-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Gc6DY3hIXF2+ufEamVpnrDmKXPbbYRAca7rCdDniHJJrZDvhheKrBKVXfeFI6+WG 457L5k+SVZ8wqIau0PfjMQ== 0000930661-01-502339.txt : 20020410 0000930661-01-502339.hdr.sgml : 20020410 ACCESSION NUMBER: 0000930661-01-502339 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20010928 FILED AS OF DATE: 20011113 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOUTHWEST SECURITIES GROUP INC CENTRAL INDEX KEY: 0000878520 STANDARD INDUSTRIAL CLASSIFICATION: SECURITY BROKERS, DEALERS & FLOTATION COMPANIES [6211] IRS NUMBER: 752040825 STATE OF INCORPORATION: DE FISCAL YEAR END: 0625 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-19483 FILM NUMBER: 1783591 BUSINESS ADDRESS: STREET 1: SUITE 3500 STREET 2: 1201 ELM STREET CITY: DALLAS STATE: TX ZIP: 75270 BUSINESS PHONE: 2146511800 MAIL ADDRESS: STREET 1: SUITE 3500 STREET 2: 1201 ELM STREET CITY: DALLAS STATE: TX ZIP: 75270 10-Q 1 d10q.txt FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 Form 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 28, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______ Commission file number 0-19483 SOUTHWEST SECURITIES GROUP, INC. (Exact name of registrant as specified in its charter) Delaware 75-2040825 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1201 Elm Street, Suite 3500, Dallas, Texas 75270 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (214) 859-1800 (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No As of November 7, 2001, there were 17,159,634 shares of the registrant's common stock, $.10 par value, outstanding. SOUTHWEST SECURITIES GROUP, INC. AND SUBSIDIARIES Index PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Statements of Financial Condition September 28, 2001 (unaudited) and June 29, 2001 Consolidated Statements of Income and Comprehensive Income (Loss) For the three months ended September 28, 2001 and September 29, 2000 (unaudited) Consolidated Statements of Cash Flows For the three months ended September 28, 2001 and September 29, 2000 (unaudited) Notes to Consolidated Financial Statements (unaudited) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures About Market Risk PART II. OTHER INFORMATION Item 1. Legal Proceedings Item 2. Changes in Securities and Use of Proceeds Item 3. Defaults Upon Senior Securities Item 4. Submission of Matters to a Vote of Security Holders Item 5. Other Information Item 6. Exhibits and Reports on Form 8-K SOUTHWEST SECURITIES GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Financial Condition September 28, 2001 and June 29, 2001 (In thousands, except par values and share amounts)
September June (unaudited) ----------------------------- Assets Cash $ 30,205 $ 31,224 Assets segregated for regulatory purposes 435,371 362,071 Marketable equity securities available for sale 5,445 9,687 Receivable from brokers, dealers and clearing organizations 1,565,674 2,221,253 Receivable from clients, net 348,674 437,620 Loans held for sale, net 122,665 155,025 Loans, net 335,893 319,949 Securities owned, at market value 142,739 146,074 Other assets 120,827 101,854 ----------------------------- $3,107,493 $3,784,757 ============================= Liabilities and Stockholders' Equity Short-term borrowings $ 2,300 $ -- Payable to brokers, dealers and clearing organizations 1,532,760 2,233,207 Payable to clients 706,579 657,955 Deposits 322,135 336,281 Securities sold, not yet purchased, at market value 30,525 28,650 Drafts payable 26,846 29,620 Advances from Federal Home Loan Bank 110,926 113,477 Other liabilities 74,410 74,831 Exchangeable subordinated notes 7,605 8,568 ----------------------------- 2,814,086 3,482,589 Minority interest in consolidated subsidiaries 2,152 2,729 Stockholders' equity: Preferred stock of $1.00 par value. Authorized 100,000 shares; none issued -- -- Common stock of $.10 par value. Authorized 60,000,000 shares, issued 17,510,685 and outstanding 17,159,393 shares at September 28, 2001; issued 17,509,771 and outstanding 17,247,914 shares at June 29, 2001 1,751 1,751 Additional paid-in capital 252,244 252,225 Retained earnings 21,881 21,269 Accumulated other comprehensive income - unrealized holding gain, net of tax of $11,041 at September 28, 2001 and $15,075 at June 29, 2001 20,504 27,997 Deferred compensation, net 1,328 1,141 Treasury stock (351,292 shares at September 28, 2001 and 261,857 shares at June 29, 2001, at cost) (6,453) (4,944) ----------------------------- Total stockholders' equity 291,255 299,439 Commitments and contingencies ----------------------------- $3,107,493 $3,784,757 =============================
See accompanying Notes to Consolidated Financial Statements. 1 SOUTHWEST SECURITIES GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Income and Comprehensive Income (Loss) For the three months ended September 28, 2001 and September 29, 2000 (In thousands, except per share and share amounts) (Unaudited)
2002 2001 (restated) ------------------------------- Net revenues from clearing operations $ 7,241 $ 15,208 Commissions 16,085 15,664 Interest 39,630 76,565 Investment banking, advisory and administrative fees 9,456 8,987 Net gains on principal transactions (including net gains on the sale of Knight Trading Group, Inc. ("Knight") common stock of $9,440 in 2001 and $2,866 in 2000 11,215 8,028 Other 3,742 6,716 ------------------------------- 87,369 131,168 ------------------------------- Commissions and other employee compensation 32,308 35,781 Interest 24,544 54,052 Occupancy, equipment and computer service costs 9,789 7,926 Communications 4,229 3,591 Floor brokerage and clearing organization charges 1,596 1,814 Advertising and promotional 3,015 3,872 Other 7,937 10,233 ------------------------------- 83,418 117,269 ------------------------------- Income before income taxes and minority interest in consolidated subsidiaries 3,951 13,899 Income taxes 1,360 4,614 ------------------------------- Income before minority interest in consolidated subsidiaries 2,591 9,285 Minority interest in consolidated subsidiaries (263) (1,067) ------------------------------- Income before cumulative effect of a change in accounting principle 2,328 8,218 Cumulative effect of a change in accounting principle, net of tax of $1,548 -- (2,874) ------------------------------- Net income 2,328 5,344 Other comprehensive income (loss): Holding gain (loss) arising during period, net of tax of ($702) in 2001 and $3,222 in 2000 (2,080) 5,956 Reclassification for hedging activities, net of tax of $390 in 2001 and $5,636 in 2000 724 10,467 Reclassification adjustment for gains realized in net income on the sale of Knight common stock, net of tax of ($3,304) in 2001 and ($1,003) in 2000 (6,137) (1,863) ------------------------------- Net gain (loss) recognized in other comprehensive income (loss) (7,493) 14,560 ------------------------------- Comprehensive income (loss) $ (5,165) $ 19,904 =============================== Earnings per share - basic Income before cumulative effect of a change in accounting principle $ .14 $ .47 Cumulative effect of a change in accounting principle, net of tax -- (.16) ------------------------------- Net income $ .14 $ .31 =============================== Weighted average shares outstanding - basic 17,239,825 17,478,997 =============================== Earnings per share - diluted Income before cumulative effect of a change in accounting principle $ .13 $ .46 Cumulative effect of a change in accounting principle, net of tax -- (.16) ------------------------------- Net income $ .13 $ .30 =============================== Weighted average shares outstanding - diluted 17,281,079 17,627,178 ===============================
