News Column

SWS GROUP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

February 6, 2014

OVERVIEW SWS Group, Inc. (" SWS Group ") (together with its subsidiaries, "we," "us," "SWS" or the "company") is engaged in full-service securities brokerage and full-service commercial banking. For the six-months ended December 31, 2013 , 87% of our total revenues were generated by our full-service brokerage business and 13% of our total revenues were generated by our commercial banking business. While brokerage and banking revenues are dependent upon trading volumes and interest rates, which may fluctuate significantly, a large portion of our expenses remain fixed. Consequently, net operating results can vary significantly from period to period. Our business is also subject to substantial governmental regulation and changes in legal, regulatory, accounting, tax and compliance requirements, which may have a substantial impact on our business and results of operations. We also face substantial competition in each of our lines of business. See Forward-Looking Statements and Risk Factors in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (the "SEC") on September 6, 2013 (the "Fiscal 2013 Form 10-K"). We operate through four segments grouped primarily by products, services and customer base: clearing, retail, institutional and banking. Clearing. We provide clearing and execution services for other broker/dealers (predominantly on a fully disclosed basis). Our clientele includes securities broker/dealers and firms specializing in high-volume trading. We currently support a wide range of clearing clients, including discount and full-service brokerage firms, registered investment advisors and institutional firms. In addition to clearing trades, we tailor our services to meet the specific needs of our clearing correspondents ("correspondents") and offer products and services such as recordkeeping, trade reporting, accounting, general back-office support, securities and margin lending, reorganization assistance and custody of securities. Revenues in this segment are generated primarily through transaction charges to our correspondent firms for clearing their trades. Revenue is also earned from various fees and other processing charges as well as through net interest income on correspondent customer balances. Retail. We offer retail securities (such as equities, mutual funds and fixed income products), insurance products and managed accounts through the activities of our employees that are registered representatives and our independent contractors. As a securities broker, we extend margin credit on a secured basis to our retail customers in order to facilitate securities transactions. This segment generates revenue primarily through commissions charged on securities transactions, fees from managed accounts and the sale of insurance products as well as net interest income from retail customer balances. Institutional. We serve institutional customers in the areas of securities borrowing and lending, municipal finance, sales, trading and underwriting of taxable and tax-exempt fixed income securities and equity trading. Our securities borrowing and lending business includes borrowing and lending securities for other broker/dealers, lending institutions, and our own clearing and retail operations. Our municipal finance operations assist public bodies in originating, syndicating and distributing securities of municipalities and political subdivisions. Our fixed income sales and trading group specializes in trading and underwriting U.S. government and government agency bonds, corporate bonds, municipal bonds, mortgage-backed, asset-backed and commercial mortgage-backed securities and structured products. The clients of our fixed income group include corporations, insurance companies, banks, mutual funds, money managers and other institutions. Our equity trading department focuses on executing equity and option orders on an agency basis for clients. We also have a portfolio trading group that executes large institutional portfolio trades. Revenues in the institutional segment are derived from the net interest spread on stock loan transactions, commissions, and trading income from fixed income and equity products and investment banking, and underwriting fees from corporate and municipal securities transactions. Banking. We offer traditional banking products and services. We specialize in three primary areas, business banking, focusing on industrial and small business lending, commercial real estate lending 45 -------------------------------------------------------------------------------- Table of Contents and mortgage purchase. We originate the majority of our loans internally, and we believe this business model helps us build more valuable relationships with our customers. The Bank earns substantially all of its net revenues on the spread between the rates charged to customers on loans and the interest rates paid to depositors as well as interest income from investments. The Bank has committed to the Office of the Comptroller of the Currency ("OCC") that the Bank will, among other things: (i) adhere to the Bank's written business and capital plan as amended from time to time; and (ii) maintain a Tier I capital ratio at least equal to nine percent (9%) of adjusted total assets and a total risk-based capital ratio of at least twelve percent (12%). The "other" category includes SWS Group , corporate administration and SWS Capital Corporation , which is a dormant entity. Loan from Hilltop and Oak Hill In March 2011 , we entered into a Funding Agreement (the "Funding Agreement") with Hilltop Holdings, Inc. ("Hilltop") and Oak Hill Capital Partners III, L.P. ("OHCP") and Oak Hill Capital Management Partners III, L.P. (collectively with OHCP, "Oak Hill"). On July 29, 2011 , after receipt of stockholder and regulatory approval, we completed the following transactions contemplated by the Funding Agreement: entered into a $100.0 million , five year, unsecured credit agreement with Hilltop and Oak Hill that accrues interest at 8% per annum (the "Credit Agreement"); issued warrants to Hilltop and Oak Hill allowing each to purchase up to 8,695,652 shares of our common stock at an exercise price of $5.75 per share (subject to anti-dilution adjustments), representing approximately 17% of the outstanding common stock of the company for each investor (assuming the warrants are exercised in full); and granted Hilltop and Oak Hill certain rights, including certain registration rights, preemptive rights, and the right for each to appoint one person to our Board of Directors ("BOD") for so long as each owns 9.9% or more of the outstanding shares of our common stock or securities convertible into at least 9.9% of our outstanding common stock. Mr. Gerald J. Ford and Mr. J. Taylor Crandall have been appointed and elected as directors of SWS Group on behalf of Hilltop and Oak Hill , respectively, pursuant to this right. We entered into this transaction with Hilltop and Oak Hill to ensure that the Bank would maintain adequate capital ratios under an Order to Cease and Desist and could continue to reduce classified assets in a strategic and efficient manner, as well as to ensure that the broker/dealer business lines would operate without disruption. See "Debt Issued with Stock Purchase Warrants" in the Notes to the Consolidated Financial Statements contained in this report for additional discussion on the loan from Hilltop and Oak Hill . The funds advanced pursuant to the Credit Agreement with Hilltop and Oak Hill were recorded on our Consolidated Statements of Financial Condition as restricted cash. We are required to keep these funds in a restricted account until our BOD, Hilltop and Oak Hill determine the amount(s) to be distributed to our subsidiaries. Upon the approval of the BOD, Hilltop and Oak Hill , SWS Group contributed $20.0 million of this cash to the Bank as capital in the second quarter of fiscal 2012, loaned $20.0 million to Southwest Securities in the third quarter of fiscal 2012 to use in general operations by reducing Southwest Securities' use of short-term borrowings for the financing of the company's day-to-day cash management needs, paid $20.0 million toward its intercompany payable to Southwest Securities and contributed $10.0 million in capital to Southwest Securities in the fourth quarter of fiscal 2012. On March 28, 2013 , the $20.0 million loan from SWS Group to Southwest Securities was repaid and the company's BOD, Hilltop and Oak Hill approved, and SWS Group contributed, $20.0 million of cash as a capital contribution to Southwest Securities. At December 31, 2013 , the remaining $30.0 million was being held in a restricted account at SWS Group to be used for general corporate purposes, subject to the approval of the BOD, Hilltop and Oak Hill . On January 8, 2014 , the remaining $30.0 million was loaned to Southwest Securities to use in general operations upon approval by the BOD, Hilltop and Oak Hill which reduced Southwest Securities' use of short-term borrowings for the financing of its day-to-day cash management needs. On January 9, 2014 , we received an unsolicited acquisition proposal from Hilltop to acquire all of the outstanding shares of SWS Group common stock that Hilltop does not already own for $7.00 per share, with the consideration to be paid 50% in cash and 50% in Hilltop common stock. On February 3, 2014 , we announced that our BOD formed a Special Committee, comprised of independent directors not affiliated with Hilltop or Oak Hill , to, among other things, carefully evaluate Hilltop's unsolicited proposal and make a recommendation to our BOD. There can be no assurance that a transaction with Hilltop or any other party will be approved or consummated. Business Environment Performance in the financial services industry in which we operate is highly correlated to the overall strength of the economy and financial market activity. Overall market conditions are a product of many factors, which are beyond our control and can be 46 -------------------------------------------------------------------------------- Table of Contents unpredictable. These factors may affect the financial decisions made by investors, including their level of participation in the financial markets, which may in turn, affect our business results. With respect to financial market activity, our profitability is sensitive to a variety of factors, including the volatility of the equity and fixed income markets, the level and shape of various yield curves, the volume of trading in securities, the value of our customers' assets under management, the demand for loans, the value of real estate in our market areas and the current political environment. As of December 31, 2013 , equity market indices were up versus a year ago with the Dow Jones Industrial Average (the "DJIA") up 26.5%, the Standard & Poor's 500 Index ("S&P 500") up 29.6% and the NASDAQ Composite Index ("NASDAQ") up 38.32%. The DJIA closed at 16,576.66 on December 31, 2013 up from 13,104.14 and 14,909.60 on December 31, 2012 and June 30, 2013 , respectively. While the indices showed improvement and reached record closing prices that have not been reached since 2008, the average daily trading volume on the NYSE decreased 9% as compared to the same period of our prior fiscal year. The continued uncertainty in the economic environment, with the federal government shutdown in October 2013 and the required implementation by businesses and individuals of the Affordable Care Act, continued low levels of workforce participation and high unemployment rates, contributed to volatility during the first six months of fiscal 2014. For our clearing, retail, and institutional segments, in particular our institutional segment, the uncertainty about the Federal Reserve's plans for monetary easing has added to the volatility in interest rates and fixed income inventory valuations. For our banking segment, this uncertainty creates issues in its approach and timing of mitigation of interest rate risk in a rising interest rate environment. Continued economic and regulatory uncertainty also created a challenging operating environment for us during the three and six-months ended December 31, 2013 . The national unemployment rate, which was approximately 6.7% at the end of December 2013 , was down from a high of 10.0% at the end of December 2009 , and 7.6% at the end of June 2013 , but remains at historically high levels. The Board of Governors of the Federal Reserve System ("FRB") reduced the federal funds target rate to 0 - 0.25% on December 16, 2008 and announced in January 2013 that it anticipated that rates were unlikely to increase as long as the unemployment rate remained above 6.5%, the short-term inflation rate was projected to be no more than 0.5% above the Federal Open Market Committee's 2% longer-run goal, and longer-term inflation expectations continue to be stable. The disruptions and developments in the world economy and the credit markets over the past three years resulted in a range of actions by the U.S. and foreign governments to attempt to bring liquidity and order to the financial markets and to prevent an extended recession in the world economy. For more details regarding some of the actions taken by U.S. and foreign governments, see the discussion under Business-Regulation contained in our Fiscal 2013 Form 10-K. Government intervention in the markets for the past several years has created artificially low short-term interest rates. Public announcements by the FRB regarding timing of reduced intervention or increased interest rates has led to substantial volatility in the fixed income markets. This volatility has produced and could continue to produce material changes in the value of our fixed income trading portfolio. Texas , along with the rest of the country, has experienced distress in residential and commercial real estate values as well as elevated unemployment rates since the last calendar quarter of 2010. Real estate values, along with unemployment statistics, have improved; however, with the improvement, competition in the banking business has increased as loan demand is not yet robust. Regulatory Environment The SEC recently adopted amendments, most of which were effective October 2013 , to its financial responsibility rules, including changes to the net capital rule, the customer protection rule, the record-keeping rules and the notification rules applicable to our broker/dealer subsidiaries. We are currently evaluating the impact of these amendments on our broker/dealer subsidiaries; however, based on our current analyses, we do not believe they will have a material adverse effect on any of our broker/dealer subsidiaries. The final provisions of the Volcker Rule of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") were issued December 10, 2013 , with an effective date of April 1, 2014 and a compliance date of July 21, 2015 . Many of our broker/dealer's securities trading and investment activities are subject to these final provisions. The Volcker Rule provision of the Dodd-Frank Act requires the federal financial regulatory agencies to adopt rules that prohibit banks, bank holding companies, and their affiliates from engaging in proprietary trading and investing in and sponsoring certain unregistered investment companies (including hedge funds and private equity funds), subject to certain exceptions. The final rules are highly complex, and many aspects of their application remain uncertain. We are evaluating the effect of these provisions on our business activities as well as on our financial statements, processes, procedures and risk management. Based on management's interpretation of the final provisions of the rule, the Bank's equity method investments would be excluded from the definition of a "covered" fund as these investments would