SWS (SWS) 10-Q 2007 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 29, 2006

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 5, 2007, there were 27,392,114 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 29, 2006(unaudited) and June 30, 2006		1
Consolidated Statements of Income and Comprehensive Income For the three and six-months ended December 29, 2006 and December 30, 2005(unaudited)		2
Consolidated Statements of Cash Flows For the six-months ended December 29, 2006 and December 30, 2005(unaudited)		4
Notes to Consolidated Financial Statements(unaudited)		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	24
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	45
Item 4.	Controls and Procedures	45
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	45
Item 1A.	Risk Factors	46
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	46
Item 3.	Defaults Upon Senior Securities	46
Item 4.	Submission of Matters to a Vote of Security Holders	46
Item 5.	Other Information	47
Item 6.	Exhibits	47
SIGNATURES		48
EXHIBIT INDEX		49

SWS Group, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

December 29, 2006 and June 30, 2006

(In thousands, except par values and share amounts)

	December (unaudited)			June
Assets
Cash	$	80,425		$	41,674
Assets segregated for regulatory purposes		338,792			345,028
Receivable from brokers, dealers and clearing organizations		2,694,493			2,821,512
Receivable from clients, net of allowances		337,117			373,245
Loans held for sale, net		128,209			124,874
Loans, net		712,747			642,541
Securities owned, at market value		158,053			159,004
Securities purchased under agreements to resell		44,633			63,636
Goodwill		7,552			7,552
Marketable equity securities available for sale		4,224			3,593
Other assets		84,307			75,192
	$	4,590,552		$	4,657,851
Liabilities and Stockholders’ Equity
Short-term borrowings	$	10,680		$	30,500
Payable to brokers, dealers and clearing organizations		2,622,955			2,775,564
Payable to clients		597,276			617,697
Deposits		803,842			705,894
Securities sold under agreements to repurchase		10,002			7,719
Securities sold, not yet purchased, at market value		82,023			96,909
Drafts payable		26,633			29,144
Advances from Federal Home Loan Bank		59,337			47,094
Other liabilities		57,914			57,217
		4,270,662			4,367,738
Minority interest in consolidated subsidiaries		883			641
Commitments and contingencies
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 27,927,174 and outstanding 27,247,393 shares at December 29, 2006; issued 27,424,611 and outstanding 26,591,891 shares at June 30, 2006		2,792			1,828
Additional paid-in capital		266,857			255,331
Retained earnings		53,201			37,968
Accumulated other comprehensive income – unrealized holding gain net of tax of $863 at December 29, 2006 and $650 at June 30, 2006		1,656			1,225
Deferred compensation, net		1,604			1,610
Treasury stock (679,781 shares at December 29, 2006 and 832,720 shares at June 30, 2006, at cost)		(7,103	)		(8,490	)
Total stockholders’ equity		319,007			289,472
	$	4,590,552		$	4,657,851

See accompanying Notes to Consolidated Financial Statements.

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SWS Group, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

For the three and six-months ended December 29, 2006 and December 30, 2005

(In thousands, except per share and share amounts)

(Unaudited)

	For the Three Months Ended						For the Six Months Ended
	December 29, 2006			December 30, 2005			December 29, 2006			December 30, 2005
Revenues:
Net revenues from clearing operations	$	3,056		$	3,449		$	6,127		$	7,166
Commissions		24,360			25,057			43,299			46,127
Interest		74,877			50,868			144,782			102,960
Investment banking, advisory and administrative fees		8,050			6,931			18,425			16,107
Net gains on principal transactions		5,655			3,844			13,853			8,844
Other		9,111			6,855			14,769			12,571
Total revenue		125,109			97,004			241,255			193,775
Interest expense		50,802			31,727			96,607			64,333
Net revenues		74,307			65,277			144,648			129,442
Non-Interest Expenses:
Commissions and other employee compensation		40,837			37,469			81,681			75,292
Occupancy, equipment and computer service costs		5,489			5,930			10,829			11,567
Communications		2,103			2,250			4,289			4,652
Floor brokerage and clearing organization charges		1,106			798			2,276			2,093
Advertising and promotional		604			673			1,059			1,326
Other		4,841			5,653			10,467			11,653
Total non-interest expenses		54,980			52,773			110,601			106,583
Income from continuing operations before income tax expense		19,327			12,504			34,047			22,859
Income tax expense		6,422			4,379			11,059			8,108
Income from continuing operations		12,905			8,125			22,988			14,751
Discontinued operations:
Income from discontinued operations		45			1,047			86			1,801
Income tax expense		(14	)		(345	)		(27	)		(599	)
Minority interest		(5	)		(62	)		(9	)		(91	)
Income from discontinued operations		26			640			50			1,111
Income before cumulative effect of change in accounting principles		12,931			8,765			23,038			15,862
Cumulative effect of a change in accounting principle, net of tax of $40.		—			—			—			75
Net income		12,931			8,765			23,038			15,937
Net income recognized in other comprehensive income		456			202			431			460
Comprehensive income	$	13,387		$	8,967		$	23,469		$	16,397

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	For the Three Months Ended				For the Six Months Ended
	December 29, 2006		December 30, 2005		December 29, 2006		December 30, 2005
Earnings per share - basic
Income from continuing operations	$	0.48	$	0.31	$	0.86	$	0.57
Income from discontinued operations		—		0.03		—		0.04
Cumulative effect of change in accounting principles, net of tax		—		—		—		—
Net income	$	0.48	$	0.34	$	0.86	$	0.61
Weighted average shares outstanding – basic		26,836,292		26,030,746		26,654,548		26,011,387
Earnings per share – diluted
Income from continuing operations	$	0.48	$	0.31	$	0.85	$	0.56
Income from discontinued operations		—		0.02		—		0.04
Cumulative effect of change in accounting principles, net of tax		—		—		—		0.01
Net income	$	0.48	$	0.33	$	0.85	$	0.61
Weighted average shares outstanding – diluted		27,147,538		26,277,206		26,950,070		26,219,651

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 29, 2006 and December 30, 2005

(In thousands)

(Unaudited)

	For the Six Months Ended
	December 29, 2006			December 30, 2005
Cash flows from operating activities:
Net income	$	23,038		$	15,937
Income from discontinued operations		(50	)		(1,111	)
Cumulative effect of a change in accounting principle		—			(75	)
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,417			2,797
Amortization/accretion of discounts/premiums on loans purchased		(771	)		218
Provision for doubtful accounts		1,240			1,851
Deferred income tax benefit		(2,086	)		(496	)
Deferred compensation		1,462			1,009
Gain on sale of loans		(497	)		(1,232	)
(Gain) loss on sale of fixed assets		(5	)		50
Gain on sale of real estate		(49	)		(27	)
Equity in losses (earnings) on of unconsolidated ventures		528			(1,431	)
Dividend received on investment in Federal Home Loan Bank stock		(80	)		(56	)
Windfall tax benefits		(227	)		(22	)
Net change in minority interest in consolidated subsidiaries		231			127
Cash flow from operating activities of discontinued operations		148			3,996
Change in operating assets and liabilities:
Decrease (increase) in assets segregated for regulatory purposes		6,236			(36,853	)
Net change in broker, dealer and clearing organization accounts		(25,590	)		(9,393	)
Net change in client accounts		15,227			39,166
Net change in loans held for sale		(3,335	)		35,166
Decrease (increase) in securities owned		951			(9,453	)
Decrease (increase) in securities purchased under agreements to resell		19,003			(5,217	)
(Increase) decrease in other assets		(3,512	)		1,407
(Decrease) increase in drafts payable		(2,511	)		5,383
(Decrease) increase in securities sold, not yet purchased		(14,886	)		8,943
Decrease in other liabilities		(759	)		(3,152	)
Net cash provided by operating activities		16,123			47,532
Cash flows from investing activities:
Purchase of fixed assets		(2,790	)		(938	)
Purchase of real estate		(284	)		(12	)
Proceeds from the sale of fixed assets		5			76
Proceeds from the sale of real estate		1,419			818
Loan originations and purchases		(367,223	)		(327,835	)
Loan repayments		296,963			257,170
Cash paid for purchase of correspondent clients of Ameritrade		(2,382	)		—
Cash paid for purchase of O’Connor & Co. Securities, net of cash acquired		—			(86	)
Cash paid on investments		—			(500	)
Cash received on investments		—			1,630
Cash flow from investing activities of discontinued operations		—			10,521
Proceeds from the sale of Federal Home Loan Bank stock		—			2,708
Purchases of Federal Home Loan Bank stock		(7	)		(487	)
Net cash used in investing activities		(74,299	)		(56,935	)
Cash flows from financing activities:
Payments on short-term borrowings		(1,050,700	)		(1,218,200	)
Cash proceeds from short-term borrowings		1,030,880			1,197,100
Increase in deposits		97,948			54,050

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	For the Six Months Ended
	December 29, 2006			December 30, 2005
Advances from the Federal Home Loan Bank		26,972			3,494,265
Payments on advances from Federal Home Loan Bank		(14,729	)		(3,512,615	)
Cash payments on notes payable – Bank		—			(1,700	)
Payment of cash dividends on common stock – SWS Group		(3,993	)		(3,505	)
Windfall tax benefits		227			22
Cash proceeds on securities sold under agreements to repurchase		2,283			21,356
Net proceeds from exercise of stock options		8,114			1,024
Cash flow from financing activities of discontinued operations		—			(17,500	)
Proceeds related to the Deferred Compensation Plan		157			145
Purchase of treasury stock		(232	)		(477	)
Net cash provided by financing activities		96,927			13,965
Net increase in cash		38,751			4,562
Cash at beginning of period		41,674			23,045
Cash at end of period	$	80,425		$	27,607
Supplemental schedule of non-cash investing and financing activities:
Granting of Restricted Stock	$	917		$	2,074
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest from continuing operations	$	54,768		$	63,393
Taxes	$	11,600		$	4,550

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 29, 2006 and December 30, 2005

(Unaudited)

GENERAL AND BASIS OF PRESENTATION

The interim consolidated financial statements as of December 29, 2006, and for the three and six-month periods ended December 29, 2006 and December 30, 2005, 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 30, 2006 filed on Form 10-K. Amounts included for June 30, 2006 are derived from the audited consolidated financial statements as filed on Form 10-K. All significant intercompany balances and transactions have been eliminated.

On November 30, 2006, the Company’s Board of Directors declared a 3-for-2 stock split effected in the form of a 50% stock dividend. The additional shares were distributed on January 2, 2007, to shareholders of record on December 15, 2006. The distribution has been reflected in the December 29, 2006 financial statements. All references in the condensed consolidated financial statements to amounts per share and the number of shares outstanding have been restated to give retroactive effect to the stock split.

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 Entities:
Southwest Securities, Inc.	“Southwest Securities”
SWS Financial Services, Inc.	“SWS Financial”
SWS Capital Corporation	“SWS Capital”
Southwest Investment Advisors, Inc.	“Southwest Advisors”
Southwest Financial Insurance Agency, Inc.
Southwest Insurance Agency, Inc.
Southwest Insurance Agency of Alabama, Inc.	collectively, “SWS Insurance”
Banking Entities:
SWS Banc Holdings, Inc.	“SWS Banc”
Southwest Securities, FSB*	“Bank”
SWS A, LLC (90%)**	“SWS A”
SWS B, LTD (88.2%)**	“SWS B”
FSB Development, LLC	“FSB Development”

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

** On March 1, 2006, FSB Financial, LTD sold substantially all of its assets. See discussion in “-Discontinued Operations.” Also, effective March 1, 2006, FSBF, LLC changed its name to SWS A, LLC and FSB Financial, LTD changed its name to SWS B, LTD.

