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Executives

William J. Dunaway -Chief Financial Officer

Paul G. (Pete) Anderson - President, Chief Executive Officer, Director

Analysts

Richard Repetto - Sandler O'Neill & Partners L.P.

Christopher Allen - Banc Of America Securities

Michael Vinciquerra - BMO Capital Markets

Mark Lane - William Blair & Company, L.L.C.

Richard Repetto - Sandler O'Neill & Partners L.P.

FCStone Group, Inc. (FCSX) F3Q08 Earnings Call July 10, 2008 11:00 AM ET

Operator

Welcome to the FCStone Group 2008 third quarter earnings conference call. (Operator Instructions) I would now like to turn the conference over to Bill Dunaway, Chief Financial Officer.

William Dunaway

I would like to welcome you to FCStone’s Fiscal Third Quarter 2008 Earnings Conference Call. Shortly before the market opened today, FCStone issued a press release reporting it’s earnings for the fiscal third quarter 2008. The press release is available on our web site at www.fcstone.com. Additionally, we are conducting a live web cast of this call which will also be available on our web site after the calls conclusion.

During today’s call, Pete Anderson, our President and CEO will first provide an overview of our results and commentary on our business in the current market environment. I will then provide some details on our financial performance for the third quarter and year-to-date. Pete will then conclude our presentation with some closing remarks, before we open the question up for some Q&A.

Please note that today’s conference call is copyrighted material of FCStone and cannot be rebroadcast without the company’s express, written consent.

I would also like to remind you that during the course of this call management will make projections or other forward-looking remarks regarding future events of the future financial performance of the company. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial means.

It is important to note that such statements about or anticipated future results, prospects, or other non historical facts or forward-looking statements can reflect FCStone’s current prospective of existing trends and information as of today’s date. FCStone disclaims any intent or obligation to update these forward-looking statements except as expressly required by law.

Actual results can be affected by inaccurate assumptions, including the risks, uncertainties, and assumptions described in the company’s filings with the Securities and Exchange Commission. In light of these risks, uncertainties and assumptions, the forward-looking statements in this earnings call may not occur and actual results could differ materially from what was anticipated or implied in the forward-looking statements. When you consider these forward-looking statements you should keep in mind these risk factors and cautionary statements during the earnings call.

I would now like to turn the call over to Pete Anderson, our President and CEO.

Pete Anderson

I want to welcome everyone and thank you for joining the call. We are pleased to report FCStone’s third fiscal quarter 2008 results. It has been an exciting time for FCStone as a result of extraordinary volatility in the commodity and financial markets.

As you can see from this mornings release, our third quarter numbers net of extraordinary items continue to reflect growth in our core operating segments as we generated stronger revenue and earnings results. Our results have been driven by our focus on our core business segment of commodity and risk management services, which has shown steadily improved performance over the past several quarters.

The clearing and execution business segment also continues to experience strong performance. Revenue for the third quarter of fiscal 2008 was $83.4 million, which was up 29% from $64.5 million in the third quarter of fiscal 2007. Net income for the third quarter of fiscal 2008 was $8 million or $0.28 per diluted share, which represents a decrease versus third quarter fiscal 2007 net income of $8.1 million or $0.29 per diluted share.

Results for the three months ended May 31, 2008 includes an after tax reduction in net income of $4.2 million or $0.14 per diluted share. This after tax reduction in net income included a $1.1 million net bad debt write off primarily related to the consequences of unprecedented synthetic settlement pricing in the cotton market and a $3.1 million decline in the fair value of interest rate derivative hedge instruments, which had the effect of reversing previously recognized unrealized gains. These derivative instruments were liquidated during the three months ended May 31, 2008 and were entered into to manage FCStone’s consolidated exposure to short-term answer straights. Excluding these particular items our net income for the third quarter of fiscal 2008 would have been $12.2 million or $0.42 per diluted share.

Before we review the company’s performance for our third fiscal quarter, I’d like to briefly address some of the recent macro economic trends and events that have impacted the markets and FCStone.

Similar to our earnings report for the second fiscal quarter, the third fiscal quarter represented a period of substantial head winds for the company in the financial services arena as well as the agricultural and energy industries. Historically high volatility commodity price levels and constrained credit capacity in both deregulated and OTC commodity derivative markets are having an impact on FCStone’s operating environment. We believe that each of these concerns should be placed into context.

In terms of the impact to either FCStone or its customers, I want to be very clear. We are making no fundamental changes to our operating model. Despite these macro-economic circumstances, our business continues to operate under the same risks, assumptions, and opportunities today as it has in the past. Rest assured that we are prudently monitoring domestic and international economic environments both for our customers and FCStone as a whole. We believe that we have the people and processes in place to mitigate potential issues as we continue to improve our methods and operating standards including, in particular, our risk management function.

