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SWS Group, Inc. (NYSE:SWS)

F3Q10 (Qtr End 03/26/10) Earnings Call Transcript

April 28, 2010 10:00 am ET

Executives

Kathy Kennedy – Corporate Communications

Don Hultgren – President and CEO

Ken Hanks – EVP, CFO and Treasurer

John Holt – Chairman, President and CEO, Southwest Securities, FSB

Jim Ross – President and CEO, Southwest Securities, Inc.

Dan Leland – EVP

Analysts

Hugh Miller – Sidoti & Company

Max Sikes [ph]

Brian Hagler [ph]

Joel Jeffrey – Keefe, Bruyette & Woods

Patrick Devitt – BofA Merrill Lynch

Jeff Smith [ph]

Kathy Kennedy

Good morning everyone and welcome to the SWS Group’s quarterly Conference Call and Webcast. This is Kathy Kennedy of the SWS Corporate Staff. We are pleased you could join us today.

The quarterly earnings press release can be found on our Web site at swsst.com or on the Yahoo! Finance Web site under SWS News. Market professionals on our distribution list should have also received the slides for today's call via e-mail. If you would like to be added to our e-mail list to receive press releases or to be notified of future quarterly calls, please contact us at 214-859-9335.

This conference call is being webcast live on the Internet along with the accompanying slides at swsst.com where it will be archived for the next 30 days. During the question-and-answer session, call participants can access the queue to ask questions by pressing star 1 on their telephone. Those participating via the Internet can ask questions from the link provided on the webcast page or by e-mailing them to questions@swst.com.

This presentation contains forward-looking statements. Participants are cautioned that any forward-looking statements, including those predicting or forecasting future events or results, which depend on future events for their accuracy, embody projections or assumptions, or express the intent, belief or current expectations of the company or management, are not guarantees of future performance and involve risks and uncertainties.

Actual results may differ materially as a result of various factors, some of which are out of our control, including, but not limited to, volume of trading in securities, volatility of securities prices and interest rates, liquidity and capital and credit market, availability of lines of credit, customer margin loan activity, creditworthiness of our correspondents and customers, demand for housing, general economic conditions, especially in Texas and New Mexico changes in the commercial lending and regulatory environment and other factors discussed in our annual report on Form 10-K and in our other reports filed with and available from the Securities and Exchange Commission.

At this point, it’s a pleasure to introduce Mr. Don Hultgren, Chief Executive Officer of SWS. Don?

Don Hultgren

Thank you, Kathy, and good morning, thank you for joining us for a discussion of our third quarter conference call. You’ll be hearing from a number of people today. I’d like to make those introductions. With me today is Ken Hanks, who is the Chief Financial Officer of SWS Group; John Holt, who is the President and Chief Executive Officer of our Southwest Securities, FSB, our bank; Jim Ross, who is the President and Chief Executive Officer of Southwest Securities and SWS Financial, our broker-dealer and also here with us today, Dan Leland who is the Executive Vice President, in-charge of our taxable fixed income department.

Our agenda this morning will be as follows

I will provide an overview of the third quarter for 2010. I will review some noteworthy items and touch on some important events since our last conference call. John will then provide an update of activities at the bank. Jim, in turn, will give an overview of our other business segment of broker-dealer segment and then Ken will finish off with detailed review of the other numbers for the quarter, then Ken, Don and I will finally discuss our market position and our three primary growth initiatives, finally, we will open it up for questions. If you have questions you can press start 1 on your telephone or if you would like to submit them by e-mail it’s questions@swst.com.

We are obviously disappointed with our third quarter results. The net revenue in the quarter decreased from $114.1 million in last year's third quarter to $95 million in this quarter. Net income decreased from $4 million in last year's third quarter to a loss of $11.5 million in this year's third quarter.

Earnings per share in the quarter decreased from $0.15 last year to a loss of $0.35 this year. We ended the quarter with a book value per share of $11.93. Intangible book value of $11.67. The quarterly loss translates to a year-to-date loss of about $2.6 million or $0.09 a share. We certainly expect our results to begin improving in the fourth quarter.

Let me now turn to some noteworthy items in the quarter. As we noted in our press release the decline in the commercial real estate environment in North Texas accelerated in the third fiscal quarter. This acceleration was evident in the bank’s portfolio as increased charge-offs and declining real estate value led to a larger than expected provision for loan losses in the quarter.

John will give you a complete update on the bank in just a few minutes.

The third quarter was a short quarter in terms of the number of trading days. The quarter includes 58 trading days compared to 67 in the December quarter. There were 59 trading days in the third quarter last year and there will be 63 trading days in the June quarter.

The corporate finance group closed two significant transactions in our quarter. This is an area which I am very excited. We waited a long time to build our corporate finance presence here in Texas. I think now we have a team that has finally got the traction and is experiencing some good success in a relatively short period of time.

And finally, after holding one auction rate bond for the extended period we have determined that a discount for lack of liquidity was warranted in the quarter. While we receive no credit issues with this bond we recorded a $1 million valuation reserve in the current quarter.

Let me turn now to important events since our last conference call. It’s important to note that the bank management has continued to proactively review its operations to address the challenging environment. Changes in roles and responsibilities, limits uncertain loans hikes and focus on REO management and marketing are some of the actions management has taken in the current and previous quarters.

As part of this process we have just moved all the banks central operations to our Dallas headquarters from Arlington just this last week-end. While with all of the centralized bank operations want building day-to-day management we believe it will be easier and more efficient.

We will hear this several times during our presentation today. But the brokerage business continues to suffer in the current depressed interest rate environment. The impact on retail and clearing is pronounced. We are making changes where possible to address this margin compression and we are very much looking forward to expanding spread sometime in the future.

Despite the interest rate environment we are beginning now finally to see improvement in the retail business. Retail customers are returning to the markets and recruiting is beginning to pick up.

And finally, as we expected our taxable fixed income results our normalizing from the above average levels we had last year. While we enjoy a very volatile market in last year’s third quarter we are still very pleased with the very good results in more stable markets of 2010.

With that let me turn it over to John Holt, CEO of the bank. John?

