Back to GetFilings.com

Table of Contents

Index to Financial Statements

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended June 25, 2004

OR

For the transition period from              to             

Commission file number 0-19483

SWS GROUP, INC.

(Exact name of Registrant as specified in its charter)

Registrant’s telephone number, including area code (214) 859-1800

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).    Yes  x    No  ¨

The aggregate market value of Common Stock held by non-affiliates of the Registrant, computed by reference to the closing price as of the last business day of the Registrant’s most recently completed second fiscal quarter, December 31, 2003, was $269,778,000.

As of September 1, 2004, there were 17,262,838 shares of the Registrant’s common stock, $.10 par value, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement to be used in connection with the solicitation of proxies to be voted at the Registrant’s Annual Meeting of Stockholders to be held November 10, 2004, which will be filed with the Securities and Exchange Commission pursuant to Regulations 240.14a(6) within 120 days after the Registrant’s fiscal year end, are incorporated by reference into Part I and Part III of this Report on Form 10-K.

Table of Contents

Index to Financial Statements

SWS GROUP, INC. AND SUBSIDIARIES

INDEX TO 2004 ANNUAL REPORT ON FORM 10-K

Table of Contents

Index to Financial Statements

PART I

BUSINESS

We are a full-service securities and banking firm delivering a broad range of investment, commercial banking and related financial services to individual, corporate and institutional investors, broker/dealers, governmental entities and financial intermediaries. We are a Delaware corporation and were incorporated in 1972.

For purposes of this annual report, references to “we,” “us,” “our” and “SWS” mean SWS Group, Inc. collectively with all of our subsidiaries, and references to “SWS Group” mean solely SWS Group, Inc. as a single entity.

Our principal executive offices are located at 1201 Elm Street, Suite 3500, Dallas, Texas 75270. Our telephone number is (214) 859-1800 and our company website is www.swsgroupinc.com. We do not intend for information contained on our website to be part of this Form 10-K. We make available free of charge on or through our website our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material or furnish it to the Securities and Exchange Commission (“SEC”). Additionally, we voluntarily will provide electronic or paper copies of our filings free of charge upon request.

We currently operate through three business segments:

Brokerage Group: We provide clearing services to over 200 correspondent broker/dealers and registered investment advisors and over 390 independent registered representatives, as well as full-service brokerage services to individual and institutional investors. Clearing involves maintaining accounts, processing securities transactions, extending margin loans and performing a variety of administrative services as agent for our correspondent broker/dealers and their clients. Our clearing business is complemented by our capital markets, securities lending and investment management businesses.

Our principal subsidiary, Southwest Securities, Inc. (“Southwest Securities”), is a registered broker/dealer and a member of the New York Stock Exchange (“NYSE”), the American Stock Exchange, Inc. and the Chicago Stock Exchange, Inc. It is also a member of the National Association of Securities Dealers (“NASD”), Securities Investor Protection Corporation (“SIPC”), and other regulatory and trade organizations. Southwest Securities provides correspondent services to securities broker/dealers and other financial institutions in 33 states, Puerto Rico, Canada and Europe. Southwest Securities serves individual investors through its Private Client Group offices in Texas, New Mexico and Oklahoma and institutional investors nationwide from its Dallas, New York, Chicago, Milwaukee, Ft. Lauderdale and Newport Beach offices. Southwest Securities’ activities include execution and clearing of securities transactions, individual and institutional securities brokerage, securities lending, management of and participation in underwriting of equity and fixed income securities, market making in corporate securities and research and investment advisory services. For the year ended June 25, 2004, revenues from Southwest Securities accounted for approximately 72% of our consolidated revenues.

We operate other broker/dealer subsidiaries engaged in certain aspects of the securities brokerage business. All are NASD registered broker/dealers. SWS Financial Services, Inc. (“SWS Financial”) contracts with over 390 individual registered representatives (who are NASD licensed salespersons) for the administration of their securities business. While these registered representatives must conduct all of their securities business through SWS Financial, they may conduct insurance, real estate brokerage or other business for others or for their own accounts. The registered representatives are responsible for all of their direct expenses and are paid higher commission rates than Southwest Securities’ registered representatives to compensate them for their added expenses. May Financial Corporation (“May Financial”) conducts trading operations as a principal for its own account. SWS Financial and May Financial are each correspondents of Southwest Securities.

-1-

Table of Contents

Index to Financial Statements

Banking Group: We offer full-service, traditional and Internet banking through Southwest Securities Bank, Arlington, Texas (the “Bank”), formerly First Savings Bank, FSB. The Bank is a federally chartered savings bank organized and existing under the laws of the United States. Headquartered in Arlington, Texas, the Bank conducts business from its main office and its branch locations in Arlington, Granbury and Dallas, Texas and two loan production offices in Hurst, Texas and Dallas, Texas. On October 1, 2003, SWS Banc Holding, Inc. (“SWS Banc”) was incorporated in the state of Delaware. On March 5, 2004, SWS Banc became a savings and loan holding company through the issuance of 1,000 shares of common stock to SWS Group in exchange for all 300,000 issued and outstanding shares of the Bank’s common stock. The new bank holding company was created to facilitate future potential financing transactions.

The Bank has two subsidiaries. FSB Financial, LTD (“FSB Financial”) purchases and originates non-prime automobile loans and FSB Development, LLC (“FSB Development”) develops single-family residential lots.

The fiscal year-end for the Bank and its subsidiaries is June 30, 2004. Any individually material transactions are reviewed and recorded in the appropriate fiscal year.

Asset Management Group: We offer asset management services through SWS Capital Corporation (“SWS Capital”), which administers the Local Government Investment Cooperative (“LOGIC”) fund for cities, counties, schools and other local governments across Texas. LOGIC is an investment program tailored to the investing needs of local governments within the state of Texas. The fund’s investments are subject to the requirements of the Texas Public Funds Act.

See Note 24 to the Consolidated Financial Statements contained in this Report for the revenue, income (loss) and asset information of each of our business segments.

-2-

Table of Contents

Index to Financial Statements

PRODUCTS AND SERVICES

Brokerage Group

Execution and Clearing. We provide clearing and execution services for other broker/dealers (predominantly on a fully disclosed basis) including general broker/dealers, bank affiliated firms and firms specializing in high volume trading. In a fully disclosed clearing transaction, the identity of the correspondent’s client is known to us and we physically maintain the client’s account and perform a variety of services as agent for the correspondent. We provide clearing and execution services for over 200 correspondents throughout the United States and Europe. Correspondent firms are charged fees based on their use of services according to a clearing schedule.

High-volume trading firms specialize in providing services to those customers who trade actively on a daily basis. As of June 25, 2004, Southwest Securities provided clearing services for 9 high-volume firms. The nature of services provided to the customers of high-volume firms and the internal costs necessary to support them are substantially different from the standard correspondent costs and services and, accordingly, fees for services to these correspondents, on a trade basis, are discounted 50-95% from the fees normally charged to other customers. The following table reflects the number of client transactions processed for each of the last three years and the number of correspondents at the end of each year:

In addition to clearing trades, we provide other products and services to our correspondents such as recordkeeping, trade reporting, accounting, general back-office support, securities lending, reorganization and custody of securities. We also attempt to add value to our correspondent relationships by advising the correspondent on communications and networking functions as well as making available to them a variety of non-brokerage products and services on favorable terms.

The terms of our agreements with our correspondents define the allocation of financial, operational and regulatory responsibility arising from the clearing relationship. To the extent that the correspondent has available resources, we are protected against claims by customers of the correspondent arising from actions by the correspondent; however, if the correspondent is unable to meet its obligations, dissatisfied customers may attempt to seek recovery from us.

