UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended February 28, 2007
or
[_] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ___________ to ___________
Commission file number 1-8989
The Bear Stearns Companies Inc.
(Exact name of registrant as specified in its charter)
Delaware 13-3286161
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
383 Madison Avenue, New York, New York 10179
(Address of Principal Executive Offices) (Zip Code)
(212) 272-2000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer" and "large accelerated filer" in Rule 12b-2 of the Exchange
Act. Large Accelerated Filer [X] Accelerated Filer [_] Non-Accelerated Filer [_]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [_] No [X]
As of April 5, 2007, the latest practicable date, there were 119,033,628
shares of Common Stock, $1 par value, outstanding.
TABLE OF CONTENTS
Page
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Available Information 3
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS (UNAUDITED)
Condensed Consolidated Statements of Income for
the three months ended February 28, 2007 and
February 28, 2006 4
Condensed Consolidated Statements of Financial
Condition as of February 28, 2007 and
November 30, 2006 5
Condensed Consolidated Statements of Cash Flows
for the three months ended February 28, 2007 and
February 28, 2006 6
Notes to Condensed Consolidated Financial Statements 7
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING 32
FIRM
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Introduction 33
Certain Factors Affecting Results of Operations 33
Forward-Looking Statements 34
Executive Overview 34
Results of Operations 36
Liquidity and Capital Resources 41
Off-Balance-Sheet Arrangements 51
Derivative Financial Instruments 52
Critical Accounting Policies 53
Accounting and Reporting Developments 56
Effects of Inflation 56
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK 58
Item 4. CONTROLS AND PROCEDURES 61
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS 62
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
PROCEEDS 63
Item 6 EXHIBITS 64
Signature 65
2
AVAILABLE INFORMATION
The Bear Stearns Companies Inc. and its subsidiaries ("Company") files current,
annual and quarterly reports, proxy statements and other information required by
the Securities Exchange Act of 1934, as amended ("Exchange Act"), with the
Securities and Exchange Commission ("SEC"). You may read and copy any document
the Company files at the SEC's public reference room located at 100 F Street,
NE, Room 1580, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for
further information on the public reference room. The Company's SEC filings are
also available to the public from the SEC's internet site at http://www.sec.gov.
Copies of these reports, proxy statements and other information can also be
inspected at the offices of the New York Stock Exchange, Inc., 20 Broad Street,
New York, New York 10005.
The Company's public internet site is http://www.bearstearns.com. The Company
makes available free of charge through its internet site, via a link to the
SEC's internet site at http://www.sec.gov, its annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements
and Forms 3, 4 and 5 filed on behalf of directors and executive officers and any
amendments to those reports filed or furnished pursuant to the Exchange Act, as
soon as reasonably practicable after it electronically files such material with,
or furnishes it to, the SEC.
In addition, the Company currently makes available on http://www.bearstearns.com
its most recent annual report on Form 10-K, its quarterly reports on Form 10-Q
for the current fiscal year and its most recent proxy statement, although in
some cases these documents are not available on that site as soon as they are
available on the SEC's internet site. Also posted on the Company's website, and
available in print upon request of any stockholder to the Investor Relations
Department, are charters for the Company's Audit Committee, Compensation
Committee, Corporate Governance Committee, Nominating Committee and Qualified
Legal Compliance Committee. Copies of the Corporate Governance Guidelines and
the Code of Business Conduct and Ethics governing our directors, officers and
employees are also posted on the Company's website within the "Corporate
Governance" section under the heading "About Bear Stearns." You will need to
have the Adobe Acrobat Reader software on your computer to view these documents,
which are in the .PDF format.
3
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Income
(Unaudited)
Three Months Ended
------------------------------
February 28, February 28,
(in thousands, except share and per share data) 2007 2006
--------------------------------------------------------------------------------
REVENUES
Commissions $ 280,645 $ 286,071
Principal transactions 1,342,377 1,150,432
Investment banking 350,179 337,853
Interest and dividends 2,657,193 1,723,989
Asset management and other income 167,345 140,073
------------------------------
Total revenues 4,797,739 3,638,418
Interest expense 2,315,967 1,453,215
------------------------------
Revenues, net of interest expense 2,481,772 2,185,203
------------------------------
NON-INTEREST EXPENSES
Employee compensation and benefits 1,204,094 1,046,850
Floor brokerage, exchange and
clearance fees 56,085 51,243
Communications and technology 127,908 104,034
Occupancy 56,745 44,627
Advertising and market development 37,073 34,673
Professional fees 71,866 53,873
Other expenses 92,795 97,550
------------------------------
Total non-interest expenses 1,646,566 1,432,850
------------------------------
Income before provision for income taxes 835,206 752,353
Provision for income taxes 281,465 238,197
------------------------------
Net income $ 553,741 $ 514,156
Preferred stock dividends 5,257 5,414
------------------------------
Net income applicable to common shares $ 548,484 $ 508,742
==============================
Basic earnings per share $ 4.23 $ 3.92
Diluted earnings per share $ 3.82 $ 3.54
==============================
Weighted average common shares outstanding:
Basic 133,094,747 132,738,565
Diluted 149,722,654 149,417,369
==============================
Cash dividends declared per common share $ 0.32 $ 0.28
==============================
See Notes to Condensed Consolidated Financial Statements.
4
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Financial Condition
(Unaudited)
February 28, November 30,
(in thousands, except share data) 2007 2006
--------------------------------------------------------------------------------
ASSETS
Cash and cash equivalents $ 5,891,313 $ 4,595,184
Cash and securities deposited with clearing
organizations or segregated in compliance
with federal regulations 9,125,941 8,803,684
Securities purchased under agreements to
resell 37,247,992 38,838,279
Securities received as collateral 21,227,351 19,648,241
Securities borrowed 84,014,630 80,523,355
Receivables:
Customers 32,529,683 29,481,799
Brokers, dealers and others 7,307,621 6,119,348
Interest and dividends 892,799 744,542
Financial instruments owned, at fair value 134,410,336 109,200,487
Financial instruments owned and pledged as
collateral, at fair value 12,754,203 15,967,964
------------------------------
Total financial instruments owned, at fair value 147,164,539 125,168,451
Assets of variable interest entities and
mortgage loan special purpose entities 41,482,566 30,303,275
Property, equipment and leasehold
improvements, net of accumulated
depreciation and amortization of
$1,192,106 and $1,152,279 as of February
28, 2007 and November 30, 2006, respectively 508,227 479,637
Other assets 7,119,263 5,726,800
------------------------------
Total Assets $394,511,925 $350,432,595
==============================
LIABILITIES AND STOCKHOLDERS' EQUITY
Short-term borrowings $ 32,229,638 $29,062,714
Securities sold under agreements to
repurchase 88,568,018 69,749,675
Obligation to return securities received as
collateral 21,227,351 19,648,241
Securities loaned 12,147,665 11,451,324
Payables:
Customers 77,892,685 72,988,661
Brokers, dealers and others 3,091,839 3,396,835
Interest and dividends 1,149,446 1,123,348
Financial instruments sold, but not yet
purchased, at fair value 42,279,250 42,256,544
Liabilities of variable interest entities
and mortgage loan special purpose entities 39,648,893 29,079,552
Accrued employee compensation and benefits 926,539 2,895,047
Other liabilities and accrued expenses 3,582,195 2,081,354
Long-term borrowings 58,494,473 54,569,916
------------------------------
Total Liabilities $381,237,992 $338,303,211
==============================
Commitments and contingencies (Note 10)
STOCKHOLDERS' EQUITY
Preferred stock 359,156 359,156
Common stock, $1.00 par value; 500,000,000
shares authorized and 184,805,847 shares
issued as of both February 28, 2007
and November 30, 2006 184,806 184,806
Paid-in capital 4,902,662 4,578,972
Retained earnings 9,894,928 9,384,595
Employee stock compensation plans 2,736,236 2,221,997
Unearned compensation (193,216) (155,596)
Treasury stock, at cost:
Common stock: 65,192,031 and 67,396,876
shares as of February 28, 2007 and
November 30, 2006, respectively (4,610,639) (4,444,546)
------------------------------
Total Stockholders' Equity 13,273,933 12,129,384
------------------------------
Total Liabilities and Stockholders' Equity $394,511,925 $350,432,595
==============================
See Notes to Condensed Consolidated Financial Statements.
5
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Cash Flows
(Unaudited)
Three Months Ended
------------------------------
February 28, February 28,
(in thousands) 2007 2006
--------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 553,741 $ 514,156
Adjustments to reconcile net income to cash
used in operating activities:
Non-cash items included in net income:
Depreciation and amortization 42,325 81,371
Deferred income taxes (67,856) (2,253)
Employee stock compensation plans 12,828 10,086
Changes in operating assets and liabilities:
Cash and securities deposited with
clearing organizations or segregated in
compliance with federal regulations (322,257) (1,513,965)
Securities borrowed, net of securities
loaned (2,794,934) (9,074,155)
Receivables from customers (3,047,884) 1,868,133
Receivables from brokers, dealers and
others (1,188,273) 1,533,983
Financial instruments owned (22,957,905) (4,222,328)
Other assets (1,722,627) (87,210)
Securities sold under agreements to
repurchase, net of securities purchased
under agreements to resell 20,408,630 6,473,250
Payables to customers 4,904,024 195,256
Payables to brokers, dealers and others (304,996) 233,209
Financial instruments sold, but not
yet purchased (54,443) (71,924)
Accrued employee compensation and benefits (1,143,631) (932,053)
Other liabilities and accrued expenses 1,525,208 (17,358)
------------------------------
Cash used in operating activities (6,158,050) (5,011,802)
------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and
leasehold improvements (67,271) (39,234)
------------------------------
Cash used in investing activities (67,271) (39,234)
------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from short-term borrowings 3,166,924 1,563,266
Proceeds from issuance of long-term
borrowings 8,082,023 4,940,564
Payments for retirement/repurchase of
long-term borrowings (3,554,476) (2,198,314)
Proceeds from issuances of derivatives
with a financing element, net 77,149 74,600
Issuance of common stock 62,450 109,715
Cash retained resulting from tax
deductibility under share-based payment
arrangements 205,055 274,076
Redemption of preferred stock - (5,393)
Treasury stock purchases - common stock (473,203) (476,427)
Cash dividends paid (44,472) (38,766)
------------------------------
Cash provided by financing activities 7,521,450 4,243,321
------------------------------
Net increase/ (decrease) in cash and
cash equivalents 1,296,129 (807,715)
------------------------------
Cash and cash equivalents, beginning of
year 4,595,184 5,859,133
------------------------------
Cash and cash equivalents, end of period $ 5,891,313 $ 5,051,418
==============================
Supplemental Disclosure of Cash Flow Information:
Cash payments for interest were $2.51 billion and $1.51 billion during the three
months ended February 28, 2007 and 2006, respectively.
Cash payments for income taxes, net of refunds, were $108.8 million and $88.4
million for the three months ended February 28, 2007 and 2006, respectively.
Cash payments for taxes, net of refunds, would have been $313.9 and $362.5 for
the three months ended February 28, 2007 and 2006, respectively, if increases in
the value of equity instruments issued under share-based payment arrangements
had not been deductible in determining taxable income.
Note: Certain prior period amounts have been reclassified to conform to the
current period's presentation.
See Notes to Condensed Consolidated Financial Statements.
6
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
The Bear Stearns Companies Inc. (the "Company") is a holding company that,
through its broker-dealer and international bank subsidiaries, principally
Bear, Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp.
("BSSC"), Bear, Stearns International Limited ("BSIL") and Bear Stearns
Bank plc ("BSB"), is primarily engaged in business as a securities
broker-dealer and operates in three principal segments: Capital Markets,
Global Clearing Services and Wealth Management. Capital Markets is
comprised of the institutional equities, fixed income and investment
banking areas. Global Clearing Services provides clearance-related
services for prime brokerage clients and clearance on a fully disclosed
basis for introducing broker-dealers. Wealth Management is comprised of
the private client services ("PCS") and asset management areas. See Note
12, "Segment and Geographic Area Data," in the Notes to Condensed
Consolidated Financial Statements for a complete description of the
Company's principal segments. The Company also conducts significant
activities through other wholly owned subsidiaries, including: Bear
Stearns Global Lending Limited; Custodial Trust Company; Bear Stearns
Financial Products Inc.; Bear Stearns Capital Markets Inc.; Bear Stearns
Credit Products Inc.; Bear Stearns Forex Inc.; EMC Mortgage Corporation;
Bear Stearns Commercial Mortgage, Inc.; and through its majority-owned
subsidiary Bear Hunter Holdings LLC. The Company participates, through
Bear Hunter Holdings LLC, in specialist activities on the New York Stock
Exchange ("NYSE"), American Stock Exchange ("AMEX") and International
Securities Exchange ("ISE").
Basis of Presentation
The Condensed Consolidated Financial Statements include the accounts of
the Company, its wholly owned subsidiaries and other entities in which the
Company has a controlling interest. Additionally, in accordance with
Financial Accounting Standards Board ("FASB") Interpretation ("FIN") No.
46 (R), "Consolidation of Variable Interest Entities (revised December
2003)--an interpretation of Accounting Research Bulletin ("ARB") No. 51"
("FIN No. 46 (R)"), the Company also consolidates any variable interest
entities ("VIEs") for which it is the primary beneficiary. The assets and
related liabilities of such variable interest entities have been shown in
the Condensed Consolidated Statements of Financial Condition in the
captions "Assets of variable interest entities and mortgage loan special
purpose entities" and "Liabilities of variable interest entities and
mortgage loan special purpose entities." See Note 5, "Variable Interest
Entities and Mortgage Loan Special Purpose Entities," in the Notes to
Condensed Consolidated Financial Statements.
As of December 1, 2006, the Company has fully adopted Emerging Issues Task
Force ("EITF") Issue No. 04-5 "Determining Whether a General Partner, or
the General Partners as a Group, Controls a Limited Partnership or Similar
Entity When the Limited Partners Have Certain Rights." The EITF consensus
requires a general partner in a limited partnership to consolidate the
limited partnership unless the presumption of control is overcome. The
general partner may overcome this presumption of control and not
consolidate the entity if the limited partners have: (a) the substantive
ability to dissolve or liquidate the limited partnership or otherwise
remove the general partner without having to show cause; or (b)
substantive participating rights in managing the partnership.
When the Company does not have a controlling interest in an entity, but
exerts significant influence over the entity's operating and financial
decisions (generally defined as owning a voting or economic interest of
20% to 50%), the Company applies the equity method of accounting.
The Condensed Consolidated Statement of Financial Condition as of February
28, 2007, the Condensed Consolidated Statements of Income for the three
months ended February 28, 2007 and February 28, 2006 and the Condensed
Consolidated Statements of Cash Flows for the three months ended February
28, 2007 and February 28, 2006 are unaudited. The Condensed Consolidated
Statement of Financial Condition at November 30, 2006 and related
information was derived from the audited consolidated financial
statements.
7
The Condensed Consolidated Financial Statements are prepared in accordance
with the rules and regulations of the Securities and Exchange Commission
("SEC") with respect to the Form 10-Q and reflect all adjustments which,
in the opinion of management, are normal and recurring, and which are
necessary for a fair statement of the results for the interim periods
presented. In accordance with such rules and regulations, certain
disclosures that are normally included in annual financial statements have
been omitted. These financial statements should be read together with the
Company's Annual Report on Form 10-K for the fiscal year ended November
30, 2006, as filed by the Company under the Securities Exchange Act of
1934, as amended ("Exchange Act") (the "Form 10-K").
The Condensed Consolidated Financial Statements are prepared in conformity
with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions, including those regarding inventory valuations, stock-based
compensation, certain accrued liabilities and the potential outcome of
litigation and tax matters, which may affect the amounts reported in the
Condensed Consolidated Financial Statements and accompanying notes. Actual
results could differ materially from these estimates. The nature of the
Company's business is such that the results of any interim period may not
be indicative of the results to be expected for an entire fiscal year. All
material intercompany transactions and balances have been eliminated in
consolidation. Certain prior period amounts have been reclassified to
conform to the current period's presentation.
Financial Instruments
Proprietary securities, futures and other derivative transactions are
recorded on a trade date basis. Financial instruments owned and financial
instruments sold, but not yet purchased, including contractual commitments
arising pursuant to futures, forward and option contracts, interest rate
swaps and other derivative contracts, are recorded at fair value with the
resulting net unrealized gains and losses reflected in "Principal
Transactions" revenues in the Condensed Consolidated Statements of Income.
The Company adopted Statement of Financial Accounting Standards ("SFAS")
No. 157, "Fair Value Measurements," in the 2007 quarter. SFAS No. 157
defines fair value, establishes a framework for measuring fair value and
requires enhanced disclosures about fair value measurements. Additionally,
SFAS No. 157 disallows the use of block discounts on positions traded in
an active market as well as nullifies certain guidance in EITF No. 02-3
regarding the recognition of inception gains on certain derivative
transactions. See Note 2 of Notes to Condensed Consolidated Financial
Statements for a complete discussion on SFAS No. 157.
Fair value is generally based on quoted market prices. If quoted market
prices are not available, fair value is determined based on other relevant
factors, including dealer price quotations, price activity for equivalent
instruments and valuation pricing models. Valuation pricing models
consider time value, yield curve and volatility factors, prepayment
speeds, default rates, loss severity, current market and contractual
prices for the underlying financial instruments, as well as other
measurements.
Equity interests and securities acquired as a result of private equity and
merchant banking activities are reflected in the Condensed Consolidated
Financial Statements at fair value, which is often represented as initial
cost until significant transactions or developments indicate that a change
in the carrying value of the securities is appropriate. This represents
the Company's best estimate of exit price as defined by SFAS No. 157.
Generally, the carrying values of these securities will be increased based
on company performance and in those instances where market values are
readily ascertainable by reference to substantial transactions occurring
in the marketplace or quoted market prices. Reductions to the carrying
value of these securities are made when the Company's estimate of net
realizable value has declined below the carrying value.
Derivative Instruments and Hedging Activities
The Company follows SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities," as amended by SFAS No. 138, "Accounting for
Certain Derivative Instruments and Certain Hedging Activities," and SFAS
No.
8
149, "Amendment of Statement 133 on Derivative Instruments and Hedging
Activities," which establishes accounting and reporting standards for
stand-alone derivative instruments, derivatives embedded within other
contracts or securities, and hedging activities. Accordingly, all
derivatives, whether stand-alone or embedded within other contracts or
securities (except in narrowly defined circumstances), are carried in the
Company's Condensed Consolidated Statements of Financial Condition at fair
value, with changes in fair value recorded in current earnings in
"Principal Transactions" revenues. Designated hedged items in fair value
hedging relationships are marked for the risk being hedged, with such
changes recorded in current earnings.
On December 1, 2006, the Company adopted SFAS No. 155, "Accounting for
Certain Hybrid Financial Instruments--an amendment of FASB Statements No.
133 and 140." SFAS No. 155 permits companies to elect on an
instrument-by-instrument basis, to apply a fair value measurement to
hybrid financial instruments that contain an embedded derivative that
would otherwise require bifurcation under SFAS No. 133. As permitted, on
December 1, 2006, the Company elected to apply a fair value measurement to
all existing hybrid financial instruments that met the SFAS No. 155
definition. The Company also elected the fair value measurement for all
qualifying hybrid financial instruments issued on or after December 1,
2006. The Company's primary reason for electing to carry these instruments
on a fair value basis was to enable the Company to more efficiently hedge
these instruments and to simplify the accounting process. The hybrid
instruments are reported as a component of "Other liabilities" in the Fair
Value Measurements disclosure. The transition adjustment related to the
adoption of SFAS No. 155 did not have a material impact on the Condensed
Consolidated Financial Statements of the Company.
The Company follows FIN No. 39, "Offsetting Amounts Related to Certain
Contracts," and offsets assets and liabilities in the Condensed
Consolidated Statements of Financial Condition provided that the legal
right of offset exists under a master netting agreement. This includes the
offsetting of payables or receivables relating to the fair value of cash
collateral received or paid associated with its derivative inventory, on a
counterparty basis.
Customer Transactions
Customer securities transactions are recorded on the Condensed
Consolidated Statements of Financial Condition on a settlement date basis,
which is generally three business days after trade date, while the related
commission revenues and expenses are recorded on a trade date basis.
Receivables from and payables to customers include amounts related to both
cash and margin transactions. Securities owned by customers, including
those that collateralize margin or other similar transactions, are
generally not reflected in the Condensed Consolidated Statements of
Financial Condition.
Mortgage Servicing Assets, Fees and Advances
Mortgage servicing rights ("MSRs") are included in "Other Assets" on the
Condensed Consolidated Statements of Financial Condition. On December 1,
2006, the Company adopted SFAS No. 156, "Accounting for Servicing of
Financial Assets--an amendment of FASB Statement No. 140," and elected to
measure servicing assets at fair value. Fair value of MSRs is determined
by using market-based models that discount anticipated future net cash
flows considering loan prepayment predictions, interest rates, default
rates, servicing costs, current market data and other economic factors.
The adoption of SFAS No. 156 did not have a material impact on the
Condensed Consolidated Financial Statements of the Company.
Contractual servicing fees, late fees and other ancillary servicing fees
earned for servicing mortgage loans are reflected in "Investment Banking"
revenues in the Condensed Consolidated Statements of Income. Contractual
servicing fees are recognized when earned based on the terms of the
servicing agreement. All other fees are recognized when received. In the
normal course of its business, the Company makes principal, interest and
other servicing advances to external investors on mortgage loans serviced
for these investors. Such advances are generally recoverable from the
mortgagors, related securitization trusts or from the proceeds received
from the sales of the
9
underlying properties. A charge to earnings is recognized to the extent
that servicing advances are estimated to be uncollectible under the
provisions of the servicing contracts.
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities--a replacement of
FASB Statement No. 125," to account for securitizations and other
transfers of financial assets and collateral. SFAS No. 140 establishes
accounting and reporting standards with a financial-components approach
that focuses on control. Under this approach, financial assets or
liabilities are recognized when control is established and derecognized
when control has been surrendered or the liability has been extinguished.
Control is deemed to be relinquished only when all of the following
conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee
is a Qualifying Special Purpose Entity ("QSPE") or has the right to pledge
or exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. The Company derecognizes
financial assets transferred in securitizations provided that such
transfer meets all of these criteria.
Mortgage securitization transactions, net of certain direct costs, are
recorded in "Principal Transactions" revenues in the Condensed
Consolidated Statements of Income.