John Holt

Thanks, Don. The Bank’s operating results during the quarter were negatively impacted by increased provision of 25 million due to the continued elevated levels of non-performing assets and related charge-offs totaling 12.2 million for the quarter. As a result, the allowance grew to $30 million representing 2.6% of loans held for investments.

Negative economic conditions experienced in other parts of the country earlier in recession appear to migrate our North Texas customers during the quarter. Indicators of the accelerating deterioration include significant decline in property values due to recent current appraisal. Further, industry statistics published by the Federal Reserve indicate increase in delinquency and charge-off rates for commercial real estate loans. Due to these factors and concert with other declining economic data and increasing deterioration loan portfolio we felt it’s prudence to modify the assumptions in the allowance methodology.

The primary modification to the allowance computation which has the largest economic impact involve change in the historic loss look back period from three years to four quarters. As evidenced by the extent and likelihood of continued deterioration the bank determine that a one year look back would more accurately reflect the inherent losses in our portfolio.

Additionally, we’ve revised the historical loss ratios upward due to concentration in certain loan tests. The resulting combination of these changes required an increase in the allowance via a larger loan loss provision. Despite the increase provision in the banking segments pretax loss of $20 million the Bank maintains a strong risk based capital ratio of 12.4% and supported liquidity position held in short-term highly liquid securities.

During the quarter we opened two full services commercial banking centers. One in Albuquerque, New Mexico and the one in Houston, Texas. Both are staffed with teams of experienced bankers and began moving their existing relationship based commercial customers to the Bank’s platform and I look forward to updating you on their progress in coming quarters.

With regard to the regulatory environment, certain provisions included in the current House and Senate bills could transfer supervision of the Bank from the OTS to out of the OTC or the Federal Reserve. We continue to monitor and analyze of potential impact of the proposed legislation.

Due to growth in deposits provided by our brokerage customers along with the decrease in the average loans held for sale portfolio the Bank’s net interest margin declined by 28 basis points during the quarter to 4.57%. Despite the decrease in loans held for sale portfolio and the average excess liquidity of over $150 million the Bank’s net interest margin remain strong and exhibit the efficient earnings power of the broker bank model.

The decrease in average gross loans for the quarter as previously mentioned was due to our mortgage purchase apartment with average balances down approximately $41 million. In regards to the investment portfolio we have focused on repositioning the balance sheet, our restricting lending in areas of residential construction, non-owner occupied commercial real estate and lien.

We plan to replace the loan of focusing primarily on mortgage purchase, SBAs and more traditional commercial and industrial loans in our existing footprint. Early indicators point to favorable conditions for increasing average outstanding in the mortgage purchased apartment because of seasonality and our increased focus on growing in this line of business.

Capital increased due to the $20 million injection into the bank in December 2009, subsequent to the bank’s capital rate, deposit growth was concentrated into the bank insured sweep account. This is consistent with the broker bank model as lead deposits account for 86% to the bank average total deposit base.

Non-performing assets increased 12.6 million during the quarter and remained at elevated levels representing 4.5% of assets. The growth in non-performing assets continues to remain concentrated and lot and land development as well as commercial real estate.

REO at the quarter represented 54% of our total non-performing assets further indicating our strategy of diligently covering non-performing loans to marketable assets. During the quarter we sold $7 million of REO and experienced write-downs on additional 1.7 million on the remaining REO properties.

We are focused on the disposition and resolution of our non-performing assets and have reorganized our credit administration department and our Chief Credit Officer has transitioned to become the director of special assets.

Further, we have allocated additional resources to this department with the goal of reposition in the existing classified credit and disposing of other real estate assets.

As I alluded to earlier, we are repositioning the Bank’s balance sheet with the focus on decreasing loan exposures in the areas of residential construction, lot and land development which is evidenced by meaningful year-over-year changes in these loan types.

Further, our new teams of commercial bankers and existing commercial lenders are primarily concentrated loan growth on SBA and more traditional commercial and industrial relationship based customers across Texas and New Mexico.

Net charge-offs for the quarter increased significantly due to deterioration in commercial real estate multi-family and land loans. The charge-offs indicate decrease in commercial real estate valuations in the markets we operate.

Further, due to the larger size of commercial real estate loans we anticipate fluctuations in the level of charge-offs to occur as we operate during this difficult economic environment. The gross yield on earning assets decreased 30 basis points from the prior quarter due to interest reversals on loans based on non-accrual lower mortgage purchase balances and higher average yielding short-term securities.

Although I’m not pleased with the operating performance of bank during the quarter I’m confident we have the team and infrastructure in place to reduce the level of non-performing assets continue to grow our existing relationship-based commercial franchise and return to utilizing the scalable efficiencies of the broker bank model.

Now, I would like to turn it over to Jim Ross, CEO of our broker dealers.

Jim Ross

Thanks, John. As we take a look at the broker-dealer, we report as many of you know by segments. So we’ll go by these pretty segments, retail, institution and clearing. In a retail segment, we are seeing great improvement and our performance metrics.

Customer assets were 10.3 billion in the third quarter of fiscal 2009 and have grown to 13.2 billion in the third quarter of fiscal 2010. This is an increase of 2.9 billion or 28%. And while the markets help to improve these assets numbers we have also been doing a lot to grow regardless or exceed market conditions. Specifically, of the 2.9 billion customer asset growth, 1.8 billion or 62% of this is from new assets and 1.1 billion or 38% of this number is market growth and both of these are net of customer outflows.

Net revenue has increased from 24 million in the third quarter of prior year to 27 million in the third quarter of 2009 or 13% increase. All of this has resulted in a 2.3 million bottom-line improvement same quarter-over-quarter prior year. The interest rate environment is a common theme is still very challenging for us. Put that in perspective we estimate a one point increase in rates which translate into 13 million in additional pretax income across the firm, across the broker deal.

In addition to driving these performance metrics we brought in key talents in the form of proven recruiting branch managers into our Houston, San Antonio complex, our Oklahoma City and our Las Vegas offices. Of the three locations that we have discussed previously and upgrades are now completed in our Monterey and our Las Vegas offices. Both of these offices have seen an increase in recruiting as a result, Oklahoma City and San Diego will be completed in the next three months and six months respectively. And these upgrades are already attracting a lot of attention from potential recruits in the markets.