meet the definition of "public welfare investment" funds that are "designed primarily to promote the public welfare." Currently, the Bank invests in these funds as a cost effective way of meeting its obligations under the Community Reinvestment Act of 1977 ("CRA"). One of these investments also meets the definition of a small business investment company. According to the rule, the Company's ownership interest in any "covered" fund would be limited to 3% of the total ownership of the fund. The provisions of the rule would also limit the aggregate 47 -------------------------------------------------------------------------------- Table of Contents ownership of all investments in "covered" funds to 3% of Tier 1 capital of the bank holding company. After the compliance date of July 21, 2015 , we can request for an additional two year extension from the FRB, if necessary, to divest "covered" fund investments to the allowable ownership levels. Currently, our ownership percentages in the limited partnership venture capital fund, one of the limited partnership equity funds and the private investment fund are greater than 3% of the total ownership of the fund. The aggregate ownership of all investments is less than 3% of Tier 1 capital of the bank holding company. In addition, at December 31, 2013 , the Bank's investment portfolio does not contain other securities subject to the Volcker Rule such as collateralized loan obligations (CLO's) and non-agency collateralized mortgage obligations (CMO's). Impact of Economic Environment Brokerage: Volatility in the U.S. credit and mortgage markets, low interest rates and reduced volume in the U.S. stock markets continue to have an adverse effect on several aspects of our brokerage business, including depressed net interest margins, reduced liquidity and lower trading volumes. Exposure to European Sovereign Debt We have no exposure to European sovereign debt or direct exposure to European banks. However, we do participate in securities lending with U.S. subsidiaries of several European banks. Receivables from securities lending are secured by collateral equal to 102% of the market value of the underlying securities, and the collateral is adjusted daily to maintain the 102% margin. Net Interest Margins Historically, the profitability of our brokerage business has been highly dependent upon net interest income. We earn net interest income on the spread between the interest rates earned and paid on customer and correspondent balances as well as from our securities lending business. With interest rates at historically low levels, the spread we are able to earn has been reduced, primarily from the extremely low yields on our portfolio of assets segregated for regulatory purposes. Additionally, the spread in our securities lending business has declined. Lastly, because the yields on money market funds have declined significantly, revenue sharing arrangements with our primary money market fund providers have been substantially reduced. We do not expect any significant changes in these dynamics until short-term interest rates rise. We have taken actions to mitigate the impact of this margin contraction by renegotiating arrangements with our clearing customers, changing the mix of our assets segregated for regulatory purposes and developing new business in our securities lending portfolio. Despite these actions, profits from net interest remain substantially below historical levels. Liquidity Dislocation in the credit markets has led to increased liquidity risk. All but $45.0 million of our borrowing arrangements are uncommitted lines of credit and, as such, can be reduced or eliminated at any time by the lenders extending the credit. While we have not experienced any reductions in our uncommitted borrowing capacity, over the past three years, our lenders have taken actions that indicate their concerns about extending liquidity in the marketplace. These actions included reduced advance rates for certain security types, more stringent requirements for collateral eligibility, higher interest rates and pre-funding of daily settlements. Should our lenders take any actions that negatively impact the terms of our lending arrangements, the cost of conducting our business could increase and our volume of business could be limited. The volatility in the U.S. stock markets has also impacted our liquidity through increased margin requirements at our clearing houses. These margin requirements are determined by the clearing houses through a combination of risk formulas that are periodically adjusted to reflect perceived risk in the market. To the extent we are required to post cash or other collateral to meet these requirements, we will have less liquidity to finance our other business. We expect these margin requirements may increase over the next 12-18 months. Valuation of Securities We regularly trade mortgage, asset-backed and other types of fixed income securities. We monitor our trading limits daily to ensure that these securities are maintained at levels we consider prudent given current market conditions. We price these securities using a third-party pricing service and we review the prices monthly to ensure reasonable valuations. At December 31, 2013 , we held mortgage and asset-backed securities of approximately $22.4 million included in securities owned, at fair value on the Consolidated Statements of Financial Condition. Included in this balance are approximately $0.9 million of long inventory in to-be-announced ("TBA") securities, which are government agency mortgage-backed securities whose collateral remain unknown until just prior to the trade settlement. Bank: Shortly after closing the Hilltop and Oak Hill transaction, we contributed $20.0 million in capital to the Bank. We believe the $20.0 million capital contribution provided the Bank with a sound foundation and with flexibility to accelerate the reduction of classified assets. 48 -------------------------------------------------------------------------------- Table of Contents The Bank continued to reduce classified assets in the quarter ended December 31, 2013 . Classified assets were $48.0 million at December 31, 2013 , down from $67.6 million at June 30, 2013 . Classified assets as a percentage of total capital plus the allowance for loan losses was 27.2% at December 31, 2013 and 37.4% at June 30, 2013 . Non-performing assets (a subset of classified assets) decreased to $26.9 million at December 31, 2013 from $38.0 million at June 30, 2013 . The Bank has significantly reduced classified assets and improved performance over the past five quarters, but the reduction in classified assets could slow and additional loans could be moved to problem status should the economic environment worsen. The Bank's loan loss allowance at December 31, 2013 was $9.4 million , or 2.29% of loans held for investment, excluding purchased mortgage loans held for investment and loans measured at fair value, as compared to $12.3 million , or 2.85% of loans held for investment, excluding purchased mortgage loans held for investment and loans measured at fair value, at June 30, 2013 and $18.6 million , or 4.10% at December 31, 2012 . The Tier I (core) capital ratio was 13.8% and the total risk-based capital ratio was 27.4% at December 31, 2013 , as compared to 13.5% and 24.9%, respectively, at June 30, 2013 (without giving effect to the Basel III final rules). With the stability of these capital ratios, the Bank's management has focused on diversifying the balance sheet by reducing loan concentrations and building an investment portfolio. In conjunction with building the security investment portfolio, the Bank entered into $140.0 million of interest rate swaps to reduce deposit cost variability by focusing on protecting earnings in a rising interest rate environment. The Bank plans to continue implementing this strategy, along with other balance sheet considerations, to manage interest rate risk. The Bank is focused on implementing and executing its business plan, which includes the continued diversification of the balance sheet and conservative growth strategies. The Bank's available for sale investment portfolio was $580.2 million and $503.1 million at December 31, 2013 and June 30, 2013 , respectively. The Bank plans to continue to manage a tiered investment portfolio designed to provide cash flows for loan originations. At December 31, 2013 and June 30, 2013 , the Bank's mortgage purchase program loan balance was $89.6 million and $174.0 million , respectively. These loans are held for investment on average for 25 days or less, which substantially limits credit risk. The primary funding source for the Bank's balance sheet growth is core deposits from Southwest Securities' brokerage customers. These core deposits provide the Bank with a stable and low cost funding source. At December 31, 2013 and June 30, 2013 , the Bank had $876.5 million and $878.4 million , respectively, in funds on deposit from customers of Southwest Securities, representing approximately 88.1% and 88.4%, respectively, of the Bank's total deposits. Events and Transactions A description of material events and transactions impacting our results of operations in the periods presented are discussed below: Employee reduction. Due to our decline in revenue for the past three fiscal years, management determined that expense reductions were needed in order to improve operating results and execute our strategic business plan. As a result, we reduced the number of our employees by approximately 7% during the three-months ended September 30, 2013 and recorded approximately $1.2 million in severance expense for three-months ended September 30, 2013 in commissions and other employee compensation on the Consolidated Statements of Comprehensive (Loss) Income. While we continue to monitor our staffing needs, we do not anticipate any additional headcount reductions at this time. Warrant valuation. The warrants issued to Hilltop and Oak Hill are presented as liabilities carried at fair value on the Consolidated Statement of Financial Condition. During the six-months ended December 31, 2013 , the value of these warrants increased primarily due to the increase in the market value of our common stock. Our stock price increased from $5.45 at June 30, 2013 to $6.08 at December 31, 2013 . The increase in the stock price, combined with other factors, resulted in an unrealized pre-tax loss of $91,000 for the six-months ended December 31, 2013 . For the three-months ended December 31, 2013 , the increase in the stock price, combined with other factors, resulted in an unrealized pre-tax loss of $2.1 million . During the six-months ended December 31, 2012 , the value of these warrants decreased due to a decrease in the stock price from $5.33 at June 29, 2012 to $5.29 at December 31, 2012 . The decrease in the stock price, combined with other factors, resulted in an unrealized pre-tax gain of $3.6 million for the six-months ended December 31, 2012 . For the three-months ended December 31, 2012 , the decrease in our stock price, combined with other factors resulted in an unrealized pre-tax gain of $11.8 million . Recapture in allowance for loan loss. The quality of the Bank's assets continued to improve in the second quarter of fiscal 2014 and 2013 resulting in a $2.8 million and $1.5 million recapture of our provision for loan loss for the three-months ended December 31, 2013 and 2012, respectively. Hurricane Sandy. On October 29, 2012 , the east coast of the United States was hit by Hurricane Sandy. As a result of this hurricane, the equity markets were closed for two days with no trading occurring during those two days, which negatively impacted our results for the three-months ended December 31, 2012 . 49 -------------------------------------------------------------------------------- Table of Contents Auction rate security. Since fiscal 2010, we held an auction rate municipal bond at 95.7% of par. As a result of a trade in a similar security at a value less than par and related market conditions, we determined that our security should be written down to 92.5% of par in the first quarter of fiscal 2013. This resulted in a $702,000 write down at September 28 , 2012,with no additional write-downs in the second quarter of fiscal 2013. During the third quarter of fiscal 2013, we sold this security with no gain or loss recognized on the transaction. RESULTS OF OPERATIONS Consolidated Net income for the three and six-months ended December 31, 2013 was $1.7 million and $2.0 million , respectively, as compared to net income for the three and six-months ended December 31, 2012 of $10.4 million and $4.7 million , respectively. The three and six-months ended December 31, 2013 and 2012 contained 64 and 128 trading days and 62 and 125 trading days, respectively. Southwest Securities was custodian for $31.5 billion and $29.6 billion in total customer assets at December 31, 2013 and 2012, respectively. The following is a summary of increases (decreases) in categories of net revenues and operating expenses for the three and six-months ended December 31, 2013 compared to the three and six-months ended December 31, 2012 (dollars in thousands): Three- Months Six- Months Ended Ended Amount Percent Amount Percent Net revenues: Net revenues from clearing operations $ 36 2 % $ 190 4 % Commissions (1,579) (5) (3,379) (5) Net interest (2,954) (22) (7,138) (26) Investment banking, advisory and administrative fees (1,411) (12) (766) (3) Net gains on principal transactions (3,705) (33) (4,012) (20) Other 2,754 49 3,132 27 $ (6,859) (9) % $ (11,973) (8) % Operating expenses: Commissions and other employee compensation $ (3,236) (6) % $ (4,932) (5) % Occupancy, equipment and computer service costs 166 2 221 1 Communications 27 1 156 2 Floor brokerage and clearing organization charges 134 14 223 11 Advertising and promotional (125) (17) (143) (10) Provision for loan loss (1,375) 95 (1,841) >100 Unrealized net gain/loss on warrant valuation 13,819 >(100) 3,667 >(100) Other (1,928) (23) (4,170) (25) 7,482 13 (6,819) (5) Pre-tax income $ (14,341) (92) % $ (5,154) (78) % Three-Months Ended: Net revenues decreased $6.9 million for the three-months ended December 31, 2013 as compared to the same period of the prior fiscal year. Net gains on principal transactions generated $3.7 million of the decrease primarily due to a $3.5 million decrease in the other segment from a $3.6 million realized gain recognized in the second quarter of fiscal 2013 from the sale of our shares of U.S. Home Systems, Inc. ("USHS") common stock. Net interest revenues were down $3.0 million primarily driven by a $2.2 million decrease in net interest revenue in our banking segment due to a 32% decrease in average loan balances and a 70 basis point decrease in net interest yield as compared to the same period of the prior fiscal year. The institutional segment contributed an additional $0.6 million of the decrease in net interest revenue primarily due to a $1.0 million decrease in interest earned on taxable and non-taxable securities from a reduction in net interest spreads, offset by a $0.2 million increase in our interest expense on short-term borrowings. Net interest income from our stock lending business increased $0.2 million primarily due to a 50% increase in average balances which overcame an 11 basis point decrease in our average net interest spread. 