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 (“Exchange 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 Capital administered the Local Government Investment Cooperative (“LOGIC”) asset management service 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

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governments within the state of Texas. SWS Capital did not renew its contract as General Manager of LOGIC upon the expiration of the original agreement on September 4, 2005. At December 29, 2006, SWS Capital had no assets under management.

Southwest Advisors is a dormant entity.

SWS Insurance holds insurance agency licenses in 46 states for the purpose of facilitating the sale of insurance and annuities for customers of Southwest Securities and its correspondents.

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 and became the sole shareholder of the Bank in 2004. SWS A is a 2% general partner of SWS B.

On March 1, 2006, FSB Financial, LTD (“FSB Financial”) a purchaser, originator and servicer of non-prime automobile loans, sold substantially all of its assets for $35,870,000 in cash and the retirement of $116,868,000 of related debt. See “-Discontinued Operations.”

FSB Development develops single-family residential lots.

Consolidated Financial Statements. The quarterly consolidated financial statements of SWS for the second fiscal quarter are prepared as of the close of business on the last Friday of December. The Bank’s quarterly financial statements are prepared as of December 31, 2006. Any individually material transactions are reviewed and recorded in the appropriate quarterly period. All significant inter-company balances and transactions have been eliminated.

Discontinued Operations.In March 2006, the Bank sold the assets of its subsidiary, FSB Financial, for $35,870,000 in cash and the retirement of $116,868,000 of related debt. Pursuant to the sale, 10% or $3,587,000 was placed in escrow until June 30, 2007 to secure the Bank’s indemnifications; until then, the Bank does not have access to the funds. This amount plus interest of $125,000 is presented in Other Assets in the accompanying Consolidated Statements of Financial Condition. A gain of $20,453,000 was recognized on the sale of which $2,965,000 was paid to the minority interest holder.

The results of FSB Financial, as summarized below, have been classified as discontinued operations for all periods presented, (in thousands).

	Three Months Ended December 31,				Six Months Ended December 31,
	2006		2005		2006		2005
Net revenues	$	45	$	4,215	$	87	$	8,552
Net income before taxes		45		1,047		86		1,801
Income tax expense		14		345		27		599
Minority interest		5		62		9		91
Income from discontinued operations		26		640		50		1,111

Amortization Expense. The Company has recorded a customer relationship intangible which is amortized over a five year period at a rate based on the estimated future economic benefit of the customer relationships. See additional discussion in “-Intangible Assets”

EMPLOYEE BENEFITS

Deferred Compensation Plan. The Company purchases company-owned life insurance as a component of the company’s deferred compensation plan. The policies are valued at the cash surrender values as of the balance sheet date and are included in other assets in the Consolidated Statement of Financial Condition. During the second quarter of fiscal 2007, the Company received

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proceeds of $2,276,000 from company owned life insurance which were recorded in other revenue in the Consolidated Statements of Income and Comprehensive Income.

Stock Option Plans. At December 29, 2006, SWS had one active stock option plan, the SWS Group, Inc. 1997 Stock Option Plan (the “1997 Plan”) and one expired plan, the SWS Group, Inc. Stock Option Plan (the “1996 Plan”) under which exerciseable options are still outstanding. All options outstanding under the 1996 Plan, which expired on February 1, 2006, may still be exercised until their contracted expiration date occurs. 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 Company has substantially eliminated the use of options as a compensation tool and currently grants restricted stock to reward directors, management and employees. Consequently, no stock options were granted during the six-months ended December 29, 2006.

SWS accounts 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.”

Restricted Stock Plan. On November 12, 2003, the stockholders of SWS Group approved the adoption of the SWS Group, Inc. 2003 Restricted Stock Plan (“Restricted Stock Plan”). The Restricted Stock Plan allows for awards of up to 750,000 shares of SWS Group’s common stock to SWS’ directors, officers and employees. No more than 300,000 of the authorized shares may be newly issued shares of common stock. The Restricted Stock Plan terminates on August 21, 2013. The vesting period 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.

At various times in fiscal 2006, the Board of Directors approved grants to various officers and employees totaling 183,298 shares with a weighted average market value of $12.26 per share. In fiscal 2007, the Board of Directors approved grants to various officers and employees totaling 91,140 shares with a market value of $16.53 per share. As a result of these grants, SWS recorded deferred compensation in Additional Paid in Capital of approximately $2,074,000 and $1,364,000, respectively. For the three and six-months ended December 29, 2006, SWS has recognized compensation expense of approximately $414,000 and $747,000, respectively. For the three and six-months ended December 30, 2005, SWS has recognized compensation expense of approximately $252,000 and $431,000, respectively.

At December 29, 2006, the total number of shares outstanding under the Restricted Stock Plan was 240,356 and the total number of securities available for future grants was 390,399.

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.

CASH

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

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INVESTMENTS

Comprehensive Software Systems, Inc. (“CSS”). In 1993, SWS became a part owner of 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 fully implement 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. This note was ultimately forgiven in January 2005. In December 2003, SWS 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 equal quarterly installments (two purchases were made in fiscal years 2004 and 2005 totaling approximately $1,443,000 in each fiscal year) and ultimately resulted in increasing SWS’ position in CSS to 30.22%. These investments were made to insure the continued operation of CSS while needed enhancements to the system were built.

SWS did not participate in CSS’ equity offering in January 2005. SWS has developed many of the functions needed to run the CSS system in-house and is no longer dependent on CSS for enhancements. 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.

In April 2006, SWS signed an agreement with CSS to pay a $1,700,000 maintenance fee to CSS if a specific member of the consortium of broker/dealers successfully converted to the CSS system by December 31, 2006. CSS made written demand of $1.7 million in additional maintenance payments from SWS in January 2007. SWS does not believe that the terms of the contract have been fulfilled and is disputing the payment. SWS has accrued its best estimate of the ultimate resolution of this matter in the financial statements as of December 29, 2006.

Also, if it is determined that the member did convert its system successfully, SWS will be obligated to make a second payment of $1,700,000 in calendar year 2007, provided certain other conditions are met.

SWS’ share of the undistributed losses of CSS for the three and six-months ended December 29, 2006 were $277,000 and $414,000, respectively. From inception of the investment to date, SWS’ pro-rata percentage of losses of $8,961,000 was greater than the $6,386,000 loaned and invested by $2,575,000. As a result, there is no recorded equity investment or loan receivable from CSS at December 29, 2006.

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

	December 31, 2006			June 30, 2006
Total assets	$	5,795		$	4,313
Total liabilities		6,773			5,639
Shareholders’ deficit		(978	)		(1,326	)

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	Three Months Ended
	December 31, 2006			December 31, 2005
Total revenues	$	933		$	1,189
Net loss		(2,024	)		(1,689	)

	Six Months Ended
	December 31, 2006			December 31, 2005
Total revenues	$	1,992		$	2,669
Net loss		(3,022	)		(3,088	)

Other Equity Investments. 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 29, 2006, SWS had contributed $4,000,000 of this commitment. During the three and six-months ended December 29, 2006, SWS recorded income of $73,000 and losses of $528,000, respectively, related to this investment. In comparison during the three and six-months ended December 30, 2005, SWS recorded income of $1,547,000 and $1,538,000, respectively, related to the investment. In December 2005, SWS received a distribution of $1,547,000.

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 sale 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.

In fiscal 2007, the Bank committed $3,000,000 to invest in a limited partnership venture capital fund as a cost effective way of meeting its obligations under the Community Reinvestment Act. As of December 31, 2006, the Bank has invested $900,000 of its commitment. No gains or losses have been recorded for the three and six-months ended December 31, 2006.

Variable Interest Entity. SWS consolidates investments which meet the definition of a “Variable Interest Entity” as defined in Financial Interpretation (“FIN”) No. 46R. 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 both December 31, 2006 and June 30, 2006, $1,606,000 was outstanding on this line of credit. The line allows the limited partnership to purchase the land to be used in the development and was amended in the March 2006 quarter to be payable on September 10, 2007. This entity is consolidated at the Bank level through FSB Development. As of December 31, 2006 and June 30, 2006, the Bank consolidated $2,405,000 and $2,124,000, respectively, in assets for this investment. For the three and six-months ended December 31, 2006, the Bank consolidated $38,000 and $75,000 in net losses, respectively, for this investment, which is eliminated in consolidation. For the three and six-months ended December 31, 2005, the Bank consolidated $29,000 and $57,000 in net losses for this investment, which is eliminated in consolidation.

ASSETS SEGREGATED FOR REGULATORY PURPOSES

At December 29, 2006, SWS had U.S. Treasury securities with a market value of approximately $40,253,000, reverse repurchase agreements of approximately $132,013,000 and related cash and accrued interest of approximately $166,526,000 segregated in special reserve bank accounts for the exclusive benefit of customers under Rule 15c3-3 of the 1934 Act. These reverse repurchase agreements were collateralized by U.S. Government securities with a market value of approximately $132,892,000. At December 29, 2006, SWS had no position in special reserve bank accounts for the Proprietary Accounts of Introducing Brokers (“PAIB”).

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At June 30, 2006, SWS had U.S. Treasury securities with a market value of approximately $137,395,000, reverse repurchase agreements of approximately $25,000,000 and related cash and accrued interest of approximately $182,633,000 segregated in special reserve bank accounts for the exclusive benefit of customers under Rule 15c3-3 of the 1934 Act. These reverse repurchase agreements were collateralized by U.S. Government securities with a market value of approximately $25,332,000. SWS had no positions in special reserve bank accounts for the PAIB at June 30, 2006.

MARKETABLE EQUITY SECURITIES

SWS owns shares of common stock in U.S. Home Systems, Inc. (“USHS”) and Westwood Holding Group, Inc., (“Westwood”) 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 29, 2006 and June 30, 2006, SWS held 357,154 shares of USHS with a cost basis of $1,576,000. The market value of the USHS shares was $4,043,000 at December 29, 2006 and $3,432,000 at June 30, 2006. There were no sales of USHS stock in the three and six-month periods ended December 29, 2006 and December 30, 2005.

At December 29, 2006 and June 30, 2006, SWS held 7,840 and 8,556 shares of Westwood, respectively, within the deferred compensation plan with a cost basis of $129,000 and $143,000, respectively. The market value of the Westwood shares was $181,000 at December 29, 2006 and $161,000 at June 30, 2006. The reduction in shares results from distributions from the deferred compensation plan.

RECEIVABLE FROM AND PAYABLE TO BROKERS, DEALERS AND CLEARING ORGANIZATIONS

At December 29, 2006 and June 30, 2006, 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	$	22,286	$	33,123
Securities borrowed		2,607,106		2,728,679
Correspondent broker/dealers		30,672		34,601
Clearing organizations		9,632		9,730
Other		24,797		15,379
	$	2,694,493	$	2,821,512
Payable
Securities failed to receive	$	24,664	$	43,723
Securities loaned		2,563,035		2,701,368
Correspondent broker/dealers		19,633		18,464
Other		15,623		12,009
	$	2,622,955	$	2,775,564

SWS participates in the securities borrowing and lending business by borrowing and lending securities other than those of its clients. SWS obtains or releases collateral as prices of the underlying securities fluctuate. At December 29, 2006, SWS had collateral of $2,607,106,000 under securities lending agreements, of which SWS had repledged $2,540,278,000. SWS had collateral of $2,728,266,000 under securities lending agreements, of which SWS had repledged $2,653,504,000 at June 30, 2006.

