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 May 31, 2006
or
[__] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ___________ to ___________
Commission file number 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 July 6, 2006, the latest practicable date, there were 120,379,528
shares of Common Stock, $1 par value, outstanding.
TABLE OF CONTENTS
Page
Available Information 3
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
Condensed Consolidated Statements of Income (Unaudited)
for the three months and six months ended May 31, 2006
and May 31, 2005 4
Condensed Consolidated Statements of Financial Condition
as of May 31, 2006 (Unaudited) and November 30, 2005 (Audited) 5
Condensed Consolidated Statements of Cash Flows (Unaudited)
for the six months ended May 31, 2006 and May 31, 2005 6
Notes to Condensed Consolidated Financial Statements (Unaudited) 7
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 28
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 29
Introduction 29
Certain Factors Affecting Results of Operations 29
Forward-Looking Statements 30
Executive Overview 30
Results of Operations 32
Liquidity and Capital Resources 39
Off-Balance-Sheet Arrangements 48
Derivative Financial Instruments 49
Critical Accounting Policies 50
Accounting and Reporting Developments 53
Effects of Inflation 53
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 54
Item 4. CONTROLS AND PROCEDURES 58
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS 59
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 61
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 62
Item 6. EXHIBITS 63
Signature 64
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 450 Fifth
Street, N.W., 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 on your computer the Adobe Acrobat Reader software 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) (Unaudited)
Three Months Ended Six Months Ended
----------------------------------------------------------------
May 31, May 31, May 31, May 31,
(in thousands, except share and per share data) 2006 2005 2006 2005
--------------------------------------------------------------------------------------------------------------------
REVENUES
Commissions $ 305,251 $ 313,608 $ 591,322 $ 610,985
Principal transactions 1,492,478 980,179 2,642,910 1,958,812
Investment banking 318,150 250,426 656,003 484,136
Interest and dividends 2,110,876 1,191,785 3,834,865 2,213,404
Asset management and other income 76,994 87,582 217,067 178,612
----------------------------------------------------------------
Total revenues 4,303,749 2,823,580 7,942,167 5,445,949
Interest expense 1,804,307 950,028 3,257,522 1,734,737
----------------------------------------------------------------
Revenues, net of interest expense 2,499,442 1,873,552 4,684,645 3,711,212
----------------------------------------------------------------
NON-INTEREST EXPENSES
Employee compensation and benefits 1,220,216 922,908 2,267,066 1,829,683
Floor brokerage, exchange and clearance fees 58,621 57,262 109,864 114,580
Communications and technology 118,169 100,343 222,203 199,282
Occupancy 45,422 40,756 90,049 80,350
Advertising and market development 35,093 34,577 69,766 63,149
Professional fees 65,468 61,278 119,341 107,997
Other expenses 122,254 193,989 219,804 275,404
----------------------------------------------------------------
Total non-interest expenses 1,665,243 1,411,113 3,098,093 2,670,445
----------------------------------------------------------------
Income before provision for income taxes 834,199 462,439 1,586,552 1,040,767
Provision for income taxes 294,866 164,329 533,063 363,852
----------------------------------------------------------------
Net income $ 539,333 $ 298,110 $ 1,053,489 $ 676,915
================================================================
Net income applicable to common shares $ 533,957 $ 291,667 $ 1,042,699 $ 663,994
================================================================
Basic earnings per share $ 4.12 $ 2.32 $ 8.04 $ 5.26
Diluted earnings per share $ 3.72 $ 2.09 $ 7.26 $ 4.74
================================================================
Weighted average common shares outstanding:
Basic 132,810,062 130,663,337 132,778,755 130,960,364
Diluted 149,945,896 148,037,979 149,780,912 148,612,374
================================================================
Cash dividends declared per common share $ 0.28 $ 0.25 $ 0.56 $ 0.50
================================================================
See Notes to Condensed Consolidated Financial Statements.
4
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Financial Condition
(Unaudited)
May 31, November 30,
(in thousands, except share data) 2006 2005
-------------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and cash equivalents $ 5,991,336 $ 5,859,133
Cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations 7,189,214 5,269,676
Securities purchased under agreements to resell 39,604,616 42,647,603
Securities received as collateral 17,117,595 12,426,383
Securities borrowed 72,765,743 62,915,010
Receivables:
Customers 33,090,874 33,254,980
Brokers, dealers and others 3,082,490 3,544,806
Interest and dividends 677,729 433,305
Financial instruments owned, at fair value 114,281,620 93,364,088
Financial instruments owned and pledged as collateral, at fair value 10,787,810 12,880,333
--------------------------------
Total financial instruments owned, at fair value 125,069,430 106,244,421
Assets of variable interest entities and mortgage loan special purpose entities 16,510,071 15,151,699
Property, equipment and leasehold improvements, net of accumulated
depreciation and amortization of $1,082,800 and $1,011,036 as of May 31,
2006 and November 30, 2005, respectively 470,620 451,247
Other assets 4,610,611 4,436,970
--------------------------------
Total Assets $ 326,180,329 $ 292,635,233
================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Short-term borrowings $ 32,906,461 $ 20,015,727
Securities sold under agreements to repurchase 67,784,627 66,131,617
Obligation to return securities received as collateral 17,117,595 12,426,383
Securities loaned 8,790,562 10,104,325
Payables:
Customers 76,629,087 73,231,067
Brokers, dealers and others 3,117,303 2,657,178
Interest and dividends 974,759 796,956
Financial instruments sold, but not yet purchased, at fair value 41,453,173 35,004,333
Liabilities of variable interest entities and mortgage loan special purpose entities 15,830,026 14,321,285
Accrued employee compensation and benefits 1,701,830 1,853,416
Other liabilities and accrued expenses 1,520,168 1,811,898
Long-term borrowings 46,647,144 43,489,616
--------------------------------
Total Liabilities 314,472,735 281,843,801
--------------------------------
Commitments and contingencies (Note 10)
STOCKHOLDERS' EQUITY
Preferred stock 366,906 372,326
Common stock, $1.00 par value; 500,000,000 shares authorized and 184,805,847
shares issued as of both May 31, 2006 and November 30, 2005 184,806 184,806
Paid-in capital 4,463,934 4,109,166
Retained earnings 8,465,035 7,492,951
Employee stock compensation plans 2,100,157 2,600,186
Unearned compensation (129,867) (143,302)
Treasury stock, at cost:
Common stock: 63,869,496 and 70,937,640 shares as of May 31, 2006 and November 30, 2005,
respectively (3,743,377) (3,824,701)
--------------------------------
Total Stockholders' Equity 11,707,594 10,791,432
--------------------------------
Total Liabilities and Stockholders' Equity $ 326,180,329 $ 292,635,233
================================
See Notes to Condensed Consolidated Financial Statements.