50 -------------------------------------------------------------------------------- Table of Contents Commissions revenue decreased $1.6 million primarily due to a $2.2 million decrease in commissions revenue in the institutional segment offset by a $0.7 million increase in commissions revenue in the retail segment as compared to the prior year comparable quarter. The decrease in the institutional segment was due primarily to a decline in portfolio trading transaction volume in the second quarter of fiscal 2014 compared to the second quarter of fiscal 2013. The increase in commissions revenue in the retail segment was generated by our private client group ("PCG") and independent registered representative group ("SWS Financial") from increased customer activity. Additionally, investment banking, advisory and administrative fees decreased $1.4 million primarily due to a $2.2 million decrease in fees earned by our institutional segment. This $2.2 million decrease was due to a $1.5 million decrease in taxable fixed income underwriting fees, and a $1.2 million decrease in corporate finance fees as we exited this business in the fourth quarter of fiscal 2013, offset by a $0.6 million increase in municipal finance fees. The $2.2 million decrease in the institutional segment was offset by a $0.9 million increase in advisory fees in our retail segment, which was generated by both our PCG and SWS Financial divisions. Other revenues increased $2.8 million . The increase was primarily due to our banking segment which recorded a $0.9 million increase, our other segment which also recorded a $0.9 million increase and our clearing segment which recorded a $0.5 million increase. The increase in the banking segment was due to a $0.3 million increase in gains on sale of Small Business Administration ("SBA") loans, a $0.7 million increase in gains on our interest rate swap transactions, a $0.7 million decrease in net losses on the sale of real estate owned ("REO"), offset by a $0.7 million decrease in the gains recognized on the valuation of the Bank's equity method investments. The increase in other revenue in our other segment was primarily due to a $0.9 million increase in value in our deferred compensation plan investments. The $0.5 million increase in our clearing segment was due to servicing fees income received from a third party administrator. Operating expenses increased $7.5 million for the three-months ended December 31, 2013 as compared to the same period of the prior fiscal year. The largest component of this increase was the $13.8 million change in the value of the warrants held by Hilltop and Oak Hill . We recognized a $2.1 million loss on the warrant valuation for the three-months ended December 31, 2013 and an $11.8 million gain on the warrant valuation for the three-months ended December 31, 2012 . Offsetting the increased expense from the valuation of the warrants was a $3.2 million decrease in commissions and other employee compensation, primarily due to the $2.3 million decrease in salaries resulting from staff reductions and $0.8 million in incentive compensation due to a decrease in overall net revenues. Additionally, other expenses decreased $1.9 million for the three-months ended December 31, 2013 as compared to the same period of the prior fiscal year primarily due to a $0.5 million decrease in professional service fees, a $0.4 million decrease in REO expense, a $0.4 million decrease in the REO loss provision and a $0.3 million decrease in Bank regulatory fees. Lastly, the Bank's loan loss recapture increased $1.4 million primarily due to the pay-off in the current period of an outstanding balance of a commercial loan for which the Bank had recorded a $2.1 million specific allowance reserve. Six-Months Ended: Net revenues decreased $12.0 million for the six-months ended December 31, 2013 as compared to the same period of the prior fiscal year. Net interest revenue decreased $7.1 million primarily driven by a $5.0 million decrease in net interest revenue in our banking segment due to a 32% decrease in our average loan balance and a 60 basis point decrease in net interest yield at the Bank as compared to the same period of the prior fiscal year. Net interest revenue in the institutional segment decreased $1.7 million primarily due to a $1.5 million reduction of interest earned on taxable and non-taxable securities due to a reduction in net interest spreads. In addition, net interest in the stock loan business was down $0.5 million primarily due to a 19 basis point decrease in our average net interest spread partially offset by a 35% increase in our average stock borrowed portfolio balances. Net gains on principal transactions decreased $4.0 million primarily due to the recognition of a $3.6 million realized gain in the second quarter of fiscal 2013 related to the sale of our shares of USHS common stock which was reflected in the other segment. Lastly, commissions revenue decreased $3.4 million primarily due to a $4.8 million decrease in the institutional segment, which was offset by a $1.5 million increase in commissions revenue in the retail segment. The decrease in commissions revenue in the institutional segment was due to a lower portfolio trading transaction volume in the first half of fiscal 2014 compared to the same period of fiscal 2013. The increase in retail commissions revenue was due primarily to increased customer activity in our PCG group. Other revenues increased $3.1 million . This increase was primarily related to our banking segment with a $1.1 million increase, our other segment with a $1.2 million increase and a $1.0 million increase in third party servicing fee income which was split between our clearing and retail segments. The increase in the banking segment was due to a $0.2 million increase in gains on sale of SBA loans, a $0.7 million increase in gains on our interest rate swap transactions, a $1.0 million decrease in net losses on the sale of REO, offset by a $0.8 million decrease in the gains recognized on the valuation of the Bank's equity method investments. The increase in other revenue in our other segment was primarily due to a $1.2 million increase in value in our deferred compensation plan investments. 51 -------------------------------------------------------------------------------- Table of Contents Operating expenses decreased $6.8 million for the six-months ended December 31, 2013 as compared to the same period of the prior fiscal year. The largest components of this decrease was a $5.0 million decrease in commissions and other employee compensation, which was primarily due to a $3.1 million decrease in incentive compensation due to a decline in overall company performance and a $1.9 million decrease in employee salaries primarily resulting from the staff reductions in the first three-months of fiscal 2014. Other expenses decreased $4.2 million primarily due to a $0.8 million decrease in legal and general operational expenses, a $0.8 million decrease in REO expenses, a $0.7 million decrease in the REO loss provision, a $0.6 million decrease in Bank regulatory fees, a $0.6 million decrease in professional services and a $0.4 million decrease in outside services at the Bank. Lastly, the Bank's loan loss recapture increased $1.8 million primarily due to the pay-off in the current period of an outstanding balance of a commercial loan for which the Bank had recorded a $2.1 million specific allowance reserve. Offsetting these operating expense reductions, we recorded $3.7 million of additional expense related to the warrant valuation. We recognized a $91,000 loss on the warrant valuation for the six-months ended December 31, 2013 and a $3.6 million gain on the warrant valuation for the six-months ended December 31, 2012 . 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 to the cost of funds. Net interest is the primary source of income for the Bank and represents the amount by which interest and fees generated by earning assets exceed the cost of funds. The Bank's cost of funds consists primarily of interest paid to the Bank's depositors on interest-bearing accounts and long-term borrowings with the FHLB. Net interest income from our brokerage, corporate and banking segments were as follows for the three and six-months ended December 31, 2013 and 2012 (in thousands): Three-Months Ended Six-Months Ended December 31, December 31, December 31, December 31, 2013 2012 2013 2012 Brokerage $ 4,999 $ 5,519 $ 9,544 $ 11,266 Bank 8,872 11,077 17,678 22,644 SWS Group(1) (3,266) (3,037) (6,491) (6,041) Net interest $ 10,605 $ 13,559 $ 20,731 $ 27,869 __________ (1) Consists primarily of interest expense under the Credit Agreement with Hilltop and Oak Hill . 52 -------------------------------------------------------------------------------- Table of Contents Average balances of interest earning assets and interest-bearing liabilities in our brokerage operations were as follows (in thousands): Three-Months Ended Six-Months Ended December 31, 2013 December 31, 2012 December 31, 2013 December 31, 2012 Average interest-earning assets: Customer margin balances $ 241,000 $ 237,000 $ 243,000 $ 236,000 Assets segregated for regulatory purposes 204,000 200,000 195,000 196,000 Stock borrowed 1,949,000 1,300,000 1,872,000 1,387,000 Average interest-bearing liabilities: Customer funds on deposit, including short credits $ 355,000 $ 344,000 $ 354,000 $ 338,000 Stock loaned 1,865,000 1,248,000 1,774,000 1,345,000 Net interest revenue generated by each segment is reviewed in detail in the segment analysis below. Income Tax Benefit For the three-months ended December 31, 2013 , income tax benefit (effective rate of -30.8%) differed from the amount that would have otherwise been calculated by applying the federal corporate tax rate (35%) to income before income tax benefit (expense) due to the value of company-owned life insurance ("COLI"), tax exempt interest and a decrease in our deferred tax valuation allowance. For the six-months ended December 31, 2013 , income tax benefit (effective rate of -39.3%) differed from the amount that would have otherwise been calculated by applying the federal corporate tax rate (35%) to income before income tax benefit (expense) due to the value of company-owned life insurance ("COLI") and tax exempt interest. See further discussion regarding reconciliation of the effective tax rate and the federal corporate tax rate in "Income Taxes" in the Notes to the Consolidated Financial Statements contained in this report. 53 -------------------------------------------------------------------------------- Table of Contents Segment Information The following is a summary of net revenues and pre-tax income (loss) by segment for the three and six-months ended December 31, 2013 as compared to the three and six-months ended December 31, 2012 (dollars in thousands): Three-Months Ended December 31, December 31, Increase/ 2013 2012 Decrease % Change Net revenues: Clearing $ 5,301 $ 4,721 $ 580 12 % Retail 28,071 26,124 1,947 7 Institutional 27,265 32,558 (5,293) (16) Banking 10,464 11,771 (1,307) (11) Other (2,615) 171 (2,786) >(100) Total $ 68,486 $ 75,345 $ (6,859) (9) % Pre-tax income (loss): Clearing $ 1,339 $ (115) $ 1,454 >100 % Retail 3,003 528 2,475 >100 Institutional 5,949 9,339 (3,390) (36) Banking 5,324 2,972 2,352 79 Other (14,346) 2,886 (17,232) >(100) Total $ 1,269 $ 15,610 $ (14,341) (92) % Six-Months Ended December 31, December 31, Increase/ 2013 2012 Decrease % Change Net revenues: Clearing $ 9,975 $ 9,679 $ 296 3 % Retail 57,909 54,190 3,719 7 Institutional 55,268 65,453 (10,185) (16) Banking 19,551 23,404 (3,853) (16) Other (5,222) (3,272) (1,950) (60) Total $ 137,481 $ 149,454 $ (11,973) (8) % Pre-tax income (loss): Clearing $ 1,112 $ 80 $ 1,032 >100 % Retail 5,254 847 4,407 >100 Institutional 12,154 19,264 (7,110) (37) Banking 6,519 4,253 2,266 53 Other (23,615) (17,866) (5,749) (32) Total $ 1,424 $ 6,578 $ (5,154) (78) % 54 -------------------------------------------------------------------------------- Table of Contents Clearing. Three-Months Ended: The following is a summary of the results for the clearing segment for the three-months ended December 31, 2013 as compared to the three-months ended December 31, 2012 (dollars in thousands): Three-Months Ended December 31, December 31, 2013 2012 % Change Net revenue from clearing $ 2,213 $ 2,177 2 % Net interest 1,549 1,488 4 Other 1,539 1,056 46 Net revenues 5,301 4,721 12 Operating expenses 3,962 4,836 (18) Pre-tax income (loss) $ 1,339 $ (115) >100 % Daily average customer margin balance $ 108,000 $ 101,000 7 % Daily average customer funds on deposit $ 178,000 $ 178,000 - % Total correspondent clearing customer assets under custody were $16.2 billion and $14.9 billion at December 31, 2013 and 2012, respectively. The following table reflects the number of client transactions processed for the three-months ended December 31, 2013 and 2012 and the number of correspondents at the end of each period. Three-Months Ended December 31, 2013 December 31, 2012 Tickets for high-volume trading firms 11,000 101,423 Tickets for general securities broker/dealers 170,319 156,749 Total tickets 181,319 258,172 Correspondents 146 146 For the three-months ended December 31, 2013 , net revenues in the clearing segment increased 12% and clearing fee revenues increased 2%. Other revenues and net interest revenue increased 46% and 4%, respectively, compared to the three-months ended December 31, 2012 . The 2% increase in clearing fee revenue was primarily due to a 9% increase in the number of general securities tickets processed and an increase in the overall revenue per ticket. Revenue per ticket increased approximately 45% from $8.43 for the three-months ended December 31, 2012 to $12.21 for the three-months ended December 31, 2013 . 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. Management believes that the increase in clearing volume for general security broker/dealers corresponds with improved conditions in the equity markets. For the three-months ended December 31, 2013 compared to the three-months ended December 31, 2012 , tickets processed for high-volume trading firms decreased 89%. One-half of this decline was due to the loss of one correspondent through a broker/dealer withdrawal. The increase in other revenues was primarily due to a $0.5 million increase in third party servicing fee income. Operating expenses decreased 18% for the three-months ended December 31, 2013 as compared to the same period last fiscal year primarily due to a 19% decrease in operations and information technology expenses and reduced overall compensation expenses. 55 -------------------------------------------------------------------------------- Table of Contents Six-Months Ended: The following is a summary of the results for the clearing segment for the six-months ended December 31, 2013 as compared to the six-months ended December 31, 2012 (dollars in thousands): Six-Months Ended December 31, December 31, 2013 2012 % Change Net revenue from clearing $ 4,505 $ 4,316 4 % Net interest 2,968 3,183 (7) Other 2,502 2,180 15 Net revenues 9,975 9,679 3 Operating expenses 8,863 9,599 (8) Pre-tax income $ 1,112 $ 80 >100 % Daily average customer margin balance $ 104,000 $ 103,000 1 % Daily average customer funds on deposit $ 354,000 $ 350,000 1 % The following table reflects the number of client transactions processed for the six-months ended December 31, 2013 and 2012. Six-Months Ended December 31, 2013 December 31, 2012 Tickets for high-volume trading firms 21,559 194,311 Tickets for general securities broker/dealers 341,245 314,258 Total tickets 362,804 508,569 For the six-months ended December 31, 2013 , net revenues in the clearing segment increased 3% while clearing fee revenues increased 4%. Other revenues increased 15% and net interest revenue decreased 7% compared to the six-months ended December 31, 2012 . The 4% increase in clearing fee revenue was primarily due to a 9% increase in the number of general securities tickets processed and an increase in the revenue per ticket. Revenue per ticket increased approximately 46% from $8.49 for the six-months ended December 31, 2012 to $12.42 for the six-months ended December 31, 2013 . 