Collateralized Securities Transactions
Transactions involving purchases of securities under agreements to resell
("reverse repurchase agreements") or sales of securities under agreements
to repurchase ("repurchase agreements") are treated as collateralized
financing transactions and are recorded at their contracted resale or
repurchase amounts plus accrued interest. Resulting interest income and
expense is generally included in "Principal Transactions" revenues in the
Condensed Consolidated Statements of Income. Reverse repurchase agreements
and repurchase agreements are presented in the Condensed Consolidated
Statements of Financial Condition on a net-by-counterparty basis, where
permitted by generally accepted accounting principles. It is the Company's
general policy to take possession of securities with a market value in
excess of the principal amount loaned plus the accrued interest thereon,
in order to collateralize reverse repurchase agreements. Similarly, the
Company is generally required to provide securities to counterparties to
collateralize repurchase agreements. The Company's agreements with
counterparties generally contain contractual provisions allowing for
additional collateral to be obtained, or excess collateral returned. It is
the Company's policy to value collateral and to obtain additional
collateral, or to retrieve excess collateral from counterparties, when
deemed appropriate.
Securities borrowed and securities loaned are recorded based upon the
amount of cash collateral advanced or received. Securities borrowed
transactions facilitate the settlement process and require the Company to
deposit cash, letters of credit or other collateral with the lender. With
respect to securities loaned, the Company receives collateral in the form
of cash or other collateral. The amount of collateral required to be
deposited for securities borrowed, or received for securities loaned, is
an amount generally in excess of the market value of the applicable
securities borrowed or loaned. The Company monitors the market value of
securities borrowed and loaned, with excess collateral retrieved or
additional collateral obtained, when deemed appropriate.
Investment Banking and Advisory Services
Underwriting revenues and fees for mergers and acquisitions advisory
services are accrued when services for the transactions are substantially
completed. Transaction expenses are deferred until the related revenue is
recognized. Investment banking and advisory services revenues are
presented net of transaction-related expenses.
Commissions
Commission revenues primarily include fees from executing and clearing
client transactions on stock, options and
10
futures markets worldwide. These fees are recognized on a trade-date
basis. The Company records its share of the commission under certain
commission sharing arrangements where the Company is acting as agent for
another broker, in accordance with EITF Statement No. 99-19, "Reporting
Revenue Gross as a Principal versus Net as an Agent."
Asset Management and Other Income
The Company receives advisory fees for investment management. In addition,
the Company receives performance incentive fees for managing certain
funds. Advisory fees are recognized over the period of advisory service.
Unearned advisory fees are treated as deferred revenues and are included
in "Other Liabilities" in the accompanying Condensed Consolidated
Statements of Financial Condition. Performance incentive fees are
recognized throughout the year as they become realizable based on
achievement of specified performance targets.
Fixed Assets
Depreciation of property and equipment is provided by the Company on a
straight-line basis over the estimated useful life of the asset.
Amortization of leasehold improvements is provided on a straight-line
basis over the lesser of the estimated useful life of the asset or the
remaining life of the lease.
Goodwill and Identifiable Intangible Assets
The Company accounts for goodwill and identifiable intangible assets under
the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." In
accordance with this guidance, the Company does not amortize goodwill, but
amortizes identifiable intangible assets over their useful lives. Goodwill
is tested at least annually for impairment and identifiable intangible
assets are tested for potential impairment whenever events or changes in
circumstances suggest that the carrying value of an asset or asset group
may not be fully recoverable in accordance with SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets."
Earnings Per Share
Earnings per share ("EPS") is computed in accordance with SFAS No. 128,
"Earnings Per Share." Basic EPS is computed by dividing net income
applicable to common shares, adjusted for costs related to vested shares
under the Capital Accumulation Plan for Senior Managing Directors, as
amended ("CAP Plan"), as well as the effect of the redemption of preferred
stock, by the weighted average number of common shares outstanding. Common
shares outstanding includes vested units issued under certain stock
compensation plans, which will be distributed as shares of common stock.
Diluted EPS includes the determinants of basic EPS and, in addition, gives
effect to dilutive potential common shares related to stock compensation
plans.
Stock-Based Compensation
The Company follows SFAS No. 123 (R), "Share-Based Payment," to account
for its stock-based compensation plans. SFAS No. 123 (R) is a revision of
SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows."
SFAS No. 123 (R) eliminated the ability to account for share-based
compensation transactions in using APB No. 25, and requires all
share-based payments to employees, including grants of employee stock
options, to be recognized in the financial statements using a fair
value-based method. The Company adopted SFAS No. 123 (R) effective
December 1, 2005, using the modified prospective method. The Company
previously elected to adopt fair value accounting for stock-based
compensation consistent with SFAS No. 123, using the prospective method
with guidance provided by SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosures," effective December 1, 2002. As
a result, commencing with options granted after November 30, 2002, the
Company expensed the fair value of stock options issued to employees over
the related vesting period.
11
Cash Equivalents
The Company has defined cash equivalents as liquid investments not held
for sale in the ordinary course of business with original maturities of
three months or less that are not part of the Company's trading inventory.
Income Taxes
The Company and certain of its subsidiaries file a US consolidated federal
income tax return. The Company accounts for income taxes under the
provisions of SFAS No. 109, "Accounting for Income Taxes." Under SFAS No.
109, deferred income taxes are based on the net tax effects of temporary
differences between the financial reporting and tax bases of assets and
liabilities. In addition, deferred income taxes are determined by the
enacted tax rates and laws expected to be in effect when the related
temporary differences are expected to be reversed.
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations.
The Company regularly evaluates the likelihood of additional assessments
in each of the tax jurisdictions resulting from these examinations. Tax
reserves have been established, which the Company believes to be adequate
in relation to the probability for additional assessments. Once
established, reserves are adjusted as information becomes available or
when an event requiring a change to the reserve occurs.
Translation of Foreign Currencies
Assets and liabilities denominated in foreign currencies are translated at
period end rates of exchange, while income statement items are translated
at daily average rates of exchange during the fiscal period. Comprehensive
income was materially the same as net income for the Company for the three
months ended February 28, 2007 and 2006. Gains or losses resulting from
foreign currency transactions are included in net income.
Accounting and Reporting Developments
During the 2007 quarter, the Company adopted SFAS No. 155, "Accounting for
Certain Hybrid Financial Instruments--an amendment of FASB Statements No.
133 and 140," SFAS No. 156, "Accounting for Servicing of Financial
Assets--an amendment of FASB Statement No. 140," and SFAS No. 157, "Fair
Value Measurements." As a result of the adoption of these standards, the
Company recorded a cumulative effect adjustment to increase the opening
retained earnings balance by approximately $3.5 million (after tax).
In July 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes--an interpretation of FASB Statement No. 109"
("FIN No. 48"). FIN No. 48 clarifies the accounting for uncertainty in
income taxes recognized in an enterprise's financial statements in
accordance with SFAS No. 109. FIN No. 48 prescribes a recognition
threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. The Company expects to adopt the provisions of
FIN No. 48 beginning in the first quarter of 2008. The Company is
currently evaluating the impact, if any, the adoption of FIN No. 48 may
have on the Condensed Consolidated Financial Statements of the Company.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities." SFAS No. 159 permits entities
to choose to measure financial assets and liabilities (except for those
that are specifically scoped out of the Statement) at fair value. The
election to measure a financial asset or liability at fair value can be
made on an instrument-by-instrument basis and is irrevocable. The
difference between carrying value and fair value at the election date is
recorded as a transition adjustment to opening retained earnings.
Subsequent changes in fair value are recognized in earnings. The effective
date for SFAS No. 159 is as of the beginning of an entity's first fiscal
year that begins after November 15, 2007. The Company will adopt SFAS No.
159 on December 1, 2007. The Company does not expect the adoption of SFAS
No. 159 to have a material impact
12
on the Condensed Consolidated Financial Statements of the Company.
2. FINANCIAL INSTRUMENTS
Financial instruments owned and financial instruments sold, but not yet
purchased, consisting of the Company's proprietary trading inventories, at
fair value, were as follows:
February 28, November 30,
(in thousands) 2007 2006
--------------------------------------------------------------------------------
FINANCIAL INSTRUMENTS OWNED:
U.S. government and agency $ 5,246,453 $ 6,136,191
Other sovereign governments 2,456,191 1,371,713
Corporate equity and convertible debt 36,423,135 28,892,588
Corporate debt and other 35,208,016 33,924,116
Mortgages, mortgage- and asset-backed 57,549,272 43,226,699
Derivative financial instruments 10,281,472 11,617,144
--------------------------------------------------------------------------------
$ 147,164,539 $ 125,168,451
================================================================================
FINANCIAL INSTRUMENTS SOLD,
BUT NOT YET PURCHASED:
U.S. government and agency $ 10,736,633 $ 11,724,095
Other sovereign governments 3,900,955 1,275,145
Corporate equity and convertible debt 12,408,671 12,623,291
Corporate debt and other 5,062,733 4,714,019
Mortgages, mortgage- and asset-backed 35,320 54,802
Derivative financial instruments 10,134,938 11,865,192
--------------------------------------------------------------------------------
$ 42,279,250 $ 42,256,544
================================================================================
Note: Certain prior period amounts have been reclassified to conform to
the current period's presentation.
As of February 28, 2007 and November 30, 2006, all financial instruments
owned that were pledged to counterparties where the counterparty has the
right, by contract or custom, to rehypothecate those securities are
classified as "Financial instruments owned and pledged as collateral" in
the Condensed Consolidated Statements of Financial Condition.
Financial instruments sold, but not yet purchased, represent obligations
of the Company to purchase the specified financial instrument at the then
current market price. Accordingly, these transactions result in
off-balance-sheet risk as the Company's ultimate obligation to repurchase
such securities may exceed the amount recognized in the Condensed
Consolidated Statements of Financial Condition.
Concentration Risk
The Company is subject to concentration risk by holding large positions or
committing to hold large positions in certain types of securities,
securities of a single issuer (including governments), issuers located in
a particular country or geographic area, or issuers engaged in a
particular industry. Positions taken and commitments made by the Company,
including underwritings, often involve substantial amounts and significant
exposure to individual issuers and businesses, including
non-investment-grade issuers. At February 28, 2007 and November 30, 2006,
the Company's most significant concentrations were related to US
government and agency inventory positions, including those of the Federal
National Mortgage Association and the Federal Home Loan Mortgage
Corporation. In addition, a substantial portion of the collateral held by
the Company for reverse repurchase agreements consists of securities
issued by the US government and agencies.
13
Fair Value Measurements
The Company has adopted SFAS No. 157, "Fair Value Measurements," in the
first quarter of 2007. SFAS No. 157 applies to all financial instruments
that are being measured and reported on a fair value basis. This includes
those items currently reported in "Financial instruments owned" and
"Financial instruments sold, but not yet purchased" on the Condensed
Consolidated Statements of Financial Condition as well as financial
instruments reported in "Other assets" and "Other liabilities" that are
reported at fair value.
As defined in SFAS No. 157, fair value is the price that would be received
to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date. In determining fair
value, the Company uses various methods including market, income and cost
approaches. Based on these approaches, the Company often utilizes certain
assumptions that market participants would use in pricing the asset or
liability, including assumptions about risk and or the risks inherent in
the inputs to the valuation technique. These inputs can be readily
observable, market corroborated, or generally unobservable firm inputs.
The Company utilizes valuation techniques that maximize the use of
observable inputs and minimize the use of unobservable inputs. Based on
the observability of the inputs used in the valuation techniques the
Company is required to provide the following information according to the
fair value hierarchy. The fair value hierarchy ranks the quality and
reliability of the information used to determine fair values. Financial
assets and liabilities carried at fair value will be classified and
disclosed in one of the following three categories:
Level 1: Quoted market prices in active markets for identical assets or
liabilities.
Level 2: Observable market based inputs or unobservable inputs that are
corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
Level 1 primarily consists of financial instruments whose value is based
on quoted market prices such as exchange-traded derivatives and listed
equities. Additionally, this category also includes those financial
instruments that are typically valued using alternative approaches but for
which the Company typically receives independent external valuation
information including US Treasuries, other US Government and agency
securities, as well as certain corporate debt securities.
Level 2 includes those financial instruments that are valued using models
or other valuation methodologies. These models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates,
loss severity, current market and contractual prices for the underlying
financial instruments, as well as other relevant economic measures.
Substantially all of these assumptions are observable in the marketplace,
can be derived from observable data or are supported by observable levels
at which transactions are executed in the marketplace. Financial
instruments in this category include non-exchange-traded derivatives such
as interest rate swaps, certain mortgage-backed securities and certain
other cash instruments.
Level 3 is comprised of financial instruments whose fair value is
estimated based on internally developed models or methodologies utilizing
significant inputs that are generally less readily observable from
objective sources. Included in this category are non-performing
mortgage-related assets, certain residual interests, Chapter 13 and other
credit card receivables from individuals, complex derivatives which can be
long-dated equity derivatives, certain credit and municipal derivatives
and other exotic derivative structures.
In determining the appropriate levels, the firm performs a detailed
analysis of the assets and liabilities that are subject to SFAS No. 157.
At each reporting period, all assets and liabilities for which the fair
value measurement is based on significant unobservable inputs are
classified as Level 3.
Assets at Fair Value as of February 28, 2007
---------------------------------------------------------------------------------------------------------
Balance as of
Impact of February 28,
(in thousands) Level 1 Level 2 Level 3 Netting 2007
----------------------------- ------------ ------------ ------------ ------------ -------------
Financial Instruments Owned
Non-Derivative Trading
Inventory $ 29,673,936 $ 96,154,346 $ 11,054,785 $ -- $136,883,067
Derivative Trading
Inventory(1) 1,036,310 62,866,804 4,585,611 (58,207,253) 10,281,472
Total Financial Instruments
Owned 30,710,246 159,021,150 15,640,396 (58,207,253) 147,164,539
Other Assets 98,748 759,222 3,322,443 -- 4,180,413
------------ ------------ ------------ ------------- ------------
Total Assets at Fair Value $ 30,808,994 $159,780,372 $ 18,962,839 $(58,207,253) $151,344,952
Liabilities at Fair Value as of February 28, 2007
-----------------------------------------------------------------------------------------------------------
Balance as of
Impact of February 28,
(in thousands) Level 1 Level 2 Level 3 Netting 2007
------------------------------- ------------ ------------ ------------ ------------ -------------
Financial Instruments Sold,
But Not Yet Purchased
Non-Derivative Trading
Inventory $ 23,839,863 $ 8,090,224 $ 214,225 $ -- $ 32,144,312
Derivative Trading Inventory 1,000,611 59,292,575 6,519,500 (56,677,748) 10,134,938
Total Financial Instruments
Sold, But Not Yet Purchased 23,858,650 67,382,799 6,733,725 (56,677,748) 42,279,250
Other Liabilities 0 7,136,407 2,285,426 -- 9,421,833
------------ ------------ ------------ ------------ ------------
Total Liabilities at Fair Value $ 24,840,474 $ 74,519,206 $ 9,019,151 $(56,677,748) $ 51,701,083
(1) Derivative contracts are reported on a gross basis by level. The
impact of netting represents an adjustment related to cash
collateral and counterparty netting.
14
As stated above SFAS No. 157 applies to all financial assets and
liabilities that are reported on a fair value basis. These valuations are
adjusted for various factors including credit risk. For applicable
financial assets carried at fair value, the credit standing of the
counterparties is analyzed and factored into the fair value measurement of
those assets. SFAS No. 157 states that the fair value measurement of a
liability must reflect the nonperformance risk of the entity. Therefore,
the impact of credit standing as well as any potential credit enhancements
(e.g. collateral) has been factored into the fair value measurement of
both financial assets and liabilities.
The non-derivative trading inventory category includes securities such as
US Government and agency, other sovereign governments, corporate equities,
convertible debt, corporate debt, mortgages, mortgage- and asset-backed,
as well as certain other items. They are reported in "Financial
instruments owned" and "Financial instruments sold, but not yet purchased"
on the Condensed Consolidated Statements of Financial Condition. The
derivatives trading inventory balances in the table above are reported on
a gross basis by level with a netting adjustment presented separately in
the "Impact of Netting" column. The Company often enters into different
types of derivative contracts with a single counterparty and these
contracts are covered under one ISDA master netting agreement. The fair
value of the individual derivative contracts are reported gross in their
respective levels based on the fair value hierarchy.
Other assets and other liabilities represent those financial assets and
liabilities that the Company carries at fair value but are not included in
"Financial instruments owned" and "Financial instruments sold, but not yet
purchased" captions. Other assets includes certain items such as
alternative investments, mortgage servicing rights, assets of VIEs and
mortgage securitizations that did not meet the criteria for sale treatment
under SFAS No. 140. Other liabilities is primarily comprised of certain
hybrid debt issuances accounted for at fair value as elected in accordance
with SFAS No. 155.
The following table provides a reconciliation of the beginning and ending
balances for the major classes of assets and liabilities measured at fair
value using significant unobservable inputs (level 3):
Level 3 Financial Assets and Liabilities
3 Months ended February 28, 2007
Changes in
unrealized
gains and
(losses)
included in
earnings
relating to
assets
and
Total gains liabilities
Balance and losses Purchases, Balance still
as of (Realized Issuances, Transfers In as of held at
November 30, and Sales, or Out of February 28, reporting
(in thousands) 2006 Unrealized) Settlements Level 3 2007 date
---------------------------------- ------------ ----------- ----------- ------------ ------------ -----------
Non-Derivative Trading Assets $ 8,999,658 $ (182,452) $ 1,008,568 $ 1,229,011 $ 11,054,785 $ (159,709)
Non-Derivative Trading Liabilities 190,141 (114,048) 153,460 (15,328) 214,225 5,565
Derivative Trading Inventory (Net) (2,223,112) (328,863) 77,920 560,307 1,913,748 (261,018)
Other Assets 2,836,060 25,129 348,358 112,896 3,322,443 9,685
Other Liabilities 3,514,847 138,875 (941,508) (326,122) 2,208,342 38,875
15
Total gains or losses represent the total (realized and unrealized) gains
and losses recorded for the Level 3 assets and liabilities and are
primarily reported in "Principal Transactions" revenues in the Condensed
Consolidated Statements of Income.
Purchases, issuances, sales and settlements represent Level 3 assets and
liabilities that were either purchased, issued, sold, or settled during
the period. The amounts are recorded at their end of period fair values.
Transfers in and/or out represents existing assets or liabilities that
were either previously categorized as a higher level and the inputs to the
model became unobservable or assets and liabilities that were previously
classified as Level 3 and the lowest significant input became observable
during the period. These assets and liabilities are recorded at their end
of period fair values.
The amount of unrealized gains and losses included in earnings
attributable to the change in unrealized gains and losses relating to
assets or liabilities still held at the end of the period is reported in
"Principal Transactions" revenues in the Condensed Consolidated Statements
of Income. Additionally, the change in the unrealized gains and losses are
often offset by realized gains and losses during the period. The risks or
volatility associated with the transactions that make up this amount are
often offset or reduced by certain hedging strategies. The Company
regularly engages in hedging strategies in which financial instruments
from different levels are used to economically hedge the risk of other
financial instruments. The hedging and underlying financial instruments
are often classified in different levels based on the Fair Value
Hierarchy. Therefore, the unrealized gains and losses for the period from
Level 3 assets and liabilities are often offset by unrealized gains and
losses on positions classified in Levels 1 or 2 as well as positions that
have been realized during the quarter.
3. DERIVATIVES AND HEDGING ACTIVITIES
The Company, in its capacity as a dealer in over-the-counter derivative
financial instruments and its proprietary market-making and trading
activities, enters into transactions in a variety of cash and derivative
financial instruments for proprietary trading and to manage its exposure
to market and credit risk. These risks include interest rate, exchange
rate, equity price, and commodity price risk. Derivative financial
instruments represent contractual commitments between counterparties that
derive their value from changes in an underlying interest rate, currency
exchange rate, index (e.g., Standard & Poor's 500 Index), reference rate
(e.g., London Interbank Offered Rate, or LIBOR), or asset value referenced
in the related contract. Some derivatives, such as futures contracts,
certain options and index-referenced warrants, can be traded on an
exchange. Other derivatives, such as interest rate and currency swaps,
caps, floors, collars, swaptions, equity swaps and options, credit
derivatives, structured notes and forward contracts, are negotiated in the
over-the-counter markets. Derivatives generate both on- and
off-balance-sheet risks depending on the nature of the contract.
Generally, these financial instruments represent commitments or rights to
exchange interest payment streams or currencies or to purchase or sell
other securities at specific terms at specified future dates. Option
contracts generally provide the holder with the right, but not the
obligation, to
16
purchase or sell a financial instrument at a specific price on or before
an established date or dates. Financial instruments sold, but not yet
purchased may result in market and/or credit risk in excess of amounts
recorded in the Condensed Consolidated Statements of Financial Condition.
Market Risk
Derivative financial instruments involve varying degrees of
off-balance-sheet market risk, whereby changes in the level or volatility
of interest rates, foreign currency exchange rates or market values of the
underlying financial instruments may result in changes in the value of a
particular financial instrument in excess of the amounts currently
reflected in the Condensed Consolidated Statements of Financial Condition.
The Company's exposure to market risk is influenced by a number of
factors, including the relationships among and between financial
instruments with off-balance-sheet risk, the Company's proprietary
securities, futures and derivatives inventories as well as the volatility
and liquidity in the markets in which the financial instruments are
traded. The Company mitigates its exposure to market risk by entering into
hedging transactions, which may include over-the-counter derivative
contracts or the purchase or sale of interest-bearing securities, equity
securities, financial futures and forward contracts. In this regard, the
utilization of derivative instruments is designed to reduce or mitigate
market risks associated with holding dealer inventories or in connection
with arbitrage-related trading activities.
Derivatives Credit Risk
Credit risk arises from the potential inability of counterparties to
perform in accordance with the terms of the contract. At any point in
time, the Company's exposure to credit risk associated with counterparty
non-performance is generally limited to the net replacement cost of
over-the-counter contracts, net of the value of collateral held. Such
financial instruments are reported at fair value on a net-by-counterparty
basis pursuant to enforceable netting agreements. Exchange-traded
financial instruments, such as futures and options, generally do not give
rise to significant unsecured counterparty exposure due to the Company's
margin requirements, which may be greater than those prescribed by the
individual exchanges. Options written by the Company generally do not give
rise to counterparty credit risk since they obligate the Company (not its
counterparty) to perform.
The Company has controls in place to monitor credit exposures by assessing
the future creditworthiness of counterparties and limiting transactions
with specific counterparties. The Company also seeks to control credit
risk by following an established credit approval process, monitoring
credit limits and requiring collateral where appropriate.
Non-Trading Derivatives Activity
To modify the interest rate characteristics of its long- and short-term
debt, the Company also engages in non-trading derivatives activities. The
Company has issued US dollar- and foreign currency-denominated debt with
both variable- and fixed-rate interest payment obligations. The Company
has entered into interest rate swaps, primarily based on LIBOR, to convert
fixed-rate interest payments on its debt obligations into variable-rate
payments. In addition, for foreign currency debt obligations that are not
used to fund assets in the same currency, the Company has entered into
currency swap agreements that effectively convert the debt into US dollar
obligations. Such transactions are accounted for as fair value hedges.
These financial instruments are subject to the same market and credit
risks as those that are traded in connection with the Company's
market-making and trading activities. The Company has similar controls in
place to monitor these risks.