Individual and Institutional Securities Brokerage. As a securities broker, we act as agent in the purchase and sale of securities, options, commodities and futures contracts traded on various securities and commodities exchanges or in the over-the-counter (“OTC”) market. In most cases, we charge commissions to our retail clients, on both exchange and OTC transactions, in accordance with our established commission schedule. In certain instances, varying discounts from the schedule are given, generally based upon the client’s level of business, the trade size and other relevant factors. We discount our commissions substantially on institutional transactions. For certain fee-based accounts, a fee is charged in lieu of standard commissions. In addition, we sell a number of professionally managed mutual funds and maintain dealer-sales agreements with most major distributors of mutual fund shares sold through broker/dealers. Some of our registered representatives maintain licenses to sell certain insurance products. We are registered with the Commodity Futures Trading Commission as a non-guaranteed introducing broker and are a member of the National Futures Association. We are a fully disclosed client of two of the largest futures commodity merchants in the United States.

-3-

Table of Contents

Index to Financial Statements

At June 25, 2004, Southwest Securities had twelve retail brokerage offices, three located in Dallas and one in each of Austin, Georgetown, Houston, Longview, Lufkin, and San Antonio, Texas; Oklahoma City, Oklahoma; and Albuquerque and Santa Fe, New Mexico. In addition, Southwest Securities has bond brokerage offices in Dallas, Texas, Chicago, Illinois, Ft. Lauderdale, Florida, Newport Beach, California and New York, New York; and institutional equity sales offices in Dallas, Texas and Milwaukee, Wisconsin. Southwest Securities also has equity trading offices in Dallas, Texas and Brighton, Michigan.

Customer Financing. We extend credit on a secured basis directly to our customers, the customers of correspondent firms and the correspondent firms themselves in order to facilitate customer and correspondent securities transactions. This credit, which earns interest income, is known as “margin lending.” Our correspondents indemnify us against margin losses on their customers’ accounts. We extend margin credit to correspondent firms only to the extent that such firms pledge proprietary assets as collateral. Since we must rely on the guarantees and general credit-worthiness of the correspondents, we may be exposed to significant risk of loss if correspondents are unable to meet their financial commitments should there be a substantial adverse change in the value of margined securities.

In margin transactions, the client pays a portion of the purchase price, and we make a loan to the client for the balance, collateralized by the securities purchased or by other securities owned by the client. Interest is charged to clients on the amount borrowed to finance margin transactions at a floating rate. The rate charged is dependent on the average net debit balance in the client’s accounts, the activity level in the accounts and the applicable cost of funds. The amount of the loan is subject to the margin regulations (“Regulation T”) of the Board of Governors of the Federal Reserve System, NYSE margin requirements, and our internal policies. In most transactions, Regulation T limits the amount loaned to a customer for the purchase of a particular security to 50% of the purchase price. Furthermore, in the event of a decline in the value of the collateral, the NYSE regulates the percentage of client cash or securities that must be on deposit at all times as collateral for the loans.

In permitting clients to purchase on margin, we are subject to the risk of a market decline, which could reduce the value of our collateral below the client’s indebtedness. Agreements with margin account clients permit us to liquidate clients’ securities with or without prior notice in the event of an insufficient amount of margin collateral. Despite those agreements, we may be unable to liquidate clients’ securities for various reasons including the fact that the pledged securities may not be actively traded, there is a concentration of certain securities pledged, or a trading halt is issued with regard to pledged securities.

The primary source of funds to finance clients’ margin account balances is credit balances in clients’ accounts. We generally pay interest to clients on these credit balances at a rate determined periodically. Available credit balances are used to lend funds to our customers purchasing securities on margin. SEC regulations restrict the use of clients’ funds to the financing of clients’ activities including margin account balances. Excess customer credit balances, as defined by SEC regulations, are invested in short-term securities segregated for the exclusive benefit of customers as required by SEC regulations. We generate net interest income from the positive interest rate spread between the rate earned from margin lending and alternative short-term investments and the rate paid on customer credit balances.

Securities Lending Activities. We engage in securities lending for our own clients, clients of correspondents and correspondents themselves as well as for other broker/dealers and lending institutions. These activities involve borrowing securities to cover short sales and to complete transactions in which clients have failed to deliver securities by the required settlement date and lending securities to other broker/dealers for similar purposes.

When borrowing securities, we are required to deposit cash or other collateral or to post a letter of credit with the lender, and we generally receive a rebate (based on the amount of cash deposited) or a fee calculated to yield a negotiated rate of return. When lending securities, we receive cash or similar collateral and generally pay interest (based on the amount of cash deposited) to the other party to the transaction. Generally, we earn net interest income based on the spread between the interest rate on cash or similar collateral deposited and the interest rate paid on cash or similar collateral received.

-4-

Table of Contents

Index to Financial Statements

Securities borrowing and lending transactions are executed pursuant to written agreements with counter-parties which require that securities borrowed and loaned be marked-to-market on a daily basis, excess collateral be refunded, and deficit collateral be furnished. Collateral adjustments are usually made on a daily basis through the facilities of various clearinghouses. We are a principal in these securities borrowing and lending transactions and are liable for losses in the event of a failure of any other party to honor its contractual obligation. Our management sets credit limits with each counter-party and reviews these limits regularly to monitor the risk level with each counter-party.

The securities lending business is conducted primarily out of Southwest Securities’ New Jersey office using a highly specialized sales force. Competition for these professionals is intense, and there can be no assurance that we will be able to retain these securities lending professionals.

Investment Banking, Underwriting and Public Finance. We earn investment banking revenues by assisting corporate and public entity clients in meeting their financial needs and advising them on the most advantageous means of raising capital. We manage or co-manage public offerings of securities or arrange private placements of securities with institutional or individual investors. In addition, we provide consulting services, including valuations of securities and companies, arranging and evaluating mergers and acquisitions and advising clients with respect to financing plans and related matters.

We are among the leaders in the Southwest in the origination, syndication and distribution of securities of municipalities and political subdivisions. The public finance department provides professional financial advisory and underwriting services to public bodies. Our syndicate department coordinates the distribution of managed and co-managed corporate equity underwritings, accepts invitations to participate in competitive or negotiated underwritings managed by other investment banking firms, and allocates and merchandises our selling allotments to our branch office system, to institutional clients and to other broker/dealers.

Southwest Securities maintains a corporate finance branch office in Dallas, Texas and public finance branch offices in Austin, Dallas, Houston, Longview and San Antonio, Texas; Newport Beach, California; New York, New York; Boston, Massachusetts; and Albuquerque, New Mexico.

The following table sets forth for the last three fiscal years, as reported to the Municipal Securities Rulemaking Board, the number and dollar amounts of municipal bond transactions of Southwest Securities:

Participation in underwritings, both corporate and municipal, can expose us to material risk, since the possibility exists that securities we have committed to purchase cannot be sold at the initial offering price. Federal and state securities laws and regulations also affect the activities of underwriters and impose substantial potential liabilities for violations in connection with sales of securities by underwriters to the public.

Market Making Activities. Southwest Securities and May Financial are market makers in OTC and exchange-listed equity securities as well as dealers in tax-exempt and governmental fixed income securities. Trading securities in the OTC market involves the purchase of securities from and the sale of securities to our own clients or to other dealers who may be purchasing or selling securities for their own account or acting as agent for their clients. Profits and losses are derived from the spreads between bid and asked prices, as well as market trends for the individual securities during the holding period. At June 25, 2004, Southwest Securities acted as a market maker in 1,130 common stocks of which 499 were exchange-listed stocks. At June 25, 2004, May Financial acted as market maker in 1,500 common stocks. Southwest Securities frequently acts as agent in the execution of OTC orders for its clients and, as such, transacts these trades with other dealers. When we receive a client order

-5-

Table of Contents

Index to Financial Statements

in a security in which we make a market, we may act as principal as long as we match or improve upon the best price in the dealer market, plus or minus a mark-up or mark-down not exceeding the equivalent agency commission charge. Regulations require that client limit orders be satisfied prior to our buying securities into or selling the securities from our own inventory at the same price.