5
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Cash Flows
(Unaudited)
Six Months Ended
May 31, May 31,
(in thousands) 2006 2005
-------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 1,053,489 $ 676,915
Adjustments to reconcile net income to cash used in operating activities:
Non-cash items included in net income:
Depreciation and amortization 169,491 123,325
Deferred income taxes (4,322) (49,912)
Employee stock compensation plans 10,237 36,258
Changes in operating assets and liabilities:
Cash and securities deposited with clearing organizations or segregated
in compliance with federal regulations (1,919,538) (1,351,309)
Securities borrowed, net of securities loaned (11,164,496) 6,334,632
Net receivables from customers 3,562,126 (193,752)
Net receivables from brokers, dealers and others 922,441 (608,835)
Financial instruments owned (18,150,812) (15,132,633)
Other assets (266,016) (352,638)
Securities sold under agreements to repurchase, net of securities purchased under
agreements to resell 4,695,997 (306,941)
Financial instruments sold, but not yet purchased 6,206,028 2,236,645
Accrued employee compensation and benefits (163,596) (312,473)
Other liabilities and accrued expenses (113,927) 293,366
-----------------------------------
Cash used in operating activities (15,162,898) (8,607,352)
-----------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements (91,541) (98,132)
-----------------------------------
Cash used in investing activities (91,541) (98,132)
-----------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from short-term borrowings 12,890,734 7,757,873
Proceeds from issuance of long-term borrowings 8,805,573 8,112,514
Payments for retirement/repurchase of long-term borrowings (6,417,374) (3,982,528)
Proceeds from issuances of derivatives with a financing element, net 242,812 151,423
Issuance of common stock 177,105 117,883
Cash retained resulting from tax deductibility under share-based payment
arrangements 300,896 283,464
Redemption of preferred stock (5,393) (5,210)
Treasury stock purchases - common stock (529,643) (382,554)
Cash dividends paid (78,068) (70,671)
-----------------------------------
Cash provided by financing activities 15,386,642 11,982,194
-----------------------------------
Net increase in cash and cash equivalents 132,203 3,276,710
Cash and cash equivalents, beginning of year 5,859,133 4,173,385
-----------------------------------
Cash and cash equivalents, end of period $ 5,991,336 $ 7,450,095
===================================
Supplemental Disclosure of Cash Flow Information:
Cash payments for interest were $3.46 billion and $1.74 billion during the six
months ended May 31, 2006 and 2005, respectively.
Cash payments for income taxes were $326.3 million and $77.6 million for the six
months ended May 31, 2006 and 2005, respectively. Cash payments for income taxes
would have been $627.2 million and $361.1 million for the six months ended May
31, 2006 and 2005, respectively, if increases in the value of equity instruments
issued under share-based payment arrangements had not been deductible in
determining taxable income.
See Notes to Condensed Consolidated Financial Statements.
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
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 comprises
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 comprises the private client services
("PCS") and asset management areas. See Note 12, "Segment Data," in the
Notes to Condensed Consolidated Financial Statements. 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. As used in this report,
the "Company" refers (unless the context requires otherwise) to The Bear
Stearns Companies Inc. and its subsidiaries.
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. In accordance with Financial Accounting
Standards Board ("FASB") Interpretation ("FIN") No. 46 (R), "Consolidation
of Variable Interest Entities" ("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.
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 May 31,
2006, the Condensed Consolidated Statements of Income for the three and six
months ended May 31, 2006 and May 31, 2005 and the Condensed Consolidated
Statements of Cash Flows for the six months ended May 31, 2006 and May 31,
2005 are unaudited. The Condensed Consolidated Statement of Financial
Condition at November 30, 2005 and related information was derived from the
audited consolidated financial statements.
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,
2005, as amended by Amendment No. 1 thereto on Form 10-K/A, each as filed
by the Company under the Securities Exchange Act of 1934, as amended
("Exchange Act") (together, 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
compensation, certain accrued liabilities and the
7
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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.
Fair value is generally based on quoted market prices. If quoted market
prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, 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.
The Company follows Emerging Issues Task Force ("EITF") Statement No. 02-3,
"Issues Involved in Accounting for Derivative Contracts Held for Trading
Purposes and Contracts Involved in Energy Trading and Risk Management
Activities." This guidance prohibits recognizing profit at the inception of
a derivative contract unless the fair value of the derivative is obtained
from a quoted market price in an active market or is otherwise evidenced by
comparison to other observable current market transactions or based on a
valuation technique that incorporates observable market data.
Equity interests and securities acquired as a result of private equity and
merchant banking activities are reflected in the condensed consolidated
financial statements at their fair value. Fair value is generally defined
as an investment's initial cost until significant transactions or
developments indicate that a change in the carrying value of the investment
is appropriate. Generally, the carrying values of these securities will be
increased 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 Statement of Financial Accounting Standards ("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. 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.
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
8
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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"), which are included in "Other assets" on
the Condensed Consolidated Statements of Financial Condition, are reported
at the lower of amortized cost or market. MSRs are amortized in proportion
to and over the period of estimated net servicing income. MSRs are
periodically evaluated for impairment based on the fair value of those
rights determined by using market-based models that discount anticipated
future net cash flows considering loan prepayment estimates, interest
rates, default rates, servicing costs and other economic factors. For
purposes of impairment evaluation and measurement, the Company stratifies
MSRs by predominant risk characteristics. The excess of amortized cost over
market value is reflected as a valuation allowance at balance sheet dates.
Contractual servicing fees, late fees and other ancillary servicing fees
earned for servicing mortgage loans are reflected net of MSR amortization
and impairment/recovery 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 underlying properties.
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.
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.
9
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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.
Asset Management and Other Income
The Company receives advisory fees for investment management. Advisory fees
are recognized over the period that the related service is provided based
upon the net asset value. Unearned advisory fees are treated as deferred
revenues and are included in "Other liabilities" in the accompanying
Condensed Consolidated Statements of Financial Condition. In addition, the
Company receives performance incentive fees for managing certain funds
based upon the achievement of specified performance targets. These fees are
accrued as earned during the period when the assets under management exceed
the applicable specific investment performance target.
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
Effective December 1, 2002, the Company elected to adopt fair value
accounting for stock-based compensation consistent with SFAS No. 123,
"Accounting for Stock-Based Compensation," using the prospective method
with guidance provided by SFAS No. 148, "Accounting for Stock-Based
Compensation--Transition and Disclosure." As a result, commencing with
options granted after November 30, 2002, the Company expenses the fair
value of stock
10
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
options issued to employees over the related vesting period. Prior to
December 1, 2002, the Company had elected to account for its stock-based
compensation plans using the intrinsic value method prescribed by
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees" ("APB No. 25"), as permitted by SFAS No. 123. Under
the provisions of APB No. 25, compensation cost for stock options is
measured as the excess, if any, of the quoted market price of the Company's
common stock at the date of grant over the amount an employee must pay to
acquire the stock. Accordingly, no compensation expense had been recognized
for stock option awards granted prior to December 1, 2002 because the
exercise price was at the fair market value of the Company's common stock
on the grant date.
The cost related to stock-based compensation included in the determination
of net income for the three and six months ended May 31, 2006 has been
fully recognized under the fair value-based method, and for the three and
six months ended May 31, 2005 is less than that which would have been
recognized if the fair value-based method had been applied to stock option
awards since the original effective date of SFAS No. 123.