See accompanying Notes to Consolidated Financial Statements. 2 SOUTHWEST SECURITIES GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows For the three months ended September 28, 2001 and September 29, 2000 (In thousands) (Unaudited) 2002 2001 ------------------------ Cash flows from operating activities: Net income $ 2,328 $ 5,344 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 1,176 975 Provision for doubtful accounts 535 794 Deferred income taxes 1,147 550 Deferred compensation (655) 13 Gain on sale of marketable equity securities (9,440) (2,866) Net change in minority interest in consolidated subsidiaries (627) 608 Cumulative effect of change in accounting principle, net of tax -- 2,874 Reclassification from other comprehensive income for SFAS No. 133 150 (837) Change in operating assets and liabilities: Decrease (increase) in assets segregated for regulatory purposes (73,300) 107,659 Net change in broker, dealer and clearing organization accounts (44,868) (36,412) Net change in client accounts 137,330 (103,754) Net change in loans held for sale 32,360 14,141 Decrease (increase) in securities owned 2,559 (3,023) Increase in other assets (15,887) (6,681) Decrease in drafts payable (2,774) (2,596) Increase in securities sold, not yet purchased 1,875 427 Increase (decrease) in other liabilities 1,138 (4,888) ------------------------ Net cash provided by (used in) operating activities 33,047 (27,672) ------------------------ Cash flows from investing activities: Purchase of fixed assets (1,804) (989) Net change in loans (16,239) (16,545) Cash paid for purchase of O'Connor, net of cash acquired (887) -- Proceeds from sale of marketable equity securities 2,236 2,878 ------------------------ Net cash used in investing activities (16,694) (14,656) ------------------------ Cash flows from financing activities: Increase in short-term borrowings 2,300 3,400 Increase (decrease) in deposits (14,146) 22,739 Decrease in advances from Federal Home Loan Bank (2,551) (30,809) Payment of cash dividends on common stock (1,725) (1,430) Net proceeds from exercise of stock options 25 166 Net proceeds from issuance of stock in consolidated subsidiary 50 -- Proceeds related to Deferred Compensation Plan 185 300 Purchase of treasury stock (1,510) (300) ------------------------ Net cash used in financing activities (17,372) (5,934) ------------------------ Net decrease in cash (1,019) (48,262) Cash at beginning of period 31,224 72,479 ------------------------ Cash at end of period $ 30,205 $ 24,217 ========================
See accompanying Notes to Consolidated Financial Statements. 3 SOUTHWEST SECURITIES GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Unaudited) GENERAL AND BASIS OF PRESENTATION The interim consolidated financial statements include the accounts of Southwest Securities Group, Inc. ("Parent") and its consolidated subsidiaries listed below (collectively, the "Company"): Brokerage Group SWS Securities, Inc. "SWS, Inc." SWS Financial Services, Inc. "SWSFS" Mydiscountbroker.com, Inc. "MDB" Southwest Clearing Corp. "Clearing" May Financial Corporation "May" O'Connor & Company Securities, Inc. "O'Connor" Asset Management Group Westwood Management Corporation "Westwood" Westwood Trust "Trust" SWS Capital Corporation "Capital" Southwest Investment Advisors, Inc. "Advisors" Banking Group First Savings Bank, FSB "FSB" First Consumer Credit, LLC (47%) "First Consumer" FSBF, LLC (75%) "FSBF LLC" FSB Financial, LTD (73.5%) "FSBF LTD" FSB Development, LLC "FSB Development" Other SWS Technologies Corporation "Technologies" SWS, Inc. is a New York Stock Exchange ("NYSE") registered broker/dealer, and SWSFS, MDB, Clearing, May and O'Connor are National Association of Securities Dealers ("NASD") registered broker/dealers under the Securities Exchange Act of 1934 ("1934 Act"). Advisors and Westwood are registered investment advisors under the Investment Advisors Act of 1940. Trust is chartered and regulated by the Texas Department of Banking. FSB is a federally chartered savings association regulated by the Office of Thrift Supervision. The interim consolidated financial statements as of September 28, 2001, and for the three-month periods ended September 28, 2001 and September 29, 2000, are unaudited; however, in the opinion of management, these interim statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial position, results of operations and cash flows. These financial statements should be read in conjunction with the audited consolidated financial statements and related notes as of and for the year ended June 29, 2001 filed on Form 10-K. Amounts included for June 29, 2001 are from the audited consolidated financial statements as filed on Form 10-K. All significant intercompany balances and transactions have been eliminated. Other comprehensive income for the first quarter of fiscal 2001 has been restated to reflect the reclassification of changes in the value of the hedged Knight stock, net of tax, of $10,467,000. The amount previously reported for comprehensive income in the first quarter of fiscal 2001 was $9,437,000. CASH FLOW REPORTING Cash paid for interest was $26,152,000 and $54,051,000 for the three-month periods ended September 28, 2001 and September 29, 2000, respectively. There was no cash paid for taxes in the three months ended September 28, 2001. Cash paid for income taxes was $6,600,000 for the three months ended September 29, 2000. 4 ASSETS SEGREGATED FOR REGULATORY PURPOSES At September 28, 2001, the Company had U.S. Treasury securities with a market value of approximately $195,902,000, reverse repurchase agreements of approximately $227,719,000, cash of $104,000 and related accrued interest of approximately $41,000 segregated in special reserve bank accounts for the exclusive benefit of customers under Rule 15c3-3 of the 1934 Act. These reverse repurchase agreements were collateralized by U.S. Government securities with a market value of approximately $247,409,000. The Company also had approximately $11,601,000 in reverse repurchase agreements, cash of $1,000 and related accrued interest of approximately $3,000 in special reserve bank accounts for the Proprietary Accounts of Introducing Brokers ("PAIB") at September 28, 2001. The reverse repurchase agreements in the PAIB accounts were collateralized by U.S. Government securities with a market value of approximately $11,831,000. At June 29, 2001, the Company had U.S. Treasury securities with a market value of approximately $124,363,000, reverse repurchase agreements of approximately $216,690,000, cash of $19,000 and related accrued interest of approximately $130,000 segregated in the special reserve bank accounts for the exclusive benefit of customers. These reverse repurchase agreements were collateralized by U.S. Government securities with a market value of approximately $220,490,000. The Company also had approximately $20,862,000 in reverse repurchase agreements, cash of $1,000 and related accrued interest of approximately $6,000 in special reserve bank accounts for the PAIB at June 29, 2001. The reverse repurchase agreements in the PAIB accounts were collateralized by U.S. Government securities with a market value of approximately $21,101,000. MARKETABLE EQUITY SECURITIES The investment in Knight common stock is classified as marketable equity securities available for sale, and the unrealized holding gains (losses), net of tax, are recorded as a separate component of stockholders' equity on the consolidated statements of financial condition. The following table summarizes the cost and market value of the investment in Knight at September 28, 2001 and June 29, 2001 (in thousands):
Gross Gross Shares Unrealized Unrealized Market Held Cost Gains Losses Value --------------------------------------------- September 28, 2001 Marketable equity securities 706,184 $ 91 5,354 -- $5,445 ============================================= June 29, 2001 Marketable equity securities 906,184 $117 9,570 -- $9,687 =============================================