SFAS No. 133, as amended by SFAS No. 138 and SFAS No. 149, establishes
accounting and reporting standards for stand-alone derivative instruments,
derivatives embedded within other contracts or securities and for hedging
activities. It requires that all derivatives, whether stand-alone or
embedded within other contracts or securities (except in very defined
circumstances) be carried on the Company's Condensed Consolidated
Statement of
17
Financial Condition at fair value. SFAS No. 133 also requires items
designated as being fair value hedged to be recorded at fair value, as
defined in SFAS No. 133, provided that the intent to hedge is fully
documented. Any resultant net change in value for both the hedging
derivative and the hedged item is recognized in earnings immediately, such
net effect being deemed the "ineffective" portion of the hedge. The gains
and losses associated with the ineffective portion of the fair value
hedges are included in "Principal transactions" revenues in the Condensed
Consolidated Statements of Income. These amounts were immaterial for the
three months ended February 28, 2007 and 2006.
On December 1, 2006, the Company adopted SFAS No. 155, "Accounting for
Certain Hybrid Financial Instruments--an amendment of FASB Statements No.
133 and 140." SFAS No. 155 permits companies to elect, on an
instrument-by-instrument basis, to apply a fair value measurement to
hybrid financial instruments that contain an embedded derivative that
would otherwise require bifurcation under SFAS No. 133. As permitted, on
December 1, 2006, the Company elected to apply a fair value measurement to
all existing hybrid financial instruments that meet the SFAS No. 155
definition. The Company has also elected the fair value measurement for
all qualifying hybrid financial instruments issued on or after December
1, 2006.
4. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES
Securitizations
The Company is a market leader in mortgage-backed securitization and other
structured financing arrangements. In the normal course of business, the
Company regularly securitizes commercial and residential mortgages,
consumer receivables and other financial assets. Securitization
transactions are generally treated as sales, provided that control has
been relinquished. In connection with securitization transactions, the
Company establishes special-purpose entities ("SPEs"), in which
transferred assets, including commercial and residential mortgages,
consumer receivables and other financial assets are sold to an SPE and
repackaged into securities or similar beneficial interests. Transferred
assets are accounted for at fair value prior to securitization. The
majority of the Company's involvement with SPEs relates to securitization
transactions meeting the definition of a QSPE under the provisions of SFAS
No. 140. Provided it has relinquished control over such assets, the
Company derecognizes financial assets transferred in securitizations and
does not consolidate the financial statements of QSPEs. For SPEs that do
not meet the QSPE criteria, the Company uses the guidance in FIN No. 46
(R) to determine whether the SPE should be consolidated.
In connection with these securitization activities, the Company may retain
interests in securitized assets in the form of senior or subordinated
securities or as residual interests. Retained interests in securitizations
are generally not held to maturity and typically are sold shortly after
the settlement of a securitization. The weighted average holding period
for retained interest positions in inventory at February 28, 2007 and
November 30, 2006 was approximately 150 days. These retained interests are
included in "Financial instruments owned" in the Condensed Consolidated
Statements of Financial Condition and are carried at fair value.
Consistent with the valuation of similar inventory, fair value is
determined by broker-dealer price quotations and internal valuation
pricing models that utilize variables such as yield curves, prepayment
speeds, default rates, loss severity, interest rate volatilities and
spreads. The assumptions used for pricing variables are based on
observable transactions in similar securities and are further verified by
external pricing sources, when available.
18
The Company's securitization activities are detailed below:
Agency Other Mortgage-
Mortgage- and
(in billions) Backed Asset-Backed Total
------------------------ --------- --------------- --------
Total securitizations
Three months ended
February 28, 2007 $4.7 $21.3 $26.0
Three months ended
February 28, 2006 $5.8 $24.8 $30.6
Retained interests
As of February 28, 2007 $1.9 $5.2 $7.1 (1)
As of November 30, 2006 $1.5 $4.1 $5.6 (2)
(1) Includes approximately $5.7 billion in investment-grade retained
interests of which $3.8 billion is AAA rated.
(2) Includes approximately $4.3 billion in investment-grade retained
interests of which $3.0 billion is AAA rated.
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the three months ended
February 28, 2007 and 2006:
Agency Other
Mortgage- Mortgage and
(in millions) Backed Asset-Backed Total
--------------------------------------- --------- ------------ -----
Cash flows received
from retained interests
Three months ended February 28, 2007 $13.5 $78.3 $91.8
Three months ended February 28, 2006 $21.1 $109.3 $130.4
Cash flows from servicing
Three months ended February 28, 2007 - $4.5 $4.5
Three months ended February 28, 2006 $ 0.1 $6.0 $6.1
The Company is an active market maker in these securities and therefore
may retain interests in assets it securitizes, predominantly highly rated
or government agency-backed securities. The models employed in the
valuation of retained interests consider possible changes in prepayment
speeds in response to changes in future interest rates, as well as
potential credit losses. Prepayment speed changes are incorporated by
calibrating to the observed levels of implied volatility in the market for
interest rate options. Credit losses are considered through
option-adjusted spreads that also incorporate additional factors such as
liquidity and model uncertainty. The models use discount rates that are
based on the Treasury curve, plus the option-adjusted spread. Key points
on the constant maturity Treasury curve at February 28, 2007 were 4.64%
for 2-year Treasuries and 4.63% for 10-year Treasuries, and ranged from
4.49% to 5.11%.
Weighted average key economic assumptions used in measuring the fair value
of retained interests in assets the Company securitized at February 28,
2007 were as follows:
Agency Other
Mortgage- Mortgage- and
Backed Asset-Backed
--------------------------------------- --------- -------------
Weighted average life (years) 6.6 4.7
Average prepayment speeds (annual rate) 8% - 40% 8% - 50%
Credit losses - 0% - 24%
19
The following hypothetical sensitivity analysis as of February 28, 2007
illustrates the potential adverse change in fair value of these retained
interests due to a specified change in the key valuation assumptions. The
interest rate changes represent a parallel shift in the Treasury curve.
This shift considers the effect of other variables, including prepayments.
The remaining valuation assumptions are changed independently. Retained
interests in securitizations are generally not held to maturity and are
typically sold shortly after the settlement of a securitization. The
Company considers the current and expected credit profile of the
underlying collateral in determining the fair value and periodically
updates the fair value for changes in credit, interest rate, prepayment
and other pertinent market factors. Actual credit losses on retained
interests have not been significant.
Agency Other
Mortgage- Mortgage- and
(in millions) Backed Asset-Backed
--------------------------------------- --------- -------------
Interest rates
Impact of 50 basis point adverse change $ (41.7) $ (154.1)
Impact of 100 basis point adverse change (87.4) (344.8)
Prepayment speeds
Impact of 10% adverse change (8.0) (56.7)
Impact of 20% adverse change (14.8) (107.9)
Credit losses
Impact of 10% adverse change (5.6) (134.3)
Impact of 20% adverse change (11.1) (257.6)
--------------------------------------- --------- -------------
The above table should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the table. Changes in fair value based on adverse variations
in assumptions generally cannot be extrapolated because the relationship
of the change in assumptions to the change in fair value is not usually
linear. In addition, the table does not consider the change in fair value
of hedging positions, which would generally offset the changes detailed in
the table, nor do they consider any corrective action that the Company
may take in response to changes in these conditions. The impact of hedges
is not presented because hedging positions are established on a portfolio
level and allocating the impact would not be practicable.
Mortgage Servicing Rights
In the normal course of business, the Company originates and purchases
conforming and non-conforming, conventional fixed-rate and adjustable-rate
residential mortgage loans and sells such loans to investors. In
connection with these activities, the Company may retain MSRs that entitle
the Company to a future stream of cash flows based on the contractual
servicing fee. In addition, the Company may purchase and sell MSRs.
As of December 1, 2006, the Company adopted SFAS No. 156 and elected to
carry its MSRs at fair value, with changes in fair value reported in
earnings. Prior to December 1, 2006, the Company reported the MSRs on a
lower of cost or market basis. The impact of adopting SFAS No. 156
resulted in an after tax increase to opening retained earnings of $1.9
million.
The determination of fair value of the Company's MSRs required management
judgment because they are not actively traded. The determination of fair
value for MSRs requires valuation processes which combine the use of
discounted cash flow models and extensive analysis of current market data
to arrive at an estimate of fair value. The cash flow and prepayment
assumptions used in the Company's discounted cash flow model are based on
empirical data drawn from the historical performance of our MSRs, which we
believe are consistent with assumptions used by market participants
valuing similar MSRs. The key assumptions used in the valuation of MSRs
include mortgage prepayment speeds and the discount rates. These variables
can, and generally will, change from quarter to quarter as market
conditions and projected interest rates change.
20
At February 28, 2007, the key economic assumptions and the sensitivity of
the current fair value of MSRs to immediate changes in those assumptions
were as follows:
February 28,
(in millions) 2007
--------------------------------------------
Fair Value of MSRs $ 580.0
Weighted average constant
prepayment rate (in CPR) 35.6%
Impact on fair value of:
5 CPR adverse change $ (50.8)
10 CPR adverse change (87.5)
Weighted average discount rate 13.3%
Impact on fair value of:
5% adverse change $ (45.6)
10% adverse change (82.2)
--------------------------------------------
The above table should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the table. Changes in fair value based on adverse variations
in assumptions generally cannot be extrapolated because the relationship
of the change in assumptions to the change in fair value is not usually
linear. In addition, the table does not consider the change in fair value
of hedging positions, which would generally offset the changes detailed in
the table, nor do they consider any corrective action that the Company
may take in response to changes in these conditions. The impact of hedges
is not presented because hedging positions are established on a portfolio
level and allocating the impact would not be practicable.
MSRs are included in "Other assets" on the Condensed Consolidated
Statements of Financial Condition. The Company's MSRs activities for the
three months ended February 28, 2007 was as follows:
Three Months Ended
------------------------------------------------------------
February 28,
(in millions) 2007
------------------------------------------------------------
Balance, beginning of period $ 502.0
Additions 111.7
Sales -
Changes in fair value:
Resulting from changes in valuation
inputs/assumptions 2.2
Changes due to adoption of SFAS 156 2.9
Paydowns (38.8)
------------------------------------------------------------
Balance, end of period $ 580.0
------------------------------------------------------------
5. VARIABLE INTEREST ENTITIES AND MORTGAGE LOAN SPECIAL PURPOSE ENTITIES
The Company regularly creates or transacts with entities that may be
variable interest entities (VIEs). These entities are an essential part of
its securitization, asset management and structured finance businesses. In
addition, the Company purchases and sells financial instruments that may
be variable interests. The Company follows the guidance in FIN No. 46(R)
and consolidates those VIEs in which the Company is the primary
beneficiary.
21
The Company may perform various functions, including acting as the seller,
servicer, investor, structurer or underwriter in securitization
transactions. These transactions typically involve entities that are
considered to be QSPEs as defined in SFAS No. 140. QSPEs are exempt from
the requirements of FIN No. 46 (R). For securitization vehicles that do
not qualify as QSPEs, the holders of the beneficial interests have no
recourse to the Company, only to the assets held by the related VIE. In
certain of these VIEs, the Company could be determined to be the primary
beneficiary through its ownership of certain beneficial interests, and
would, therefore, be required to consolidate the assets and liabilities of
the VIE.
The Company has a limited number of mortgage securitizations that did not
meet the criteria for sale treatment under SFAS No. 140, including
transactions where the retained call option did not meet the definition of
a clean up call under SFAS No. 140. As such, the Company continues to
carry the assets and liabilities from these transactions on its
Consolidated Statement of Financial Condition.
The Company also acts as portfolio manager and/or underwriter in several
collateralized debt obligation transactions. In these transactions, the
Company establishes a trust that purchases a portfolio of assets and
issues trust certificates that represent interests in the portfolio of
assets. In addition, the Company may receive variable compensation for
managing the portfolio and may also retain certain trust certificates. In
certain of these transactions, these interests result in the Company
becoming the primary beneficiary of these entities. The holders of the
trust certificates have recourse only to the underlying assets of the
trusts and not to other assets of the Company.
The Company establishes and operates funds for the benefit of its
employees. These funds are considered to be VIEs of which the Company is
the primary beneficiary.
Additionally, the Company invests in certain distressed debt instruments
of which the issuers are VIEs. The Company has determined that it is the
primary beneficiary of the VIEs.
The Company has made investments in entities that own power plants. These
entities are VIEs of which the Company is the primary beneficiary.
The following table sets forth the Company's total assets and maximum
exposure to loss associated with its significant variable interests in
consolidated VIEs and securitizations that did not qualify for sale
treatment. This information is presented based on principal business
activity, as reflected in the first column.
As of February 28, 2007 As of November 30, 2006
--------------------------------------------------------------------------------
Maximum Maximum
Exposure Exposure
(in millions) VIE Assets to Loss (1) VIE Assets to Loss (1)
--------------------------------------------------------------------------------
Mortgage
Securitizations $ 39,314.5 $ 1,136.3 $ 28,984.3 $ 762.0
Collateralized Debt
Obligations 1,281.5 37.5 685.0 47.9
Employee Funds (2) 709.9 483.4 575.1 355.0
Distressed Debt 57.4 57.2 58.9 58.8
Energy Investments 119.3 119.3 - -
--------------------------------------------------------------------------------
Total $ 41,482.6 $ 1,833.7 $ 30,303.3 $ 1,223.7
--------------------------------------------------------------------------------
(1) Represents the fair value of the Company's interest in these
entities and is reflected on the Condensed Consolidated Statements
of Financial Condition.
(2) Maximum exposure to loss includes loans the Company has made to
employees who participate in the funds, for which the Company is in
a second loss position.
Note: Certain prior period amounts have been reclassified to conform to
the current period's presentation.
The Company also owns significant variable interests in several VIEs
related to collateralized debt obligations for which the Company is not
the primary beneficiary and therefore does not consolidate these entities.
In aggregate, these VIEs had assets approximating $12.5 billion and $14.8
billion at February 28, 2007 and November 30, 2006, respectively. At
February 28, 2007 and November 30, 2006, the Company's maximum exposure to
loss from these entities approximated $136.7 million and $163.2 million,
respectively, which represents the fair value of its interests
22
and is reflected in the Condensed Consolidated Statements of Financial
Condition.
The Company purchases and sells interests in entities that may be deemed
to be VIEs in its market-making capacity in the ordinary course of
business. As a result of these activities, it is reasonably possible that
such entities may be consolidated or deconsolidated at various points in
time. Therefore, the Company's variable interests included above may not
be held by the Company in future periods.
6. COLLATERALIZED FINANCING ARRANGEMENTS
The Company enters into secured borrowing and lending agreements to obtain
collateral necessary to effect settlements, finance inventory positions,
meet customer needs or re-lend as part of its dealer operations.
The Company receives collateral under reverse repurchase agreements,
securities borrowing transactions, derivative transactions, customer
margin loans and other secured money-lending activities. In many
instances, the Company is also permitted by contract or custom to
rehypothecate securities received as collateral. These securities may be
used to secure repurchase agreements, enter into securities lending or
derivative transactions or cover short positions.
At February 28, 2007 and November 30, 2006, the fair value of securities
received as collateral by the Company that can be repledged, delivered or
otherwise used was approximately $291.84 billion and $286.06 billion,
respectively. Of these securities received as collateral, those with a
fair value of approximately $199.97 billion and $189.54 billion were
delivered, repledged or otherwise used at February 28, 2007 and November
30, 2006, respectively.
The Company also pledges financial instruments owned to collateralize
certain financing arrangements and permits the counterparty to pledge or
rehypothecate the securities. These securities are recorded as "Financial
instruments owned and pledged as collateral, at fair value" in the
Condensed Consolidated Statements of Financial Condition. The carrying
value of securities and other inventory positions owned that have been
pledged or otherwise encumbered to counterparties where those
counterparties do not have the right to sell or repledge was approximately
$54.57 billion and $41.58 billion at February 28, 2007 and November 30,
2006, respectively.
7. LONG-TERM BORROWINGS
The Company's long-term borrowings (which have original maturities of at
least 12 months) at February 28, 2007 and November 30, 2006 consisted of
the following:
February 28, November 30,
(in thousands) 2007 2006
-------------------------------------------------------------------
Fixed rate notes due 2007 to 2037 $22,766,235 $22,516,745
Floating rate notes due 2007 to 2046 26,965,733 23,227,794
Index/equity/credit-linked notes 8,762,505 8,825,377
-------------------------------------------------------------------
Total long-term borrowings $58,494,473 $54,569,916
-------------------------------------------------------------------
The Company's long-term borrowings include fair value adjustments in
accordance with SFAS No. 133 as well as hybrid financial instruments
accounted for at fair value as elected under SFAS No. 155. During the
three months ended February 28, 2007, the Company issued and
retired/repurchased $8.08 billion and $3.55 billion of long-term
borrowings, respectively. The weighted average maturity of the Company's
long-term borrowings, based upon stated maturity dates, was approximately
4.4 years at February 28, 2007.
8. EARNINGS PER SHARE
Basic EPS is computed by dividing net income applicable to common shares,
adjusted for costs related to vested shares under the CAP Plan, as well as
the effect of the redemption of preferred stock, by the weighted average
number of common shares outstanding. Common shares outstanding includes
vested units issued under certain stock
23
compensation plans, which will be distributed as shares of common stock.
Diluted EPS includes the determinants of basic EPS and, in addition, gives
effect to dilutive potential common shares related to stock compensation
plans.
The computations of basic and diluted EPS are set forth below:
Three Months Ended
---------------------------------------------------------------------
(in thousands, except February 28, February 28,
per share amounts) 2007 2006
---------------------------------------------------------------------
Net income $ 553,741 $ 514,156
Preferred stock dividends (5,257) (5,414)
Redemption of preferred stock - 27
Income adjustment (net of tax)
applicable to deferred
compensation arrangements-vested
shares 14,051 11,777
---------------------------------------------------------------------
Net earnings used for basic EPS 562,535 520,546
Income adjustment (net of tax)
applicable to deferred
compensation arrangements-
nonvested shares 9,654 8,786
---------------------------------------------------------------------
Net earnings used for diluted EPS $ 572,189 $ 529,332
=====================================================================
Total basic weighted average common
shares outstanding (1) 133,095 132,739
---------------------------------------------------------------------
Effect of dilutive securities:
Employee stock options 6,536 5,288
CAP and restricted units 10,092 11,390
---------------------------------------------------------------------
Dilutive potential common shares 16,628 16,678
---------------------------------------------------------------------
Weighted average number of common
shares outstanding and dilutive
potential common shares 149,723 149,417
=====================================================================
Basic EPS $ 4.23 $ 3.92
Diluted EPS $ 3.82 $ 3.54
=====================================================================
(1) Includes 13,808,471 and 14,684,386 vested units for the three months
ended February 28, 2007 and 2006, respectively, issued under stock
compensation plans which will be distributed as shares of common stock.
9. REGULATORY REQUIREMENTS
The Company is regulated by the SEC as a consolidated supervised entity
("CSE"). As a CSE, the Company is subject to group-wide supervision and
examination by the SEC and is required to compute allowable capital and
allowances for market, credit and operational risk on a consolidated
basis. As of February 28, 2007, the Company was in compliance with the CSE
capital requirements.
Bear Stearns and BSSC are registered broker-dealers and futures commission
merchants and, accordingly, are subject to Rule 15c3-1 under the
Securities Exchange Act of 1934 ("Net Capital Rule") and Rule 1.17 under
the Commodity Futures Trading Commission. Bear Stearns uses Appendix E of
the Net Capital Rule which establishes alternative net capital
requirements for broker-dealers that are part of consolidated supervised
entities. Appendix E allows Bear Stearns to calculate net capital charges
for market risk and derivatives-related credit risk based on mathematical
models provided that Bear Stearns holds tentative net capital in excess of
$1 billion and net capital in excess of $500 million. At February 28,
2007, Bear Stearns' net capital of $3.65 billion exceeded the minimum
requirement by $3.10 billion. Bear Stearns' net capital computation, as
defined, includes $561.7 million, which is net capital of BSSC in excess
of 5.5% of aggregate debit items arising from customer transactions.
BSIL and Bear Stearns International Trading Limited ("BSIT"), London-based
broker-dealer subsidiaries, are subject to the regulatory capital
requirements of the United Kingdom's Financial Services Authority.
BSB, an Ireland-based bank principally involved in the trading and sales
of fixed income products, is registered in
24
Ireland and is subject to the regulatory capital requirements of the
Financial Regulator.
Custodial Trust Company ("CTC"), a Federal Deposit Insurance Corporation
("FDIC") insured New Jersey state chartered bank, offers a range of trust,
lending and securities-clearing services. CTC provides the Company with
banking powers, including access to the securities and funds-wire services
of the Federal Reserve System. CTC is subject to the regulatory capital
requirements of the FDIC.
At February 28, 2007, Bear Stearns, BSSC, BSIL, BSIT, BSB and CTC were in
compliance with their respective regulatory capital requirements. Certain
other subsidiaries are subject to various securities regulations and
capital adequacy requirements promulgated by the regulatory and exchange
authorities of the countries in which they operate. At February 28, 2007,
these other subsidiaries were in compliance with their applicable local
capital adequacy requirements.
10. COMMITMENTS AND CONTINGENCIES
In the ordinary course of business, the Company has commitments in
connection with various activities, the most significant of which are as
follows:
Leases
The Company occupies office space under leases that expire at various
dates through 2024. At February 28, 2007, future minimum aggregate annual
rentals payable under non-cancelable leases (net of subleases), including
383 Madison Avenue in New York City, for fiscal years 2007 through 2011
and the aggregate amount thereafter, are as follows:
(in thousands)
-----------------------------
FISCAL YEAR
2007 (remaining) $ 78,462
2008 108,298
2009 102,553
2010 104,440
2011 104,966
Thereafter 600,157
-----------------------------
Total $1,098,876
=============================
Lending - Related Commitments
In connection with certain of the Company's business activities, the
Company provides financing or financing commitments to investment-grade
and non-investment-grade companies in the form of senior and subordinated
debt, including bridge financing. Commitments have varying maturity dates
and are generally contingent on the accuracy and validity of certain
representations, warranties and contractual conditions applicable to the
borrower. Lending-related commitments to investment-grade borrowers
aggregated approximately $3.23 billion and $3.83 billion at February 28,
2007 and November 30, 2006, respectively. Of this amount, approximately
$764.5 million and $697.8 million was hedged at February 28, 2007 and
November 30, 2006, respectively. Lending-related commitments to
non-investment-grade borrowers approximated $2.14 billion and $2.04
billion at February 28, 2007 and November 30, 2006, respectively. Of this
amount, approximately $102.8 million and $88.8 million was hedged at
February 28, 2007 and November 30, 2006, respectively.
The Company also had contingent commitments to investment-grade and
non-investment-grade companies of approximately $6.47 billion and $17.48
billion as of February 28, 2007 and November 30, 2006, respectively.