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. Management believes that the increase in clearing volume for general security broker/dealers corresponds with improved conditions in the equity markets. For the six-months ended December 31, 2013 compared to the six-months ended December 31, 2012 , tickets processed for high-volume trading firms decreased 89%. One-half of this decline was due to the loss of one correspondent through a broker/dealer withdrawal. The increase in other revenue was primarily driven by a $0.5 million increase in third party servicing fee income. Operating expenses decreased 8% for the six-months ended December 31, 2013 as compared to the same period last fiscal year primarily due to a 6% decrease in other expenses. The decrease in other expenses was mainly attributed to a 3% decrease in operations and information technology expenses and reduced overall compensation expenses. 56 -------------------------------------------------------------------------------- Table of Contents Retail. Three-Months Ended: The following is a summary of the results for the retail segment for the three-months ended December 31, 2013 as compared to the three-months ended December 31, 2012 (dollars in thousands): Three-Months Ended December 31, December 31, 2013 2012 % Change Net revenues: Private Client Group (PCG) Commissions $ 12,495 $ 12,008 4 % Advisory fees 2,909 2,247 29 Insurance products 1,155 806 43 Other 301 73 >100 Net interest revenue 626 541 16 17,486 15,675 12 Independent registered representatives (SWS Financial) Commissions 5,703 5,549 3 Advisory fees 1,008 912 11 Insurance products 2,029 2,551 (20) Other 440 248 77 Net interest revenue 286 299 (4) 9,466 9,559 (1) Other Commissions 131 107 22 Advisory fees 527 381 38 Insurance products 347 378 (8) Other 114 24 >100 1,119 890 26 Total 28,071 26,124 7 Operating expenses 25,068 25,596 (2) Pre-tax income $ 3,003 $ 528 >100 % Daily average customer margin balances $ 129,000 $ 134,000 (4) % Daily average customer funds on deposit $ 126,000 $ 114,000 11 % PCG representatives 160 165 (3) % SWS Financial representatives 280 308 (9) % Net revenues in the retail segment increased 7% for the three-months ended December 31, 2013 as compared to the same period in the last fiscal year. Improvement in PCG accounted for most of the additional revenues reflecting the underlying improvement in retail client activity and success in retaining key producers. Advisory fees were up in all areas of the retail business due to a 27% increase in assets under management resulting in a $0.9 million increase in advisory fees, which included a $0.7 million increase in our PCG division. In addition, commissions revenue increased 4% in our PCG group and 3% for SWS Financial. Other revenues also increased $0.5 million for the three-months ended December 31, 2013 as compared to the same period in the last fiscal year primarily due to a $0.4 million increase in third party servicing fee income. Total customer assets were $14.8 billion at December 31, 2013 and $13.6 billion at December 31, 2012 . Assets under management were $1.1 billion at December 31, 2013 versus $865.0 million at December 31, 2012 . 57 -------------------------------------------------------------------------------- Table of Contents Operating expenses decreased 2% for the three-months ended December 31, 2013 as compared to the same period last fiscal year primarily due to a $0.3 million decrease in legal expenses. Six-Months Ended: The following is a summary of the results for the retail segment for the six-months ended December 31, 2013 as compared to the six-months ended December 31, 2012 (dollars in thousands): Six-Months Ended December 31, December 31, 2013 2012 % Change Net revenues: PCG Commissions $ 26,207 $ 24,503 7 % Advisory fees 5,760 4,288 34 Insurance products 2,595 1,792 45 Other 380 179 >100 Net interest revenue 1,403 1,111 26 36,345 31,873 14 SWS Financial Commissions 11,932 12,219 (2) Advisory fees 1,957 1,820 8 Insurance products 4,227 5,367 (21) Other 687 507 36 Net interest revenue 564 598 (6) 19,367 20,511 (6) Other Commissions 251 217 16 Advisory fees 1,032 768 34 Insurance products 769 746 3 Other 145 75 93 2,197 1,806 22 Total 57,909 54,190 7 Operating expenses 52,655 53,343 (1) Pre-tax income $ 5,254 $ 847 >100 % Daily average customer margin balances $ 136,000 $ 130,000 5 % Daily average customer funds on deposit $ 259,000 $ 224,000 16 % Net revenues in the retail segment increased 7% for the six-months ended December 31, 2013 as compared to the same period in the last fiscal year. Improvement in PCG accounted for most of the additional revenues reflecting underlying improvement in retail client activity and success in retaining key producers. Advisory fees were up in all areas of the retail business due to a 27% increase in assets under management. In addition, commissions revenue increased 7% in our PCG group but decreased 2% for SWS Financial. Overall, there was a $1.9 million increase in advisory fees due primarily to the 34% increase in PCG advisory fee revenues and a 15% increase in advisory fees for the other retail entities. Other revenues also increased $0.5 million for the six-months ended December 31, 2013 as compared to the same period in the last fiscal year primarily due to a $0.4 million increase in third party servicing fee income. Operating expenses decreased 1% for the six-months ended December 31, 2013 as compared to the same period last fiscal year. This decrease was primarily due to a $1.0 million decrease in legal expenses offset by a $0.6 million increase in commissions and 58 -------------------------------------------------------------------------------- Table of Contents other employee compensation on higher revenues. While overall compensation expense was up 2%, the relative mix of revenues between PCG and SWS Financial resulted in a lower blended compensation ratio, improving segment profitability. Institutional. Three-Months Ended: The following is a summary of the results for the institutional segment for the three-months ended December 31, 2013 as compared to the three-months ended December 31, 2012 (dollars in thousands): Three-Months Ended December 31, December 31, 2013 2012 % Change Net revenues: Commissions Taxable fixed income $ 6,811 $ 7,254 (6) % Municipal finance 2,441 2,519 (3) Portfolio trading 2,174 3,890 (44) 11,426 13,663 (16) Investment banking fees Taxable fixed income 756 2,294 (67) Municipal finance 4,928 4,376 13 Corporate finance - 1,230 (100) 5,684 7,900 (28) Net gains on principal transactions Taxable fixed income 3,172 5,071 (37) Municipal finance 4,158 2,568 62 Other (8) (5) 60 7,322 7,634 (4) Other 258 171 51 Net interest revenue Stock loan 2,211 1,977 12 Other 364 1,213 (70) Total 27,265 32,558 (16) Operating expenses 21,316 23,219 (8) Pre-tax income $ 5,949 $ 9,339 (36) % Taxable fixed income representatives 30 35 (14) % Municipal distribution representatives 23 25 (8) % 59 -------------------------------------------------------------------------------- Table of Contents Average balances of interest-earning assets and interest-bearing liabilities for the institutional segment for the three-months ended December 31, 2013 as compared to the three-months ended December 31, 2012 were as follows (in thousands): Three-Months Ended December 31, December 31, 2013 2012 Daily average interest-earning assets: Stock borrowed $ 1,949,000 $ 1,300,000 Daily average interest-bearing liabilities: Stock loaned $ 1,865,000 $ 1,248,000 The following table sets forth the number and aggregate dollar amount of new municipal bond underwritings conducted by Southwest Securities for the three-months ended December 31, 2013 and 2012: Three-Months Ended December 31, December 31, 2013 2012 Number of Issues 116 167 Aggregate Amount of Offerings $ 6,060,216,000 $ 10,018,732,000 Net revenues from the institutional segment decreased 16% while pre-tax income was down 36% for the three-months ended December 31, 2013 as compared to the three-months ended December 31, 2012 . Commissions revenues decreased $2.2 million , primarily driven by a $1.7 million decrease in portfolio trading volumes during the three-months ended December 31, 2013 as compared to the same period in the prior fiscal year. Investment banking, advisory and administrative fees decreased $2.2 million primarily due to a $1.5 million decrease in underwriting fees earned by our taxable fixed income group and a $1.2 million reduction in corporate finance fees as we exited the business during the fourth quarter of fiscal year 2013. These reductions were offset by a $0.6 million increase in fees earned by our municipal finance department, primarily our public finance group, due to a more favorable mix in public finance deal flow. Net interest revenue decreased $0.6 million primarily due to a $1.0 million decrease in interest earned on our taxable and non-taxable securities offset by a $0.2 million increase in our interest expense on short-term borrowings. Additionally, we experienced a $0.2 million increase in net interest income from our stock lending business. The increase in net interest income from our stock lending business was due primarily to the 50% increase in our average quarterly stock borrow balance, offset by an 11 basis point decrease in the average net interest spread in our stock loan business. Operating expenses decreased 8% in the second quarter of fiscal 2014 as compared to second quarter of fiscal 2013, primarily due to a $2.4 million decrease in compensation expenses due to weaker segment revenues. 60 -------------------------------------------------------------------------------- Table of Contents Six-Months Ended: The following is a summary of the results for the institutional segment for the six-months ended December 31, 2013 as compared to the six-months ended December 31, 2012 (in thousands): Six-Months Ended December 31, December 31, 2013 2012 % Change Net revenues: Commissions Taxable fixed income $ 12,903 $ 13,243 (3) % Municipal finance 5,054 5,331 (5) Portfolio trading 3,893 8,095 (52) 21,850 26,669 (18) Investment banking fees Taxable fixed income 1,869 4,808 (61) Municipal finance 10,908 9,076 20 Corporate finance - 1,354 (100) 12,777 15,238 (16) Net gains on principal transactions Taxable fixed income 5,609 9,463 (41) Municipal finance 9,915 7,402 34 Other (10) (19) (47) 15,514 16,846 (8) Other 481 327 47 Net interest revenue Stock loan 3,988 4,463 (11) Other 658 1,910 (66) Total 55,268 65,453 (16) Operating expenses 43,114 46,189 (7) Pre-tax income $ 12,154 $ 19,264 (37) % Average balances of interest-earning assets and interest-bearing liabilities for the institutional segment for the six-months ended December 31, 2013 as compared to the six-months ended December 31, 2012 were as follows (in thousands): Six-Months Ended December 31, December 31, 2013 2012 Daily average interest-earning assets: Stock borrowed $ 1,872,000 $ 1,387,000 Daily average interest-bearing liabilities: Stock loaned $ 1,774,000 $ 1,345,000 61 -------------------------------------------------------------------------------- Table of Contents The following table sets forth the number and aggregate dollar amount of new municipal bond underwritings conducted by Southwest Securities for the six-months ended December 31, 2013 and 2012: Six-Months Ended December 31, December 31, 2013 2012 Number of Issues 298 322 Aggregate Amount of Offerings $ 23,065,290,000 $ 26,642,673,000 Net revenues from the institutional segment decreased 16% while pre-tax income was down 37% for the six-months ended December 31, 2013 as compared to the six-months ended December 31, 2012 . Commissions revenue decreased $4.8 million primarily driven by a $4.2 million decrease in the portfolio trading business on lower trading volumes when compared to the same period in the prior fiscal year. Investment banking, advisory and administrative fees decreased $2.5 million primarily due to a $2.9 million reduction in underwriting fees earned by our taxable fixed income group. In addition, corporate finance fees were down $1.4 million as we exited the business in the fourth quarter of fiscal 2013. These reductions were partially offset by a $1.8 million increase in municipal finance fees during the period primarily in our public finance group due to a more favorable mix in public finance deal flow. Net interest revenue decreased $1.7 million primarily due to a $1.5 million decrease in interest earned on our taxable and non-taxable securities offset by a $0.4 million increase in our interest expense on short-term borrowings. In addition, net interest income from our stock lending business was also down due to a 19 basis point decrease in the average net interest spread, which was partially offset by a 35% increase in our average stock lending balances. Net gains on principal transactions decreased $1.3 million primarily due to a $3.9 million decrease in our taxable fixed income gains partially offset by a $2.5 million increase in municipal finance trading gains. The decrease in the taxable fixed income trading gains was primarily the result of an ongoing challenging market environment during the first half of fiscal 2014, as compared to the more robust market environment during the first half of fiscal 2013. Operating expenses decreased 7% during the first half of fiscal 2014, primarily due to a $4.3 million decrease in compensation expense due to weaker segment revenues, which was partially offset by a $0.6 million increase in operations and technology expense and a $0.5 million increase in quotation costs. Banking. Three-Months Ended: The following is a summary of the results for the banking segment for the three-months ended December 31, 2013 as compared to the three-months ended December 31, 2012 (dollars in thousands): Three-Months Ended December 31, December 31, 2013 2012 % Change Net revenues: Net interest revenue $ 8,872 $ 11,077 (20) % Other 1,592 694 >100 Total net revenues 10,464 11,771 (11) Operating expenses 5,140 8,799 (42) Pre-tax income $ 5,324 $ 2,972 79 % For the three-months ended December 31, 2013 as compared to the three-months ended December 31, 2012 , the Bank's net revenues decreased 11% due primarily to a $2.2 million reduction in net interest revenues. This reduction in net interest revenues was primarily due to a 32% decrease in average loan balances, as well as a 70 basis point decrease in the net yield on interest-earning assets. Excess cash generated from loan repayments was reinvested in an investment portfolio with lower comparable yields, which was the main driver of the overall reduction in yield. Other revenue increased $0.9 million due primarily to a $0.7 million decrease in net losses on the sale of REO, a $0.7 million increase in earnings from interest rate swap transactions and a $0.3 million increase in gains on SBA loan sales offset by a $0.7 million decrease in the gains recognized on the valuation of the Bank's equity method investments. The Bank's operating expenses decreased $3.7 million , or 42%, for three-months ended December 31, 2013 compared to the three-months ended December 31, 2012 and was primarily attributable to the $0.8 million decrease in commissions and other employee compensation and a $1.4 million increase in the Bank's loan loss recapture for the three-months ended December 31, 2013 62 -------------------------------------------------------------------------------- Table of Contents primarily due to the pay-off of an outstanding balance of a commercial loan for which the Bank had recorded a $2.1 million specific allowance reserve. Additionally, other operating expenses decreased $1.4 million for the three-months ended December 31, 2013 compared to the three-months ended December 31, 2012 due primarily to a $0.8 million decrease in REO related expenses, including a $0.4 million decrease in the REO loss provision, a $0.3 million decrease in regulatory fees and a $0.2 million decrease in outside services. The decreases in REO expense and the REO loss provision was related to the continued