SWS (SWS) 10-Q 2006 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

Form 10-Q

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

For the quarterly period ended December 30, 2005

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

SWS GROUP, INC.

(Exact name of registrant as specified in its charter)

Delaware	75-2040825
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer 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  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨                Accelerated filer  x                Non-accelerated filer  ¨

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

As of February 3, 2006, there were 17,615,153 shares of the registrant’s common stock, $.10 par value, outstanding.

SWS GROUP, INC. AND SUBSIDIARIES

INDEX

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
	Consolidated Statements of Financial Condition December 30, 2005 and June 24, 2005(unaudited)	1
	Consolidated Statements of Income and Comprehensive Income For the three and six months ended December 30, 2005 and December 31, 2004(unaudited)	2
	Consolidated Statements of Cash Flows For the six months ended December 30, 2005 and December 31, 2004(unaudited)	3
	Notes to Consolidated Financial Statements(unaudited)	5
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
Item 3.Quantitative and Qualitative Disclosures About Market Risk		41
Item 4.Controls and Procedures		41
PART II. OTHER INFORMATION
Item 1.Legal Proceedings		41
Item 2.Unregistered Sales of Equity Securities and Use of Proceeds		42
Item 3.Defaults Upon Senior Securities		42
Item 4.Submission of Matters to a Vote of Security Holders		42
Item 5.Other Information		42
Item 6.Exhibits		42
SIGNATURES		43
EXHIBIT INDEX		44

SWS Group, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

December 30, 2005 and June 24, 2005

(In thousands, except par values and share amounts)

(Unaudited)

	December			June
Assets
Cash	$	27,607		$	23,045
Assets segregated for regulatory purposes		367,641			330,788
Marketable equity securities available for sale		3,077			2,372
Receivable from brokers, dealers and clearing organizations		2,427,645			2,855,296
Receivable from clients, net		366,407			372,143
Loans held for sale, net		136,857			172,023
Loans, net		647,434			591,857
Securities owned, at market value		176,407			166,954
Securities purchased under agreements to resell		34,107			28,890
Goodwill		11,746			11,660
Other assets		70,153			76,116
	$	4,269,081		$	4,631,144
Liabilities and Stockholders’ Equity
Short-term borrowings	$	47,300		$	68,400
Payable to brokers, dealers and clearing organizations		2,318,032			2,755,076
Payable to clients		643,387			609,477
Deposits		642,028			587,978
Securities sold under agreements to repurchase		29,417			8,061
Securities sold, not yet purchased, at market value		115,106			106,163
Drafts payable		37,401			32,018
Advances from Federal Home Loan Bank		75,189			93,539
Bank borrowings		27,950			47,150
Other liabilities		52,261			56,346
		3,988,071			4,364,208
Minority interest in consolidated subsidiaries		1,273			1,166
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 18,048,475 and outstanding 17,484,402 shares at December 30, 2005; issued 17,977,240 and outstanding 17,329,779 shares at June 24, 2005		1,804			1,797
Additional paid-in capital		250,903			248,955
Retained earnings		36,012			23,920
Accumulated other comprehensive income – unrealized holding gain net of tax of $314 at December 30, 2005 and $66 at June 24, 2005		598			138
Deferred compensation, net		(907	)		529
Treasury stock (564,073 shares at December 30, 2005 and 647,461 shares at June 24, 2005, at cost)		(8,673	)		(9,569	)
Total stockholders’ equity		279,737			265,770
Commitments and contingencies
	$	4,269,081		$	4,631,144

See accompanying Notes to Consolidated Financial Statements.

1

SWS Group, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

For the three and six months ended December 30, 2005 and December 31, 2004

(In thousands, except per share and share amounts)

(Unaudited)

	For the Three Months Ended						For the Six Months Ended
	December 30, 2005			December 31, 2004			December 30, 2005			December 31, 2004
Net revenues from clearing operations	$	3,449		$	3,724		$	7,166		$	7,391
Commissions		25,056			24,304			46,126			43,529
Interest		55,307			38,167			112,175			65,519
Investment banking, advisory and administrative fees		6,931			6,459			16,107			13,306
Net gains on principal transactions		3,844			3,456			8,844			25,772
Other		7,147			5,122			13,115			10,338
		101,734			81,232			203,533			165,855
Commissions and other employee compensation		38,680			35,853			77,698			67,346
Interest		32,158			17,442			65,349			27,722
Occupancy, equipment and computer service costs		6,078			6,699			11,838			13,566
Communications		2,338			3,098			4,822			6,185
Floor brokerage and clearing organization charges		798			1,587			2,093			3,169
Advertising and promotional		709			1,093			1,398			1,925
Other		7,423			8,120			15,676			13,946
		88,184			73,892			178,874			133,859
Income before income tax expense and minority interest in consolidated subsidiaries		13,550			7,340			24,659			31,996
Income tax expense		4,723			2,546			8,706			11,052
Income before minority interest in consolidated subsidiaries		8,827			4,794			15,953			20,944
Minority interest in consolidated subsidiaries		(62	)		(253	)		(91	)		(515	)
Income before cumulative effect of a change in accounting principle		8,765			4,541			15,862			20,429
Cumulative effect of a change in accounting principle, net of tax of $40.		—			—			75			—
Net income		8,765			4,541			15,937			20,429
Other comprehensive income (loss):
Holding gains and losses arising during the three and six months ended December 30, 2005, net of tax of $109 and $248 and the three and six months ended December 31, 2004, net of tax of ($138) and ($169).		202			327			460			166
Reclassification for hedging activities, net of tax of $9.		—			—			—			17
Reclassification for delivery of Knight shares in settlement of DARTSSM obligation, net of tax of $6,262.		—			—			—			(12,471	)
Net income (loss) recognized in other comprehensive income		202			327			460			(12,288	)
Comprehensive income	$	8,967		$	4,868		$	16,397		$	8,141
Earnings per share - basic
Income before cumulative effect of change in accounting principles	$	0.51		$	0.27		$	0.91		$	1.19
Cumulative effect of change in accounting principles		—			—			0.01			—
Net income	$	0.51		$	0.27		$	0.92		$	1.19
Weighted average shares outstanding – basic		17,353,831			17,181,347			17,340,925			17,158,916
Earnings per share – diluted
Income before cumulative effect of change in accounting principles	$	0.50		$	0.26		$	0.90		$	1.18
Cumulative effect of change in accounting principles		—			—			0.01			—
Net income	$	0.50		$	0.26		$	0.91		$	1.18
Weighted average shares outstanding – diluted		17,615,354			17,436,580			17,564,369			17,340,738

See accompanying Notes to Consolidated Financial Statements.

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SWS Group, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the six months ended December 30, 2005 and December 31, 2004

(In thousands)

(Unaudited)

	For the Six Months Ended
	December 30, 2005			December 31, 2004
Cash flows from operating activities:
Net income	$	15,937		$	20,429
Cumulative effect of a change in accounting principle		(75	)		—
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		2,875			3,149
Amortization of discounts on loans purchased		(454	)		(609	)
Provision for doubtful accounts		5,242			2,598
Deferred income tax expense		(496	)		(2,787	)
Deferred compensation		1,009			635
Gain on sale of loans		(1,232	)		(349	)
Loss on sale of fixed assets		50			51
Loss on sale of real estate		121			3
Gain on delivery of Knight shares in settlement of DARTSSM obligation		—			(18,732	)
Dividend received on investment in Federal Home Loan Bank stock		(56	)		—
Equity (gains) losses on investments		(1,431	)		1,350
Net change in minority interest in consolidated subsidiaries		107			199
Change in operating assets and liabilities:
Increase in assets segregated for regulatory purposes		(36,853	)		(14,273	)
Net change in broker, dealer and clearing organization accounts		(9,393	)		(59,854	)
Net change in client accounts		39,166			21,407
Net change in loans held for sale		35,166			(35,227	)
Increase in securities owned		(9,453	)		(8,547	)
Increase in securities purchased under agreements to resell		(5,217	)		(43,524	)
(Increase) decrease in other assets		1,672			(3,019	)
Increase in drafts payable		5,383			7,517
Increase in securities sold, not yet purchased		8,943			38,337
Decrease in other liabilities		(3,495	)		(2,616	)
Windfall tax benefits		(22	)		—
Net cash provided by (used in) operating activities		47,494			(93,862	)
Cash flows from investing activities:
Purchase of fixed assets		(1,051	)		(2,235	)
Purchase of real estate		(12	)		(538	)
Proceeds from the sale of fixed assets		76			51
Proceeds from the sale of real estate		2,465			2,528
Loan originations and purchases		(327,835	)		(277,823	)
Loan repayments		266,195			214,447
Cash paid for purchase of O’Connor		(86	)		(360	)
Cash paid on investments		(500	)		(1,443	)
Cash received on investments		1,630			20
Proceeds from the sale of Federal Home Loan Bank stock		2,708			—
Purchases of Federal Home Loan Bank stock		(487	)		(556	)
Net cash used in investing activities		(56,897	)		(65,909	)
Cash flows from financing activities:
Payments on short-term borrowings		(1,218,200	)		(1,014,965	)
Cash proceeds from short-term borrowings		1,197,100			1,074,390
Payments on capital leases		—			(253	)
Increase in deposits		54,050			9,108
Increase (decrease) in advances from Federal Home Loan Bank		(18,350	)		12,333
Cash payments on notes payable – Bank		(27,300	)		—
Cash proceeds on notes payable – Bank		8,100			10,050

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	For the Six Months Ended
	December 30, 2005			December 31, 2004
Payment of cash dividends on common stock – SWS Group		(3,505	)		(3,459	)
Windfall tax benefits		22			—
Cash proceeds on securities sold under agreements to repurchase		21,356			—
Net proceeds from exercise of stock options		1,024			1,379
Proceeds related to the Deferred Compensation Plan		145			161
Purchase of treasury stock		(477	)		(161	)
Net cash provided by financing activities		13,965			88,583
Net increase (decrease) in cash		4,562			(71,188	)
Cash at beginning of period		23,045			88,589
Cash at end of period	$	27,607		$	17,401
Supplemental schedule of non-cash investing and financing activities:
Granting of Restricted Stock	$	2,074		$	948
Delivery of Knight shares in settlement of DARTSSM obligation	$	—		$	18,732
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest	$	64,626		$	27,234
Taxes	$	4,550		$	9,150

See accompanying Notes to Consolidated Financial Statements.

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SWS Group, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

Three and Six Months Ended December 30, 2005 and December 31, 2004

(Unaudited)

GENERAL AND BASIS OF PRESENTATION

The interim consolidated financial statements as of December 30, 2005, and for the three and six-month periods ended December 30, 2005 and December 31, 2004, 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 24, 2005 filed on Form 10-K. Amounts included for June 24, 2005 are derived from the audited consolidated financial statements as filed on Form 10-K. All significant intercompany balances and transactions have been eliminated. Certain amounts in fiscal 2005 have been reclassified to conform to the 2006 presentation.

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

Brokerage Group
Southwest Securities, Inc.	“Southwest Securities”
SWS Financial Services, Inc.	“SWS Financial”
Asset Management Group
SWS Capital Corporation	“SWS Capital”
Southwest Investment Advisors, Inc.	“Southwest Advisors”
Banking Group
SWS Banc Holdings, Inc.	“SWS Banc”
Southwest Securities, FSB(*)	“Bank”
FSBF, LLC (90%)	“FSBF”
FSB Financial, LTD (88.2%)	“FSB Financial”
FSB Development, LLC	“FSB Development”
Other
Southwest Financial Insurance Agency, Inc.
Southwest Insurance Agency, Inc.
Southwest Insurance Agency of Alabama, Inc.	collectively, “SWS Insurance”

^(*) Effective January 1, 2006, the Bank changed its name from Southwest Securities Bank to Southwest Securities, FSB.

Brokerage Group.Southwest Securities is a New York Stock Exchange (“NYSE”) member broker/dealer and SWS Financial is a National Association of Securities Dealers (“NASD”) member broker/dealer. Each is registered under the Securities Exchange Act of 1934 (“1934 Act”). Southwest Securities and SWS Financial are also registered with the Securities and Exchange Commission (“SEC”) as registered investment advisors under the Investment Advisors Act of 1940.

SWS filed a broker/dealer withdrawal with the NASD for May Financial Corporation (“May Financial”) on October 26, 2004. The effective date of the withdrawal was November 1, 2004. May Financial was dissolved December 31, 2004.

Asset Management Group.Asset management services are offered through SWS Capital, which administered the Local Government Investment Cooperative (“LOGIC”) fund for cities, counties, schools and other local governments across Texas through September 4, 2005. LOGIC is an investment program tailored to the investing needs of local governments within the state of Texas. SWS Capital did not renew its contract as General Manager of LOGIC upon the expiration of the

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original agreement on September 4, 2005. LOGIC represented 100% of the assets under management at June 24, 2005. At December 30, 2005, SWS Capital had no assets under management.

Southwest Advisors, although dormant, is a registered investment advisor under the Investment Advisors Act of 1940.

Banking Group.The Bank is a federally chartered savings association regulated by the Office of Thrift Supervision. SWS Banc was incorporated as a wholly owned subsidiary of SWS Group in the state of Delaware and became the sole shareholder of the Bank in 2004. SWS Banc was created to facilitate future potential financial transactions. FSBF is a 2% general partner of FSB Financial which purchases non-prime automobile loans. FSB Development develops single-family residential lots.