Recent trends in agriculture have caused significant concerns about anticipated grain production for the current crop year and the access to adequate capital and credit capacity to produce future crops, carry inventories, and maintain hedge positions.

In order to understand the current situation, we must look at historical supply and demand. The 2007 corn crop in the United States as reported by the USDA set an all time record with 93.6 million acres planted and production of 13.1 billion bushels. By comparison, the latest USDA projection of corn production for 2008 was 86 million acres, with projected production of 11.7 billion bushels.

The current estimates for potential loss of production this year caused by current flooding conditions across the mid western corn belt would reduce USDA estimates to 11.3 billion bushels. Despite a significant loss of production from flooding and crop damage, if the above estimates hold true, the 2008 corn crop would still be the third largest domestic corn crop in history.

In addition, the state of the soybean and wheat crop must be taken into account. Both soybean and wheat production have seen increases over the past year. If considered in terms of the June 8, 2008 USDA domestic bushel production estimates of corn, soybeans and wheat for crop year 2007 to 2008 the expected reduction currently stands at only 2.56%. Although this volume reduction will be reflected in the amount of corn and soybeans that FCStone’s commercial customers handle, merchandise or consumed, we expect declines in bushels of corn and soybeans hedged will be offset by the continued volatility and strong volume in both domestic and international commodity markets we serve.

FCStone may also benefit from increased funds required to be deposited by customers as a result of higher absolute price levels for corn and soybeans resulting in potential margin increases from increased volatility.

Another concern for us and our investors is the continuing ability of our commercial customers in both the agricultural and energy sectors to access adequate financial capacity to carry inventories and adequately margin hedge positions. Today, and to the great credit of lenders in both the agricultural and energy industries, such lenders have done a stellar job in providing leverage to their borrowers and our customers through these turbulent and volatile periods. Both industries in general have moved to a spot market to provide liquidity and to maintain a reserve against significant moves on the market they use to hedge; however, we recognize that credit capacity is not unlimited and it is FCStone’s responsibility in conjunction with our customers and their lenders to manage demands for capital within specific limits.

Thus far the credit capacity of our customers have been adequate and we anticipate, with measures taken to provide liquidity to the market, the shortened tenor of positions, as well as customers obtaining increased leverage were warranted, we will continue to see adequate financing in the agricultural and energy markets.

During this critical time of extreme volatility and tight credit, the industry experienced an unprecedented circumstance in the cotton markets. In early March the exchange settled the cotton contracts synthetically, leaving the commercial industry and market participants unprepared or unable to meet the margin call. As a result of this situation, FCStone experienced bad debt write offs of $1.1 million or $0.03 per diluted share for the quarter. FCStone’s customers were adequately margined for a lemon move that neither they nor we could have anticipated that settlement prices would be established synthetically by the exchange. We are aggressively pursuing collection of these debts and understand and have received assurance that the process of synthetically settling commodity prices will not be used again.

In spite of the current macro economic headwinds and industry environment, FCStone’s growth initiatives continue to be implemented and accelerated in the current environment. This is evidenced by our continued growth in the contract volumes in both the exchange-based instruments as well as OTC and instruments instructors.

In the commodity and risk management section, exchange volume was up 220,580 contracts year-to-date for an increased year-over-year of 9.9%, while OTC volumes are up over 500,000 contracts for a year-over-year increase of 108.8%.

The clearing and execution segment has also seen significant growth with an increase of 36.6 million contracts for an increase of 90.5% year-to-date versus the same period in 2007.

The growth in all market segments as a company has been driven by volatility in virtually every commodity and financial market around the world. This volatility is a reflection of the increased demand and consumption of underlying energy, agricultural products, metal, and soft commodities around the globe, as well as the increased speculative interest in commodities as an investment asset class.

All of the demands for additional production and inventories of underlying commodities has taken place during a period of tightening credit access. This atmosphere has increased the necessity to manage volatility through conservative risk management, services, products, platforms, and structures that are offered by FCStone. Beyond our traditional core business of agriculture and energy, we anticipate continued growth opportunities in the areas of renewable energy, particularly bio diesel, international markets, food service, dairy production and consumption, livestock, cotton and textile, forest products, carbon credits, and foreign exchange.

Internationally the company continues to expand in Brazil where the focus is on the company’s core competency of commercial grain production and handling. Other commodities and industries that represent significant growth in Brazil include sugar, ethanol, coffee, foreign exchange, and consulting. Revenues through fiscal third quarter 2008 have increased 109% versus the same period in 2007.

As the United States market and domestic demand for grain and production increases, we expect Brazil to see continued expansion in grain production and exports, with China driving the consumption side of worldwide demand.

Our China division continues to add customers in commercial grain processing and handling, metals, energy, cotton and foreign exchange. Revenues for this region have increased through fiscal third quarter 2008 by 90% over the same period in 2007.