Generally, these commitments are provided in connection with leveraged
acquisitions. These commitments are not indicative of the Company's actual
risk because the borrower may never draw upon the commitment. In fact, the
25
borrower may not be successful in the acquisition, the borrower may access
the capital markets instead of drawing on the commitment, or the Company's
portion of the commitment may be reduced through the syndication process.
Additionally, the borrower's ability to draw may be subject to there being
no material adverse change in either market conditions or the borrower's
financial condition, among other factors. These commitments generally
contain certain flexible pricing features to adjust for changing market
conditions prior to closing.
Private Equity-Related Investments and Partnerships
In connection with the Company's merchant banking activities, the Company
has commitments to invest in merchant banking and private equity-related
investment funds as well as commitments to invest directly in private
equity-related investments. At February 28, 2007 and November 30, 2006,
such commitments aggregated $1.44 billion and $788.3 million,
respectively. These commitments will be funded, if called, through the end
of the respective investment periods, with the longest of such periods
ending in 2017.
Underwriting
In connection with the Company's mortgage-backed securitizations and fixed
income underwriting, the Company had commitments to purchase new issues of
securities aggregating $531.3 million and $205.0 million, respectively, at
February 28, 2007 and November 30, 2006.
Commercial and Residential Loans
The Company participates in the origination, acquisition, securitization,
servicing, financing and disposition of commercial and residential loans.
At February 28, 2007 and November 30, 2006, the Company had entered into
commitments to purchase or finance mortgage loans of $5.63 billion and
$4.23 billion, respectively.
Letters of Credit
At February 28, 2007 and November 30, 2006, the Company was contingently
liable for unsecured letters of credit of approximately $2.87 billion and
$3.30 billion, respectively, and secured (by financial instruments)
letters of credit of $1.08 billion and $1.25 million, respectively. These
letters of credit are primarily used to provide collateral for securities
borrowed and to satisfy margin requirements at fixed income and commodity
exchanges.
Other
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $195.7 million and $95.7 million, respectively, at February
28, 2007 and November 30, 2006.
With respect to certain of the commitments outlined above, the Company
utilizes various hedging strategies to actively manage its market, credit
and liquidity exposures. Additionally, since these commitments may expire
unused, the total commitment amount may not necessarily reflect the actual
future cash funding requirements.
Litigation
The Company is the sole defendant in an action commenced in the United
States Bankruptcy Court for the Southern District of New York by the
Chapter 11 Trustee for Manhattan Investment Fund Ltd. As previously
reported in the Company's Form 10-K for fiscal year ended November 30,
2006, the Bankruptcy Court granted the Trustee's motion for summary
judgment on the fraudulent transfer claims against the Company. The
Company has appealed the Bankruptcy Court's decision to the United States
District for the Southern District of New York.
In the normal course of business, the Company has been named as a
defendant in various legal actions, including
26
arbitrations, class actions and other litigation. Certain of the legal
actions include claims for substantial compensatory and/or punitive
damages or claims for indeterminate amounts of damages. The Company is
also involved in other reviews, investigations and proceedings by
governmental and self-regulatory agencies regarding the Company's
business, certain of which may result in adverse judgments, settlements,
fines, penalties, injunctions or other relief.
Because litigation is inherently unpredictable, particularly in cases
where claimants seek substantial or indeterminate damages or where
investigations and proceedings are in the early stages, the Company cannot
predict with certainty the loss or range of loss related to such matters,
how such matters will be resolved, when they will ultimately be resolved,
or what the eventual settlement, fine, penalty or other relief might be.
Consequently, the Company cannot estimate losses or ranges of losses for
matters where there is only a reasonable possibility that a loss may have
been incurred. Although the ultimate outcome of these matters cannot be
ascertained at this time, it is the opinion of management, after
consultation with counsel, that the resolution of the foregoing matters
will not have a material adverse effect on the financial condition of the
Company, taken as a whole; such resolution may, however, have a material
effect on the operating results in any future period, depending on the
level of income for such period.
The Company has provided reserves for such matters in accordance with SFAS
No. 5, "Accounting for Contingencies." The ultimate resolution may differ
materially from the amounts reserved.
Tax
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations.
The Company regularly evaluates the likelihood of additional assessments
in each of the tax jurisdictions resulting from these examinations. Tax
reserves have been established, which the Company believes to be adequate
in relation to the potential for additional assessments. Once established,
reserves are adjusted as information becomes available or when an event
requiring a change to the reserve occurs.
11. GUARANTEES
In the ordinary course of business, the Company issues various guarantees
to counterparties in connection with certain derivative, leasing,
securitization and other transactions. FIN No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees
of Indebtedness of Others," requires the Company to recognize a liability
at the inception of certain guarantees and to disclose information about
its obligations under certain guarantee arrangements.
The guarantees covered by FIN No. 45 include contracts that contingently
require the guarantor to make payments to the guaranteed party based on
changes related to an asset, a liability or an equity security of the
guaranteed party, contracts that contingently require the guarantor to
make payments to the guaranteed party based on another entity's failure to
perform under an agreement and indirect guarantees of the indebtedness of
others, even though the payment to the guaranteed party may not be based
on changes to an asset, liability or equity security of the guaranteed
party. In addition, FIN No. 45 covers certain indemnification agreements
that contingently require the guarantor to make payments to the
indemnified party, such as an adverse judgment in a lawsuit or the
imposition of additional taxes due to either a change in the tax law or an
adverse interpretation of the tax law.
27
The following table sets forth the maximum payout/notional amounts
associated with the Company's guarantees as of February 28, 2007:
Amount of Guarantee Expiration Per Period
---------------------------------------------------------------------------------------
One to Three to Greater
Less Than Three Five than
(in millions) One Year Years Years Five Years Total
---------------------------------------------------------------------------------------
Certain derivative
contracts (notional)(1) $ 213,947 $ 340,929 $ 539,086 $ 489,176 $1,583,138
Municipal securities 2,651 653 -- -- 3,304
Residual value guarantee -- -- 570 -- 570
---------------------------------------------------------------------------------------
(1) The carrying value of these derivatives approximated $2.9 billion as of
February 28, 2007.
Derivative Contracts
The Company's dealer activities cause it to make markets and trade a
variety of derivative instruments. Certain derivative contracts that the
Company has entered into meet the accounting definition of a guarantee
under FIN No. 45. Derivatives that meet the FIN No. 45 definition of
guarantees include credit default swaps (whereby a default or significant
change in the credit quality of the underlying financial instrument may
obligate the Company to make a payment), put options, as well as floors,
caps and collars. Since the Company does not track the counterparties'
purpose for entering into a derivative contract, it has disclosed
derivative contracts that are likely to be used to protect against a
change in an underlying financial instrument, regardless of their actual
use.
On certain of these contracts, such as written interest rate caps and
foreign currency options, the maximum payout cannot be quantified since
the increase in interest rates and foreign exchange rates is not
contractually limited by the terms of the contracts. As such, the Company
has disclosed notional amounts as a measure of the extent of its
involvement in these classes of derivatives rather than maximum payout.
Notional amounts do not represent the maximum payout and generally
overstate the Company's exposure to these contracts. These derivatives
contracts are recorded at fair value, which approximated $2.9 billion at
February 28, 2007.
In connection with these activities, the Company attempts to mitigate its
exposure to market risk by entering into a variety of offsetting
derivatives contracts and security positions.
Municipal Securities
In 1997, the Company established a program whereby it created a series of
municipal securities trusts in which it has retained interests. These
trusts purchase fixed-rate, long-term, highly rated, insured or escrowed
municipal bonds financed by the issuance of trust certificates. Certain of
the trust certificates entitle the holder to receive future payments of
principal and variable interest and to tender such certificates at the
option of the holder on a periodic basis. The Company acts as placement
agent and as liquidity provider. The purpose of the program is to allow
the Company's clients to purchase synthetic short-term, floating-rate
municipal debt that does not otherwise exist in the marketplace. In the
Company's capacity as liquidity provider to the trusts, the maximum
exposure to loss at February 28, 2007 was approximately $3.30 billion,
which represents the outstanding amount of all trust certificates. This
exposure to loss is mitigated by the underlying municipal bonds held by
trusts. The underlying municipal bonds in the trusts are either AAA or AA
rated, insured or escrowed to maturity. Such bonds had a market value, net
of related hedges, approximating $3.39 billion at February 28, 2007.
Residual Value Guarantee
The Company has entered into an operating lease arrangement for its world
headquarters at 383 Madison Avenue in New York City (the "Synthetic
Lease"). Under the terms of the Synthetic Lease, the Company is obligated
to make monthly payments based on the lessor's underlying interest costs.
The Synthetic Lease expires on August 12, 2011 unless both parties agree
to a renewal prior to expiration. At the expiration date of the Synthetic
Lease, the Company
28
has the right to purchase the building for the amount of the then
outstanding indebtedness of the lessor or to arrange for the sale of the
property with the proceeds of the sale to be used to satisfy the lessor's
debt obligation. If the sale of the property does not generate sufficient
proceeds to satisfy the lessor's debt obligation, the Company is required
to fund the shortfall up to a maximum residual value guarantee. As of
February 28, 2007, there was no expected shortfall and the maximum
residual value guarantee approximated $570 million.
Indemnifications
The Company provides representations and warranties to counterparties in
connection with a variety of commercial transactions, including certain
asset sales and securitizations and occasionally indemnifies them against
potential losses caused by the breach of those representations and
warranties. To mitigate these risks with respect to assets being
securitized that have been originated by third parties, the Company seeks
to obtain appropriate representations and warranties from such third-party
originators upon acquisition of such assets. The Company generally
performs due diligence on assets purchased and maintains underwriting
standards for assets originated. The Company may also provide
indemnifications to some counterparties to protect them in the event
additional taxes are owed or payments are withheld, due either to a change
in or adverse application of certain tax laws. These indemnifications
generally are standard contractual terms and are entered into in the
normal course of business. Generally, there are no stated or notional
amounts included in these indemnifications.
Maximum payout information under these indemnifications is not readily
available because of the number, size and lives of these transactions. In
implementing this accounting interpretation, the Company reviewed its
experience with the indemnifications on these structures. Based on such
experience, it is unlikely that these arrangements will have a material
impact on the Condensed Consolidated Financial Statements of the Company.
Other Guarantees
The Company is a member of numerous exchanges and clearinghouses. Under
the membership agreements, members are generally required to guarantee the
performance of other members. Additionally, if a member becomes unable to
satisfy its obligations to the clearinghouse, other members would be
required to meet these shortfalls. To mitigate these performance risks,
the exchanges and clearinghouses often require members to post collateral.
The Company's maximum potential liability under these arrangements cannot
be quantified. However, the potential for the Company to be required to
make payments under these arrangements is remote. Accordingly, no
contingent liability is recorded in the consolidated financial statements
for these arrangements.
12. SEGMENT DATA
The Company operates in three principal segments -- Capital Markets,
Global Clearing Services and Wealth Management. These segments offer
different products and services and are managed separately as different
levels and types of expertise are required to effectively manage the
segments' transactions.
The Capital Markets segment comprises the institutional equities, fixed
income and investment banking areas. The Capital Markets segment operates
as a single integrated unit that provides the sales, trading and
origination effort for various fixed income, equity and advisory products
and services. Each of the three businesses work in tandem to deliver these
services to institutional and corporate clients.
Institutional equities consists of sales, trading and research, in areas
such as domestic and international equities, block trading,
over-the-counter equities, equity derivatives, energy and commodity
activities, risk and convertible arbitrage and, through a majority-owned
joint venture, specialist activities on the NYSE, AMEX and ISE. Fixed
income includes sales, trading, origination and research provided to
institutional clients across a variety of products such as mortgage- and
asset-backed securities, corporate and government bonds, municipal bonds,
high yield products, including bank and bridge loans, foreign exchange and
interest rate and credit derivatives. Investment
29
banking provides services in capital raising, strategic advice, mergers
and acquisitions and merchant banking. Capital raising encompasses the
Company's underwriting of equity, investment grade, municipal and high
yield debt products.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to
clearing clients worldwide. Prime brokerage clients include hedge funds
and clients of money managers, short sellers and other professional
investors. Fully disclosed clients engage in either the retail or
institutional brokerage business.
The Wealth Management segment is composed of the PCS and asset management
areas. PCS provides high-net-worth individuals with an institutional level
of investment service, including access to the Company's resources and
professionals. Asset management manages equity, fixed income and
alternative assets for leading corporate pension plans, public systems,
endowments, foundations, multi-employer plans, insurance companies,
corporations, families and high-net-worth individuals in the United States
and abroad.
The three business segments comprise many business areas, with
interactions among each. Revenues and expenses include those that are
directly related to each segment. Revenues from intersegment transactions
are based upon specific criteria or agreed upon rates with such amounts
eliminated in consolidation. Individual segments also include revenues and
expenses relating to various items, including corporate overhead and
interest, which are internally allocated by the Company primarily based on
balance sheet usage or expense levels. The Company generally evaluates
performance of the segments based on net revenues and profit or loss
before provision for income taxes.
Three Months Ended
--------------------------------
February 28, February 28,
(in thousands) 2007 2006
----------------------------------------------------------------
NET REVENUES
Capital Markets
Institutional Equities $ 512,653 $ 499,893
Fixed Income 1,149,352 907,138
Investment Banking 303,109 295,550
----------------------------------------------------------------
Total Capital Markets 1,965,114 1,702,581
Global Clearing Services 275,558 263,425
Wealth Management
Private Client Services (1) 136,153 129,611
Asset Management 119,159 95,076
----------------------------------------------------------------
Total Wealth Management 255,312 224,687
Other (2) (14,212) (5,490)
----------------------------------------------------------------
Total net revenues $ 2,481,772 $ 2,185,203
================================================================
PRE-TAX INCOME
Capital Markets $ 736,311 $ 652,327
Global Clearing Services 112,800 124,859
Wealth Management 43,753 31,786
Other (3) (57,658) (56,619)
----------------------------------------------------------------
Total pre-tax income $ 835,206 $ 752,353
================================================================
30
(1) Private Client Services
Three Months Ended
--------------------------------
February 28, February 28,
(in thousands) 2007 2006
----------------------------------------------------------------
Gross revenues, before
transfer to Capital
Capital Markets segment $ 165,589 $ 153,895
Revenue transferred to
Capital Markets segment (29,436) (24,284)
------------- -------------
Private Client Services
net revenues $ 136,153 $ 129,611
============= =============
(2) Includes consolidation and elimination entries.
(3) Includes certain legal costs and costs related to the CAP Plan.
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
As of
--------------------------------
February 28, February 28,
(in thousands) 2007 2006
----------------------------------------------------------------
SEGMENT ASSETS
Capital Markets $ 278,015,971 $ 240,448,857
Global Clearing Services 101,082,764 98,532,526
Wealth Management 3,981,070 3,138,239
Other 11,432,120 8,312,973
----------------------------------------------------------------
Total segment assets $ 394,511,925 $ 350,432,595
================================================================
31
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
The Bear Stearns Companies Inc.
We have reviewed the accompanying condensed consolidated statement of financial
condition of The Bear Stearns Companies Inc. and subsidiaries as of February 28,
2007, and the related condensed consolidated statements of income and cash flows
for the three-month periods ended February 28, 2007 and 2006. These interim
financial statements are the responsibility of The Bear Stearns Companies Inc.'s
management.
We conducted our reviews in accordance with the standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board (United States), the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to such condensed consolidated interim financial statements for them to
be in conformity with accounting principles generally accepted in the United
States of America.
We have previously audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated statement
of financial condition of The Bear Stearns Companies Inc. and subsidiaries as of
November 30, 2006, and the related consolidated statements of income, cash flows
and changes in stockholders' equity for the fiscal year then ended (not
presented herein); and in our report dated February 12, 2007, we expressed an
unqualified opinion on those consolidated financial statements. In our opinion,
the information set forth in the accompanying condensed consolidated statement
of financial condition as of November 30, 2006 is fairly stated, in all material
respects, in relation to the consolidated statement of financial condition from
which it has been derived.
/s/ Deloitte & Touche LLP
New York, New York
April 6, 2007
32
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The Bear Stearns Companies Inc. (the "Company") is a holding company that
through its broker-dealer and international bank subsidiaries, principally Bear,
Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp. ("BSSC"),
Bear, Stearns International Limited ("BSIL") and Bear Stearns Bank plc ("BSB"),
is a leading investment banking, securities and derivatives trading, clearance
and brokerage firm serving corporations, governments, institutional and
individual investors worldwide. BSSC, a subsidiary of Bear Stearns, provides
professional and correspondent clearing services in addition to clearing and
settling customer transactions and certain proprietary transactions of the
Company. The Company also conducts significant activities through other wholly
owned subsidiaries, including: Bear Stearns Global Lending Limited; Custodial
Trust Company; Bear Stearns Financial Products Inc.; Bear Stearns Capital
Markets Inc.; Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc.; EMC
Mortgage Corporation; Bear Stearns Commercial Mortgage, Inc.; and through its
majority owned subsidiary Bear Hunter Holdings LLC. The Company is primarily
engaged in business as a securities broker-dealer operating in three principal
segments: Capital Markets, Global Clearing Services and Wealth Management. As
used in this report, the "Company" refers (unless the context requires
otherwise) to The Bear Stearns Companies Inc. and its subsidiaries. Unless
specifically noted otherwise, all references to the three months of 2007 and
2006 refer to the three months ended February 28, 2007 and 2006, respectively,
and all references to quarters are to the Company's fiscal quarters.
For a description of the Company's business, including its trading in cash
instruments and derivative products, its underwriting and trading policies, and
their respective risks, and the Company's risk management policies and
procedures, see the Company's Annual Report on Form 10-K for the fiscal year
ended November 30, 2006, as filed by the Company under the Securities Exchange
Act of 1934, as amended ("Exchange Act").
The Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read together with the Management's Discussion and Analysis
of Financial Condition and Results of Operations and the Consolidated Financial
Statements in the Company's Annual Report on Form 10-K.
CERTAIN FACTORS AFFECTING RESULTS OF OPERATIONS
The Company's principal business activities--investment banking, securities and
derivatives sales and trading, clearance, brokerage and asset management--are,
by their nature, highly competitive and subject to various risks, including
volatile trading markets and fluctuations in the volume of market activity.
Consequently, the Company's net income and revenues have been, and are likely to
continue to be, subject to wide fluctuations, reflecting the effect of many
factors, including general economic conditions, securities market conditions,
the level and volatility of interest rates and equity prices, competitive
conditions, liquidity of global markets, international and regional political
conditions, regulatory and legislative developments, monetary and fiscal policy,
investor sentiment, availability and cost of capital, technological changes and
events, outcome of legal proceedings, changes in currency values, inflation,
credit ratings and the size, volume and timing of transactions.
These and other factors can affect the Company's volume of new securities
issuances, mergers and acquisitions and business restructurings; the stability
and liquidity of securities and futures markets; and ability of issuers, other
securities firms and counterparties to perform on their obligations. A decrease
in the volume of new securities issuances, mergers and acquisitions or
restructurings generally results in lower revenues from investment banking and,
to a lesser extent, reduced principal transactions. A reduced volume of
securities and futures transactions and reduced market liquidity generally
results in lower revenues from principal transactions and commissions. Lower
price levels for securities may result in a reduced volume of transactions, and
may also result in losses from declines in the market value of securities held
in proprietary trading and underwriting accounts. In periods of reduced sales
and trading or investment banking activity, profitability may be adversely
affected because certain expenses remain relatively fixed. The Company's
securities trading, derivatives, arbitrage, market-making, specialist, leveraged
lending, leveraged buyout and underwriting activities are conducted by it on a
principal basis and expose the Company to significant risk of loss. Such risks
include market, counterparty credit and liquidity risks. For a discussion of how
the Company seeks to manage risks, see the "Risk Management" and "Liquidity and
Capital Resources" sections of the Company's Annual Report on Form 10-K.
33
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company tests goodwill for impairment at least annually in accordance with
SFAS No. 142, "Goodwill and Other Intangible Assets." In addition, as required,
the Company amortizes identifiable intangible assets over their useful lives and
tests for impairment whenever events or changes in circumstances suggest the
carrying value of an asset or asset group may not be fully recoverable. The
majority of the Company's goodwill and identifiable intangible assets relate to
the acquisition of NYSE specialist rights. The Company's most recent annual
goodwill impairment test did not result in an identified impairment. However, a
prolonged period of weakness in the equity markets and/or certain events that
could adversely affect the Company's specialist business could indicate a
potential impairment in the value of goodwill and/or identifiable intangible
assets.
Substantial legal liability or a significant regulatory action against the
Company could have a material adverse effect or cause significant reputational
harm to the Company, which in turn could seriously harm the Company's business
prospects. Firms in the financial services industry have been operating in a
stringent regulatory environment. The Company faces significant legal risks in
its businesses, and the volume of claims and amount of damages and penalties
claimed in litigation and regulatory proceedings against financial institutions
have been increasing.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements concerning management's expectations, strategic
objectives, business prospects, anticipated economic performance and financial
condition and other similar matters are subject to risks and uncertainties,
including those described in the prior paragraphs, which could cause actual
results to differ materially from those discussed in the forward-looking
statements. Forward-looking statements speak only as of the date of the document
in which they are made. We disclaim any obligation or undertaking to provide any
updates or revisions to any forward-looking statement to reflect any change in
our expectations or any change in events, conditions or circumstances on which
the forward-looking statement is based.
EXECUTIVE OVERVIEW
Summary of Results
Revenues, net of interest expense ("net revenues") for the three months ended
February 28, 2007 increased 13.6% to $2.48 billion from $2.19 billion for the
three months ended February 28, 2006, while pre-tax earnings increased 11.0%
during the same period. Pre-tax profit margins for the 2007 quarter decreased to
33.7% when compared with 34.4% in the 2006 quarter. Annualized return on average
common equity was 18.3% for the quarter ended February 28, 2007 compared with
20.1% in the 2006 quarter.
The increases in net revenues and pre-tax earnings in the first quarter of 2007
reflect increased net revenues in all three segments and all geographic regions.
Capital Markets net revenues increased substantially from the 2006 quarter
driven by strong performances from the institutional equities, structured equity
products, international equity sales and trading and risk arbitrage businesses,
reflecting favorable market conditions. Partially offsetting these results were
reduced net revenues from our New York Stock Exchange ("NYSE") specialist
activities and energy related activities. The prior year quarter included a
significant gain from the monetization of certain energy properties. Fixed
income net revenues increased substantially from the prior year quarter on
record levels from the credit businesses, particularly credit trading and
distressed trading, on tighter spreads and increased activity. In addition,
interest rate derivatives had a strong quarter reflecting higher volatility and
customer volumes. Partially offsetting these increases were decreased mortgage
related net revenues during the quarter. Although volumes were strong during
most of the quarter, mortgage markets became more challenging later in the
quarter as investor concern over the rising delinquency levels in the subprime
mortgage market escalated. Investment banking net revenues increased reflecting
a favorable mergers and acquisitions ("M&A") environment and an active calendar
for equity and high yield underwritings. The investment banking increases were
partially offset by reduced merchant banking revenues.