The "specific identification" method is used to determine the cost of marketable securities sold. In the three-month periods ended September 28, 2001 and September 29, 2000, the Company sold approximately 200,000 and 91,000 shares of Knight, respectively, with proceeds from the sales totaling $2,236,000 and $2,878,000, respectively. Realized gains on these sales totaled approximately $2,210,000 and $2,866,000 for the three-month periods ended September 28, 2001 and September 29, 2000, respectively. As of September 28, 2001 and June 29, 2001, 373,550 shares of this stock are hedged by the Company's 5% Exchangeable Subordinated Notes ("the Notes"). In December 2000, the Company repurchased and retired 640,782 Notes. A like number of Knight shares were released from the hedging provisions of SFAS No. 133. Upon final disposition of these previously hedged shares of Knight stock, the Company will recognize a non-cash gain of approximately $23.50 per share, net of tax, equal to the decrease in the value of Knight stock from the hedging date (June 16, 1999), to the termination date of hedge accounting (December 20, 2000). The Company disposed of 200,000 shares of this previously hedged stock in the first quarter of fiscal 2002, therefore, a $7,230,000 non-cash gain on sale of stock was recorded in net 5 gains from principal transactions in the accompanying consolidated statements of income and comprehensive income (loss). There were no such gains in the first quarter of fiscal 2001. RECEIVABLE FROM AND PAYABLE TO BROKERS, DEALERS AND CLEARING ORGANIZATIONS At September 28, 2001 and June 29, 2001, the Company had receivable from and payable to brokers, dealers and clearing organizations related to the following (in thousands): September June ---------- ---------- Receivable Securities failed to deliver $ 60,622 $ 25,825 Securities borrowed 1,457,466 2,162,467 Correspondent broker/dealers 16,283 16,353 Clearing organizations 2,498 1,776 Other 28,805 14,832 ---------- ---------- $1,565,674 $2,221,253 ========== ========== Payable Securities failed to receive $ 51,708 $ 22,596 Securities loaned 1,433,515 2,166,165 Correspondent broker/dealers 29,304 31,660 Other 18,233 12,786 ---------- ---------- $1,532,760 $2,233,207 ========== ========== LOANS AND ALLOWANCE FOR POSSIBLE LOAN LOSSES Loans receivable, excluding loans held for sale, at September 28, 2001 and June 29, 2001 are summarized as follows (in thousands): September June ---------- ---------- First mortgage loans (principally conventional): Real estate $ 158,548 $ 153,573 Construction 121,050 116,195 ---------- ---------- 279,598 269,768 ---------- ---------- Consumer and other loans: Commercial 24,080 18,757 Other 36,030 35,640 ---------- ---------- 60,110 54,397 ---------- ---------- Factored receivables 10,612 11,021 ---------- ---------- 350,320 335,186 Unearned income (11,057) (11,957) Allowance for possible loan losses (3,370) (3,280) ---------- ---------- $ 335,893 $ 319,949 ========== ========== Impairment of loans with a recorded investment of approximately $5,257,000 and $4,084,000 at September 28, 2001 and June 29, 2001, respectively, has been recognized in conformity with SFAS No. 114 as amended by SFAS No. 118. 6 An analysis of the allowance for possible loan losses for the three-month periods ended September 28, 2001 and September 29, 2000 is as follows (in thousands): 2001 2000 -------- -------- Balance at beginning of period $ 3,280 $ 3,699 Provision for loan losses 295 529 Loans charged to the allowance, net (205) (1,578) -------- -------- Balance at end of period $ 3,370 $ 2,650 ======== ======== SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED At September 28, 2001 and June 29, 2001, the Company held securities owned and securities sold, not yet purchased as follows (in thousands): September June --------- --------- Securities owned Corporate equity securities $ 30,140 $ 28,279 Municipal obligations 23,124 28,280 U.S. Government and Government agency obligations 23,924 26,361 Corporate obligations 40,107 40,240 Funds and trusts 25,434 22,914 Other 10 -- --------- --------- $ 142,739 $ 146,074 ========= ========= Securities sold, not yet purchased Corporate equity securities $ 10,565 $ 3,690 Municipal obligations 330 2,731 U.S. Government and Government agency obligations 16,859 19,150 Corporate obligations 2,506 2,904 Funds and trusts 265 175 --------- --------- $ 30,525 $ 28,650 ========= ========= SHORT-TERM BORROWINGS The Company has credit arrangements with commercial banks, which include broker loan lines up to $360,000,000. These lines of credit are used primarily to finance securities owned, securities held for Correspondent broker/dealer accounts and receivables in customers' margin accounts. These lines may also be used to release pledged collateral against day loans. These credit arrangements are provided on an "as offered" basis and are not committed lines of credit. These arrangements can be terminated at any time by the lender. Any outstanding balance under these credit arrangements is due on demand and bears interest at rates indexed to the federal funds rate. At September 28, 2001, there was $2.3 million outstanding under these secured arrangements which were fully collateralized by securities held in customer margin accounts with a market value of approximately $14 million. There were no amounts outstanding under these secured arrangements at June 29, 2001. The Company also has an irrevocable letter of credit agreement aggregating $55,000,000 and $80,000,000 at September 28, 2001 and June 29, 2001, respectively, pledged to support its open options positions with an options clearing organization. The letter of credit bears interest at the brokers' call rate, if drawn, and is renewable annually. This letter of credit is fully collateralized by marketable securities held in clients' and nonclients' margin accounts with a value of $77,254,000 and $129,677,000 at September 28, 2001 and June 29, 2001, respectively. 7 In addition to the broker loan lines, the Company has a $20,000,000 unsecured line of credit that is due on demand and bears interest at rates indexed to the federal funds rate. There were no amounts outstanding under this line of credit at September 28, 2001 and June 29, 2001. At September 28, 2001 and June 29, 2001, the Company had no repurchase agreements outstanding. DEPOSITS Deposits at September 28, 2001 and June 29, 2001 are summarized as follows (dollars in thousands):
September June Amount Percent Amount Percent ------------------ ------------------ Noninterest bearing demand accounts $ 19,073 5.9% $ 22,406 6.6% Interest bearing demand accounts 8,457 2.6 5,088 1.5 Savings accounts 739 0.2 560 0.2 Limited access money market accounts 16,954 5.3 14,008 4.2 Certificates of deposit, less than $100,000 174,385 54.1 179,681 53.4 Certificates of deposit, $100,000 and greater 102,527 31.9 114,538 34.1 ------------------ ------------------ $322,135 100.0% $336,281 100.0% ================== ==================
The weighted average interest rate on deposits was approximately 4.9% at September 28, 2001 and 5.5% at June 29, 2001. At September 28, 2001, scheduled maturities of certificates of deposit were as follows (in thousands): 2002 2003 2004 Thereafter Total -------- ------- ------ ---------- -------- Certificates of deposit, less than $100,000 $124,942 $29,940 $2,069 $17,434 $174,385 Certificates of deposit, $100,000 and greater 93,853 -- 1,140 7,534 102,527 -------- ------- ------ ---------- -------- $218,795 $29,940 $3,209 $24,968 $276,912 ======== ======= ====== ========== ========