The recent purchase of Downes-O’Neill and Globecot demonstrates our ability to further expand our presence and service offerings in new industries through successful add on acquisitions. These types of acquisitions allow us to both, leverage our industry experience, while also adding seasoned, high quality consultants to the FCStone family.

We continue to explore opportunities with potential acquisition candidates that have similar interests and philosophies in servicing customers and we will continue to remain disciplined regarding the price we would be willing to pay and the returns we would need to see from such an opportunity. The company’s focus and interest regarding strategic acquisitions is in all the various commodities and industries we serve, both here domestically and internationally.

None of this growth would be possible without the hard work of our risk management consultants. Our current roster of 130 consultants, trainees, and interns, has been built through a combination of hiring established industry expertise, our internal training program and through acquisitions.

The mix of consultants includes 28 focused on international business in Latin America, Asia and Europe, with the balance targeting the domestic markets. We continue to reassess and develop our training programs to address new and developing products as well as additional industries and regions that have growth potential and will make the necessary additions where we deem appropriate.

Our goal through acquisitions and additional hires is to add five to ten additional consultants by the end of our fiscal year.

Finally, I’d like to provide an update on a few other recent initiatives that FCStone has been diligently working on.

We continue to make solid progress on Agora-X, our innovative OTC trading platform that we are developing in partnership with NASDAQ OMX. When completed, this platform will provide liquidity, transparency, and trading efficiency for FCStone, our clients and qualified institutional participants.

Agora-X is currently in discussions with a number of potential qualified equity participants that will make an investment in the platform as well as commit to significant transactional volume. The platform is also negotiating with a number of plain facilities to provide centralized clearing for Agora-X. We anticipate that the platform will be operational in the last calendar quarter of 2008.

FCStone Carbon also continues to develop aggregation agreements. Technology and the carbon credit inventory that it has burned [ph]. To date the coming at several aggregation agreements that represent creation of significant tons of carbon credit annually after underlying protocol to validate and verify. As the carbon markets mature, we believe that the FCStone carbon is positioned to effectively represent our customers and marketing their carbon credit production or emission credit needs.

We are confident in our ability to drive in all market environments and remain excited about the new growth prospects that we have in place as well as our ability to continue to expand the business and grow over the long-term by focusing both domestically and internationally on the corn issues and business segments that have been the foundation of the organization, the agricultural and energy markets.

Now I would like to turn the call over to Bill Dunaway, our CFO, for a detailed financial review.

William Dunaway

As Pete mentioned we are pleased to report continued growth across our core operating segments during our third fiscal quarter, as revenues net of cost of commodities sold reached $83.4 million. Compared to the prior year period of $64.5 million, the third quarter’s revenues increased 29%.

Our pretax income was $13.2 million of the quarter, compared to $13 million for the same period last year. Our net income was $8 million of the third quarter this year, compared to $8.1 million for the prior year period. As Pete mentioned earlier, excluding the effective interest rate derivative instrument and the bad debt write off, our net income for the quarter would have been $12.2 million, a 51% increase over the prior year period.

Now let me take a few minutes to talk through the main components of the quarters results, starting with the $18.9 million increase in revenue.

First, commissions and clearing fees were up more than $14.1 million or 40% with approximately $13.5 million of this increase coming from exchange credit contracts and the other $600,000 of this increase coming from 4X commissions.

Next, our service, consulting and brokerage fees, which are primarily our over the counter brokerage fees, were up $15.9 million or 147% for the quarter over the same period last year. $15.5 million of this increase was related to over the counter brokerage with the remaining $400,000 comprised of an increase in consulting fees.

The increase in the over the counter brokerage was driven by continued strong growth in our international operations, primarily Brazil, as well as with our renewable fields’ customers. Continued volatility in the energy markets has also driven growth in our over the counter brokerage with customers in that industry.

Interest income was $5.3 million for the quarter, down from $12 million in the same period last year. $5 million of this decrease was attributable to the decline in the fair value of the interest rate derivative hedge, which was liquidated during the third quarter. The remainder of the decline in interest income was a result of significantly lower short-term interest rates during the third quarter when compared to the prior year quarter. This was partially offset by much higher customer segregated and over the counter margin deposits that we were carrying during the quarter.

Now I would like to address some of the issues we have experienced this quarter related to the interest rate market.

Across our two primary operating segments we have recognized a substantial impact during the recent quarters based on market interest rates. During the month of September 2007, the first month of FCStone’ fiscal year, the average charge refill rate for 90 day T-bills, set at 3.99%. Since that time, the average monthly 90-day T-bill hit a low in this past quarter, in April, of 1.32%.

During the first nine months of the current fiscal year the average rate earned on our money markets investments declined from 4.82% in September 2007 to 2.68% in May 2008. In spite of this substantial headwind, FCStone experienced a $6.4 million increase in interest income during the first nine months of the current fiscal year, when compared to the same period for the previous fiscal year, driven by growth in customer segregated assets from $997 million at the beginning of the fiscal year, to $1.4 billion at the conclusion of our third quarter.