Most promising trend we currently see in the retail divisions coming from our new recruits. They are moving more of their book of business, their client assets in a shorter amount of time. And even though head count is what we like it to be the fact we are recruiting a higher quality advisor with the greater impact from a bottom-line numbers.

Turning to institutional, our taxable fixed income grew kind of record year last year as fixed income markets drive. It will continue part of this momentum we deployed proceeds from the recent capital ways to broaden our product offerings in this area. The increased activity from a broaden product offering has offset some of the slowdown in the environment.

The municipal unit is consistently delivering good results and although commission revenues are down slightly due to this environment investment banking fees and trading revenue are up 19% versus third quarter of prior year of 4.4 million versus 3.7 million. We anticipate an improving new issue calendar in the coming quarter.

Our corporate finance team as John alluded to earlier continued to increase market presence and closed two transactions in the March quarter. And we’re pleased with the progress in this area. Our securities lending continues to grow the number of broker-dealer relationship they have and this will position us for greater growth opportunities in a better way environment.

In a depressed way as reduced profits in the clearing segment we are focused on decreasing fixed cost immediately to increase profitability. Clearing decreased the expenses by 10% in the March quarter versus the prior year of 1.4 million versus 1.6 million.

And with that I will turn it over to Ken Hanks, CFO of SWS Group.

Ken Hanks

Thanks, Jim. This morning I’d like to spend a few moments discussing our quarterly summary financial results, then move on to a more detailed discussion of our operating results and conclude by discussing our segment results.

First, on our income statement. Net revenues for the quarter, that is operating revenue plus interest revenues less interest expense, were down by $11.7 million or 12% for the quarter, while pre-tax earnings were down by 25.2 million. Operating expenses excluding the provision for loan losses was down 5.8 million or 7%.

Taking a look at some of the individual line items, net revenues from clearing were up 3% for the quarter. In the quarter we processed 478,000 trade, down from 728,000 in the same quarter a year ago. Day trading tickers were the primary driver of the decline in tickets as one of our correspondents has previously announced consolidated their business at another clearing firm.

On the other hand, revenue for ticket was up in the March 2010 quarter and was $5.18 versus $3.30 per ticket in the same quarter last year. This change is primarily attributed to the reduced volume from day traders in the current quarter of the last year.

Commissions were down $11.1 million or 24% in the quarter. As expected, the record results we experienced in the last year’s quarter in taxable fixed income have leveled off during the March 2010 quarter, causing most of the decline in commissions.

The equity side of the business did pick up during the March quarter versus the same quarter last year but the increase was not large enough to offset the decline in fixed income.

Investment banking and advisory fees were up 7% in the quarter. Corporate finance led the increase with fees up $1.4 million in the quarter. Unit investment trust underwriting activity and a 66% increase in fees from managed accounts also contributed to the increase. Reduced revenue sharing with money market funds of 1.5 million offset the increases from these other areas as revenue sharing continues to decline in the well interest rate environment.

Net gains on principal transactions trading, which are derived principally from trading in fixed income securities, were down $3.7 million or 32% in the third quarter compared to the third quarter of last year. Net gains were reduced by a write-down in value of our auction rate securities by $1 million. The result of the fluctuation from last year is due to reduced profits from taxable trading.

Other revenue was up 2.4 million for the quarter, primarily due to increase sales in insurance products in the quarter as well as gains on deferred comp plan assets and an $885,000 gain in our venture capital investments.

Net interest revenue, which is interest revenue less interest expense, of $24 million was in line with last year's quarter. The Bank's net interest was up 8% while net interest at the brokerage was down 17%. The decrease in brokerage net interest was driven by reduced spread on our matched book securities lending business as spread dropped 33 basis points from last year’s quarter. Net interest at the bank was up 8% due to an increase in average loan balances held for investments.

Average margin balances in the customer side of the brokerage business of $175 million are up 3% from the previous quarter and up 8% from the same quarter last year. This is a third consecutive quarter of increases in margin balances.

Credit balances are flat with December and up 7% from March of last year. Stock loan balances were down about 5% from last year as equity in the markets related to this business continues to be depressed due to the continuing low interest rates.

Average growth loans at the Bank were down 2% from the December quarter and were flat with last year. This was primarily driven by a reduction in the mortgage purchase business as rates on mortgages grow during the quarter reducing demand for refinancing activity. Additionally, bank management is focused on reducing the concentration in several loan types causing a reduction in certain categories of loans. Most notably, residential construction and residential land loans.

Turning to operating expenses. They were up $13.5 million overall from the prior year's quarter with the provision for loan losses accounting for 19.3 million of the increase. Excluding the provision expenses were down 7% or 5.8 million. Compensation expense was down at 8.5 million was primarily due to the reduced revenue in the taxable fixed income businesses.

Occupancy and equipment, communications, floor brokerage and promotional expenses were relatively in line with last year. Other expense was up 2.8 million and was driven by Bank expenses. These include increased REO expenses, loan collection of the real estate expenses and increase in the Bank’s deposit insurance loan assessment.

This slide presents operating results by segment for the third quarter. Our first segment is clearing. This business encompasses our share of all the fee revenue collected from our correspondent or their customers, as well as the net interest earned on correspondent and correspondent customer accounts.

For the third quarter, the segment earned $96,000, roughly even with last year. Clearing fees were impacted by reduced fees from day trading client while compressed interest spread and reduced revenue sharing with money market fund had continued to be a drag on profitability. The division is focused on expense reduction primarily from reduced head count to offset the revenue decline in the challenging interest rate environment.

The retail segment which encompasses our Private Client Group as well as our independent contractor brokers that are housed in SWS Financial Services. This segment also includes the product lines that directly support these sales forces.

The retail segment posted a 13% increase in net revenue as commissions and fee revenue for managed account and insurance sales increased in both the employee broker and independent contractor business. While net interest revenue increased due to smaller increases and margin balances in small improvements in the spread under our customer credit, segment profitability is still depressed due to interest rate. The segment posted a pretax loss of 956,000 versus a loss of 3.3 million in the third quarter of last year. The third quarter also had an impact on the segment.