ADVANCES FROM THE FEDERAL HOME LOAN BANK At September 28, 2001 and June 29, 2001, advances from the FHLB were due as follows (in thousands): September June --------- -------- Maturity: Due within one year $ 99,036 $101,456 Due within two years 1,507 1,517 Due within five years 3,138 3,164 Due within seven years 593 223 Due within ten years 1,012 1,411 Due within twenty years 5,640 5,706 --------- -------- $ 110,926 $113,477 ========= ======== Pursuant to collateral agreements, the advances from the FHLB, with interest rates ranging from 3.1% to 7.7%, are secured by approximately $145,000,000 of collateral value (as defined) in qualifying first mortgage loans at September 28, 2001. At June 29, 2001, advances with interest rates from 3.9% to 7.7% were secured by approximately $145,116,000 of collateral value in qualifying first mortgages. 8 EXCHANGEABLE SUBORDINATED NOTES The Company adopted Statement of Financial Accounting Standards No. 133 (SFAS No. 133) "Accounting for Derivative Instruments and Hedging Activities", as amended, effective July 1, 2000. SFAS No. 133 is applicable to the Notes due 2004 with a face value of $36.6 million. The Company issued the Notes in June 1999 in the form of DARTS(SM), or Derivative Adjustable Ratio Securities(SM). As mentioned above, 373,550 DARTS remain outstanding as of September 28, 2001 and June 29, 2001. SFAS No. 133 requires fair value recognition of the Notes' embedded derivative in the consolidated statements of financial condition. Changes in the fair value of the embedded derivative are required to be recognized in earnings, along with the change in fair value of the Knight shares. For the first quarter of fiscal 2002, the Company recognized a loss of $150,000 that represents the change in the time value of the embedded equity option in the DARTS. Under SFAS No. 133, such gain or loss will be calculated on a quarterly basis until such time as the embedded derivative ceases to exist. To properly adjust the value of the embedded derivative on the consolidated statements of financial condition as of September 28, 2001 for SFAS No. 133, the Company decreased the Notes' liability by approximately $963,000. The Company also reclassified a loss of $724,000 from other comprehensive income, net of tax of $390,000 to earnings to record the value of the hedged Knight shares. The following table reflects the activity in the Notes' liability account for the quarterly periods ended September 28, 2001 and September 29, 2000 (in thousands): 2002 2001 ------ -------- Balance at beginning of fiscal year $8,568 $ 57,500 Adoption of SFAS No. 133 -- (17,956) Change in value of embedded derivative (963) 5,439 ------ -------- Balance at end of first quarter $7,605 $ 44,983 ====== ======== NET CAPITAL REQUIREMENTS Brokerage Group. The broker/dealer subsidiaries are subject to the Securities and Exchange Commission's Uniform Net Capital Rule (the "Rule"), which requires the maintenance of minimum net capital. Southwest has elected to use the alternative method, permitted by the Rule, which requires that it maintain minimum net capital, as defined in Rule 15c3-1 under the 1934 Act, equal to the greater of $1,500,000 or 2% of aggregate debit balances, as defined in Rule 15c3-3 under the 1934 Act. At September 28, 2001, Southwest had net capital of $110,086,000, or approximately 24.9% of aggregate debit balances, which is $101,241,000 in excess of its minimum net capital requirement of $8,845,000 at that date. Additionally, the net capital rule of the New York Stock Exchange, Inc. (the "Exchange") provides that equity capital may not be withdrawn or cash dividends paid if resulting net capital would be less than 5% of aggregate debit items. At September 28, 2001, Southwest had net capital of $87,972,000 in excess of 5% of aggregate debit items. Clearing, May and O'Connor also follow the alternative method. At September 28, 2001, Clearing had net capital of $1,268,000, which is $1,018,000 in excess of its minimum net capital requirement of $250,000 at that date. May had net capital of $5,361,000, which is $5,043,000 in excess of its net capital requirement of $318,000 at September 28, 2001. At September 28, 2001, O'Connor had net capital of $345,000, which is $95,000 in excess of its minimum net capital requirement of $250,000 at that date. SWSFS and MDB follow the primary (aggregate indebtedness) method under Rule 15c3-1, which requires the maintenance of minimum net capital of $250,000. At September 28, 2001, the net capital and excess net capital were $320,000 and $70,000, respectively, for SWSFS and $3,097,000 and $2,847,000, respectively, for MDB. Asset Management Group. Trust is subject to the capital requirements of the Texas Department of Banking, and has a minimum capital requirement of $1,000,000. Trust had total stockholder's equity of approximately $3,571,000, which is $2,571,000 in excess of its minimum capital requirement at September 28, 2001. 9 Banking Group. FSB is subject to various regulatory capital requirements administered by Federal agencies. Quantitative measures, established by regulation to ensure capital adequacy, require the maintaining of minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of September 28, 2001, that FSB meets all capital adequacy requirements to which it is subject. As of September 28, 2001 and June 29, 2001, FSB is considered "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well capitalized," FSB must maintain minimum total risk-based, Tier I risk- based, Tier I leverage ratios as set forth in the table. FSB's actual capital amounts and ratios are presented in the following tables (in thousands):
To Be Well Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions Amount Ratio Amount Ratio Amount Ratio ------------------- ------------------ ----------------- September 29, 2001: Total capital (to risk weighted assets) $44,833 10.8% $33,076 8.0% $41,345 10.0% Tier I capital (to risk weighted assets) 43,132 10.4 16,538 4.0 24,807 6.0 Tier I capital (to adjusted total assets) 43,132 8.9 19,368 4.0 24,210 5.0 June 29, 2001: Total capital (to risk weighted assets) $43,095 10.7% $32,222 8.0% $40,277 10.0% Tier I capital (to risk weighted assets) 42,020 10.4 16,111 4.0 24,166 6.0 Tier I capital (to adjusted total assets) 42,020 8.4 19,993 4.0 24,991 5.0
EARNINGS PER SHARE A reconciliation between the weighted average shares outstanding used in the basic and diluted EPS computations is as follows for the three months ended September 28, 2001 and September 29, 2000 (in thousands, except share and per share amounts): 2002 2001 ---------------------------- Income before cumulative effect of a change in accounting principle $ 2,328 $ 8,218 Cumulative effect of a change in accounting principle -- (2,874) ---------------------------- Net income $ 2,328 $ 5,344 ============================ Weighted average shares outstanding - basic 17,239,825 17,478,997 Effect of dilutive securities: Assumed exercise of stock options 41,254 148,181 ---------------------------- Weighted average shares outstanding - diluted 17,281,079 17,627,178 ============================ Earnings per share - basic Income before cumulative effect of a change in accounting principle $ .14 $ .47 Cumulative effect of a change in accounting principle -- (.16) ---------------------------- Net income $ .14 $ .31 ============================ Earnings per share - diluted Income before cumulative effect of a change in accounting principle $ .13 $ .46 Cumulative effect of a change in accounting principle -- (.16) ---------------------------- Net income $ .13 $ .30 ============================
10 At September 28, 2001, the Company had two stock option plans, the Southwest Securities Group, Inc. Stock Option Plan (the "1996 Plan") and the Southwest Securities Group, Inc. 1997 Stock Option Plan (the "1997 Plan"). At September 28, 2001, there were approximately 1,449,000 options outstanding under the 1996 Plan and approximately 56,000 options outstanding under the 1997 Plan. As of September 28, 2001, 1.1 million options were antidilutive and therefore were not included in the calculation of weighted average shares outstanding-diluted. SEGMENT REPORTING The Company operates three principal segments within the financial services industry: the Brokerage Group, the Asset Management Group and the Banking Group. Acquired in August 2001, O'Connor is now included in the brokerage group. The category "other consolidated entities" includes the Parent and Technologies. The Parent is a holding company that owns various investments, including the investment in Knight common stock. Technologies provides Internet design and marketing strategies and other Internet-related services, as well as disaster recovery services. There are no material reconciling adjustments included in this category. There have been no changes in the basis of segmentation or in the basis of measurement of segment profit or loss since last reported.