The company also saw substantial increases in its customer deposits in its over the counter platform from FCStone trading during the period.

At the same time net interest rates began to decline, we began to scale in hedges on FCStone’s exposure to short-term interest rates using three-month LIBOR instruments with a two-year tenor. While the instruments were intended to be hedges against interest rate declines over a two-year period, in order to meet GAAP accounting standards, FCStone was required to mark the infrastructures to market at the end of each quarter. During the current fiscal year we recognized a $652,000 unrealized gain on our first quarter or $1.4 cents per dilute share and a $4.4 million unrealized gain in our second quarter or roughly $0.10 per diluted share.

The difficulty that this commentator presents is the fact that the hedge instrument is structured for a 24-month period, but the gain is recognized at each snap shot in time. While the three months LIBOR settings were virtually unchanged during the third quarter, the LIBOR curve steepened sharply with two-year LIBOR softs rising 106 basis points during the quarter. The entire structure was liquidated during our fiscal third quarter with substantially no gain, which had the effect of reversing all of the previously recognized unrealized gains, reducing the companies income for the third quarter by $0.11 per diluted share.

As we look at our total expenses, our expenses net of the cost of commodities sold increased approximately $19 million for the quarter over the same period last year. Upon a closer examination of the expenses, revenue volume related variable expenses of brokerage commissions and compensations as well as benefits and pit brokeraging currencies accounted for approximately $16.4 million of these increased expenses.

This increase was offset by lower interest income, fair interest expense of $1.2 million primarily due to the sale of our majority interest in our grain-merchandising segment that we no longer consolidate. In addition, as discussed by Pete earlier, bad debt expense increased to $1.6 million over the previous year period.

Taking a closer look at the performance within our two main business segments, our commodity and risk management full service segment generated operating income of $15.4 million compared to $90.9 million last year. This segment benefited some significantly higher OTC revenues, as noted earlier, and exchange related commissions and clearing fees were up $3.9 million. This total increase was offset by $4.7 million in lower interest revenues from this segment.

Our clearing and execution segment had operating income of $1.3 million compared to $3.8 million in the prior year. The segment had a 44% increase in commissions and clearing fee revenue, but interest income declined by $1.7 million.

Reviewing our balance sheet, our total assets are $2.43 billion as of May 31, 2008, up from the $1.42 billion as of August 31, 2007. This $1 billion increase was primarily the result of approximately $400 million in additional customer segregated funds, $142 million from additional OTC customer margin deposits, a $272 million increase in the value of open customer over the counter positions, $31 million from our financial services repurchase program.

These increases were primarily driven by continued commodity volatility and increased trading volumes of our customers related to higher margin deposits. Despite several items discussed earlier, operationally we had another strong quarter with growth in our core revenues of commission and clearing fees and service consulting and brokerage fees in comparison to both the prior year quarter and the second quarter of the current fiscal year. Additionally, with the significant increase in customer margin deposits, we are positioned to benefit from a rise in short-term interest rates. We remain excited about the core growth of our company and anticipate a continued trajectory of growth moving forward.

With that I’ll turn it back over to Pete for some concluding remarks.

Pete Anderson

FCStone remains to its mission of improving our customer’s bottom line results by leveraging the expertise and experience of our consultants, as well as utilizing the most appropriate platform or instrument to manage commodity risk. FCStone intends to leverage the industry dynamics and momentum that are in place to drive our volumes and the growth of the company in the future. We believe the company is well positioned for long-term success and to drive shareholder value.

With that, that concludes our prepared remarks.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Richard Repetto - Sandler O'Neill.

Richard Repetto - Sandler O'Neill & Partners L.P.

I don’t want to get too elaborate on the call, but on this hedge, you said you reversed an unrealized gain, but what I don’t understand is that you had a realized gain in the prior quarter; so what was this unrealized portion that you had to reverse?

William Dunaway

Rick, it was unrealized in the fact that we had not liquidated or got out of the position. We mark-to-market the position at the end of each reporting quarter; so technically an accounting standpoint, it’s not realized. It’s recognized as a mark-to-market valuation of the interest rate derivative, but the only way it would technically be a realized gain is in fact if you closed it out.

That makes sense. We saw the first quarter, the value of those instruments rose to $652,000, but we did not close them out. It’s an unrealized appreciation in the fair value of the instrument.

Richard Repetto - Sandler O'Neill & Partners L.P.

I think it was $4 million in the first quarter, are we not talking about the same instruments or not?

William Dunaway

It was $652,000 in the first quarter, it was $4.4 million in the second quarter and in the third quarter we liquidated it and it becomes a recognized, realized gain, because we close it out and in effect reverse out those previously unrealized, but recognized gains.