Global Clearing Services net revenues increased in the 2007 quarter. Net
interest revenues continued to increase but were partially offset by reduced
commission and other revenues. Prime broker margin debt and short balances
reached record levels during the 2007 quarter.
Wealth Management net revenues increased during the 2007 quarter driven by
increases in both Private Client Services ("PCS") and Asset Management net
revenues. PCS revenues increased on improved retail activity, particularly
higher fee-based income on advisory products. Asset Management net revenues
increased on higher performance fees and management fees on both traditional and
alternative assets under management.
From a geographical perspective, net revenues from our international
activities increased by 59.2% to $455 million.
34
Business Environment
Fiscal 2007 Quarter
The business environment during the Company's first quarter ended February 28,
2007 was generally favorable due to a combination of factors including low
unemployment, low corporate interest rates, and strong consumer confidence. The
unemployment rate dropped to 4.5% at the end of February 2007, reflecting a
strong labor market. Additionally, the price of oil decreased from approximately
$63 a barrel at the beginning of the quarter and closed the quarter at
approximately $62 on February 28, 2007. The Federal Reserve Board (the "Fed")
met twice during the 2007 quarter, leaving the federal funds rate unchanged at
5.25%, citing cooling of the housing market and moderate economic expansion.
Each of the major US equity indices increased during the 2007 quarter. The
Standard & Poor's 500 Index ("S&P 500"), the Dow Jones Industrial Average
("DJIA"), and the Nasdaq Composite Index ("NASDAQ") increased 9.9%, 11.6% and
5.9%, respectively, during the 2007 quarter. Average daily trading volume on the
NYSE decreased 7.7% while average daily trading volume on the Nasdaq increased
13.6% in the 2007 quarter, compared to the 2006 quarter. Industry-wide
US-announced M&A volumes increased 196.2% while industry-wide US-completed M&A
volumes increased 22.4% compared to the first quarter of 2006. Total equity
issuance volumes increased 9.2% while initial public offering ("IPO") volumes
increased 27.1% compared to the 2006 quarter.
Fixed income activity remained strong during the 2007 quarter as corporate
credit spreads tightened and trading volumes increased. Long-term interest
rates, as measured by the 10-year Treasury bond, remained relatively stable
during the 2007 quarter. The 10-year Treasury bond yield was 4.57% at the end of
the 2007 quarter, up from 4.46% at the beginning of the quarter. Overall US
mortgage-backed securities new issue volume decreased 11.9% during the 2007
quarter compared with the strong results achieved in the 2006 quarter. Agency
CMO volumes decreased approximately 35.1% industry-wide during the 2007 quarter
from the levels reached in the 2006 quarter, while non-agency mortgage-backed
originations volumes decreased approximately 8.5% industry-wide compared to the
2006 quarter. During February 2007, the ABX subprime mortgage credit indices
widened dramatically, reflecting investor concern due to increased delinquencies
in subprime mortgages. Through quarter end, problems in the subprime market had
not spread to the broader mortgage market.
Fiscal 2006 Quarter
The business environment during the Company's first quarter ended February 28,
2006 was favorable due to a combination of factors including an expanding US
economy, improved corporate profitability and low unemployment. The unemployment
rate dropped to 4.7% in January 2006, its lowest level in 4 1/2 years. Despite
these favorable factors, energy prices continued to be a concern during the 2006
quarter as the price of oil increased from approximately $57 a barrel at the
beginning of the quarter to approximately $68 in January 2006 and closed the
quarter at $61 on February 28, 2006. The Fed met twice during the quarter,
raising the federal funds rate, in 25 basis point increments, from 4.00% to
4.50%.
Each of the major US equity indices increased during the 2006 quarter. The S&P
500, the DJIA, and NASDAQ increased 2.5%, 1.7% and 2.2%, respectively, during
the 2006 quarter. Average daily trading volume on the NYSE increased 9.2% while
average daily trading volume on the Nasdaq decreased 4.9% in the 2006 quarter,
compared to the 2005 quarter. Industry-wide US-announced M&A volumes decreased
15% while industry-wide US-completed M&A volumes increased 89% compared to the
first quarter of 2005. Total equity issuance volumes increased 35% while IPOs
volumes decreased 32% compared to the 2005 quarter.
Fixed income activity was robust during the 2006 quarter despite the increase in
short term interest rates and a flattening yield curve. While the Fed continued
to raise the federal funds rate during the 2006 quarter, long-term interest
rates, as measured by the 10-year Treasury bond, remained relatively stable
during the 2006 quarter. The 10-year Treasury bond yield was 4.56% at the end of
the 2006 quarter, up slightly from 4.50% at the beginning of the quarter. The
housing market experienced declines in refinancing and purchasing levels as
rates for 30-year fixed rate mortgages increased modestly during the 2006
quarter. The Mortgage Bankers Association Purchase Index and Mortgage Bankers
Association Refinance Index decreased approximately 2% and 25%, respectively,
compared to the 2005 quarter. However, overall US mortgage-backed
35
securities new issue volume increased 25% during the 2006 quarter compared with
the strong results achieved in the 2005 quarter. Agency CMO volumes increased
approximately 5% industry-wide during the 2006 quarter from the levels reached
in the 2005 quarter while non-agency mortgage-backed originations volumes
increased approximately 33% industry-wide compared to the 2005 quarter.
RESULTS OF OPERATIONS
Firmwide Results
The following table sets forth an overview of the Company's financial results:
Three Months Ended
(in thousands, except per share ------------------------------------------
amounts, pre-tax profit margin February 28, February 28, %
and return on average common equity) 2007 2006 Increase
------------------------------------------------------------------------------
Revenues, net of interest expense $ 2,481,772 $ 2,185,203 13.6%
Income before provision for income
taxes $ 835,206 $ 752,353 11.0%
Net Income $ 553,741 $ 514,156 7.7%
Diluted earnings per share $ 3.82 $ 3.54 7.9%
Pre-tax profit margin 33.7% 34.4%
Return on average common equity
(annualized) 18.3% 20.1%
===============================================================================
The Company reported net income of $553.7 million, or $3.82 per share (diluted),
for the quarter ended 2007, which represented an increase of 7.7% from $514.2
million, and 7.9% from $3.54 per share (diluted), for the quarter ended 2006.
Net revenues increased 13.6% to $2.48 billion for the quarter ended 2007 from
$2.19 billion for the quarter ended 2006, due to increases in principal
transactions revenues, net interest revenues, asset management and other
revenues and investment banking revenues, partially offset by a decrease in
commission revenues.
The Company's commission revenues by reporting category were as follows:
Three Months Ended
--------------------------------------------
February 28, February 28, % Increase
(in thousands) 2007 2006 (Decrease)
-----------------------------------------------------------------
Institutional $ 192,714 $ 188,440 2.3%
Clearance 53,516 59,196 (9.6%)
Retail 34,415 38,435 (10.5%)
-----------------------------------------------------------------
Total commissions $ 280,645 $ 286,071 (1.9%)
-----------------------------------------------------------------
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
Commission revenues for the 2007 quarter decreased 1.9% to $280.6 million from
$286.1 million for the comparable prior year quarter. Institutional commissions
remained stable, increasing 2.3% to $192.7 million for the 2007 quarter from
$188.4 million for the comparable prior year quarter. Clearance commissions
decreased 9.6% to $53.5 million for the 2007 quarter from $59.2 million for the
comparable prior year quarter, reflecting lower trading volumes from
fully-disclosed clients and lower average rates from prime broker clients.
Retail commissions decreased 10.5% to $34.4 million in the 2007 quarter from
$38.4 million in the comparable prior year quarter primarily due to the transfer
of certain accounts from a commission-based to a fee-based platform.
36
The Company's principal transactions revenues by reporting category were as
follows:
Three Months Ended
-----------------------------------------
February 28, February 28, %
(in thousands) 2007 2006 Increase
-------------------------------------------------------------------------
Fixed income $ 969,974 $ 802,917 20.8%
Equities 372,403 347,515 7.2%
-------------------------------------------------------------------------
Total principal transactions $ 1,342,377 $ 1,150,432 16.7%
=========================================================================
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
Revenues from principal transactions for the 2007 quarter increased 16.7% to
$1.34 billion from $1.15 billion for the 2006 quarter due to increases in both
fixed income and equities revenues. Fixed income revenues increased 20.8% to
$970 million for the 2007 quarter from $802.9 million for the prior year
quarter. Revenues from credit derivatives and distressed trading increased
significantly as corporate credit spreads tightened and customer activity
increased. Interest rate derivatives also increased in the 2007 quarter compared
with the 2006 quarter, primarily attributable to higher interest rate volatility
and increased customer volumes. Despite strong trading volumes during the 2007
quarter, the challenging market conditions in the subprime mortgage sector
resulted in a decrease in mortgage-back securities revenues when compared to the
2006 quarter. Revenues derived from equities activities increased 7.2% to $372.4
million during the 2007 quarter from $347.5 million in the 2006 quarter.
Structured equity products net revenues increased significantly on strong
customer activities and favorable market conditions. In addition, revenues from
international equity sales and trading increased, reflecting continued strength
in both European and Asian equities. Risk arbitrage revenues also rose on higher
levels of global announced M&A volumes. Partially offsetting these increases was
a decrease in revenues from specialist activities and revenues from the
Company's energy and commodity activities.
The Company's investment banking revenues by reporting category were as follows:
Three Months Ended
--------------------------------------------
February 28, February 28, % Increase
(in thousands) 2007 2006 (Decrease)
------------------------------------------------------------------------
Underwriting $ 155,256 131,400 18.2%
Advisory and other fees 161,187 134,992 19.4%
Merchant banking 33,736 71,461 (52.8%)
------------------------------------------------------------------------
Total investment
banking $ 350,179 $ 337,853 3.6%
========================================================================
Investment banking revenues increased 3.6% to $350.2 million for the 2007
quarter from $337.9 million for the 2006 quarter. Underwriting revenues
increased 18.2% to $155.3 million for the 2007 quarter from $131.4 million for
the corresponding prior year quarter. Equity underwriting revenues rose,
reflecting increased volumes of lead and co-managed IPO and follow-on offerings
as a result of improved global equity market conditions and increased market
share. High grade underwriting revenues also increased on higher new issue
volumes. These increases were partially offset by a decrease in high yield
revenues. Advisory and other fees for the 2007 quarter increased 19.4% to $161.2
million from $135.0 million for the prior year quarter, reflecting increased M&A
fees due to an increase in completed M&A assignments as well as an increase in
fee income from mortgage servicing. Merchant banking revenues decreased to $33.7
million in the 2007 quarter from $71.5 million during the 2006 quarter,
reflecting lower gains on the Company's portfolio of investments and lower
performance fees on managed merchant banking funds.
Net interest revenues (interest and dividends revenue less interest expense)
increased 26.0% to $341.2 million for the 2007 quarter from $270.8 million for
the 2006 quarter. The increase in net interest revenues was primarily
attributable to higher average customer margin debt balances and customer short
balances. Average customer margin debt balances increased 26.0% to $81.3 billion
for the 2007 quarter from $64.5 billion for the prior year quarter. Average
customer short balances increased 20.2% to $94.0 billion for the 2007 quarter
from $78.2 billion for the 2006 quarter and average securities borrowed balances
increased 13.2% to $59.9 billion for the 2007 quarter from $52.9 billion for the
2006 quarter.
37
Asset management and other revenues increased 19.5% to $167.3 million for the
2007 quarter from $140.1 million for the 2006 quarter, reflecting growth in
management fees and performance fees on higher levels of traditional and
alternative assets under management as well as improved investment returns on
proprietary investments. Private Client Services net revenues also increased due
to higher levels of fee-based assets.
Non-Interest Expenses
The Company's non-interest expenses were as follows:
Three Months Ended
--------------------------------------------
February 28, February 28, % Increase
(in thousands) 2007 2006 (Decrease)
------------------------------------------------------------------------
Employee compensation and
benefits $ 1,204,094 $ 1,046,850 15.0%
Floor brokerage, exchange
and clearance fees 56,085 51,243 9.4%
Communications and
technology 127,908 104,034 22.9%
Occupancy 56,745 44,627 27.2%
Advertising and market
development 37,073 34,673 6.9%
Professional fees 71,866 53,873 33.4%
Other expenses 92,795 97,550 (4.9%)
------------------------------------------------------------------------
Total non-interest
expenses $ 1,646,566 $ 1,432,850 14.9%
========================================================================
Employee compensation and benefits includes the cost of salaries, benefits and
incentive compensation, including Capital Accumulation Plan ("CAP Plan") units,
restricted stock units and option awards. Employee compensation and benefits
increased 15.0% to $1.20 billion for the 2007 quarter from $1.05 billion for the
2006 quarter, primarily due to higher discretionary compensation associated with
the increase in net revenues and increased headcount. Employee compensation and
benefits as a percentage of net revenues increased to 48.5% for the 2007 quarter
from 47.9% for the 2006 quarter. Full-time employees increased to 14,409 at
February 28, 2007 from 12,061 at February 28, 2006. The growth in headcount is
primarily due to the expansion of the Company's domestic and international
businesses, resulting from increased business activities and growth initiatives
including acquisitions.
Non-compensation expenses increased 14.6% to $442.5 million for the 2007 quarter
from $386.0 million for the 2006 quarter. Non-compensation expenses as a
percentage of net revenues increased slightly to 17.8% for the 2007 quarter
compared with 17.7% for the corresponding prior year quarter. Communications and
technology costs increased 22.9% as increased headcount resulted in higher voice
and market data-related costs. Occupancy costs increased 27.2% reflecting
additional office space requirements and higher leasing costs associated with
the Company's headquarters building at 383 Madison Avenue in New York City.
Professional fees increased 33.4% due to higher levels of employment agency and
consulting fees. CAP Plan related costs increased to $41.5 million for the 2007
quarter from $36.0 million in the comparable prior year quarter, due to a higher
level of earnings. The Company achieved a pre-tax profit margin of 33.7% for the
2007 quarter, down from 34.4% in the 2006 quarter.
The Company's effective tax rate increased to 33.7% for the 2007 quarter from
31.7% for the 2006 quarter.
Business Segments
The remainder of "Results of Operations" is presented on a business segment
basis. The Company's three business segments--Capital Markets, Global Clearing
Services and Wealth Management--are analyzed separately due to the distinct
nature of the products they provide and the clients they serve. Certain Capital
Markets products are distributed by the Wealth Management and Global Clearing
Services distribution networks, with the related revenues of such intersegment
services allocated to the respective segments. See Note 12, "Segment Data" in
the Notes to Condensed Consolidated Financial Statements for complete segment
information.
38
Capital Markets
Three Months Ended
---------------------------------------------
February 28, February 28, %
(in thousands) 2007 2006 Increase
-------------------------------------------------------------------------
Net revenues
Institutional equities $ 512,653 $ 499,893 2.6%
Fixed income 1,149,352 907,138 26.7%
Investment banking 303,109 295,550 2.6%
-------------------------------------------------------------------------
Total net revenues $ 1,965,114 $ 1,702,581 15.4%
Pre-tax income $ 736,311 $ 652,327 12.9%
-------------------------------------------------------------------------
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
The Capital Markets segment comprises the institutional equities, fixed income
and investment banking areas. The Capital Markets segment operates as a single
integrated unit that provides the sales, trading and origination effort for
various fixed income, equity and advisory products and services. Each of the
three businesses work in tandem to deliver these services to institutional and
corporate clients.
Institutional equities consists of sales, trading and research, in areas such as
domestic and international equities, block trading, over-the-counter equities,
equity derivatives, energy and commodity activities, risk and convertible
arbitrage and, through a majority-owned joint venture, specialist activities on
the NYSE, American Stock Exchange ("AMEX") and International Securities Exchange
("ISE"). Fixed income includes sales, trading, origination and research provided
to institutional clients across a variety of products such as mortgage- and
asset-backed securities, corporate and government bonds, municipal bonds, high
yield products, including bank and bridge loans, foreign exchange and interest
rate and credit derivatives. Investment banking provides services in capital
raising, strategic advice, mergers and acquisitions and merchant banking.
Capital raising encompasses the Company's underwriting of equity, investment
grade, municipal and high yield debt products.
Net revenues for Capital Markets increased 15.4% to $1.97 billion for the 2007
quarter compared with $1.70 billion for the 2006 quarter. Pre-tax income for
Capital Markets increased 12.9% to $736.3 million for the 2007 quarter from
$652.3 million for the comparable prior year quarter. Pre-tax profit margin was
37.5% for the 2007 quarter compared with 38.3% for the 2006 quarter.
Institutional equities net revenues for the 2007 quarter increased 2.6% to
$512.7 million from $499.9 million for the comparable prior year quarter.
Structured equity products net revenues achieved record levels due to increased
customer activities and improved market conditions. Net revenues from the
Company's international equity sales and trading area rose, reflecting higher
trading volumes and increased market share. In addition, net revenues from the
risk arbitrage business increased to record levels on higher global announced
M&A volumes. Partially offsetting these increases, was a decrease in revenues
from specialist activities and revenues from the Company's energy and commodity
activities.
Fixed income net revenues increased 26.7% to $1.15 billion for the 2007 quarter
from $907.1 million for the comparable prior year quarter. Net revenues from
credit derivatives and distressed trading reached record levels during the 2007
quarter as corporate credit spreads tightened and customer activity levels
remained robust. Interest rate derivatives also increased in the 2007 quarter
compared with the 2006 quarter, primarily attributable to higher interest rate
volatility and increased customer volumes. Despite strong trading volumes during
the 2007 quarter the challenging market conditions in the subprime mortgage
sector resulted in a decrease in mortgage-backed securities revenues when
compared to the 2006 quarter. While subprime activities have historically
represented only a small portion of the Company's mortgage activities, investor
concerns over the direction of the delinquencies served to temporarily reduce
liquidity in other sectors of the MBS market.
39
Investment banking revenues increased 2.6% to $303.1 million for the 2007
quarter from $295.6 million for the 2006 quarter. Underwriting revenues
increased 26.5% to $172.2 million for the 2007 quarter from $136.1 million for
the corresponding prior year quarter, as equity and high grade underwriting
revenues increased, reflecting increased new issue volumes, partially offset by
a decrease in high yield underwriting. Advisory and other fees for the 2007
quarter increased 10.5% to $97.2 million from $88.0 million for the prior year
quarter reflecting increased M&A fees due to an increase in completed M&A
assignments during the quarter. Merchant banking revenues decreased to $33.7
million in the 2007 quarter from $71.5 million during the 2006 quarter,
reflecting lower gains on the Company's portfolio of investments and lower
performance fees on managed merchant banking funds.
Global Clearing Services
Three Months Ended
---------------------------------------------
February 28, February 28, % Increase
(in thousands) 2007 2006 (Decrease)
-------------------------------------------------------------------------
Net revenues $ 275,558 $ 263,425 4.6%
Pre-tax income $ 112,800 $ 124,859 (9.7%)
-------------------------------------------------------------------------
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to clearing
clients worldwide. Prime brokerage clients include hedge funds and clients of
money managers, short sellers, arbitrageurs and other professional investors.
Fully disclosed clients engage in either the retail or institutional brokerage
business. At February 28, 2007 and 2006, the Company held approximately $298.0
billion and $276.0 billion, respectively, in equity in Global Clearing Services
client accounts.
Net revenues for Global Clearing Services increased 4.6% to $275.6 million for
the 2007 quarter from $263.4 million in the 2006 quarter. Net interest revenues
increased 7.2% to a record $212.2 million for the 2007 quarter from $198.0
million for the prior year quarter, on record levels of prime broker margin debt
and customer short balances. Commissions and other revenues decreased 3.1% to
$63.4 million for the 2007 quarter from $65.4 million for the comparable prior
year quarter reflecting lower trading volumes from fully-disclosed clients and
lower average rates from prime brokers. Pre-tax income decreased 9.7% to $112.8
million, from $124.9 million for the 2006 quarter.
The following table presents the Company's interest-bearing balances for the
fiscal quarters ended:
-------------------------------------------------------------
February 28, February 28,
(in billions) 2007 2006
-------------------------------------------------------------
Margin debt balances,
average for period $ 81.3 $ 64.5
Margin debt balances,
at period end 86.6 64.5
Customer short balances,
average for period 94.0 78.2
Customer short balances,
at period end 95.1 78.1
Securities borrowed,
average for period 59.9 52.9
Securities borrowed,
at period end 59.4 52.4
Free credit balances,
average for period 33.8 29.9
Free credit balances,
at period end 37.1 30.6
Equity held in client accounts 298.0 276.0
-------------------------------------------------------------
40
Wealth Management
Three Months Ended
-----------------------------------------------
February 28, February 28,
(in thousands) 2007 2006 % Increase
----------------------------------------------------------------------------
Private client services
revenues $ 165,589 $ 153,895 7.6%
Revenue transferred to
Capital Markets segment (29,436) (24,284) 21.2%
----------------------------------------------------------------------------
Private client services
net revenues 136,153 129,611 5.0%
Asset management 119,159 95,076 25.3%
----------------------------------------------------------------------------
Total net revenues $ 255,312 $ 224,687 13.6%
Pre-tax income $ 43,753 $ 31,786 37.6%
----------------------------------------------------------------------------
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
The Wealth Management segment is composed of the PCS and asset management areas.
PCS provides high-net-worth individuals with an institutional level of
investment service, including access to the Company's resources and
professionals. At February 28, 2007, PCS has approximately 500 account
executives in its principal office, six regional offices and two international
offices. Asset management manages equity, fixed income and alternative assets
for corporate pension plans, public systems, endowments, foundations,
multi-employer plans, insurance companies, corporations, families and
high-net-worth individuals in the United States and abroad.
Net revenues for Wealth Management increased 13.6% to $255.3 million for the
2007 quarter from $224.7 million for the 2006 quarter. PCS revenues increased
5.0% to $136.2 million for the 2007 quarter from $129.6 million for the 2006
quarter reflecting higher levels of fee-based income. Asset management revenues
increased 25.3% to $119.2 million for the 2007 quarter from $95.1 million for
the 2006 quarter. This increase reflects increased performance fees and growth
in management fees on traditional and alternative assets under management.
Pre-tax income for Wealth Management increased 37.6% to $43.8 million in the
2007 quarter from $31.8 million for the 2006 quarter.
Assets under management were $54.1 billion at February 28, 2007, reflecting a
19.2% increase from $45.4 billion in assets under management at February 28,
2006. The increase in assets under management is due to the growth in
traditional equity assets and hedge funds. Assets under management at February
28, 2007 includes $8.7 billion of assets from alternative investment products,
an increase from $7.0 billion at February 28, 2006.