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LOANS HELD FOR SALE

Loans held for sale are carried at the lower of aggregate cost or market value. Loans held for sale consisted of first mortgage loans and home improvement loans which had been purchased or originated but had not yet been sold in the secondary market.

LOANS AND ALLOWANCE FOR PROBABLE LOAN LOSSES

Loans receivable at December 31, 2006 and June 30, 2006 are summarized as follows (in thousands):

	December			June
First mortgage loans (principally conventional):
Real estate	$	412,663		$	379,895
Construction		225,306			200,523
		637,969			580,418
Consumer and other loans:
Commercial		67,784			55,634
Other		6,483			6,753
		74,267			62,387
Factored receivables		8,965			8,445
		721,201			651,250
Unearned income		(2,957	)		(3,662	)
Allowance for probable loan losses		(5,497	)		(5,047	)
	$	712,747		$	642,541

Impairment of loans with a recorded investment of approximately $695,000 and $682,000 at December 31, 2006 and June 30, 2006, 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 by SFAS No. 118“Accounting for Creditors for Impairment of a Loan-Income Recognition and Disclosures-an amendment of SFAS No. 114”. No specific allowance for loan losses is recorded if the impaired loans are adequately collateralized. The total allowance for loan losses related to these loans was approximately $49,000 and $98,000 at December 31, 2006 and 2005, respectively. No material amount of interest income on impaired loans was recognized for cash payments received in the second quarter of fiscal 2007 and fiscal 2006.

An analysis of the allowance for probable loan losses for the three and six-months ended December 31, 2006 and 2005 is as follows (in thousands):

	Three Months Ended December 31,						Six Months Ended December 31,
	2006			2005			2006			2005
Balance at beginning of period	$	5,347		$	7,558		$	5,047		$	7,450
Continuing operations:
Provision for loan losses		421			614			715			1,165
Net recoveries (charge-offs)		(271	)		(151	)		(265	)		(158	)
		150			463			450			1,007
Discontinued operations:
Provision for loan losses		—			1,454			—			3,392
Net charge-offs		—			(2,324	)		—			(4,698	)
Sale of FSB Financial		—			—			—			—
		—			(870	)		—			(1,306	)
Balance at end of period	$	5,497		$	7,151		$	5,497		$	7,151

The reserve to loan ratio as of December 31, 2006 and 2005 was 0.77% and 0.83%, respectively.

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SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED

At December 29, 2006 and June 30, 2006, SWS held securities owned and securities sold, not yet purchased as follows (in thousands):

	December		June
Securities owned
Corporate equity securities	$	19,084	$	14,676
Municipal obligations		29,896		30,971
U.S. Government and Government agency obligations		23,322		46,168
Corporate obligations		74,784		54,076
Other		10,967		13,113
	$	158,053	$	159,004
Securities sold, not yet purchased
Corporate equity securities	$	1,983	$	1,715
Municipal obligations		—		57
U.S. Government and Government agency obligations		49,715		76,132
Corporate obligations		29,627		18,220
Other		698		785
	$	82,023	$	96,909

During the quarter, certain of the above securities were pledged to secure short-term borrowings and as security deposits at clearing organizations for SWS’ clearing business. Securities pledged as security deposits at clearing organizations were $5,110,000 and $5,044,000 at December 29, 2006 and June 30, 2006, respectively. Additionally, at December 29, 2006 and June 30, 2006, SWS had pledged firm securities valued at $2,816,000 and $2,025,000, respectively, in conjunction with securities lending activities.

Southwest Securities has been a member of the NYSE since 1972 owning one seat carried at a cost of $230,000. Upon the merger of the NYSE and Archipelago Holdings, L.L.C. (“Archipelago”) in March 2006, Southwest Securities surrendered its seat for the right to receive from the new entity, NYSE Group, Inc. (“NYSE Group”), $300,000 in cash and 80,177 restricted shares of NYSE Group common stock (NYX), par value $0.01 per share.

SWS also had an investment in Archipelago recorded at its cost of zero. SWS owned 23,721 shares of Archipelago stock prior to the merger of the NYSE and Archipelago. Upon the merger, each outstanding share of Archipelago common stock was converted into one share of NYX stock. At December 29, 2006, the market value of these shares was $ 2,299,000.

Also, 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 allows Southwest Securities continued physical and electronic access to the NYSE trading facilities following the close of the merger.

The 80,177 NYX shares received from the merger are restricted shares. These restrictions prohibit any “direct or indirect assignment, sale, exchange, transfer, tender or other disposition of NYX stock.” The restrictions on the shares lapse based on a three year vesting schedule with restrictions lapsing on one-third of the restricted shares annually. There are no restrictions on the 23,721 shares from our investment in Archipelago upon conversion to NYX stock.

The 80,177 NYX shares have been discounted at an overall rate of 11.88% of the market price of NYX stock at December 29, 2006. The discount rate was determined based on the length of time of the restrictions, expected rate of return for this type of investment and the relative amount of restricted NYX stock versus fully tradable stock.

As of December 29, 2006, our total investment, 103,898 of NYX shares, was valued at $9,166,000.

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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 29, 2006, SWS held reverse repurchase agreements totaling $44,633,000, collateralized by U.S. Government and Government agency obligations with a market value of approximately $44,447,000. At June 30, 2006, SWS held reverse repurchase agreements totaling $63,636,000, collateralized by U.S. Government and Government agency obligations with a market value of approximately $63,266,000.

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 during fiscal 2006 in June 2006, 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 segments with goodwill, clearing and institutional brokerage, both part of Southwest Securities. There were no changes in the carrying value of goodwill during the six-month period ended December 29, 2006.

INTANGIBLE ASSETS

On March 22, 2006, the Company entered into an agreement with TD Ameritrade Holding Corporation, (“Ameritrade”) to transfer 15 correspondent clients to the Company. This transaction closed in July 2006, with 12 of the 15 correspondents agreeing to transfer to the Company’s clearing platform. The purchase price was based on the estimated value of the transferred correspondents. One half of the purchase price, $2.4 million, was paid upon closing with the remainder to be paid on the one year anniversary of the closing date. Ameritrade will receive 100 percent of the remaining amount if the transferred correspondents meet agreed upon ticket volumes. If these volumes are not met, the second payment will be pro-rated by the ticket volumes incurred compared to the agreed upon ticket volume. The maximum purchase price is approximately $5.8 million. As a result of this transaction, the Company has recorded a customer relationship intangible of $4.4 million, which is the Company’s estimate of the minimum amount to be paid. The intangible asset is amortized over a five year period at a rate based on the estimated future economic benefit of the customer relationships. SWS has recognized approximately $372,000 of amortization expense for the six-months ended December 29, 2006. The intangible is included in Other Assets on the Consolidated Statement of Financial Condition.

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 29, 2006, the amount outstanding under these secured arrangements was $10,680,000, which was collateralized by securities held for firm accounts valued at $84,148,000. At June 30, 2006, the amount outstanding under these secured arrangements was $30,500,000, which was collateralized by securities held for firm accounts valued at $68,089,000.

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SWS has unsecured letters of credit, aggregating $2,250,000 at both December 29, 2006 and June 30, 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 both December 29, 2006 and June 30, 2006, 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 $571,000 and $714,000, respectively. The letter of credit bears a 1% commitment fee and is renewable annually.

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 29, 2006 and June 30, 2006, the total amount available for borrowings was $17,179,000 and $17,036,000, respectively. There were no amounts outstanding on this line other than $2,821,000 and $2,964,000, under unsecured letters of credit at both December 29, 2006 and June 30, 2006, respectively.

SWS has an irrevocable letter of credit agreement aggregating $53,000,000 at December 29, 2006 and June 30, 2006, 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 $67,990,000 and $81,303,000 at December 29, 2006 and June 30, 2006, respectively.

In addition to using customer securities to collateralize bank loans, SWS also loans client securities as collateral in conjunction with SWS’ securities lending activities. At December 29, 2006, approximately $421,953,000 of client securities under customer margin loans was available to be pledged, of which SWS has pledged $22,701,000 under securities loan agreements. At June 30, 2006, approximately $479,956,000 of client securities under customer margin loans was available to be pledged, of which SWS had pledged $47,049,000 under securities loan agreements.

DEPOSITS

Deposits at December 31, 2006 and June 30, 2006 are summarized as follows (dollars in thousands):

	December				June
	Amount		Percent		Amount		Percent
Noninterest bearing demand accounts	$	50,551	6.3	%	$	46,942	6.7	%
Interest bearing demand accounts		48,241	6.0			79,198	11.2
Savings accounts		598,119	74.4			468,767	66.4
Limited access money market accounts		27,176	3.4			26,092	3.7
Certificates of deposit, less than $100,000		54,382	6.8			59,304	8.4
Certificates of deposit, $100,000 and greater		25,373	3.1			25,591	3.6
	$	803,842	100.0	%	$	705,894	100.0	%

The weighted average interest rate on deposits was approximately 4.06% at December 31, 2006 and 3.67% at June 30, 2006.

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At December 31, 2006, scheduled maturities of certificates of deposit were as follows (in thousands):

	Fiscal 2007		Fiscal 2008		Fiscal 2009		Fiscal 2010		Thereafter		Total
Certificates of deposit, less than $100,000	$	41,192	$	6,509	$	2,896	$	2,527	$	1,258	$	54,382
Certificates of deposit, $100,000 and greater		17,887		2,776		2,288		2,069		353		25,373
	$	59,079	$	9,285	$	5,184	$	4,596	$	1,611	$	79,755

SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Securities sold under repurchase agreements, 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 29, 2006 and June 30, 2006 were $10,002,000 and $7,719,000, respectively.

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

At December 31, 2006 and June 30, 2006, advances from the FHLB were due as follows (in thousands):

	December		June
Maturity:
Due within one year	$	6,076	$	9,753
Due within two years		721		—
Due within five years		13,278		12,544
Due within seven years		2,811		4,421
Due within ten years		7,373		6,657
Due within twenty years		29,078		13,719
	$	59,337	$	47,094

Pursuant to collateral agreements, the advances from the FHLB, with interest rates ranging from 2% to 8%, are collateralized by approximately $259,000,000 of collateral value (as defined) in qualifying loans at December 31, 2006 (calculated at September 30, 2006). At June 30, 2006 (calculated at March 31, 2006), advances with interest rates from 2% to 8% were collateralized by approximately $192,000,000 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 bore interest at a rate equal to the federal funds rate plus 0.25%. In the third quarter ended March 31, 2006, the agreement was amended to increase the available credit to $30,000,000. Beginning in the second quarter of fiscal 2007, the interest rate charged on any borrowed funds is at a rate quoted by the unaffiliated bank and accepted by the Bank. The unaffiliated bank is not obligated by this agreement to sell federal funds to the Bank. The agreement is being used by the Bank to support short-term liquidity needs. At December 31, 2006 and June 30, 2006, there were no amounts outstanding on this line of credit.