Consolidated Asset Other Southwest Brokerage Management Banking Consolidated Securities (in thousands) Group Group Group Entities Group, Inc. - ---------------------------------------------------------------------------------------------------------------------------- Three months ended September 28, 2001 Net revenues from external sources $ 61,669 $5,066 $13,156 $ 7,478 $ 87,369 Net intersegment revenue (expense) (1,308) 169 (11) 1,150 -- Income (loss) before income taxes and minority interest in consolidated subsidiaries (6,912) 2,096 3,183 5,584 3,951 Net income (loss) (3,934) 1,292 1,908 3,062 2,328 Three months ended September 29, 2000 Net revenues from external sources $111,520 $4,568 $14,147 $ 933 $131,168 Net intersegment revenue (expense) (1,864) 165 (23) 1,722 -- Income (loss) before income taxes and minority interest in consolidated subsidiaries 8,702 1,868 5,518 (2,189) 13,899 Net income (loss) 6,388 1,146 2,787 (4,977) 5,344
On the consolidated statements of income and comprehensive income (loss), minority interest is solely related to the banking group, and the cumulative effect of a change in accounting principle and other comprehensive income (loss) are solely related to the Parent, which is included in the other category. ACQUISITION OF O'CONNOR & COMPANY SECURITIES, INC. In August 2001, the Company acquired O'Connor in a cash transaction. O'Connor is engaged in the origination, sale and trading of taxable and tax-exempt municipal bonds and is located in Newport Beach, California. The Company recorded approximately $744,000 in goodwill on the transaction. REPURCHASE OF TREASURY STOCK In November 2000, the Company's Board of Directors authorized management to repurchase up to one million shares of the Company's common stock in the open market. In the first quarter of fiscal 2002, the Company repurchased 80,000 shares at a cost of approximately $1,325,000. The Company also repurchased 9,000 shares of its stock under the Deferred Compensation Plan at a cost of $185,000. 11 COMMITMENTS AND CONTINGENCIES On October 21, 1999, the Company filed an arbitration claim with the NASD against a former correspondent broker dealer and its principal for non- performance under the correspondent clearing agreement relating to a $5.7 million margin loan. On January 22, 2001, the Company was notified that it was successful in obtaining a $4.7 million award against the correspondent broker/dealer but was unsuccessful in its cause against the individual principal of the correspondent firm. The Company is pursuing collection of the award. The Company has fully reserved for this margin loan. In the general course of our brokerage business and the business of clearing for other brokerage firms, we have been named as defendants in various pending lawsuits and arbitration proceedings. These claims allege violation of Federal and state securities laws. FSB is also involved in certain claims and legal actions arising in the ordinary course of business. We believe that resolution of these claims will not result in any material adverse effect on our business, consolidated financial condition or operating results. SUBSESQUENT EVENTS On October 2, 2001, a bankruptcy court awarded SWS, Inc. approximately 175,000 accounts of Minneapolis-based MJK Clearing. The Securities Investor Protection Corporation ("SIPC") assumed responsibility for the accounts when MJK Clearing reported that it was in violation for minimum capital requirements. The accounts of MJK Clearing were transferred to the Company's wholly-owned subsidiary, Clearing. Also in October 2001, FSB sold its interest in its minority-owned subsidiary First Consumer, receiving $470,000 and approximately 366,000 common shares of U.S. Home Systems, Inc. ("USHS"), a company publicly traded on NASDAQ. The shares of USHS were dividended to the Parent. A gain of approximately $1.2 million was recorded on the sale of First Consumer. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations FACTORS AFFECTING FORWARD-LOOKING STATEMENTS From time to time, Southwest Securities Group, Inc. (the "Parent") and subsidiaries (collectively, the "Company") may publish "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, (the "Acts") or make oral statements that constitute forward-looking statements. These forward-looking statements may relate to such matters as anticipated financial performance, future revenues or earnings, business prospects, projected ventures, new products, anticipated market performance and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, the Company cautions readers that a variety of factors could cause the Company's actual results to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. These risks and uncertainties, many of which are beyond the Company's control, include, but are not limited to (1) transaction volume in the securities markets; (2) volatility of the securities markets; (3) fluctuations in interest rates; (4) changes in regulatory requirements which could affect the cost of doing business; (5) general economic conditions, both domestic and foreign; (6) state of the housing market; (7) changes in the rate of inflation and related impact on financial markets; (8) competition from existing financial institutions and other new participants in the financial markets; (9) legal developments affecting the litigation experience of the financial services industry; (10) successful implementation of technology solutions; (11) changes in Federal and state tax laws which could affect the popularity of products sold by the Company and (12) acts of terrorism and other acts of war. The Company does not undertake any obligation to publicly update or revise any forward- looking statements. GENERAL The Company is primarily engaged in securities execution and clearance, securities brokerage, investment banking, securities lending and borrowing and trading as a principal in equity and fixed 12 income securities. The Company also engages in full-service banking and asset management activities. All of these activities are highly competitive and are sensitive to many factors outside the control of the Company, including volatility of securities prices and interest rates; trading volume of securities; economic conditions in the regions where the Company does business; income tax legislation; and demand for financial services. While revenues are dependent upon the level of trading and underwriting volume, which may fluctuate significantly, a large portion of the Company's expenses remain fixed. Consequently, net earnings can vary significantly from period to period. RESULTS OF OPERATIONS During the first quarter of fiscal 2002, net income totaled $2,328,000, a decrease of $3,016,000, or 56%, from the first quarter of fiscal 2001. The adoption of Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended, ("SFAS No. 133") in the first quarter of fiscal 2001 created a non-cash earnings impact in the first quarters of both fiscal 2002 and 2001. SFAS No. 133 is applicable to the Company's 5% Exchangeable Subordinated Notes, issued in the form of DARTSSM (or, "Derivative Adjustable Ratio SecuritiesSM"). The DARTS contain an equity- based derivative designed to hedge changes in fair value of the Company's investment in Knight Trading Group, Inc. ("Knight") common stock. The embedded derivative has been designated as a fair value hedge of the Company's investment in Knight shares. SFAS No. 133 requires fair value recognition of the DARTS' embedded derivative in the consolidated statements of financial condition. Changes in the fair value of the embedded derivative are required to be recognized in earnings, along with the change in fair value of the Knight shares. Under SFAS No. 133, the Company recognized a net transition loss in the first quarter of fiscal 2001, which includes gains on the change in the value of the embedded derivative, net of losses on the change in value of the corresponding Knight common stock reclassified from other comprehensive income (loss). The net transition loss represents the differences in the time value of money related to the embedded derivative. In the first quarter of fiscal 2002 the Company recognized a loss of $150,000 in other expense on the consolidated statements of income and comprehensive income (loss), while in the first quarter of fiscal 2001, the Company recognized a gain of $837,000 in other revenue representing the change in the time value of money in the embedded derivative. Under SFAS No. 133, the related change in the time value of money in the embedded derivative and the changes in the fair value of the embedded derivative, along with the change in fair value of the hedged Knight shares, will be calculated on a quarterly basis and recognized in the consolidated statements of income and comprehensive income (loss) until such time as the fair value hedge ceases to exist. A calculation of the Company's brokerage, asset management and banking income, excluding the aforementioned items for the first quarters of fiscal 2002 and 2001 follows (in thousands): 2002 2001 ------- ------ Net income $ 2,328 $5,344 Non-cash gain on sale of Knight stock released from hedge under SFAS No. 133, net of tax (4,700) -- Cumulative effect of a change in accounting principle, net of tax -- 2,874 Loss (gain) on hedging activities, net of tax 98 (544) --------- ------ $(2,274) $7,674 -======== ======