Pete Anderson

The issue I think from second quarter to the third quarter was at the end of the second quarter its brought the market, but we still looked at it in terms of, it was a 24-month hedge position and at that time, all indications were that fed fund rates were going to continue to decline, which they did over time, but at the same time there became really a disconnect between hedge fund rates and LIBOR, which is what the hedge position was in, or the collar was in.

So as that disconnect became more dramatic, really we looked at it in terms of at some point we had to make the determination, is there value in keeping that position on or is there real substantial risk incurring that position forward and we’ve really made the determination that there was far more risk carrying it forward than there was to maintain the hedge going forward.

Hindsight is always 20-20. Had we picked a time, or a spot in time where we should have liquidated it, probably at the end of the second quarter would have been that time.

Richard Repetto - Sandler O'Neill & Partners L.P.

Understood and I can follow up offline more. The next question is on the actual volumes of contracts and the respective rates. For example the OTC volume quarter-to-quarter from the prior fiscal second quarter went down 20%, 21%, but your rate went way up. Even on the exchange contract volume it was a little bit less than say the proxy, but your weight went up again

Did we lose any of the high volume, active traders that are at a lower rate? Would that explain what we’re seeing in the volume and the rate numbers?

William Dunaway

Certainly on the exchange traded volumes yes, you saw some of the customers that had came on that were the very high-volume, low-rate. Their volumes were reduced from the second to the third quarter, but once again, the impact of revenues is fairly small from those customers because it is very low-rate, lower-margin. Good incremental business, but it does not have near as effect on revenues as it does on volume.

We actually saw increases in volume across some of our other exchange traded customers and with that shift, in the mix there, it really helped the rate per contract. When it comes to the over the counter, while volumes were down a little bit, we saw more of a mix of structured products that carry with them a little bit more, a higher margin basically per contract. It’s a little something that’s not quite as fixed as an exchange rate per contract, so the over the counter rate per contract is more fluid.

Operator

Your next question comes from Christopher Allen - Banc of America Securities.

Christopher Allen - Banc Of America Securities

If we could just start on the bad debt expense, if you could just give us a little bit more color on what actually occurred; because I know I don’t understand when you say synthetic settlement of cotton prices.

Pete Anderson

Basically the cotton over a period of time in early March was moving limit higher and as it moved limit higher it continued to trade in the option market. So, the exchange settled, basically, versus the option trading and marked or settled the futures contract versus that option trading or structure synthetically. They basically took an estimated price out of the options trade or pit and brought it back to the futures settlement price.

The industry looked at really locked limit prices for a number of days and the real confusion, I think, became for the customer as well as the lender, the bank providing capital to make those margin calls, got confusing enough that it got to the point where basically lenders just stopped making loans for margin requirements.

We were fortunate as we went through that process that it really only amounted to a handful of accounts that it affected and just didn’t have the leverage or the capital to adequately margin the account, but that was caused by the confusion of just settlement pricing. You’d see a limit move and then a significantly higher price would be what the settlement was required on.

Christopher Allen - Banc of America Securities

So ex the cotton, the bad debt expense would have been roughly about $600,000 is that fair?

William Dunaway

No, virtually the entire was, where you may have gotten the $600,000 was Pete was talking it after tax and I mentioned it pre-tax.

Christopher Allen - Banc Of America Securities

So it virtually zero x-d this issue. You alluded to a little bit before. Is the health of your overall customer in a satisfactory state where you don’t see any meaningful bad debt issues going forward?

Pete Anderson

I think the really good news is we have gone through the third quarter and really the last six months or even the entire fiscal year in the most volatile period that we’ve ever seen, at least in my career in commodities, in my experience, our bad debt in the traditional grain and agricultural industries, as well as energy, has been really minimal.

Like I said in my comments earlier, to the credit of the lenders and agriculture and energy, they’ve really stepped up and supported their customers as well as our client and provided that leverage that was really needed.

If you look historically the balance sheet for agriculture was really built for $250 corn and we’re trading $650 to $7 to $8.00 corn and those lenders have stepped up and made the margin call and so I think that’s the real good news, as we have gone through this period is that the systems and the processes and the margin requirements that we’ve had through this period have really performed and been adequate.

Christopher Allen - Banc Of America Securities

Just on the compensation expense, this is probably the really big surprise for me, was the bit sequential increase and looking as a percentage of revenues, XNII jumped as well. I’m just wondering what drove the sequential increase from the prior quarter.

William Dunaway

I think Chris that the piece to point out there is that we do not pay compensation expense on interest.

Christopher Allen - Banc Of America Securities

Even when you pull that out it looks like it increased sequentially.

William Dunaway

Yes I think there was a slight increase. I think it was about 21% to 23% and the rate that we pay out to our consultants fluctuates based on what revenues they are generating. Given the higher margins in the over the counter markets, we do pay a higher compensation rate out to the brokers or the consultants on over the counter products, so that’s going to drive it as much as anything.