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REGULATORY CAPITAL REQUIREMENTS

Brokerage. The broker/dealer subsidiaries are subject to the SEC’s Uniform Net Capital Rule (the “Rule”), which requires the maintenance of minimum net capital. Southwest Securities has elected to use the alternative method, permitted by the Rule, which requires that it maintain minimum net capital, as defined in Rule 15c3-1 under the 1934 Act, equal to the greater of $1,000,000 or 2% of aggregate debit balances, as defined in Rule 15c3-3 under the 1934 Act. At December 29, 2006, Southwest Securities had net capital of $141,641,000, or approximately 33.65% of aggregate debit balances, which was $133,224,000 in excess of its minimum net capital requirement of $8,417,000 at that date. Additionally, the net capital rule of the NYSE provides that equity capital may not be withdrawn or cash dividends paid if resulting net capital would be less than 5% of aggregate debit items. At December 29, 2006, Southwest Securities had net capital of $120,597,000 in excess of 5% of aggregate debit items.

SWS Financial follows the basic (aggregate indebtedness) method under Rule 15c3-1, which requires the maintenance of minimum net capital of $250,000. At December 29, 2006, the net capital and excess net capital of SWS Financial were $1,041,000 and $791,000, respectively.

Banking. 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 (as defined in 12 CFR 565 and 12 CFR 567) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2006 and June 30, 2006, that the Bank meets all capital adequacy requirements to which it is subject.

As of December 31, 2006 and June 30, 2006, 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, 2006:
Total capital to risk weighted assets	$	84,824	10.3	%	$	65,683	8.0	%	$	82,104	10.0	%
Tier I capital to risk weighted assets		79,326	9.7			32,842	4.0			49,262	6.0
Tier I capital to adjusted total assets		79,326	8.4			37,853	4.0			47,316	5.0
June 30, 2006:
Total capital to risk weighted assets	$	75,574	10.6	%	$	56,831	8.0	%	$	71,039	10.0	%
Tier I capital to risk weighted assets		70,526	9.9			28,416	4.0			42,624	6.0
Tier I capital to adjusted total assets		70,526	8.5			33,114	4.0			41,393	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 29, 2006 and December 30, 2005 (in thousands, except share and per share amounts):

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	Three Months Ended				Six Months Ended
	December 29, 2006		December 30, 2005		December 29, 2006		December 30, 2005
Income from continuing operations	$	12,905	$	8,125	$	22,988	$	14,751
Income from discontinued operations		26		640		50		1,111
Cumulative effect of a change in accounting principles		—		—		—		75
Net income	$	12,931	$	8,765	$	23,038	$	15,937
Weighted average shares outstanding – basic		26,836,292		26,030,746		26,654,548		26,011,387
Effect of dilutive securities:
Assumed exercise of stock options		239,042		171,806		223,215		146,998
Restricted stock		72,204		74,654		72,307		61,266
Weighted average shares outstanding – diluted		27,147,538		26,277,206		26,950,070		26,219,651
Earnings per share – basic
Income from continuing operations	$	0.48	$	0.31	$	0.86	$	0.57
Income from discontinued operations		—		0.03		—		0.04
Cumulative effect of a change in accounting principles		—		—		—
Net income	$	0.48	$	0.34	$	0.86	$	0.61
Earnings per share – diluted
Income from continuing operations	$	0.48	$	0.31	$	0.85	$	0.56
Income from discontinued operations		—		0.02		—		0.04
Cumulative effect of a change in accounting principles		—		—		—		0.01
Net income	$	0.48	$	0.33	$	0.85	$	0.61

At December 29, 2006 and December 30, 2005, there were approximately 909,000 and 1.9 million options outstanding under the two stock option plans, respectively. See “-Employee Benefits.” As of December 29, 2006 there were no anti-dilutive options outstanding. As of December 30, 2005, approximately 160,389 outstanding options were anti-dilutive and therefore were not included in the calculation of weighted average shares outstanding-dilutive.

REPURCHASE OF 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 June 30, 2008, to repurchase up to 500,000 shares. No shares were repurchased by SWS under the previous program which expired December 31, 2006 for the six-months ended December 29, 2006. In October 2005, 46,635 shares were repurchased at a cost of $478,000, or $10.24 per share, in accordance with the repurchase 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 months ended December 29, 2006. The plan purchased 15,560 shares in the six months ended December 29, 2006 at a cost of approximately $232,000 or $14.88 per share. 15,572 shares were distributed pursuant to the plan in the six-month period ended December 29, 2006. The plan did not purchase any shares in the three and six-month periods ended December 30, 2005. 917 shares were sold or distributed pursuant to the plan in the six-month period ended December 30, 2005.

During the first half of fiscal 2007, one-third of the shares for the August 18, 2004, August 25, 2005, November 11, 2003 and November 25, 2005 grants previously granted under the restricted stock

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plan vested. 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, 13,581 shares were repurchased with a market value of approximately $239,000 or $17.60 per share.

SEGMENT REPORTING

SWS operates four business segments: 1) Clearing; 2) Retail Brokerage; 3) Institutional Brokerage and 4) Banking. Such segments are managed separately based on types of products and services offered and their related client bases. The segments are consistent with how SWS manages its resources and assesses its performance. SWS evaluates the performance of its segments based primarily on income before income taxes and discontinued operations. Our business segment information is prepared using the following methodologies:

• The financial results for each segment are determined using the same policies as those described in Note 1, “Significant Accounting Policies” contained in our Annual Report on Form 10-K for the fiscal year ended June 30, 2006;

• Segment financial information includes the allocation of interest based on each segment’s earned interest spreads;

• Information system and operation expenses are allocated based on each segments trading volumes;

• Trading expenses are allocated to the segments based on production levels;

• Money market fee revenue is allocated based on each segment’s earned fees; and

• Clearing charges are allocated based on clearing levels from each segment.

Intersegment balances are eliminated upon consolidation and have been applied to the appropriate segment. Also, SWS reports net interest revenue (expense) by segment as management relies primarily on net interest revenue in assessing a segment’s performance. Segment assets are not disclosed because they are not used for evaluating segment performance or in deciding how to allocate resources to the segments.

• Clearing:We provide clearing and execution services (generally on a fully disclosed basis) for general securities broker/dealers, including SWS Financial, and for bank affiliated firms and firms specializing in high volume trading.

• Retail Brokerage:The retail brokerage segment includes retail securities products and services (equities, mutual funds and fixed income products), insurance products and managed accounts and encompasses the activities of our employee registered representatives and our independent contractors.

• Institutional Brokerage:The institutional brokerage segment serves institutional customers in securities lending, investment banking and public finance, fixed income sales and trading, and equity trading.

• Banking:The Bank offers traditional banking products and services and focuses on several sectors of the residential housing market, including interim construction and short-term funding for mortgage bankers.

Clearing and institutional brokerage services are offered exclusively through Southwest Securities. The Bank and its subsidiaries comprise the bank segment. Retail brokerage services are offered through Southwest Securities (the Private Client Group and the Managed Advisors and Accounts department), the insurance subsidiaries and through SWS Financial (which contracts with independent representatives for the administration of their securities business).

Other. The category “other” includes SWS Group, Corporate Administration, SWS Capital and Capital Markets, which includes the financial results of SWS’ Institutional Sales & Research departments. Certain assets of this business were sold in January 2006 and as a result, the financial

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results of this department are included in the analysis for three and six-month periods ending December 30, 2005. SWS Group is a holding company that owns various investments, including USHS and NYX common stock.

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The following tables provide additional information regarding our segmentation for the three and six-month periods ended December 29, 2006 and December 30, 2005:

UNAUDITED QUARTERLY FINANCIAL INFORMATION
(in thousands)	Clearing			Retail Brokerage		Institutional Brokerage		Banking		Other			Consolidated SWS Group, Inc.
Three months ended December 29, 2006
Operating revenue	$	5,753		$	17,879	$	21,503	$	708	$	4,389		$	50,232
Net intersegment revenues		(234	)		256		365		1,421		(1,808	)		__
Net interest revenue		4,144			1,821		5,263		12,265		582			24,075
Net revenues		9,897			19,700		26,766		12,973		4,971			74,307
Operating expenses		4,664			16,062		18,638		6,221		9,395			54,980
Depreciation and amortization		323			138		114		140		556			1,271
Income (loss) from continuing operations before taxes		5,233			3,638		8,128		6,752		(4,424	)		19,327
Income from discontinued operations		—			—		—		26		—			26
Three months ended December 30, 2005
Operating revenue	$	5,689		$	16,043	$	19,983	$	653	$	3,768		$	46,136
Net intersegment revenues		(244	)		244		127		1,102		(1,229	)		—
Net interest revenue		3,232			1,612		3,168		10,314		815			19,141
Net revenues		8,921			17,655		23,151		10,967		4,583			65,277
Operating expenses		5,256			15,466		16,415		5,709		9,927			52,773
Depreciation and amortization		24			166		131		205		854			1,380
Income (loss) from continuing operations before taxes		3,665			2,189		6,736		5,258		(5,344	)		12,504
Income from discontinued operations		—			—		—		640		—			640

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(in thousands)	Clearing			Retail Brokerage		Institutional Brokerage		Banking		Other			Consolidated SWS Group, Inc.
Six months ended December 29, 2006
Operating revenue	$	11,051		$	33,765	$	44,164	$	1,360	$	6,133		$	96,473
Net intersegment revenues		(438	)		466		542		2,713		(3,283	)		—
Net interest revenue		7,873			3,480		11,842		23,935		1,045			48,175
Net revenues		18,924			37,245		56,006		25,295		7,178			144,648
Operating expenses		9,295			30,687		37,786		12,327		20,506			110,601
Depreciation and amortization		405			267		231		337		1,177			2,417
Income (loss) from continuing operations before taxes		9,629			6,558		18,220		12,968		(13,328	)		34,047
Income from discontinued operations		—			—		—		50		—			50
Six months ended December 30, 2005
Operating revenue	$	11,738		$	31,276	$	39,738	$	1,412	$	6,651		$	90,815
Net intersegment revenues		(492	)		514		309		2,121		(2,452	)		—
Net interest revenue		6,785			3,137		7,183		20,314		1,208			38,627
Net revenues		18,523			34,413		46,921		21,726		7,859			129,442
Operating expenses		10,447			30,095		33,312		11,763		20,966			106,583
Depreciation and amortization		49			324		265		402		1,757			2,797
Income (loss) from continuing operations before taxes		8,076			4,318		13,609		9,963		(13,107	)		22,859
Income from discontinued operations		—			—		—		1,111		—			1,111

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COMMITMENTS, CONTINGENCIES and GUARANTEES

Litigation. 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.

Venture Capital Funds.SWS has committed $5,000,000 to invest in a limited partnership venture capital fund. As of December 29, 2006, SWS had contributed $4,000,000 of its commitment. The Bank has committed $3,000,000 to invest in a limited partnership venture capital fund. As of December 31, 2006, the Bank has invested $900,000 of its commitment.

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 29, 2006 were $301,859,000. 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.

Guarantees.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 $1,297,000. 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.

The Company provides representations and warranties to counterparties in connection with a variety of commercial transactions and occasionally indemnifies them against potential losses caused by the breach of those representations and warranties. These indemnifications generally are standard contractual terms and are entered into in the normal course of business. The maximum potential amount of future payments that the Company could be required to make under these indemnifications cannot be estimated. However, the Company believes that it is unlikely it will have to make material payments under these arrangements and has not recorded any contingent liability in the consolidated financial statements for these indemnifications.

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.