We execute principal transactions to facilitate individual and institutional customer trades and maintain certain inventory positions for our own accounts. These inventories require the commitment of capital and expose us to the risk of a loss if market prices of the securities held in inventory decrease. We have established internal guidelines to limit the size and risk of inventories, and management periodically reviews these guidelines.

Research Activities. We have a research department dedicated to the analysis of market/industry conditions and the performance and recommendation of stocks with an emphasis on the Southwest region. Research is a part of the capital markets effort, which works cooperatively to meet the needs of both our investor and issuer clients. At June 25, 2004, we had 9 senior securities analysts publishing research on 80 companies in sectors that include digital/interactive entertainment, specialty retail, natural gas, healthcare services, special situations and enterprise software.

Insurance. Southwest Financial Insurance Agency, Inc. and Southwest Insurance Agency, Inc., together with its subsidiary, hold insurance agency licenses in 42 states for the purpose of facilitating the sale of insurance and annuities for Southwest Securities and its correspondents.

Banking Group

The Bank offers services and products, such as certificates of deposit and checking and savings accounts, through traditional channels, the Internet, and direct offerings to customers of Southwest Securities. The Bank focuses on several sectors of the residential housing market, including interim construction lending and short term funding for mortgage bankers. In addition, the Bank originates commercial loans and purchases loans for investment. The Bank also recently entered the single-family mortgage banking business in the Dallas-Fort Worth and South Texas markets.

FSB Financial purchases non-prime loans collateralized by liens on automobiles and light trucks. The loans are generally originated by car dealerships and other institutions dealing in such consumer paper. The Bank currently owns approximately 74% of the voting interest in FSB Financial.

FSB Development currently is a limited partner in Terra/Estes Park II, LP, a Texas Limited partnership (“Terra/Estes Park”). Terra/Estes Park develops single family residential lots in the Dallas-Fort Worth, Texas metropolitan area. The lots will be sold to builders whose operating history indicates they will have the ability to complete the planned development. The Bank currently owns 100% of FSB Development.

Asset Management Group

SWS Capital administers the LOGIC program, which is targeted to the investing needs of cities, counties, schools and other local governments across Texas. LOGIC conforms to the Interlocal Cooperation Act and the Public Funds Investment Act of the Texas Government Code. This program allows participants to pool their available funds, resulting in increased economies of scale, which allow higher returns while maintaining a high degree of safety and liquidity. For the 12-month period ended June 25, 2004, the average assets under management for the Asset Management Group were $959,000,000.

-6-

Table of Contents

Index to Financial Statements

Revenues by Source

The following table shows our revenue by source for the last three fiscal years (dollars in thousands):

-7-

Table of Contents

Index to Financial Statements

COMPETITION

We encounter intense competition in our business. We compete directly with securities firms and banks, many of which have substantially greater capital and other resources. We also encounter additional competition from insurance companies and financial institutions in many elements of our business. During the past few years, a number of banks acquired securities firms and, in so doing, gained increased entry into the securities industry. These acquisitions have brought entirely new sources of capital into the securities industry, resulting in more formidable competition.

We compete principally on the basis of service, product selection, price, location and reputation in local markets. We operate at a price disadvantage to discount brokerage firms that do not offer equivalent services. Southwest Securities competes for the correspondent clearing business on the basis of service, price, technology, product selection and reputation. We compete in asset management services with other portfolio managers principally based on portfolio performance, price and service.

Competition for successful securities traders, securities analysts, stock loan professionals and investment bankers among securities firms and other competitors is intense and continuous, as is competition for experienced financial advisors. We recognize the importance of hiring and retaining skilled professionals, as well as hiring new professionals and invest heavily in the recruiting process.

The Bank also operates in an intensely competitive environment. This environment includes other banks, credit unions and insurance companies. There have been numerous new entrants into the Bank’s market area over the past few years. The competition ranges from small community banks to trillion dollar commercial banks. As with the securities industry the ability to attract and retain skilled professionals is critical to the Bank’s success. To enhance these activities the Bank utilizes SWS for assistance in recruiting and educational programs. The Bank competes for community banking products locally based on reputation, service, location and price. The Bank also competes nationally through its mortgage warehouse lending division and factoring division.

REGULATION

The securities industry in the United States is subject to extensive regulation under federal and state laws. The SEC is charged with administration of the federal securities laws. Much of the regulation of broker/dealers, however, has been delegated to self-regulatory organizations, principally the NASD and the NYSE. These self-regulatory organizations adopt rules (which are subject to approval by the SEC) for governing the industry and conduct periodic examinations of member broker/dealers. Securities firms are also subject to regulation by state securities commissions in the states in which they conduct business. Southwest Securities and SWS Financial are registered in all 50 states. Southwest Securities is also registered in Puerto Rico. May Financial is registered in California, Colorado, Connecticut, Florida, Georgia, Illinois, Massachusetts, Michigan, Minnesota, New Jersey, Ohio, South Carolina and Texas.

The regulations to which broker/dealers are subject cover all aspects of the securities business, including sales methods, trade practices among broker/dealers, capital structure of securities firms, record keeping and the conduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the SEC and by self-regulatory organizations or changes in the interpretation or enforcement of existing laws and rules often directly affect the method of operation and profitability of broker/dealers. The SEC and the self-regulatory organizations may conduct administrative proceedings that can result in censure, fine, suspension or expulsion of a broker/dealer, its officers or employees. The principal purpose of regulation and discipline of broker/dealers is the protection of clients and the securities markets rather than protection of creditors and shareholders of broker/dealers.

The enactment of the Sarbanes-Oxley Act of 2002 has led to significant changes in corporate governance, accounting requirements and corporate reporting. In order to comply with these new requirements promulgated by the SEC, the Financial Accounting Standard Board, the NYSE and the Public Company Accounting Oversight Board, we have incurred substantial expenses. We have reflected all costs incurred in our Consolidated Statements of Income (Loss) and Comprehensive Income (Loss). See the Consolidated Financial Statements contained in this Report.

-8-

Table of Contents

Index to Financial Statements

The SEC’s investigations into mutual fund trading practices and adherence to breakpoint schedules have lead to several rule proposals by the SEC, which inherently have lead to a stricter regulatory environment and significant fines and penalties for a number of financial services companies. See “-Legal Proceedings” for additional discussion.

The Bank, as a federal savings bank, is registered with the Office of Thrift Supervision (“OTS”) and is subject to OTS regulation, examination, supervision and reporting requirements. Regulations applicable to the Bank generally relate to lending and investment activities, payment of dividends and maintenance of appropriate levels of capital. Failure to comply with these regulations may be considered an unsafe and unsound practice and may result in the imposition by the OTS of various sanctions. Because the Bank’s deposits are insured by the Savings Association Insurance Fund (“SAIF”), the Federal Deposit Insurance Corporation (“FDIC”) also has the authority to conduct special examinations. The Bank is required to file periodic reports with the OTS describing its activities and financial condition. This supervision and regulation is intended primarily for the protection of the Bank’s depositors.

INSURANCE

Our broker/dealer subsidiaries are required by federal law to belong to SIPC. SIPC provides protection for clients up to $500,000 each with a limitation of $100,000 for claims for cash balances. Southwest Securities purchases insurance which, when combined with the SIPC insurance, provides total coverage in certain circumstances of up to $20.0 million per client for securities held in clients’ accounts with an $80 million aggregate limit.

The Bank’s deposits are insured by the SAIF, which is administered by the FDIC, up to applicable limits for each depositor.