The institutional segment consists of our brokerage businesses that service institutional customers, including fixed income sales and trading, municipal origination and distribution, corporate finance, equity and portfolio trading as well as stock loans. Pre-tax for this segment was down 7.8 million for the quarter as commissions and trading revenue from the fixed income business was down from record high from last year’s quarter. Stock loans spreads also continued to decline reducing profitability in that business line. Public finance and corporate finance fees both increased in the quarter while portfolio trading produced increased commission revenue.

The banking segment net interest margin remain strong at 4.57% but the previously discussed provision in loan expenses generated the large loss in the quarter. The other segment includes corporate investment as well as the unallocated corporate administration expenses. This is where we recorded the results of our venture capital investment as well as the administrative cost of accounting, legal and other corporate shared service. The segment’s pretax loss was in line with last year and increased revenue from gains efficient capital investments was substantially offset by the write-down of the firm’s corporate own auction rate bond.

Lastly, I would like to discuss a few operating statistics for the quarter. Tickets processed decreased 29% from last year's in the December quarter, activities from day trading customers of the primary driver of that change. We’re continuing to hold a line on employee count. They are down slightly to both comparable periods. Retail customer asset grows 28% from last year’s quarter and were also up slightly from December.

I hand it back to you, Don.

Don Hultgren

Thank you, Ken. Before I continue I’d like to remind you if you do have questions to get in the queue it’s star one. You can also submit questions online at a questions@swst.com.

We took a punch in this quarter and I’m not any happy about it. We’re not happy about it. No one’s happy about it. But it does not change some basic fundamentals and the opportunities.

SWS Group operate a great business model in the broker-bank model. We’re in an environment today that offers us great opportunities to grow our firm. We operate in a great marketplace in the southwest part of the country and we’re very fortunate to have great employees who are motivated and excited about executing our growth plan.

Let me turn back to the broker-bank model. This is the model that we believe creates a tremendous opportunity for us to grow our firm. It also creates many opportunities for our investing customers. They are able to receive FDIC insurance on their cash balances. And as a result of that there is an attractive alternative for their cash balances and it provides 85% of the deposits at our bank.

Because it’s a low cost source of funds it allows our bank to generate a net interest margin that is above 4.5%. A very attractive net interest rate margin growing the business going forward. It also allows our bankers to focus and generating loans, creating relationships, without having to focus on deposits. In addition to the broker-bank model as Jim discussed we have some very robust institutional businesses. I’m very excited that we were able to continue to invest in those businesses, thanks to our capital raise last December and we’re seeing that money being put to good use, certainly in our trading desks.

As I mentioned we have great opportunities in terms of (inaudible) going forward. We have opportunities to grow organically by acquiring more employee brokers, independent advisors, clearing relationships and institutional professionals.

We continue to see a marketplace where those professionals are available and interested in the platform that SWS Group is offering. At the same time we continue to be (inaudible) marketplace where we’re seeing bankers who are interested in the platform than SWS Group is offering.

But we can do more than grow organically, we can continue to look and we are looking and we are exploring acquisitions that exist in our current lines of businesses. We can strengthen the Southwest Securities footprint in the southwest part of the country with core acquisitions in our brokerage business, our clearing business, and our bank business. And as we speak we continue to look at those opportunities going forward.

Finally, in terms of our marketplace as you look at the map in the nine states that we have identified these are the states was relative growth for bank model, these states offer outstanding growth in terms of the economic health, especially in Texas and California and they offer us outstanding opportunity to grow because there is minimal competition in these states going forward.

In closing, let me say that I’m enthusiastic about these strategies, I’m glad to have this quarter behind us, I believe that we have the people here that can achieve our growth objectives and I want to thank our employees who go above and beyond the call of duty to help us execute the strategies every day. I also want to thank our customers, that’s why we’re here and I want to thank you our shareholders for your continued support and I look forward to demonstrating how we can grow from here in upcoming quarters.

And with that let me turn it open to questions, it's star one on the telephone and questions@swst.com. I think first, Ken, would you like to answer some of the questions that we got in online.

Ken Hanks

While there are two questions I think that management believes it’d be answered perhaps before we even move forward with the rest of the call and that is why no preannouncement be in the first. In the past when the firm has had significant items that have come up in the quarter we have tried to get that information out to the investing public as soon as was practical, especially when results were about to happen to be significantly different from those at the Street had been estimating and that obviously did not have in this quarter.

And the primary reason for that is not happening this quarter is that we wanted to have the advantage of being able to listen to and kind of take the temperature of the regulators that were in our offices during the quarter. They came in, in mid-March, late March, and we’re here through actually only about eight days ago or ten days ago we have our final exit interview, we don’t have their final report, but at least we’re able to bake in some of the comments that they were making to us and their view of the market into our county.

If we had preannounced we would not have been able to do that and we think that would have probably been a big mistake and a lot more risky. So we want to take advantage of the information we received from them before we announce. So that’s how we did not have a preannouncement. We were talking at the management level in early March to mid March about a preannouncement but determined that that was not in the best interest of the firm.

The second question is out there is why this particular timing? And that really has more components in it than just the one. Two of the largest components of why this timing is in the quarter the significant increase in charge-off, 12.2 million of charge-off is significantly more than any we’ve had ever, I guess, in the history of the Bank. And so, that contributed significantly to the $25 million provision.

The other two items I guess would come in to play are that because both the appraisers and the regulators seem to have become significantly more conservative during the quarter, frankly compared to the October/November timeframe when we were having conversations with the regulators about a very specific review they did in our special mention assets. And we notice this is a pretty significant change. And looking at that and the appraisal that were coming in during the quarter we determined that we needed to shorten the time frame that we looked at for projecting potential future losses back to the loan portfolio.

This is described in starting on Page #56 of the Q, but essentially what happened is we move from looking at a really three year average charge-off to looking at the last four quarters. And in projecting that last four quarters over the loan portfolio versus the three years of the loan portfolio. Because we have had more charge-off in the last four quarters that increased the potential for losses in the loan portfolio and that attributed about $10 million to the $25 million. So those two items were substantially the reason for the increased provision and the timing of the provision.

Don Hultgren

Very good, Ken, thank you and let’s open it up for questions on the phone.

Question-and-Answer Session

Operator

Thank you. Our first question comes from Hugh Miller.