In January 2005, the Bank purchased an additional 15% of FSBF at a cost of $84,000, bringing the Bank’s percentage ownership to 90%. Also, the Bank purchased an additional 14.7% of FSB Financial at a cost of $4,367,000 bringing the Bank’s percentage of ownership to 88.2%. FSBF owns 2% of FSB Financial effectively giving the Bank a 90% interest in FSB Financial. Of the $4,451,000 total purchase price, $3,062,000 was paid in cash and the remaining $1,389,000 was given in the form of a promissory note. As of December 31, 2005, $845,000 is still outstanding on this note. The monthly note payment is 35% of the monthly after-tax income allocated to the Bank from FSB Financial until the amount has been paid in full.

The Bank’s quarterly financial statements are prepared as of December 31 for each period presented. All significant intercompany balances and transactions have been eliminated.

Other Consolidated Entities.SWS Insurance holds insurance agency licenses in 44 states for the purpose of facilitating the sale of insurance and annuities for customers of Southwest Securities and its correspondents.

STOCK OPTION AND RESTRICTED STOCK PLANS

Stock Option Plans. At December 30, 2005, SWS had two stock option plans; the SWS Group, Inc. Stock Option Plan (the “1996 Plan”) and the SWS Group, Inc. 1997 Stock Option Plan (the “1997 Plan”). The 1996 Plan reserves shares of SWS Group’s common stock for issuance to eligible officers, directors and employees of SWS Group or its subsidiaries, as well as to non-employee members of the Board of Directors. The 1997 Plan reserves shares of SWS Group’s common stock for eligible employees or potential employees of SWS Group or its subsidiaries. Officers and directors are not eligible to receive options under the 1997 Plan. Options granted under the 1996 and 1997 Plans have a maximum ten-year term, and the vesting period is determined on an individual basis by the Compensation Committee of the Board of Directors. However, options granted to non-employee directors under the 1996 Plan are fully vested six months after grant and have a five-year term.

The 1996 Plan expired on February 1, 2006. At December 30, 2005, there were 2,589,176 shares available for future issuances under the 1996 Plan. All options outstanding under the 1996 Plan may still be exercised until their contracted expiration date occurs.

On June 7, 2005, all outstanding options were vested upon approval by the Board of Directors. The Company has substantially eliminated the use of options as a compensation tool and currently grants restricted stock to reward management and employees. Consequently, no stock options were granted during the six months ended December 30, 2005.

As of June 25, 2005, SWS began accounting for the plans under the recognition and measurement principles of the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment.” For all periods prior to June 25, 2005, SWS accounted for the plans under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.”

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The following table illustrates the effect on net income and earnings per share if SWS had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation for the three and six months ended December 31, 2004 (in thousands, except per share amounts):

	Three Months Ended December 31, 2004			Six Months Ended December 31, 2004
Net income:
As reported	$	4,541		$	20,429
Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		(100	)		(307	)
Pro forma	$	4,441		$	20,122
Earnings per share - basic:
As reported	$	0.27		$	1.19
Pro forma		0.26			1.17
Earnings per share - diluted:
As reported	$	0.26		$	1.18
Pro forma		0.25			1.16

The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions for the three and six months ended December 31, 2004:

	December 31, 2004
Expected volatility	57	%
Risk-free interest rate	3.94	%
Expected dividend yield	2.66	%
Expected life	5 years

Restricted Stock Plan. The SWS Group, Inc. 2003 Restricted Stock Plan (“Restricted Stock Plan”) allows for awards of up to 500,000 shares of SWS Group’s common stock to SWS’ directors, officers and employees. No more than 200,000 of the authorized shares may be newly issued shares of common stock. The Restricted Stock Plan terminates on August 21, 2013. The vesting period is determined on an individualized basis by the Compensation Committee of the Board of Directors. In general, restricted stock granted to employees under the Restricted Stock Plan is fully vested after three years, and restricted stock granted to non-employee directors vests on the one year anniversary of the date of grant.

On August 25, 2005, the Board of Directors approved grants to various officers and employees totaling 72,199 shares with a fair market value of $16.65 per share. On November 28, 2005, a grant was approved totaling 50,000 shares with a fair market value of $20.89 per share. As a result of these grants and previous grants, SWS has recorded cumulative deferred compensation of approximately $3,896,500. For the three and six months ended December 30, 2005, SWS recognized compensation expense of approximately $252,000 and $431,000, respectively. For the three and six months ended December 31, 2004, SWS recognized compensation expense of approximately $129,000 and $241,000, respectively.

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On June 25, 2005, SWS adopted the provisions of SFAS No. 123R in relation to the Restricted Stock Plan. This adoption resulted in income of $75,000 recorded as a cumulative effect of a change in accounting principle, net of tax. The adoption affected SWS’ accounting for forfeitures and dividends. The adoption required SWS to estimate and record future forfeitures on previously granted restricted stock awards. SWS was also required to change its accounting for dividends paid to restricted stock stockholders. Under APB Opinion No. 25, dividends paid to restricted stock stockholders were recorded in equity. SFAS No. 123R requires dividends paid to restricted stock stockholders to be recorded as compensation expense.

CASH

The Company considers cash to include cash on hand and in depository accounts.

INVESTMENTS

In 1993, SWS became a part owner of Comprehensive Software Systems, Inc. (“CSS”), a software development company formed to develop a new brokerage front and back office system. By fiscal 2002, SWS held a 25.08% ownership interest in CSS, and implemented the equity method of accounting, prescribed by APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” SWS is the only company to have fully implemented the CSS system. SWS completed its installation of the system in September 2002. In June 2002, SWS determined that the investment in CSS and its related goodwill were fully impaired based on an analysis of the projected cash flow from the investment.

To facilitate the continued enhancement of the CSS system, SWS entered into an agreement in December 2002, amended in June 2003, to loan CSS $3,500,000 under a note bearing interest at 6% per annum. In December 2003, SWS agreed to an additional equity investment in CSS of $2,900,000, resulting in the purchase of 5.8 million shares of CSS common stock. The purchases were made in equal quarterly installments (two purchases totaling approximately $1,443,000 were made in fiscal years 2004 and 2005) and ultimately resulted in increasing SWS’ position in CSS to 30.22%. In January 2005, SWS forgave the $3,500,000 loan made in fiscal 2003, converting it to an equity contribution. These investments were made to insure the continued operation of CSS while needed enhancements to the system were built.

In January 2005, SWS did not participate in CSS’ equity offering because SWS is no longer dependent on CSS for enhancements to the system. SWS has developed many of the functions needed to run the CSS system in-house. Subsequent to the equity offering in January 2005, SWS owned 13.7% of CSS. SWS has not made any additional investments in CSS since January 2005.

SWS’ share of the undistributed losses of CSS for the three and six months ended December 30, 2005 were $232,000 and $423,000, respectively. From inception of the investment to date, SWS’ pro-rata percentage of losses of $8,155,000 was greater than the $6,386,000 loaned and invested by $1,769,000. As a result, there is no recorded equity investment from CSS at December 30, 2005.

Summarized financial information of CSS is as follows (in thousands):

	December 31, 2005			June 30, 2005
Total assets	$	4,691		$	7,719
Total liabilities		4,346			4,273
Shareholders’ equity		345			3,446
	Three Months Ended
	December 31, 2005			December 31, 2004
Total revenues	$	1,189		$	1,263
Net loss		(1,689	)		(2,933	)

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	Six Months Ended
	December 31, 2005			December 31, 2004
Total revenues	$	2,669		$	2,607
Net loss		(3,088	)		(5,525	)

SWS has two other investment vehicles that are accounted for under the equity method. One is a limited partnership venture capital fund to which SWS has committed $5,000,000. As of December 30, 2005, SWS had contributed $4,000,000 from inception to date. During the three and six months ended December 30, 2005, SWS recorded income of $1,547,000 and $1,538,000, respectively, related to this investment. In December 2005, SWS received a distribution of $1,547,000. In comparison, during the three and six months ended December 31, 2004, SWS recorded losses of $57,000 and income of $101,000, respectively.

SWS’ remaining equity investment sold its assets to a third party in December 2005, with SWS receiving a distribution of $83,000 for its portion of the proceeds. As a result, SWS recorded total losses for the three and six months ended December 30, 2005 of $105,000 and $106,600, respectively. The comparable periods of fiscal 2005 had total losses of $5,100 and $7,700, respectively.

The FASB issued Financial Interpretation (“FIN”) No. 46 on January 17, 2003 and the revised version, FIN No. 46R, in December 2003. Upon review of its investments, SWS determined that it has one Variable Interest Entity (“VIE”), as defined by FIN No. 46R, that should be consolidated. In March 2005, FSB Development contributed $475,000 for a limited partnership interest in a land development limited partnership. The Bank has established a $2,400,000 line of credit with this limited partnership. If drawn this line bears a rate of prime plus 1%. At December 31, 2005, $1,456,000 was outstanding on this line of credit. The line allows the limited partnership to purchase the land to be used in the development and is payable on May 10, 2006. This entity is consolidated at the Bank level through FSB Development. As of December 31, 2005, the Bank consolidated $1,945,000 in assets and $57,000 in net losses for this investment.

FSB Development had a limited partnership interest of $1,000,000 in a land development limited partnership at December 2004. FSB Development’s interest in the limited partnership was sold on February 3, 2005 for $1,125,000, resulting in a gain of $223,000. The Bank had loaned this limited partnership $3,000,000 with an interest rate of prime plus 1% payable on December 17, 2005 to allow the limited partnership to purchase the land and finance the second phase of the development. This loan was paid off on August 4, 2005. For the three and six months ended December 31, 2004, the Bank consolidated $42,000 and $77,000 in net losses for this investment, respectively.

SWS also has an investment in 23,721 shares of Archipelago Holdings, L.L.C., an electronic stock exchange, (“Archipelago”). This stock is included in securities owned and marked to market. At December 30, 2005 and June 24, 2004, the market value of Archipelago was $1,147,000 and $948,000, respectively. See “-Securities Owned and Securities Sold, Not Yet Purchased.” See “-Subsequent Events” for information on the merger of Archipelago and the NYSE.

Southwest Securities has been a member of the NYSE since 1972 and as such owns one seat on the NYSE carried at a cost of $230,000. See “-Subsequent Events” for information on the merger of Archipelago and the NYSE.

ASSETS SEGREGATED FOR REGULATORY PURPOSES

At December 30, 2005, SWS had U.S. Treasury securities with a market value of approximately $76,314,000, reverse repurchase agreements of approximately $107,766,000 and related cash and accrued interest of approximately $183,561,000 segregated in special reserve bank accounts for the exclusive benefit of customers under Rule 15c3-3 of the 1934 Act. The reverse repurchase agreements were collateralized by U.S. Government securities with a market value of approximately $110,326,000. At December 30, 2005, SWS had no positions in special reserve bank accounts for the Proprietary Accounts of Introducing Brokers (“PAIB”).

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At June 24, 2005, SWS had U.S. Treasury securities with a market value of approximately $25,620,000, reverse repurchase agreements of approximately $140,696,000 and related cash and accrued interest of approximately $164,472,000 segregated in special reserve bank accounts for the exclusive benefit of customers under Rule 15c3-3 of the 1934 Act. The reverse repurchase agreements were collateralized by U.S. Government securities with a market value of approximately $141,720,000. SWS had no positions in special reserve bank accounts for the PAIB at June 24, 2005.

MARKETABLE EQUITY SECURITIES

SWS owns shares of common stock that are classified as marketable equity securities available for sale. Consequently, the unrealized holding gains (losses), net of tax, are recorded as a separate component of stockholders’ equity on the consolidated statements of financial condition.

At December 30, 2005 and June 24, 2005, SWS held 457,154 shares of U.S. Home Systems, Inc. (“USHS”) with a cost basis of $2,018,000. The market value of the USHS shares was $2,916,000 at December 30, 2005 and $2,208,000 at June 24, 2005. There were no sales of USHS stock in the three and six-month periods ended December 30, 2005 and 2004.

At December 30, 2005, SWS held 8,825 shares of Westwood Holdings Group, Inc. (“Westwood”) within the deferred compensation plan with a cost basis of $148,000. At June 24, 2005, SWS held 8,954 shares of Westwood within the deferred compensation plan with a cost basis of $150,650. The market value of the Westwood shares was $161,000 and $164,000 at December 30, 2005 and June 24, 2005, respectively. The reduction in shares results from a distribution from the deferred compensation plan.

RECEIVABLE FROM AND PAYABLE TO BROKERS, DEALERS AND CLEARING ORGANIZATIONS

At December 30, 2005 and June 24, 2005, SWS had receivable from and payable to brokers, dealers and clearing organizations related to the following (in thousands):

	December		June
Receivable
Securities failed to deliver	$	16,149	$	21,459
Securities borrowed		2,327,618		2,768,922
Correspondent broker/dealers		37,718		39,940
Clearing organizations		8,574		8,196
Other		37,586		16,779
	$	2,427,645	$	2,855,296
Payable
Securities failed to receive	$	29,997	$	42,916
Securities loaned		2,259,594		2,688,266
Correspondent broker/dealers		13,531		14,064
Other		14,910		9,830
	$	2,318,032	$	2,755,076

SWS participates in the securities borrowing and lending business by lending excess margin securities of its clients as well as by borrowing and lending securities other than those of its clients. SWS adjusts open positions to market value according to standard industry practices. SWS received collateral of $2,327,618,000 under securities lending agreements, of which the Company repledged $2,221,847,000 at December 30, 2005. SWS received collateral of $2,768,921,000 under securities lending agreements, of which SWS repledged $2,655,647,000 at June 24, 2005.