EMPLOYEES

At June 25, 2004, we employed 927 individuals. Southwest Securities employed 797 of these individuals, 137 of whom were full-time registered representatives. In addition, 396 registered representatives were affiliated as independent contractors.

CUSTOMERS

As of the date of this report, through our broker/dealer subsidiaries, we provide full-service securities brokerage services to approximately 29,000 client accounts. Through our securities clearance business, we provide securities services to approximately 217,000 additional client accounts. No single client constitutes a material percentage of our total business.

As of the date of this report, we provide deposit and loan services to approximately 17,600 customers through the Bank and its subsidiaries. No single customer constitutes a material percentage of the Bank’s total business.

As of the date of this report, we provide investment management services to approximately 1,900 accounts representing over 360 cities, counties, schools and other local governments within the State of Texas.

TRADEMARKS

We own various registered trademarks and service marks, including “Investorview,” “My View,” and “Sovereign Securities.” We also own various design marks related to logos for various business segments. We do not consider any of these marks to be materially important to any of our business segments.

-9-

Table of Contents

Index to Financial Statements

EXECUTIVE OFFICERS OF THE REGISTRANT

The following table lists our executive officers and their respective ages and positions, followed by a brief description of their business experience over the past five years. Each listed person has been elected to the indicated office by our board of directors.

Donald W. Hultgren was elected Director and Chief Executive Officer in August 2002. He served as Executive Vice President and Director of Capital Markets from March 2000 to August 2002. From 1989 to 2000, Mr. Hultgren was employed by Raymond James & Associates in various capacities including Managing Director in the Healthcare sector of Corporate Finance and Director of Research. He is a member of the Association of Investment Management and Research and a member of the Advisory Committee for the University of Texas MBA Investment Fund. He serves as a board member for the American Heart Association, Dallas, Texas Division, and is on the association’s Executive Committee. He also serves on the Strategic Advisory Board of the Dallas Society of Financial Analysts.

William D. Felder was elected President of SWS Group, Inc. in August 2002 and President and Chief Executive Officer of Southwest Securities, Inc. in September 2004. He served as Executive Vice President of SWS Group, Inc. from December 1995 to August 2002 and prior to that as Senior Vice President from 1993 to 1995. Mr. Felder has been associated with Southwest Securities in various other capacities since 1980, including Director since August 1993 and Senior Vice President in charge of Clearing Services from 1988 to 1998. Mr. Felder is a past Chairman of the District 6 Business Conduct Committee of the NASD and a past member of the Board of Governors of the Chicago Stock Exchange.

Kenneth R. Hanks was elected Treasurer and Chief Financial Officer in August 2002 and has served as Executive Vice President since June 1996. He served as Chief Operating Officer from August 1998 to August 2002. Mr. Hanks was the Chief Financial Officer from June 1996 to August 1998 and has been a Director of Southwest Securities since June 1997. Mr. Hanks served in various executive capacities of Rauscher Pierce Refsnes, Inc. from 1981 to 1996, including Executive Vice President and Chief Financial Officer. He serves as an arbitrator with the NASD and formerly served as a member of the NASD’s District 6 Business Conduct Committee.

Stacy M. Hodges has served as Executive Vice President since February 1999. She served as Treasurer and Chief Financial Officer from August 1998 to August 2002. Ms. Hodges was Controller from September 1994 to August 1998. Ms. Hodges served as Director of Southwest Securities from June 1997 to August 2002 and has served as Chief Financial Officer of Southwest Securities since June 1997. Prior to joining Southwest Securities, Ms. Hodges was a Senior Audit Manager in the Financial Services division of KPMG LLP. Ms. Hodges is a member of the American Institute of Certified Public Accountants and the Texas Society of CPAs.

Richard H. Litton has served as Executive Vice President and Executive Vice President of Southwest Securities in charge of the Public Finance Division since July 1995. Previously, Mr. Litton was President of a regional investment bank and headed the Municipal Group in the Southwest for Merrill Lynch. Mr. Litton served on various advisory committees for the Texas House of Representatives’ Financial Institutions Committee, is past member and director of the Municipal Advisory Council of Texas and is a past member of the Marketing Committee of the Public Securities Association. He currently represents Southwest Securities on the Bond Market Association’s Legal and Legislative Committee.

-10-

Table of Contents

Index to Financial Statements

W. Norman Thompson has served as Executive Vice President and Chief Information Officer since January 1995. Mr. Thompson was associated with Kenneth Leventhal & Co. (now a part of Ernst & Young LLP) in various capacities ranging from Audit Manager to Senior Consulting Manager from 1987 to 1994. Previously, Mr. Thompson was an auditor with KPMG LLP from 1981 to 1987. In the capacities he held with both Kenneth Leventhal & Co. and KPMG LLP, he was heavily involved in information technology auditing and consulting.

Paul D. Vinton has served as Executive Vice President since November 1998 and as Senior Vice President of Southwest Securities since June 1995. Mr. Vinton was associated with Stephens Inc. in various capacities from 1993 through 1995. Mr. Vinton has been employed within the securities industry since 1972 with various firms dealing primarily in operational, clearance and settlement activities. Mr. Vinton has served on various industry group boards including, most recently, the Depository Trust Company Settlement Advisory Board.

Richard J. Driscoll was elected Executive Vice President in August 2003. He has served as Chairman of the Board of Directors of the Bank since March 2002. He joined the Bank in 1991 as Chief Executive Officer and President and a member of the Board of Directors. Mr. Driscoll is a Director of the Texas Savings and Community Banker’s Association and serves as a member of the Federal Reserve Board Thrift Institutions Advisory Council.

Allen R. Tubb was elected Vice President, General Counsel and Secretary in August of 2002. He joined SWS as Corporate Counsel and Secretary in October 1999. From 1979 to 1999, Mr. Tubb was employed with Oryx Energy Company and its predecessor Sun Exploration and Production Company in various capacities including Chief Counsel, Worldwide Exploration and Production. Mr. Tubb is a member of the Texas Bar Association.

PROPERTIES

Our executive offices and primary operations are located in approximately 188,000 square-feet of leased space in an office building in Dallas, Texas. The lease expires in 2008. Our branch office locations are leased and generally do not exceed 10,000 square feet of space. We conduct our clearing operations primarily at the Dallas headquarters and in our office in New York, and our securities lending activities are primarily conducted from our office in New Jersey.

We have twelve retail brokerage offices with nine in Texas, one in Oklahoma and two in New Mexico. In keeping with Management’s goal to become the leading brokerage firm in the Southwest, we plan to expand our offices throughout the region.

We have eight public finance branch offices, five in Texas, one in New Mexico, one in Massachusetts and one in California. (Public finance has one additional branch in New York for which SWS does not maintain an office.) We have five fixed income branch offices with one branch in each of Illinois, Texas, California, Florida and New York. We have two equity trading offices in Texas and Michigan and two institutional sales offices in Texas and Wisconsin. We have one corporate finance office located in Dallas, Texas. We also have a disaster recovery site in Dallas, Texas.

The consolidation of trading operations and the sale of the Mydiscountbroker.com, Inc. (“Mydiscountbroker”) accounts left us with approximately 47,000 square feet of excess office space with lease terms ending through 2011. Currently, all of the excess space is subject to subleases with terms ending concurrently with the original leases.

The Bank leases its approximately 25,000 square-foot main office located in Arlington, Texas, leases branch offices in Arlington, Dallas and Granbury, Texas, and leases separate space in Hurst and Dallas, Texas for loan production offices. The Bank owns drive-in facilities located next to the main office and branch offices in Arlington, Texas.

-11-

Table of Contents

Index to Financial Statements

Management believes that our present and planned facilities and equipment are adequate for current and planned operations.