Hugh Miller – Sidoti & Company

Hi, good morning. Maybe a question or two for John Holt. Obviously, I think the additional color on the provisioning methodology was, was certainly very helpful. I guess in the past you guys have talked about NPAs and anticipating that they would be range bound may be between 4% and 5%, now getting to the middle of that range, is that still your comfort level? And how should we be thinking about charge-offs going forward? I know you mentioned they could be lumpy given the size of CRE relationships, but how should we be thinking about those? And how aggressive were you in the quarter in identifying any weakness and taking it now? Any color there would be appreciative.

John Holt

Thanks, Hugh. This is John Holt. I do still feel comfortable with that 4% to 5% range where NPAs I don’t see it’s going up dramatically higher. In addition, I don’t anticipate the level of charge-off necessarily going forward that we had in this particular quarter. Again, a lot that was based on the collateral valuations that came in. I guess from the other side is on loans of accruing over 90 days we have none there. And the 30 days to 90 days category dropped to 1.6% which is the lowest in five quarters, so there maybe some early indicators that that should start going forward.

Hugh Miller – Sidoti & Company

So thinking about the $12 million taken in this quarter, that’s barring any type of strange occurrence could potentially be a high water mark?

John Holt

Could be. I think can’t predict with any certainty that it will be, but they could be and certainly the same can be said with the allowance, the allowance could be in a situation where required additional revision or maybe where we can recall recoveries in future.

Hugh Miller – Sidoti & Company

Okay. But you are expecting that the reserve ratio should probably trend somewhere at this pace until you see moderation in kind of risk in the portfolio?

John Holt

I would say that that again, can’t predict with certainty, but I think that should be in that range.

Hugh Miller – Sidoti & Company

Okay. And I guess last question I had on the bank was with regards to expectations for loan growth. I know you guys are obviously trying to grow the portfolio and doing it in a reasonable fashion given some of the risks that are out there in the market. But how should we be thinking about growth go forward, given some of the deterioration in the CRE side of the portfolio, even though that that actually was up about 2% on a sequential basis?

John Holt

Yes, I would think if you look at the C&I loan portfolio there’s two things we bought in both from the Houston as well as Albuquerque. They are primarily focused on C&I. So our anticipation is that both SBA and traditional, commercial, industrial loans will be the area for increasing.

Hugh Miller – Sidoti & Company

Okay. And I guess a question or two with regards to the fixed income trading segment. I was wondering how much of a factor increased competition maybe from some of the larger dealers that have repaired their balance sheets are coming back in and trying to maybe retake some share. How much of an influence that’s had on the business and whether or not you guys are seeing any maybe recruiting efforts on the hiring side from the large peers for some of the talent that you do have at the firm?

Jim Ross

Yes, this is Jim Ross. And in anticipation of these questions we have Dan Leland, who is the EVP of the firm and heads of all taxable fixed income that join us. Dan? Do you handle that please?

Dan Leland

Yes, we ask the first question again, I’m sorry.

Hugh Miller – Sidoti & Company

The first question was with regards to competition levels from the larger peers, whether or not you are seeing that as a driving factor of the business.

Dan Leland

Yes, there is definitely coming back into the market. We’re seeing competition from them. You go back and look at last year I think a lot of them have taken their eye off the ball or talk about bulge bracket firms. You had there Lehman, and Merrill in their foray with BofA. And so you had a lot of large shops out there I think a lot of the sales in training staff kind of set back and hopefully focus on what they should be doing. I think you’re only going to see the both bracket firms come back and start use balance sheet but I think one of the things we look at is a plan we started back in 2006 with steady growth in a little risk profile, we don’t have the risk profile that will allow the majors do and back when they were losing money we were still making money.

So we’ve been real pleased with the growth that we had over the years and I think while spreads have reduced and tightened up this year we’re still going to have a relatively good year. I think if you look at other regionals that are out there I think that timeframe from October '08 to October '09i think most regional dealers probably had one of the best years they had in the history of their existence. I know we did. But the bar has been set for us to where our revenue now what back in '06 and '07 was a great month is kind of a month that it’s a sad month for us today. I mean we had a full year compound annual growth rate of 41% and a three year compound annual growth rate of 37%. We’re pretty pleased with that. And then we can have a quarter luck we had less March we like to see those come along. But we had steady growth with the loan growth profile and that’s we’re going to stick with the game plan that we have.

Hugh Miller – Sidoti & Company

And I guess any commentary? Have you seen a pickup in recruiting efforts there in the fixed income segment from the larger peers trying to step into the market?

Dan Leland

We haven’t really felt it yet. Actually we’ve seen a lot of talent come back to us just in the last three months or four months. I’ve been rather surprised by the number of folks knocking on our door, they have conversations with us. We’ve opened another office out in San Francisco, we had a number of people out there, want to speak with us, but we have added people in New Jersey, New York, so the majors are probably out there hiring but it doesn’t seem to affect what we’re seeing.

Hugh Miller – Sidoti & Company

Okay. And the last question, I apologize if you guys had mentioned on the call, I didn't hear it. But can you just talk about the sequential contraction in financial advisor head count and I guess how confident you guys are that you’ll be able to kind of grow that going forward? I know you mentioned that that activity levels have improved but just more on the recruiting side.

Jim Ross

The things we’re looking at in particularly, in Ken’s numbers, we’re looking in over the fiscal year, etc., that a lot of things will go into that. One, we discussed before we converted our outlook for key office from an employee broker office into an independent contractor and while most of those people transfer to that format, I think there was a 11 and 9 of them moved so we lost a couple there. The biggest area where our head count is shrunk has been in the Middle Coast. Some of that by invitation, where we’ve asked people to seek life elsewhere the (inaudible) goes. That’s what’s accounted for on the West Coast.

We just asked some people to move on down the road. We have had a bad quarter as far as people in the quarter that did leave us. We lost three good producers in this last quarter. We slowed down a little bit in our recruiting efforts as we focused on the capital raise up it took a little lot of time away from us. We have a lot of people on the road, what we call a little headquarters two years of home office business. We got into Christmas, so this doesn’t mean make any excuses, but we didn’t have that great recruiting of the third quarter. At the same time I’m looking at the pipeline, I’m looking at where we finished off offices that we committed we would retrofit, we would move, we would build out our offices, talking to the branch managers, I feel good about the pipeline for recruiting going forward.