Christopher Allen - Banc Of America Securities

Going back to Rich’s question with the structured products driving up the rate per contract, when something like that occurs you should always expect to comp the revenue ratios to inflate that way as well.

William Dunaway

Yes, when over the counter revenues are growing faster than exchange-based revenues, you will see a slight up tick in the compensation expense as a percentage of revenues.

Christopher Allen - Banc Of America Securities

Just on the over the counter business, was there any weather related trades in there? Also, is the environment such that it lent itself more to structured products and will that change going forward?

William Dunaway

There were no weather contracts. We did not have any of those during the current quarter and I think that in times of volatility like we’re seeing in the markets where you have people wanting to have the ability to lock in prices, or limit prices at certain levels and still benefit from possible prices dropping or possible prices rising, in a real volatile market like this I would say it lends itself more to structured products where you really give yourself some real optionality of really covering yourself from a hedge standpoint, but still benefiting from, depending on which side of the market you are on, benefiting from falling prices or rising prices; still being able to participate in those markets.

Christopher Allen - Banc Of America Securities

The follow up in customer segregated assets from April levels, or prior quarter levels at the end of May have spooked some people here. Was that just a function of where the markets ended up in May, have we seen an improvement in June as agricultural volumes have picked up?

William Dunaway

That’s the real kind of, the main number is just a snap shot in time, that’s closing balance one day. The grain markets were significantly off on the last day of May. When you see a significant price move in something like that we’ll be sending money out to the exchange and seg funds will decrease for that one day and you’ll collect them back the next morning. So, big price volatility movements there will affect that. If you look at it not on an average basis, it would be virtually unchanged from April to May.

Christopher Allen - Banc of America Securities

Now we’re seeing a big pick up in volumes on the Ag side.

William Dunaway

And you’ve seen some margin requirements in the agricultural space go back to where they were back in the May period, when we reported seg funds. You’ve seen those go up, accordingly back up to $0.30 per bushel, so.

Operator

Your next question comes from Michael Vinciquerra - BMO Capital Markets.

Michael Vinciquerra - BMO Capital Markets

I want to go back to the OTC thing one more time because I think one of the big questions is that like a volume is down as Rich said 21%, the same number we got. What are we thinking about in terms of a go-forward basis? It seems like you’ve benefited from a mix shift which helped you actually grow revenues sequentially in the consulting business this quarter, but next quarter how do we think about what volumes are going to be? Did you actually have lower volumes because of the structured product mix shift or are those two pieces actually independent, Volume versus the mix?

William Dunaway

Part of the issue is I think some market segments are really migrating almost totally to OPC products, instruments, or structures. We see that by region, we see it by commodity to some degree.

I mentioned in my comments earlier, the grain industry and not as much maybe in the energy industry, but the grain industry has really gone through, to some degree I think, a significant change in process almost from really a forward cash contract and contracting method of buying and selling to, for all practical purposes, a spot market. A year ago we probably could have gotten you a bid for ’08 corn 9, 10 and today, you can get a bid out maybe six months or so, but for all practical purposes the market has moved back to a spot on a spot basis.

I think It’s still yet to be seen how that will affect us and the industry, but I think going forward we will deal in shorter tenured instruments and to some degree, I think, that volume dropped off a little bit just because there was so much value already captured by the producer or the farmer and the industry. I think as they went through a late planning season as well that the exchange of base volume stepped back from that.

I do think a lot of the new business, a lot of the new regions, a lot of the new commodities that we’re dealing in, are really ramping up on the OTC side versus traditional exchange based products.

Michael Vinciquerra - BMO Capital Markets

So the take away then is that the drop off in volume we should not look at that as being any sign that your customers have pulled back in terms of their hedging, or that it’s a long term issue. It was an issue in the May quarter that would not really be expected to be repeated on a go-forward basis?

William Dunaway

Yes, I think to a large extent and like I said earlier, we still raise the 13 billion books of corn crop last year, that’s yet to be seen, but 11+ probably, this coming year; so the supply eventually will come across our commercial customers or clients books and that will be reflected on our and through our volumes at some point. That traditionally, historically has been exchange based instruments or products versus OTC.

Michael Vinciquerra - BMO Capital Markets

Back to just on the interest rate issue one more time, Bill. Am I reading it right that basically you had a basis risk issue in terms of how you hedge versus the way the interest rates actually moved, at least the risk between LIBOR versus seg funds?

William Dunaway

As it relates to the interest rate derivative?

Michael Vinciquerra - BMO Capital Markets

Yes.

William Dunaway

Yes, there is not a perfect hedge out there for interest rate exposure.

Historically the LIBOR has been as liquid and as correlated as you’ve seen and it’s one that we’ve used before. But, you certainly saw a significant disconnect here in the third quarter and you saw a rapid steepening of that LIBOR curve. I think some of that had a little bit to do with, there seemed to be a little bit of funny business being played in the LIBOR rates that were reported. I think that they were reacting and even the curve in the trading of two-year swaps and LIBOR were affected a little bit more by some economic data than were the underlying investments that we were investing in.