The following table illustrates the effect on net income and earnings per
share for the three and six months ended May 31, 2005 if the fair
value-based method under SFAS No. 123 had been applied to stock options
granted for the year ended November 30, 2002.
Three Months Six Months
ended ended
-----------------------------------------------------------------
May 31, May 31,
(in millions, except per share amounts) 2005 2005
-----------------------------------------------------------------
Net income, as reported $ 298.1 $ 676.9
Add:
Stock-based employee compensation plans
expense included in reported net income,
net of related tax effects 8.5 20.7
Deduct:
Total stock-based employee compensation
plans expense determined under the fair
value based on method, net of related
tax effects (12.0) (27.7)
-----------------------------------------------------------------
Pro forma net income $ 294.6 $ 669.9
=================================================================
Earnings per share:
Basic - as reported $ 2.32 $ 5.26
Basic - pro forma $ 2.29 $ 5.21
Diluted - as reported $ 2.09 $ 4.74
Diluted - pro forma $ 2.07 $ 4.69
=================================================================
In December 2004, the FASB issued SFAS No. 123 (R), "Share-Based Payment."
SFAS No. 123 (R) is a revision of SFAS No. 123 and supersedes APB No. 25
and amends SFAS No. 95, "Statement of Cash Flows." SFAS No. 123 (R)
eliminates the ability to account for share-based compensation transactions
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), as required, on December 1, 2005, using the modified
prospective method with no material impact on the consolidated financial
statements of the Company.
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.
11
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Cash Equivalents
The Company has defined cash equivalents as liquid investments with
original maturities of three months or less that are not held for sale in
the ordinary course of business as 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.
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. Gains or
losses resulting from foreign currency transactions are included in net
income.
Accounting and Reporting Developments
In June 2005, the EITF reached a consensus on 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. This guidance became effective upon ratification by the FASB
on June 29, 2005 for all newly formed limited partnerships and for existing
limited partnerships for which the partnership agreements have been
modified. For all other limited partnerships, the guidance is effective no
later than the beginning of the first reporting period in fiscal years
beginning after December 15, 2005. For new and modified limited
partnerships, the adoption of the EITF did not have a material impact on
the consolidated financial statements of the Company. For the previously
existing limited partnerships, the Company does not expect the EITF
consensus to have a material impact on the consolidated financial
statements of the Company.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments." SFAS No. 155 is an amendment of SFAS No. 133
and SFAS No. 140. SFAS No. 155 permits companies to elect, on a deal by
deal basis, to apply a fair value remeasurement for any hybrid financial
instrument that contains an embedded derivative that otherwise would
require bifurcation. SFAS No. 155 is effective for all financial
instruments acquired or issued after the beginning of an entity's first
fiscal year that begins after September 15, 2006. The Company does not
expect SFAS No. 155 to have a material impact on the consolidated financial
statements of the Company.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets." SFAS No. 156 amends SFAS No. 140. SFAS No. 156 requires
that all separately recognized servicing assets and servicing liabilities
be initially measured at fair value. For subsequent measurements, SFAS No.
156 permits companies to choose between using an amortization method or a
fair value measurement method for reporting purposes. SFAS No. 156 is
effective as of the beginning of a company's first fiscal year that begins
after September 15, 2006. The Company does not expect SFAS No. 156 to have
a material impact on the consolidated financial statements of the Company.
12
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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:
May 31, November 30,
(in thousands) 2006 2005
---------------------------------------------------------------------------
FINANCIAL INSTRUMENTS OWNED:
U.S. government and agency $ 9,536,192 $ 9,914,866
Other sovereign governments 683,193 1,159,265
Corporate equity and convertible debt 26,134,957 18,601,132
Corporate debt and other 30,373,223 21,571,914
Mortgages, mortgage- and asset-backed 41,063,531 40,297,016
Derivative financial instruments 17,278,334 14,700,228
---------------------------------------------------------------------------
$ 125,069,430 $ 106,244,421
===========================================================================
FINANCIAL INSTRUMENTS SOLD, BUT NOT YET
PURCHASED:
U.S. government and agency $ 11,007,916 $ 10,115,133
Other sovereign governments 970,537 1,617,998
Corporate equity and convertible debt 10,565,983 6,900,004
Corporate debt and other 3,598,897 3,274,034
Mortgages, mortgage- and asset-backed 130,686 139,988
Derivative financial instruments 15,179,154 12,957,176
---------------------------------------------------------------------------
$ 41,453,173 $ 35,004,333
===========================================================================
As of May 31, 2006 and November 30, 2005, 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 May 31, 2006 and November 30, 2005, the Company's most
significant concentrations are 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 securities
purchased under agreements to resell consists of securities issued by the
US government and agencies.
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
and equity price risk. Derivative financial instruments represent
contractual commitments
13
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 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 attempts
to mitigate 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.
14
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 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 and six months ended May 31, 2006 and 2005.
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 May 31, 2006 and November
30, 2005 was approximately 94 days and 90 days, respectively. 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.
15
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company's securitization activities are detailed below:
Agency
Mortgage- Other Mortgage-
(in billions) Backed and Asset-Backed Total
---------------------------------------------------------------------------
Total securitizations
Six months ended May 31, 2006 $10.8 $49.6 $60.4
Six months ended May 31, 2005 $14.2 $39.6 $53.8
Retained interests
As of May 31, 2006 $2.3 $3.2 $5.5 (1)
As of November 30, 2005 $1.8 $3.7 $5.5 (2)
---------------------------------------------------------------------------
(1) Includes approximately $0.9 billion in non-investment-grade and
unrated retained interests.
(2) Includes approximately $0.8 billion in non-investment-grade and
unrated retained interests.
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the six months ended May 31,
2006 and May 31, 2005:
Agency
Mortgage- Other Mortgage-
(in millions) Backed and Asset-Backed Total
---------------------------------------------------------------------------
Cash flows received from retained
interests
Six months ended May 31, 2006 $ 68.3 $180.9 $249.2
Six months ended May 31, 2005 $158.6 $115.6 $274.2
Cash flows from servicing
Six months ended May 31, 2006 $0.1 $27.2 $27.3
Six months ended May 31, 2005 $0.4 $14.0 $14.4
---------------------------------------------------------------------------
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 use discount rates that are based on the Treasury
curve plus a spread. Key points on the constant maturity Treasury curve at
May 31, 2006 were 5.05% for 2-year Treasuries and 5.20% for 10-year
Treasuries, and ranged from 4.92% to 5.36%. These models also consider
prepayment speeds as well as credit losses. Credit losses are considered
through option-adjusted spreads that also incorporate additional factors
such as liquidity and optionality.