ACCOUNTING PRONOUNCEMENTS

The Financial Accounting Standards Board (“FASB”) has recently issued the following SFAS and FASB interpretations, which are applicable to SWS:

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EITF 06-05,“Accounting for Purchases of Life Insurance—Determining the Amount that Could be Realized in Accordance with FASB Technical Bulletin No. 85-4.The EITF provides guidance on the recording of the value of company owned life insurance and appropriate disclosure in the financial statements. The EIFT is effective for fiscal years beginning after December 15, 2006, our fiscal 2008. SWS is assessing the impact of this interpretation on its financial statements and processes.

Staff Accounting Bulletin No. 108. The staff accounting bulletin, which was issued by the SEC on September 13, 2006, provides guidance on the consideration of effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The staff accounting bulletin is effective for the interim period of the first fiscal year ending after November 15, 2006, our second quarter of fiscal 2007. SWS has assessed the impact of staff accounting bulletin No. 108 and has determined that no material adjustments were required to comply with the terms of this bulletin.

SFAS No. 157,“Fair Value Measurement.”In September 2006, FASB issued this standard which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. The standard is effective for fiscal years beginning after November 15, 2007, our fiscal 2009. SWS is assessing the impact of this interpretation on its financial statements and processes.

SFAS No. 156,“Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140.”In March 2006, FASB issued this standard which amends SFAS 140,“Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,” with respect to the accounting for separately recognized servicing assets and servicing liabilities. This statement requires an entity to recognize a servicing asset or servicing liability, initially measured at fair value, each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations. The Bank, and thus SWS Group, will implement this standard July 1, 2007. The Bank has determined the impact of this SFAS on the financial statements to be immaterial.

FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement 109.” In July 2006, the FASB issued this interpretation with respect to all uncertain positions for taxes accounted for under FASB Statement 109,“Accounting for Income Taxes.” The interpretation addresses the recognition, measurement, accrual of interest and penalties, balance sheet classification and disclosure of any uncertain tax positions. This interpretation is effective for SWS beginning in fiscal 2008. SWS is assessing the impact of this interpretation on its financial statements and processes.

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 and full-service commercial banking. 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” and “Item 1A. Risk Factors” of the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on September 13, 2006.

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We are currently focused on three aspects of our business: growing our clearing business by expanding our correspondent base, focusing on our retail brokerage business by increasing our distribution capabilities and growing the Bank through the addition of experienced bankers.

We operate through four segments grouped primarily by products and services:

• Clearing: We provide clearing and execution services (generally on a fully disclosed basis) for general securities broker/dealers, including SWS Financial, and for bank affiliated firms and firms specializing in high volume trading.

• Retail Brokerage: The retail brokerage segment includes retail securities products and services (equities, mutual funds and fixed income products), insurance products and managed accounts and encompasses the activities of our employee registered representatives and our independent contractors.

• Institutional Brokerage: The institutional brokerage segment serves institutional customers in securities lending, investment banking and public finance, fixed income sales and trading and equity trading.

• Banking:The Bank offers traditional banking products and services and focuses on several sectors of the residential housing market, including interim construction and short-term funding for mortgage bankers.

Business Environment

Financial market conditions improved during the second quarter of fiscal 2007. Short-term interest rates increased 100 basis points since December 2005 but have been unchanged since June 30, 2006. After several months of increasing energy prices, prices began to stabilize in the first half of fiscal 2007. The Federal Reserve Board’s federal funds rate was 5.25% during the second quarter of fiscal 2007 and 4.25% for that same period in fiscal 2006. The Dow Jones Industrial Average increased 16.29% from the end of the second quarter of fiscal 2006 to the second quarter of fiscal 2007 while the Standard & Poor’s 500 Index and the NASDAQ Composite Index rose 13.62% and 9.52%, respectively, for the same time periods. Average daily volume on the New York Stock Exchange rose 11.38% for fiscal 2007.

Our clearing segment is dependent on active markets. Generally, increasing volume on the national securities exchanges indicates increasing volumes in our clearing segment. Clearing volumes increased 48% from the second quarter of fiscal 2006 to fiscal 2007, driven by higher volumes in the market primarily from our high volume trading customers. During the second quarter of fiscal 2007, one of our clearing customers sold certain businesses to another regional brokerage firm, and we are no longer clearing this business. This customer accounted for $4.4 million in net revenue and $2.9 million in income in fiscal 2006, and accounted for $1.6 million in net revenue and $1.1 million in income for fiscal 2007.

The interest rate environment is significant for our institutional brokerage segment as well as for the Bank. Rising interest rates give us the opportunity to increase spreads in the securities lending business while negatively impacting the value of our fixed income inventories and the opportunities for debt offerings.

Our fixed income areas are also impacted by the relationship of key short-term and long-term rates. In the current environment, short-term and long-term rates are similar (a “flat” yield curve). This generally has a negative impact on the fixed income business. As the yield curve normalizes, this business should be positively impacted. The stable interest rate environment over the current fiscal year has led to slight increases in volumes in this business.

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Positive directional movements in key equity indices are key indicators of a good environment for our retail brokerage segment. As equity indices continued to rise in the second quarter of fiscal 2007, so did the revenues in this segment.

The Banking segment is also impacted by interest rates, specifically mortgage rates because a substantial portion of the bank’s portfolio relates to real estate lending. National rates for a 30 year mortgage decreased 4 basis points from the second quarter of fiscal 2006 to the second quarter of fiscal 2007, from 6.22% to 6.18%. Attractive mortgage rates and a healthy housing market are key indicators of the growth prospects at the Bank. The North Texas housing market has experienced some slow-down over the past six months with reduced housing starts and increased inventories. However, prices have remained stable. Overall, the housing market in Texas remains healthy.

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.

3-for-2 Stock Split.On November 30, 2006, the Company’s Board of Directors declared a 3-for-2 stock split effected in the form of a 50% stock dividend. The additional shares were distributed on January 2, 2007, to shareholders of record on December 15, 2006. All references in the condensed consolidated financial statements to amounts per share and the number of shares outstanding have been restated to give retroactive effect to the stock split.

Payments to the Deferred Compensation Plan.We purchase company-owned life insurance as a component of the company’s deferred compensation plan. The policies are valued at the cash surrender values as of the balance sheet date and are included in other assets in the Consolidated Statement of Financial Condition. During the second quarter of fiscal 2007, we received proceeds of $2,276,000 from company owned life insurance which were recorded in other revenue in the Consolidated Statements of Income and Comprehensive Income.

TD Ameritrade Transaction:On March 22, 2006, the Company entered into an agreement with TD Ameritrade Holding Corporation, (“Ameritrade”) to transfer 15 correspondent clients to the Company. This transaction closed in July 2006, with 12 of the 15 correspondents agreeing to transfer to our clearing platform. As an inducement to transfer, we generally provided substantial clearing fee discounts for a transition period. As a result of this transaction, we have recorded a customer relationship intangible of $4,400,000, which is being amortized over a five year period at a rate based on the future economic benefit of the customer relationships. As a result, we recognized approximately $306,510 and $371,763 of amortization expense for the three and six-months ended December 29, 2006, respectively. See additional discussion in “-Intangible Assets” in the Notes to the Consolidated Financial Statements contained in this Report.

Discontinued operations/FSB Financial, LTD (“FSB Financial”).In March 2006, the Bank sold the assets of its subsidiary, FSB Financial, for $35,870,000 in cash and the retirement of $116,868,000 of related debt. Pursuant to the sale, 10% of the cash purchase price, or $3,587,000, was placed in escrow until June 30, 2007 to secure the Bank’s indemnifications; until then, the Bank does not have access to these funds. This amount plus interest of $125,000 is presented in Other Assets in the accompanying Consolidated Statement of Financial Condition. The results of FSB Financial are classified as discontinued operations for all periods presented.

NYSE/Archipelago.SWS owned 23,721 shares of Archipelago Holdings, LLC (“Archipelago”) stock prior to the merger of Archipelago and the NYSE in March 2006. As part of the merger, Southwest Securities surrendered its one NYSE seat (carried at a cost of $230,000) in return for $300,000 in cash and 80,177 restricted shares of the new entity, NYSE Group, Inc. (“NYX”). The gain on this transaction was $5,200,000. For the three and six-months ended December 29, 2006, we have recorded gains on the restricted shares of $1,770,000 and $2,435,000, respectively.

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Upon the merger of NYSE and Archipelago, each share of our Archipelago stock was converted into one share of NYX common stock. For the three and six-months ended December 29, 2006, we recorded gains of $538,000 and $687,000, respectively, from the market appreciation of these shares. For the three and six-months ended December 30, 2005, we recorded gains of $210,000 and $199,000, respectively, from the change in the market value of these shares.

Investment in Comprehensive Software Systems, Inc. (“CSS”).In 1993, SWS became a part owner of CSS, a software development company formed to develop a new brokerage front and back office system. Our ownership in CSS increased to 25.08% in fiscal 2002, and 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.

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 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 were built.

Subsequent to an equity offering by CSS in January 2005, we own 13.7% of CSS. Because no additional investments were made in CSS since the last half of fiscal 2005, we did not record any equity in losses of CSS. As of December 29, 2006, there is no recorded equity investment in CSS.

Our pro-rata share of CSS’ losses for the three and six-month periods ended December 29, 2006 were $277,000 and $414,000, respectively. For the three and six-months periods ended December 30, 2005, our pro-rata share of CSS’ losses was $232,000 and $423,000, respectively. From inception of the investment to date, our pro-rata percentage of losses of $8,961,000 was greater than the $6,386,000 loaned and invested by $2,575,000.

In April 2006, we signed an agreement with CSS to pay a $1,700,000 maintenance fee to CSS if a specific member of the consortium of broker/dealers successfully converted to the CSS system by December 31, 2006. CSS made written demand of $1.7 million in additional maintenance payments from us in January 2007. We do not believe that the terms of the contract have been fulfilled and are disputing the payment. We have accrued our best estimate of the ultimate resolution of this matter in the financial statements as of December 29, 2006.

Also, if it is determined that the member did convert its system successfully, we are obligated to make a second payment of $1,700,000 in calendar 2007, provided certain other conditions are met. See additional discussion in“-Investment”in the Notes to the Consolidated Financial Statements contained in this Report.

RESULTS OF OPERATIONS

Net income for the three and six-month periods ended December 29, 2006 was $12,931,000 and $23,038,000, representing an increase of $4,166,000 and $7,101,000, respectively, over net income for the comparable three and six-month period ended December 30, 2005. The three and six-month

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periods ended December 29, 2006 and December 30, 2005 contained 63 and 126 and 63 and 131 trading days, respectively.

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 29, 2006 compared to the three and six-month periods ended December 30, 2005 (dollars in thousands):

	Three Months Ended					Six Months Ended
	Amount			%		Amount			%
Net revenues:
Net revenues from clearing operations	$	(393	)	(11	)%	$	(1,039	)	(14	)%
Commissions		(697	)	(3	)		(2,828	)	(6	)
Net interest		4,934		26			9,548		25
Investment banking, advisory and administrative fees		1,119		16			2,318		14
Net gains on principal transactions		1,811		47			5,009		57
Other		2,256		33			2,198		17
		9,030		14			15,206		12
Operating expenses:
Commissions and other employee compensation	$	3,368		9	%	$	6,389		8	%
Occupancy, equipment and computer service costs		(441	)	(7	)		(738	)	(6	)
Communications		(147	)	(7	)		(363	)	(8	)
Floor brokerage and clearing organization charges		308		39			183		9
Advertising and promotional		(69	)	(10	)		(267	)	(20	)
Other		(812	)	(14	)		(1,186	)	(10	)
		2,207		4			4,018		4
Pretax income	$	6,823		55	%	$	11,188		49	%

Net revenues increased for the second quarter of fiscal 2007 by $9,030,000. The largest components of the increase were in net interest revenue, $4,934,000, other, $2,256,000 and net gains on principal transactions, $1,811,000. The increase in net interest revenue is primarily due to an increase at the Bank in average loans balances over the prior fiscal year. The increase was also due to an increase in spreads and average balances in the stock lending business. The increase in other is due primarily to proceeds from company owned life insurance policies. The increase in net gains on principal transactions is primarily due to an increase in the value of our NYX stock investment and an increase in fixed income trading revenue.