LIQUIDITY AND CAPITAL RESOURCES
Financial Leverage
Asset Composition
The Company's actual level of capital, capital requirements and thereby the
level of financial leverage, is a function of numerous variables, including
asset composition, rating agency/creditor perception, business prospects,
regulatory requirements, balance sheet liquidity, cost/availability of capital
and risk of loss. The Company consistently maintains a highly liquid balance
sheet, with the vast majority of the Company's assets consisting of cash,
marketable securities inventories and collateralized receivables arising from
customer-related and proprietary securities transactions.
Collateralized receivables consist of resale agreements secured predominantly by
US government and agency securities, customer margin loans and securities
borrowed, which are typically secured by marketable corporate debt and equity
securities. The nature of the Company's business as a securities dealer requires
it to carry significant levels of securities inventories to meet its customer
and proprietary trading needs. Additionally, the Company's role as a financial
intermediary for customer activities, which it conducts on a principal basis,
together with its customer-related activities in its clearance business, results
in significant levels of customer-related balances, including customer margin
debt, securities borrowed and
41
reverse repurchase activity. The Company's total assets and financial leverage
can and do fluctuate, depending largely on economic and market conditions,
volume of activity and customer demand.
The Company's total assets at February 28, 2007 increased to $394.5 billion from
$350.4 billion at November 30, 2006. The increase was primarily attributable to
increases in financial instruments owned, assets of variable interest entities
and mortgage loan special purpose entities, securities borrowed, and customer
receivables partially offset by a decrease in securities purchased under
agreements to resell. The Company's total capital base, which consists of
long-term debt, preferred equity issued by subsidiaries and total stockholders'
equity, increased to $71.8 billion at February 28, 2007 from $66.7 billion at
November 30, 2006. This change was primarily due to a net increase in long-term
debt and an increase in stockholders' equity primarily due to earnings in the
February 2007 quarter as well as income tax benefits attributable to the
distribution of common stock under the Company's deferred compensation plans.
The Company's total capital base as of February 28, 2007 and November 30, 2006
was as follows:
February 28, November 30,
(in millions) 2007 2006
--------------------------------------------------------------
Long-term borrowings:
Senior debt $ 57,232.0 $ 53,307.4
Subordinated debt (1) 1,262.5 1,262.5
--------------------------------------------------------------
Total long-term borrowings $ 58,494.5 $ 54,569.9
Stockholders' equity:
Preferred stockholders' equity $ 359.2 $ 359.2
Common stockholders' equity 12,914.7 11,770.2
--------------------------------------------------------------
Total stockholders' equity $ 13,273.9 $ 12,129.4
--------------------------------------------------------------
Total capital $ 71,768.4 $ 66,699.3
==============================================================
(1) Includes $1.0 billion in subordinated debt issued by the Company and $262.5
million in junior subordinated deferrable interest debentures ("Debentures")
issued by the Company and held by Bear Stearns Capital Trust III ("Capital Trust
III") at February 28, 2007 and November 30, 2006.
The amount of long-term debt as well as total capital that the Company maintains
is driven by a number of factors, with particular focus on asset composition.
The Company's ability to support increases in total assets is a function of its
ability to obtain short-term secured and unsecured funding, as well as its
access to longer-term sources of capital (i.e., long-term debt and equity). The
Company regularly measures and monitors its total capital requirements, which
are primarily a function of the self-funding ability of its assets. The equity
portion of total capital is primarily a function of on- and off-balance-sheet
risks (i.e., market, credit and liquidity) and regulatory capital requirements.
As such, the liquidity and risk characteristics of assets being held are
critical determinants of both total capital and the equity portion thereof, thus
significantly influencing the amount of leverage that the Company can employ.
Given the nature of the Company's market-making and customer-financing activity,
the overall size of the balance sheet fluctuates from time to time. The
Company's total assets at each quarter end are typically lower than would be
observed on an average basis. At the end of each quarter, the Company typically
uses excess cash to finance high-quality, highly liquid securities inventory
that otherwise would be funded via the repurchase agreement market. In addition,
the Company reduces its matched book repurchase and reverse repurchase
activities at quarter end. Finally, the Company may reduce the aggregate level
of inventories through ordinary course, open market activities in the most
liquid portions of the balance sheet, which are principally US government and
agency securities and agency mortgage pass-through securities. At February 28,
2007, total assets of $394.5 billion were approximately 5.6% higher than the
average of the month-end balances observed over the trailing 12-month period,
while total assets at November 30, 2006 were approximately 0.5% higher than the
average of the same time period in the prior year. Despite reduced total assets
at each quarter end, the Company's overall market, credit and liquidity risk
profile does not change materially, since the reduction in asset balances is
predominantly in highly liquid, short-term instruments that are financed on a
secured basis. This periodic reduction verifies the inherently liquid nature of
the balance sheet and provides consistency with respect to creditor
constituents' evaluation of the Company's financial condition.
42
Leverage Ratios
Balance sheet leverage measures are one approach to assessing the capital
adequacy of a securities firm, such as the Company. Gross leverage equals total
assets divided by stockholders' equity, inclusive of preferred and trust
preferred equity. The Company views its trust preferred equity as a component of
its equity capital base given the equity-like characteristics of the securities.
The Company also receives rating agency equity credit for these securities. Net
adjusted leverage equals net adjusted assets divided by tangible equity capital,
which excludes goodwill and intangible assets from both the numerator and the
denominator, as equity used to support goodwill and intangible assets is not
available to support the balance of the Company's net assets. With respect to a
comparative measure of financial risk and capital adequacy, the Company believes
that the low-risk nature of the items excluded in deriving net adjusted assets
(see table) renders net adjusted leverage as the relevant measure.
February 28, November 30,
(in millions, except ratios) 2007 2006
--------------------------------- ------------ ------------
Total assets $ 394,512 $ 350,433
Deduct:
Cash and securities deposited
with clearing organizations
or segregated in compliance
with federal regulations 9,126 8,804
Securities purchased under
agreements to resell 37,248 38,838
Securities received as collateral 21,227 19,648
Securities borrowed 84,015 80,523
Receivables from customers 32,530 29,482
Assets of variable interest entities
and Mortgage loan special purpose
entities, net 39,649 29,080
Goodwill & intangible assets 422 383
------------------------------------------------------------------
Subtotal 170,295 143,675
------------------------------------------------------------------
Add:
Financial instruments sold, but
not yet purchased 42,279 42,256
Deduct:
Derivative financial instruments
sold, but not yet purchased 10,135 11,865
------------------------------------------------------------------
Net adjusted assets $ 202,439 $ 174,066
==================================================================
Stockholders' equity
Common equity $ 12,915 $ 11,770
Preferred stock 359 359
Stock-based compensation -- 816(1)
------------------------------------------------------------------
Total stockholders' equity 13,274 12,945
------------------------------------------------------------------
Add:
Trust preferred equity 263 263
------------------------------------------------------------------
Subtotal - leverage equity 13,537 13,208
------------------------------------------------------------------
Deduct:
Goodwill & intangible assets 422 383
------------------------------------------------------------------
Tangible equity capital $ 13,115 $ 12,825
==================================================================
Gross leverage 29.1x 26.5x
Net adjusted leverage 15.4x 13.6x
------------------------------------------------------------------
(1) Represents stock-based compensation associated with fiscal 2006 awards that
was reflected in equity as of the grant date in December 2006, in accordance
with SFAS No. 123(R), "Share-based Payment." Excluding this adjustment for
stock-based compensation, gross leverage and net adjusted leverage at November
30, 2006 would have been 28.3x and 14.5x, respectively.
43
Funding Strategy & Liquidity Risk Management
General Funding Strategy
Liquidity is extraordinarily important for financial services firms in general
and for securities firms such as the Company in particular, given their reliance
on market confidence. The Company's overall objective and general funding
strategy seeks to ensure liquidity and diversity of funding sources to meet the
Company's financing needs at all times and under all market environments. In
financing its balance sheet, the Company attempts to maximize its use of secured
funding where economically competitive. Short-term sources of cash consist
principally of collateralized borrowings, including repurchase transactions,
sell/buy arrangements, securities lending arrangements and customer free credit
balances. Short-term unsecured funding sources expose the Company to rollover
risk, as providers of credit are not obligated to refinance the instruments at
maturity. For this reason, the Company seeks to prudently manage its reliance on
short-term unsecured borrowings by maintaining an adequate total capital base
and extensive use of secured funding. In addition to this strategy, the Company
places emphasis on diversification by product, geography, maturity and
instrument in order to further ensure prudent, moderate usage of more
credit-sensitive, potentially less stable, funding. Short-term unsecured funding
sources include commercial paper, medium-term notes and bank borrowings, which
generally have maturities ranging from overnight to one year. The Company views
its secured funding as inherently less credit sensitive and therefore a more
stable source of funding due to the collateralized nature of the borrowing.
In addition to short-term funding sources, the Company utilizes equity and
long-term debt, including floating- and fixed-rate notes, as longer-term sources
of unsecured financing. The Company regularly monitors and analyzes the size,
composition and liquidity characteristics of its asset base in the context of
each asset's ability to be used to obtain secured financing. This analysis helps
the Company in determining its aggregate need for longer-term funding sources
(i.e., long-term debt and equity). The Company views long-term debt as a stable
source of funding, which effectively strengthens its overall liquidity profile
and mitigates liquidity risk.
Alternative Funding Strategy
The Company maintains an alternative funding strategy focused on the liquidity
and self-funding ability of the underlying assets. The objective of this
strategy is to maintain sufficient cash capital (i.e., equity plus long-term
debt maturing in more than 12 months) and funding sources to enable the Company
to refinance short-term, unsecured borrowings with fully secured borrowings. As
such, the Company is not reliant upon nor does it contemplate forced balance
sheet reduction to endure a period of constrained funding availability. This
underlying approach is supported by maintenance of a formal contingency funding
plan, which includes a detailed delegation of authority and precise action steps
for managing an event-driven liquidity crisis. The plan identifies the crisis
management team, details an effective internal and external communication
strategy, and facilitates the greater information flow required to effect a
rapid and efficient transition to a secured funding environment.
As it relates to the alternative funding strategy discussed above, the Company
prepares an analysis that focuses on a 12-month time period and assumes that the
Company does not liquidate assets and cannot issue any new unsecured debt,
including commercial paper. Under these assumptions, the Company monitors its
cash position and the borrowing value of unencumbered, unhypothecated financial
instruments in relation to its unsecured debt maturing over the next 12 months,
striving to maintain the ratio of liquidity sources to maturing debt at 110% or
greater. Also within this strategy, the Company seeks to maintain cash capital
in excess of that portion of its assets that cannot be funded on a secured basis
(i.e., positive net cash capital). These two measures, liquidity ratio and net
cash capital, are complementary and constitute the core elements of the
Company's alternative funding strategy and, consequently, its approach to
funding and liquidity risk management.
The borrowing value advance rates used in the Company's liquidity ratio
calculation and the haircuts incorporated in the cash capital model are
symmetrical. These advance rates are considered readily available, even in a
stress environment. In the vast majority of circumstances/asset classes, advance
rates are derived from committed secured bank facilities, whereby a bank or
group of banks are contractually obligated to lend to the Company at a
pre-specified advance rate on specific types of collateral regardless of "market
environment." As such, the advance rates/haircuts in the alternative liquidity
models are
44
typically worse than those the Company realizes in normalized repo and secured
lending markets. The advance rates in the liquidity ratio reflect what can be
reliably realized in a stressed liquidity environment. The haircuts used in the
cash capital model are consistent with the advance rates used in the liquidity
ratio in that the haircut is equal to one minus the advance rate.
As of February 28, 2007, the market value of unencumbered, unhypothecated
financial instruments owned by the Company was approximately $48.3 billion with
a borrowing value of $38.0 billion. The assets are primarily comprised of
mortgage- and asset-backed securities, investment grade municipal and corporate
bonds, US equities and residential and commercial mortgage whole loans. The
average advance rate on these different asset types ranges from 58% to 98% and,
as described above, is based predominantly on committed, secured facilities that
the Company and its subsidiaries maintain in different regions globally. The
liquidity ratio, explained above, based solely on Company-owned securities, has
averaged 125% over the previous 12 months, including the Company's $4.0 billion
unused committed unsecured bank credit, and 119%, excluding the committed
unsecured revolving credit facility. On this same basis, the liquidity ratio as
of February 28, 2007 was 149% and 136%, respectively.
While The Bear Stearns Companies Inc. ("Parent Company") is the primary issuer
of unsecured debt in the marketplace, the collateral referred to in the
preceding paragraph is held in various subsidiaries, both regulated and
unregulated. A subsidiary's legal entity status and the Company's intercompany
funding structure may constrain liquidity available to the Parent Company, as
regulators may prevent the flow of funds and/or securities from a regulated
subsidiary to its parent company or other subsidiaries. In recognition of this
potential for liquidity to be trapped in subsidiaries, the Company maintains a
minimum of $5.0 billion of liquidity immediately accessible by the Parent
Company at all times. This liquidity reserve takes the form of cash deposits and
money market instruments that are held at the Parent Company and high-quality
collateral (corporate bonds, municipal bonds, equity securities) that is owned
by subsidiaries and explicitly pledged to and segregated for the benefit of the
Parent Company and maintained at a third-party custodian. For purposes of
calculating the aggregate value of the liquidity reserve, the contractually
obligated advance rates described herein are used to determine the borrowing
value of collateral pledged. In addition to this immediately available
liquidity, the Company monitors unrestricted liquidity available to the Parent
Company via the ability to monetize unencumbered assets held in unregulated and
regulated entities. As of February 28, 2007, approximately $28.1 billion of the
market value identified in the liquidity ratio data above was held in
unregulated entities and thus likely to be available to the Parent Company,
while an additional $4.0 billion market value had been pledged to the Parent
Company as collateral for inter-company borrowings and was thus readily
available. The remaining $16.2 billion market value of unencumbered securities
was held in regulated entities, a portion of which may not be available to
provide liquidity to the Parent Company.
The cash capital framework is utilized to evaluate the Company's long-term
funding sources and requirements in their entirety. Cash capital required to
support all of the Company's assets is determined on a regular basis. For
purposes of broadly classifying the drivers of cash capital requirements, cash
capital usage can be delineated across two very broad categories as (1) firmwide
haircuts and (2) illiquid assets/long-term investments. More precisely, the
Company holds cash capital to support longer-term funding requirements,
including, but not limited to, the following:
o That portion of financial instruments owned that cannot be funded on
a secured basis (i.e., the haircuts);
o Margin loans and resale principal in excess of the borrowing value
of collateral received;
o Operational cash deposits required to support the regular activities
of the Company (e.g., exchange initial margin);
o Unfunded committed funding obligations, such as corporate loan
commitments;
o Less liquid and illiquid assets, such as goodwill and fixed assets;
o Uncollateralized funded loans and funded loans secured by illiquid
and/or non-rehypothecatable collateral;
o Merchant banking assets and other long-term investments; and
o Regulatory capital in excess of a regulated entity's cash capital
based longer-term funding requirements.
At February 28, 2007, the Company's net cash capital position was $5.4 billion.
Fluctuations in net cash capital are common and are a function of variability in
total assets, balance sheet composition and total capital. The Company attempts
to maintain cash capital sources in excess of the aggregate longer-term funding
requirements of the firm (i.e., positive net cash capital). Over the previous 12
months, the Company's total cash capital requirement, cash capital intensity
ratio (average
45
haircut), and net cash capital position have averaged $57.4 billion, 15.9% and
$1.2 billion, respectively.
In addition to the alternative funding measures above, the Company monitors the
maturity profile of its unsecured debt to minimize refinancing risk, maintains
relationships with a broad global base of debt investors and bank creditors,
establishes and adheres to strict short-term debt investor concentration limits,
and periodically tests its secured and unsecured committed credit facilities. An
important component of the Company's funding and liquidity risk management
efforts involves ongoing dialogues with a large number of creditor constituents.
Strong relationships with a diverse base of creditors and debt investors are
crucial to the Company's liquidity. The Company also maintains available sources
of short-term funding that exceed actual utilization, thus allowing it to endure
changes in investor appetite and credit capacity to hold the Company's debt
obligations.
With respect to the management of refinancing risk, the maturity profile of the
long-term debt portfolio of the Company is monitored on an ongoing basis and
structured within the context of two diversification guidelines. The Company has
a general guideline of no more than 20% of its long-term debt portfolio maturing
in any one year, as well as no more than 10% maturing in any one quarter over
the next five years. The Company continued to meet these guidelines at the end
of the quarter ended February 28, 2007. As of February 28, 2007, the weighted
average maturity of the Company's long-term debt was 4.4 years.
Committed Credit Facilities
The Company has a committed revolving credit facility ("Facility") totaling $4.0
billion, which permits borrowing on a secured basis by the Parent Company, BSSC,
BSIL and certain other subsidiaries. The Facility also allows the Parent
Company, BSIL and Bear Stearns International Trading Limited ("BSIT") to borrow
up to $4.0 billion of the Facility on an unsecured basis. Secured borrowings can
be collateralized by both investment-grade and non-investment-grade financial
instruments as the Facility provides for defined advance rates on a wide range
of financial instruments eligible to be pledged. The Facility contains financial
covenants, the most significant of which require maintenance of specified levels
of stockholders' equity of the Company and net capital of BSSC. The Facility
terminates in February 2008, with all loans outstanding at that date payable no
later than February 2009. There were no borrowings outstanding under the
Facility at February 28, 2007.
The Company has a $1.5 billion committed revolving securities repo facility
("Repo Facility"), which permits borrowings secured by a broad range of
collateral under a repurchase arrangement by the Parent Company, BSIL, BSIT and
BSB. The Repo Facility contains financial covenants that require, among other
things, maintenance of specified levels of stockholders' equity of the Company.
The Repo Facility terminates in August 2007, with all repos outstanding at that
date payable no later than August 2008. There were no borrowings outstanding
under the Repo Facility at February 28, 2007.
The Company has a $350 million committed revolving credit facility ("Pan Asian
Facility"), which permits borrowing on a secured basis by the Parent Company,
BSSC, Bear Stearns Japan Limited ("BSJL"), and BSIL. The Pan Asian Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company and net capital of BSSC.
The Pan Asian Facility terminates in December 2007 with all loans outstanding at
that date payable no later than December 2008. There were no borrowings
outstanding under the Pan Asian Facility at February 28, 2007.
The Company has a $350 million committed revolving credit facility ("Tax Lien
Facility"), which permits borrowing on a secured basis by the Parent Company,
Plymouth Park Tax Services and Madison Tax Capital LLC. The Tax Lien Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company. In March 2007, the
Company renewed the Tax Lien Facility at a $450 million committed level with
substantially the same terms. The Tax Lien Facility terminates in March 2008
with all loans outstanding at that date payable no later than March 2009. There
were no borrowings outstanding under the Tax Lien Facility at February 28, 2007.
The Company also maintains a series of committed credit facilities, which permit
borrowing on a secured basis, to support liquidity needs for the financing of
investment-grade and non-investment-grade corporate loans, residential
mortgages,
46
commercial mortgages, listed options and whole loans. The facilities are
expected to be drawn from time to time and expire at various dates, the longest
of such periods ending in fiscal 2008. All of these facilities contain a
term-out option of one year or more for borrowings outstanding at expiration.
The banks providing these facilities are committed to provide up to an aggregate
of approximately $4.7 billion. At February 28, 2007, the borrowings outstanding
under these committed credit facilities were $435.8 million.
Capital Resources
The Parent Company, operating as the centralized unsecured funding arm of the
Company, raises the vast majority of the Company's unsecured debt, including
both commercial paper and long-term debt. The Parent Company is thus the
"central bank" of the Company, where all capital is held and from which capital
is deployed. The Parent Company advances funds in the form of debt or equity to
subsidiaries to meet their operating funding needs and regulatory capital
requirements. In addition to the primary regulated subsidiaries, the Company
also conducts significant activities through other wholly owned subsidiaries,
including: Bear Stearns Global Lending Limited, Custodial Trust Company, Bear
Stearns Financial Products Inc., Bear Stearns Capital Markets Inc., Bear Stearns
Credit Products Inc., Bear Stearns Forex Inc., EMC Mortgage Corporation and Bear
Stearns Commercial Mortgage, Inc. and through its majority owned subsidiary Bear
Hunter Holdings LLC. In connection with all of the Company's operating
activities, a substantial portion of the Company's long-term borrowings and
equity has been used to fund investments in, and advances to, these
subsidiaries, including subordinated debt advances.
Within this funding framework, the Company attempts to fund equity investments
in subsidiaries with equity from the Parent Company (i.e., utilize no equity
double leverage). At February 28, 2007, the Parent Company's equity investment
in subsidiaries was $8.4 billion versus common stockholders' equity and
preferred equity of $12.9 billion and $359.2 million, respectively. As such, at
February 28, 2007, the ratio of the equity investment in subsidiaries to Parent
Company equity (equity double leverage) was approximately 0.65 based on common
equity and 0.63 including preferred equity. At November 30, 2006, these measures
were 0.67 based on common equity and 0.65 including preferred equity.
Additionally, all subordinated debt advances to regulated subsidiaries for use
as regulatory capital, which totaled $10.5 billion at February 28, 2007, are
funded with long-term debt issued by the Company, having a remaining maturity
equal to or greater than the maturity of the subordinated debt advance. The
Company regularly monitors the nature and significance of assets or activities
conducted in all subsidiaries and attempts to fund such assets with both capital
and/or borrowings having a maturity profile and relative mix consistent with the
nature and self-funding ability of the assets being financed. The funding mix
also takes into account regulatory capital requirements for regulated
subsidiaries.
Long-term debt totaling $52.3 billion and $48.1 billion had remaining maturities
beyond one year at February 28, 2007 and November 30, 2006, respectively. The
Company accesses funding in a variety of markets in the United States, Europe
and Asia. The Company issues debt through syndicated US registered offerings,
US-registered and 144A medium-term note programs, other US and non-US bond and
note offerings and other methods. The Company's access to external sources of
financing, as well as the cost of that financing, is dependent on various
factors and could be adversely affected by a deterioration of the Company's
long- and short-term debt ratings, which are influenced by a number of factors.
These include, but are not limited to: material changes in operating margins;
earnings trends and volatility; the prudence of funding and liquidity management
practices; financial leverage on an absolute basis or relative to peers; the
composition of the balance sheet and/or capital structure; geographic and
business diversification; and the Company's market share and competitive
position in the business segments in which it operates. Material deterioration
in any one or a combination of these factors could result in a downgrade of the
Company's credit ratings, thus increasing the cost of and/or limiting the
availability of unsecured financing. Additionally, a reduction in the Company's
credit ratings could also trigger incremental collateral requirements,
predominantly in the over-the-counter derivatives market. As of February 28,
2007, a downgrade by either Moody's Investors Service or Standard & Poor's in
the Company's long-term credit ratings to the level of A2 or A (i.e., one notch)
would have resulted in the Company being required to post $18.8 million in
additional collateral pursuant to contractual arrangements for outstanding
over-the-counter derivatives contracts. A downgrade to A3 or A- (i.e., two
notches) would have resulted in the Company being required to post an additional
$45.4 million in collateral.