The other thing that I would throw out there is there was a big event that happened as far as retail recruiting in this quarter. And that is the first time, I mean, business now for 30 some odd years. And the first time we saw one of the major firms pay a retention package to brokers to just stay seated. And that was always kind of a third rail. Nobody would ever do that. And we saw that and it caused everybody kind of freeze and retract and reevaluate maybe I’m going to get that if I stay close, etc., So that kind of slowed things now but I see that loosening up now.

Hugh Miller – Sidoti & Company

Great color there, I appreciate that. Thank you so much.

John Holt

You’re welcome.

Operator

The next question is from Max Sikes [ph].

Max Sikes

Hi, good morning, guys. How are you?

John Holt

Good morning, Max. Good.

Max Sikes

Just a couple quick questions. Go back to the bank, thinking about the more conservative appraisals, do you think it was more of a surprise in the decrease in valuations at CRE this quarter or that you sort of had to change the appraisals or the accounting for the appraisals?

John Holt

I think there’s a combination of what you’re saying in terms of how you look at an appraisal to where it would have been net realizable value versus market value, et cetera. So I think it was ultimately the appraisal but I also think it is how you evaluate that appraisal when you do receive it. And we did about a year and a half ago, implement an appraisal value where we actually have a chief appraiser in-house that reviews our appraisals from outside third-parties.

Max Sikes

Okay. I guess what I am trying to get is did it surprise you in the quarter that maybe the decline in commercial real estate was as high as it was?

John Holt

I think so.

Max Sikes

Okay. And then just looking at the average rate on the loans in the one year to five year category, do you have that number you can break out? I guess my question is we talked about the sensitivity to or the positive sensitivity to higher interest rates and just thinking about the potential reset I guess in that group in the one year to five year. We did have higher interest rates. Would that accelerate potential foreclosures, etc.? And is that sort of in your model?

John Holt

Yes and there’s two things. One is the majority of all our loans are on a floating rate basis versus a fixed. If you see in that one to five bucket that are fixed, they are match funded by the Federal Home Loan Bank. Those are (inaudible) all the loan we do on fixed rate. We have a match funding. So the spread would be locked in. We wouldn’t have a higher or lower spread. What I think you would see is in the initial compression if their rate only went up a very small amount but a lot of those have moves in them, and then once the pass-through the floor you would see a significant increase in the income.

Max Sikes

Is there any way to sort of gauge what those amount of reset would be? 50 basis points on average I guess. Just to see what the sensitivity might be.

John Holt

I don’t have that sensitivity analysis completed. I think we do, do a rate shock in their 3 percentage points to show what the rate how well that would impact the portfolio (inaudible).

Max Sikes

Great, thank you.

Operator

The next question is from Brian Hagler [ph].

Brian Hagler

Good morning, guys. Appreciate the color on the provision. It sounds to me like with the change in methodology on the look back that was, I think you said $10 million of the provision this quarter. Should we assume that obviously doesn’t recur next quarter or could there be a smaller amount or was that kind of a cumulative adjustment?

John Holt

I think you start making predict with certainty that it won’t occur, but I wouldn’t see it necessarily at the same level. That was a pin down how the appraisals come in. How other things can happen. Again, I think we’re adequately covered on the allowance and the conditions change we could go either directionally to report recoveries in future periods or that have additional provisions but I don’t see necessarily the same starts coming in?

Brian Hagler

Okay. And then just a clarification question, during your commentary there was a comment about the low interest rate environments, obviously, affecting a few of your businesses. And I think at one point you said that a one point increase in interest rates would increase pre-tax income by $13 million. Was that just at the broker or was that the entire firm?

John Holt

At the entire firm.

Brian Hagler

Okay. And that’s an annual figure?

Ken Hanks

Yes.

Brian Hagler

Great, thanks.

Ken Hanks

Thank you.

Operator

Our next question is from Joel Jeffrey.

Joel Jeffrey – Keefe, Bruyette & Woods

Good morning, guys.

Ken Hanks

Good morning, Joel.

John Holt

Good morning, Joel.

Joel Jeffrey – Keefe, Bruyette & Woods

Just thinking about taxable fixed income business again. I know you guys have said it's come back to more reasonable levels down from last year's but I mean in terms of future growth I mean what are you guys thinking about in terms of what’s reasonable for growth from this point out?

John Holt

Once again we’ll let Dan Leland handle that.

Dan Leland

I mean I don’t have a predicted growth rate going into the future. If you look back and we have a four-year compounded annual growth rate of 41.3%, we had steady growth, we manage our risk, we have a lower risk profile than other firms, we had steady growth with head count, product area is that we’re involved with, one product area we’ve entered into is trading in non-US dollar debt. We saw a lot of demand from our customers and that has started and it is starting to pick up and there is a number of other avenues that we’ve started to add to what we’re currently doing.

So I don’t have a predicted growth rate that will allow but last quarter things tightened up, the last quarter of last year, the December quarter of last year things started to tighten up again, we’ve seen the (inaudible) go from an average of 45 in 2009, down to 20 in 2010. Spreads are in. Our taxable fixed income department works primarily in the secondary market. We don’t underwrite any product.

And if you look at the other bulge bracket firms out there their underwriting product and if you look at the new issuance that’s come to market, last year versus this year it’s roughly the same except for the fees. The fees average last year about $4 on bond and this year the $5 bond. The secondary market is still relatively good. So, we’re starting to see the activities that back up, we’re starting to see I think better numbers that what we saw in the March quarter, but I don’t think we’re going to see the same thing we saw on 2009, I mean that was an anomaly. Like I said before regional dealers across the country had a great year and they are all happy with this, but nobody expected to repeat that this year.

Joel Jeffrey – Keefe, Bruyette & Woods

Dan, what’s your recruiting pipeline look like?

Dan Leland

I guess three new people start in the next few weeks. And we’re going out next week to San Francisco to fix we got people coming in New York and I don’t have a number to drop in table, we’re talking probably 7, 8 people.

John Holt

Dan, I don't want to put words in your mouth, but just kind of get maybe back at Joel’s question in terms of growth. Joel, I don't think we have a rate that we can pass out to you. I think the way we look at it at this point is that 2009 was a great birthday present. We all loved it. At this point we are back to more modest growth levels that are really going to be driven by penetration into additional accounts and then adding additional product lines back to the firm that we have eliminated in the past. I think if you do that you are going to get some single-digit type growth rates versus double-digit type growth rates.