Key economic assumptions used in measuring the fair value of retained
interests in assets the Company securitized at May 31, 2006 were as
follows:
Agency
Mortgage- Other Mortgage-
Backed and Asset-Backed
---------------------------------------------------------------------------
Weighted average life (years) 8.1 3.8
Average prepayment speeds (annual rate) 7% - 20% 6% - 50%
Credit losses - 0% - 8%
---------------------------------------------------------------------------
16
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following hypothetical sensitivity analysis as of May 31, 2006
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
Mortgage- Other Mortgage-
(in millions) Backed and Asset-Backed
---------------------------------------------------------------------------
Interest rates
Impact of 50 basis point adverse change $ (53.8) $ (82.1)
Impact of 100 basis point adverse change (109.2) (174.0)
---------------------------------------------------------------------------
Prepayment speeds
Impact of 10% adverse change (1.3) (18.4)
Impact of 20% adverse change (2.2) (35.0)
---------------------------------------------------------------------------
Credit spread
Impact of 10% adverse change (6.0) (39.7)
Impact of 20% adverse change (11.9) (76.6)
---------------------------------------------------------------------------
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. At May 31, 2006, the key
economic assumptions and the sensitivity of the current fair value of MSRs
to immediate changes in those assumptions were as follows:
Fixed- Adjustable-Rate
Sub- Rate Prime Prime &
(in millions) Prime Loans & Alt-A Loans Alt-A Loans
---------------------------------------------------------------------------
Fair Value of MSRs $ 180,918 $ 93,656 $ 200,739
Constant prepayment rate
(in CPR) 20% - 40% 13% - 34% 20% - 53%
Impact on fair value of:
5 CPR adverse change $ (19.2) $ (7.5) $ (8.1)
10 CPR adverse change (33.2) (14.2) (14.9)
Discount Rate 15% 13% 13%
Impact on fair value of:
5% adverse change $ (15.3) $ (10.6) $ (13.9)
10% adverse change (27.8) (18.9) (25.9)
---------------------------------------------------------------------------
The previous tables 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 tables. Changes in fair value based on a 10% adverse
variation 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 tables do not consider the change in
fair value of hedging positions, which would generally offset the changes
detailed in the tables, 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.
17
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
MSRs are included in "Other assets" on the Condensed Consolidated
Statements of Financial Condition. The Company's MSRs activities for the
six months ended May 31, 2006 and 2005 were as follows:
May 31, May 31,
(in millions) 2006 2005
-------------------------------------------------------------------
Balance, beginning of period $ 431.1 $ 230.2
Additions 194.8 154.4
Sales (94.4) -
Amortization (91.2) (55.4)
(Impairment)/Recovery (2.2) 2.7
-------------------------------------------------------------------
Balance, end of period $ 438.1 $ 331.9
===================================================================
Changes in the MSR valuation allowance for the six months ended May 31,
2006 and 2005 were as follows:
May 31, May 31,
(in millions) 2006 2005
-------------------------------------------------------------------
Balance, beginning of period $ (10.6) $ (33.7)
(Impairment)/Recovery (2.2) 2.7
-------------------------------------------------------------------
Balance, end of period $ (12.8) $ (31.0)
===================================================================
5. VARIABLE INTEREST ENTITIES AND MORTGAGE LOAN SPECIAL PURPOSE ENTITIES
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 financial 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.
The Company may perform various functions, including being 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 is the primary beneficiary often through its
ownership of certain beneficial interests, and is, therefore, 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 because the
securitization vehicles were not QSPEs. The assets in these mortgage
securitizations approximated $3.7 billion and $5.3 billion at May 31, 2006
and November 30, 2005, respectively.
The Company has retained call options on a limited number of securitization
transactions that require the Company to continue recognizing the assets
subject to the call options. The total assets in these transactions
approximated $11.0 billion and $8.7 billion, at May 31, 2006 and November
30, 2005, respectively.
Assets held by VIEs, which are currently consolidated because the Company
is the primary beneficiary, approximated $1.3 billion and $1.2 billion at
May 31, 2006 and November 30, 2005, respectively. At May 31, 2006 and
November 30, 2005, the Company's maximum exposure to loss as a result of
its relationship with these VIEs is approximately $386.6 million and $531.0
million, respectively, which represents the fair value of its interests in
the VIEs.
The Company also owns significant variable interests in several VIEs
related to collateralized debt obligations or asset securitizations for
which the Company is not the primary beneficiary and therefore does not
consolidate these entities. In aggregate, these VIEs have assets
approximating $8.3 billion and $4.7 billion at May 31, 2006 and November
30, 2005, respectively. At May 31, 2006 and November 30, 2005, the
Company's maximum exposure to
18
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
loss from these entities approximated $96.5 million and $29.6 million,
respectively, which represents the fair value of its interests and is
reflected on 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 and deconsolidated at various points in time.
Therefore, the Company's variable interests included above may not be held
by the Company in future periods.
The Company was the general partner of certain limited partnerships in
which the limited partners did not have sufficient voting or control
rights. Under EITF No. 04-5, the Company was required to consolidate these
limited partnerships. The assets held by the limited partnerships
approximated $426.5 million as of May 31, 2006. The Company's maximum
exposure to loss as a result of its relationship with these limited
partnerships is approximately $12.3 million as of May 31, 2006, which
represents the fair value of its interests and is reflected on the
Condensed Consolidated Statements of Financial Condition.
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 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 May 31, 2006 and November 30, 2005, the fair value of securities
received as collateral by the Company that can be repledged, delivered or
otherwise used was approximately $253.6 billion and $254.6 billion,
respectively. Of these securities received as collateral, those with a fair
value of approximately $179.3 billion and $184.3 billion were delivered or
repledged at May 31, 2006 and November 30, 2005, 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
$29.2 billion and $20.8 billion at May 31, 2006 and November 30, 2005,
respectively.
19
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
7. LONG-TERM BORROWINGS
The Company's long-term borrowings (which have original maturities of at
least 12 months) at May 31, 2006 and November 30, 2005 consisted of the
following:
May 31, November 30,
(in thousands) 2006 2005
---------------------------------------------------------------------------
Fixed rate notes due 2006 to 2036 $ 20,359,117 $ 21,973,171
Floating rate notes due 2006 to 2036 18,142,325 14,208,786
Index/equity/credit-linked notes 8,145,702 7,307,659
---------------------------------------------------------------------------
Total long-term borrowings $ 46,647,144 $ 43,489,616
===========================================================================
The Company's long-term borrowings include fair value adjustments in
accordance with SFAS No. 133. During the six months ended May 31, 2006, the
Company issued and retired/repurchased $8.8 billion and $6.4 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 May 31, 2006.