Net revenues increased for the first half fiscal 2007 by $15,206,000. The largest components of the increase were in net interest revenue, $9,548,000, net gains on principal transactions, $5,009,000, and other, $2,198,000. These increases were due to substantially the same reasons as described in the paragraph above. Investment banking, advisory and administrative fees also increased by $2,318,000 due to an increase in fees from our corporate finance business. These increases are offset by a decrease in clearing revenue of $1,039,000 and commissions of $2,828,000. The decrease in clearing revenues is due primarily to decreased revenue from general securities correspondents. The decrease in commissions is due primarily to the sale of our institutional sales business line in the third quarter of fiscal 2006.

Operating expenses increased $2,207,000 for the three-months ended December 29, 2006 as compared to the same period of fiscal 2005. The largest increase was in commissions and other employee compensation. The increase in commissions and other employee compensation is due primarily to increased business profitability.

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Operating expenses increased $4,018,000 for the six-months ended December 29, 2006 as compared to the same period of fiscal 2005. The largest increase was in commissions and other employee compensation as described above.

Net Revenues from Clearing Operations. Net clearing revenues decreased $393,000 and $1,039,000 for the three and six-month periods ended December 29, 2006 when compared to the three and six-months periods ended December 30, 2005, respectively. We processed 3,790,892 and 8,231,010 transactions during the second quarter and first half of fiscal 2007 compared to 2,559,500 and 4,969,401 transactions in the same periods of fiscal 2006. Revenue decreased despite the increase in transactions because the additional tickets were primarily in the day trader business, which has a lower fee per ticket than our general securities processing. Average revenue per ticket decreased to $0.81 from $1.35 when comparing the second quarter of fiscal 2007 to the same period of fiscal 2006. Revenue per ticket decreased to $0.81 from $1.44 for the six-month periods of fiscal 2007 and 2006, respectively. Additionally, the correspondents acquired from Ameritrade in July 2006 received substantially discounted clearing fees in the first half of fiscal 2007. Correspondent count at December 29, 2006 was 215 versus 216 at December 30, 2005.

Commissions.Commission revenue decreased 3% and 6%, respectively, for the three and six-month periods ended December 29, 2006 compared to the three and six-month periods ended December 30, 2005. The primary reason for the decline was the sale of the Institutional Equity Sales in January of 2006. Commissions from the retail brokerage segment were up $681,000 and $12,000, respectively, for the three and six-months periods ended December 29, 2006 primarily due to an increase in business by our Private Client Group in December. 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 29, 2006		December 30, 2005		December 29, 2006		December 30, 2005		December 29, 2006	December 30, 2005
Retail brokerage:
Private Client Group	$	6,572	$	6,146	$	11,959	$	11,513	94	97
Independent registered representatives		5,414		5,159		10,171		10,605	371	372
		11,986		11,305		22,130		22,118	465	469
Institutional brokerage:
Fixed income sales & trading		5,987		5,927		10,833		11,537	34	37
Institutional equity sales		—		1,088		—		2,354	—	5
Portfolio trading		6,288		6,664		10,129		9,966
		12,275		13,679		20,962		23,857
Other		99		73		207		152
	$	24,360	$	25,057	$	43,299	$	46,127

Net Interest Income.Net interest income from the brokerage segments (retail, institutional and clearing) 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 29, 2006 and December 30, 2005 (in thousands):

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	Three Months Ended				Six Months Ended
	December 29, 2006		December 30, 2005		December 29, 2006		December 30, 2005
Interest revenue:
Customer margin accounts and assets segregated for regulatory purposes	$	11,349	$	9,527	$	21,374	$	18,586
Stock borrowed		40,490		24,523		76,886		51,557
Bank loans		20,047		15,587		39,069		30,242
Other		2,991		1,231		7,453		2,575
	$	74,877	$	50,868	$	144,782	$	102,960
Interest expense:
Customer funds on deposit	$	5,986	$	4,667	$	12,021	$	8,725
Stock loaned		34,914		21,043		65,825		44,152
Bank deposits		8,325		4,613		15,914		8,458
Federal Home Loan Bank advances		723		753		1,336		1,661
Notes Payable		—		—		—		—
Other		854		651		1,511		1,337
		50,802		31,727		96,607		64,333
Net interest	$	24,075	$	19,141	$	48,175	$	38,627

Brokerage:For the three and six-months ended December 29, 2006, net interest income from the brokerage segments accounted for approximately 15.9% and 16.7%, respectively, of our net revenue. For the three and six-months ended December 30, 2005, net interest income from the brokerage segments accounted for approximately 13.5% and 14.2%, 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 29, 2006		December 30, 2005		December 29, 2006		December 30, 2005
Average interest-earning assets:
Customer margin balances	$	288,000	$	326,000	$	309,000	$	325,000
Assets segregated for regulatory purposes		380,000		352,000		358,000		346,000
Stock borrowed		3,072,000		2,491,000		3,014,000		2,532,000
Average interest-bearing liabilities:
Customer funds on deposit		546,000		565,000		549,000		556,000
Stock loaned		3,003,000		2,417,000		2,957,000		2,454,000

Net interest revenue from customer balances increased slightly for the three-months ended December 29, 2006 over the second quarter of fiscal 2006 due primarily to increased interest earnings on assets segregated for regulatory purposes. The increase in net interest revenue generated from securities lending activities for the quarter is due to an increase in the net interest spread of 18 basis points and a 23% increase in average balances. The type of securities borrowed or loaned and the interest rate environment influence the spread earned in this business. The increase in other interest revenue is due to increased activity in fixed income securities.

Net interest revenue from customer balances decreased 5% for the six-months ended December 29, 2006 over the second half of fiscal 2006 due primarily to lower average margin balances. The increase in net interest revenue generated from securities lending activities for the quarter is due to an increase in the net interest spread of 21 basis points and a 19% increase in average balances. The type of securities borrowed or loaned and the interest rate environment influence the spread earned

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in this business. The increase in other interest revenue is due to increased activity in fixed income securities.

Banking:Net interest revenue generated by the Bank accounted for approximately 16.5% and 16.6% of net revenue for the three and six-month periods ended December 31, 2006 and 15.8% and 15.7% for the three and six-month periods ended December 31, 2005, respectively. 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 table sets forth an analysis of the Bank’s net interest income by each major category of interest-earning assets and interest-bearing liabilities for the three and six-month periods ended December 31, 2006 and December 31, 2005 (dollars in thousands):

	Three Months Ended
	December 31, 2006						December 31, 2005
	Average Balance		Interest Income/ Expense		Yield/ Rate		Average Balance		Interest Income/ Expense		Yield/ Rate
Assets:
Interest-earning assets:
Loans:
Real estate – mortgage	$	155,353	$	3,705	9.5	%	$	186,803	$	3,941	8.4	%
Real estate – construction		222,779		5,303	9.4			168,662		3,943	9.3
Commercial		306,356		7,652	9.9			241,522		5,445	8.9
Individual		6,887		135	7.8			9,939		147	5.9
Land		130,800		3,252	9.9			95,291		2,111	8.8
Investments		100,113		1,266	5.0			9,472		93	3.9
		922,288	$	21,313	9.2	%		711,689	$	15,680	8.7	%
Interest-earning assets from discontinued operations								32,831
Noninterest-earning assets:
Cash and due from banks		9,164						9,838
Other assets		23,874						25,867
	$	955,326					$	780,225
Liabilities and Stockholders’ Equity:
Interest-bearing liabilities:
Certificates of deposit	$	81,915		869	4.2	%	$	95,254	$	798	3.3	%
Money market accounts		29,070		243	3.3			23,297		147	2.5
Interest-bearing demand accounts		63,347		555	3.5			64,282		423	2.6
Savings accounts		586,993		6,658	4.5			407,072		3,245	3.2
Federal Home Loan Bank advances		58,349		723	4.9			70,550		753	4.2
		819,674		9,048	4.4	%		660,455		5,366	3.2	%
Noninterest-bearing liabilities:
Non interest-bearing demand accounts		51,312						40,502
Other liabilities		7,209						7,374
		��
		878,195						708,331
Stockholders’ equity		77,131						71,894
	$	955,326					$	780,225
Net interest income			$	12,265					$	10,314
Net yield on interest-earning assets					5.3	%					5.8	%

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	Six Months Ended
	December 31, 2006						December 31, 2005
	Average Balance		Interest Income/ Expense		Yield/ Rate		Average Balance		Interest Income/ Expense		Yield/ Rate
Assets:
Interest-earning assets:
Loans:
Real estate – mortgage	$	158,907	$	7,490	9.4	%	$	204,380	$	8,465	8.2	%
Real estate – construction		215,899		10,505	9.7			157,921		7,221	9.1
Commercial		291,616		14,276	9.7			238,888		10,276	8.5
Individual		6,926		273	7.8			10,252		296	5.7
Land		130,663		6,525	9.9			88,276		3,984	9.0
Investments		82,850		2,116	5.1			10,039		191	3.8
		886,861	$	41,185	9.2	%		709,756	$	30,433	8.5	%
Interest-earning assets from discontinued operations								29,067
Noninterest-earning assets:
Cash and due from banks		10,955						9,376
Other assets		22,943						28,010
	$	920,759					$	776,209
Liabilities and Stockholders’ Equity:
Interest-bearing liabilities:
Certificates of deposit	$	82,754		1,709	4.1	%	$	108,775	$	1,799	3.3	%
Money market accounts		28,562		478	3.3			21,482		263	2.4
Interest-bearing demand accounts		66,507		979	2.9			59,955		710	2.4
Savings accounts		555,098		12,748	4.6			387,728		5,686	2.9
Federal Home Loan Bank advances		54,828		1,336	4.8			81,928		1,661	4.0
		787,749		17,250	4.3	%		659,868		10,119	3.0	%
Noninterest-bearing liabilities:
Non interest-bearing demand accounts		50,606						38,389
Other liabilities		7,091						7,671
		845,446						705,928
Stockholders’ equity		75,313						70,281
	$	920,759					$	776,209
Net interest income			$	23,935					$	20,314
Net yield on interest-earning assets					5.4	%					5.7	%

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, 2006 compared to December 31, 2005
	Total Change			Attributed to
				Volume			Rate			Mix
Interest income:
Real estate - mortgage	$	(236	)	$	(663	)	$	513		$	(86	)
Real estate - construction		1,360			1,265			72			23
Commercial		2,207			1,461			588			158
Individual		(12	)		(45	)		48			(15	)
Land		1,141			787			258			96
Investments		1,173			863			28			282
	$	5,633		$	3,668		$	1,507		$	458
Interest expense:
Certificates of deposit	$	71		$	(112	)	$	213		$	(30	)
Money market accounts		96			36			48			12
Interest-bearing demand accounts		132			(6	)		141			(3	)
Savings accounts		3,413			1,434			1,372			607
Federal Home Loan Bank advances		(30	)		(112	)		(270	)		352
		3,682			1,240			1,504			938
Net interest income	$	1,951		$	2,428		$	3		$	(480	)

	Six months ended December 31, 2006 compared to December 31, 2005
	Total Change			Attributed to
				Volume			Rate			Mix
Interest income:
Real estate - mortgage	$	(975	)	$	(1,883	)	$	1,169		$	(261	)
Real estate - construction		3,284			2,651			463			170
Commercial		4,000			2,268			1,419			313
Individual		(23	)		(96	)		107			(34	)
Land		2,541			1,913			424			204
Investments		1,925			1,260			62			603
	$	10,752		$	6,113		$	3,644		$	995
Interest expense:
Certificates of deposit	$	(90	)	$	(430	)	$	447		$	(107	)
Money market accounts		215			86			97			32
Interest-bearing demand accounts		269			78			172			19
Savings accounts		7,062			2,454			3,219			1,389
Federal Home Loan Bank advances		(325	)		(471	)		492			(346	)
		7,131			1,717			4,427			987
Net interest income	$	3,621		$	4,396		$	(783	)	$	8

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. The primary reason for the increase for the three months ended December 29, 2006 compared to the three months ended December 30, 2005 and the first half of fiscal 2007 over the comparable period in the prior year is an increase in advisory fees from corporate finance of $1,244,000 and $2,767,000, respectively. The increase in fees is due to the closing of several merger and acquisition transactions in both the first quarter and second quarters of fiscal 2007.