Joel Jeffrey – Keefe, Bruyette & Woods

So I hear what you’re saying, I am just curious. If the VIX stays where it is, is that the primary driver of what you are seeing in terms of activity levels? In the near-term should we be expecting relatively very little growth to flat to sort of a run rate based out of this quarter?

Dan

I think that’s fair. As long as you have low volatility you’re going to see spreads down. And as long as you’re seeing spreads down it’s more difficult to make money on transaction. So I think the run rate that (inaudible) now I think it’s a reasonable run rate that’s expected into the future.

Joel Jeffrey – Keefe, Bruyette & Woods

Okay. And then on the private client side of the business, given that you guys sound like you’ve done a bunch of build out or refurbishing of certain offices. Do you expect given your recruiting plan that it will essentially increase the profit margins going forward given that it looks like you’ve already sunk some costs into this thing and that the margins should be a little bit higher on recruiting going forward?

Jim Ross

Yes, yes, in simple terms, if you look at both the improvement this quarter over same quarter a year ago, it’s not right at profitability, it’s a pretty good delta there. It’s about a $2.3 million to $2.7 million improvement in profitability. There’re lot of things happen at the same time. We’re working off costs. We’re coming out from under some contracts. We were able to restructure out some leases. So you’re seeing that improvement.

In addition, to the people that we’ve recruited as we alluded or discussed earlier, we’re talking about of their movement that book over one of the big things that I look at and we look at are the assets and asset growth. These assets grow. We picked this up from the road show and raise up coiled springs. Things that we see that give us substantial role so as we see these assets grow exclusively of market performance of bringing in these assets in and then there’s a good anticipation, we’re going to see growth there, incrementally, additional revenue at little or no incremental costs. So we’re excited about that.

We’re sitting on about 40 empty seats just in what we call the Gulf Coast. We get back with the facilities management people. We think we will end up with about 25 empty seats on the West Coast and go fill those seats with high quality people.

Joel Jeffrey – Keefe, Bruyette & Woods

Okay. And then just lastly for John, I apologize if I missed this, but in terms of thinking about provisioning going forward, are you guys relatively happy with your coverage ratios at this point and should we expect provisioning to essentially be in line with what you’re expecting to charge off?

John Holt

It should be. I think that 2.6% assets and as it relates to classified loans we’re almost 1 to 1 there. So I think that where we’re at we feel good about.

Joel Jeffrey – Keefe, Bruyette & Woods

All right, great, thanks.

Don Hultgren

Thank you.

Operator

(Operator instructions) And Patrick Devitt, your line is open.

Patrick Devitt – BofA Merrill Lynch

On the private client business what were the reasons those kind of three producers gave for wanting to go somewhere else?

John Holt

Sure. One was newly married wanted by house. It’s the nature of the business. If you get to call it and people go on and leave him. Another was got wanted to pursue a business model that we can’t offer here. One runs on hedge fund and we’re wishing well. Other one probably would tell you over his dreams that he just didn’t like me. And you got a big check. Now, our HR department does a great job in reaching out. We treat producers as other employees and have actually introduced. I’m not real true exactly how valuable that is for commission retail producer, but there were some pretty good reasons. I mean we like those people when they were here. There is sample, people have situations in their life and they want to move on at some point, can’t get to access (inaudible) talking to people about their other consider movement.

Patrick Devitt – BofA Merrill Lynch

Okay. And then on the appraisals, I know in the past you kind of given us an 18% to 20% kind of loss rate you’ve been seeing on the real estate you sell. How much different are the appraisals you are seeing from that rate and has that rate gotten meaningfully worse?

Jim Ross

It has picked up after somewhat I don’t have the exact number here. But it is running over the 20% range that it was at that time period.

Patrick Devitt – BofA Merrill Lynch

And are the appraisals that you’re seeing meaningfully higher than that? The change I guess appraisal drove a significant portion of the charge-off, right?

John Holt

Yes.

Patrick Devitt – BofA Merrill Lynch

So I would assume that you had previously marked it to a level that was in line with that 18 to 20. So how much higher are you seeing from the appraisals or am I misunderstanding this?

Jim Ross

You’re right. What we’ve done is at each annual we have an REO property. Annually, we give that reappraised and exactly what you’re seeing is it’s happening is the appraisal is coming in at a lower value than it was at the previous time period it is appraised. That annually, but if we see a market that we think is being impacted more frequently then we’ll do that as a six month or a shorter timeframe.

Ken Hanks

Patrick, this is Ken. If you think about the math of the formula, when we look at the latest four quarters and those charge-off and the rates of those charge-off and we project that back to the loan portfolio versus an average of three years whether there were some times is smaller that is really a big driver.

Patrick Devitt – BofA Merrill Lynch

And that leads to my next question. Given how quickly the market deteriorated and how large your NCO was in the quarter, how can you be that comfortable in a historical allowance model, given your charge-off just went up so much. So what if the charge-off is that big again it would suggest you’d need a much larger allowance, right?

Ken Hanks

The methodology says a various thing. We took the assumption of time periods and so that what moving it from a three year rolling, historical loss average to a four quarter as what we thought would be prudent based on what occurring in the market like. So I think that would it can take certainly that GAAP accounting to do that too.

John Holt

(inaudible) they would do if it’s 25 today. We think all in two months is going to be 32.

Patrick Devitt – BofA Merrill Lynch

So they won't let you over provision?

John Holt

Right.

Patrick Devitt – BofA Merrill Lynch

The only thing that you have a say in changing is the amount of time you look back.

Jim Ross

We looked at also the market deterioration. There were out some other factors that went in. That was the largest win. It had about $10 million impact.

Patrick Devitt – BofA Merrill Lynch

Okay. And then is the deterioration in the appraisal issue in kind of DFW area, is that very localize that area? Are there any other regions that you’re in that you’re seeing a similar pattern?

Ken Hanks

I think it’s overall what we’re seeing in fact in New Mexico sort of majority (inaudible).

Patrick Devitt – BofA Merrill Lynch

You mentioned North Texas, yes.

Ken Hanks

North Texas is where the majority of our loans are the reason for that segment.

