in net revenue earned on correspondent customer balances. This decrease was partially offset by a 3% increase in administrative fee income earned by the clearing segment from money market providers on higher revenue sharing with various money market funds.
In fiscal 2011, tickets processed for high-volume trading firms increased 9% while tickets processed for general securities broker/dealers decreased by 17% due to a loss of two general securities correspondents in the third quarter of fiscal 2011 as well as an overall decline in volume. In addition, revenue per ticket decreased approximately 4% from $4.52 for fiscal 2010 to $4.35 for fiscal 2011 due to a change in the mix of trades from general securities trades to day trading trades. The fees charged to the day trading firms are discounted substantially from the fees charged to general securities broker/dealers.
Operating expenses for fiscal 2011 decreased $5.7 million, or 21%, from fiscal 2010 due primarily to a $6.1 million decrease in other expenses, which included a $6.3 million loss incurred on a correspondents short sale of securities in the first quarter of fiscal 2010 as well as a decrease in legal expenses of $1.0 million. This decrease was partially offset by a $882,000 increase in operations and information technology expenses and a $320,000 increase in professional services and licenses and fees from fiscal 2010 to fiscal 2011.
Retail. The following is a summary of the results for the retail segment for fiscal 2012, 2011 and 2010 (dollars in thousands):
Fiscal 2012 versus 2011
Net revenues in the retail segment decreased 3% in fiscal 2012 as compared to fiscal 2011 due primarily to a $4.1 million decrease in commissions resulting from a reduction in PCG representative headcount in fiscal 2011, with the bulk of the reduction coming in the fourth quarter of fiscal 2011. The average PCG representative headcount for fiscal 2011 was 184 representatives compared to 166 in fiscal 2012. The decrease in net revenues can also be attributed to reduced activity overall. Despite these challenges, insurance product sales for fiscal 2012 increased from fiscal 2011 due to improved volumes in both our PCG and SWS Financial businesses.
Total customer assets were $13.6 billion at June 29, 2012 and $12.9 billion at June 24, 2011. Assets under management were $761.1 million at June 29, 2012 versus $688.5 million at June 24, 2011.
Operating expenses increased less than 1% from fiscal 2011 to fiscal 2012. However, other expenses increased 10% from fiscal 2011 to fiscal 2012. The increase in other expenses was primarily due to a $0.9 million
increase in legal fees and a $0.4 million increase in operational and information technology costs. This increase in other expenses was offset by a decrease in occupancy, equipment and computer service costs of $0.6 million, which was due to the completion of an M.L. Stern & Co., LLC computer services contract in early fiscal 2012.
Fiscal 2011 versus 2010
Net revenues in the retail segment decreased 1% in fiscal 2011 as compared to fiscal 2010 due primarily to a $7.0 million decrease in net revenues from our PCG business. This decline was due to closing one PCG office during December 2010 and an 18% decrease in the number of PCG representatives. The closed PCG office had five representatives. The decline in net revenues from PCG was partially offset by a $5.7 million increase in net revenues in our independent registered representative business.
Total customer assets were $12.9 billion at June 24, 2011 and $12.6 billion at June 25, 2010. Assets under management were $688.5 million at June 24, 2011 versus $517.0 million at June 25, 2010.
Operating expenses decreased 2% from fiscal 2010 to fiscal 2011. This decrease was primarily due to a 1% decrease in commission and other employee compensation expense, the primary component of operating expense in the retail segment.
Institutional. The following is a summary of the results for the institutional segment for fiscal 2012, 2011 and 2010 (dollars in thousands):
Average balances of interest-earning assets and interest-bearing liabilities for the institutional segment as of June 29, 2012, June 24, 2011 and June 25, 2010 were as follows (in thousands):
Although daily average balances for stock borrowed decreased, net interest revenue for stock loan increased due to an increase in the spread from fiscal 2011 to fiscal 2012 of 11 basis points.