After adjusting for the items mentioned above, net income in the first quarter of fiscal 2002 decreased $9,948,000 over the comparable quarter of the fiscal 2001. The decrease is attributed to reduced margin and stock loan balances and tightened margins and reduced volumes in the clearing business. Additionally, the Company's operations were impacted by the closure of the U.S. financial markets in the 13 wake of the tragedies of September 11. There were 59 trade days in the first quarter of fiscal 2002 versus 63 trade days in the first quarter of fiscal 2001. The following is a summary of increases (decreases) in categories of net revenues and operating expenses for the three-month periods ended September 28, 2001 and September 30, 2000 (dollars in thousands): Amount Percent ------------------- Net revenues: Net revenues from clearing operations $ (7,967) (52%) Commissions 421 3% Net interest (7,427) (33%) Investment banking, advisory and administrative fees 469 5% Net gains on principal transactions 3,187 40% Other (2,974) (44%) ------------------- (14,291) (19%) ------------------- Operating expenses: Commissions and other employee compensation (3,473) (10%) Occupancy, equipment and computer service costs 1,863 24% Communications 638 18% Floor brokerage and clearing organization charges (218) (12%) Advertising and promotional (857) (22%) Other (2,296) (22%) ------------------- (4,343) (7%) ------------------- Income before income taxes and minority interest $ (9,948) (72%) =================== Net Revenues from Clearing Operations. Net revenues from clearing decreased as a result of a decrease in transaction volumes and lower clearing fees per transaction. Total transactions processed in the first quarter of fiscal 2002 decreased 12% to approximately 11.9 million from approximately 13.5 million in fiscal 2001. Trade volume was reduced due to fewer trading days in the fiscal 2002 first quarter as well as general market conditions. Margin pressure also impacted net clearing revenues in the first quarter of fiscal 2002 as average revenue per trade declined to $.61 from $1.12 in the first quarter of fiscal 2001. Commissions. Commission revenue increased slightly, despite fewer trading days, in the first quarter of fiscal 2002 over the comparable period in fiscal 2001. Increased commissions generated by the Company's fixed income, institutional sales and trading departments were offset by decreased commissions from the SWS Financial Services, Inc. ("SWSFS") independent contractor network and Mydiscountbroker.com, Inc. ("MDB"), the Company's on-line brokerage subsidiary. Although MDB commissions decreased, core accounts at MDB increased 25% to 24,531 at September 28, 2001 from 19,654 at September 29, 2000. May, acquired in February 2001, generated $1.1 million in commissions in the first quarter of fiscal 2002. Commission revenue by type of representative is as follows (dollars in thousands): 2002 2001 ---------------------- ---------------------- Commission No. of Commission No. of Revenue Reps Revenue Reps -------------------------------------------------- SWS, Inc. brokers $ 8,567 128 $ 8,379 111 Independent contractors 4,280 452 5,785 544 Other 3,238 1,500 ---------- ----------- $16,085 $15,664 ========== =========== 14 Net Interest Income. The Company's net interest income is dependent upon the level of customer and stock loan balances as well as the spread between the rates it earns on those assets compared with the cost of funds. Net interest is the primary source of income for FSB and represents the amount by which interest and fees generated by earning assets exceed the cost of funds, primarily interest paid to FSB's depositors on interest-bearing accounts. The components of interest earnings are as follows for the first quarters of fiscal years 2002 and 2001 (in thousands): 2002 2001 ------- ------- Interest revenue: Customer margin accounts $ 6,716 $17,624 Assets segregated for regulatory purposes 3,231 4,302 Stock borrowed 15,794 40,114 Loans 11,726 11,383 Other 2,163 3,142 ------- ------- $39,630 $76,565 ------- ------- Interest expense: Customer funds on deposit $ 4,958 $13,148 Stock loaned 13,669 35,085 Deposits 4,492 4,171 Other 1,425 1,648 ------- ------- 24,544 54,052 ------- ------- Net interest $15,086 $22,513 ======= ======= Brokerage Group. For the three months ended September 28, 2001, net interest income accounted for 14% of the Company's net revenue versus 20% for the three months ended September 29, 2000. Interest revenue from customer margin balances and interest expense from customer funds on deposit have fluctuated in relation to average balances over the past two fiscal years. Net interest revenue generated from securities lending activities has decreased as have average balances borrowed and loaned in the current fiscal year versus the prior year. Average balances of interest-earning assets and interest-bearing liabilities are as follows for the first quarters of fiscal years 2002 and 2001 (in thousands): 2002 2001 --------------------------- Average interest-earning assets: Customer margin balances $ 392,000 $ 684,000 Stock borrowed 2,037,000 2,728,000 Average interest-bearing liabilities: Customer funds on deposit 669,000 736,000 Stock loaned 2,037,000 2,718,000 Rates on customer margin balances and funds on deposit are influenced by changes in leading market interest rates and competitive factors. Spreads on securities lending transactions are influenced by the types of securities borrowed or loaned, market conditions and counter-party risk. Banking Group. Net interest revenue generated by the Bank accounted for approximately 10% of net revenue in the first quarter of fiscal 2002 and 9% in the first quarter of fiscal 2001. At the Bank, changes in net interest revenue are generally attributable to the timing of loan payoffs and volume. 15 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 first quarters of fiscal years 2002 and 2001 (dollars in thousands):
2002 2001 ---------------------------------------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate -------------------------- ------------------------- Assets: Interest-earning assets: Real estate - mortgage $154,674 $ 3,609 9.3% $ 97,239 $ 3,027 12.5% Real estate - construction 118,987 2,490 8.4% 86,695 2,530 11.7% Commercial 105,772 2,966 11.2% 79,353 2,559 12.9% Individual 31,691 1,853 23.4% 25,982 2,125 32.7% Land 37,078 808 8.7% 38,120 1,142 12.0% Investments 9,388 97 4.1% 10,693 185 6.9% ------------------ ------------------ 457,590 $11,823 10.3% 338,082 $11,568 13.7% Noninterest-earning assets: Cash and due from banks 2,281 4,052 Other assets 12,016 7,270 -------- -------- $471,887 $349,404 ======== ======== Liabilities and Stockholders' Equity: Interest-bearing liabilities: Certificates of deposit $290,161 $ 4,307 5.9% $247,567 $ 4,010 6.5% Money market accounts 17,118 139 3.2% 12,152 139 4.6% Interest-bearing demand accounts 6,094 43 2.8% 2,507 19 3.0% Savings accounts 641 3 1.9% 498 3 2.4% Federal Home Loan Bank ("FHLB") advances 86,955 916 4.2% 33,506 562 6.7% Notes payable 1,933 52 10.8% 1,317 111 33.7% ------------------ ------------------ 402,902 5,460 5.4% 297,547 4,844 6.5% Noninterest-bearing liabilities: Non interest-bearing demand accounts 17,761 12,811 Other liabilities 9,687 5,881 -------- -------- 430,350 316,239 Stockholders' equity 41,537 33,165 -------- -------- $471,887 $349,404 ======== ======== -------- -------- Net interest income $ 6,363 $ 6,724 ======== ======== Net yield on interest-earning assets 5.6% 8.0% ====== ======
Interest rate trends, changes in the economy and the scheduled maturities and interest rate sensitivity of the investment and loan portfolios and deposits affect the spreads earned by FSB. The following table sets forth a summary of the changes in the Bank's interest earned and interest paid resulting from changes in volume and rate (dollars in thousands): 2002 vs. 2001 --------------------------------------- Attributed to Total ----------------------------- Change Volume Rate Mix --------------------------------------- Interest income: Real estate - mortgage $ 582 $1,788 $ (758) $(448) Real estate - construction (40) 942 (716) (266) Commercial 407 851 (333) (111) Individual (272) 467 (606) (133) Land (334) (31) (311) 8 Investments (88) (26) (64) 2 --------------------------------------- $ 255 $3,991 $(2,788) $(948) --------------------------------------- 16 2002 vs. 2001 --------------------------------------- Attributed to Total ----------------------------- Change Volume Rate Mix --------------------------------------- Interest expense: Certificates of deposit $ 297 $ 690 $ (335) $ (58) Money market accounts -- 57 (40) (17) Interest-bearing demand accounts 24 26 (1) (1) Savings accounts -- 1 (1) -- Federal Home Loan Bank advances 354 903 (179) (370) Notes payable (59) 52 (76) (35) --------------------------------------- 616 1,729 (632) (481) --------------------------------------- Net interest income $(361) $2,262 $(2,156) $(467) ======================================= Net Gains on Principal Transactions. For the three months ended September 28, 2001 and September 29, 2000, $2,210,000 and $2,866,000, respectively, represent net gains realized on the sale of approximately 200,000 shares and 91,000 shares, respectively, of Knight common stock to fund MDB's advertising commitments. Net gains also includes the previously mentioned $7.2 million gain related to SFAS No. 133 in the first quarter of fiscal 2002. Excluding these items, net gains on principal transactions from the Company's trading operations were $1,775,000 and $5,162,000 for the three-month periods ended September 28, 2001 and September 29, 2000, respectively. The decrease is attributed to a weakened trading environment in both the equity and fixed income markets in the first quarter of