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LOANS AND ALLOWANCE FOR PROBABLE LOAN LOSSES

Loans receivable, excluding loans held for sale, at December 31, 2005 and June 30, 2005 are summarized as follows (in thousands):

	December			June
First mortgage loans (principally conventional):
Real estate	$	331,313		$	308,517
Construction		177,161			135,444
		508,474			443,961
Commercial and Consumer loans:
Commercial		57,940			51,312
Consumer		90,815			109,125
		148,755			160,437
Factored receivables		7,753			7,803
		664,982			612,201
Unearned income		(10,397	)		(12,894	)
Allowance for probable loan losses		(7,151	)		(7,450	)
	$	647,434		$	591,857

Impairment of loans with a recorded investment of approximately $6,536,000 and $4,949,000 at December 31, 2005 and June 30, 2005, respectively, has been recognized in conformity with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan - an Amendment of SFAS No. 5 and SFAS No. 15,” as amended.

An analysis of the allowance for probable loan losses for the three and six-months ended December 31, 2005 and 2004 is as follows (in thousands):

	Three Months Ended December 31,						Six Months Ended December 31,
	2005			2004			2005			2004
Balance at beginning of period	$	7,558		$	4,627		$	7,450		$	4,643
Provision for loan losses		2,068			1,473			4,557			2,119
Loans charged to the allowance, net		(2,475	)		(708	)		(4,856	)		(1,370	)
Balance at end of period	$	7,151		$	5,392		$	7,151		$	5,392

SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED

At December 30, 2005 and June 24, 2005, SWS held securities owned and securities sold, not yet purchased as follows (in thousands):

	December		June
Securities owned
Corporate equity securities	$	6,250	$	7,259
Municipal obligations		25,540		32,894
U.S. Government and Government agency obligations		44,594		30,079
Corporate obligations		89,575		88,877
Other		10,448		7,845
	$	176,407	$	166,954

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	December		June
Securities sold, not yet purchased
Corporate equity securities	$	2,270	$	3,121
Municipal obligations		730		277
U.S. Government and Government agency obligations		46,003		43,933
Corporate obligations		65,587		58,451
Other		516		381
	$	115,106	$	106,163

During the quarter, certain of the above securities were pledged to secure short-term borrowings or as security deposits at clearing organizations for SWS’ clearing business. Securities deposited as security at clearing organizations were $4,704,000 and $4,669,000 at December 30, 2005 and June 24, 2005, respectively. Additionally, at December 30, 2005 and June 24, 2005, SWS had deposited firm securities valued at $550,000 and $130,000, respectively, in conjunction with securities lending activities.

SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL

Transactions involving purchases of securities under agreement to resell (“reverse repurchase agreements”) are accounted for as collateralized financings except where SWS does not have an agreement to sell the same or substantially the same securities before maturity at a fixed or determinable price. At December 30, 2005, SWS held reverse repurchase agreements totaling $34,107,000, collateralized by U.S. Government and Government agency obligations with a market value of approximately $33,826,000. At June 24, 2005, SWS held reverse repurchase agreements totaling $28,890,000, collateralized by U.S. Government and Government agency obligations with a market value of approximately $28,885,000.

GOODWILL

SWS accounts for goodwill under the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” SWS performed its annual assessment of the fair value of goodwill in June 2005 for fiscal 2005, as required by SFAS No. 142 and based on the results of the valuation, SWS’ goodwill balance was not impaired. There have been no events in the last six months that would trigger an interim assessment on the fair value of goodwill.

SWS has two reporting units with goodwill: Southwest Securities in the Brokerage Group segment and the Bank in the Banking Group segment. Changes in the carrying value of goodwill during the six-month period ended December 30, 2005, by segment and in the aggregate, are summarized in the following table (in thousands):

	Brokerage Group		Banking Group		Consolidated SWS Group, Inc.
Balance, June 24, 2005	$	7,466	$	4,194	$	11,660
Arising from earn-out provision of completed business combination		86		—		86
Balance, December 30, 2005	$	7,552	$	4,194	$	11,746

In August 2001, SWS Group acquired O’Connor & Company Securities, Inc. (“O’Connor”) and recorded approximately $744,000 of goodwill on the transaction. SWS Group transferred the goodwill to Southwest Securities after the adoption of SFAS No. 142. Pursuant to the terms of the acquisition agreement, contingent consideration based upon future operating performance of O’Connor was calculated on an annual basis through July 2005. The maximum additional earn-out consideration was $2,500,000 which was reached in July 2005. No additional goodwill will be recorded related to this agreement.

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SHORT-TERM BORROWINGS

Southwest Securities has credit arrangements with commercial banks, which include broker loan lines up to $275,000,000. 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 December 30, 2005, the amount outstanding under these secured arrangements was $47,300,000, which was collateralized by securities held for firm accounts valued at $92,103,000. At June 24, 2005, the amount outstanding under these secured arrangements was $63,400,000, which was collateralized by securities held for firm accounts valued at $88,488,000.

In addition to the broker loan lines, SWS 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. The total amount of borrowings available under this line of credit is reduced by the amount outstanding on the line and under the unsecured letters of credit at the time of borrowing. At December 30, 2005 and June 24, 2005, the total amount available for borrowings was $17,036,000 and $11,893,000, respectively. At December 30, 2005 there were no amounts outstanding on this line and $2,964,000 under unsecured letters of credit. There was $5,000,000 outstanding on this line and $3,107,000 under unsecured letters of credit at June 24, 2005.

SWS also has unsecured letters of credit, aggregating $2,250,000 at both December 30, 2005 and June 24, 2005, pledged to support its open positions with securities clearing organizations. The unsecured letters of credit bear a 1% commitment fee and are renewable semi-annually.

At December 30, 2005 and June 24, 2005, SWS had an additional unsecured letter of credit issued for a sub-lease to the sub-lessee of space previously occupied by Mydiscountbroker.com, Inc., a subsidiary of SWS that was dissolved in July 2004, in the amount of $714,000 and $857,000, respectively. The letter of credit bears a 1% commitment fee and is renewable annually.

SWS has an irrevocable letter of credit agreement aggregating $45,000,000 and $49,000,000 at December 30, 2005 and June 24, 2005, 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 semi-annually. The letter of credit is fully collateralized by marketable securities held in client and non-client margin accounts with a value of $57,378,000 and $66,974,000 at December 30, 2005 and June 24, 2005, respectively.

In addition to using customer securities to finance bank loans, SWS also loans client securities as collateral in conjunction with SWS’ securities lending activities. At December 30, 2005, approximately $464,293,000 of client securities under customer margin loans was available to be loaned, of which SWS has loaned $37,325,000 under securities loan agreements. At June 24, 2005, approximately $469,399,000 of client securities under customer margin loans was available to be loaned, of which SWS had loaned $32,156,000 under securities loan agreements.

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DEPOSITS

Deposits at December 31, 2005 and June 30, 2005 are summarized as follows (dollars in thousands):

	December				June
	Amount		Percent		Amount		Percent
Noninterest bearing demand accounts	$	45,581	7.1	%	$	34,504	5.9	%
Interest bearing demand accounts		68,719	10.7			48,524	8.2
Savings accounts		419,312	65.3			359,520	61.1
Limited access money market accounts		25,020	3.9			19,172	3.3
Certificates of deposit, less than $100,000		60,172	9.4			67,704	11.5
Certificates of deposit, $100,000 and greater		23,224	3.6			58,554	10.0
	$	642,028	100.0	%	$	587,978	100.0	%

The weighted average interest rate on deposits was approximately 3.72% at December 31, 2005 and 2.92% at June 30, 2005.

At December 31, 2005, scheduled maturities of certificates of deposit were as follows (in thousands):

	Fiscal 2006		Fiscal 2007		Fiscal 2008		Thereafter		Total
Certificates of deposit, less than $100,000	$	41,932	$	8,460	$	3,468	$	6,312	$	60,172
Certificates of deposit, $100,000 and greater		16,267		2,061		1,150		3,746		23,224
	$	58,199	$	10,521	$	4,618	$	10,058	$	83,396

SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Securities sold under agreements to repurchase, which are secured borrowings, generally mature within one to four days from the transaction date. Securities sold under repurchase agreements are reflected at the amount of cash received in connection with the transactions. The Company may be required to provide additional collateral based on the fair value of the underlying securities. The Company monitors the fair value of the underlying securities on a daily basis. Securities sold under repurchase agreements at December 30, 2005 and June 24, 2005 were $29,417,000 and $8,061,000, respectively.

ADVANCES FROM THE FEDERAL HOME LOAN BANK (“FHLB”)

At December 31, 2005 and June 30, 2005, advances from the FHLB were due as follows (in thousands):

	December		June
Maturity:
Due within one year	$	36,488	$	58,731
Due within two years		7,443		12,487
Due within five years		8,628		6,556
Due within seven years		8,773		3,787
Due within ten years		6,307		4,746
Due within twenty years		7,550		7,232
	$	75,189	$	93,539

Pursuant to collateral agreements, the advances from the FHLB, with interest rates ranging from 2% to 8%, are collateralized by approximately $185,000,000 of collateral value (as defined by the credit

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policy of the FHLB) in qualifying loans at December 31, 2005 (calculated at September 30, 2005). At June 30, 2005 (calculated at March 31, 2005), advances with interest rates from 2% to 8% were collateralized by approximately $170,000,000 of collateral value in qualifying loans.

BANK BORROWINGS

In June 2005, the Bank entered into an agreement with an unaffiliated bank for a $20,000,000 unsecured line of credit for the purchase of federal funds. The line bears interest at a rate equal to the federal funds rate plus 0.25%. The line is used by the Bank to support short-term liquidity needs and expires on May 31, 2006. At December 31, 2005 and June 30, 2005, there were no amounts outstanding on this line of credit.

On June 8, 2005, FSB Financial obtained a secured line of credit from an unaffiliated bank in the amount of $75,000,000. At December 31, 2005 and June 30, 2005, $18,600,000 and $35,300,000 were outstanding on this line of credit, respectively. The note related to this line of credit matures on June 7, 2008. Interest is paid on a monthly basis at a rate of 30-day LIBOR plus a variable rate that is determined by the status of certain financial ratios at the time of the advance. The interest rate was 6.54% and 5.38% at December 31, 2005 and June 30, 2005, respectively. This line of credit contains certain restrictive covenants that, among other things, limit the ability of FSB Financial to incur indebtedness, engage in transactions with affiliates, create liens, engage in mergers and consolidations, or sell collateral. The line of credit also requires FSB Financial and the Bank to maintain certain financial ratios. FSB Financial and the Bank were in compliance with all covenants and provisions of the agreement at December 31, 2005. This line of credit is secured by automobile loans totaling $30,367,000.

FSB Financial also has a line of credit with its parent Bank. At December 31, 2005, the total credit line is $44,350,000 of which FSB Financial has drawn $44,350,000. At June 30, 2005, the total credit line was $46,000,000 of which FSB Financial had drawn $37,250,000. Participations by third parties totaled $9,350,000 and $11,850,000 at December 31, 2005 and June 30, 2005, respectively. The loan bears interest for unaffiliated participants at 30-day LIBOR plus 2.25%. The loan bears interest for the Bank at the Bank Insured Funds rate plus 0.9%, 4.34% at December 31, 2005. The loan matures on March 27, 2006. SWS Group guarantees $10,000,000 of this credit line to the Bank. See “-Commitments and Contingencies – Guarantees.” The portion of the credit line from the Bank to FSB Financial is eliminated in consolidation.

FSB Financial has a line of credit with SWS Group up to $5,000,000. The line of credit with SWS Group bears interest at prime plus 1.0% and matures on June 8, 2008. At December 31, 2005, there were no amounts outstanding on this line of credit. At June 30, 2005, $5,000,000 was outstanding on this line of credit, which was eliminated in consolidation.

NET CAPITAL REQUIREMENTS

Brokerage Group. The broker/dealer subsidiaries are subject to the Securities and Exchange Commission’s (“SEC”) Uniform Net Capital Rule (the “Net Capital Rule”), which requires the maintenance of minimum net capital. Southwest Securities has elected to use the alternative method, permitted by the Net Capital Rule, which requires that it maintain minimum net capital, as defined in Rule 15c3-1 under the 1934 Act, equal to the greater of $1,000,000 or 2% of aggregate debit balances, as defined in Rule 15c3-3 under the 1934 Act. At December 30, 2005, Southwest Securities had net capital of $119,749,000, or approximately 26.2% of aggregate debit balances, which was $110,604,000 in excess of its minimum net capital requirement of $9,145,000 at that date. Additionally, the net capital rule of the NYSE provides that equity capital may not be withdrawn and cash dividends may not be paid if resulting net capital would be less than 5% of aggregate debit items. At December 30, 2005, Southwest Securities had net capital of $96,887,000 in excess of 5% of aggregate debit items.

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SWS Financial follows the primary (aggregate indebtedness) method under Rule 15c3-1, which requires the maintenance of minimum net capital of $250,000. At December 30, 2005, the net capital and excess net capital of SWS Financial were $1,109,000 and $859,000, respectively.

Banking Group. The Bank is subject to various regulatory capital requirements administered by federal agencies. Quantitative measures, established by regulation to ensure capital adequacy, require maintaining minimum amounts and ratios (set forth in the table below) of total and Tier I capital to risk-weighted assets, and of Tier I capital to adjusted total assets (all as defined in 12 CFR 565 and 12 CFR 567). Management believes, as of December 31, 2005 and June 30, 2005, that the Bank meets all capital adequacy requirements to which it is subject.

As of December 31, 2005 and June 30, 2005, the Bank is considered “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized,” the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios.