The following table sets forth the number and aggregate dollar amount of new municipal bond underwritings conducted by Southwest Securities for the last three fiscal years:
Fiscal 2012 versus 2011
Net revenues from the institutional segment decreased 11% while pre-tax income was down 14% from fiscal 2011 to fiscal 2012. Commissions decreased $6.7 million from fiscal 2011 to fiscal 2012 due to reduced customer activity, primarily in the taxable fixed income business due to increased economic uncertainty. These decreases for fiscal 2012 were partially offset by a 19% increase in portfolio trading commissions due to increased customer activity and a one time change in customer business mix.
Net gains on principal transactions decreased $8.2 million, or 21%, in fiscal 2012 as compared to fiscal 2011. Taxable fixed income trading gains decreased $3.6 million and municipal finance trading gains decreased $5.2 million from fiscal 2011 to fiscal 2012.
Operating expenses decreased 9% for fiscal 2012 as compared to the same period in fiscal 2011, primarily due to decreased commissions and other employee compensation from reduced revenue produced by the institutional segment.
Fiscal 2011 versus 2010
Net revenues from the institutional segment decreased 8% while pre-tax income was down 13% from fiscal 2010 to fiscal 2011. Tighter spreads and reduced volatility, primarily in taxable fixed income, led to a $12.2 million decline in commission revenue.
Investment banking fees were up 12% from fiscal 2010 to fiscal 2011. Taxable fixed income represented $2.1 million of this increase and corporate finance contributed $2.0 million. The increase in taxable fixed income in fiscal 2011 was due to increased unit investment trust underwriting activity while corporate finance closed a larger number of transactions in fiscal 2011 compared to fiscal 2010. These increases in taxable fixed income and corporate finance were partially offset by a $957,000 decrease in municipal finance fees due to a decline in new issuances in the last half of fiscal 2011.
Net gains on principal transactions were down 7% in fiscal 2011 as compared to fiscal 2010. Taxable fixed income trading gains decreased $3.6 million, which was partially offset by an increase in municipal finance trading gains of $1.3 million.
In fiscal 2011, net interest revenue in the institutional segment was down less than 1%, however, net interest revenue from stock loan was down 18%. This decrease was due to a 15 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 $3.1 million.
Operating expenses were down 5% for fiscal 2011 as compared to the same period in fiscal 2010, primarily due to decreases in commissions and other employee compensation on lower net revenue.
Banking. The following is a summary of the results for the banking segment for fiscal 2012, 2011 and 2010 (dollars in thousands):
Fiscal 2012 versus 2011
For fiscal 2012 as compared to fiscal 2011, the Banks net revenues decreased 22%, but the Bank posted pre-tax income of $7.3 million, up from a pre-tax loss of $46.3 million. The decrease in net interest revenue at the Bank for fiscal 2012 as compared to the prior fiscal year was due primarily to a 27% decrease in average loan balances, as well as a decrease in the net yield on interest-earning assets of 70 basis points. Other revenue increased $3.6 million for fiscal 2012 as compared to the prior fiscal year. This increase was primarily due to a $3.1 million decrease in net losses on the sale of REO, a $1.2 million increase in earnings on equity investments and a $0.5 million net decrease in losses on the sale of loans. These increases were offset by a decrease on the gain of sale of securities of $0.6 million and a $0.5 million decrease in miscellaneous revenue.
The Banks operating expenses decreased 61% for fiscal 2012 compared to fiscal 2011. This decrease was due primarily to a $48.5 million decrease in the Banks loan loss provision and a $17.1 million decrease in other expenses, which included the following: (i) a $13.0 million decrease in the Banks REO loss provision; (ii) a $1.4 million decrease in third-party loan review services; (iii) a $1.1 million decrease in the Banks fee assessments from regulatory agencies; (iv) a $0.7 million decrease in real estate related and other loan related expense and (v) a $0.2 million decrease in legal expenses. The decrease in the Banks loan loss provision was due to greater stability in the rate of decline of commercial real estate values and a reduction in size of the Banks loan portfolio. The allowance computation is discussed in detail under -Financial Condition-Loans and Allowance for Probable Loan Loss below.