All of that really made the correlation, not what it had been historically.

Michael Vinciquerra - BMO Capital Markets

So when we look at where you are investing your client’s cash today, what is the best instrument in the open market for us to look at in terms of gauging whether or not you’re seeing higher yields or lower yields?

William Dunaway

Really it gets back to what roughly the 90-day Treasury Bill is doing in conjunction with money market rates. As I discussed earlier, the money market rates are about $270, $260, $270 at the end of the quarter and 90-day Treasury bill’s, they had dropped to $132 in April. They actually rallied about 40 basis points towards the end of May. So they’ve come up a little bit and I think they’ve stayed fairly flat from there.

Then one of the other rates is that over night reversal repurchase that we talked about in the past, but really it’s going to correlate pretty closely to the 90-day Treasury.

Michael Vinciquerra - BMO Capital Markets

If you were to look at a 25 basis point increase in Fed funds is that not really a direct connection and it doesn’t sound like it, to what you’re going to earn. We can’t actually say, for every 25 basis point increase you are going to see an X million dollar increase in your net interest revenue.

William Dunaway

I think Fed funds and when you get rid of some of the flight to quality issues you’ve had with treasury bills and then being driven very low, they got the correlation between that and Fed funds and T-bills really got as wide as it could there in the second quarter. But I think going forward that would be a fairly accurate measure. I think it’s going to track some correlation to Fed funds. I think you could look at roughly a 1 ¼ million, $1.5 dollars worth of interest based on a couple billion worth of assets between the seg funds and the OTC at being increased interest income as you see rates go up.

Michael Vinciquerra - BMO Capital Markets

On an annualized or on a quarterly basis?

William Dunaway

That would be quarterly.

Operator

Your next question comes from Mark Lane - William Blair & Company, L.L.C.

Mark Lane - William Blair & Company, L.L.C.

Pete, on the bad debt issue, between June 1 and as of five minutes ago, are you saying that you’ve had no material bad debt write off in the fiscal fourth quarter so far?

Pete Anderson

Fiscal fourth quarter?

Mark Lane - William Blair & Company, L.L.C.

Yes.

Pete Anderson

Yes, that we’ve had no bad debt write off.

Mark Lane - William Blair & Company, L.L.C.

Have you had any credit issues in the current quarter up until this call?

William Dunaway

We haven’t had anything material that we would report, no.

Mark Lane - William Blair & Company, L.L.C.

Pete, the number of consultants was 130 at the end of May and it was also 130 as of the end of February, so what gives you confidence that you’re going to be able to hire five to ten people in the fourth quarter?

William Dunaway

We look at it in terms of, really we added basically ten consultants through the acquisition of Downes-O’Neill and the Globecot Jernigan, we’re still talking to a number of potential acquisition candidates, and our intent is to continue to pursue those. Through that process, if we get that done, it could be more than ten, but the intent is to try and reach that goal. At the beginning of the fiscal year we wanted to add 20 and we’ve basically added 12 so the goal still is to basically get to about, close to 140.

Mark Lane - William Blair & Company, L.L.C.

What I hear you saying is that includes the high probability of doing another deal?

William Dunaway

We’re trying.

Mark Lane - William Blair & Company, L.L.C.

Then on the net interest income, so Pete if I take out the interest revenue from the financial services business and I take out the hedge, the last three quarters including this quarter, the underlying interest revenue in the first quarter was $11.1 million and the second quarter was $12.1 million and then it dropped to $8.5 million and I don’t know if, I know the business grew more first quarter to second quarter then it did second quarter to this quarter. But, you didn’t see the fall off last quarter from the drop in interest rates, which was probably quite similar to this quarter.

It seems like this $8.5 million is a pretty washed out number, that all your duration risk is run through, everything is rolled over, etc. Would you consider this as a low point from a yield perspective, everything else equal?

Mark Lane - William Blair & Company, L.L.C.

I would certainly think so, Mark. At the beginning of that second quarter you saw four money market rates at the $4.8, $4.9 range and Treasury Bills up over 3%. The most dramatic fall in the Treasury’s and even the money market and certainly the overnight rates happen much more in the February to March time frame than it did earlier in the second quarter, so I think you’re seeing a significantly larger interest rate drop off in the third quarter than you did from first to second.

The first to second Treasury Bills started to sell off, but the money market rates really held their value.

Mark Lane - William Blair & Company, L.L.C.

But you don’t have anything that’s extended or anything that’s going to roll off at lower rates? Everything that’s been invested right now is invested at these low rates correct?