LEGAL PROCEEDINGS

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

Dottie Boykin, Individually and as Next Friend of Vielle Nichole Boykin, a Minor Child v. Westwood Trust (District Court, Alabama).

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

SEC/NYSE Mutual Fund Inquiry

Southwest Securities, the company’s largest operating subsidiary, has been the subject of investigations of improper mutual fund trading alleged to have occurred from October 2002 through September 2003. The inquiries, which are being conducted by the U.S. Securities and Exchange Commission (“SEC”) and the New York Stock Exchange (“NYSE”), have questioned the adequacy of Southwest’s supervision of certain employees and the firm’s compliance with books and records and document production requirements. A former branch manager and two of the subsidiary’s former officers, including its former President, are expected to be fined and suspended from serving in a supervisory capacity.

While there have been lengthy settlement discussions, no final settlement documents have been submitted to the SEC, the NYSE or our Board of Directors for approval. At June 25, 2004, a total of $10.0 million had been reserved for this contingency.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

-12-

Table of Contents

Index to Financial Statements

PART II

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock trades on the NYSE under the symbol “SWS.” At September 1, 2004, there were 298 holders of record of our common stock and in excess of 6,700 beneficial holders of our common stock. The following table sets forth for the periods indicated the high and low market prices for the common stock and the cash dividend declared per common share:

The following table provides information about purchases by SWS during the quarter ended June 25, 2004 of equity securities that are registered by SWS pursuant to Section 12 of the Exchange Act:

-13-

Table of Contents

Index to Financial Statements

Equity Compensation Plan Information

Stock Option Plans. We have two stock option plans, the SWS Group, Inc. Stock Option Plan (the “1996 Plan”), and the SWS Group, Inc. 1997 Stock Option Plan (the “1997 Plan”). The 1996 Plan reserves shares of our common stock for issuance to our eligible employees, as well as to non-employee members of the Board of Directors. The 1997 Plan reserves shares of our common stock for eligible employees or potential employees. Officers and directors are not eligible to receive options under the 1997 Plan. Options granted under the 1996 and 1997 Plans have a maximum ten-year term. Generally, options granted under the 1996 Plan have a four-year vesting schedule and options granted under the 1997 Plan have a five-year vesting schedule. However, options granted to non-employee directors under the 1996 Plan are fully vested six months after the date of grant and have a five-year term. The 1996 Plan was approved by our stockholders, while the 1997 Plan was not approved by the stockholders, as it was not required.

Deferred Compensation Plan. In July 1999, we implemented the Deferred Compensation Plan for eligible officers and employees to defer a portion of their bonus compensation and commissions. Our stockholders approved the amended and restated Deferred Compensation Plan at the November 12, 2003 annual meeting. Contributions to the Plan consist of employee pre-tax contributions and our matching contributions up to a specified limit. Participants can invest in our common stock or a variety of mutual funds. Our stock is carried at cost and is held as treasury stock, with an offsetting deferred compensation liability in the equity section of our consolidated statements of financial condition. For the fiscal year ended June 25, 2004, approximately $7,060,000, with a market value of $6,394,000, was invested in the Deferred Compensation Plan. At June 25, 2004, funds totaling $1,533,000 were invested in 86,258 shares of our common stock, with the remainder invested in mutual funds. Approximately $1,458,000 of compensation expense was recorded for participant contributions and employer matching contributions related to the Deferred Compensation Plan in fiscal year 2004. On August 21, 2003 the Board amended the Deferred Compensation Plan to limit the number of shares that may be issued under the Deferred Compensation Plan to 200,000 shares and provide for a June 30, 2009 termination date. The trustee of the Deferred Compensation Plan is Westwood Trust. The number of shares available for future issuance under the plan is 113,742 at June 25, 2004.

Restricted Stock Plan. On November 12, 2003, the stockholders of SWS Group approved the adoption of the SWS Group, Inc. 2003 Restricted Stock Plan (“Restricted Stock Plan”). The Restricted Stock Plan allows for awards of up to 500,000 shares of SWS common stock to SWS’ directors, officers and employees. No more than 200,000 of the authorized shares may be newly issued shares of common stock. The Restricted Stock Plan terminates on August 21, 2013. The vesting period is determined on an individualized basis by the Compensation Committee of the Board of Directors. In general, restricted stock granted under the Restricted Stock plan is fully vested after three years. At June 25, 2004, the total number of shares outstanding was 43,437 and the total number of securities available for future grants was 456,563.

-14-

Table of Contents

Index to Financial Statements

The following table sets forth certain information concerning all equity compensation plans approved by our stockholders and all equity compensation plans not approved by our stockholders as of June 25, 2004.

EQUITY COMPENSATION PLAN INFORMATION AS OF JUNE 25, 2004

-15-

Table of Contents

Index to Financial Statements

SELECTED FINANCIAL DATA

The selected financial data presented below for the five years ended June 25, 2004 have been derived from our Consolidated Financial Statements as audited by our independent registered public accounting firm. The historical financial data are qualified in their entirety by, and should be read in conjunction with, the Consolidated Financial Statements and the notes thereto, the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information contained in this Report.

The following items, all of which impact the comparability of the data from year-to-year, should be considered: (i) the sale of the accounts of Mydiscountbroker in June 2003; (ii) the spin-off of Westwood Holdings Group (“Westwood Group”) in June 2002; (iii) the sale of First Consumer Credit, LLC (“First Consumer”) in October 2001; and (iv) the consolidation into our brokerage operations or discontinuance of the services provided by SWS Technologies Corporation (“SWS Technologies”) in the first quarter of fiscal 2003. Additional items that should be considered are included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Results of Operations-Events and Transactions.”

(In thousands, except ratios and per share amounts)

-16-

Table of Contents

Index to Financial Statements

-17-

Table of Contents

Index to Financial Statements

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

We are primarily engaged in securities execution and clearing, securities brokerage, investment banking, securities lending and borrowing, and trading as a principal in equity and fixed income securities. We also engage in full-service banking and asset management. All of these activities are highly competitive.

While brokerage and banking revenues are dependent upon trading volumes and interest rates, which may fluctuate significantly, a large portion of our expenses remain fixed. Consequently, net-operating results can vary significantly from period to period. Our business is also subject to substantial governmental regulation and changes in legal, regulatory, accounting, tax and compliance requirements that may have a substantial impact on our business and results of operations. See “-Forward-Looking Statements.”

Brokerage Group

The U.S. equities market continued to show improvement from the conditions experienced in comparable periods of fiscal 2003. However, growth was tempered due to continued investor uncertainty resulting from political events, both foreign and domestic, November 2004 elections, continued threats of terrorist attacks, oil prices and the potential for rising interest rates. While trading volumes overall remained relatively light with average daily volume on the NYSE of 1.426 billion shares in fiscal 2004 and 1.475 in fiscal 2003, the Dow Jones Industrial Average increased to 10,435.48 at the end of June versus 8,989.05 in June 2003. The revenues generated by our clearing business are dependent on active markets. Sustained growth in trading volumes is necessary for growth in our clearing business. While the volume of trades we processed in fiscal 2004 increased slightly when compared to the same period in the prior year, clearing revenue remained flat during the same period, reflecting price competition and changes in business mix. Continued improvement in share prices should result in increases in trading volume, which in turn should facilitate growth in revenues in the clearing business. However, growth could be encumbered in this business line by competitive restrictions on our ability to raise or sustain pricing. Additionally, changes in the mix of business processed and volume discounts can impact the revenue growth as well. Lastly, we have been informed by one of our high volume trading customers that they expect to become self-clearing in fiscal 2005. This customer represented $3.7 million in net revenues from clearing in fiscal 2004.