Patrick Devitt – BofA Merrill Lynch

And then finally, you’ve been hiring a lot of originators and growing the loan book outside of the types of loans that you’re not really growing any more, obviously but are you seeing in most of the losses coming from those older vintages and is the new stuff performing well?

Jim Ross

Patrick, we actually have on Page #59 shown the vintage of all of our non-performing assets, trouble the restructuring, and REO. And less than 10% of it comes from after July of '08. Everything is June related before is the vast majority of it which would just shortly after the new management team at the bank took control.

Patrick Devitt – BofA Merrill Lynch

Great, thanks a lot.

Operator

The next question is from Jeff Smith [ph].

Jeff Smith

Hi, guys. I was wondering if you could maybe give us some more color around the severities that you are seeing. You mentioned commercial real estate but how about lot and land and construction? Within commercial real estate what kind of properties are getting hit the most? Is it hotels, retail, warehouse? And then how does that compare to the LTVs that you were underwriting at?

Jim Ross

Look at it Jeff, the biggest severities typically are coming with of the special purpose type properties whether that we, hotel, etc., and then retail and by retail would be more of the strip centers and those are taking larger impact than our obviously the owner occupied or even the office in the market that we’re serving. So the severities are coming in those areas. The loans of value since the 2008 time period have all been below 80% loans of value, the issue you have is some of the pre-2008 loans we’re certainly transaction oriented versus relationship oriented and focused on being sold out into the commercial mortgage backed security market. And that didn’t necessarily happen. And so some of those loans were taken into the banks mini firm portfolio.

Jeff Smith

How big is that retail strip center loan book?

Jim Ross

I don’t have that broken out in that detail.

Jeff Smith

And how about lot and land and construction? Have you seen any additional declines in severity there?

Jim Ross

We really haven’t. That’s one thing that probably is held up better as the residential market has been in North Texas and Texas and New Mexico is much better than the commercial. So as we take out those back and we reduced the construction portfolio on residential construction from over 300 million to less than 100 million so we revisited over $200 million and we’re not taking the hit on that portfolio that we have relinquished it down that we would be in the commercial real estate area.

Jeff Smith

Just going back to the CRE book, how about the debt service coverage ratios? You’ve taken a hit on the collateral values but are the people still paying?

Jim Ross

We did. That’s a very valid question. We have some loans that are certainly looked at being collateral dependent however, the today, and are paying but because of their collateral dependent, they’ve been classified. So I think you see performance and that’s why you see for the first time a little bit of trouble debt restructured if you have to negotiate go into interest some way, etc., we would look at that as an alternative.

Jeff Smith

Okay. And just going back to the provision, what percentage of the provision that you provided this quarter is unallocated?

John Holt

Unallocated would be –

Jeff Smith

Specific credit.

Jim Ross

Yes, that’s a good point. What we used to do most specific allocations and we’ve gone away quite honestly from doing specific allocations to going over the whole portfolio.

Jeff Smith

Any detail on the watch list, the direction of the watch list? You mentioned 30 to 89 days was stable.

Jim Ross

Yes, there is about a point, that’s the lowest it's been and if we compare it to the previous quarter I believe it’s 2.4, but 1.6% in the 30 to 89 is the lowest we’ve had in the last five quarters and we do see the watch list improving.

Jeff Smith

Okay. The capital that was raised back in December, I think it was like $20 million was supposed to go to the bank, how much of that is being used to help with the losses here and how much of that is still going to be used for growth, I guess?

John Holt

We did put the $20 million in the bank in December and that’s allowed us to go out and hire the bankers then and we actually purchased a portfolio in Albuquerque, so we’ve been able to purchase that portfolio of loans in Albuquerque, have been able to hire the Houston team and even with this additional provision we’re still within the 12% and 8% ratios or risk based capital and forecasting.

Jeff Smith

All right, thank you, guys. Thanks for answering my question.

John Holt

Thanks, Jeff.

Operator

The next question is from Max Sykes [ph].

Max Sikes

Hi, guys, just one quick follow up. What is the LTV now in aggregate for commercial real estate? And what was it two quarters ago?

John Holt

We don’t have that broken out by the aggregate on the portfolio.

Max Sikes

Okay. Thank you.

Operator

The next question is from Joel Jeffrey

Joel Jeffrey – Keefe, Bruyette & Woods

With the stock at these levels would you consider doing a buyback?

Don Hultgren

No, Joel, I think that the fact that we went to the market and raised over $50 million was indicative of the fact that we have opportunities for growth here that we are excited about and that we need to fund. If we didn’t have the opportunities in front of us than we have there will be very legitimate use of the capital. But right now we are facing a marketplace where we can get a better return on capital by expanding our business.

Joel Jeffrey – Keefe, Bruyette & Woods

Great, thanks.

Don Hultgren

Thank you, Joel.

Operator

At this time there are no further questions.

Don Hultgren

Okay, we got a few online that look like they’re all talking about, thanks, John. Well, I’ll actually read the questions and then follow-up with the answers. A lot of these have already been answered, but I’ll try to recap in summary. How are your existing loan loss reserves allocated? What triggers reserve allocation and what is your watch list or criticized credits look like. And who is the bank’s primary regulator? Well, all of those questions have been answered except who is the bank’s primary regulatory. And that is the OTS today understanding that there’s certainly a legislation that could change that.

The next question was when was your most recent bank examination? And we just completed that and had our exit. However, we do not have the final result of that and probably won’t for five weeks to six weeks. And the last question is what is the exact geographic spread of your commercial real estate and construction loan exposures, Texas and New Mexico and other? And that’s going to be primarily North Texas with some exposure in New Mexico and a very little other.

Okay, that looks like it wraps up our questions. Again, this was a difficult quarter. We certainly aren’t pleased with this quarter nor should we be. But I would reiterate for you that we remain committed to the broker bank model. It is a model we think will allow us to make tremendous returns on our invested capital. And as I mentioned to Joel’s question we have substantial opportunities in front of us to grow this firm both organically and through acquisition. We are here to take advantage of those opportunities. And so I look forward to being talk and talking with you next quarter. As we demonstrate that we can (inaudible) those opportunities and I thank you very much for your commitment of time this morning. Have a great day.

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