fiscal 2002 and to fewer trading days as a result of the closure of the U.S. financial markets following September 11. Coverage from market making activities has increased to 728 over-the-counter securities and 555 exchange-listed securities from 667 over-the-counter securities and 410 exchange-listed securities. Revenue in this area can fluctuate significantly from quarter to quarter based on market conditions. Other Income. Other income decreased due to reduced non-interest income from the Bank, as well as decreased revenue from the sale of insurance products. Additionally, in the first quarter of fiscal 2001, the Company recorded an $837,000 gain related to SFAS No. 133 in other income, whereas in the first quarter of fiscal 2002, the Company recorded a $150,000 loss in other expense related to SFAS No. 133. Commissions and Other Employee Compensation. Commissions and other employee compensation are generally affected by the level of operating revenues, earnings and the number of employees. During the three month period ended September 28, 2001, commissions and other employee compensation expense decreased 10% over the same period in the prior year. The decrease in compensation was principally due to decreased commissions and benefits paid to revenue-producing employees generating lower levels of operating income. Additionally, accruals for profit sharing and incentive compensation decreased over the prior year due to the operating performance of the Company. The number of full-time employees also decreased to 1,073 at September 28, 2001 compared to 1,097 at September 29, 2000. Occupancy, Equipment and Computer Service Costs. Occupancy, equipment and computer service costs increased for three month period ended September 28, 2001 over the same period of the prior year due to an increase in leased computer hardware related to the implementation of its new brokerage software, Comprehensive Software Systems, Ltd. ("CSS"). Advertising and Promotional. Advertising and promotional expense decreased in fiscal 2001 over the prior year as a result of reduced expenditures on the MDB ad campaign. The Company sold shares of Knight common stock to offset the advertising commitments. Gains on the sale of Knight stock to fund the MDB advertising were $2.2 million and $2.9 million in fiscal 2002 and 2001, respectively. The Company has committed to spending approximately $1.6 million to expand and promote MDB during the remainder of calendar 2001. Other Expense. Other expense decreased due to reduced use of contract labor and professional consulting services in the operations and information systems areas in the first quarter of fiscal 2002 over 2001. 17 The number of independent contractors decreased 83% to 13 at September 28, 2001 from 76 at September 29, 2000. FINANCIAL CONDITION Loans and Allowance for Possible Loan Losses. The Bank grants loans to customers primarily within the Dallas/Fort Worth, Texas metropolitan area. Also, the Bank purchases loans, in the ordinary course of business, which have been originated in various other areas of the United States. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the general economic conditions of the area. Substantially all of the Bank's loans are collateralized with real estate or automobiles. Loans receivable at September 28, 2001 and June 29, 2001 are summarized as follows (in thousands): 2002 2001 -------- -------- Real estate - mortgage $154,814 $187,967 Real estate - construction 135,544 126,771 Commercial 99,231 92,855 Individuals 36,284 31,982 Land 32,685 35,399 -------- -------- $458,558 $474,974 ======== ======== The following table shows the expected life of certain loans at September 28, 2001, 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 $ 27,843 $26,767 $44,621 $ 99,231 Real estate - construction 129,095 3,215 3,234 135,544 --------------------------------------- Total $156,938 $29,982 $47,855 $234,775 ======================================= Amount of loans based upon: Fixed interest rates $ 4,194 $10,744 $25,787 $ 40,725 Floating or adjustable interest rates 152,744 19,238 22,068 194,050 --------------------------------------- Total $156,938 $29,982 $47,855 $234,775 =======================================
Loans are classified as non-performing when they are 90 days or more past due as to principal or interest or when reasonable doubt exists as to timely collectibility. A standardized review process exists to determine which loans should be placed on non-accrual status. At the time a loan is placed on non- accrual status, previously accrued and uncollected interest is reversed against interest income. Interest income on non-accrual loans is credited to income on a cash basis. Non-performing assets as of September 28, 2001 and June 29, 2001 are as follows (dollars in thousands): 2002 2001 ------ ------ Loans accounted for on a non-accrual basis $5,258 $4,084 ====== ====== Non-performing loans as a percentage of total loans 1.1% 0.9% ====== ====== Loans past due 90 days or more, not included above $ 595 $ 608 ====== ====== Troubled debt restructurings $ 916 $ 446 ====== ====== 18 An analysis of the allowance for possible loan losses for the first quarters of fiscal 2002 and 2001 is as follows (dollars in thousands): 2002 2001 ------ ------- Balance at beginning of period $3,280 $ 3,699 Charge-offs: Real estate - mortgage -- 5 Individuals 360 1,598 ------ ------- 360 1,603 Recoveries: Real estate - mortgage -- 1 Individuals 155 24 ------ ------- 155 25 ------ ------- Net charge-offs (205) (1,578) Additions charged to operations 295 529 ------ ------- Balance at end of period $3,370 $ 2,650 ====== ======= Ratio of net charge-offs during the period to average loans outstanding during the period 0.0% 0.5% ====== ======= The allowance for possible loan losses is applicable to the following types of loans as of September 28, 2001 and June 29, 2001 (dollars in thousands): 2002 2001 -------------------- -------------------- Percent of Percent of loans to loans to Amount total loans Amount total loans ---------------------------------------------- Commercial $ 487 6.7% $ 462 19.6% Real estate - construction 1,033 29.4 837 26.7 Real estate - mortgage 776 56.9 689 47.0 Individuals 816 7.0 797 6.7 Unallocated 258 -- 495 -- -------------------- -------------------- $3,370 100.0% $3,280 100.0% ==================== ==================== Deposits. Average deposits and the average interest rate paid on the deposits for the first quarters of fiscal 2002 and 2001 are summarized as follows (dollars in thousands): 2002 2001 ------------------ ------------------ Interest Interest Amount Rate Amount Rate --------------------------------------- Noninterest bearing demand accounts $ 17,761 $ 12,811 Interest bearing demand accounts 6,094 2.8% 2,507 3.0% Savings accounts 641 1.9 498 2.4 Limited access money market accounts 17,118 3.2 12,152 4.6 Certificates of deposit 290,161 5.9 247,567 6.5 -------- -------- $331,775 5.7% $275,535 6.4% ======== ======== Certificates of deposit of $100,000 or greater were $102,527,000 and $114,538,000 at September 28, 2001 and June 29, 2001, respectively. 19 Advances from Federal Home Loan Bank. The Bank finances its short-term borrowing needs through advances from the FHLB. This table represents advances from the FHLB which were due within one year, generally 2-7 days, during the first quarters of fiscal 2002 and 2001 (dollars in thousands): 2002 2001 ------------------ ------------------- Interest Interest Amount Rate Amount Rate ---------------------------------------- At end of quarter $ 99,036 3.2% $ 7,000 6.6% Average during quarter 74,973 4.8% 24,637 6.7% Maximum month-end balance during year 110,393 -- 48,100 -- LIQUIDITY AND CAPITAL RESOURCES Brokerage Group. The Company's assets are substantially liquid in nature and consist mainly of cash or assets readily convertible into cash. These assets are financed by the Company's equity capital, short-term bank borrowings, interest bearing and non-interest bearing client credit balances, Correspondent deposits and other payables. The Company maintains an allowance for doubtful accounts which represents amounts, in the judgment of management, that are necessary to adequately absorb losses from known and inherent risks in receivables from clients, clients of Correspondents and Correspondents. The Company has credit arrangements with commercial banks, which include broker loan lines up to $360,000,000. 