Month-end margin balances reported by NYSE member firms averaged $170 billion in fiscal 2004 versus $136 billion in fiscal 2003, an increase of 25%. We rely on margin lending to our customers to generate revenue. During fiscal 2004, our average margin balance was $340 million, an increase of $40 million, or 13%, over the prior fiscal year. If the markets show sustained improvement, we expect these balances to continue to grow.

Stock loan balances are also influenced by the volumes in the market as well as interest rates. Stock lending balances were up 40% over the level in the last fiscal year. As markets improve, these balances generally increase subject to credit limits imposed by our counter-parties and us. We earn an interest spread in this business that is impacted by the overall interest rate environment. When rates begin to rise, we may have an opportunity to widen the interest spread we earn.

The interest rate environment also impacts our fixed income businesses. Fiscal 2004, with flat interest rates, produced a less favorable rate environment versus the falling interest rate environment that occurred in fiscal 2003. The fixed income business activity level is driven by spreads to published rates, the direction of rates and economic expectations. Management constantly monitors our exposure to interest rate fluctuations to mitigate risk of loss in volatile environments.

We are currently focused on three aspects of our business: growing the clearing business, taking advantage of our prominence in the Southwest to become a nationally recognized full-service regional brokerage firm and growing the Bank. Continued improvement in the equity markets is critical to growth in both our clearing and brokerage businesses. As management continues to refine our focus, acquisitions or dispositions could be warranted.

-18-

Table of Contents

Index to Financial Statements

In evaluating the clearing business, management is focused on growth in clearing fees as well as increased margin balances and tickets processed. While growth in the number of correspondents is important, margin balances and tickets processed are the key variables used to determine growth in the business.

To realize our goal to become a nationally recognized full-service regional brokerage firm, it is essential to grow the retail brokerage distribution network. This will be accomplished through the hiring of additional registered representatives and the opening of new branch office locations in the Southwest. During fiscal 2004, we recruited 20 new Private Client Group representatives and opened one new branch office in Houston, Texas. Opening new branch offices requires outlay of capital that may not be immediately offset by revenues, which will negatively impact results of operations until new locations become positive contributors. New office locations generally take at least a year after permanent space is occupied to achieve a breakeven point, depending on the successful recruiting of registered representatives. We are currently focused on filling our existing offices with producing registered representatives.

Equity capital markets are an integral part of a full-service regional firm. Revenue from this area is cyclical and varies significantly with the growth in the equity markets. Consequently, investment in personnel could negatively impact earnings in periods of limited equity capital markets activity.

As our full service brokerage segment grows, management will be reviewing profitability as well as productivity by registered representatives, transactions processed and deals completed, to measure success in this area.

Our emphasis on the full-service brokerage aspect of our business is expected to diversify the revenue stream and to enhance areas of our business that have relatively higher margins than our traditional clearing business. In the full service brokerage section of our business, we retain more of each dollar of commission than in a traditional clearing arrangement. As the full service business grows, we expect to be able to take advantage of the increased margin.

We completed our conversion to a new electronic brokerage operating system in August of 2002, but continue with ongoing efforts to upgrade and enhance the core system with investments in the technology area. Management continually reviews equipment and communications in an effort to offset some of the costs of software enhancement. Our system was developed by Comprehensive Software Systems, Ltd. (“CSS”), an entity that is backed by a consortium of brokerage firms, including Southwest Securities. The development of the system required more time and capital from these brokerage firms than was originally anticipated. While the system is fully functional at SWS, other consortium members have yet to completely install the system. Decisions by these other firms will impact CSS’ ability to continue to deliver new modules and enhancements and could impact the cost of technology to us.

Banking Group

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

The purchased mortgage loan program operated at record levels during 2003 due to the high level of mortgage refinancing transactions driven by lower mortgage interest rates. Mortgage interest rates began to rise in July 2003 and volumes in this business have declined 61% from June 27, 2003 to June 25, 2004. Mortgage interest rates stabilized in the second quarter of fiscal 2004 and we expect this line of business to remain at current levels until mortgage interest rates move again. In the event interest rates increase, the Bank could experience lower revenues from these operations. With the decrease in mortgage loan originations, the Bank has moved funds to cash and investments. The yield rates for investments range from 1% to 3.1%, while the yield rates on mortgage loans range from 6% to 7.9%, resulting in a decrease in interest revenue. To counter this trend, the Bank also began to diversify its lending base through increased commercial lending. The Bank’s commercial real estate lending was up 21% from prior fiscal year, and consumer and commercial loans were both up more than 25% over the prior fiscal year, due to a continued focus on the Bank’s Community Banking division. This focus is due to the hiring, in the fourth quarter of fiscal 2003, of a new bank President with extensive residential, consumer and commercial lending experience to facilitate the growth of the community banking business. The Bank has planned to and recently entered the single-family mortgage banking business in the Dallas-Fort Worth and South Texas markets.

-19-

Table of Contents

Index to Financial Statements

RESULTS OF OPERATIONS

Net income (loss) for the fiscal years ended June 25, 2004, June 27, 2003 and June 28, 2002 totaled $2,710,000, $2,868,000 and $(7,184,000), respectively, representing a decrease of $158,000, or 6% from fiscal 2003 to 2004 and an increase of $10,052,000, or 140% from fiscal 2002 to 2003. Fiscal years 2004, 2003, and 2002 contained 251, 251 and 247 trading days, respectively.

Events and Transactions

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

SEC/NYSE Mutual Fund Inquiry. Southwest Securities has been the subject of investigations of improper mutual fund trading alleged to have occurred from October 2002 through September 2003. The inquiries are being conducted by the SEC and the NYSE and question the adequacy of the subsidiary’s supervision of certain employees and the firm’s compliance with books and records and document production requirements.

During the third quarter of fiscal 2004, we recorded $2.0 million for this contingent liability. In the fourth quarter, we recorded an additional $8.0 million for a total reserve of $10 million ($9.3 million after tax). While these estimates are based on lengthy settlement discussions with the SEC and the NYSE, no settlement has yet been reached. And while we do not currently anticipate any further material liability related to these regulatory actions, no assurance can be given that these matters will be settled or settled substantially on these terms.

Archipelago. During the second quarter of fiscal 2004, we tendered half of our stake in Archipelago Holdings, L.L.C. (“Archipelago”), an electronic stock exchange, or 303,456 shares of Archipelago common stock, for cash. We recognized a gain of $903,000 (after-tax gain of $587,000). After the tender, we owned 303,456 shares of Archipelago at a cost of zero.

Mydiscountbroker. On June 13, 2003, we sold the accounts of Mydiscountbroker to Ameritrade Inc. and Ameritrade Canada, Inc., subsidiaries of Ameritrade Holding Corporation. The sales price of $4,200,000 (generating an after tax gain of $2,730,000), which was recognized in June of 2003, was based on the actual accounts transferred at closing, approximately 16,500 accounts. Mydiscountbroker had recorded revenues of $2,678,000 and expenses of $3,970,000 for a net loss before taxes for the fiscal year ended June 27, 2003 of $1,292,000.

Fraudulent Mortgages. During the first quarter of fiscal 2003, the Bank provided $3.4 million ($2.2 million after tax impact on earnings) to establish a reserve for fraudulent mortgages purchased from one New York based mortgage bank. Sixteen loans, aggregating approximately $3.4 million, were sold twice by the mortgage bank. Of these sixteen loans, the Bank has recorded assignments on fifteen, for which the Bank has verification from the County Clerk’s office of the county where the mortgaged property is located. However, the Bank is not receiving payments on these loans. A court appointed receiver for the New York mortgage bank is investigating the fraud at the mortgage bank, including the potential recovery of fraudulently received funds. The Bank is currently working with a court-appointed receiver, who is leading the efforts to recover some of the loss from the underlying collateral or from other parties. At this time, the likelihood of recovery from any of these sources cannot be estimated.