47
At February 28, 2007, the Company's long-term/short-term debt ratings were as
follows:
Long-Term Short-Term
Rating Rating
------------------------------------ --------- ------------
Dominion Bond Rating Service Limited A(high) R-1 (middle)
Fitch Ratings A+ F1+
Japan Credit Rating Agency, Ltd. AA NR
Moody's Investors Service A1 P-1
Rating & Investment
Information, Inc. AA- NR
Standard & Poor's Ratings Services A+ A-1
-----------------------------------------------------------------
NR - does not assign a short-term rating
In October 2006, Standard & Poor's Ratings Services ("S&P") upgraded The Bear
Stearns Companies Inc. long-term rating to A+. In a press release, S&P stated
that the rating change reflects the Company's relatively low profit volatility,
conservative management and cost flexibility, as well as long-term improvements
in its liquidity and risk management. In addition, in June 2006, Japan Credit
Rating Agency, Ltd. assigned a rating of AA with a "Stable" outlook to the
Company, while in August 2006, Rating and Investment Information, Inc. upgraded
the Company to AA- from A+ with a "Stable" outlook.
Stock Repurchase Program
The Company has various employee stock compensation plans designed to increase
the emphasis on stock-based incentive compensation and align the compensation of
its key employees with the long-term interests of stockholders. Such plans
provide for annual grants of stock units and stock options. The Company intends
to offset the potentially dilutive impact of the annual grants by purchasing
common stock throughout the year in open market and private transactions. On
December 13, 2006, the Board of Directors of the Company approved an amendment
to the Stock Repurchase Program ("Repurchase Program") to replenish the previous
authorizations to allow the Company to purchase up to $2.0 billion of common
stock in fiscal 2007 and beyond. During the quarter ended February 28, 2007, the
Company purchased under the current and prior authorizations a total of
2,634,388 shares at a cost of approximately $431.7 million. Approximately $1.58
billion was available to be purchased under the current authorization as of
February 28, 2007. The Company expects to utilize the repurchase authorization
to offset the dilutive impact of annual share awards. The Company may, depending
on price and other factors, repurchase additional shares in excess of that
required for annual share awards.
During the quarter ended February 28, 2007, the Company also purchased a total
of 248,556 shares of its common stock at a total cost of $41.5 million pursuant
to a $200 million CAP Plan Earnings Purchase Authorization, which was approved
by the Compensation Committee of the Board of Directors of the Company on
December 12, 2006.
Cash Flows
Cash and cash equivalents increased $1.30 billion to $5.89 billion at February
28, 2007 from $4.60 billion at November 30, 2006. Cash used in operating
activities was $6.16 billion, primarily attributable to increases in financial
instruments owned, receivables from customers and securities borrowed, net of
securities loaned, partially offset by increases in securities sold under
agreements to repurchase, net of securities purchased under agreements to resell
and payables to customers which occurred in the normal course of business as a
result of changes in customer needs, market conditions and trading strategies.
Cash used in investing activities of $67.3 million reflected purchases of
property, equipment and leasehold improvements. Cash provided by financing
activities of $7.52 billion reflected net proceeds from the issuance of
long-term borrowings of $8.08 billion and net proceeds relating to short-term
borrowings of $3.17 billion, primarily to fund normal operating activities. This
was partially offset by net payments for the retirement/repurchase of long-term
borrowings of $3.55 billion. Treasury stock purchases of $473.2 million were
made to provide for the annual grant of CAP Plan units, restricted stock and
stock options.
48
Cash and cash equivalents decreased $807.7 million to $5.05 billion at February
28, 2006 from $5.86 billion at November 30, 2005. Cash used in operating
activities was $5.01 billion, primarily attributable to increases in securities
borrowed, net of securities loaned and financial instruments owned, partially
offset by an increase in securities sold under agreements to repurchase, net of
securities purchased under agreements to resell which occurred in the normal
course of business as a result of changes in customer needs, market conditions
and trading strategies. Cash used in investing activities of $39.2 million
reflected purchases of property, equipment and leasehold improvements. Cash
provided by financing activities of $4.24 billion reflected net proceeds from
the issuance of long-term borrowings of $4.94 billion and net proceeds relating
to short-term borrowings of $1.56 billion, primarily to fund normal operating
activities. This was partially offset by net payments for the
retirement/repurchase of long-term borrowings of $2.20 billion. Treasury stock
purchases of $476.4 million were made to provide for the annual grant of CAP
Plan units, restricted stock and stock options.
Regulated Subsidiaries
The Company is regulated by the SEC as a consolidated supervised entity ("CSE").
As a CSE, the Company is subject to group-wide supervision and examination by
the SEC and is required to compute allowable capital and allowances for market,
credit and operational risk on a consolidated basis. As of February 28, 2007,
the Company was in compliance with the CSE capital requirements.
As registered broker-dealers and futures commission merchants, Bear Stearns and
BSSC are subject to the net capital requirements of the Exchange Act and Rule
1.17 under the Commodity Futures Trading Commission. Bear Stearns uses Appendix
E of the Net Capital Rule which establishes alternative net capital requirements
for broker-dealers that are part of consolidated supervised entities. Appendix E
allows Bear Stearns to calculate net capital charges for market risk and
derivatives-related credit risk based on mathematical models provided that Bear
Stearns holds tentative net capital in excess of $1 billion and net capital in
excess of $500 million. BSIL and BSIT, the Company's London-based broker-dealer
subsidiaries, are subject to the regulatory capital requirements of the United
Kingdom's Financial Services Authority. Additionally, BSB is subject to the
regulatory capital requirements of the Financial Regulator. Custodial Trust
Company ("CTC"), a Federal Deposit Insurance Corporation ("FDIC") insured New
Jersey state chartered bank, is subject to the regulatory capital requirements
of the FDIC. At February 28, 2007, Bear Stearns, BSSC, BSIL, BSIT, BSB and CTC
were in compliance with their respective regulatory capital requirements.
Certain other subsidiaries are subject to various securities regulations and
capital adequacy requirements promulgated by the regulatory and exchange
authorities of the countries in which they operate. At February 28, 2007, these
other subsidiaries were in compliance with their applicable local capital
adequacy requirements.
The Company's broker-dealer subsidiaries and other regulated subsidiaries are
subject to minimum capital requirements and may also be subject to certain
restrictions on the payment of dividends, which could limit the Company's
ability to withdraw capital from such regulated subsidiaries, which in turn
could limit the Company's ability to pay dividends. See Note 9, "Regulatory
Requirements," in the Notes to Condensed Consolidated Financial Statements.
Merchant Banking and Private Equity Investments
In connection with the Company's merchant banking activities, the Company had
investments in merchant banking and private equity-related investment funds as
well as direct investments in private equity-related investments. At February
28, 2007, the Company held investments with an aggregate recorded fair value of
approximately $1.08 billion, reflected in the Condensed Consolidated Statements
of Financial Condition in "Other assets." At November 30, 2006, the Company held
investments with an aggregate recorded value of approximately $822.4 million. In
addition to these various direct and indirect principal investments, the Company
has made commitments to invest in private equity-related investments and
partnerships (see the summary table under "Commitments").
High Yield Positions
As part of its fixed income activities, the Company participates in the
underwriting and trading of non-investment-grade corporate debt securities and
also invests in, syndicates and trades in loans to highly leveraged, below
investment grade rated
49
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
companies (collectively, "high yield positions"). Non-investment-grade debt
securities have been defined as non-investment-grade corporate debt and emerging
market debt rated BB+ or lower, or equivalent ratings recognized by credit
rating agencies. At February 28, 2007 and November 30, 2006, the Company held
high yield positions approximating $9.96 billion and $10.73 billion,
respectively, substantially all of which are in "Financial instruments owned" in
the Condensed Consolidated Statements of Financial Condition, and $719.9 million
and $605.4 million, respectively, reflected in "Financial instruments sold, but
not yet purchased" in the Condensed Consolidated Statements of Financial
Condition. Included in the high yield positions are extensions of credit to
highly leveraged companies. At February 28, 2007 and November 30, 2006, the
amount outstanding to highly leveraged borrowers totaled $6.60 billion and $7.70
billion, respectively. The largest industry concentration was the
telecommunications industry, which approximated 15.6% and 22.8% of these highly
leveraged borrowers' positions at February 28, 2007 and November 30, 2006,
respectively. Additionally, the Company has lending commitments with highly
leveraged borrowers (see the summary table under "Commitments").
The Company's Risk Management Department and senior trading managers monitor
exposure to market and credit risk for high yield positions and establish limits
and concentrations of risk by individual issuer. High yield positions generally
involve greater risk than investment grade debt securities due to credit
considerations, liquidity of secondary trading markets and increased
vulnerability to changes in general economic conditions. The level of the
Company's high yield positions, and the impact of such activities on the
Company's results of operations, can fluctuate from period to period as a result
of customer demand, economic conditions and market considerations.
Contractual Obligations
-----------------------
In connection with its operating activities, the Company enters into contractual
obligations that require future cash payments. At February 28, 2007, the
Company's contractual obligations by maturity, excluding derivative financial
instruments, were as follows:
Payments Due By Period
----------------------------------------------------------
(in millions) Remaining Fiscal Fiscal
Fiscal 2007 2008- 2009 2010- 2011 Thereafter Total
-----------------------------------------------------------------------------------------------------------------
Long-term borrowings (1) (2) $ 4,050 $ 20,246 $ 14,357 $ 19,841 $ 58,494
Future minimum lease payments (3) (4) 79 211 209 600 1,099
-----------------------------------------------------------------------------------------------------------------
(1) Amounts include hybrid debt issuances accounted for at fair value as
elected under SFAS No. 155 and fair value adjustments in accordance with
SFAS No. 133 as well as $262.5 million of junior subordinated deferrable
interest debentures ("Debentures"). The Debentures will mature on May 15,
2031; however, the Company, at its option, may redeem the Debentures
beginning May 15, 2006. The Debentures are reflected in the table at their
contractual maturity dates.
(2) Included in fiscal 2008-2009 are approximately $1.83 billion of
floating-rate notes that are redeemable prior to maturity at the option of
the noteholder. These notes contain certain provisions that effectively
enable noteholders to put these notes back to the Company and, therefore,
are reflected in the table at the date such notes first become redeemable.
The final maturity dates of these notes are during fiscal 2010-2011.
(3) Includes 383 Madison Avenue Headquarters in New York City.
(4) See Note 10, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
50
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Commitments
-----------
The Company has commitments(1) under a variety of commercial arrangements. At
February 28, 2007 the Company's commitments associated with lending and
financing, private equity-related investments and partnerships, outstanding
letters of credit, underwriting and other commercial commitments summarized by
period of expiration were as follows:
Amount of Commitment Expiration Per Period
---------------------------------------------------------------------------------
Commitments
Remaining Fiscal Fiscal With no stated
(in millions) Fiscal 2007 2008- 2009 2010- 2011 Thereafter maturity Total
-------------------------------------------------------------------------------------------------------------------------
Lending-related commitments:
Investment-grade (2) $ 896 $ 634 $ 1,437 $ 265 $ - 3,232
Non-investment-grade(2) 281 305 945 606 - 2,137
Contingent commitments 5,467 1,004 - - - 6,471
Commitments to invest in private
equity-related investments
and partnerships (3) - - - - 1,440 1,440
Underwriting commitments 531 - - - - 531
Commercial and residential loans 4,988 503 42 102 - 5,635
Letters of credit 3,917 - 34 - - 3,951
Other commercial commitments 74 105 17 - - 196
-------------------------------------------------------------------------------------------------------------------------
(1) See Note 10, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
(2) In order to mitigate the exposure to investment-grade and
non-investment-grade borrowings, the Company entered into credit default
swaps approximating $764.5 million and $102.8 million, respectively, in
notional value, at February 28, 2007.
(3) These commitments will be funded, if called, through the end of the
respective investment periods, the longest of such periods ending in 2017.
OFF-BALANCE-SHEET ARRANGEMENTS
In the normal course of business, the Company enters into arrangements with
special purpose entities ("SPEs"), also known as variable interest entities
("VIEs"). SPEs are corporations, trusts or partnerships that are established for
a limited purpose. SPEs, by their nature, are generally not controlled by their
equity owners, as the establishing documents govern all material decisions. The
Company's primary involvement with SPEs relates to securitization transactions
in which transferred assets, including commercial and residential mortgages,
consumer receivables, securities and other financial assets are sold to an SPE
and repackaged into securities or similar beneficial interests. SPEs may also be
used to create securities with a unique risk profile desired by investors and as
a means of intermediating financial risk. The Company, in the normal course of
business, may establish SPEs, sell assets to SPEs, underwrite, distribute and
make a market in securities or other beneficial interests issued by SPEs,
transact derivatives with SPEs, own securities or other beneficial interests,
including residuals, in SPEs, and provide liquidity or other guarantees for
SPEs.
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities-a Replacement of FASB
Statement No. 125," to account for securitizations and other transfers of
financial assets. In accordance with SFAS No. 140, the Company accounts for
transfers of financial assets as sales provided that control has been
relinquished. Control is deemed to be relinquished only when all of the
following conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee is a
Qualifying Special Purpose Entity ("QSPE") or has the right to pledge or
exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. Therefore, the Company
derecognizes financial assets transferred in securitizations, provided that such
transfer meets all of these criteria. See Note 4, "Transfers of Financial Assets
and Liabilities," in the Notes to Condensed Consolidated Financial Statements
for a more complete discussion of the Company's securitization activities.
51
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company regularly creates or transacts with entities that may be VIEs. These
entities are an essential part of its securitization, asset management and
structured finance businesses. In addition, the Company purchases and sells
instruments that may be variable interests. The Company adopted FIN No. 46 (R)
for its variable interests in fiscal 2004. The Company consolidates those VIEs
in which the Company is the primary beneficiary. See Note 5, "Variable Interest
Entities and Mortgage Loan Special Purpose Entities," in the Notes to Condensed
Consolidated Financial Statements for a complete discussion of the consolidation
of VIEs.
The majority of the SPEs that the Company sponsors or transacts with are QSPEs,
which the Company does not consolidate in accordance with this guidance. QSPEs
are entities that have little or no discretionary activities and may only
passively hold assets and distribute cash generated by the assets they hold. The
Company reflects the fair value of its interests in QSPEs on its balance sheet
but does not recognize the assets or liabilities of QSPEs. QSPEs are employed
extensively in the Company's mortgage and asset securitization business.
Certain other SPEs do not meet the requirements of a QSPE, because their
activities are not sufficiently limited or they have entered into certain
non-qualifying transactions. The Company follows the criteria in FIN No. 46 (R)
in determining whether it should consolidate such entities. These SPEs are
commonly employed in collateralized debt obligation transactions where portfolio
managers require the ability to buy and sell assets or in synthetic credit
transactions.
In addition to the above, in the ordinary course of business the Company issues
various guarantees to counterparties in connection with certain derivatives,
leasing, securitization and other transactions. See Note 11, "Guarantees," in
the Notes to Condensed Consolidated Financial Statements for a complete
discussion on guarantees.
DERIVATIVE FINANCIAL INSTRUMENTS
Derivative financial instruments are contractual commitments between
counterparties that derive their values from changes in an underlying interest
rate, currency exchange rate, index (e.g., S&P 500), reference rate (e.g.,
LIBOR), or asset value referenced in the related contract. Some derivatives,
such as futures contracts, certain options and index-referenced warrants, can be
traded on an exchange. Other derivatives, such as interest rate and currency
swaps, caps, floors, collars, swaptions, equity swaps and options, structured
notes and forward contracts, are negotiated in the over-the-counter markets.
Derivatives generate both on- and off-balance-sheet risks depending on the
nature of the contract. The Company is engaged as a dealer in over-the-counter
derivatives and, accordingly, enters into transactions involving derivative
instruments as part of its customer-related and proprietary trading activities.
The Company's dealer activities require it to make markets and trade a variety
of derivative instruments. In connection with these activities, the Company
attempts to mitigate its exposure to market risk by entering into hedging
transactions that may include over-the-counter derivative contracts or the
purchase or sale of interest-bearing securities, equity securities, financial
futures and forward contracts. The Company also utilizes derivative instruments
to hedge proprietary market-making and trading activities. In this regard, the
utilization of derivative instruments is designed to reduce or mitigate market
risks associated with holding dealer inventories or in connection with
arbitrage-related trading activities. The Company also utilizes interest rate
and currency swaps, futures contracts and US Treasury positions to hedge certain
debt issuances as part of its asset and liability management.
To measure derivative activity, notional or contract amounts are frequently
used. Notional/contract amounts are used to calculate contractual cash flows to
be exchanged and are generally not actually paid or received, with the exception
of currency swaps, foreign exchange forwards and mortgage-backed securities
forwards. The notional/contract amounts of financial instruments that give rise
to off-balance-sheet market risk are indicative only to the extent of
involvement in the particular class of financial instruments and are not
necessarily an indication of overall market risk.
As of February 28, 2007 and November 30, 2006, the Company had notional/contract
amounts of approximately $8.63 trillion and $8.74 trillion, respectively, of
derivative financial instruments, of which $1.34 trillion and $1.25 trillion,
respectively, were listed futures and option contracts. The aggregate
notional/contract value of derivative contracts is a
52
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
reflection of the level of activity and does not represent the amounts that are
recorded in the Condensed Consolidated Statements of Financial Condition. The
Company's derivative financial instruments outstanding, which either are used to
hedge trading positions, modify the interest rate characteristics of its long-
and short-term debt, or are part of its derivative dealer activities, are marked
to fair value.
The Company's derivatives had a notional weighted average maturity of
approximately 4.4 years and 4.1 years at February 28, 2007 and November 30,
2006, respectively. The maturities of notional/contract amounts outstanding for
derivative financial instruments as of February 28, 2007 were as follows:
Less Than One to Three to Greater Than
(in billions) One Year Three Years Five Years Five Years Total
-------------------------------------------------------------------------------------------------------------------
Swap agreements, including options, $ 1,561.2 $ 1,628.3 $ 1,674.5 $ 2,188.1 $ 7,052.1
swaptions, caps, collars and floors
Futures contracts 489.1 389.5 37.9 0.1 916.6
Forward contracts 170.9 - - - 170.9
Options held 252.6 20.2 1.7 0.5 275.0
Options written 194.8 14.4 1.8 0.6 211.6
-------------------------------------------------------------------------------------------------------------------
Total $ 2,668.6 $ 2,052.4 $ 1,715.9 $ 2,189.3 $ 8,626.2
===================================================================================================================
Percent of total 30.9% 23.8% 19.9% 25.4% 100.0%
===================================================================================================================
CRITICAL ACCOUNTING POLICIES
The Condensed Consolidated Financial Statements of the Company are prepared in
conformity with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions that could materially affect reported amounts in the financial
statements (see Note 1, "Summary of Significant Accounting Policies," in the
Notes to Condensed Consolidated Financial Statements). Critical accounting
policies are those policies that are the most important to the financial
statements and/or those that require significant management judgment related to
matters that are uncertain.
Valuation of Financial Instruments
The Company has identified the valuation of financial instruments as a critical
accounting policy due to the complex nature of certain of its products, the
degree of judgment required to appropriately value these products and the
pervasive impact of such valuation on the financial condition and earnings of
the Company.
The Company has adopted SFAS No. 157, "Fair Value Measurements," in the first
quarter of 2007. SFAS No. 157 applies to all financial instruments that are
being measured and reported on a fair value basis. This includes those items
reported in "Financial instruments owned" and "Financial instruments sold, but
not yet purchased" as well as other assets and liabilities that are reported at
fair value.
As defined in SFAS No. 157, fair value is the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date. In determining fair value the
Company uses various methods including market, income and cost approaches. Based
on these approaches, the Company often utilizes certain assumptions that market
participants would use in pricing the asset or liability, including assumptions
about risk and or the risks inherent in the inputs to the valuation technique.
These inputs can be readily observable, market corroborated, or generally
unobservable firm inputs. The Company utilizes valuation techniques that
maximize the use of observable inputs and minimize the use of unobservable
inputs. Based on the observability of the inputs used in the valuation
techniques the Company is required to provide the following information
according to the fair value hierarchy. The fair value hierarchy ranks the
quality and reliability of the information used to determine fair values.
Financial assets and liabilities carried at fair value will be classified and
disclosed in one of the following three categories:
53
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Level 1: Inputs based on quoted market prices for identical assets or
liabilities in active markets.
Level 2: Observable market based inputs or unobservable inputs that are
corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
(1) Financial Instruments Valued Based on Inputs That Are Quoted Market Prices
for Identical Assets or Liabilities in Active Markets
The Company's valuation policy is to use quoted market prices from securities
and derivatives exchanges where they are available and reliable. Financial
instruments valued based on quoted market prices are primarily exchange-traded
derivatives and listed equities. Financial instruments that are most typically
valued using alternative approaches but for which the Company typically receives
independent external valuation information include US Treasuries, other US
Government and agency securities, as well as certain corporate debt securities.
(2) Financial Instruments Whose Inputs are Observable Market Based or
Unobservable Inputs that are Corroborated By Market Data
The second broad category consists of financial instruments for which the
Company does not receive quoted prices; therefore, models or other methodologies
are utilized to value these financial instruments. Such models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates, loss
severity, current market and contractual prices for the underlying financial
instruments,as well as other relevant economic measures. Substantially all these
assumptions are observable in the marketplace, can be derived from observable
data or are supported by observable levels at which transactions are executed in
the marketplace. A degree of subjectivity is required to determine appropriate
models or methodologies as well as appropriate underlying assumptions. This
subjectivity makes these valuations inherently less reliable than quoted market
prices. Financial instruments in this category include non-exchange-traded
derivatives such as interest rate swaps, certain mortgage-backed securities and
certain other cash instruments. For an indication of the Company's involvement
in derivatives, including maturity terms, see the table setting forth
notional/contract amounts outstanding in the preceding "Derivative Financial
Instruments" section.
(3) Financial Instruments Whose Inputs Used to Determine the Fair Value Is
Estimated Based on Internally Developed Models or Methodologies Utilizing
Significant Assumptions or Other Data That Are Generally Less Readily Observable
from Objective Sources
Certain complex financial instruments and other investments have significant
data inputs that cannot be validated by reference to readily observable data.
These instruments are typically illiquid, long dated or unique in nature and
therefore engender considerable judgment by traders and their management who, as
dealers in many of these instruments, have the appropriate knowledge to estimate
data inputs that are less readily observable. For certain instruments,
extrapolation or other methods are applied to observed market or other data to
estimate assumptions that are not observable.
The Company participates in the underwriting, securitization or trading of
non-performing mortgage-related assets, real estate assets and certain
residuals. In addition, the Company has a portfolio of Chapter 13 and other
credit card receivables from individuals. Certain of these high yield positions
have limited price observability. In these instances, fair values are determined
by statistical analysis of historical cash flows, default probabilities,
recovery rates, time value of money and discount rates considered appropriate
given the level of risk in the instrument and associated investor yield
requirements.