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

	Actual				For Capital Adequacy Purposes				To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio
December 31, 2005:
Total capital to risk weighted assets	$	75,870	11.0	%	$	55,391	8.0	%	$	69,238	10.0	%
Tier I capital to risk weighted assets		68,719	9.9			27,695	4.0			41,543	6.0
Tier I capital to adjusted total assets		68,719	8.4			32,880	4.0			41,100	5.0
June 30, 2005:
Total capital to risk weighted assets	$	69,874	10.6	%	$	52,817	8.0	%	$	66,021	10.0	%
Tier I capital to risk weighted assets		62,425	9.5			26,409	4.0			39,613	6.0
Tier I capital to adjusted total assets		62,425	7.8			32,198	4.0			40,247	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 and six-months ended December 30, 2005 and December 31, 2004 (in thousands, except share and per share amounts):

	Three Months Ended				Six Months Ended
	December 30, 2005		December 31, 2004		December 30, 2005		December 31, 2004
Income before cumulative effect of a change in accounting principles	$	8,765	$	4,541	$	15,862	$	20,429
Cumulative effect of a change in accounting principles		—		—		75		—
Net income	$	8,765	$	4,541	$	15,937	$	20,429

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	Three Months Ended				Six Months Ended
	December 30, 2005		December 31, 2004		December 30, 2005		December 31, 2004
Weighted average shares outstanding – basic		17,353,831		17,181,347		17,340,925		17,158,916
Effect of dilutive securities:
Assumed exercise of stock options		114,534		155,728		97,994		96,138
Restricted stock		146,989		99,505		125,450		85,684
Weighted average shares outstanding – diluted		17,615,354		17,436,580		17,564,369		17,340,738
Earnings per share – basic
Income before cumulative effect of a change in accounting principles	$	0.51	$	0.27	$	0.91	$	1.19
Cumulative effect of a change in accounting principles		—		—		0.01		—
Net income	$	0.51	$	0.27	$	0.92	$	1.19
Earnings per share – diluted
Income before cumulative effect of a change in accounting principles	$	0.50	$	0.26	$	0.90	$	1.18
Cumulative effect of a change in accounting principles		—		—		0.01		—
Net income	$	0.50	$	0.26	$	0.91	$	1.18

At December 30, 2005 and December 31, 2004, there were approximately 1.2 million and 1.5 million options outstanding under the two stock option plans, respectively. See “-Stock Option and Restricted Stock Plans.” As of December 30, 2005 and December 31, 2004, approximately 107,274 and 97,789 outstanding options, respectively, were anti-dilutive and therefore were not included in the calculation of weighted average shares outstanding-dilutive.

REPURCHASE OF TREASURY STOCK

The Board of Directors has authorized the repurchase of up to 500,000 shares of SWS common stock on or prior to December 31, 2006. In October 2005, 31,090 shares were repurchased at a cost of $478,000, or $15.36 per share, in accordance with the repurchase plan. No shares were repurchased by SWS under this program from February 2003 through September 30, 2005. As of December 30, 2005, 468,910 shares may be repurchased under the plan.

Additionally, the trustee under SWS’ deferred compensation plan periodically purchases stock in the open market in accordance with the terms of the plan. This stock is classified as treasury stock in the consolidated financial statements, but participates in future dividends declared by SWS. The plan did not purchase any shares in the three and six-month periods ended December 30, 2005. The plan purchased 2,004 and 10,772 shares in the three and six-month periods ended December 31, 2004 at a cost of $35,600 and $161,000, or $17.74 and $14.91 per share, respectively. During the three and six-month periods ended December 30, 2005, 611 shares were sold or distributed pursuant to the plan. During the three and six-month periods ended December 31, 2004, 8,106 and 10,092 shares were sold or distributed pursuant to the plan, respectively.

On August 18, 2005, one-third of the shares previously granted under the restricted stock plan on August 18, 2004 vested. The fair value of the vested shares was $391,000. Upon vesting, a portion of the grantees chose to sell a portion of their vested shares to cover the tax liabilities arising from the vesting. As a result, 3,468 shares were repurchased with a market value of $58,000 or $16.84 per share.

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On November 11, 2005, one-third of the shares previously granted under the restricted stock plan on November 11, 2003 vested. The fair value of the vested shares was $272,000. Upon vesting, a portion of the grantees chose to sell a portion of their vested shares to cover the tax liabilities arising from the vesting. As a result, 2,219 shares were repurchased with a market value of $44,000 or $19.89 per share.

SEGMENT REPORTING

SWS operates three principal segments within the financial services industry: the Brokerage Group, the Asset Management Group and the Banking Group. There have been no changes in the basis of segmentation or in the basis of measurement of segment profit or loss since last reported. The Brokerage Group no longer includes May Financial as this entity was dissolved on December 31, 2004. The balances for this entity are included in the amounts presented for the three and six-month periods ended and as of December 31, 2004, but are not included in the December 30, 2005 amounts.

SWS Capital, an entity within the Asset Management Group, determined that it would not renew its contract as General Manager of LOGIC upon the expiration of the original agreement on September 4, 2005. LOGIC represented 100% of the assets under management for this entity through the expiration of the agreement.

The category “other consolidated entities” includes SWS Group and SWS Insurance. SWS Group is a holding company that owns various investments, including the investment in USHS common stock. See “-Marketable Equity Securities.” SWS Insurance facilitates the sale of insurance and annuities for customers of Southwest Securities and its correspondents. There are no material reconciling adjustments included in this category.

(in thousands)	Brokerage Group			Asset Management Group			Banking Group		Other Consolidated Entities			Consolidated SWS Group, Inc.
Three months ended December 30, 2005
Net revenues from external sources	$	78,675		$	—		$	21,064	$	1,995		$	101,734
Net intersegment revenue (expense)		(1,017	)		—			1,102		(85	)		—
Net interest revenue (expense)		8,861			—			14,322		(34	)		23,149
Depreciation and amortization		1,174			1			244		—			1,419
Income (loss) before income taxes and minority interest in consolidated subsidiaries		6,441			(22	)		6,304		827			13,550
Net income (loss)		4,096			(15	)		4,067		617			8,765
Segment assets		3,417,978			537			827,922		22,644			4,269,081
Expenditures for long-lived assets		102			—			119		—			221
Three months ended December 31, 2004
Net revenues from external sources	$	66,413		$	86		$	14,763	$	(30	)	$	81,232
Net intersegment revenue (expense)		(754	)		—			910		(156	)		—
Net interest revenue (expense)		9,392			—			11,336		(3	)		20,725
Depreciation and amortization		1,309			1			171		—			1,481
Income (loss) before income taxes and minority interest in consolidated subsidiaries		5,102			(38	)		4,765		(2,489	)		7,340
Net income (loss)		3,237			(25	)		2,960		(1,631	)		4,541
Segment assets		4,066,138			572			672,029		21,869			4,760,608
Expenditures for long-lived assets		559			—			566		1			1,126

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(in thousands)	Brokerage Group			Asset Management Group			Banking Group		Other Consolidated Entities			Consolidated SWS Group, Inc.
Six months ended December 30, 2005
Net revenues from external sources	$	159,246		$	131		$	41,605	$	2,551		$	203,533
Net intersegment revenue (expense)		(1,930	)		—			2,121		(191	)		—
Net interest revenue (expense)		18,398			—			28,513		(85	)		46,826
Depreciation and amortization		2,394			1			480		—			2,875
Income (loss) before income taxes and minority interest in consolidated subsidiaries		13,488			(23	)		11,764		(570	)		24,659
Net income (loss)		8,518			(15	)		7,582		(148	)		15,937
Segment assets		3,417,978			537			827,922		22,644			4,269,081
Expenditures for long-lived assets		457			—			594		—			1,051
Six months ended December 31, 2004
Net revenues from external sources	$	119,002		$	234		$	27,476	$	19,143		$	165,855
Net intersegment revenue (expense)		(1,501	)		—			1,670		(169	)		—
Net interest revenue (expense)		16,678			—			21,142		(23	)		37,797
Depreciation and amortization		2,809			3			337		—			3,149
Income (loss) before income taxes and minority interest in consolidated subsidiaries		7,336			(33	)		9,462		15,231			31,996
Net income (loss)		4,746			(22	)		5,821		9,884			20,429
Segment assets		4,066,138			572			672,029		21,869			4,760,608
Expenditures for long-lived assets		1,213			—			1,021		1			2,235

On the consolidated statements of income and comprehensive income, minority interest is solely related to the Banking Group and other comprehensive income (loss) is solely related to SWS Group, which is included in the “Other Consolidated Entities” category, above.

COMMITMENTS, CONTINGENCIES and GUARANTEES

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

Fraudulent Mortgages:During the first quarter of fiscal 2003, the Bank provided $3,400,000 ($2,200,000 after tax impact on earnings) to establish a reserve for fraudulent mortgages purchased from one New York based mortgage bank. Sixteen loans, aggregating approximately $3,400,000 were sold twice by the mortgage bank and the Bank is not receiving payments on these loans. At this time, the likelihood of recovery cannot be estimated.

Venture Capital Fund: SWS has committed $5,000,000 to invest in a limited partnership venture capital fund. As of December 30, 2005, SWS had contributed $4,000,000 of its commitment. Under the terms of the agreement, no more than 30% of the commitment will be drawn in any 12-month period.

Underwriting: Through its participation in underwriting, both corporate and municipal, SWS could expose itself to material risk since the possibility exists that securities SWS has committed to purchase cannot be sold at the initial offering price. Federal and state securities laws and regulations also affect the activities of underwriters and impose substantial potential liabilities for violations in connection with sales of securities by underwriters to the public. Total open underwritings at December 30, 2005 were $162,817,000. All open underwritings are generally scheduled to be settled within the next 60 days and are expected to have no material effect on the consolidated financial statements.

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In March 2002, SWS issued a loan guarantee for FSB Financial for $10,000,000. The guarantee is based on a loan agreement between FSB Financial and the Bank. SWS has agreed to guarantee funds drawn on the loan in excess of $25,000,000, up to a maximum of $35,000,000. At December 31, 2005, the Bank had loaned $35,000,000 to FSB Financial. As a result of this loan, if FSB Financial defaults on the loan to the Bank, SWS would be liable for $10,000,000 of the total loan outstanding. SWS has not recorded a liability for the guarantee in its financial statements, as the guarantee is to a subsidiary.

In connection with the 2002 spin-off of SWS’ primary asset management subsidiary, the Westwood Holdings Group, Inc., SWS agreed to indemnify the Westwood Holdings Group, Inc. from and against any and all past and future liabilities or expenses in excess of $500,000 arising from the Richard A. Boykin Jr. Family Trust (“Boykin Trust”), for which Westwood Trust currently serves as trustee. The Boykin Trust is currently in bankruptcy. SWS settled litigation with the beneficiaries of the Boykin Trust in May 2002 for $2,000,000. SWS’ management believes that the resolution of the remaining issues associated with the Boykin Trust in bankruptcy will not have a material impact on SWS’ consolidated financial statements.

The Bank has stand-by letters of credit primarily issued for assigned notes and real estate. The maximum potential amount of future payments the Bank could be required to make under the letters of credit is $594,000 at December 31, 2005. The recourse provisions of the letters of credit allow the amount of the letters of credit to become a part of the fully collateralized loans with total repayment. The collateral on these letters of credit consist of assigned notes, real estate, equipment, accounts receivable or furniture and fixtures.

On December 29, 2005, SWS entered into the eighth amendment of the existing operating lease for its corporate headquarters originally dated November 30, 1994. The amendment of the lease extends the term for 151 months, from June 1, 2008 until December 31, 2020. The amount of rentable square feet was reduced from approximately 188,000 square feet to 155,000 square feet with the potential to reduce the rentable square feet by an additional 31,000 square feet. Total future rental payments under the amended lease are $32,700,000 from December 31, 2005 through December 31, 2020.

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

SUBSEQUENT EVENTS

NYSE Electronic Blue Sheet Reporting Inquiry. In the ordinary course of business, Southwest Securities receives and responds to requests from regulatory agencies (the SEC, the NYSE, the AMEX, etc.) for information regarding trading in specific securities. These requests are often made in connection with investigations of suspected insider trading. The responses are automated and are known as “blue sheets” or “electronic blue sheets.”

In July 2005, Southwest Securities was notified by the NYSE that it, along with a number of other NYSE members, had allegedly failed to provide accurate blue sheet responses by failing to identify short sales, as distinguishable from sales (thereby impeding regulatory investigations), and could face fines, penalties and other sanctions.

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On August 26, 2005, Southwest Securities received a demand from the NYSE requiring it to agree to a censure and a fine of $300,000. This amount was accrued for in the consolidated statement of financial condition at June 24, 2005. In January 2006, Southwest Securities and the NYSE settled this inquiry for the $300,000.

NYSE / Archipelago merger. Southwest Securities has been a member of the NYSE since 1972 and as such owns one seat on the NYSE carried at a cost of $230,000. Contingent upon and pursuant to the plan of merger between the NYSE and Archipelago, Southwest Securities will surrender its seat for the right to receive from NYSE Group $300,000 in cash and 80,177 restricted shares of NYSE Group common stock, par value $0.01 per share. In lieu of a seat, on January 4, 2006, Southwest Securities secured the right to a trading license at the inaugural NYSE license auction for $49,290. This license will allow Southwest Securities continued physical and electronic access to the NYSE trading facilities following the close of the merger which is targeted for early February 2006.

Upon the merger, each outstanding share of Archipelago common stock will be converted into one share of NYSE Group common stock.

Sale of certain assets of the Institutional Sales / Trading and Research departments. On January 20, 2006, the sale of certain assets of the Institutional Sales/Trading and Research departments was finalized resulting in no material financial statement impact.

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

OVERVIEW

SWS Group, Inc. (“we,” “us,” “SWS” or the “Company”) is engaged in full-service securities brokerage primarily through Southwest Securities, Inc. (“Southwest Securities”) and full-service commercial banking through Southwest Securities, FSB (the “Bank”). 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 that 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.”

We are currently focused on three aspects of our business: growing our clearing business, taking advantage of our prominence in the Southwest to become a nationally recognized full-service regional brokerage firm and growing the Bank’s business.