improvement in classified assets. As classified assets decrease, the expenses related to managing and disposing of these assets also decreases. The decrease in Bank regulatory fees was related to the overall improvement at the Bank. Net Interest Income The following table sets forth an analysis of the Bank's net interest income by each major category of interest-earning assets and interest-bearing liabilities for the three-months ended December 31, 2013 and 2012 (dollars in thousands): Three-Months Ended December 31, 2013 December 31, 2012 Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense(*) Rate Balance Expense(*) Rate Assets: Interest-earning assets: Loans: Residential construction $ 755 $ 2 1.1 % $ 2,804 $ 29 4.1 % Lot and land development 7,172 321 17.8 13,438 258 7.6 1-4 family 135,508 1,733 5.1 385,319 4,861 5.0 Commercial real estate and multifamily 316,980 4,026 5.0 305,634 4,246 5.5 Commercial 68,120 657 3.8 65,250 881 5.4 Consumer 1,713 18 4.2 1,888 32 6.6 Total loans 530,248 6,757 774,333 10,307 Investments: Money market 57,186 62 0.4 24,959 31 0.5 U.S. government and government agency obligations - held to maturity 15,159 91 2.4 22,825 134 2.3 U.S. government and government agency obligations - available for sale 541,252 2,492 1.8 346,404 1,354 1.6 Municipal obligations - available for sale 42,312 159 1.5 - - - Interest bearing deposits in banks 1,604 - - 5,016 1 0.1 Federal reserve funds 62,762 47 0.3 84,951 53 0.3 Investments - other 4,705 4 0.3 3,405 3 0.4 Total interest-earning assets $ 1,255,228 $ 9,612 3.0 % $ 1,261,893 $ 11,883 3.7 % Non interest-earning assets: Cash and due from banks 3,034 3,458 Other assets 17,733 42,021 $ 1,275,995 $ 1,307,372 Liabilities and Stockholder's Equity: Interest-bearing liabilities: Certificates of deposit $ 28,414 $ 63 0.9 % $ 33,935 $ 86 1.0 % Money market accounts 19,663 3 0.1 19,625 2 0.1 Interest-bearing demand accounts 8,996 2 0.1 9,326 1 0.1 Savings accounts 883,806 23 - 948,355 34 - Federal Home Loan Bank advances 98,837 649 2.6 63,892 683 4.2 $ 1,039,716 $ 740 0.3 % $ 1,075,133 $ 806 0.3 % 63 -------------------------------------------------------------------------------- Table of Contents Three-Months Ended December 31, 2013 December 31, 2012 Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense(*) Rate Balance Expense(*) Rate Non interest-bearing liabilities: Non interest-bearing demand accounts $ 55,468 $ 56,311 Other liabilities 11,921 5,279 1,107,105 1,136,723 Stockholder's equity 168,890 170,649 $ 1,275,995 $ 1,307,372 Net interest income $ 8,872 $ 11,077 Net yield on interest-earning assets 2.8 % 3.5 % __________ (*) Loan fees included in interest income for the three-months ended December 31, 2013 and 2012 were $354 and $654 , respectively. A number of factors, including 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 interest rate spreads earned by the Bank. The following table sets forth a summary of the changes in the Bank's interest income and interest expense resulting from changes in volume and rate (in thousands): Three-Months Ended December 31, 2013 as compared to December 31, 2012 Total Attributed to Change Volume Rate Mix Interest income: Loans: Residential construction $ (27) $ (21) $ (22) $ 16 Lot and land development 63 (120) 343 (160) 1-4 family (3,128) (3,152) 67 (43) Commercial real estate and multifamily (220) 158 (364) (14) Commercial (224) 39 (252) (11) Consumer (14) (3) (12) 1 Investments: Money market 31 40 (4) (5) U.S. government and government agency obligations - held to maturity (43) (45) 2 - U.S. government and government agency obligations - available for sale 1,138 762 241 135 Municipal obligation - available for sale 159 - - 159 Interest bearing deposits in banks (1) (1) (1) 1 Federal reserve funds (6) (14) 11 (3) Investments - other 1 1 - - $ (2,271) $ (2,356) $ 9 $ 76 64 -------------------------------------------------------------------------------- Table of Contents Three-Months Ended December 31, 2013 as compared to December 31, 2012 Total Attributed to Change Volume Rate Mix Interest expense: Certificates of deposit $ (23) $ (14) $ (11) $ 2 Money market accounts 1 - 1 - Interest bearing deposits in banks 1 - 1 - Savings accounts (11) (2) (9) - Federal Home Loan Bank advances (34) 373 (263) (144) (66) 357 (281) (142) Net interest income $ (2,205) $ (2,713) $ 290 $ 218 Six-Months Ended: The following is a summary of the results for the banking segment for the six-months ended December 31, 2013 as compared to the six-months ended December 31, 2012 (dollars in thousands): Six-Months Ended December 31, December 31, 2013 2012 % Change Net revenues: Net interest revenue $ 17,678 $ 22,644 (22) % Other 1,873 760 >100 Total net revenues 19,551 23,404 (16) Operating expenses 13,032 19,151 (32) Pre-tax income $ 6,519 $ 4,253 53 % For the six-months ended December 31, 2013 as compared to the six-months ended December 31, 2012 , the Bank's net revenues decreased $3.9 million due primarily to a $5.0 million reduction in net interest revenues offset by a $1.1 million increase in other revenues. The reduction in net interest revenues was primarily due to the 32% decrease in average loan balances, as well as a 60 basis point decrease in the net yield on interest earning assets. Excess cash generated from loan repayments was reinvested in an investment portfolio with lower comparable yields, which was the main driver of the overall reduction in yield. The increase in other revenue was due to a $1.0 million decrease in net losses on the sale of REO, a $0.7 million increase in earnings from interest rate swap transactions and a $0.2 million increase in gains on SBA loan sales offset by a $0.8 million decrease in the gains recognized on the valuation of the Bank's equity method investments. The Bank's operating expenses decreased $6.1 million for the six-months ended December 31, 2013 compared to the six-months ended December 31, 2012 . The expense reduction was primarily attributable to a $1.4 million decrease in commissions and other employee compensation and a $1.8 million increase in the Bank's loan loss recapture for the six-months ended December 31, 2013 . Additionally, other operating expenses decreased $2.7 million for the six-months ended December 31, 2013 compared to the six-months ended December 31, 2012 . The decrease was primarily due to a $1.5 million decrease in REO related expenses, including a $0.7 million decrease in the REO loss provision, a $0.6 million decrease in the Bank's regulatory fees and a $0.4 million decrease in outside service fees. The decreases in REO expense and the REO loss provision was related to the continued improvement in classified assets. As classified assets decrease, the expenses related to managing and disposing of these assets also decreases. The decrease in Bank regulatory fees was related to the overall improvement at the Bank. 65 -------------------------------------------------------------------------------- Table of Contents Net Interest Income The following table sets forth an analysis of the Bank's net interest income by each major category of interest-earning assets and interest-bearing liabilities for the six-months ended December 31, 2013 and 2012 (dollars in thousands): Six-Months Ended December 31, 2013 December 31, 2012 Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense(*) Rate Balance Expense(*) Rate Assets: Interest-earning assets: Loans: Residential construction $ 999 $ 13 2.6 % $ 3,088 $ 71 4.6 % Lot and land development 7,804 454 11.5 15,168 465 6.1 1-4 family 154,899 3,931 5.0 384,340 9,712 5.0 Commercial real estate and multifamily 313,388 8,016 5.1 318,921 8,901 5.5 Commercial 65,778 1,313 4.0 73,720 1,903 5.1 Consumer 1,793 41 4.5 1,944 62 6.3 Total loans 544,661 13,768 797,181 21,114 Investments: Money market 41,662 95 0.5 24,346 62 0.5 U.S. government and government agency obligations - held to maturity 15,872 191 2.4 23,875 288 2.4 U.S. government and government agency obligations - available for sale 527,067 4,737 1.8 343,721 2,773 1.6 Municipal obligations - available for sale 35,856 269 1.5 - - - Interest bearing deposits in banks 1,623 - - 3,631 - - Federal reserve funds 79,023 112 0.3 76,908 103 0.3 Investments - other 4,684 8 0.3 3,473 7 0.4 Total interest-earning assets $ 1,250,448 $ 19,180 3.1 % $ 1,273,135 $ 24,347 3.8 % Non interest-earning assets: Cash and due from banks 3,124 3,668 Other assets 19,338 41,938 $ 1,272,910 $ 1,318,741 Liabilities and Stockholder's Equity: Interest-bearing liabilities: Certificates of deposit $ 29,234 $ 131 0.9 % $ 34,842 $ 179 1.0 % Money market accounts 18,641 5 0.1 22,239 6 0.1 Interest-bearing demand accounts 8,560 3 0.1 9,165 3 0.1 Savings accounts 884,601 46 - 954,111 82 - Federal Home Loan Bank advances 98,790 1,317 2.6 65,796 1,433 4.3 Other financed borrowings 5 - - - - - $ 1,039,831 $ 1,502 0.3 % $ 1,086,153 $ 1,703 0.3 % 66 -------------------------------------------------------------------------------- Table of Contents Six-Months Ended December 31, 2013 December 31, 2012 Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense(*) Rate Balance Expense(*) Rate Non interest-bearing liabilities: Non interest-bearing demand accounts $ 53,822 $ 55,743 Other liabilities 11,426 6,459 1,105,079 1,148,355 Stockholder's equity 167,831 170,386 $ 1,272,910 $ 1,318,741 Net interest income $ 17,678 $ 22,644 Net yield on interest-earning assets 2.9 % 3.5 % __________ (*) Loan fees included in interest income for the six-months ended December 31, 2013 and 2012 were $785 and $1,326 , respectively. The following table sets forth a summary of the changes in the Bank's interest income and interest expense resulting from changes in volume and rate (in thousands): Six-Months Ended December 31, 2013 as compared to December 31, 2012 Total Attributed to Change Volume Rate Mix Interest income: Loans: Residential construction $ (58) $ (48) $ (31) $ 21 Lot and land development (11) (226) 417 (202) 1-4 family (5,781) (5,798) 42 (25) Commercial real estate and multifamily (885) (154) (744) 13 Commercial (590) (205) (431) 46 Consumer (21) (5) (17) 1 Investments: Money market 33 44 (6) (5) U.S. government and government agency obligations - held to maturity (97) (96) (1) - U.S. government and government agency obligations - available for sale 1,964 1,479 316 169 Municipal obligation - available for sale 269 - - 269 Federal reserve funds 9 3 6 - Investments - other 1 2 (1) - $ (5,167) $ (5,004) $ (450) $ 287 67 -------------------------------------------------------------------------------- Table of Contents Six-Months Ended December 31, 2013 as compared to December 31, 2012 Total Attributed to Change Volume Rate Mix Interest expense: Certificates of deposit $ (48) $ (29) $ (23) $ 4 Money market accounts (1) (1) - - Savings accounts (36) (6) (32) 2 Federal Home Loan Bank advances (116) 719 (556) (279) (201) 683 (611) (273) Net interest income $ (4,966) $ (5,687) $ 161 $ 560 Other. Three-Months Ended: The following discusses the financial results for SWS Group , corporate administration and SWS Capital Corporation . Pre-tax loss from the other segment was $14.3 million for three-months ended December 31, 2013 compared to pre-tax income of $2.9 million for the three-months ended December 31, 2012 . The primary driver of the $17.2 million increase in the pre-tax loss was related to the change in warrant valuation resulting in a $13.8 million increase in expense in the second quarter of fiscal 2014 compared to the second quarter of fiscal 2013. We recorded a $2.0 million unrealized loss on the valuation of the warrants held by Hilltop and Oak Hill for the three-months ended December 31, 2013 compared to an $11.8 million unrealized gain on the valuation for the warrants held by Hilltop and Oak Hill for the three-months ended December 31, 2012 . Net revenues decreased $2.8 million for three-months ended December 31, 2013 compared to the three-months ended December 31, 2012 . The decrease was primarily due to a $3.4 million reduction in net gains on principal transactions as the second quarter of fiscal 2013 included a $3.6 million gain recognized from the sale of our shares of USHS common stock. This decrease was partially offset by a $0.9 million increase in the value of our deferred compensation plan's investments. Overall operating expenses increased $0.6 million for the three-months ended December 31, 2013 as compared to the three-months ended December 31, 2012 primarily due to a $1.0 million increase in expenses related to the increase in the value of our deferred compensation plan investments which were partially offset by a $0.5 million decrease in professional services fees. Six-Months Ended: Pre-tax loss from the other segment was $23.6 million for the six-months ended December 31, 2013 compared to a pre-tax loss of $17.9 million for the six-months ended December 31, 2012 . The primary driver of the $5.7 million increase in the pre-tax loss was related to the change in warrant valuation resulting in a $3.7 million increase in expense in the first half of fiscal 2014 compared to the first half of fiscal 2013. We recorded a $91,000 unrealized loss on the valuation of the warrants held by Hilltop and Oak Hill for the six-months ended December 31, 2013 compared to a $3.6 million unrealized gain on the valuation for the warrants held by Hilltop and Oak Hill for the six-months ended December 31, 2012 . Net revenues decreased $2.0 million for the six-months ended December 31, 2013 compared to the six-months ended December 31, 2012 . The decrease was primarily due to a $2.8 million increase in net gains on principal transactions as the first half of fiscal 2013 included a $3.6 million gain recognized from the sale of our shares of USHS common stock offset by a $0.7 million loss related to our auction rate security owned. Net interest expense increased $0.5 million primarily due to a $0.3 million increase in the long-term debt discount's accretion expense. The value of our deferred compensation plan's investments increased by $1.2 million during the first half of fiscal 2014 compared to the last year offsetting a portion of the decrease. Overall operating expenses increased $0.1 million for the six-months ended December 31, 2013 compared to the six-months ended December 31, 2012 primarily due to a $1.3 million increase in expenses related to the increase in the value of our deferred compensation plan investments offset by a $1.3 million decrease in executive and administrative compensation expense savings. 