SWS GROUP INC

Included in the balance of securities sold, not yet purchased-U.S. government and government agency obligations, are $1,972,000 of “to-be-announced” securities (“TBAs”). TBAs are purchase and sale agreements of forward mortgage-backed securities whose collateral remains to-be-announced until just prior to the trade settlement. The TBAs are accounted for as derivatives under Accounting Standards Codification (“ASC”) 815  “Derivatives and Hedging.” The Company does not apply hedge accounting for these TBA securities.  Accordingly, the securities are carried at fair value with unrealized and realized gains recorded in net gains on principal transactions on the Consolidated Statements of Comprehensive Loss.  All of the Company’s derivative transactions are entered into to facilitate customer transactions. 

The loan is recorded as a liability with an interest rate of 8% per annum, a five year term and an effective interest rate of 14.9%. At July 29, 2011, the discount on the loan was initially valued at $24,136,000 and is being accreted using the effective interest method. At September 26, 2014, the long-term debt balance was $89,048,000, which is shown net of a  total unaccreted discount of $10,952,000, and upon exercise of the warrants at September 26, 2014, the company extinguished $37,500,000 of the amount outstanding due to Oak Hill, which had a carrying value, net of unaccreted discount, of $33,393,000,  and as a result recognized a loss on the early extinguishment of debt of $4,107,000, which was recorded as a  loss on early extinguishment of debt on the Consolidated Statements of Comprehensive Loss. For the three-months ended September 30, 2014, the Company recorded $1,279,000 in accretion expense on the discount.  In comparison, for the three-months ended September 30, 2013, the Company recorded $1,103,000 in accretion expense on the discount.  The resulting long-term debt balance at September 30, 2014, after exercise of the warrants, and June 30, 2014 was $55,655,000 and $87,769,000, respectively.  For the three-months ended September 30, 2014 and September 30, 2013, the cash portion of the interest expense paid on the loan to Hilltop and Oak Hill was $1,967,000 and $2,000,000, respectively.

Additionally, as a result of Oak Hill’s exercise of their warrants on September 26, 2014, we expensed  $0.3 million of deferred debt issuance costs, which was recorded in interest expense on the Consolidated Statements of Comprehensive Loss, and recognized a loss of $4.1 million on the extinguishment of debt, which was recorded as a loss on early extinguishment of debt on the Consolidated Statements of Comprehensive Loss.  As Oak Hill exercised its warrants prior to maturity, we also recognized a $0.5 million gain representing the time to maturity portion of the warrant fair value recorded in unrealized gain on warrants valuation on the Consolidated Statements of Comprehensive Loss.

In the institutional segment, net revenues decreased 16% and pre-tax income decreased 28% for the three-months ended September 30, 2014 as compared to the three-months ended September 30, 2013.  The decline in net revenues was primarily due to a $3.9 million decrease in net gains on principal transactions with the municipal finance business down $2.5 million and the taxable fixed income business down $1.4 million as a result of less robust trading activity when compared to the same period in the prior fiscal year.    Additionally, investment banking and advisory fees and commissions revenue decreased $0.9 million and $0.7 million, respectively.  Investment banking and advisory fees in our municipal finance business decreased $0.6 million while our taxable fixed income fees were down $0.3 million.  The fee decline in both businesses was a result of fewer underwriting transactions.  Municipal finance recorded a $1.1 million decline and taxable fixed income recorded a $0.8 million decline in commissions revenue as a result of the tighter spreads and a decline in municipal new issue volume.  Portfolio trading commissions revenue was up $1.2 million primarily due to increased customer activity.  These decreases were offset by a $0.9 million increase in net interest revenue. The increase in net interest revenue is primarily due to 24% increase in our average stock borrowed portfolio balances and a 12 basis point increase in the net interest spread earned in our stock lending business.

Operating expenses decreased $2.9 million for the three-months ended September 30, 2014 as compared to the three-months ended September 30, 2013.  This decrease is primarily due to a $2.6 million decrease in commissions and other employee compensation due to the staff reductions made in September 2013 and the lower commissions paid as a result of lower revenues in the first three-months of fiscal 2015 compared to the same period of fiscal 2014.

On October 2, 2014, Hilltop exercise its warrant to purchase 8,695,652 shares of SWS Group common stock for $5.75 per share paid by automatically reducing the amount outstanding due to Hilltop as a lender under the Credit Agreement by $50,000,000, as required by the terms of the warrant.

The sales of the above securities were deemed exempt from registration under Section 4(a)(2) and Regulation D of the Securities Act of 1933, as amended (the “Securities Act”), as a transaction not involving a public offering. All of the foregoing securities are deemed restricted securities for purposes of the Securities Act. The recipients of securities in the transactions exempt under Section 4(a)(2) and Regulation D of the Securities Act represented their intention to acquire the securities for investment purposes only and not with a view to or for sale in connection with any distribution thereof and appropriate legends were affixed to shares of common stock or restricted stock issued in such transactions.