Brokerage Group

Growth in the U.S. equities market increased in the second quarter of fiscal 2006 as the Dow Jones Industrial Average rose from 10,297.83 at June 24, 2005 to 10,717.50 at December 30, 2005. Trading volumes also increased with average daily volume on the New York Stock Exchange (“NYSE”) of 1.6 billion shares for the first half of fiscal 2006 compared to 1.41 billion in the same period last year.

The revenues generated by our clearing business are dependent on active markets. Sustained growth in volumes is necessary for growth in our clearing business. While the overall volume of trades we processed in the first six months of fiscal 2006 was down compared to the same period in the prior year, the decrease was a result of one of our high volume trading customers clearing through an affiliate of its parent beginning in the second quarter of fiscal 2005. In contrast, trading volume from our general securities customers increased 24% over last year due to a more active market.

Month-end margin balances reported by NYSE member firms averaged $216 billion in the second quarter of fiscal 2006 versus $195 billion in fiscal 2005. We rely on margin lending to our customers

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to generate revenue. Sustained improvement in stock prices is necessary to promote growth in margin balances and to facilitate earnings growth from margin lending to our customers. Our second quarter margin balances averaged $326,411,000, down 8.9% over the comparable period last year but up 1% from the September 2005 levels. The decrease from prior year is primarily related to the decreased margin balances of our clearing customers.

Stock loan balances are also influenced by the volumes in the market as well as interest rates. Our stock lending balances for the second quarter of fiscal 2006 decreased 27% over the comparable period last year, but were down just under 3% from the September 2005 levels. As markets improve, these balances generally increase subject to credit limits imposed by our counter-parties and us. Stock lending generates an interest spread that is impacted by the overall interest rate environment. As rates have risen, we have had the opportunity to widen the interest spread we earn.

The interest rate environment also impacts our fixed income business. In the first six months of fiscal 2006, the Federal Reserve Board continued to increase the discount rate with the rate rising 100 basis points. This negatively impacted revenues in our fixed income business. The volume of our fixed income business is driven by market perception of the direction and volatility of rates and economic expectations. Management constantly monitors our exposure to interest rate fluctuations to mitigate risk of loss in volatile interest rate environments.

To realize our goal of becoming a nationally recognized full-service regional brokerage firm, it is essential to grow the retail brokerage distribution network. This will be accomplished by hiring additional registered representatives and, secondarily, by opening new branch office locations in the Southwest. Opening new branch offices requires an outlay of capital that is not immediately offset by revenues, which negatively impacts results of operations until new locations become positive contributors. We are currently focused on filling our existing offices with producing registered representatives and have no present intentions to open any branch offices. Although we only increased the number of our registered representatives by one in the second quarter of fiscal 2006, we have hired 6 new registered representatives in the first half of fiscal 2006 as we are focusing on hiring larger producers. The year-end holidays are traditionally a slow recruiting period.

Our emphasis on the full-service brokerage aspect of our business is expected to diversify our revenue stream and to enhance areas of our business that have relatively higher margins than our traditional clearing business because we retain more of each dollar of commission than in a traditional clearing arrangement. As the full-service business grows, we expect to be able to take advantage of the increased margins. Management will be reviewing profitability as well as productivity by registered representatives, transactions processed and deals completed to measure success in our full service brokerage business.

We continue to upgrade and enhance the core operating system with investments in technology. Management continually reviews equipment and communications in an effort to offset some of the costs of software enhancement. Our system was developed by Comprehensive Software Systems, Inc. (“CSS”), an entity that is backed by a consortium of brokerage firms, including Southwest Securities. The development of the system required more time and capital from these brokerage firms than was originally anticipated. While the system is fully functional at SWS, other consortium members have yet to completely install the system. Decisions by these other firms will impact CSS’ ability to continue to deliver new modules and enhancements and could impact the cost of technology to us. See “-Investments” in the Notes to the Consolidated Financial Statements for additional discussion.

Banking Group

A substantial portion of the Bank’s revenue is generated from the single-family construction loan and single-family mortgage loan markets. While the Bank’s purchased mortgage loan and auto loan programs are nationwide, the majority of the Bank’s other lending is concentrated in North Texas. A strong housing market in North Texas is important to growing the Bank’s loan portfolio.

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Mortgage interest rates increased slightly in the second quarter of fiscal 2006 as compared to the second quarter of fiscal 2005. The average balances in the Bank’s purchased mortgage loan program, increased 20% over the average balances in the second quarter of fiscal 2005. In the event mortgage interest rates increase, the Bank could experience lower revenues from these operations.

The Bank’s primary liquidity source outside of client deposits is the deposits of brokerage clients in the PC2 Bank Fund. To fund loan growth in excess of the existing liquidity, the Bank utilized Federal Home Loan Bank (“FHLB”) short-term borrowings and brokered certificates of deposit.

The Bank continued to diversify its lending base through increased commercial lending. The Bank’s commercial real estate lending was up 16% from the comparable quarter last year due to a continued focus on the Bank’s Community Banking division.

Events and Transactions

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

Distribution from an equity investment. In December 2005, the limited partnership venture capital fund in which SWS has an equity investment realized a significant gain and made a subsequent distribution to its partners. SWS’ portion of this gain was $1,547,000 and is included in other revenue in the consolidated statement of income and comprehensive income. See “-Investments” in the Notes to the Consolidated Financial Statements.

Archipelago. In August 2004, Archipelago Holdings, L.L.C. (“Archipelago”) declared an approximately 1 for 4.5 reverse stock split. After the split, we owned 67,435 shares of Archipelago stock. On August 19, 2004, Archipelago completed an initial public offering of its common stock in which we sold 23,714 shares at $10.695 per share, yielding a gain of $254,000 (an after-tax gain of $165,100). On May 24, 2005, SWS sold 20,000 shares at an average price of $32.97 for a gain of $659,000. After giving effect to these transactions, we own 23,721 shares of Archipelago stock. We recorded gains of $242,000 and $900,000 for the three and six months ended December 31, 2004, respectively, from the market appreciation of the remaining Archipelago shares. Comparably, we recorded gains of $210,000 and $199,000 for the three and six months ended December 30, 2005, respectively, from the change in market price. See “-Subsequent Events” for information regarding the merger of Archipelago and the NYSE.

Maturity of DARTS^SM. In June 1999, we issued 5% Exchangeable Subordinated Notes in the form of DARTS^SM (or, “Derivative Adjustable Ratio Securities^SM”). The DARTS^SM contained an equity-based derivative designed to hedge changes in the fair value of our investment in Knight Trading Group, Inc. common stock. The embedded derivative was designated as a fair value hedge of our investment in Knight shares. The DARTS^SM matured June 30, 2004, at which time we delivered 373,550 shares of Knight stock to the DARTS^SM holders in satisfaction of our obligation in accordance with the terms of the governing agreements. Delivery of the Knight shares upon maturity of this obligation resulted in a gain of $18,732,000, equal to the difference in the fair value of the Knight stock upon acquisition and the fair value of the Knight stock on the issuance date of the DARTS^SM (i.e. the hedging date).

Investment in Comprehensive Software Systems, Inc.In 1993, SWS became a part owner of CSS, a software development company formed to develop a new brokerage front and back office system. We initially acquired a 7.96% interest in CSS and accounted for the investment on the cost basis. Through subsequent investments, our ownership in CSS increased to 25.08% in fiscal 2002. Consequently, we implemented the equity method of accounting prescribed by APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” We were the first company, and to date the only company, to fully implement the CSS system. We completed our installation of the system in September 2002. At June 28, 2002, we determined that the investment in CSS and its related goodwill were fully impaired based on an analysis of the projected cash flow from the investment.

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To facilitate the continued enhancement of the CSS system, we entered into an agreement in December 2002, amended in June 2003, to loan CSS $3,500,000. In December 2003, we agreed to an additional equity investment of $2,900,000, resulting in the purchase of 5.8 million shares of CSS common stock. The purchases were made in four equal quarterly installments totaling $2,885,900 (two purchases totaling approximately $1,443,000 were made in fiscals 2004 and 2005) and ultimately resulted in increasing our position in CSS to 30.22%. In January 2005, we forgave the $3,500,000 loan made in fiscal 2003, converting it to an equity contribution. These investments were made to insure the continued operation of CSS while development of needed enhancements to the system was built.

In January 2005, we did not participate in CSS’ equity offering because we were no longer dependent on CSS for enhancements to the system. We have developed many of the functions needed to run the CSS system in-house. Subsequent to the equity offering in January 2005, we own 13.7% of CSS. Because no additional investments were made in CSS in the last half of fiscal 2005 and the first half of fiscal 2006, we did not record any equity in losses of CSS. As of December 30, 2005, there is no recorded equity investment in CSS.

For the three and six-month periods ended December 30, 2005, our pro-rata share of CSS’ losses was $232,000 and $423,000, respectively. For the three and six-month periods ended December 31, 2004, our pro-rata share of CSS’ losses was $886,000 and $1,654,000, respectively. These losses were greater than the $721,000 and $1,443,000 purchased during the same periods of fiscal 2005 by $165,000 and $211,000, respectively. From inception of the investment to date, based on our percentage of ownership, our pro-rata share of losses of $8,155,000 was greater than the $6,386,000 invested by $1,769,000.

RESULTS OF OPERATIONS

Net income for the three and six-month periods ended December 30, 2005 was $8,765,000 and $15,937,000, representing an increase of $4,224,000 and a decrease of $4,492,000, respectively, compared to net income for the comparable periods of fiscal 2005. The three and six-month periods ended December 30, 2005 and December 31, 2004 contained 63 and 131 trading days, respectively.

Our pretax income was $13,550,000 and $24,659,000 for the three and six month periods ended December 30, 2005 as compared to $7,340,000 and $31,996,000 for the same periods of fiscal 2005.

The following is a summary of increases (decreases) in categories of net revenues and operating expenses for the three and six-month periods ended December 30, 2005 compared to the three and six-month periods ended December 31, 2004 (dollars in thousands):

	Three Months Ended					Six Months Ended
	Amount			%		Amount			%
Net revenues:
Net revenues from clearing operations	$	(275	)	(7	)%	$	(225	)	(3	)%
Commissions		752		3			2,597		6
Net interest		2,424		12			9,029		24
Investment banking, advisory and administrative fees		472		7			2,801		21
Net gains on principal transactions		388		11			(16,928	)	(66	)
Other		2,025		40			2,777		27
		5,786		9			51		—
Operating expenses:
Commissions and other employee compensation		2,827		8			10,352		15
Occupancy, equipment and computer service costs		(621	)	(9	)		(1,728	)	(13	)
Communications		(760	)	(25	)		(1,363	)	(22	)
Floor brokerage and clearing organization charges		(789	)	(50	)		(1,076	)	(34	)
Advertising and promotional		(384	)	(35	)		(527	)	(27	)
Other		(697	)	(9	)		1,730		12
		(424	)	(1	)		7,388		7
Pretax income	$	6,210		85	%	$	(7,337	)	(23	)%

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Net revenues increased for the second quarter of fiscal 2006 by $5,786,000. The largest components of the increase were in net interest revenue, which increased $2,424,000, and in other revenue, which increased $2,025,000. Net interest revenue increased primarily due to increased revenue from securities lending business and an increase in the Bank’s average loans outstanding, offset by lower revenue from customer balances. The increase in other revenues is a result of the equity distribution from our equity investment and the gain on the sale of certain loan portfolios by FSB Financial.

Net revenues for the first half of fiscal 2006 were relatively stable when compared to the first half of fiscal 2005. However, there were large fluctuations in net gains on principal transactions, net interest, investment banking and other. Net gains on principal transaction decreased $16,928,000 due primarily to the $18,732,000 gain attributable to the DARTS^SM maturity recorded in the first quarter of fiscal 2005, which was offset slightly by increases in fixed income trading revenue. Net interest revenue increased primarily due to increased revenue from securities lending business and an increase in the Bank’s average loans outstanding, offset by lower revenue from customer balances. The increase in other revenues is a result of the equity distribution from our equity investment and the gain on the sale of certain loan portfolios by FSB Financial.

Overall operating expenses decreased by $424,000 for the three months ended December 30, 2005 as compared to the same period of fiscal 2005. The only increase was in commissions and other employee compensation, which is primarily due to increased business line revenues and health insurance costs. Reductions in floor brokerage, communications, occupancy, equipment and service costs, and other expense offset this increase.

Operating expenses increased by $7,388,000 for the six months ended December 30, 2005 as compared to the same period of fiscal 2005. The changes are consistent with those discussed above for the three month change with the exception of other expense, which increased $1,730,000 during the six month period. The increase in other expense is primarily the result of the Bank’s increase in its allowance for probable loan losses offset by reduced losses from CSS.

Net Revenues from Clearing Operations. Net clearing revenues decreased $275,000 and $225,000 for the three and six-month periods ended December 30, 2005 compared to the three and six-month periods ended December 31, 2004, respectively. We processed 2,559,500 and 4,969,401 transactions in the second quarter and first half of fiscal 2006 compared to 2,421,960 and 7,292,442 transactions in the same periods of fiscal 2005. Revenue per ticket decreased to $1.35 from $1.54 when comparing the second quarter of fiscal 2006 to the same period of fiscal 2005. In contrast, revenue per ticket increased to $1.44 from $1.01 for the six-month periods of fiscal 2006 and 2005, respectively. Correspondent count at December 30, 2005 was 216 versus 221 at December 31, 2004.

Commissions.Commission revenue increased 3% and 6%, respectively, for the three and six-month periods ended December 30, 2005 compared to the three and six-month periods ended December 31, 2004 as a result of increased trading volumes. The largest increases for both periods were recorded in Portfolio Trading due to a significant increase in trading from a customer that is starting a new fund and is trading a large amount of shares. These increases were offset by decreases in commission revenue in Institutional Equity Sales and Fixed Income Sales and Trading. The reduction in Institutional Equity Sales primarily results from the closure of the Milwaukee, Wisconsin office, as well as the impending sale of the Institutional Sales business. See “Subsequent Events” in the Notes to the Consolidated Financial Statements contained in this Report. Fixed Income Sales and Trading’s decrease is the result of reduced sales of corporate and municipal bonds.