68 -------------------------------------------------------------------------------- Table of Contents FINANCIAL CONDITION Investments In fiscal 2013, 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 to ensure that adequate funds are available for new loan originations. The book value of the Bank's investment portfolio at December 31, 2013 and June 30, 2013 was as follows (in thousands): December 31, 2013 June 30, 2013 Government-sponsored enterprises- held to maturity securities $ 14,595 $ 17,423 Government-sponsored enterprises- FHLB stock 4,709 4,657 Government-sponsored enterprises- available for sale securities 536,243 474,906 Municipal obligations- available for sale securities 43,911 28,224 Equity method investments 4,190 3,844 $ 603,648 $ 529,054 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 portfolio is dependent upon the general economic conditions in Texas and New Mexico . Substantially all of the Bank's loans are collateralized with real estate. The allowance for loan losses is maintained to absorb management's 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 borrower's financial condition, payment status, historical payment record and any adverse situations affecting the borrower's 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 borrower's 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 (i) the present value of expected future cash flows discounted at the loan's original effective rate, (ii) the fair value of collateral if the loan is collateral-dependent or (iii) the 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 guarantor's capacity and willingness to perform, when appropriate, and the borrower's resources available for repayment when measuring impairment. The general allowance provides for estimated and probable losses inherent in the remainder of the Bank's loan portfolio. The general allowance is determined through a statistical calculation based on the Bank's 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 69 -------------------------------------------------------------------------------- Table of Contents as the average ratio of charge-offs, net of recoveries, to the average recorded investment for the current and previous seven quarters. During the second quarter of fiscal 2014, management changed from using the current and the previous five quarters in the calculation to the current and the previous seven quarters for a more conservative approach and to be more indicative of the current economic outlook. Management adjusts the historical loss rates to reflect changes in the real estate market, current market environment for commercial loans, credit quality to reflect increased credit risk not captured in the historical loss, significant concentrations of product types and trends in portfolio volume 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 adjustable rate mortgage ("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 December 31, 2013 , the Bank had $7.5 million in junior lien mortgages. These loans represented less than 2% of the Bank's total loans at December 31, 2013 . At December 31, 2013 , the Bank did not have any exposure to sub-prime loans or loans with initial teaser rates and had no single family interest only loans. At December 31, 2013 , the Bank's loan portfolio included a total of $1.0 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 December 31, 2013 , all 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 December 31, 2013 , the Bank had no loans with a high loan-to-value ratio that were deemed impaired. Regulatory guidelines suggest that high loan-to-value ratio loans should not exceed 100% of total capital. At December 31, 2013 , the Bank's high loan-to-value ratio loans represented less than 1% of total capital. We obtain appraisals on real estate loans at the time of origination from third party appraisers approved by the Bank's BOD. We may also obtain additional appraisals when the borrower's performance indicates it may default. After a loan default and foreclosure, we obtain new appraisals to determine the fair value of the foreclosed asset. We obtain updated appraisals on foreclosed properties on an annual basis, 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. In the past four years, because our problem loans and losses were concentrated in real estate related loans, we paid 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 markets may have an impact on these factors in future quarters. To the extent we underestimate the impact of these risks, our allowance for loan losses could be materially understated. 70 -------------------------------------------------------------------------------- Table of Contents Loans receivable, including loans measured at fair value, at December 31, 2013 and June 30, 2013 are summarized as follows (in thousands): December 31, 2013 June 30, 2013 Residential Purchased mortgage loans held for investment $ 89,583 $ 174,037 1-4 family 55,155 59,910 144,738 233,947 Lot and land development Residential land 599 3,102 Commercial land 5,399 5,886 5,998 8,988 Residential construction 731 1,367 Commercial construction 3,549 1,668 Commercial real estate 187,020 214,446 Multifamily 123,203 99,833 Commercial loans 69,690 58,718 Consumer loans 2,736 1,959 537,665 620,926 Allowance for probable loan loss (*) (9,448) (12,343) $ 528,217 $ 608,583 __________ (*) There is no allowance for probable loan loss for loans measured at fair value or purchased mortgage loans held for investment. Purchase mortgage loans held for investment are held on average for 25 days or less, substantially reducing credit risk. The decrease in purchased mortgage loans held for investment from June 30, 2013 to December 31, 2013 was representative of an overall decline in the first half of fiscal 2014 in the mortgage industry's production levels. The nature of purchased mortgage loans held for investment business is volatile and subject to significant variation depending on interest rates, competition and general economic conditions. The following table shows the scheduled maturities of certain loan categories at December 31, 2013 , and segregates those loans with fixed interest rates from those with floating or adjustable rates (in thousands): 1 year 1-5 Over 5 or less years years Total Commercial construction, commercial real estate and multifamily $ 46,417 $ 134,262 $ 133,093 $ 313,772 Commercial loans 34,403 23,379 11,908 69,690 Residential construction loans 51 680 - 731 Total $ 80,871 $ 158,321 $ 145,001 $ 384,193 Amount of loans based upon: Floating or adjustable interest rates $ 72,030 $ 86,120 $ 72,128 $ 230,278 Fixed interest rates 8,841 72,201 72,873 153,915 Total $ 80,871 $ 158,321 $ 145,001 $ 384,193 We maintain an internally classified loan list that helps us assess the overall quality of the loan portfolio and the adequacy of the allowance for loan losses. Loans on this list are classified as substandard, doubtful or loss based on probability of repayment, collateral valuation and related collectibility. This list is used to identify loans that are considered non-performing. We classify loans as non-performing when they are 90 days or more past due as to principal or interest or when reasonable doubt exists as to timely collectability. The Bank uses a standardized review process to determine which non-performing loans should be placed on non-accrual status. At the time a loan is placed on non-accrual status, we reverse previously accrued and uncollected interest against interest income. We recognize interest income on non-accrual loans to the extent we receive cash payments for the loans with respect to which ultimate full collection is likely. For loans where full collection is not likely, we apply interest payments to the outstanding principal and we recognize income only if full payment is made. 71 -------------------------------------------------------------------------------- Table of Contents Non-performing assets and classified loans as of December 31, 2013 and June 30, 2013 were as follows (dollars in thousands): December 31, 2013 June 30, 2013 Loans accounted for on a non- accrual basis 1-4 family $ 6,485 $ 7,792 Lot and land development 992 2,418 Residential construction 573 601 Commercial real estate 4,076 7,611 Commercial loans 3,891 4,024 16,017 22,446 Non-performing loans as a percentage of total loans 3.0% 3.6% REO 1-4 family 1,669 1,801 Lot and land development 1,967 4,008 Commercial real estate 3,226 4,065 Commercial loans 493 291 7,355 10,165 Performing troubled debt restructuring (*) 3,544 5,349 Non-performing assets $ 26,916 $ 37,960 Non-performing assets as a percentage of total assets 2.1% 3.0% Current classified assets 1-4 family $ 99 $ 223 Lot and land development 317 965 Multifamily - 692 Commercial real estate 19,536 22,616 Commercial loans 1,147 5,114 21,099 29,610 Total classified assets 1-4 family 8,405 10,080 Lot and land development 3,276 7,391 Multifamily - 692 Residential construction 573 601 Commercial real estate 29,915 38,801 Commercial loans 5,846 10,005 $ 48,015 $ 67,570 __________ (*) The remaining balance of loans modified as a troubled debt restructuring is included in non-performing loans. See discussion of the Bank's troubled debt restructuring loans in "Loans and Allowance for Probable Loan Loss" in the Notes to the Consolidated Financial Statements contained in this report. Approximately $226,000 , $305,000 , $445,000 , and $703,000 of gross interest income would have been recorded in the three and six-months ended December 31, 2013 and 2012, respectively, had the non-accrual loans been recorded in accordance with their original terms. There was $1,000 and $8,000 of interest income recorded on the non-accrual loans, prior to being placed on non-accrual status, in the three and six-months ended December 31, 2013 and no interest income for the three-months ended December 31, 2012 , and approximately $15,000 in the six-months ended December 31, 2012 . The Bank has managed the growth in REO and non-performing assets and reduced these loans and properties by preparing an asset-by-asset plan for each asset category. Management's focus on the continued reduction of these asset classes may have a material impact on the Bank's future results of operations. 72 -------------------------------------------------------------------------------- Table of Contents Total classified assets to Bank capital plus allowance for loan loss was 27.2% at December 31, 2013 . Classified assets decreased $19.6 million from June 30, 2013 and substantially all classified loans by collateral location are in Texas . Bank management continues to be focused on reducing the classified asset ratio through the disposal of these assets. Depending on the method used, the Bank may be required to record additional write-downs of these assets. While management is diligently working to dispose of these assets quickly, lack of demand for certain property types, length of sales cycle and manpower limitations will impact the time required to ultimately reduce the classified assets to a more acceptable level. The following table presents an analysis of REO for the three and six-months ended December 31, 2013 and 2012 (in thousands): Three-Months Ended Six-Months Ended December 31, December 31, December 31, December 31, 2013 2012 2013 2012 Balance at beginning of period $ 5,721 $ 32,488 $ 10,165 $ 32,257 Foreclosures 2,270 8,405 2,674 10,891 Sales (636) (11,105) (5,283) (13,006) Write-downs - (367) (201) (926) Other - - - 205 Balance at end of period $ 7,355 $ 29,421 $ 7,355 $ 29,421 The following table presents the Bank's classified assets as of December 31, 2013 by year of origination of the loan (in thousands): Performing Non- Troubled Current Year Performing Debt Classified Originated Loans REO Restructuring Assets Total Fiscal 2008 or prior $ 5,371 $ 4,548 $ 358 $ 7,130 $ 17,407 Fiscal 2009 1,303 1,518 - 7,948 10,769 Fiscal 2010 8,534 1,289 1,343 4,571 15,737 Fiscal 2011 411 - 35 1,255 1,701 Fiscal 2012 398 - 108 9 515 Fiscal 2013 - - 1,700 138 1,838 Fiscal 2014 - - - 48 48 $ 16,017 $ 7,355 $ 3,544 $ 21,099 $ 48,015 73 -------------------------------------------------------------------------------- Table of Contents The following table presents an analysis of the allowance for probable loan losses for the three and six-months ended December 31, 2013 and 2012 (dollars in thousands): Three-Months Ended Six-Months Ended December 31 , December 31 , December 31 , December 31 , 2013 2012 2013 2012 Balance at beginning of period $ 12,206 $ 20,892 $ 12,343 $ 22,402 Continuing operations: Charge-offs: Lot and land development - - (4) (182) 1-4 family - (12) (97) (163) Commercial real estate (35) (410) (51) (1,113) Commercial loans (47) (680) (67) (1,608) Total charge-offs (82) (1,102) (219) (3,066) Recoveries: Residential construction 5 17 63 36 Lot and land development 3 54 10 187 1-4 family 9 13 61 69 Commercial real estate 116 20 439 83 Commercial loans 16 188 42 371 Consumer loans - 5 - 5 Total recoveries 149 297 615 751 Net (charge-offs) recoveries 67 (805) 396 (2,315) (Recapture) provision charged to operations (2,825) (1,450) (3,291) (1,450) (2,758) (2,255) (2,895) (3,765) Balance at end of period $ 9,448 $ 18,637 $ 9,448 $ 18,637 Ratio of net charge-offs during the period to average loans outstanding during the period -0.01% 0.10% -0.07% 0.29% With the continued challenging economic environment and persistent high unemployment rates, the Bank frequently reviews and updates its processes and procedures for the extension of credit, allowance for loan loss computation and internal asset review and classification. Recent changes include more stringent underwriting guidelines for loan-to-value ratios, guarantor's financial condition, owner-occupied versus investor loans and speculative versus custom construction. The Bank currently requires more extensive documentation and data than it did in prior years in order to reclassify existing non-performing loans as performing loans. The Bank is also updating appraisals more frequently, including for performing loans, to serve as an early indicator of loan deterioration. As a result of the current economic environment, the Bank significantly limited the growth of its loan portfolio in fiscal 2011 and 2012 in order to allocate the time, resources and capital necessary to support the existing loan portfolio. During fiscal 2013, the Bank reestablished marketing efforts to implement a conservative loan growth plan which we believe will enhance our core earnings in future years. Through the second quarter of fiscal 2014, the Bank has continued these marketing efforts in order to grow the Bank's loan portfolio. 74 -------------------------------------------------------------------------------- Table of Contents The allowance for probable loan losses by type of loans as of December 31, 2013 and June 30, 2013 was as follows (dollars in thousands): December 31, 2013 June 30, 2013 Percent Percent Percent of the Percent of the of loans allowance of loans allowance to total for loan to total for loan Amount loans loss Amount loans loss Residential construction $ 6 0.1 % 0.1 % $ 49 0.2 % 0.4 % Lot and land development 124 1.1 1.3 374 1.4 3.0 1-4 family 1,319 26.9 14.0 1,528 37.7 12.4 Commercial real estate 3,069 35.5 32.5 3,290 34.8 26.7 Multifamily 2,893 22.9 30.6 3,567 16.1 28.9 Commercial loans 2,018 13.0 21.3 3,530 9.5 28.6 Consumer loans 19 0.5 0.2 5 0.3 - $ 9,448 100.0 % 100.0 % $ 12,343 100.0 % 100.0 % At December 31, 2013 , approximately 32.5% of the Bank's loan loss allowance was allocated to its commercial real estate loan portfolio while the Bank's commercial real estate loan portfolio represented approximately 35.5% of its total loan portfolio. This was up from June 30, 2013 when approximately 26.7% of the Bank's loan loss allowance was allocated to its commercial real estate loan portfolio. Commercial real estate loans tend to be individually larger than residential loans and deterioration in this portfolio can lead to volatility in earnings. At December 31, 2013 , the loan loss allowance related to multifamily loans was 30.6% as compared to multifamily loans constituting 22.9% of the Bank's total loan portfolio. The larger allocation of the allowance to multifamily loans reflects the recent growth in this portfolio. Additionally, at December 31, 2013 , approximately 21.3% of the Bank's loan loss allowance was allocated to its commercial loans portfolio, while the Bank's commercial loan portfolio represented approximately 13.0% of its total loan portfolio. This decrease from June 30, 2013 was due primarily to the approximately $2.1 million payment received on an outstanding loan for which the Bank had a specific impairment reserve recorded. The Bank's written loan policies address specific underwriting standards for commercial real estate loans. These policies include loan to value requirements, cash flow requirements, acceptable amortization periods and appraisal guidelines. In addition, specific covenants, unique to each relationship, may be used where deemed appropriate to further protect the lending relationship. Collateral in the commercial real estate portfolio varies from owner-occupied properties to investor properties. We periodically review the portfolio for concentrations by industry as well as geography. All commercial relationships are stress tested at the time of origination and major relationships are then stress tested on an annual basis. Deposits Average deposits and the average interest rate paid on the deposits for the three and six-months ended December 31, 2013 can be found in the discussion of the Bank's net interest income under the caption "Results of Operations-Segment Information-Banking." The Bank had $11.4 million and $12.5 million in certificates of deposit of $100,000 or greater at December 31, 2013 and June 30, 2013 , respectively. The Bank is funded primarily by deposits from SWS's brokerage customers, which are classified as core deposits. These core deposits provide the Bank with a stable and low cost funding source. The Bank also utilizes long-term Federal Home Loan Bank ("FHLB") borrowings to match long-term fixed rate loan funding. At December 31, 2013, the Bank had $876.5 million in funds on deposit from customers of Southwest Securities, representing approximately 88% of the Bank's total deposits. 