Investment in Comprehensive Software Systems, Ltd. We are a part owner of CSS, a software development company formed in 1993 to develop a new brokerage front-and back-office system. We initially acquired a 7.96% interest in CSS and accounted for the investment on a cost basis. Through subsequent investments, our ownership in CSS increased to 25.08% in fiscal 2002. Consequently, we implemented the equity method of accounting prescribed by APB Opinion No. 18, “The Equity Method of Accounting for Investment in

-20-

Table of Contents

Index to Financial Statements

Common Stock,” with respect to our investment in CSS. As required by APB Option No. 18, we recorded our portion of the loss from CSS’ operations of $2.9 million and amortization expense of the CSS goodwill of $370,000 in fiscal 2002. At June 28, 2002, we determined that the investment in CSS and its related goodwill was fully impaired based on an analysis of the projected cash flow from the investment. Therefore, we wrote off the investment in CSS of $3,084,000 and the related goodwill of $933,000 in June 2002. We made no additional equity investments in CSS during fiscal 2003.

The continued enhancement of our brokerage system is important to the growth of our clearing and retail brokerage business. To facilitate enhancement of the systems developed by CSS, we entered into a loan agreement on December 6, 2002 with CSS that called for the total advance of $3,250,000 in quarterly installments of $812,500 beginning January 6, 2003. In June of 2003, we amended the loan agreement to provide that our two remaining quarterly installments would be increased to $937,500. All other terms of the agreement were unchanged. Because of this commitment, we began recognizing our share of the undistributed losses of CSS in January of 2003. Effective December 20, 2003, SWS agreed to an additional equity investment in CSS of $2.9 million, resulting in the purchase of 5.8 million shares of CSS common stock. This purchase will be made in equal quarterly installments and will ultimately result in increasing SWS’ position in CSS to 30.22%. Two purchases totaling approximately $1,443,000 were made in fiscal 2004. For the fiscal year ended June 25, 2004, our percentage interest in CSS’ losses was $3,380,000. Based on our percentage of ownership, our pro-rata share of CSS’ losses was more than the $3,318,000 loaned and invested during the fiscal year ended June 25, 2004 by $62,000. From inception of the loan to date, our pro-rata percentage of losses of $5,456,000 was greater than the $4,943,000 loaned and invested by $513,000. As a result, there is no recorded equity investment or loan receivable from CSS at June 25, 2004.

Impairment of Long-Lived Assets. In accordance with SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,” we recorded $6.3 million in fiscal 2002 in charges related to leasehold and fixed asset impairments resulting from consolidating and reorganizing certain business units. The impairment of fixed assets totaled $3.4 million, and represented 100% of the net book value of the fixed assets at the time of the charge. Leasehold impairments totaled $2.9 million as determined by the present value of future cash flows on the impaired leases offset by estimated sublease income. These charges are included in occupancy, equipment and computer service costs on the consolidated statements of income (loss) and comprehensive income (loss). In fiscal 2003, we recorded additional leasehold and fixed asset impairment charges of $1.4 million. Of the charges recorded in fiscal 2003, $891,000 relates to the space formerly occupied by Mydiscountbroker, $305,000 relates to space formerly occupied by a trading operation and $125,000 relates to space formerly occupied by a Private Client Group office. All of this space is currently subleased.

Westwood Group Spin-Off. In December 2001, we contributed all of the issued and outstanding common stock of two wholly owned subsidiaries, Westwood Management and Westwood Trust to the newly formed Westwood Group and announced our intention to spin-off the Westwood Group to our stockholders.

Also in December 2001, we sold 1,065 shares of the Westwood Group’s common stock, constituting 19.8% of the Westwood Group’s outstanding common stock, to five of the Westwood Group’s executive officers for cash consideration of $4,093,000, a price premised upon an understanding reached in October 2001. The shares sold to management were not distributed in the spin-off. We recorded the difference between the book value of the minority interest we sold and the purchase price as an increase of $518,000 to additional paid-in capital.

To finance the purchase, the Westwood Group loaned its executive officers $4,093,000 on a full-recourse basis, evidenced by notes secured by the stock, payable in nine years bearing interest at 3.93%. The notes receivable were distributed to stockholders as a part of the spin-off transaction and, accordingly, were not included in our consolidated statements of stockholders’ equity.

The difference between the fair value for financial reporting purposes of the stock on December 14, 2001, $7,512,000 and the cash consideration paid of $4,093,000, is an expense incurred by us for the Westwood Group and is reflected as a compensation expense with the offset as a contribution to the Westwood Group’s additional paid-in capital. On a consolidated basis, 80.18% of this charge, or $2,741,000, is reflected in our stockholders’ equity as additional paid-in capital.

-21-

Table of Contents

Index to Financial Statements

The purchase price paid for the stock by the executives and the fair value of the stock for financial reporting purposes on December 14, 2001, differed due to changes in assets under management and the common stock prices of comparable public companies between September 30, 2001 and December 14, 2001. In addition, the purchase price was net of a 35% discount for lack of marketability. For financial accounting purposes, no discount for lack of marketability was recorded.

The record date for the spin-off was June 17, 2002, with a distribution date of June 28, 2002. Because the spin-off occurred on June 28, 2002, Westwood Group’s statement of financial condition is not included in the consolidated statement of financial condition as of that date; however, our share of Westwood Group’s operations is included in the consolidated statements of income (loss) and comprehensive income (loss) for fiscal 2002. During fiscal 2002, the Westwood Group generated $20,575,000 in revenue and $648,000 in net income. As of the date of the spin-off, the Westwood Group held $20,976,000 in total assets. For a detailed description of the financial condition and results of operations of the Westwood Group, see Note 2 to the Consolidated Financial Statements contained in this Report.

SFAS No. 133 and Sales of Knight Stock. The adoption of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended, in the first quarter of fiscal 2001 created a non-cash earnings impact on our financial statements in fiscal years 2004, 2003 and 2002. SFAS No. 133 is applicable to our 5% Exchangeable Subordinated Notes (“Notes”), issued in the form of DARTS^SM (or, “Derivative Adjustable Ratio Securities^SM”) in June 1999. The DARTS contain an equity-based derivative designed to hedge changes in fair value of our investment in Knight Trading Group, Inc. (“Knight”) common stock. The embedded derivative has been designated as a fair value hedge of our investment in Knight shares.

SFAS No. 133 requires fair value recognition of the DARTS’ embedded derivative in the consolidated statements of financial condition. Changes in the fair value of the embedded derivative are required to be recognized in earnings, along with the change in fair value of the Knight shares.

For fiscal year ended June 25, 2004, the impact on the consolidated statements of income (loss) and comprehensive income (loss), representing the change in the time value of money of the embedded derivative was a loss of $14,000. For the comparable periods ended June 27, 2003 and June 28, 2002, SWS recognized losses of $21,000 and $253,000, respectively. Under SFAS No. 133, the related change in the time value of money in the embedded derivative and the changes in the fair value of the embedded derivative, along with the change in fair value of the hedged Knight shares, is calculated on a quarterly basis and recognized in the consolidated statements of income (loss) and comprehensive income (loss) until such time as the fair value hedge ceases to exist.

In December 2000, we repurchased 640,782, or 63%, of our 1,014,332 outstanding DARTS at a cost of approximately $17 million and recorded no material gain or loss on the repurchase. A like number of Knight shares were released from the hedging provisions of SFAS No. 133. Upon final disposition of these previously hedged shares of Knight stock, we recognized a non-cash gain of approximately $23.50 per share, equal to the decrease in the value of Knight stock from the hedging date (June 16, 1999), to the termination date of hedge accounting for these shares (December 20, 2000).

There were no sales of Knight stock in the fiscal years ended June 25, 2004 and June 27, 2003.