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Commission revenue by type of representative is as follows (dollars in thousands):

	Commission Revenue								No. of Reps
	Three Months Ended				Six Months Ended				As of
	December 30, 2005		December 31, 2004		December 30, 2005		December 31, 2004		December 30, 2005	December 31, 2004
Southwest Securities brokers:
Private Client Group	$	6,146	$	5,986	$	11,513	$	10,639	97	91
Fixed Income Sales & Trading		5,927		6,855		11,537		12,716	37	39
Institutional Equity Sales		1,088		2,329		2,354		4,192	5	10
SWS Financial Representatives		5,159		5,761		10,605		10,514	372	381
Portfolio Trading		6,664		3,199		9,966		5,054
Other		72		174		151		414
	$	25,056	$	24,304	$	46,126	$	43,529

Net Interest Income.Net interest income from the Brokerage Group is dependent upon the level of customer and stock loan balances as well as the spread between the rates we earn on those assets compared with the cost of funds. Net interest is the primary source of income from the Bank and represents the amount by which interest and fees generated by earning assets exceed the cost of funds, primarily interest paid to the Bank’s depositors on interest-bearing accounts.

The components of interest earnings are as follows for the three and six-month periods ended December 30, 2005 and December 31, 2004 (in thousands):

	Three Months Ended				Six Months Ended
	December 30, 2005		December 31, 2004		December 30, 2005		December 31, 2004
Interest revenue:
Customer margin accounts and assets segregated for regulatory purposes	$	9,527	$	7,304	$	18,586	$	13,169
Stock borrowed		24,523		15,659		51,557		24,681
Bank loans		20,026		13,949		39,457		25,816
Other		1,231		1,255		2,575		1,853
	$	55,307	$	38,167	$	112,175	$	65,519
Interest expense:
Customer funds on deposit	$	4,667	$	1,757	$	8,725	$	2,823
Stock loaned		21,043		12,440		44,152		19,099
Bank deposits		4,613		1,837		8,458		3,335
Federal Home Loan Bank advances		753		374		1,661		759
Notes payable		516		619		1,207		952
Other		566		415		1,146		754
		32,158		17,442		65,349		27,722
Net interest	$	23,149	$	20,725	$	46,826	$	37,797

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Brokerage Group:For the three and six months ended December 30, 2005, net interest income from the Brokerage Group accounted for approximately 12.7% and 13.3%, respectively, of our net revenue. Average balances of interest-earning assets and interest-bearing liabilities are as follows (in thousands):

	Three Months Ended				Six Months Ended
	December 30, 2005		December 31, 2004		December 30, 2005		December 31, 2004
Average interest-earning assets:
Customer margin balances	$	326,000	$	358,000	$	325,000	$	362,000
Assets segregated for regulatory purposes		352,000		369,000		346,000		374,000
Stock borrowed		2,491,000		3,412,000		2,532,000		3,129,000
Average interest-bearing liabilities:
Customer funds on deposit		565,000		595,000		556,000		601,000
Stock loaned		2,417,000		3,315,000		2,454,000		3,030,000

Net interest revenue from customer balances decreased 12% for the three months ended December 30, 2005 over the second quarter of fiscal 2005 due primarily to the decreases in average balances on customer margin accounts by $32 million and in assets segregated for regulatory purposes of $17 million.

The increase in net interest revenue generated from securities lending activities for the quarter of 8% is due to an increase in the net interest spread of 14 basis points.

For the six months ended, net interest revenue from customer balances decreased 5% due to the decreases in average balances on customer margin accounts of $37 million and on assets segregated for regulatory purposes of $28 million.

Net interest revenue from stock lending activities for the six months ended December 30, 2005 when compared to December 31, 2004 increased 33% due to the increased net interest spread.

Banking Group:Net interest revenue generated by the Bank accounted for approximately 21% of net revenue for both the three and six-month periods ended December 31, 2005. At the Bank, changes in net interest revenue are generally attributable to the timing of loan payoffs and volume. Changes in net interest revenue are also a result of average balance changes and the overall interest rate environment.

The following tables set 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 and six-month periods ended December 31, 2005 and 2004 (dollars in thousands):

	Three Months Ended
	December 31, 2005						December 31, 2004
	Average Balance		Interest Income/ Expense		Yield/ Rate		Average Balance		Interest Income/ Expense		Yield/ Rate
Assets:
Interest-earning assets:
Real estate – mortgage	$	186,803	$	3,941	8.4	%	$	153,637	$	2,425	6.3	%
Real estate – construction		168,662		3,943	9.3			115,053		2,053	7.1
Commercial		241,468		5,445	9.0			192,095		3,574	7.4
Individual(*)		81,756		4,586	22.3			90,819		4,867	21.3
Land		96,746		2,111	8.7			54,732		1,030	7.5
Investments		9,472		93	3.9			14,920		61	1.6
		784,907	$	20,119	10.2	%		621,256	$	14,010	9.0	%
Noninterest-earning assets:
Cash and due from banks		9,838						8,280
Other assets		16,041						12,849
	$	810,786					$	642,385
Liabilities and Stockholders’ Equity:
Interest-bearing liabilities:
Certificates of deposit	$	95,254	$	798	3.3	%	$	105,889	$	862	3.2	%
Money market accounts		23,297		147	2.5			15,361		38	1.0
Interest-bearing demand accounts		64,282		423	2.6			54,691		120	0.9
Savings accounts		407,072		3,245	3.2			297,208		817	1.1
Federal Home Loan Bank advances		70,550		753	4.2			36,278		374	4.1
Notes payable		29,117		516	7.0			36,637		619	6.7
		689,572		5,882	3.4	%		546,064		2,830	2.1	%
Noninterest-bearing liabilities:
Non interest-bearing demand accounts		40,502						28,015
Other liabilities		8,818						6,364
		738,892						580,443
Stockholders’ equity		71,894						61,942
	$	810,786					$	642,385
Net interest income			$	14,237					$	11,180
Net yield on interest-earning assets					7.2	%					7.1	%

^(*) Individual interest-earning assets are primarily composed of sub-prime automobile loans.

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	Six Months Ended
	December 31, 2005						December 31, 2004
	Average Balance		Interest Income/ Expense		Yield/ Rate		Average Balance		Interest Income/ Expense		Yield/ Rate
Assets:
Interest-earning assets:
Real estate – mortgage	$	206,091	$	8,465	8.2	%	$	148,923	$	4,580	6.1	%
Real estate – construction		157,921		7,221	9.1			113,450		3,909	6.8
Commercial		239,250		10,276	8.5			189,297		6,991	7.3
Individual(*)		84,019		9,511	22.5			80,989		8,438	20.7
Land		89,732		3,984	8.8			51,860		1,898	7.3
Investments		10,039		192	3.8			29,777		204	1.4
		787,052	$	39,649	10.0	%		614,296	$	26,020	8.4	%
Noninterest-earning assets:
Cash and due from banks		9,376						8,102
Other assets		16,538						12,481
	$	812,966					$	634,879
Liabilities and Stockholders’ Equity:
Interest-bearing liabilities:
Certificates of deposit	$	108,775	$	1,799	3.3	%	$	108,204	$	1,732	3.2	%
Money market accounts		21,482		263	2.4			16,150		71	0.9
Interest-bearing demand accounts		59,955		710	2.4			54,410		197	0.7
Savings accounts		387,728		5,686	2.9			296,119		1,335	0.9
Federal Home Loan Bank advances	��	81,928		1,661	4.0			36,060		759	4.2
Notes payable		35,338		1,207	6.8			29,443		952	6.4
		695,206		11,326	3.2	%		540,386		5,046	1.9	%
Noninterest-bearing liabilities:
Non interest-bearing demand accounts		38,389						27,220
Other liabilities		9,090						6,090
		742,685						573,696
Stockholders’ equity		70,281						61,183
	$	812,966					$	634,879
Net interest income			$	28,323					$	20,974
Net yield on interest-earning assets					7.1	%					6.8	%

^(*) Individual interest-earning assets are primarily composed of sub-prime automobile loans.

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

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

	Three months ended
	December 31, 2005 compared to December 31, 2004
	Total Change			Attributed to
				Volume			Rate		Mix
Interest income:
Real estate - mortgage	$	1,516		$	524		$	816	$	176
Real estate - construction		1,890			956			637		297
Commercial		1,871			918			758		195
Individual		(281	)		(486	)		228		(23	)
Land		1,081			791			164		126
Investments		32			(11	)		83		(40	)
	$	6,109		$	2,692		$	2,686	$	731
Interest expense:
Certificates of deposit	$	(64	)	$	(87	)	$	25	$	(2	)
Money market accounts		109			20			59		30
Interest-bearing demand accounts		303			21			240		42
Savings accounts		2,428			302			1,552		574
Federal Home Loan Bank advances		379			214			23		142
Notes payable		(103	)		(127	)		30		(6	)
		3,052			343			1,929		780
Net interest income	$	3,057		$	2,349		$	757	$	(49	)
	Six months ended
	December 31, 2005 compared to December 31, 2004
	Total Change			Attributed to
				Volume			Rate		Mix
Interest income:
Real estate - mortgage	$	3,885		$	1,758		$	1,537	$	590
Real estate - construction		3,312			1,532			1,279		501
Commercial		3,285			1,845			1,139		301
Individual		1,073			316			730		27
Land		2,086			1,386			405		295
Investments		(12	)		(108	)		322		(226	)
	$	13,629		$	6,729		$	5,412	$	1,488
Interest expense:
Certificates of deposit	$	67		$	10		$	57	$	—
Money market accounts		192			23			127		42
Interest-bearing demand accounts		513			20			447		46
Savings accounts		4,351			413			3,007		931
Federal Home Loan Bank advances		902			527			20		355
Notes payable		255			190			54		11
		6,280			1,183			3,712		1,385
Net interest income	$	7,349		$	5,546		$	1,700	$	103

Investment Banking, Advisory and Administrative Fees.Investment banking, advisory and administrative fees include revenue derived from underwriting or distribution of corporate and municipal securities, unit trusts and money market and other mutual funds, as well as revenue generated by the Asset Management Group. The primary reason for the increases for the three months ended December 30, 2005 compared to the three months ended December 31, 2004 and the first half of fiscal 2006 over the comparable period in the prior year is an increase in public finance fees of $430,000 and $2,706,000, respectively.

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Average assets under management by the Asset Management Group were $713,000,000 at December 31, 2004. SWS Capital did not renew its contract as General Manager of LOGIC upon the expiration of the original agreement on September 4, 2005. As a result, there were no assets under management at December 30, 2005. Revenue generated from the management of these assets was $131,000 and $234,000 for the six months ended December 30, 2005 and December 31, 2004, respectively.

Net Gains on Principal Transactions. The increase of $388,000 for the three months ended December 30, 2005 compared to the three months ended December 31, 2004 is due to an increase in fixed income trading revenue primarily from corporate bonds.

The decrease in net gains on principal transactions of $16,928,000 for the six months ended December 30, 2005 versus December 31, 2004 was due primarily to the $18,732,000 recognized upon the maturity of the DARTS^SM during the first quarter of fiscal 2005. This amount represents the difference between the fair value of the Knight stock upon acquisition and the Knight stock on the hedging date. Offsetting this decrease was an increase in fixed income trading revenue of $2,275,000 primarily from the mortgage-backed and corporate bonds areas.

Other Revenue. Other revenue increased approximately $2,025,000 for the three-month period ended December 30, 2005 compared to the three-month period ended December 31, 2004. The increase is due primarily to the $1,547,000 increase from the distribution from an equity investment. Additionally, we recorded gains of $308,000 on the sale of certain loan portfolios at FSB Financial and a $192,000 increase in fees from insurance products.

Other revenue increased approximately $2,777,000 for the six-month period ended December 30, 2005 compared to the six-month period ended December 31, 2004. The increase is due primarily to the $1,547,000 increase from distribution related to an equity investment. Additionally, a gain of $635,000 resulted from the sale of certain loan portfolios at FSB Financial and we recorded increased fees from insurance products of $531,000

Commissions and Other Employee Compensation.Commissions and other employee compensation is generally the most significant expense, other than interest expense, on our Consolidated Statements of Income and Comprehensive Income. The commission portion is variable in nature based on the level of operating revenues, earnings and the number of registered representatives employed.

Overall, commissions and other employee compensation increased $2,827,000 for the second quarter of fiscal 2006 over the comparable period in fiscal 2005. The primary driver of the increase was $1,831,000 in variable compensation due to increased business line profitability in the brokerage segment. Additionally, an increase of $997,000 in other compensation expense is a result of increases in profit sharing and health insurance expense, offset by lower deferred compensation plan expenses.

Total commissions and other employee compensation increased by $10,352,000 for the first half of fiscal 2006 over the comparable period in fiscal 2005. An increase of $2,608,000 was due to commissions paid to revenue-producing employees generating higher levels of commission revenue. We also experienced an increase of $4,724,000 in incentive compensation due to increased business line profitability. Additionally, an increase of $3,021,000 in other compensation expense is a result of annual raises and increases in profit sharing and health insurance expenses.

Occupancy, Equipment and Computer Services.The $621,000 decrease in the three-month period ended December 30, 2005 from the comparable period in the prior year is primarily due to decreases of $383,000 in statement processing costs and $216,000 in rent expense. The reduction in statement processing costs is a result of favorable contract negotiations. Rent expense decreased due to a non-recurring lease termination costs in fiscal 2005 of $213,000 related to the closure of the May Financial office in Brighton, Michigan.