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 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 Six Months Ended
-----------------------------------------------------------------------------------------------------------------------
May 31, May 31, May 31, May 31,
(in thousands, except per share amounts) 2006 2005 2006 2005
-----------------------------------------------------------------------------------------------------------------------
Net income $ 539,333 $ 298,110 $ 1,053,489 $ 676,915
Preferred stock dividends (5,376) (6,443) (10,790) (12,921)
Redemption of preferred stock - - 27 -
Income adjustment (net of tax) applicable to deferred
compensation arrangements-vested shares 12,597 10,894 24,374 24,761
-----------------------------------------------------------------------------------------------------------------------
Net earnings used for basic EPS 546,554 302,561 1,067,100 688,755
Income adjustment (net of tax) applicable to deferred
compensation arrangements-nonvested shares 11,679 7,099 20,465 14,937
-----------------------------------------------------------------------------------------------------------------------
Net earnings used for diluted EPS $ 558,233 $ 309,660 $ 1,087,565 $ 703,692
=======================================================================================================================
Total basic weighted average common
shares outstanding (1) 132,810 130,663 132,779 130,960
-----------------------------------------------------------------------------------------------------------------------
Effect of dilutive securities:
Employee stock options 6,120 3,879 5,801 4,117
CAP and restricted units 11,016 13,496 11,201 13,535
-----------------------------------------------------------------------------------------------------------------------
Dilutive potential common shares 17,136 17,375 17,002 17,652
-----------------------------------------------------------------------------------------------------------------------
Weighted average number of common shares
outstanding and dilutive potential common shares 149,946 148,038 149,781 148,612
-----------------------------------------------------------------------------------------------------------------------
Basic EPS $ 4.12 $ 2.32 $ 8.04 $ 5.26
Diluted EPS $ 3.72 $ 2.09 $ 7.26 $ 4.74
=======================================================================================================================
(1) Includes 12,153,620 and 17,447,208 vested units for the three months
ended May 31, 2006 and May 31, 2005, respectively, and 13,409,146 and
18,856,095 vested units for the six months ended May 31, 2006 and May
31, 2005, respectively, issued under stock compensation plans which
will be distributed as shares of common stock.
20
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
9. REGULATORY REQUIREMENTS
Effective December 1, 2005, the Company became 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 May 31, 2006, 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. Effective December 1, 2005, the SEC approved
Bear Stearns' use of 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 May 31, 2006, Bear Stearns' net capital of $5.28 billion
exceeded the minimum requirement by $4.71 billion. Bear Stearns' net
capital computation, as defined, includes $670.2 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 U.K.'s Financial Services Authority.
BSB, an Ireland-based bank principally involved in the trading and sales of
fixed income products, is registered in Ireland and is subject to the
regulatory capital requirements of the Financial Regulator.
At May 31, 2006, Bear Stearns, BSSC, BSIL, BSIT and BSB were in compliance
with their respective regulatory capital 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 May 31, 2006, future minimum aggregate annual rentals
payable under non-cancelable leases (net of subleases), including 383
Madison Avenue in New York City, for fiscal years 2006 through 2010 and the
aggregate amount thereafter, are as follows:
(in thousands)
-------------------------------------
FISCAL YEAR
2006 (remaining) $ 41,856
2007 85,710
2008 85,408
2009 81,302
2010 64,903
Thereafter 228,983
=====================================
Total $ 588,162
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
21
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
and validity of certain representations, warranties and contractual
conditions applicable to the borrower. Lending-related commitments to
investment-grade borrowers aggregated approximately $3.15 billion and $2.37
billion at May 31, 2006 and November 30, 2005, respectively. Of these
amounts, approximately $736.3 million and $652.5 million were hedged at May
31, 2006 and November 30, 2005, respectively. Lending-related commitments
to non-investment-grade borrowers approximated $1.96 billion and $1.44
billion at May 31, 2006 and November 30, 2005, respectively.
The Company also had contingent commitments to investment-grade and
non-investment-grade companies of approximately $4.91 billion and $3.89
billion as of May 31, 2006 and November 30, 2005, 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 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 May 31, 2006 and November 30, 2005, such
commitments aggregated $191.6 million and $222.1 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 and equity underwriting, the Company had commitments to purchase new
issues of securities aggregating $439.1 million and $943.1 million,
respectively, at May 31, 2006 and November 30, 2005.
Commercial and Residential Loans
The Company participates in the acquisition, origination, securitization,
servicing, financing and disposition of commercial and residential loans.
At May 31, 2006 and November 30, 2005, the Company had entered into
commitments to purchase or finance mortgage loans of $2.50 billion and $5.1
billion, respectively.
Letters of Credit
At May 31, 2006 and November 30, 2005, the Company was contingently liable
for unsecured letters of credit of approximately $2.40 billion and $2.50
billion, respectively, and letters of credit of $1.46 billion and $985.6
million, respectively, secured by financial instruments, primarily used to
provide collateral for securities borrowed and to satisfy margin
requirements at option and commodity exchanges.
Other
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $87.4 million and $159.8 million, respectively, at May 31,
2006 and November 30, 2005.
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 reflect the actual future cash
funding requirements.
22
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Litigation
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.
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.
23
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following table sets forth the maximum payout/notional amounts
associated with the Company's guarantees as of May 31, 2006:
Amount of Guarantee Expiration Per Period
-------------------------------------------------------
Less Than One to Three Three to Five Greater than
(in millions) One Year Years Years Five Years Total
----------------------------------------------------------------------------------------------------------------
Certain derivative contracts (notional)(1) $ 116,849 $ 296,629 $ 250,941 $ 991,050 $ 1,655,469
Municipal securities 2,614 121 - - 2,735
Residual value guarantee - - 570 - 570
----------------------------------------------------------------------------------------------------------------
(1) The carrying value of these derivatives approximated $383.3 million as
of May 31, 2006.
Derivative Contracts
The Company's dealer activities cause it to make markets and trade a
variety of derivative instruments. Certain derivatives 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
derivatives 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 $383.3 million at May 31, 2006.
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 May 31, 2006 was approximately $2.73 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 $2.77 billion at May 31, 2006.
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 13, 2010 unless both parties agree to
a renewal prior to expiration. At the expiration date of the Synthetic
Lease, the Company has the right to purchase the building for the amount of
the then outstanding indebtedness of the lessor or to arrange
24
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 May 31, 2006, 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,
and the contingencies triggering the obligation to indemnify are not
expected to occur.
Maximum payout information under these indemnifications is not readily
available because of the number, size and duration 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 the Company will have to make significant
payments under these arrangements.
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. 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 research, sales and trading in areas
such as domestic and international equities, block trading, convertible
bonds, over-the-counter equities, equity derivatives, risk and convertible
arbitrage and the NYSE, American Stock Exchange and International
Securities Exchange specialist activities. Fixed income includes sales,
trading 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, 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.
25
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 US 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.
26
Three Months ended Six Months ended
------------------------------------------------------
(in thousands) May 31, 2006 May 31, 2005 May 31, 2006 May 31, 2005
------------------------------------------------------------------------------------------
NET REVENUES
Capital Markets
Institutional Equities $ 554,469 $ 390,453 $ 1,042,963 $ 703,393
Fixed Income 1,167,308 808,013 2,056,046 1,673,520
Investment Banking 278,405 231,935 574,999 449,329
------------------------------------------------------------------------------------------
Total Capital Markets 2,000,182 1,430,401 3,674,008 2,826,242
Global Clearing Services 289,523 276,160 553,515 546,552
Wealth Management
Private Client Services (1) 128,889 105,637 257,683 219,512
Asset Management 22,182 50,148 116,657 105,463
------------------------------------------------------------------------------------------
Total Wealth Management 151,071 155,785 374,340 324,975
Other (2) 58,666 11,206 82,782 13,443
------------------------------------------------------------------------------------------
Total net revenues $ 2,499,442 $ 1,873,552 $ 4,684,645 $ 3,711,212
==========================================================================================
PRE-TAX INCOME
Capital Markets $ 702,005 $ 455,776 $ 1,336,756 $ 937,459
Global Clearing Services 139,045 142,989 268,617 280,763
Wealth Management (13,317) 6,054 18,856 21,033
Other (2) 6,466 (142,380) (37,677) (198,488)
------------------------------------------------------------------------------------------
Total pre-tax income $ 834,199 $ 462,439 $ 1,586,552 $ 1,040,767
==========================================================================================
Three Months ended Six Months ended
-------------------------- --------------------------
May 31, 2006 May 31, 2005 May 31, 2006 May 31, 2005
-------------------------- --------------------------
(1) Private Client Services detail:
Gross revenues, before
transfer to Capital
Markets segment $ 153,014 $ 130,284 $ 306,092 $ 263,579
Revenue transferred
to Capital Markets segment (24,125) (24,647) (48,409) (44,067)
-------------------------- --------------------------
Private Client Services net
revenues $ 128,889 $ 105,637 $ 257,683 $ 219,512
========================== ==========================
(2) Includes consolidation and elimination entries, unallocated revenues
(predominantly interest), and certain corporate administrative
functions, including certain legal costs and costs related to the CAP
Plan. CAP Plan costs were $42.5 million and $31.5 million for the
three months ended May 31, 2006 and May 31, 2005, respectively and
$78.5 million and $69.5 million for the six months ended May 31, 2006
and May 31, 2005, respectively.