75 -------------------------------------------------------------------------------- Table of Contents Short-Term Borrowings and Advances from FHLB The following table represents short-term borrowings and advances from the FHLB that were due within one year during the three and six-months ended December 31, 2013 and 2012 (dollars in thousands): Three-Months Ended December 31, Six-Months Ended December 31, 2013 2012 2013 2012 Interest Interest Interest Interest Amount Rate Amount Rate Amount Rate Amount Rate At end of period $ 14,344 3.93 % $ 14,061 4.10 % $ 14,344 3.93 % $ 14,061 4.10 % Average balance during period 14,398 3.93 % 14,524 4.10 % 14,480 3.93 % 14,792 4.20 % Maximum month-end balance during year 14,453 - 16,429 - 14,615 - 16,704 - LIQUIDITY AND CAPITAL RESOURCES Management believes that our current assets and available liquidity are adequate to meet our liquidity needs over the next 12 months. However, our forecast may not prove to be accurate or we may need to raise additional capital. As a result, from time to time, management evaluates various opportunities to supplement the company's sources of liquidity and capital. In fiscal 2012, this evaluation led to our entering into the Credit Agreement with Hilltop and Oak Hill , as discussed below. Should we determine we need to obtain additional long-term debt at SWS Group , regulatory approval and approval from Hilltop and Oak Hill would be required. Credit Agreement On July 29, 2011 , we entered into a Credit Agreement with Hilltop and Oak Hill pursuant to which we obtained a $100.0 million , five year, unsecured loan that accrues interest at a rate of 8% per annum. In addition, we issued warrants to Hilltop and Oak Hill allowing each to purchase up to 8,695,652 shares of common stock at an exercise price of $5.75 per share (subject to anti-dilution adjustments), representing approximately 17% of the common stock of our company per investor as of July 29, 2011 (assuming the warrants are exercised in full). The Credit Agreement contains restrictions and covenants that we must adhere to as long as the unsecured loan is outstanding. As of December 31, 2013 , SWS Group had utilized $70.0 million of the $100.0 million by (i) contributing $20.0 million in capital to the Bank to promote growth in the Bank's loan portfolio, (ii) reducing SWS Group's intercompany payable to Southwest Securities by $20.0 million and (iii) contributing $30.0 million in capital to Southwest Securities. On January 8, 2014 , the remaining $30.0 million was loaned to Southwest Securities to use in general operations by reducing Southwest Securities' use of short-term borrowings for the financing of its day-to-day cash management needs. See "Debt Issued with Stock Purchase Warrants" in the Notes to the Consolidated Financial Statements contained in this report. Brokerage A substantial portion of our assets are highly liquid in nature and consist mainly of cash or assets that are readily convertible into cash. Our equity capital, short-term bank borrowings, interest bearing and non-interest bearing client credit balances, correspondent deposits and other payables finance these assets. We maintain an allowance for doubtful accounts that represents amounts that are necessary in the judgment of management to adequately absorb losses from known and inherent risks in receivables from clients, clients of correspondents and correspondents. The highly liquid nature of our assets provides us with flexibility in financing and managing our anticipated operating needs. Management believes that the present liquidity position of the brokerage businesses is adequate to meet its needs over the next 12 months. Short-Term Borrowings. At December 31, 2013 , we had short-term borrowing availability under broker loan lines, a $20.0 million unsecured line of credit, an irrevocable letter of credit agreement, and a $45.0 million revolving committed credit facility, each of which is described below. Broker Loan Lines . At December 31, 2013 , we had uncommitted broker loan lines of up to $425.0 million . These lines of credit are used primarily to finance securities owned, securities held for correspondent broker/dealer accounts and receivables in customers' margin accounts. These lines may also be used to release pledged collateral against day loans. These credit arrangements are provided on an "as offered" basis, are not committed lines of credit and can be terminated at any time by the lender. Any outstanding balances under these credit arrangements are due on demand and bear interest at rates indexed to the federal funds rate. At December 31, 2013 , $75.0 million was outstanding under these secured arrangements, which was collateralized by securities held for firm accounts valued at $126.8 million . Our ability to borrow additional funds is limited by our eligible collateral. 76 -------------------------------------------------------------------------------- Table of Contents Unsecured Line of Credit. We also have a $20.0 million unsecured line of credit that is due on demand and bears interest at rates indexed to the federal funds rate. This credit arrangement is provided on an "as offered" basis and is not a committed line of credit. The total amount of borrowings available under this line of credit is reduced by the amount outstanding under any unsecured letters of credit at the time of borrowing. At December 31, 2013 , we had no outstanding unsecured letters of credit, there were no amounts outstanding on this line, and we had $20.0 million available for borrowing under this line of credit. Letter of Credit Agreement. At December 31, 2013 , we had an irrevocable letter of credit agreement aggregating $75.0 million pledged to support our open options positions with an options clearing organization. Until drawn, the letter of credit bears interest of 0.5% per annum. If drawn, the letter of credit bears interest at a rate of 0.5% per annum plus a fee. The letter of credit agreement is renewable semi-annually. At December 31, 2013 , we had no outstanding undrawn letters of credit. This letter of credit had no collateral balance at December 31, 2013 as there is no outstanding undrawn letters of credit. We also pledge customer securities to the Options Clearing Corporation to support open customer positions. At December 31, 2013 , we had pledged $86.4 million to support these open customer positions. Revolving Committed Credit Facility. On January 28, 2011 , Southwest Securities entered into a $45.0 million committed revolving credit facility with an unaffiliated bank. The commitment fee for the credit facility is 0.375% per annum and, when drawn, the interest rate is equal to the federal funds rate plus 125 basis points. The agreement was renewed on January 23, 2014 and has the same terms as the initial agreement. The credit facility requires Southwest Securities to maintain tangible net worth of $150.0 million . As of December 31, 2013, there was no outstanding balance under this credit facility. Net Capital Requirements. Our broker/dealer subsidiaries are subject to the requirements of the SEC relating to liquidity, capital standards and the use of client funds and securities. The amount of the broker/dealer subsidiaries' net assets that may be distributed to the parent of the broker/dealer is subject to restrictions under applicable net capital rules. Historically, we have operated in excess of the minimum net capital requirements. See " Regulatory Capital Requirements" in the Notes to the Consolidated Financial Statements contained in this report. Secured Borrowings. We participate in transactions involving securities sold under repurchase agreements ("repos"), which are secured borrowings that we record in our statement of financial condition as other liabilities. These securities generally mature within one to four days from the transaction date. Securities sold under repurchase agreements are reflected at the amount of cash received in connection with the transactions. We may be required to provide additional collateral based on the fair value of the underlying securities. Banking Liquidity is monitored daily to ensure the Bank's ability to meet deposit withdrawals, maintain reserve requirements and otherwise sustain operations. The Bank's liquidity is maintained in the form of readily marketable loans and investment securities, balances with the FHLB, Federal Reserve Bank of Dallas , federal funds sold to correspondent banks and vault cash. At December 31, 2013 , the Bank had net borrowing capacity from the FHLB of $92.6 million . In addition, at December 31, 2013 , the Bank had the ability to borrow up to $36.6 million in funds from the Federal Reserve Bank of Dallas under its secondary credit program. In the second quarter of fiscal 2010, the Bank entered into a secured line of credit agreement with the Federal Reserve Bank of Dallas . This line of credit is secured by the Bank's commercial loan portfolio. This line is due on demand and bears interest at a rate of 50 basis points over the federal funds target rate. At December 31, 2013 , there were no amounts outstanding under this line of credit. The Bank's asset and liability management policy is intended to manage interest rate risk. The Bank manages the periodic repricing of its interest-earning assets and its interest-bearing liabilities. Overall interest rate risk is monitored through reports showing both sensitivity ratios, a simulation model, and existing "GAP" data. (See the Bank's GAP analysis in "-Risk Management-Market Risk-Interest Rate Risk-Banking.") At December 31, 2013 , $876.5 million of the Bank's deposits were from the brokerage customers of Southwest Securities. Current events in the securities markets could impact the amount of these funds available to the Bank. Capital Requirements. The Bank is subject to various regulatory capital requirements administered by federal agencies. Quantitative measures, established by regulation to ensure capital adequacy, require maintaining minimum amounts and ratios of total and Tier I capital (as defined in 12 CFR 165 and 12 CFR 167) to risk-weighted assets (as defined) and of Tier I (core) capital (as defined) to adjusted assets (as defined) (without giving effect to the Basel III final rule). At December 31, 2013 , the Bank had a total risk-based capital ratio of 27.4% and the Bank had a Tier I (core) capital ratio of 13.8%. At December 31, 2013 , the Bank had a Tier I risk-based capital ratio of 26.2% Under federal law, the OCC may require the Bank to apply other measures of risk-weight or capital ratios that the OCC deems appropriate. In connection with the termination of the Order to Cease and Desist, Order No. WN-11-003, effective on February 4, 2011 , on January 14, 2013 , the Bank committed to the OCC 77 -------------------------------------------------------------------------------- Table of Contents that the Bank would, among other things, maintain a Tier I capital ratio at least equal to 9% of adjusted total assets and a total risk-based capital ratio of at least 12%. The Bank has historically met all of its capital adequacy requirements. As of December 31, 2013 , the Bank met all capital requirements to which it was subject and satisfied the requirements to be defined as well-capitalized. Off-Balance Sheet Arrangements We generally do not enter into off-balance sheet arrangements, as defined by the SEC . However, our broker/dealer subsidiaries enter into transactions in the normal course of business that expose us to off-balance sheet risk. See "Note 27. Financial Instruments with Off-Statement of Financial Condition Risk" in the Notes to the Consolidated Financial Statements in the Fiscal 2013 Form 10- K. Cash Flow Net cash provided by operating activities totaled $36.7 million for the six-months ended December 31, 2013 compared to net cash used in operating activities of $105.2 million for the six-months ended December 31, 2012 . The net cash provided by operating activities for the six-months ended December 31, 2013 was due to the $84.2 million decrease in net receivable from client accounts and other broker, dealer and clearing organizations offset by a $21.4 million increase in securities purchased under agreements to resell and a $26.6 million increase in our securities owned inventory. Net cash provided by investing activities was $3.0 million and $6.8 million for the six-months ended December 31, 2013 and 2012, respectively. Proceeds from cash received at the Bank from loan pay-downs net of originations of $78.1 million , along with $5.7 million in proceeds from the sale of REO were used to increase the Bank's net investment portfolio by $74.6 million . Net cash used in financing activities totaled $29.6 million for the six-months ended December 31, 2013 compared to net cash provided by financing activities of $96.2 million for the six-months ended December 31, 2012 . The primary driver of the cash used in financing activities was a decrease in net cash proceeds from short-term borrowings offset by increases in cash proceeds from repurchase agreements, the FHLB and an increase in deposits at the Bank. We expect that cash flows provided by operating activities and short-term borrowings will be the primary source of working capital for the next 12 months. Treasury Stock We periodically repurchase our shares of common stock. We currently have not approved a repurchase plan, and any such plan would require, in addition to BOD approval, the approval of Hilltop, Oak Hill and regulatory authorities. The trustee under our deferred compensation plan periodically purchases shares of our common stock in the open market in accordance with the terms of the plan. This stock is classified as treasury stock in our consolidated financial statements, but participates in future dividends declared by us. During the six-months ended December 31, 2013 , the plan purchased approximately 50,000 shares of common stock at a cost of approximately $288,000 , or $5.76 per share, and approximately 31,500 shares were sold or distributed to participants pursuant to the plan. As restricted stock grants vest, grantees may sell a portion of their vested shares to us to cover the tax liabilities arising from vesting. As a result, in the six-months ended December 31, 2013 , we repurchased approximately 1,100 shares of common stock with a market value of approximately $6,000 , or an average of $5.55 per share, to cover tax liabilities. Inflation Our financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). GAAP requires us to measure our financial position and operating results primarily in terms of historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered under GAAP. Our assets are primarily monetary, consisting of cash, securities inventory and receivables from customers and broker/dealers. These monetary