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The $1,728,000 decrease in the six-month period ended December 30, 2005 from the comparable period in the prior year is primarily due to decreases of $707,000 in statement processing costs, the $213,000 in rent expense noted above and $620,000 from reduced expenditures for leased computer equipment and software licenses.

Communications. Communications expense decreased $760,000 for the three-month period ended December 30, 2005 as compared to the same period of the prior year. Quotation costs were down $463,000 due to the closure of two offices (Michigan and Wisconsin) as well as reduced headcount in equity trading. Additionally, telephone expenses were reduced by $198,000 due to favorable restructuring of our telecommunications contracts.

Communications expense decreased $1,363,000 for the six-month period ended December 30, 2005 as compared to the same period of the prior year. Quotation costs were down $1,079,000 and telephone expenses were down $267,000 due to the reasons noted above.

Floor Brokerage and Clearing Organization Charges. Floor brokerage and clearing organization charges change in relation to the transactions processed in our clearing business as well as changes in the costs from our clearing agencies. These charges decreased $789,000 and $1,076,000 when comparing the three and six month periods ended December 30, 2005 to the same period in the prior year, respectively. The reductions are due to reduced clearing costs as we significantly reduced our market making business in September 2005 and rebates received from the Depository Trust Company.

Advertising and Promotional. Advertising and promotional expense decreased $384,000 and $527,000 when comparing the three and six months ended December 30, 2005 to the same periods in the prior fiscal year, respectively. This decrease reflects the reduction in advertising, external recruiting, and travel and entertainment costs.

Other Expense.The decrease in other expense for the second quarter of fiscal 2006 was $697,000 compared to the second quarter of last year. The reduction is primarily due to reduced losses from CSS of $721,000, a decrease in professional services of $375,000, and $260,000 reduction in other tax expense due to the receipt of a state franchise tax refund. The reduction in professional services is due to costs related to Sarbanes-Oxley Section 404 (“SOX 404”) compliance that were incurred in fiscal 2005 that did not recur in fiscal 2006. These decreases are offset by increases of $595,000 in the Bank’s provision for loan losses due to an increasing portfolio size.

The increase in other expense for the first half of fiscal 2006 was $1,730,000 compared to the first half of last year. The increase is primarily composed of a $2,644,000 increase in the Bank’s provision for loan losses as well as $994,000 in non-recurring items in fiscal 2005 related to a state tax refund and the resolution of items from the purchase of a clearing business by Southwest Clearing Corporation. These increases were offset by reduced losses from CSS of $1,433,000 and reduced SOX 404 consulting fees of $501,000.

Income Tax Expense. For the first half of fiscal 2006, income tax expense (effective rate was 35.3%) differed from the amount that would have otherwise been calculated by applying the federal corporate tax rate (35%) to income before income taxes and minority interest in consolidated subsidiaries. The effective rate was higher than the statutory rate because of permanently excluded items, primarily the state income tax provision and meals and entertainment expenses offset by tax exempt interest and income from company-owned life insurance policies.

Minority Interest in Consolidated Subsidiaries. The decrease in minority interest in consolidated subsidiaries of $191,000 and $424,000 for the three and six months ended December 30, 2005 when compared to similar periods in the prior year is primarily due to the increase in the Bank’s total investment in FSB Financial from 75% in the first quarter of fiscal 2005 to 90% in January of fiscal 2005.

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FINANCIAL CONDITION

Loans and Allowance for Probable Loan Losses. The Bank grants loans to customers primarily within North Texas. The Bank also 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 North Texas. Substantially all of the Bank’s loans are collateralized with real estate.

The allowance for probable loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Management’s periodic evaluation of the adequacy of the allowance is based on the Bank’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, and current economic conditions.

Loans receivable at December 31, 2005 and June 30, 2005 are summarized as follows (in thousands):

	December 31, 2005		June 30, 2005
Real estate – mortgage	$	190,217	$	225,256
Real estate – construction		224,233		168,343
Commercial		191,891		197,045
Individuals		80,228		95,382
Land		97,722		77,854
	$	784,291	$	763,880

The following table shows the expected life of certain loans at December 31, 2005, and segregates those loans with fixed interest rates from those with floating or adjustable rates (in thousands):

	1 year or less		1-5 years		Over 5 years		Total
Real estate – construction	$	179,246	$	26,006	$	18,981	$	224,233
Commercial		31,178		74,159		86,554		191,891
Total	$	210,424	$	100,165	$	105,535	$	416,124
Amount of loans based upon:
Floating or adjustable interest rates	$	208,778	$	75,906	$	80,226	$	364,910
Fixed interest rates		1,646		24,259		25,309		51,214
Total	$	210,424	$	100,165	$	105,535	$	416,124

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. The Bank uses a standardized review process to determine which loans should be placed on non-accrual status. At the time a loan is placed on non-accrual status, previously accrued and uncollected interest is reversed against interest income. Interest income on non-accrual loans is credited to income on a cash basis.

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Non-performing assets as of December 31, 2005 and June 30, 2005 are as follows (dollars in thousands):

	December 31, 2005			June 30, 2005
Loans accounted for on a non-accrual basis	$	6,536		$	4,949
Non-performing loans as a percentage of total gross loans		0.9	%		0.7	%
Loans past due 90 days or more, not included above	$	486		$	804
Troubled debt restructurings	$	2,428		$	2,027

An analysis of the allowance for probable loan losses for the three and six-month periods ended December 31, 2005 and 2004 is as follows (dollars in thousands):

	Three Months Ended December 31,						Six Months Ended December 31,
	2005			2004			2005			2004
Balance at beginning of period	$	7,558		$	4,627		$	7,450		$	4,643
Charge-offs – commercial		(113	)		—			(113	)		—
Charge-offs – individual		(2,356	)		(753	)		(4,832	)		(1,441	)
Charge-offs – real estate-mortgage		(50	)		—			(102	)		—
Recoveries – individual		32			45			134			71
Recoveries – commercial		12			—			57			—
Net charge-offs		(2,475	)		(708	)		(4,856	)		(1,370	)
Additions charged to operations		2,068			1,473			4,557			2,119
Balance at end of period	$	7,151		$	5,392		$	7,151		$	5,392
Ratio of net charge-offs during the period to average loans outstanding during the period		0.32	%		0.12	%		0.64	%		0.23	%

The allowance for probable loan losses is applicable to the following types of loans as of December 31, 2005 and June 30, 2005 (dollars in thousands):

	December 31, 2005				June 30, 2005
	Amount		Percent of loans to total loans		Amount		Percent of loans to total loans
Commercial	$	1,616	24.5	%	$	1,446	25.7	%
Real estate – construction		1,377	28.5			1,033	22.0
Real estate – mortgage & land		1,802	36.6			1,313	39.5
Individuals		2,356	10.4			3,658	12.8
	$	7,151	100.0	%	$	7,450	100.0	%

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Deposits.Average deposits and the average interest rate paid on the deposits for the three and six-month periods ended December 31, 2005 and 2004 can be found in the discussion of the Banking Group’s net interest income under the caption “-Results of Operations-Net Interest Income-Banking Group.”

Certificates of deposit of $100,000 or greater were $23,224,000 and $58,554,000 at December 31, 2005 and June 30, 2005, respectively. The Bank funds its loans through short-term borrowings at the Federal Home Loan Bank (“FHLB”), internally generated deposits, brokered certificates of deposit and funds on deposit in an FDIC insured interest bearing checking account from Southwest Securities’ brokerage customers. The Bank has in excess of $400 million ($475,000,000 at December 31, 2005) in funds on deposit from customers of Southwest Securities. This funding source has reduced the Bank’s reliance on short-term borrowings from the FHLB and brokered certificates of deposit.

Advances from Federal Home Loan Bank.The Bank has historically financed its short-term borrowing needs through advances from the FHLB. This table represents advances from the FHLB which were due within one year (generally two to seven days) during the three and six-month periods ended December 31, 2005 and 2004 (dollars in thousands):

	Three Months Ended December 31,								Six Months Ended December 31,
	2005				2004				2005				2004
	Amount		Interest Rate		Amount		Interest Rate		Amount		Interest Rate		Amount		Interest Rate
At end of period	$	36,488	4.2	%	$	17,398	2.5	%	$	36,488	4.2	%	$	17,398	2.5	%
Average during period		35,457	4.0	%		3,400	3.5	%		48,444	3.8	%		2,180	4.2	%
Maximum balance during period		77,442	—			18,900	—			77,442	—			18,900	—

LIQUIDITY AND CAPITAL RESOURCES

Brokerage Group

A substantial portion of our assets are highly liquid in nature and consist mainly of cash or assets readily convertible into cash. Our equity capital, short-term bank borrowings, interest bearing and non-interest bearing client credit balances, correspondent deposits and other payables finance these assets. We maintain an allowance for doubtful accounts 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 highly liquid nature of our assets provides us with flexibility in financing and managing our anticipated operating needs.

Short-Term Borrowings.We have credit arrangements with commercial banks, which include broker loan lines up to $275,000,000. 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 Southwest Securities and its clients. At December 30, 2005, the amount outstanding under these secured arrangements was $47,300,000, which was collateralized by securities held for firm accounts valued at $92,103,000.

In addition to the broker loan lines, SWS 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. The total amount of borrowings available under this line of credit is reduced by the amount outstanding on the line and under the unsecured letters of credit at the time of borrowing. There were no amounts outstanding on this line and $2,964,000 under unsecured letters of credit at December 30, 2005. At December 30, 2005, the total amount available for borrowings was $17,036,000.

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We also have unsecured letters of credit, aggregating $2,250,000 at December 30, 2005, pledged to support our open positions with securities clearing organizations. The unsecured letters of credit bear a 1% commitment fee and are renewable semi-annually.

At December 30, 2005, we had an additional unsecured letter of credit issued for a sub-lease to the sub-lessee of space previously occupied by Mydiscountbroker.com, Inc., a subsidiary of SWS dissolved in July 2004, in the amount of $714,000. This letter of credit bears a 1% commitment fee and is renewable annually.

We also have an irrevocable letter of credit agreement aggregating $45,000,000 at December 30, 2005 pledged to support our open options positions with an options clearing organization. The letter of credit bears interest at the brokers’ call rate, if drawn, and is renewable semi-annually. This letter of credit is fully collateralized by marketable securities held in client and non-client margin accounts with a value of $57,378,000 at December 30, 2005.

In the opinion of management, these credit arrangements are adequate to meet our operating capital needs of the Brokerage Group for the foreseeable future.

Off-Balance Sheet Arrangements.Off-balance sheet arrangements, as defined by the SEC, include certain contractual arrangements pursuant to which a company has a binding obligation which is not reflected on the balance sheet. Included are contingent obligations, certain guaranteed contracts, retained or contingent interest in assets transferred to an unconsolidated entity, certain derivative investments classified as equity or material variable interests in unconsolidated entities that provide financing, liquidity, market risk or credit risk support. We generally do not enter into off-balance sheet arrangements, as defined, other than those described in the Contractual Obligations and Contingent Payments section of our annual report on Form 10-K for the fiscal year ended June 24, 2005. In addition, our broker/dealer subsidiaries enter into transactions in the normal course of business that expose us to off-balance sheet risk. See Note 25 of the Notes to Consolidated Financial Statements contained in our annual report on Form 10-K for the fiscal year ended June 24, 2005.

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

Banking Group

Liquidity is monitored daily to ensure the Bank’s ability to support asset growth, meet deposit withdrawals, maintain reserve requirements and otherwise sustain operations. The Bank’s liquidity is maintained in the form of readily marketable loans, balances with the FHLB and vault cash. In addition, the Bank has borrowing capacity with the FHLB and a $20,000,000 federal funds line of credit for the purpose of purchasing short-term funds should additional liquidity be needed. Current net available borrowing capacity at FHLB is $110,103,000. Management believes that the Bank’s present position is adequate to meet its current and future liquidity needs.

The Bank’s asset and liability management policy is intended to manage interest rate risk. The Bank accomplishes this through management of the repricing of its interest-earning assets and its interest-bearing liabilities. See discussion of the Bank’s gap analysis in “Risk Management-Market Risk-Interest Rate Risk/Banking Group.” At December 31, 2005, $475,000,000 of the Bank’s deposits was from broker customers of Southwest Securities. Events in the securities markets could impact the amount of these funds available to the Bank.

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FSB Financial has borrowing capacity of $75,000,000 through a secured line of credit for the purpose of purchasing pools of loans.

The Bank is subject to capital standards imposed by regulatory bodies, including the Office of Thrift Supervision and the Federal Deposit Insurance Corporation. The Bank has historically met all the capital adequacy requirements to which it is subject.

We created a new bank holding company that could be used to issue trust-preferred securities to facilitate additional capital at the Bank. There is no current plan for the holding company to issue securities.

Bank Borrowings. In June 2005, the Bank entered into an agreement with an unaffiliated bank for a $20,000,000 unsecured line of credit for the purchase of federal funds. The line bears interest at a rate equal to the federal funds rate plus 0.25%. The line is used by the Bank to support short-term liquidity needs and expires on May 31, 2006. At December 31, 2005, there were no amounts outstanding on this line of credit.

On June 8, 2005, FSB Financial obtained a secured line of credit from an unaffiliated bank in the amount of $75,000,000. At December 31, 2005, $18,600,000 was outstanding on this line of credit. The note related to this line of credit matures on June 7, 2008. Interest is paid on a monthly basis at a rate of 30-day LIBOR plus a variable rate that is determined by the status of certain financial ratios at the time of the advance. The interest rate was 6.54% December 31, 2005. This line of credit is secured by automobile loans totaling $30,367,000.