As of
-----------------------------------------------
May 31, November 30, May 31,
(in thousands) 2006 2005 2005
---------------------------------------------------------------------------
SEGMENT ASSETS
Capital Markets $ 216,888,711 $ 195,292,625 $ 158,526,191
Global Clearing Services 98,289,543 85,625,396 103,978,620
Wealth Management 3,003,208 2,751,749 2,719,933
Other 7,998,867 8,965,463 11,556,865
---------------------------------------------------------------------------
Total segment assets $ 326,180,329 $ 292,635,233 $ 276,781,609
===========================================================================
27
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 May 31,
2006, and the related condensed consolidated statements of income for the three
month and six month periods ended May 31, 2006 and 2005 and cash flows for the
six month periods ended May 31, 2006 and 2005. These interim financial
statements are the responsibility of The Bear Stearns Companies Inc.'s
management.
We conducted our reviews in accordance with 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 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 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, 2005, and the related consolidated statements of income, cash flows
and changes in stockholders' equity for the fiscal year then ended (not
presented herein) included in The Bear Stearns Companies Inc.'s Annual Report on
Form 10-K for the fiscal year ended November 30, 2005, as amended by Amendment
No. 1 thereto on Form 10-K/A; and in our report dated February 10, 2006, 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, 2005 is fairly
stated, in all material respects, in relation to the consolidated statement of
financial condition from which it has been derived.
New York, New York
July 7, 2006
28
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; and 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 and six months of 2006
and 2005 refer to the three and six months ended May 31, 2006 and May 31, 2005,
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, 2005, as amended by Amendment No. 1 thereto on Form 10-K/A,
each as filed by the Company under the Securities Exchange Act of 1934, as
amended ("Exchange Act") (together, the "Form 10-K").
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 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 security new issues,
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 security new issues, 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 on a principal basis and expose
the Company to significant risk of loss. Such risks include market, 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 Form
10-K.
29
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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
difficult 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
May 31, 2006 increased 33.4% to $2.50 billion from $1.87 billion for the three
months ended May 31, 2005, while pre-tax earnings increased 80.4% during the
same period. The pre-tax profit margin for the 2006 quarter increased to 33.4%
when compared with 24.7% in the 2005 quarter. Annualized return on average
common equity was 20.1% for the quarter ended May 31, 2006 versus 13.5% in the
prior year quarter.
Capital Markets net revenues increased 39.8% to $2.00 billion for the 2006
quarter compared to $1.43 billion for the 2005 quarter. Within the Capital
Markets segment, institutional equities net revenues for the 2006 quarter
increased 42.0% to $554.5 million from $390.5 million for the comparable prior
year quarter. Equity derivatives net revenues increased on strong market
conditions and active institutional and corporate customer volumes.
International equity sales and trading net revenues also increased, reflecting
higher customer trading volumes and market share gains in both European and
Asian equities. The increase in institutional equities in the 2006 quarter also
reflects gains on the IPO and secondary sale of the Company's NYSE Group Inc.
shares. Fixed income net revenues increased 44.5% to $1.17 billion for the 2006
quarter from $808.0 million for the comparable prior year quarter, reflecting
active primary and secondary market activity across mortgage, credit and
interest rate product businesses. Mortgage-backed securities revenues achieved
record levels during the 2006 quarter as origination volumes rose and mortgage
product spreads narrowed on increased investor demand. During the 2006 quarter,
origination revenues increased reflecting higher volumes in adjustable rate
mortgage securities ("ARMS"), fixed rate whole loans and asset-backed
securities. Secondary trading revenues from ARMS, non-agency fixed rate whole
loans and asset-backed securities also increased significantly. Net revenues
from the distressed debt and leveraged finance areas increased as spreads
tightened and acquisition related finance activity increased. Revenues derived
from interest rate derivatives increased significantly on strong customer demand
and improved market conditions. Currency markets also continued to be very
active, driving strong growth in the company's foreign exchange business.
Investment banking revenues increased 20.0% to $278.4 million for the 2006
quarter from $231.9 million for the 2005 quarter, as a result of increased
mergers and acquisition ("M&A") advisory fees and equity underwriting revenues
reflecting favorable US equity market conditions.
Global Clearing Services net revenues increased 4.8% to $289.5 million from
$276.2 million in the 2005 quarter. Net interest revenues increased 7.6% to
$211.0 million from $196.1 million in the 2005 quarter on improved net interest
margin. Offsetting this increase, clearance commission revenues decreased 7.2%
to $62.6 million in the 2006 quarter from $67.5 million in the 2005 quarter
reflecting lower average rates from prime brokerage clients.
30
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Wealth Management net revenues decreased 3.0% to $151.1 million for the 2006
quarter from $155.8 million in the fiscal quarter ended May 31, 2005. Revenues
from private client services ("PCS") increased on higher fee-based income
derived from the Company's private client advisory services products. Asset
management revenues decreased mainly due to reduced performance fees on our
proprietary hedge fund products. Partially offsetting this decline was an
increase in management fees resulting from the growth in assets under
management.
Business Environment
Fiscal 2006 Quarter
The business environment during the second quarter ended May 31, 2006 was
characterized by an expanding US economy, strong US capital market conditions
and low unemployment. The Federal Reserve Board (the "Fed") met twice during the
quarter and raised the federal funds rate, in 25 basis point increments, from
4.5% to 5%, citing a continued effort to keep inflationary pressures low in the
midst of a cooling housing market and increasing energy costs. In May 2006, the
unemployment rate fell to 4.6%, its lowest rate for the year. Oil prices
continued to soar, however, climbing three straight months to close at $71 a
barrel at the end of May, up 16% from the prior quarter's close of $61.