Net Gains on Principal Transactions.The increase in net gains on principal transactions of $1,811,000 for the three-months ended December 29, 2006 versus December 30, 2005 is due

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primarily to an increase in the valuation of our NYX stock. We recognized a gain of $2,308,000 in the second quarter of fiscal 2007 compared to a gain of $210,000 in the second quarter of fiscal 2006. Fixed income trading revenue primarily from the mortgage-backed area also increased $479,000. Offsetting these increases was a loss in the value of the treasury bills in our 15c3-3 reserve account of $582,000.

The increase in net gains on principal transactions of $5,009,000 for the six-months ended December 29, 2006 versus December 30, 2005 is due primarily to a gain of $3,122,000 in the value of our NYX stock in the first half of fiscal 2007 compared to a gain of $199,000 recognized in the first half of fiscal 2006. Fixed income trading revenue from the mortgage-backed area also increased $1,882,000. Lastly, we recorded a gain of $180,000 on our treasury bills owned for the 15c3-3 reserve account.

Other Revenue. Other revenue increased approximately $2,256,000 for the three-month period ended December 29, 2006 compared to the three-month period ended December 30, 2005. The increase in other revenue is due primarily to proceeds from company owned life insurance policies of $2,276,000, an $883,000 increase in fees from the sale of insurance products, a $400,000 termination fee paid by a clearing customer and an increase of $208,000 from floor brokerage specialist rebates. Offsetting these increases is a decrease in earnings from our joint venture investment of $1,473,000.

Other revenue increased approximately $2,198,000 for the six-month period ended December 29, 2006 compared to the six-month period ended December 30, 2005 for substantially the same reasons as the quarterly period discussed above.

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 $3,368,000 for the second quarter of fiscal 2007 over the comparable period in fiscal 2006. An increase of $1,516,000 was due to commissions paid to revenue-producing employees. We also experienced an increase of $709,000 in incentive compensation due to increased business line profitability.

Total commissions and other employee compensation increased $6,389,000 in the first half of fiscal 2007 over the comparable period in fiscal 2006. An increase of $2,650,000 was due to commissions paid to revenue-producing employees. We also experienced an increase of $2,112,000 in incentive compensation due to increased business line profitability.

Occupancy, Equipment and Computer Services.The $441,000 decrease in the three-month period ended December 29, 2006 from the comparable period in the prior year is primarily due to decreases in rent due to the renegotiation of our headquarters’ lease in January of 2006 and reduced depreciation expense. The decrease in depreciation is due to the write-off of our leasehold improvements upon renegotiation of our lease, decreasing the number of floors occupied by one, in the third quarter of fiscal 2006. These decreases are offset by an increase in amortization expenses of $310,000, $307,000 for the amortization of the customer relationship intangible generated in the recent purchase of correspondent customers.

The $738,000 decrease in occupancy and equipment expense in the six-month period ended December 29, 2006 from the comparable period in the prior year is primarily due to the previously discussed reductions in rent and depreciation, which were $248,000 and $762,000, respectively in the six-month period offset by an increase in amortization expenses of $382,000, primarily for the amortization of the customer relationship intangible.

Communications. Communications expense decreased $147,000 for the three-month period ended December 29, 2006 as compared to the same period of the prior year. This decrease is primarily due to a decrease in our quotes expenses due to a reduced headcount in institutional equity trading.

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Communications expense decreased $363,000 for the six-month period ended December 29, 2006 as compared to the same period of the prior year. This decrease is primarily due to a decrease in our quotes expenses due to a reduced headcount in institutional equity trading.

Floor Brokerage and Clearing Organization Charges. Floor brokerage and clearing organization charges change in relation to the transactions processed in our clearing business and changes in the costs from our clearing agencies. These charges increased $308,000 and $183,000 when comparing the three and six-month period ended December 29, 2006 to the same period in the prior year, respectively. The increase is due to the increase in the number of transactions processed in our clearing area as well as rebates received from the Depository Trust Company in fiscal 2006.

Advertising and Promotional. Advertising and promotional expense decreased $69,000 and $267,000 when comparing the three and six-months ended December 29, 2006 to the same periods in the prior fiscal year, respectively. This decrease reflects the reduction in advertising and external recruiting costs.

Other Expense.The decrease in other expense for the second quarter of fiscal 2007 was $812,000 when compared to the second quarter of last year. The decrease is primarily composed of reduced legal fees of $747,000 and the positive settlement of a tax obligation for $900,000, offset by an increase in a contingency reserve.

The decrease in other expense for the first half of fiscal 2007 was $1,186,000 when compared to the first half of last year. The decrease is primarily composed of the reduced legal fees and settlements discussed above as well as a reduced provision for loan losses at the Bank offset by increased accruals for contingencies.

Income Tax Expense. For the first half of fiscal 2007, income tax expense (effective rate of 32.5%) differed from the amount that would have otherwise been calculated by applying the federal corporate tax rate (35%) to income from continuing operations before income taxes. The effective rate was lower than the statutory rate because of permanently excluded items, primarily tax exempt interest and proceeds from company owned life insurance policies, offset by state income taxes deductible for federal income tax purposes.

Segment Operations Analysis

Clearing:The clearing segment benefited from increased net interest revenue with net interest earned by clearing up 28%. Clearing fees were down $400,000 in the quarter offset by the termination fee from one clearing correspondent. Expense reductions from operational and information technology expense allocations offset by $372,000 in amortization expenses from new correspondent acquisitions led to increased income from continuing operations of $1.6 million in the quarter.

For the six month period, net income from continuing operations also increased by $1.6 million for generally the same reasons as discussed above.

Retail:Income from continuing operations for the retail segment increased $1.5 million and $2.2 million for the three and six-month periods ending December 29, 2006 when compared to the same periods last year. For the quarter, commission revenue increased 6%. Fees from the sale of insurance products also increased substantially as did fees from managed accounts. Assets under management in the retail area increased from $5.6 billion at December 30, 2005 to $6.9 billion at December 29, 2006. Reduced legal fees also contributed to the improved results. Results for the six-month period varied for substantially similar reasons as the quarterly results.

Institutional:Income from continuing operations for the institutional segment increased $1.4 million and $4.6 million for the three and six-months ended December 29, 2006 when compared to

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the same periods for fiscal 2006. Increased net interest earnings from the stock loan area, increased fees from corporate finance transactions and increased trading revenues in the fixed income area all contributed to the increased profitability. These were offset by the elimination of institutional equity trading commissions upon the sale of this business last year.

Banking:The bank’s income from continuing operations increased $1.5 million and $3 million for the three and six-month periods ending December 31, 2006 when compared to the same periods last year. Growth in the loan portfolio at the bank as well as reduced legal expenses offset by increased compensation expenses from the branch expansion were the primary drivers for the increases in both period.

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 the North Texas area. 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, 2006 and June 30, 2006 are summarized as follows (in thousands):

	December 31, 2006		June 30, 2006
Real estate – mortgage	$	179,014	$	177,587
Real estate – construction		289,379		250,664
Commercial		237,583		210,641
Individuals		4,560		4,553
Land		130,420		123,970
	$	840,956	$	767,415

The following table shows the expected life of certain loans at December 31, 2006, 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	$	248,069	$	16,324	$	24,986	$	289,379
Commercial		50,443		98,681		88,459		237,583
Total	$	298,512	$	115,005	$	113,445	$	526,962
Amount of loans based upon:
Floating or adjustable interest rates	$	291,852	$	80,414	$	82,088	$	454,354
Fixed interest rates		6,660		34,591		31,357		72,608
Total	$	298,512	$	115,005	$	113,445	$	526,962

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

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is placed on non-accrual status, previously accrued and uncollected interest is reversed against interest income. Interest income on non-accrual loans is credited to income on a cash basis.

Non-performing assets as of December 31, 2006 and June 30, 2006 are as follows (dollars in thousands):

	December 31, 2006			June 30, 2006
Loans accounted for on a non-accrual basis	$	8,497		$	4,115
Non-performing loans as a percentage of total gross loans		1.0	%		0.6	%
Loans past due 90 days or more, not included above	$	312		$	334
Troubled debt restructurings	$	695		$	1,785

An analysis of the allowance for probable loan losses for the three and six-month periods ended December 31, 2006 and December 31, 2005 is as follows (dollars in thousands):

	Three Months Ended December 31,						Six Months Ended December 31,
	2006			2005			2006			2005
Balance at beginning of period	$	5,347		$	7,558		$	5,047		$	7,450
Continuing operations:
Charge-offs:
Charge-offs – commercial, financial and agricultural		(86	)		(113	)		(110	)		(113	)
Charge-offs – real estate-mortgage		(224	)		(50	)		(224	)		(102	)
Charge-offs – Installment loans to individuals		(9	)		—			(9	)		—
		(319	)		(163	)		(343	)		(215	)
Recoveries:
Recoveries – construction		10			—			12			—
Recoveries – mortgage					—			2			—
Recoveries – commercial, financial and agricultural		38			12			64			57
		48			12			78			57
Net charge-offs		(271	)		(151	)		(265	)		(158	)
Additions charged to operations		421			614			715			1,165
					463						1,007
Discontinued operations:
Provision for loan losses		—			1,454			—			3,392
Loans charged to allowance, net		—			(2,324	)		—			(4,698	)
		—			(870	)		—			(1,306	)
Balance at end of period	$	5,497		$	7,151		$	5,497		$	7,151
Ratio of net charge-offs during the period to average loans outstanding during the period		0.03	%		0.02	%		0.03	%		0.02	%

The allowance for probable loan losses is applicable to the following types of loans as of December 31, 2006 and June 30, 2006 (dollars in thousands):

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	December 31, 2006				June 30, 2006
	Amount		Percent of loans to total loans		Amount		Percent of loans to total loans
Commercial	$	2,337	28.4	%	$	1,954	27.5	%
Real estate – construction		1,741	34.4			1,178	32.6
Real estate – mortgage & land		1,397	36.7			1,914	39.3
Individuals		22	0.5			1	0.6
	$	5,497	100.0	%	$	5,047	100.0	%

Deposits.Average deposits and the average interest rate paid on the deposits for the three and six-month periods ended December 31, 2006 and December 30, 2005 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 $25,373,000 and $25,591,000 at December 31, 2006 and June 30, 2006, 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 approximately $630 million 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. The Bank currently uses the FHLB advances to fund fixed rate loans. Short-term borrowing needs are covered by deposits. 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, 2006 and December 31, 2005 (dollars in thousands):

	Three Months Ended December 31,								Six Months Ended December 31,
	2006				2005				2006				2005
	Amount		Interest Rate		Amount		Interest Rate		Amount		Interest Rate		Amount		Interest Rate
At end of period	$	6,076	3.2	%	$	36,488	4.2	%	$	6,076	3.2	%	$	36,488	4.2	%
Average during period		7,480	3.2	%		35,457	4.0	%		8,367	3.1	%		48,444	3.8	%
Maximum balance during period		8,865	—			77,442	—			18,127	—			77,442	—

LIQUIDITY AND CAPITAL RESOURCES

Brokerage

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.