Fiscal 2011 versus 2010
For fiscal 2011 as compared to fiscal 2010, the Banks net revenues decreased 16%. The Bank posted a pre-tax loss of $46.3 million for fiscal 2011, up from a $17.8 million pre-tax loss reported in fiscal 2010. The decrease in net interest revenue at the Bank was due primarily to a decrease in the net yield on earning assets from 4.8% at June 30, 2010 to 4.3% at June 30, 2011, as well as a decline in the average outstanding balance of loans of 13%. Other revenue for the Bank decreased more than 100% for fiscal 2011 as compared to the same period in fiscal 2010. This decrease was primarily due to a $688,000 increase in net losses on the sale of REO property, a $1.4 million increase on the loss on loans held for sale and a $471,000 decrease in gains on the sale of SBA loans. These decreases were partially offset by a $1.2 million gain on the sale/redemption of securities.
The Banks operating expenses were up 17% for fiscal 2011 over the same period in fiscal 2010. This increase was due primarily to a $5.8 million increase in the Banks loan loss provision, an $8.7 million increase in the Banks REO write-downs, a $1.3 million increase in outside loan and real estate related services and fees, a $1.1 million increase in legal fees and a $1.2 million increase in fee assessments from regulatory agencies. The increase in the Banks loan loss provision was due to continued deterioration in the real estate market and the Banks commercial real estate loan portfolio as well as the continuing uncertainty in the U.S. economy, in particular the Texas economy. The allowance computation is discussed in detail in -Financial Condition-Loans and Allowance for Probable Loan Loss below.
Net Interest Income
The following table sets forth an analysis of the Banks net interest income by each major category of interest-earning assets and interest-bearing liabilities for fiscal 2012, 2011 and 2010 (dollars in thousands):
(*) Loan fees included in interest income for fiscal 2012, 2011 and 2010 were $2,083, $3,245 and $4,985, 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 Banks interest income and interest expense resulting from changes in volume and rate (in thousands):
Other. The following discusses the financial results for SWS Group, corporate administration and SWS Capital Corporation.
Fiscal 2012 versus 2011
Pre-tax loss from the other segment was $49.3 million for fiscal 2012 compared to $35.2 million for fiscal 2011. Net revenues decreased $13.3 million in fiscal 2012 primarily due to a decline in net interest revenue of $10.9 million and a decrease in other revenue of $1.7 million. The decline in net interest revenue was due to the interest expense recorded related to the $100 million loan from Hilltop and Oak Hill in fiscal 2012. The decrease in other revenue was primarily due to a $1.6 million decrease in the value of our deferred compensation plans investments and a $0.4 million decrease in earnings on our equity investment. Operating expenses remained flat during the year with a slight increase of $0.7 million from fiscal 2011 to fiscal 2012. This increase included the $3.7 million unrealized loss in the value of the warrants issued to Hilltop and Oak Hill. The unrealized loss in the value of the warrants was offset by a $1.6 million decrease in the value of our deferred compensation plans investments and a $1.6 million decrease in legal expenses.
Fiscal 2011 versus 2010
Overall other segment net revenues in fiscal 2011 were flat with net gains on principal transactions increasing $1.6 million and other revenues decreasing $1.3 million from the same period in fiscal 2010. The decrease in other revenues was substantially due to a $1.4 million decrease in the income earned on our limited partnership venture capital fund investment.
Pre-tax loss from the other segment was $35.2 million for fiscal 2011 as compared to $34.9 million for fiscal 2010. The change was primarily due to a $2.3 million increase in legal expenses and a $396,000 increase in communication expenses in fiscal 2011 as compared to fiscal 2010. 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 expenses were partially offset by decreases in commissions and employee compensation expense of $2.5 million, primarily due to a decrease in deferred compensation expenses related to our restricted stock plan, occupancy, equipment and computer service expenses of $640,000 and promotional expenses of $460,000.
In fiscal 2012, the Bank implemented an investment strategy to diversify its balance sheet, absorb excess liquidity, and maximize interest income through investment in a conservative securities portfolio. The securities portfolio is structured to provide cash flows that will mitigate interest rate risk and ensure adequate funds are available for new loan originations. The book value of the Banks investment portfolio at June 30, 2012, 2011 and 2010 was as follows (in thousands):
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 that 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 Banks loans are collateralized with real estate.