The major indices were mixed during the second quarter of 2006. The Dow Jones
Industrial Average ("DJIA") increased 1.6%, while the Nasdaq Composite Index
("NASDAQ") and the Standard & Poor's 500 Index ("S&P 500") decreased 4.5% and
0.8%, respectively, during the quarter. Average daily trading volume on the
Nasdaq and New York Stock Exchange ("NYSE") increased 19.0% and 5.9%,
respectively, in the 2006 quarter, compared to the 2005 quarter. M&A activity
was robust during the 2006 quarter. Industry-wide US-announced M&A volumes
increased 86% while industry-wide US-completed M&A volumes increased 115%
compared to the comparable prior year quarter. Total equity issuance volumes
increased 100% while initial public offering ("IPO") volumes increased 99%
compared to the 2005 quarter.
Fixed income activity continued to be robust during the 2006 quarter despite the
increase in short-term interest rates and a flattening yield curve. Long-term
interest rates, as measured by the 10-year Treasury bond, increased during the
2006 quarter. The 10-year Treasury bond yield increased to 5.11% at the end of
the 2006 quarter from 4.56% 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. However,
overall US mortgage-backed securities new issue volume increased 51% during the
2006 quarter compared with the results achieved in the 2005 quarter. Non-agency
mortgage-backed origination volumes increased approximately 88% industry-wide
during the 2006 quarter from the levels reached in the 2005 quarter.
Fiscal 2005 Quarter
The business environment during the Company's second quarter ended May 31, 2005
was generally favorable due to an expanding US economy and continued low
interest rates. Favorable job reports and an active housing market provided
ongoing support to economic activity. However, concerns about rising energy
prices and inflation caused consumer confidence to decline from the levels
reached during the Company's first fiscal quarter. The Fed met twice during the
quarter and raised the federal funds rate, in 25 basis point increments, from
2.50% to 3.00% while continuing to maintain its position of taking a "measured"
approach to monetary policy.
The major equity indices were mixed during the second quarter of 2005. The DJIA
and the S&P 500 decreased 2.8% and 1.0%, respectively, while the NASDAQ
increased 0.8% during the quarter. Average daily trading volume on the NYSE and
Nasdaq increased 7.2% and 0.1%, respectively, compared to the 2004 quarter.
Industry-wide announced M&A volumes increased 29.7% while industry-wide
completed M&A volumes decreased 39.8% in the 2005 quarter compared to the second
quarter of 2004.
Fixed income activity continued to be strong during the 2005 quarter despite an
increase in short term interest rates, a flattening yield curve and the widening
of corporate credit spreads. While the Fed continued to raise the federal funds
rate during the 2005 quarter, long-term interest rates, as measured by the
10-year Treasury bond decreased during the 2005 quarter. At the close of the
Company's second quarter of 2005, the 10-year Treasury bond yield was 4.00%,
compared to
31
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
4.36% at the beginning of the quarter. Interest rates on 30-year fixed rate
mortgages also decreased, causing home purchasing and refinance activity to
remain at relatively high levels. However, agency CMO activity experienced an
industry-wide decline from the levels achieved during the 2004 quarter. This
decline was partially offset by growth in non-agency volumes.
RESULTS OF OPERATIONS
Firmwide Results
The following table sets forth an overview of the Company's financial results:
Three Months Ended Six Months Ended
(in thousands, except per share amounts, pre- ---------------------------------------------------------------------------------
tax profit margin and return on average May 31, May 31, % May 31, May 31, %
common equity) 2006 2005 Increase 2006 2005 Increase
------------------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense $ 2,499,442 $ 1,873,552 33.4% $ 4,684,645 $ 3,711,212 26.2%
Income before provision for income taxes $ 834,199 $ 462,439 80.4% $ 1,586,552 $ 1,040,767 52.4%
Net Income $ 539,333 $ 298,110 80.9% $ 1,053,489 $ 676,915 55.6%
Diluted earnings per share $ 3.72 $ 2.09 78.0% $ 7.26 $ 4.74 53.2%
Pre-tax profit margin 33.4% 24.7% 33.9% 28.0%
Return on average common equity (annualized) 20.1% 13.5% 20.1% 15.6%
------------------------------------------------------------------------------------------------------------------------------------
The Company reported net income of $539.3 million, or $3.72 per share (diluted),
for the quarter ended 2006, which represented an increase of 80.9% from $298.1
million, and 78.0% from $2.09 per share (diluted), for the quarter ended 2005.
Net revenues increased 33.4% to a record $2.50 billion for the quarter ended
2006 from $1.87 billion for the quarter ended 2005, due to increases in
principal transactions revenues, investment banking revenues and net interest
revenues, partially offset by decreases in commission revenues and asset
management and other revenues.
The Company reported net income of $1.05 billion, or $7.26 per share (diluted),
for the six months ended 2006, which represented an increase of 55.6% from
$676.9 million, and 53.2% from $4.74 per share (diluted), for the six months
ended 2005. Net revenues increased 26.2% to $4.68 billion for the six months
ended 2006 from $3.71 billion for the six months ended 2005, due to increases in
principal transactions revenues, investment banking revenues, asset management
and other revenues and net interest revenues, partially offset by a decrease in
commission revenues.
The Company's commission revenues by reporting category were as follows:
Three Months Ended Six Months Ended
---------------------------------------------------------------------------------
May 31, May 31, %(Decrease) May 31, May 31, %
(in thousands) 2006 2005 Increase 2006 2005 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Institutional $ 173,307 $ 177,373 (2.3%) $ 335,766 $ 341,806 (1.8%)
Clearance 62,607 67,469 (7.2%) 121,803 134,612 (9.5%)
Retail & other 69,337 68,766 0.8% 133,753 134,567 (0.6%)
------------------------------------------------------------------------------------------------------------------------------------
Total commissions $ 305,251 $ 313,608 (2.7%) $ 591,322 $ 610,985 (3.2%)
====================================================================================================================================
Commission revenues for the 2006 quarter decreased 2.7% to $305.3 million from
$313.6 million for the comparable prior year quarter. Institutional commissions
decreased 2.3% to $173.3 million for the 2006 quarter from $177.4 million for
the comparable prior year quarter due to a decline in listed trading compared
with the 2005 quarter. Clearance commissions decreased 7.2% to $62.6 million for
the 2006 quarter from $67.5 million for the comparable prior year quarter
reflecting lower average rates from prime brokerage clients. Retail and other
commissions were $69.3 million in the 2006 quarter, up slightly from $68.8
million in the 2005 quarter.
Commission revenues for the six months ended May 31, 2006 decreased 3.2% to
$591.3 million from $611.0 million for the comparable prior year period.
Institutional commissions decreased 1.8% to $335.8 million for the 2006 period
from $341.8 million for the comparable prior year period due to a decline in
listed trading compared with the 2005 period. Clearance commissions decreased
9.5% to $121.8 million for the 2006 period from $134.6 million for the
comparable prior year period
32
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
reflecting lower trading volumes and rates from prime brokerage clients. Retail
and other commissions decreased 0.6% to $133.8 million in the 2006 period from
$134.6 million in the comparable prior year period.