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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 29, 2006, the amount outstanding under these secured arrangements was $10,680,000 which was collateralized by securities held for firm accounts valued at $84,148,000.

We have unsecured letters of credit, aggregating $2,250,000 at December 29, 2006, 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 29, 2006, 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 $571,000. This letter of credit bears a 1% commitment fee and is renewable annually.

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 under the unsecured letters of credit at the time of borrowing. There were no amounts outstanding on this line other than the $2,821,000 under unsecured letters of credit at December 29, 2006. At December 29, 2006, the total amount available for borrowings was $17,179,000.

We have an irrevocable letter of credit agreement aggregating $53,000,000 at December 29, 2006 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 $67,990,000 at December 29, 2006.

In the opinion of management, these credit arrangements are adequate to meet our operating capital needs of the Brokerage segments 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 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 30, 2006. 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 30, 2006.

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.

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Banking

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 other un-affiliated banks and vault cash. In addition, the Bank has borrowing capacity with the FHLB and a $30,000,000 federal funds agreement for the purpose of purchasing short-term funds should additional liquidity be needed. Current net available borrowing capacity at FHLB is $200,067,000. 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. Overall interest rate risk is monitored through reports showing both sensitivity ratios, a simulation model and existing “gap” data. See the Bank’s gap analysis in “Risk Management-Market Risk-Interest Rate Risk/Banking.” At December 31, 2006, $633,000,000 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.

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.

Borrowings. In June 2005, the Bank entered into an agreement with an unaffiliated bank for the availability of a $20,000,000 unsecured line of credit for the purchase of federal funds. In the third quarter of fiscal 2006, the agreement was amended to increase the available credit to $30,000,000. The unaffiliated bank is not obligated by this agreement to sell federal funds to the Bank. Interest is charged on any borrowed funds at a rate quoted by the unaffiliated bank and accepted by the Bank. The line is used by the Bank to support short-term liquidity needs. At December 31, 2006, there were no amounts outstanding on this line of credit.

Cash Flow

Net cash provided by operating activities was $16,122,000 and $47,532,000 for the six-months ended December 29, 2006 and December 30, 2005, respectively. The primary reasons for the decrease in cash provided by operating activities from fiscal 2006 to fiscal 2007 were:

• a decrease of $14,900,000 in securities sold, not yet purchased versus a $8,900,000 increase last year;

• an increase in securities lending and other broker/dealer balances of $26,000,000 versus a decrease of $10,000,000 last year; and

• reduced cash flow from client accounts;

offset by:

• reduced investment in assets segregated for regulatory purposes; and

• a decrease of $19,000,000 in investments held in reverse repurchase agreements.

Net cash used in investing activities for the six-month periods ended December 29, 2006 and December 30, 2005 was $74,299,000 and $56,935,000, respectively. The primary reason for the increase in cash used for investing activities was our purchase of correspondent clients of Ameritrade and the elimination of cash provided by our discontinued operations.

Net cash flows provided by financing activities totaled $96,927,000 for the six-month period ended December 29, 2006 compared to $13,965,000 for the six-month period ended December 30, 2005. The primary reasons for the increase in cash proceeds is from increases in deposits at the Bank, increased net advances from the FHLB and an increase in proceeds from the options exercised by our employees.

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 2007.

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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 June 30, 2008, to repurchase up to 500,000 shares.

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. The plan purchased 15,560 shares in the six-month period ended December 29, 2006 at a cost of approximately $232,000 or $14.88 per share. 15,572 shares were distributed pursuant to the plan in the six-month period ended December 29, 2006. See “Part II. Other Information-Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.”

As restricted stock grants vest, some of the grantees choose to sell a portion of their vested shares to cover the tax liabilities arising from such vesting. As a result, in the six-month period ended December 29, 2006, 13,581 shares were repurchased by the Company at an average price of $17.60 per share to cover tax liabilities.

RISK MANAGEMENT

We manage risk exposure by involving various levels of management in establishing, maintaining and regularly monitoring 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 counterparty risk through the use of credit exposure 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. Credit risk arises from the potential nonperformance by counterparties, customers or debt security issuers. We are exposed to credit risk as a trading counterparty and as a stock loan counterparty to dealers and customers, as a holder of securities and as a member of 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. Credit risk is the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms and is inherent in all types of lending 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. Also, the Bank 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

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North Texas area. The policies and procedures, which are in place to manage credit risk, are designed to be responsive to changes in these economic conditions.

Operational Risk

Operational risk refers generally to risk of loss resulting from our operations, including but not limited to, improper or unauthorized execution and processing of transactions, deficiencies in our operating systems, and inadequacies or breaches in our control processes. We operate in diverse markets and 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 reasonably 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, investor expectations and changes in credit ratings of the issuer. Our exposure to market risk is directly related to our role as a financial intermediary in customer-related transactions and to our proprietary trading activities.

Interest Rate Risk / Brokerage. 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. 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 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.

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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	-3.91%
+200	-2.40%
+100	-0.89%
0	0%
-100	0.87%
-200	1.16%

The following GAP Analysis table indicates the Bank’s interest rate sensitivity position at December 31, 2006 (in thousands):

	Repricing Opportunities
	0-6 months		7-12 months			1-3 years		3+ years
Earning Assets:
Loans	$	758,792	$	15,069		$	38,643	$	33,949
Securities and FHLB Stock		3,211		—			—		268
Interest Bearing Deposits		65,363		—			—		—
Total Earning Assets		827,366		15,069			38,643		34,217
Interest Bearing Liabilities:
Transaction Accounts and Savings		673,536		—			—		—
Certificates of Deposit		33,990		25,090			14,469		6,206
Borrowings		6,076		721			178		52,362
Total Interest Bearing Liabilities		713,602		25,811			14,647		58,568
GAP	$	113,764	$	(10,742	)	$	23,996	$	(24,351	)
Cumulative GAP	$	113,764	$	103,022		$	127,018	$	102,667

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 securities owned and securities sold, not yet purchased, portfolios and marketable equity securities in our available-for-sale portfolio, which are 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	$	225	$	5,459		$	7,352		$	16,860		$	29,896
U.S. Government and Government agency obligations		8,178		(25,995	)		(259	)		(8,317	)		(26,393	)
Corporate obligations		2,914		(519	)		(4,563	)		47,325			45,157
Total debt securities		11,317		(21,055	)		2,530			55,868			48,660
Corporate equity		—		—			—			17,101			17,101
Other		10,269		��			—			—			10,269
	$	21,586	$	(21,055	)	$	2,530		$	72,969		$	76,030

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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	%		3.7	%		3.9	%		4.3	%		4.1	%
U.S. Government and Government agency obligations		4.8	%		4.8	%		4.8	%		5.2	%		4.8	%
Corporate obligations		6.2	%		5.9	%		5.4	%		5.7	%		5.7	%
Available-for-sale securities, at fair value
Marketable equity securities	$	—		$	—		$	—		$	4,224		$	4,224

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 30, 2006. 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, counterparties in securities lending transactions and of our banking and margin customers;

• the demand for investment banking services;

• 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.

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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 “Risk Factors” in our Annual Report on Form 10-K filed with the SEC and 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 29, 2006. Based on such evaluation, the principal executive officer and principal financial officer have concluded that, as of December 29, 2006, 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 six-month period ended December 29, 2006 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, we 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 1A. Risk Factors

We may lose existing correspondents to self-clearing or otherwise.As our correspondents’ operations grow, they often consider the option of performing clearing functions themselves, in a process referred to in the securities industry as “self clearing.” As the transaction volume of a broker/dealer grows, the cost of implementing the necessary infrastructure for self-clearing may be eventually offset by the elimination of per transaction processing fees that would otherwise be paid to a clearing firm. Additionally, performing their own clearing services allows self-clearing broker/dealers to retain their customers’ margin balances, free credit balances and securities for use in margin lending activities. Significant losses to self-clearing could have a material adverse affect on our business, financial condition, results of operations and cash flow. Additionally, industry consolidations or acquisitions may result in the loss of correspondents to self-clearing or to our competitors. Significant losses of correspondents could have a material adverse affect on our business, financial condition, results of operations and cash flow.

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 29, 2006 of equity securities that are registered by SWS pursuant to Section 12 of the Exchange Act:

ISSUER PURCHASES OF EQUITY SECURITIES

Period	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(2)
9/30/06 to 10/27/06	—	$   —	—	468,910
10/28/06 to 11/24/06	3,110	19.71	—	468,910
11/25/06 to 12/29/06	—	—	—	468,910
	3,110	$  19.71	—

⁽¹⁾ Upon vesting of restricted stock in accordance with the restricted stock plan, a grantee may choose to sell a portion of their vested shares to cover the tax liabilities arising from the vesting. This amount represents the number repurchased as a result of vesting in November 2006.

⁽²⁾ 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 expired on December 31, 2006, to repurchase a total of 500,000 shares. In November 2006, the Board of Directors approved a stock repurchase program effective January 1, 2007 and expires June 30, 2008. The program allows for the purchase of up to 500,000 shares of our common stock.

Item 3. Defaults upon Senior Securities

None.

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

The annual meeting of shareholders was held on November 30, 2006. The following directors were elected at the meeting:

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Nominees	For	Withheld	Abstain
Don A. Buchholz	15,724,415	170,122	—
Donald W. Hultgren	15,725,245	169,292	—
Brodie L. Cobb	15,759,637	134,900	—
Larry A. Jobe	15,567,892	326,645	—
Dr. R. Jan LeCroy	15,619,025	275,512	—
Frederick R. Meyer	15,278,507	616,030	—
Dr. Mike Moses	15,772,164	122,373	—
Jon L. Mosle, Jr.	15,241,769	652,768	—

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

Item 5. Other Information

None.

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 7, 2007	/S/ Donald W. Hultgren
Date	(Signature)
	Donald W. Hultgren
	Chief Executive Officer and Duly Authorized Officer
	(Principal Executive Officer)
February 7, 2007	/S/ Kenneth R. Hanks
Date	(Signature)
	Kenneth R. Hanks
	Treasurer and Chief Financial Officer
	(Principal Financial Officer)
February 7, 2007	/S/ Stacy Hodges
Date	(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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