William Dunaway

Yes, we’ve generally always stayed, the money markets may have a 60 to 90-day weighted average maturity and the T-Bill investments will sometimes be — you were generally less than 90-days. Sometimes we have historically gone a little bit farther than that, but typically never farther than six months so, as far as the duration, yes, you would be correct.

Operator

Your next question comes from Richard Repetto - Sandler O'Neill.

Richard Repetto - Sandler O'Neill & Partners L.P.

Not to beat the interest rate thing to death, the run rate that you came out, again Bill you talked about the rate drop early in the quarter. The run rate that you exit, say in June, would that be a run rate? I didn’t subtract the financing for it, but say your net interest X the hedge of about $10.2 million?

William Dunaway

Yes, gross.

Richard Repetto - Sandler O'Neill & Partners L.P.

Yes, exactly gross. Then my only other question was in the prepared remarks you talked about the constrained, the market conditions and I’m just trying to get a better understanding for what you really were talking about there. Is that the volatility that we’re seeing that constrained people from or what?

Pete Anderson

I think the real issue for us, especially for a lot of our commercial clients both in Ag and energy is, as I said earlier, one of our regional managers, Bob Mortinson [ph], I think described it best when he said, the Ag industries balance sheet was built for $2.50 corn and we’ve seen basically $6.50 or $7.50 corn and the capital and the leverage that it takes to really finance those inventories going forward is substantially greater than what it was, let’s say, two years ago.

A lot of that leverage that you looked at, let’s say two years ago, might have been for every dollar of working capital you had $5.00 of financing capacity or borrowing capacity and that leverage went from 1 to 5, to 1 to 8, to 1 to 10 in some cases as high as 1 to 15.

So, I think the industry, to a large extent, and I think to the great credit of the lenders and the participants in the industry, they stepped up and made the margin call and provided the leverage. But I think, they and the industry got to the point where they just could not and were not willing to take any more risks beyond that amount of leverage. That’s really what forced, I think, the industry back to a spot market and substantially more liquidity than we’ve seen in the past.

I don’t necessarily believe that we’ll probably go back to the historical model of forward cash contracts out for tenure of one or two or three years, at least utilizing the process where the commercial entity takes that risk and provides that capital and that leverage. I think we and others are working on alternatives to provide that capital and leverage and you’ll see the system evolve, but that’s really the difficulty that you see in agriculture and energy to some degree.

As we go through that process I think there’s really a need for our services and products and the expertise of our consultants, even more today in that atmosphere than there was even before.

Richard Repetto - Sandler O'Neill & Partners L.P.

It appears we’re going to shorter durations on everything because of volatility, but, as a guy new to the Ag market, if it moves more towards spot and the prices are so, at historic highs, isn’t this the most profitable period of your client’s right now other than again the financing? When you understand the financing positions of the longer durations, but on a spot basis these people are making as much money as they ever have. Wouldn’t you agree?

William Dunaway

From a firm of producer prospective, that’s really true and that’s the real benefit of those forward-cash contracts is really for the producer or the farmer. The real difficulty though is that commercial participant, that temporary elevator grain handler is, the leverage and the capital that he’s been required to really provide for the last year or two years has really put them under significant pressure of basically covering the need for the capital, number one and then the cost of carrying that margin position for the last 12 months or 24 months and really borne the cost of that.

Operator

Your last question is a follow-up from Michael Vinciquerra - BMO Capital Markets.

Michael Vinciquerra - BMO Capital Markets

I’m staying on the hedging and consulting side here. Just to be sure, your clients, although they are selling more in the spot market, they are not being less aggressive in utilizing your services, is that fair to say?

Pete Anderson

No, in fact, the markets are so volatile now that you just, to a large extent you can’t afford to be un-hedged. We’ve seen corn go from early spring down to $5.50 in basically in the spot mark $5.50 per bushel to now near $8.00 a bushel and back down to what, $6.50 right now. So you’ve seen a range of almost $3.00 in a 980-day period, so you just cannot afford to just sit open. The exposure and the risk is just too substantial.

William Dunaway

And that’s going to be Mike, basically, for all of the commodity markets that we deal in. There is not really a market without volatility right now.

Michael Vinciquerra - BMO Capital Markets

How do you benefit or how do you make money in a spot market if your clients aren’t using over the counter forwards or futures contracts, how do you get paid when clients are selling all their product spot?

William Dunaway

It’s still our utilizing imagine staying in a shorter duration, rather than hedging their corn in diesel nine or dees [ph] ten corn, they’re hedging it in the September 2008 contract. They are staying a quarter duration, still utilizing either exchange-traded derivatives or over the counter derivatives, their just staying shorter in tenor with their hedges.

Michael Vinciquerra - BMO Capital Markets

When you say spot you’re meaning like a 90-day market.

William Dunaway

Right, not like a spot currency or anything, not a cash [inaudible].

Pete Anderson

We appreciate everyone participating on today’s call and we look forward to talking after our fiscal year end on August 31 and thank you all for your support.

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