For the fiscal year ended June 28, 2002, we sold 532,634 shares of Knight with cash proceeds from the sales totaling $5,063,000. Realized cash gains on these sales totaled $4,994,000 for the fiscal year ended June 28, 2002. As all of the shares sold in fiscal 2002 were previously hedged stock under SFAS No. 133, we recorded a $19,257,000 non-cash gain on sale of stock in net gains from principal transactions in the accompanying consolidated statements of income (loss) and comprehensive income (loss). Therefore, total gains related to the sales of Knight common stock were $24,251,000 during fiscal 2002.

Of the Knight shares sold in fiscal 2002, 206,634 Knight shares were sold at a gain of $1,304,000 in order to reduce our position and relative risk in Knight. The remaining shares sold during fiscal 2002 were sold to fund the advertising commitment of Mydiscountbroker, our former on-line brokerage subsidiary. All shares sold in fiscal 2001 were sold to fund Mydiscountbroker’s advertising commitments. Knight sales benefiting Mydiscountbroker are discussed below in “- -Advertising and Promotional.”

-22-

Table of Contents

Index to Financial Statements

At June 25, 2004 and June 27, 2003, we held 373,550 shares of Knight common stock and had 373,550 DARTS outstanding as of both dates.

The DARTS matured on June 30, 2004. At that time, we chose to deliver our remaining shares of Knight stock in satisfaction of our obligation. Extinguishment of this obligation resulted in a non-cash gain of $23,567,000. $4,835,000 of the gain was on the extinguishment of debt. The remainder of the gain was equal to the difference in the fair value of the Knight stock upon acquisition and the fair value of the Knight stock on the hedging date. This transaction did not affect the results of operations in fiscal 2004 and will be reflected in the results of operations for fiscal 2005. See Note 25 to the Consolidated Financial Statements contained in this Report.

Sale of First Consumer Credit. In October 2001, the Bank sold its interest in its minority-owned subsidiary, First Consumer, receiving $1,050,000 and approximately 366,000 common shares of U.S. Home Systems, Inc. (“USHS”), a company publicly traded on NASDAQ. The shares of USHS were paid to SWS Group as a dividend by the Bank and were recorded at fair market value. The Bank recorded a gain of approximately $1,163,000 on the sale of First Consumer.

During the second quarter of fiscal 2004, we received an additional 91,431 shares of the common stock of USHS, which had been held in escrow under the terms of the sales agreement. The additional shares were issued after no material contingencies were found related to the operations of First Consumer. The Bank paid the shares to SWS Group in the form of a dividend. The shares were recorded at fair market value resulting in a gain of $1,082,000 (after-tax gain of $703,000).

Southwest Clearing Corp. On October 2, 2001, a bankruptcy court awarded us the accounts of a Midwest NASD broker/dealer. The SIPC assumed responsibility for the accounts when the Midwest broker/dealer reported that it was in violation of minimum capital requirements and its accounts were transferred to our wholly owned subsidiary, Southwest Clearing, in October 2001. In April 2002, all remaining customer accounts were transferred to Southwest Securities from Southwest Clearing. Southwest Clearing has ceased operations as a broker/dealer and the corporation was liquidated in July 2004.

-23-

Table of Contents

Index to Financial Statements

Analysis of Operations

Our pretax income was $9,292,000 and $5,015,000, in fiscal 2004 and 2003, respectively, versus pretax loss of $(7,385,000) in fiscal 2002. The following is a summary of year-to-year increases (decreases) in categories of net revenues and operating expenses (dollars in thousands):

Net Revenues increased for fiscal year 2004 by $16,429,000. The largest component of the increase was commission revenue, which was up $13.2 million. Also contributing to the increase was a $2.8 million increase in investment banking, advisory and administrative fee revenues. This increase can be principally attributed to fees received for corporate finance transactions. We also noted an increase of $5.1 million in net interest revenue. This increase is primarily due to an increase in customer and stock loan balances. We also experienced a $4.2 million decrease in other revenue. This decrease is due to the $4.2 million gain recognized on the sale of Mydiscountbroker accounts in fiscal year 2003.

Net Revenues declined for fiscal year 2003 by $42.8 million. Of the total change, the spin-off of Westwood Group represents $20.6 million. In addition, we had $24.3 million of gains on the sale of Knight stock in fiscal 2002.

Operating expenses increased $12.2 million from fiscal 2003 to fiscal 2004. However, taking into account the Bank’s $3.4 million fraud charge recorded in fiscal 2003, operating expenses would have increased $15.6 million. The largest components of this increase were the $10 million accrual for contingent losses from regulatory investigations and the increase in the variable compensation portion of commissions and employee compensation, an increase of $9.9 million. Offsetting these increases was a reduction of $3.8 million in operating expenses from the sale of Mydiscountbroker accounts and reduced occupancy and equipment costs.

For fiscal year 2003, operating expenses declined $55.1 million. The spin-off of Westwood Group accounted for $17.3 million of the decrease. An additional $10.9 million of the savings in operating expenses relates to the clearing business acquired in October 2001 through a SIPC liquidation. See “—Events and Transactions-Southwest Clearing Corp.” That business was operated on a separate system from the rest of our operations until April 2002. Upon completion of the conversion to our internal system, the costs for personnel and systems relating to that business were eliminated. Additionally, in fiscal 2002, we recorded $6.3 million in charges related to leasehold and fixed asset impairments resulting from consolidating and reorganizing certain business units. Lastly, in fiscal 2002, we recorded impairment charges of $4.0 million related to our investment in CSS.

-24-

Table of Contents

Index to Financial Statements

Net Revenues from Clearing Operations. Net revenues from clearing decreased slightly from fiscal 2003 to 2004. Total transactions processed in fiscal 2004 increased to approximately 28.8 million from approximately 27.8 million in the prior year. The slight increase in transactions was offset by the reduction in revenue per ticket of 3% due to price competition, volume discounts and changes in the mix of clearing transactions. Transactions for high volume customers were up 2% while transactions for general securities customers were up over 50%. Revenue per transaction was $0.67 in fiscal 2004 versus $0.69 in fiscal 2003.

Net revenues from clearing decreased $11.8 million, or 38%, from fiscal 2002 to 2003 as a result of reduced transaction volumes. Total transactions processed in fiscal 2003 decreased 44% to approximately 29.3 million from approximately 52.3 million in the prior year. The decline in transactions processed was most pronounced in the company’s high volume trading correspondents. Revenue per transaction increased over the prior year as lower volumes led to reduced discounts for clearing customers. Revenue per transaction was $0.66 in fiscal 2003 versus $0.59 in fiscal 2002.

Commissions. Commission revenue increased $13.2 million for fiscal 2004 versus 2003, an increase of 16%. The largest increases were recorded in the Private Client Group, independent registered representatives and portfolio trading. Improved market conditions and revenue from newly recruited representatives were the primary reasons for the increased revenue.

Commission revenue increased $8.3 million for fiscal 2003 versus 2002, an increase of 11%. Increases in fixed income commissions due to a strong bond market, as well as 33% growth in institutional equity sales, drove the improvement. These increases were offset by decreased commissions from SWS Financial, the independent contractor network, and reduced commissions in the portfolio trading area.

Commission revenue by type of representative follows for the fiscal years ended 2004, 2003 and 2002 (dollars in thousands):

All the increases were offset somewhat by a decrease in commissions from the sale of our Mydiscountbroker accounts in fiscal 2003. The sold accounts generated $2.3 million in commission revenue in fiscal 2003 and $3.3 million in fiscal 2002.

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

-25-

Table of Contents

Index to Financial Statements

The components of interest earnings are as follows for the fiscal years ended 2004, 2003 and 2002 (dollars in thousands):