The Company is also engaged in structuring and acting as principal in complex
derivative transactions. Complex derivatives include certain long-dated equity
derivatives, certain credit and municipal derivatives and other exotic
derivative structures. These non-exchange-traded instruments may have immature
or limited markets and, by their nature, involve complex valuation methodologies
and models, which are often refined to correlate with the market risk of these
instruments.
See Note 2 of Notes to Condensed Consolidated Financial Statements for a
description of the financial assets and liabilities carried at fair value.
54
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Controls Over Valuation of Financial Instruments
In recognition of the importance the Company places on the accuracy of its
valuation of financial instruments as described in the three categories above,
the Company engages in an ongoing internal review of its valuations. Members of
the Controllers and Risk Management Departments perform analysis of internal
valuations, typically on a monthly basis but often on an intra-month basis as
well. These departments are independent of the trading areas responsible for
valuing the positions. Results of the monthly validation process are reported to
the Mark-to-Market Committee ("MTMC"), which is composed of senior management
from the Risk Management and Controllers Departments. The MTMC is responsible
for ensuring that the approaches used to independently validate the Company's
valuations are robust, comprehensive and effective. Typical approaches include
valuation comparisons with external sources, comparisons with observed trading,
independent comparisons of key model valuation inputs, independent trade
modeling and a variety of other techniques.
Merchant Banking
As part of its merchant banking activities, the Company participates from time
to time in principal investments in leveraged transactions. As part of these
activities, the Company originates, structures and invests in merger,
acquisition, restructuring and leveraged capital transactions, including
leveraged buyouts. The Company's principal investments in these transactions are
generally made in the form of equity investments, equity-related investments or
subordinated loans and have not historically required significant levels of
capital investment.
Equity interests and securities acquired as a result of leveraged acquisition
transactions are reflected in the condensed consolidated financial statements at
their initial cost until significant transactions or developments indicate that
a change in the carrying value of the securities is appropriate. This represents
the Company's best estimate of exit price as defined by SFAS No. 157. Generally,
the carrying values of these securities will be increased based on company
performance and in those instances where market values are readily ascertainable
by reference to substantial transactions occurring in the marketplace or quoted
market prices. Reductions to the carrying value of these securities are made in
the event that the Company's estimate of net realizable value has declined below
the carrying value. See "Merchant Banking and Private Equity Investments" in
Management's Discussion and Analysis for additional details.
Legal, Regulatory and Tax Contingencies
In the normal course of business, the Company has been named as a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental and self-regulatory agencies regarding the Company's
business, certain of which may result in adverse judgments, settlements, fines,
penalties, injunctions or other relief.
Reserves for litigation and regulatory proceedings are generally determined on a
case-by-case basis and represent an estimate of probable losses after
considering, among other factors, the progress of each case, prior experience,
and the experience of others in similar cases, and the opinions and views of
internal and external legal counsel. Because litigation is inherently
unpredictable, particularly in cases where claimants seek substantial or
indeterminate damages or where investigations and proceedings are in the early
stages, the Company cannot predict with certainty the loss or range of loss
related to such matters, the ultimate resolution, the timing of resolution or
the amount of eventual settlement, fine, penalty or relief, if any.
The Company is subject to the income tax laws of the United States, its states
and municipalities and those of the foreign jurisdictions in which the Company
has significant business operations. These tax laws are complex and subject to
different interpretations by the taxpayer and the relevant governmental taxing
authorities. The Company must make judgments and interpretations about the
application of these inherently complex tax laws when determining the provision
for income taxes and must also make estimates about when in the future certain
items affect taxable income in the various tax jurisdictions. Disputes over
interpretations of the tax laws may be settled with the taxing authority upon
examination or audit. The Company regularly evaluates the likelihood of
assessments in each of the taxing jurisdictions resulting from current and
subsequent years' examinations and tax reserves are established as appropriate.
55
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company establishes reserves for potential losses that may arise out of
litigation, regulatory proceedings and tax audits to the extent that such losses
are probable and can be estimated, in accordance with SFAS No. 5, "Accounting
for Contingencies." Once established, reserves are adjusted as additional
information becomes available or when an event requiring a change to the
reserves occurs. Significant judgment is required in making these estimates and
the ultimate resolution may differ materially from the amounts reserved.
ACCOUNTING AND REPORTING DEVELOPMENTS
During the 2007 quarter, the Company adopted SFAS No. 155, "Accounting for
Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and
140," SFAS No. 156, "Accounting for Servicing of Financial Assets-an amendment
of FASB Statement No. 140," and SFAS No. 157, "Fair Value Measurements." As a
result of the adoption of these standards, the Company recorded a cumulative
effect adjustment to increase the opening retained earnings balance by
approximately $3.5 million (after tax).
In July 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty
in Income Taxes-an interpretation of FASB Statement No. 109" ("FIN No. 48"). FIN
No. 48 clarifies the accounting for uncertainty in income taxes recognized in an
enterprise's financial statements in accordance with SFAS No. 109. FIN No. 48
prescribes a recognition threshold and measurement attribute for the financial
statement recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. The Company expects to adopt the provisions of FIN
No. 48 beginning in the first quarter of 2008. The Company is currently
evaluating the impact, if any, the adoption of FIN No. 48 may have on the
Condensed Consolidated Financial Statements of the Company.
In February 2007, the FASB issued Statement No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities." SFAS 159 permits entities to choose
to measure financial assets and liabilities (except for those that are
specifically scoped out of the Statement) at fair value. The election to measure
a financial asset or liability at fair value can be made on an
instrument-by-instrument basis and is irrevocable. The difference between
carrying value and fair value at the election date is recorded as a transition
adjustment to opening retained earnings. Subsequent changes in fair value are
recognized in earnings. The effective date for this Statement is as of the
beginning of an entity's first fiscal year that begins after November 15, 2007.
The Company will adopt SFAS No. 159, effective December 1, 2007. The Company
does not expect the adoption of SFAS No. 159 to have a material impact on the
Condensed Consolidated Financial Statements of the Company.
EFFECTS OF INFLATION
The Company's assets are primarily recorded at their current market value and,
to a large extent, are liquid in nature. The rate of inflation affects the
Company's expenses, such as employee compensation, office leasing costs,
information technology and communications charges, which may not be readily
recoverable in the price of services offered by the Company. In addition, to the
extent that inflation causes interest rates to rise and has other adverse
effects on the securities markets and on the value of securities held in
inventory, it may adversely affect the Company's financial position and results
of operations.
For a description of the Company's risk management policies, including a
discussion of the Company's primary market risk exposures, which include
interest rate risk, foreign exchange rate risk, equity price risk and commodity
price risk, as well as a discussion of the Company's credit risk and a
discussion of how those exposures are managed, refer to the Company's Annual
Report on Form 10-K for the fiscal year ended November 30, 2006.
56
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Value-at-Risk
An estimation of potential losses that could arise from changes in market
conditions is typically accomplished through the use of statistical models known
as value-at-risk ("VaR") that seek to predict risk of loss based on historical
and/or market-implied price and volatility patterns. VaR estimates the
probability of the value of a financial instrument rising above or falling below
a specified amount. The calculation uses the simulated changes in value of the
market risk-sensitive financial instruments to estimate the amount of change in
the current value that could occur at a specified probability level.
The Company has performed an entity-wide VaR analysis of the Company's financial
assets and liabilities, including financial instruments owned and sold,
repurchase and resale agreements and funding assets and liabilities. The Company
regularly evaluates and enhances such VaR models in an effort to more accurately
measure risk of loss. Certain equity-method investments and non-publicly traded
investments are not reflected in the VaR results. The VaR related to certain
non-trading financial instruments has been included in this analysis and is not
reported separately because the amounts are not material. The calculation is
based on a methodology that uses a one-day interval and a 95% confidence level.
The Company uses a historical simulation approach for VaR, which is supplemented
by statistical risk add-ons for risk factors that do not lend themselves readily
to historical simulation. Historical simulation involves the generation of price
movements in a portfolio using price sensitivities, and actual historical
movements of the underlying risk factors to which the securities are sensitive.
Risk factors incorporated via historical simulation include interest rate
movements, yield curve shape, general market credit spreads, equity price
movement, option volatility movement (for certain option types) and foreign
exchange movement, among others. Risk factors incorporated via add-on factors
include the risk of specific bond issuers, among others. The Company believes
that its VaR methodologies are consistent with industry practices for these
calculations.
VaR has inherent limitations, including reliance on historical data, which may
not accurately predict future market risk, and the quantitative risk information
generated is limited by the parameters established in creating the models. There
can be no assurance that actual losses occurring on any one day arising from
changes in market conditions will not exceed the VaR amounts shown below or that
such losses will not occur more than once in 20 trading days. VaR is not likely
to accurately predict exposures in markets that exhibit sudden fundamental
changes or shifts in market conditions or established trading relationships.
Many of the Company's hedging strategies are structured around likely
established trading relationships and, consequently, those hedges may not be
effective and VaR models may not accurately predict actual results. Furthermore,
VaR calculated for a one-day horizon does not fully capture the market risk of
positions that cannot be liquidated in a one-day period. However, the Company
believes VaR models are an established methodology for the quantification of
risk in the financial services industry despite these limitations. VaR is best
used in conjunction with other financial disclosures in order to assess the
Company's risk profile.
The aggregate VaR presented here is less than the sum of the individual
components (i.e., interest rate risk, foreign exchange rate risk, equity risk,
and commodity risk), due to the benefit of diversification among the risks.
Diversification benefit equals the difference between aggregate VaR and the sum
of the VaRs for the four risk categories. This benefit arises because the
simulated one-day losses for each of the three primary market risk categories
occur on different days and because of general diversification benefits
introduced when risk is measured across a larger set of specific risk factors
than exist in the respective categories; similar diversification benefits also
are taken into account across risk factors within each category. The following
table illustrates the VaR for each component of market risk as of February 28,
2007, November 30, 2006, August 31, 2006 and May 31, 2006.
57
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
February 28, November 30, August 31, May 31,
(in millions) 2007 2006 2006 2006
----------------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 27.6 $ 30.6 $ 37.7 $ 32.5
Currency 1.3 0.8 1.4 1.0
Equity 6.9 3.0 3.9 5.4
Commodity/Energy 1.0 0.0 0.0 0.0
Diversification benefit (8.9) (5.7) (9.1) (8.1)
----------------------------------------------------------------------------------------
Aggregate VaR $ 27.9 $ 28.7 $ 33.9 $ 30.8
========================================================================================
The table below illustrates the high, low and average VaR for each component of
market risk and aggregate market risk during the quarters ended February 28,
2007 and November 30, 2006:
Quarter Ended February 28, 2007 Quarter Ended November 30, 2006
------------------------------------------------------------------------------------------------------------
(in millions) High Low Average High Low Average
------------------------------------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 35.9 $ 22.8 $ 27.7 $ 41.3 $ 22.9 $ 30.8
Currency 2.7 0.0 0.9 3.2 0.3 1.2
Equity 12.2 1.6 6.4 11.3 1.3 3.0
Commodity/Energy 1.8 0.1 1.0 0.6 0.0 0.2
Aggregate VaR 31.6 22.8 27.2 35.4 21.5 27.5
------------------------------------------------------------------------------------------------------------
Aggregate average VaR decreased slightly to $27.2 million for the 2007 quarter
from $27.5 for the quarter ended November 30, 2006. The decrease was primarily
due to lower levels of exposure to interest rates, offset by higher levels of
exposure to equity price risks.
The Company utilizes a wide variety of market risk management methods, including
trading limits; marking all positions to market on a daily basis; daily profit
and loss statements; position reports; daily risk highlight reports; aged
inventory position reports; and independent verification of inventory pricing.
Additionally, management of each trading department reports positions, profits
and losses and notable trading strategies to the Risk Committee on a weekly
basis. The Company believes that these procedures, which stress timely
communication between traders, trading department management and senior
management, are the most important elements of the risk management process.
Stress testing (also referred to as scenario analysis) measures the risk of loss
over a variety of extreme market conditions that are defined in advance. Stress
testing is a key methodology used in the management of market risk as well as
counterparty credit risk (see "Credit Risk"). Stress tests are calculated at the
firmwide level for particular trading books, customer accounts and individual
positions. Stress tests are performed on a regular basis as well as on an ad hoc
basis, as deemed appropriate. The ongoing evaluation process of trading risks as
well as the consideration of new trading positions commonly incorporates an ad
hoc discussion of "what-if" stressed market conditions and their impact on
profitability. This analysis varies in its degree of formality based on the
judgment of trading department management, risk management and senior managers.
While the Company recognizes that no methodology can perfectly predict future
market conditions, it believes that these tools are an important supplement to
the Company's risk management process. The Company expects to continue to
develop and refine its formal stress testing methodologies.
58
The following chart represents a summary of the daily principal transactions
revenues and reflects a combination of trading revenues, net interest revenues
for certain trading areas and other revenues for the quarters ended February 28,
2007 and 2006. The chart represents a historical summary of the results
generated by the Company's trading activities as opposed to the probability
approach used by the VaR model. The average daily trading profit was $22.4
million and $19.2 million for the quarters ended February 28, 2007 and 2006,
respectively. There were 4 daily trading losses for the quarter ended February
28, 2007, one of which was slightly greater than the reported average VaR for
the quarter, and 3 daily trading losses for the quarter ended February 28, 2006.
None of the daily trading losses in the 2006 quarter exceeded the reported
average VaR amounts. The frequency distribution of the Company's daily net
trading revenues reflects the Company's historical ability to manage its
exposure to market risk and the diversified nature of its trading activities.
Market conditions were favorable for the Company's trading activity in both its
quarters ending February 28, 2007 and 2006. Hedging strategies were generally
effective as established trading relationships remained substantially intact and
volatility tended to be lower than historical norms. No guarantee can be given
regarding future net trading revenues or future earnings volatility. However,
the Company believes that these results are indicative of its commitment to the
management of market trading risk.
DISTRIBUTION OF DAILY NET TRADING REVENUES
Quarters Ended February 28, 2007 and February 28, 2006
[GRAPHIC CHART OMITTED]
The following is a graphic chart represented as a table.
(10)+ (10)-(5) (5)-0 0-5 5-10 10-15 15-20 20-25 25-30 30-35 35-40 40+
4 5 2 5 12 8 10 6 2 6 2007
3 6 6 9 11 9 6 3 2 5 2006
59
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Credit Risk
The Company measures its actual credit exposure (the replacement cost of
counterparty contracts) on a daily basis. Master netting agreements, collateral
and credit insurance are used to mitigate counterparty credit risk. The credit
exposures reflect these risk-reducing features to the extent they are legally
enforceable. The Company's net replacement cost of derivative contracts in a
gain position at February 28, 2007 and November 30, 2006 approximated $4.71
billion and $4.99 billion, respectively. Exchange-traded financial instruments,
which typically are guaranteed by a highly rated clearing organization, have
margin requirements that substantially mitigate the risk of credit loss.
The following table summarizes the counterparty credit quality of the Company's
exposure with respect to over-the-counter derivatives (including foreign
exchange and forward-settling mortgage transactions) as of February 28, 2007:
Over-the-Counter Derivative Credit Exposure (1)
($ in millions)
Percentage
of
Exposure, Exposure,
Net of Net
Collateral Collateral of
Rating (2) Exposure (3) (4) Collateral
------------ ------------ ------------ ------------ ----------
AAA $ 1,266 $ 54 $ 1,227 26%
AA 5,164 3,630 1,808 38%
A 2,816 1,822 1,117 24%
BBB 435 450 214 5%
BB and lower 1,347 2,800 237 5%
Non-rated 154 75 106 2%
(1) Excluded are covered transactions structured to ensure that the market
values of collateral will at all times equal or exceed the related
exposures. The net exposure for these transactions will, under all
circumstances, be zero.
(2) Internal counterparty credit ratings, as assigned by the Company's Credit
Department, converted to rating agency equivalents.
(3) For lower-rated counterparties, the Company generally receives collateral
in excess of the current market value of derivative contracts.
(4) In calculating exposure net of collateral, collateral amounts are limited
to the amount of current exposure for each counterparty. Excess collateral
is not applied to reduce exposure because such excess in one counterparty
portfolio cannot be applied to deficient collateral in a different
counterparty portfolio.
60
Item 4. CONTROLS AND PROCEDURES
As required by Rule 13a-15(b) of the Exchange Act, the Company's management,
including the Company's Chief Executive Officer and Chief Financial Officer, has
evaluated the effectiveness of its disclosure controls and procedures as of the
end of the period covered by this quarterly report. Based on that evaluation,
the Chief Executive Officer and Chief Financial Officer have concluded that the
Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under
the Exchange Act) were effective as of the end of the period covered by this
quarterly report (i) to ensure that information required to be disclosed by the
company in the reports that it files or submits under the Exchange Act is
recorded, processed, summarized and reported, within the time periods specified
in the SEC's rules and forms and (ii) to ensure that information required to be
disclosed by the Company in the reports that the Company submits under the
Exchange Act is accumulated and communicated to the Company's management,
including the Company's principal executive and principal financial officers, or
persons performing similar functions, as appropriate, to allow timely decisions
regarding required disclosure. As required by Rule 13a-15(d) under the Exchange
Act, the Company's management, including the Company's Chief Executive Officer
and Chief Financial Officer, has evaluated the Company's internal control over
financial reporting to determine whether any changes occurred during the quarter
covered by this quarterly report that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting. Based on that evaluation, there have been no such changes during the
quarter covered by this quarterly report.
61
Part II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
In the normal course of business, the Company has been named a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental and self-regulatory organizations regarding the
Company's business. Certain of the foregoing could result in adverse judgments,
settlements, fines, penalties or other relief.
Because litigation is inherently unpredictable, particularly in cases where
claimants seek substantial or indeterminate damages or where investigations and
proceedings are in the early stages, the Company cannot predict with certainty
the loss or range of loss related to such matters, how such matters will be
resolved, when they will be ultimately resolved, or what the eventual
settlement, fine, penalty or other relief might be. Consequently, the Company
cannot estimate losses or ranges of losses for matters where there is only a
reasonable possibility that a loss may have been incurred. Although the ultimate
outcome of these matters cannot be ascertained at this time, it is the opinion
of management, that the resolution of the foregoing matters will not have a
material adverse effect on the financial condition of the Company, taken as a
whole; such resolution may, however, have a material effect on the operating
results in any future period, depending on the level of income for such period.
The Company has provided reserves for such matters in accordance with Statement
of Financial Accounting Standards No. 5, "Accounting for Contingencies". The
ultimate resolution may differ from the amounts reserved.
Certain legal proceedings in which the Company is involved are discussed in Note
17 to the consolidated financial statements included in the Company's 2006
Financial Report; Part I, Item 3, of the Company's Annual Report on Form 10-K
for the fiscal year ended November 30, 2006. The following discussion is limited
to recent developments concerning our legal proceedings and should be read in
conjunction with those earlier Reports.
Helen Gredd, Chapter 11 Trustee for Manhattan Investment Fund Ltd. v. Bear,
Stearns Securities Corp.: As previously reported in the Company's Form 10-K for
fiscal year ended November 30, 2006 ("Form 10-K"), in connection with the
parties' cross motions for summary judgment, by Order and Decision dated January
9, 2007, the Bankruptcy Court denied BSSC's motion for summary judgment seeking
dismissal of the Trustee's complaint in its entirety and granted the Trustee's
motion for summary judgment on the fraudulent transfer claims against BSSC. BSSC
has appealed the Bankruptcy Court's decision to the United States District for
the Southern District of New York.
62
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The table below sets forth the information with respect to purchases made by the
Company of the Company's common stock during the first quarter of fiscal 2007:
Approximate Dollar
Total Number of Shares Value of Shares that
Total Number of Average Price Purchased as Part of May Yet Be Purchased
Shares Paid per Publicly Announced Under the Plans or
Period Purchased Share Plans or Programs (1) Programs (1)
------------------- ----------------- -------------- ---------------------- ---------------------
12/1/06 - 12/31/06 2,175,293 $ 164.20 2,175,293 $ 1,858,781,531
1/1/07 - 1/31/07 307,485 166.05 307,485 1,807,724,398
2/1/07 - 2/28/07 400,166 162.32 400,166 1,742,769,110
----------------- ----------------------
Total 2,882,944 164.14 2,882,944
----------------- ----------------------
(1) On December 13, 2006, the Board of Directors of the Company approved an
amendment to the Stock Repurchase Program ("Repurchase Program") to replenish
the previous authorizations to allow the Company to purchase up to $2.0 billion
of common stock in fiscal 2007 and beyond. During the quarter ended February 28,
2007, the Company purchased under the current and prior authorizations a total
of 2,634,388 shares at a cost of approximately of $431.7 million. Approximately
$1.58 billion was available to be purchased under the current authorization as
of February 28, 2007. The Company expects to utilize the repurchase
authorization to offset the dilutive impact of annual share awards. The Company
may, depending upon price and other factors, repurchase additional shares in
excess of that required for annual share awards. During the quarter ended
February 28, 2007, the Company also purchased a total of 248,556 shares of its
common stock at a total cost of $41.5 million pursuant to a $200 million CAP
Plan Earnings Purchase Authorization, which was approved by the Compensation
Committee of the Board of Directors of the Company on December 12, 2006.
63
Item 6. EXHIBITS
Exhibits
(11) Computation of Per Share Earnings. (The calculation of per share
earnings is in Note 8, "Earnings Per Share," of Notes to Condensed
Consolidated Financial Statements (Earnings Per Share) and is omitted
here in accordance with Section (b) (11) of Item 601 of Regulation S-K)
(12) Computation of Ratio of Earnings to Fixed Charges and to Combined
Fixed Charges and Preferred Stock Dividends
(15) Letter re: Unaudited Interim Financial Information
(31.1) Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) or
15d -14(a) of the Securities Exchange Act of 1934, as Adopted Pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002
(31.2) Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) or
15d-14(a) of the Securities Exchange Act of 1934, as Adopted Pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002
(32.1) Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section
1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002
(32.2) Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section
1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002
64
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
The Bear Stearns Companies Inc.
------------------------------
(Registrant)
Date: April 9, 2007 By: /s/ Jeffrey M. Farber
Jeffrey M. Farber
Senior Vice President -
Finance,
Controller
(Principal Accounting
Officer)
65
THE BEAR STEARNS COMPANIES INC.
FORM 10-Q
EXHIBIT INDEX
Exhibit No. Description Page
----------- ----------- ----
(12) Computation of Ratio of Earnings to Fixed Charges and to Combined Fixed Charges 67
and Preferred Stock Dividends
(15) Letter re: Unaudited Interim Financial Information 68
(31.1) Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) or 15d 69
-14(a) of the Securities Exchange Act of 1934, as Adopted Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
(31.2) Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) or 15d 70
-14(a) of the Securities Exchange Act of 1934, as Adopted Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
(32.1) Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as 71
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(32.2) Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as 72
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
66