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 credit arrangements are provided on an "as offered" basis and are not committed lines of credit. Outstanding balances under these credit arrangements are due on demand, bear interest at rates indexed to the federal funds rate and are collateralized by securities of the Company and its clients. At September 28, 2001, there was $2.3 million outstanding under these secured arrangements which were fully collateralized by securities held in customer margin accounts with a market value of approximately $14 million. In the opinion of management, these credit arrangements are adequate to meet the short-term operating needs of the Company. The Company also has an irrevocable letter of credit agreement aggregating $55,000,000 at September 28, 2001 pledged to support its open options positions with an options clearing organization. The letter of credit bears interest at the brokers' call rate, if drawn, and is renewable annually. This letter of credit is fully collateralized by marketable securities held in clients' and nonclients' margin accounts with a value of $77,254,000 at September 28, 2001. In addition to the broker loans lines, the Company has a $20,000,000 unsecured line of credit that is due on demand and bears interest at rates indexed to the federal funds rate. There were no amounts outstanding under this line of credit at September 28, 2001. The Company has issued $57.5 million of Notes due June 30, 2004. At maturity, the principal of the Notes will be paid in shares of the Class A common stock of Knight or, at the option of the Company, their cash equivalent. The Notes, which are in the form of DARTS(SM) (or, "Derivative Adjustable Ratio Securities(SM)"), were issued in denominations of $56.6875, the closing bid price of Knight on June 10, 1999. At maturity, Noteholders are entitled to one share of Knight common stock for each DARTS if the average price for the 20 days immediately preceding the Notes' maturity is equal to or less than the DARTS issue price. Noteholders are entitled to .833 shares of Knight common stock for each DARTS if the average price of Knight's common stock is 20% or more greater than the DARTS' issue price. If the average price of the Knight common stock is between the Notes' issue price and 20% greater than the issue price, the exchange rate will be determined by a formula. At September 28, 2001, the Company had 373,550 DARTS outstanding with a face value of $21.2 million. After adjusting for the impact of SFAS No. 133, the DARTS are recorded at $7.6 million on the consolidated statements of financial condition at September 28, 2001. 20 The Company's broker/dealer subsidiaries are subject to the requirements of the Securities and Exchange Commission relating to liquidity, capital standards and the use of client funds and securities. The Company has historically operated in excess of the minimum net capital requirements. Banking Group. FSB's asset and liability management policy is intended to manage interest rate risk. FSB accomplishes this through management of the 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. Liquidity is monitored daily to ensure the ability to support asset growth, meet deposit withdrawals, lending needs, maintain reserve requirements, and otherwise sustain operations. FSB's liquidity is maintained in the form of readily marketable loans, balances with the FHLB, vault cash, and advances from the FHLB. In addition, FSB has significant borrowing capacity with the FHLB for the purpose of purchasing short-term funds should additional liquidity be needed. Management believes that FSB's present position is adequate to meet its current and future liquidity needs. FSB is subject to extensive capital standards imposed by regulatory bodies, including the Office of Thrift Supervision and the Federal Deposit Insurance Corporation. FSB has historically met all the capital adequacy requirements to which it is subject. Cash Flow. Net cash provided by operating activities during the three-month period ended September 28, 2001 was $33,047,000. The cash was provided by the change in the net receivables from customers, net of the changes in the net receivable from brokers, dealers and clearing organizations and increased assets segregated for regulatory purposes. 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, equity prices, and changes in credit ratings of the issuer. The Company's exposure to market risk is directly related to its role as a financial intermediary in customer-related transactions and to its proprietary trading activities. Interest Rate Risk. Interest rate risk is a consequence of maintaining inventory positions and trading in interest-rate-sensitive financial instruments. The Company does not maintain material positions in interest-rate- sensitive financial instruments. The Company's fixed income activities also expose it 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. At FSB, interest rate risk arises when an interest-earning asset matures or when its rate of interest changes in a timeframe different from that of the supporting interest-bearing liability. Equity Price Risk. The Company is exposed to equity price risk as a result of making markets and taking proprietary positions in equity securities. Equity price risk results from changes in the level or volatility of equity prices, which affect the value of equity securities or instruments that derive their value from a particular stock, a basket of stocks or a stock index. In accordance with the Securities and Exchange Commission's risk disclosure requirements, the following table categorizes securities owned, net of securities sold, not yet purchased which are in the Company's 21 trading portfolio, as well as marketable equity securities in the Company's available-for-sale portfolio, which are subject to interest rate and equity price risk (in thousands):
Years to Maturity 1 or less 1 to 5 5 to 10 Over 10 Total - ---------------------------------------------------------------------------------------------------------- Trading securities, at fair value Municipal obligations $ (25) $ 2,810 $ 3,232 $16,777 $ 22,794 U.S. Government and Government agency obligations 3,156 1,913 1,021 975 7,065 Corporate obligations 1,586 11,096 15,394 9,525 37,601 -------------------------------------------------------------------- Total debt securities 4,717 15,819 19,647 27,277 67,460 Corporate equity -- -- -- 19,575 19,575 Funds & trusts 25,169 -- -- -- 25,169 Other 10 -- -- -- 10 -------------------------------------------------------------------- $29,896 $15,819 $19,647 $46,852 $112,214 ==================================================================== Weighted average yield Municipal obligations 3.1% 4.1% 4.3% 4.5% 4.4% U.S. Government and Government agency obligations 2.6% 3.5% 3.1% 6.9% 3.5% Corporate obligations 9.8% 6.5% 6.2% 10.9% 7.6% Available-for-sale securities, at fair value Marketable equity securities $ -- $ -- $ -- $ 5,445 $ 5,445 ====================================================================
Exchangeable Subordinated Debt. In addition to the financial instruments included in the above table, the Company has 373,550 DARTS outstanding with a face value of $21.2 million. These Notes mature June 30, 2004 and bear a fixed coupon of 5%. Market risks associated with the DARTS include equity price risk, in that the amount that the Company will pay at maturity depends on the value of Knight common stock. As such, these Notes contain an embedded equity derivative which is subject to accounting treatment under SFAS No. 133. SFAS No. 133 requires fair value recognition of the DARTS' embedded derivative in the consolidated statements of financial condition. Changes in the fair value of the embedded derivative are required to be recognized in earnings, along with the change in fair value of the Knight shares. Credit Risk. Credit risk arises from the potential nonperformance by counterparties, customers or debt security issuers. The Company is exposed to credit risk as a trading counterparty to dealers and customers, as a holder of securities and as a member of exchanges and clearing organizations. Credit exposure is also associated with customer margin accounts, which are monitored daily. The Company monitors exposure to industry sectors and individual securities and performs sensitivity analysis on a regular basis in connection with its margin lending activities. The Company adjusts its margin requirements if it believes its risk exposure is not appropriate based on market conditions. Managing Risk Exposure. The Company manages risk exposure through the involvement of various levels of management. Position limits in trading and inventory accounts are well established and monitored on an ongoing basis. Current and proposed underwriting, banking and other commitments are subject to due diligence reviews by senior management, as well as professionals in the appropriate business and support units involved. FSB 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", by 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. The Company monitors its exposure to counterparty risk through the use of credit exposure information, the monitoring of collateral values and the establishment of credit limits. 22 Item 3. Quantitative and Qualitative Disclosures About Market Risk The information required by this item is incorporated in Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations under the caption Market Risk. PART II. OTHER INFORMATION Item 1. Legal Proceedings None Reportable (229.103) Item 2. Changes in Securities and Use of Proceeds None Reportable (Per Instructions to Form 10-Q) Item 3. Defaults upon Senior Securities None Reportable (Per Instructions to Form 10-Q) Item 4. Submission of Matters to a Vote of Security Holders None Reportable (Per Instructions to Form 10-Q) Item 5. Other Information None Reportable (Per Instructions to Form 10-Q) Item 6. Exhibits and Reports on Form 8-K None Reportable (Per Instructions to Form 10-Q) 23 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Southwest Securities Group, Inc. -------------------------------------- (Registrant) November 13, 2001 /S/ David Glatstein - ----------------- -------------------------------------- Date (Signature) David Glatstein President and Chief Executive Officer (Principal Executive Officer) November 13, 2001 /S/ Stacy M. Hodges - ----------------- -------------------------------------- Date (Signature) Stacy M. Hodges Treasurer and Chief Financial Officer (Principal Financial Officer) November 13, 2001 /S/ Laura Leventhal - ----------------- -------------------------------- Date (Signature) Laura Leventhal Controller (Principal Accounting Officer) 24 -----END PRIVACY-ENHANCED MESSAGE-----