FSB Financial also has a line of credit with its parent Bank. At December 31, 2005, the total credit line is $44,350,000 of which FSB Financial has drawn $44,350,000. Participations by third parties totaled $9,350,000 at December 31, 2005. The loan bears interest for unaffiliated participants at 30-day LIBOR plus 2.25%. The loan bears interest for the Bank at the Bank Insured Funds rate plus 0.9%, 4.34% at December 31, 2005. The loan matures on March 27, 2006. SWS Group guarantees $10,000,000 of this credit line to the Bank. See “Commitments and Contingencies” in the Notes to the Consolidated Financial Statements contained in this Report.

FSB Financial has the ability to borrow up to $5 million from SWS Group, if needed. Any funds borrowed bear interest at prime plus 1.0% and mature on June 8, 2008. At December 31, 2005, there were no amounts outstanding on this borrowing.

Cash Flow

Net cash provided by operating activities was $47,494,000 for the six months ended December 30, 2005 compared to net cash used in operating activities of $93,862,000 for the six months ended December 31, 2004. The primary reasons for the increase in cash from operating activities were decreases in client receivable accounts of $39,166,000 and loans held for sale of $35,166,000 compared to a net change in client receivable accounts of only $21,407,000 for the six months ended December 31, 2004 and an increase in loans held for sale of $35,227,000. These are offset by a small increase in securities purchased under agreements to resell and net change in broker, dealer and clearing organization accounts of $5,217,000 and $9,393,000, respectively, for the six months ended December 30, 2005 compared to $43,524,000 and $59,854,000, respectively, for the six months ended December 31, 2004.

Net cash used in investing activities for the six-month periods ended December 30, 2005 and December 31, 2004 was $56,897,000 and $65,909,000, respectively. The primary reason for the decrease in cash used for investing activities was increased mortgage payments.

Net cash flows provided by financing activities totaled $13,965,000 for the six-month period ended December 30, 2005 compared to $88,583,000 for the six-month period ended December 31, 2004. The primary differences were the reduced reliance on borrowings by the Bank from the FHLB due to cash inflows from Southwest Securities’ customers and payments on borrowings at the Bank, offset by the increases in cash proceeds from securities sold under agreements to repurchase and in deposits at the Bank.

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We expect that cash flows provided by operating activities as well as short-term borrowings will be the primary source of working capital for fiscal 2006.

Treasury Stock

Periodically, we repurchase our common stock under a plan approved by our Board of Directors. Currently, we have authorization, which will expire in December 31, 2006, to repurchase 500,000 shares. In October 2005, we repurchased 31,090 shares at a cost of $478,000 or $15.36 per share.

Additionally, the trustee under our deferred compensation plan periodically purchases 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 three and six-month periods ended December 30, 2005, 611 shares were sold or distributed pursuant to the plan. See “Part II. Other Information-Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.”

RISK MANAGEMENT

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

Credit Risk

Brokerage Group. Credit risk arises from the potential nonperformance by counter-parties, customers or debt security issuers. We are exposed to credit risk as a trading counter-party and as a stock loan counter-party 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. 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 Group. Credit risk is the possibility that a borrower or counter party will fail to meet its obligations in accordance with agreed terms and is inherent in all types of lending provided. The Bank has developed and implemented extensive policies and procedures to provide a robust process for proactively managing credit risk. These policies and procedures include underwriting guidelines, credit and collateral tracking and detailed loan approval procedures which include officer and director loan committees. The Bank also maintains a detailed loan review process to monitor the quality of the loan portfolio. The Bank grants loans to customers primarily within the Dallas / Fort Worth metropolitan area. The Bank also purchases loans which have been originated in other areas of the United States. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon the general economic conditions of the North Texas area. Policies and procedures, which are in place to manage credit risk, are designed to be responsive to changes in these economic conditions.

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At FSB Financial, the valuation of residual non-prime auto loans involves both credit risk and collateral value risk. Non-prime loans involve higher loss risk due to the lower credit quality of the borrower. Creditors mitigate this risk in pricing the loan at origination; generally, the interest rate is higher to compensate for the higher credit risk. FSB Financial further mitigates credit risk by purchasing bulk loans at a discount to increase the overall yield which compensates for inherent losses in the purchased portfolios. We also purchase seasoned loans, which reduce credit losses due to early defaults, or seek indemnifications from the seller for early defaults. Collateral value risk is addressed by adhering to established criteria regarding vehicle age, loan-to-value ratio and vehicle mileage limitations. In addition, we will not purchase a loan if the borrower has not provided proof of insurance on the collateral vehicle.

Operational Risk

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

Legal Risk

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

Market Risk

Market risk generally represents the risk of loss that may result from the potential change in value of a financial instrument as a result of fluctuations in interest rates, equity prices, 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.

Interest Rate Risk/Brokerage Group. Interest rate risk is a consequence of maintaining inventory positions and trading in interest-rate-sensitive financial instruments. 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 Group. Our primary emphasis in interest rate risk management for the Bank is the matching of assets and liabilities of similar cash flow and re-pricing time frames. This matching of assets and liabilities reduces exposure to rate movements and aids in stabilizing positive interest spreads. We strive to structure our balance sheet as a natural hedge by matching floating rate assets with variable short term funding and by matching fixed rate liabilities with similar longer term fixed rate assets. The Bank has established percentage change limits in both interest margin and net

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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 by the Office of Thrift and Supervision (“OTS”) for interest rate sensitivity of the Bank’s net portfolio. These analyses are conducted on a monthly basis for the Bank’s Board of Directors.

The following table illustrates the estimated change in net interest margin based on shifts in interest rates of positive 300 basis points and negative 200 basis points:

Hypothetical Change in Interest Rates	Projected Change in Net Interest Margin
+300	0.70	%
+200	0.48	%
+100	0.25	%
0	0	%
-100	-0.26	%
-200	-0.72	%

The following GAP Analysis table indicates the Bank’s interest rate sensitivity position at December 31, 2005:

	Repricing Opportunities
(in thousands)	0-6 months		7-12 months			1-3 years		3+ years
Earning Assets:
Loans	$	649,924	$	28,757		$	75,994	$	36,767
Securities and FHLB Stock		4,217		—			—		269
Interest Bearing Deposits		2,562		—			—		—
Total Earning Assets		656,703		28,757			75,994		37,036
Interest Bearing Liabilities:
Transaction Accounts and Savings		513,051		—			—		—
Certificates of Deposit		24,443		33,756			15,139		10,058
Borrowings		60,450		3,988			7,443		31,258
Total Interest Bearing Liabilities		597,944		37,744			22,582		41,316
GAP	$	58,759	$	(8,987	)	$	53,412	$	(4,280	)
Cumulative GAP	$	58,759	$	49,772		$	103,184	$	98,904

Equity Price Risk. We are 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.

The following table categorizes securities owned, net of securities sold, not yet purchased, which are in our trading portfolio, marketable equity securities in our available-for-sale portfolio, which are subject to interest rate and equity price risk, as well as net securities purchased under agreements to resell, repurchase which are also subject to interest rate and equity price risk (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	$	556	$	6,963		$	6,012		$	11,279		$	24,810
U.S. Government and Government agency obligations		4,913		3,757			(4,862	)		(5,217	)		(1,409	)
Corporate obligations		2,675		(3,728	)		(9,851	)		34,892			23,988
Total debt securities		8,144		6,992			(8,701	)		40,954			47,389
Corporate equity		—		—			—			3,980			3,980
Securities purchased under agreements to resell, net		—		(4,890	)		9,413			167			4,690
Other		9,932		—			—			—			9,932
	$	18,076	$	2,102		$	712		$	45,101		$	65,991

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	Years to Maturity
	1 or less			1 to 5			5 to 10			Over 10			Total
Weighted average yield
Municipal obligations		3.9	%		3.5	%		4.0	%		2.4	%		3.2	%
U.S. Government and Government agency obligations		3.8	%		4.4	%		3.7	%		5.3	%		4.2	%
Corporate obligations		6.7	%		5.2	%		5.4	%		5.6	%		5.4	%
Securities purchased under agreements to resell, net		—	%		4.2	%		3.4	%		4.4	%		3.9	%
Available-for-sale securities, at fair value
Marketable equity securities	$	—		$	—		$	—		$	3,077		$	3,077

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect reported amounts and disclosures. Actual results may differ from these estimates under different assumptions or conditions. Our accounting policies and methodology used in establishing estimates (primarily related to loan loss reserves and other contingency estimates) have not changed materially since June 24, 2005. (See our Annual Report on Form 10-K for the fiscal year then ended.)

FORWARD-LOOKING STATEMENTS

From time to time, we make statements (including some contained in this Report) that predict or forecast future events, depend on future events for their accuracy, or otherwise contain “forward-looking information.” These statements may relate to anticipated changes in revenues or earnings per share, anticipated changes in our businesses or in anticipated expense levels, or in expectations regarding financial market conditions.

We caution readers that any forward-looking information we provide is not a guarantee of future performance. Actual results may differ materially as a result of various factors, some of which are outside of our control.

Our business and future prospects may fluctuate due to numerous factors, such as:

• the interest rate environment;

• the volume of trading in securities;

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

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

• the demand for housing in the North Texas area and the national market;

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

• the demand for investment banking services;

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• general economic conditions and investor sentiment and confidence;

• competitive conditions in each of our business segments;

• changes in accounting, tax and regulatory compliance requirements; and

• the ability to attract and retain key personnel.

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 or other contingencies.

Additionally, factors which may cause actual results to differ materially from our forward-looking statements include those factors discussed in this Report in “Management’s Discussion and Analysis of Financial Condition and Results of Operations –Overview,” “-Risk Management” and “-Critical Accounting Policies and Estimates” and those discussed in our other reports filed with and available from the SEC. All forward-looking statements we make speak only as of the date on which they are made, and we undertake no obligation to update them to reflect events or circumstances occurring after the date on which they were made or to reflect the occurrence of unanticipated events.

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 “-Risk Management.”

Item 4. Controls and Procedures

The management of SWS, including the principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934) as of December 30, 2005. Based on such evaluation, the principal executive officer and principal financial officer have concluded that, as of December 30, 2005, such disclosure controls and procedures were effective for the purpose of ensuring that material information required to be in the reports SWS submits, files, furnishes or otherwise provides to the SEC is made known to them by others on a timely basis and is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. There have not been any changes in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f) of the Securities Exchange Act of 1934) during the three and six-month periods ended December 30, 2005 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

In the general course of our brokerage business and the business of clearing for other brokerage firms, SWS Group and/or our subsidiaries have been named as defendants in various pending lawsuits and arbitration proceedings. These claims allege violation of federal and state securities laws. The Bank is also involved in certain claims and legal actions arising in the ordinary course of business. We believe that resolution of these claims will not result in any material adverse effect on our business, consolidated financial condition, results of operations or cash flows.

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

The following table provides information about purchases by SWS during the quarter ended December 30, 2005 of equity securities that are registered by SWS pursuant to Section 12 of the Exchange Act:

ISSUER PURCHASES OF EQUITY SECURITIES

	Total Number of Shares Purchased(1)	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plan	Maximum Number of Shares that May Yet be Purchased Under the Plans(1)
10/1/05 to 10/28/05	31,090	$	15.36	31,090	468,910
10/29/05 to 11/25/05	—		—	—	468,910
11/26/05 to 12/30/05	—		—	—	468,910
	31,090	$	15.36	31,090

⁽¹⁾ 31,090 shares were repurchased under the Stock Repurchase Program in the quarter ended December 30, 2005. After this repurchase, there are 468,910 shares available for purchase under a stock repurchase program approved by our Board of Directors pursuant to which SWS has authorization, which will expire on December 31, 2006, to repurchase a total of 500,000 shares.

Item 3. Defaults upon Senior Securities

None Reportable.

Item 4. Submission of Matters to a Vote of Security Holders

The annual meeting of shareholders was held on November 29, 2005. The following directors were elected at the meeting:

Nominees	For	Withheld	Abstain
Don A. Buchholz	16,000,354	96,014	—
Donald W. Hultgren	16,004,438	91,930	—
Brodie L. Cobb	12,472,592	3,623,776	—
Larry A. Jobe	16,010,083	86,285	—
R. Jan LeCroy	15,853,714	242,654	—
Frederick R. Meyer	15,652,163	444,205	—
Jon L. Mosle, Jr.	15,581,950	514,418	—

There were no other matters voted on at the annual meeting.

Item 5. Other Information

None Reportable.

Item 6. Exhibits

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

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SIGNATURES

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

	SWS Group, Inc. (Registrant)
February 8, 2006 Date	/S/ Donald W. Hultgren
	(Signature)
	Donald W. Hultgren
	Chief Executive Officer and Duly Authorized Officer
	(Principal Executive Officer)
February 8, 2006 Date	/S/ Kenneth R. Hanks
	(Signature)
	Kenneth R. Hanks
	Treasurer and Chief Financial Officer
	(Principal Financial Officer)
February 8, 2006 Date	/S/ Stacy Hodges
	(Signature)
	Stacy Hodges
	Executive Vice President
	(Principal Accounting Officer)

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SWS GROUP, INC. AND SUBSIDIARIES

INDEX TO EXHIBITS

Exhibit Number	Description
3.1	Restated Certificate of Incorporation of the Registrant incorporated by reference to Exhibit 3.1 to the Registrant’s Annual Report on Form 10-K filed September 8, 2004
3.2	Restated By-laws of the Registrant incorporated by reference to Exhibit 3.2 to the Registrant’s Current Report on Form 8-K filed November 12, 2004
31.1*	Chief Executive Officer Certification filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*	Chief Financial Officer Certification filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1*	Chief Executive Officer Certification furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2*	Chief Financial Officer Certification furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

* Filed herewith

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