The allowance for loan losses is maintained to absorb managements estimate of probable loan losses inherent in the loan portfolio at each reporting date. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management determines the collection of principal is remote. Subsequent recoveries are recorded through the allowance. The determination of an adequate allowance is inherently subjective, as it requires estimates that are susceptible to significant revision as additional information becomes available or circumstances change.
The allowance for loan losses consists of a specific and a general allowance component.
The specific component provides for estimated probable losses for loans identified as impaired. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts of principal and interest when due according to the contractual terms of the loan agreement. Management considers the borrowers financial condition, payment status, historical payment record and any adverse situations affecting the borrowers ability to repay when evaluating whether a loan is deemed impaired. Loans that experience insignificant payment delays and shortfalls generally are not classified as impaired. Management determines the significance of payment delays and shortfalls on a case-by-case basis taking into consideration all circumstances surrounding the loan and the borrower, including the length of delay, the reasons for the delay, the borrowers prior payment record and the amount of shortfall in relation to the principal and interest outstanding.
A specific reserve is recorded when and to the extent the present value of expected future cash flows discounted at the loans original effective rate, fair value of collateral if the loan is collateral-dependent or observable market price of the impaired loan is lower than its recorded investment. If the fair value of collateral is used to measure impairment of a collateral-dependent loan and repayment is dependent on the sale of the collateral, the fair value is adjusted to incorporate estimated costs to sell. Impaired loans that are collateral-dependent are primarily measured for impairment using the fair value of the collateral as determined by third party appraisals using the income approach, recent comparable sales data or a combination thereof. In certain instances it is necessary for management to adjust the appraised value, less estimated costs to sell, to reflect changes in fair value occurring subsequent to the appraisal date. Management considers a guarantors capacity and willingness to perform, when appropriate, and the borrowers resources available for repayment when measuring impairment.
The general allowance provides for estimated and probable losses inherent in the remainder of the Banks loan portfolio. The general allowance is determined through a statistical calculation based on the Banks historical loss experience adjusted for certain qualitative factors as deemed appropriate by management. The statistical calculation is conducted on a disaggregated basis for groups of homogeneous loans with similar risk characteristics
(product types). The historical loss element is calculated as the average ratio of charge-offs, net of recoveries, to the average recorded investment for the current and previous three quarters. Management adjusts the historical loss rates to reflect deterioration in the real estate market, significant concentrations of product types, trends in portfolio volume and the credit quality of the loan portfolio to capture additional risk of loss associated with concentrations of criticized and classified loans in the total loan portfolio. Prevailing economic conditions and specific industry trends are taken into consideration when establishing the adjustments to historical loss rates.
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 June 30, 2012, the Bank had $12.3 million in junior lien mortgages. These loans represented less than 2% of total loans at June 30, 2012. At June 30, 2012, the Bank did not have any exposure to sub-prime loans or loans with initial teaser rates. At June 30, 2012, the Bank had $2.0 million of single family interest only loans.
At June 30, 2012, the Banks loan portfolio included a total of $5.4 million in loans with high loan-to-value ratios. High loan-to-value ratios are defined by regulation and range from 75%-90% depending on the type of loan. At June 30, 2012, approximately 24% 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 June 30, 2012, the Bank had one loan with a high loan-to-value ratio that was deemed impaired. The impairment analysis on this loan resulted in no partial charge-off or impairment allocation. Regulatory guidelines suggest that high loan-to-value ratio loans should not exceed 100% of total capital. At June 30, 2012, the Banks high loan-to-value ratio loans represented 3% of total capital.
We obtain appraisals on real estate loans at the time of origination from third party appraisers approved by the Banks Board of Directors. We may also obtain additional appraisals when the borrowers 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, or more frequently if required by market conditions, 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.
Loans receivable at June 30, 2012, 2011, 2010, 2009 and 2008 are summarized as follows (in thousands):