assets are generally liquid and turn over rapidly and, consequently, are not significantly affected by inflation. The rate of inflation affects various expenses of the company, such as employee compensation and benefits, communications, and occupancy and equipment, which may not be readily recoverable in the price of our services. The rate of inflation can also have a significant impact on securities prices and on investment preferences by our customers, generally. In management's opinion, changes in interest rates affect the financial condition of a financial services firm to a greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. Interest rates are highly sensitive to many factors that are beyond our 78 -------------------------------------------------------------------------------- Table of Contents control, including changes in the expected rate of inflation, the influence of general and local economic conditions and the monetary and fiscal policies of the United States government , its agencies and various other governmental regulatory authorities among other things. RISK MANAGEMENT In an effort to assist the company in managing enterprise risk, and at the Board of Director's request, the company engaged a firm to perform an analysis of the company's enterprise risk management process in 2010. During fiscal 2011, based on the Board of Director's recommendations, we initiated an enterprise risk management program and formed an enterprise risk management committee. Enterprise risk is viewed as the threat from an event, action of loss of opportunity that, if it occurs or has occurred, may adversely affect any, or any combination of, our company objectives, business strategies, business model, regulatory compliance, reputation and existence. The committee works with our various departments and committees to manage our enterprise risk management program and reports the results of this work to the Audit Committee of the BOD on a quarterly basis. During fiscal 2013, we hired a full time risk manager for the consolidated group who serves as the primary liaison with our risk management consultants. We continue to utilize the consultants to improve risk management processes, procedures and reporting. We manage risk exposure through the involvement of various levels of management. We establish, maintain and regularly monitor maximum positions by industry and issuer in both trading and inventory accounts. Current and proposed underwriting, banking and other commitments are subject to due diligence reviews by senior management, as well as professionals in the appropriate business and support units. The Bank seeks to reduce the risk of significant adverse effects of market rate fluctuations by minimizing the difference between rate-sensitive assets and liabilities, referred to as "GAP," and maintaining an interest rate sensitivity position within a particular timeframe. Credit risk related to various financing activities is reduced by the industry practice of obtaining and maintaining collateral. We monitor our exposure to counterparty risk through the use of credit information, the monitoring of collateral values and the establishment of credit limits. We have established various other risk management committees that are responsible for reviewing and managing risk related to interest rates, trading positions, margin and other credit risk and risks from capital market transactions. CREDIT RISKS A description of the credit risk for our brokerage and banking segments is as follows: Brokerage. Credit risk arises from the potential nonperformance by counterparties, customers or debt security issuers. We are exposed to credit risk as a trading counterparty and as a stock loan counterparty to dealers and customers, as a holder of securities and as a member of clearing organizations. We have established credit risk committees to review our credit exposure in our various business units. These committees are composed of senior management of the company. Credit exposure is also associated with customer margin accounts, which are monitored daily. We monitor exposure to individual securities and perform sensitivity analysis on a regular basis in connection with our margin lending activities. We adjust our margin requirements if we believe our risk exposure is not appropriate based on market conditions. Banking. Credit risk is the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms and is inherent in all types of lending. The Bank has developed and continues to update its policies and procedures to provide a process for managing credit risk. These policies and procedures include underwriting guidelines, credit and collateral tracking and detailed loan approval procedures. The Bank also maintains a detailed loan review process to monitor the quality of its loan portfolio. The Bank makes loans to customers primarily within Texas and New Mexico . The Bank also purchases mortgage loans, which have been originated in other areas of the United States . Although the Bank has a diversified loan portfolio, a substantial portion of its portfolio is dependent upon the general economic conditions in Texas and New Mexico . Policies and procedures, which are in place to manage credit risk, are designed to be responsive to changes in these economic conditions. Operational Risk Operational risk refers generally to risk of loss resulting from our operations, including but not limited to, improper or unauthorized execution and processing of transactions, deficiencies in our operating systems, and inadequacies or breaches in our control processes. We operate in diverse markets and rely on the ability of our employees and systems to process large numbers of transactions. In order to mitigate and control operational risk, we have developed and continue to update specific policies and procedures that are designed to identify and manage operational risk at appropriate levels. We also use periodic self-assessments and internal audit examinations as further review of the effectiveness of our controls and procedures in mitigating our operational risk. 79 -------------------------------------------------------------------------------- Table of Contents Legal Risk Legal risk includes the risk of non-compliance with applicable legal and regulatory requirements. We are subject to extensive regulation in the different jurisdictions in which we conduct business. We have established procedures based on legal and regulatory requirements that are designed to reasonably ensure compliance with applicable statutory and regulatory requirements. We also have established procedures that are designed to ensure that executive management's policies relating to conduct, ethics and business practices are followed. In connection with our business, we have various procedures addressing significant issues such as regulatory capital requirements, sales and trading practices, new products, use and safekeeping of customer funds and securities, granting credit, collection activities, money laundering, privacy and record keeping. Market Risk Market risk generally represents the risk of loss that may result from the potential change in value of a financial instrument as a result of fluctuations in interest rates, market prices, investor expectations and changes in credit ratings of the issuer. Our exposure to market risk is directly related to our role as a financial intermediary in customer-related transactions and to our proprietary trading activities and securities lending activities. Interest Rate Risk. A description of the interest rate risk for our brokerage and banking segments is as follows: Brokerage. Interest rate risk is a consequence of maintaining inventory positions and trading in interest rate sensitive financial instruments and maintaining a matched stock loan book. Our fixed income activities also expose us to the risk of loss related to changes in credit spreads. Credit spread risk arises from the potential that changes in an issuer's credit rating or credit perception could affect the value of financial instruments. Banking. Our primary emphasis in interest rate risk management for the Bank is the matching of assets and liabilities of similar cash flow and re-pricing time frames. This matching of assets and liabilities reduces exposure to interest rate movements and aids in stabilizing positive interest spreads. We strive to structure our balance sheet as a natural hedge by matching floating rate assets with variable short term funding and by matching fixed rate liabilities with similar longer term fixed rate assets. The Bank has established percentage change limits in both interest margin and net portfolio value. To verify that the Bank is within the limits established for interest margin, the Bank prepares an analysis of net interest margin based on various shifts in interest rates. To verify that the Bank is within the limits established for net portfolio value, the Bank analyzes data prepared using internal modeling data for net portfolio value. These analyses are conducted on a quarterly basis for the Bank's BOD. The following table illustrates the estimated change in net interest margin based on shifts in interest rates of positive 300 basis points to negative 100 basis points: Hypothetical Change in Interest Rates Projected Change in Net Interest Margin +300 -28.21% +200 -18.55% +100 -9.13% 0 0.00% -100 -7.14% 80 -------------------------------------------------------------------------------- Table of Contents The following GAP Analysis table indicates the Bank's interest rate sensitivity position at December 31, 2013 (in thousands): Repricing Opportunities 0-6 months 7-12 months 1-3 years 3+ years Earning assets: Loans-gross $ 354,278 $ 34,420 $ 84,189 $ 64,778 Securities and FHLB stock 27,150 21,907 36,404 513,997 Interest-bearing deposits 98,141 - - - Total earning assets 479,569 56,327 120,593 578,775 Interest-bearing liabilities: Transaction accounts and savings 910,055 - - - Certificates of deposit 11,098 9,047 7,155 745 Borrowings 12,526 1,812 8,709 75,204 Total interest-bearing liabilities 933,679 10,859 15,864 75,949 GAP $ (454,110) $ 45,468 $ 104,729 $ 502,826 Cumulative GAP $ (454,110) $ (408,642) $ (303,913) $ 198,913 Market Price Risk . We are exposed to market price risk as a result of making markets and taking proprietary positions in securities. Market price risk results from changes in the level or volatility of prices, which affect the value of securities or instruments that derive their value from a particular stock or bond, a basket of stocks or bonds or an index. The following table categorizes "Securities owned, at fair value" net of "Securities sold, not yet purchased, at fair value," which are in our securities owned and securities sold, not yet purchased, portfolios, "Restricted cash and cash equivalents", and "Securities available for sale" in our available-for-sale portfolio which are subject to interest rate and market price risk at December 31, 2013 (dollars in thousands): Years to Maturity 1 or less 1 to 5 5 to 10 Over 10 Total Trading securities, at fair value Municipal obligations $ 46 $ 6,466 $ 10,914 $ 38,756 $ 56,182 U.S. government and government agency obligations 6,749 (507) (8,925) (169) (2,852) Corporate obligations (5,657) (13,723) 3,566 20,342 4,528 Total debt securities $ 1,138 $ (7,764) $ 5,555 $ 58,929 $ 57,858 Corporate equity securities - - - 1,200 1,200 Other 22,041 - - - 22,041 $ 23,179 $ (7,764) $ 5,555 $ 60,129 $ 81,099 81 -------------------------------------------------------------------------------- Table of Contents Years to Maturity 1 or less 1 to 5 5 to 10 Over 10 Total Weighted average yield Municipal obligations 1.30 % 1.71 % 2.94 % 5.03 % 4.24 % U.S. government and government agency obligations 0.04 1.25 2.93 3.11 2.54 Corporate obligations 1.19 2.08 3.93 4.83 3.15 Restricted cash and cash equivalents Restricted cash and cash equivalents $ 30,049 $ - $ - $ - $ 30,049 Available-for-sale securities, at fair value Securities available for sale $ 44,484 $ 60,910 $ 33,083 $ 441,814 $ 580,291 CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect reported amounts of assets, liabilities, revenues, expenses and related disclosures. We review our estimates on an on-going basis. We base our estimates on our experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Our accounting policies and methodology used in establishing estimates have not changed materially since June 30, 2013 . See Fiscal 2013 Form 10-K for a discussion of our critical accounting policies. 82 -------------------------------------------------------------------------------- Table of Contents FORWARD- LOOKING STATEMENTS From time to time we make statements (including some contained in this report) that predict or forecast future events, depend on future events for their accuracy, or otherwise contain "forward-looking" information and constitute "forward-looking statements" within the meaning of applicable U.S. securities laws. Such statements are generally identifiable by terminology 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 forward-looking statements and should recognize that such statements are predictions of future results, which may not occur as anticipated. Actual results may differ materially as a result of various factors, some of which are outside of our control, including: the interest rate environment; the volume of trading in securities; the liquidity in capital markets; the volatility and general level of securities prices and interest rates; the ability to meet regulatory capital requirements administered by federal agencies; the level of customer margin loan activity and the size of customer account balances; the demand for real estate in Texas , New Mexico and the national market; the credit-worthiness of our correspondents, trading counterparties and of our banking and margin customers; the demand for investment banking services; general economic conditions, especially in Texas and New Mexico , and investor sentiment and confidence; the value of collateral securing the loans we hold; competitive conditions in each of our business segments; changes in accounting, tax and regulatory compliance requirements; changes in federal, state and local tax rates; the ability to attract and retain key personnel; the availability of borrowings under credit lines, credit agreements and credit facilities; the potential misconduct or errors by our employees or by entities with whom we conduct business; the ability of borrowers to meet their contractual obligations and the adequacy of our allowance for loan losses; and the potential for litigation and other regulatory liability. Our future operating results also depend on our operating expenses, which are subject to fluctuation due to: variations in the level of compensation expense incurred as a result of changes in the number of total employees, competitive factors or other market variables; variations in expenses and capital costs, including depreciation, amortization and other non-cash charges incurred to maintain our infrastructure; and unanticipated costs which may be incurred from time to time in connection with litigation, regulation and compliance, loan analyses and modifications or other contingencies. 83 -------------------------------------------------------------------------------- Table of Contents 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 this report under the headings "Overview," "Risk Management," "Risk Factors" and "Critical Accounting Policies and Estimates," in the Fiscal 2013 Form 10-K under the heading Risk Factors and our other reports filed with and available from the SEC . Our forward-looking statements are based on current beliefs, assumptions and expectations. All forward-looking statements 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.


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