The Company's principal transactions revenues by reporting category were as
follows:
Three Months Ended Six Months Ended
---------------------------------------------------------------------------------
May 31, May 31, % May 31, May 31, %
(in thousands) 2006 2005 Increase 2006 2005 Increase
------------------------------------------------------------------------------------------------------------------------------------
Fixed income $ 860,845 $ 546,836 57.4% $ 1,519,322 $ 1,177,706 29.0%
Equities 269,150 132,719 102.8% 477,869 229,860 107.9%
Derivative financial instruments 362,483 300,624 20.6% 645,719 551,246 17.1%
------------------------------------------------------------------------------------------------------------------------------------
Total principal transactions $ 1,492,478 $ 980,179 52.3% $ 2,642,910 $ 1,958,812 34.9%
====================================================================================================================================
Revenues from principal transactions for the 2006 quarter increased 52.3% to
$1.49 billion from $980.2 million for the comparable prior year quarter due to
increases in fixed income revenues, equities revenues and derivative financial
instruments revenues. Fixed income revenues increased 57.4% to $860.8 million
for the 2006 quarter from $546.8 million for the prior year quarter.
Mortgage-backed securities revenues increased in the 2006 quarter when compared
to the comparable prior year quarter on higher origination volumes for
non-agency mortgage-backed securities as well as strong secondary trading
revenues, particularly in ARMS, non-agency fixed rate whole loans and
asset-backed securities. During the 2006 quarter the Company ranked as the No. 1
underwriter of US mortgage-backed securities, capturing approximately 11% of the
overall US mortgage-backed securities market. In addition, net revenues from the
distressed debt and leveraged finance areas reached record levels during the
2006 quarter as spreads tightened and acquisition related finance activity
increased. Revenues derived from equities activities increased 102.8% to $269.2
million during the 2006 quarter from $132.7 million in the 2005 quarter. Net
revenues from the Company's international equity sales and trading rose,
reflecting higher trading volumes as well as market share gains in both European
and Asian equities. The 2006 quarter also included gains on the Company's
investment in NYSE Group Inc. Revenues from derivative financial instruments
increased 20.6% to $362.5 million in the 2006 quarter from $300.6 million in the
2005 quarter. Equity and interest rate derivatives net revenues rose on
increased customer activities and favorable market conditions. These increases
were partially offset by a decline in credit derivatives revenues resulting from
less favorable market conditions.
Revenues from principal transactions for the six months ended May 31, 2006
increased 34.9% to $2.64 billion from $1.96 billion for the comparable prior
year period due to increases in fixed income revenues, equities revenues and
derivative financial instruments revenues. Fixed income revenues increased 29.0%
to $1.52 billion for the 2006 period from $1.18 billion for the comparable prior
year period. Mortgage-backed securities revenues increased when compared to the
2005 period on higher origination volumes from non-agency mortgage-backed
securities and increased secondary trading revenues in non-agency
mortgage-backed securities, particularly in ARMS and fixed rate whole loans. Net
revenues from distressed trading increased as spreads tightened during the 2006
period. Revenues derived from equities activities increased 107.9% to $477.9
million during the 2006 period from $229.9 million in the 2005 period. Net
revenues from the Company's international equity sales and trading area rose,
reflecting higher trading volumes as well as market share gains in both European
and Asian equities. In addition, net revenues from the risk arbitrage business
increased on increased global announced M&A volumes. Revenues from derivative
financial instruments increased 17.1% to $645.7 million in the 2006 period from
$551.2 million in the 2005 period. Equity derivatives net revenues rose on
increased customer activities and favorable market conditions. These increases
were partially offset by a decline in credit derivatives revenues resulting from
less favorable market conditions.
33
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's investment banking revenues by reporting category were as follows:
Three Months Ended Six Months Ended
---------------------------------------------------------------------------------
May 31, May 31, % May 31, May 31, %
(in thousands) 2006 2005 Increase 2006 2005 Increase
------------------------------------------------------------------------------------------------------------------------------------
Underwriting $ 132,099 $ 108,048 22.3% $ 263,499 $ 252,038 4.5%
Advisory and other fees 190,555 97,219 96.0% 325,547 177,349 83.6%
Merchant banking (4,504) 45,159 nm 66,957 54,749 22.3%
------------------------------------------------------------------------------------------------------------------------------------
Total investment banking $ 318,150 $ 250,426 27.0% $ 656,003 $ 484,136 35.5%
====================================================================================================================================
nm - not meaningful
Investment banking revenues increased 27.0% to $318.2 million for the 2006
quarter from $250.4 million for the 2005 quarter. Underwriting revenues
increased 22.3% to $132.1 million for the 2006 quarter from $108.0 million for
the corresponding prior year quarter. Equity underwriting revenues increased
during the 2006 quarter, reflecting an increase in the volume of lead and
co-managed IPO's and equity follow-on offerings, partially offset by a decrease
in fixed income underwriting revenues. Advisory and other fees for the 2006
quarter increased 96.0% to $190.6 million from $97.2 million for the 2005
quarter reflecting a significant increase in completed M&A assignments during
the 2006 quarter as well as an increase in mortgage servicing fees. Merchant
banking revenues decreased to a $4.5 million loss in the 2006 quarter from a
$45.2 million gain during the 2005 quarter. An unrealized loss on our remaining
investment in portfolio company New York & Company, Inc. offset other gains in
the portfolio during the 2006 quarter.
Investment banking revenues increased 35.5% to $656.0 million for the six months
ended May 31, 2006 from $484.1 million for the 2005 period. Underwriting
revenues increased 4.5% to $263.5 million for the 2006 period from $252.0
million for the corresponding prior year period as equity underwriting revenues
increased, reflecting favorable US equity market conditions. The increase in
equity underwriting revenues during the 2006 period was partially offset by a
decrease in fixed income underwriting revenues. Advisory and other fees for the
2006 period increased 83.6% to $325.5 million from $177.3 million for the 2005
period reflecting a significant increase in completed M&A assignments during the
2006 period as well as an increase in mortgage servicing fees. Merchant banking
revenues increased to $67.0 million in the 2006 period from $54.7 million during
the 2005 period attributable to gains from the Company's principal investments
as well as improved performance fees on merchant banking funds.
Net interest revenues (interest and dividend revenue less interest expense)
increased 26.8% to $306.6 million for the 2006 quarter from $241.8 million for
the 2005 quarter. The increase in net interest revenues was primarily
attributable to improved net interest margins. Average customer margin debt
balances increased 5.7% to $68.4 billion for the 2006 quarter from $64.7 billion
for the 2005 quarter. Average customer short balances decreased 7.6% to $80.2
billion for the 2006 quarter from $86.8 billion for the 2005 quarter and average
securities borrowed balances decreased 11.5% to $54.8 billion for the 2006
quarter from $61.9 billion for the 2005 quarter.
Net interest revenues increased 20.6% to $577.3 million for the six months ended
May 31, 2006 from $478.7 million for the 2005 period. The increase in net
interest revenues was primarily attributable to improved net interest margins.
Average customer margin debt balances increased 3.3% to $66.5 billion for the
2006 period from $64.4 billion for the 2005 period. Average customer short
balances decreased 9.6% to $79.2 billion for the 2006 period from $87.7 billion
for the 2005 period and average securities borrowed balances decreased 16.2% to
$53.9 billion for the 2006 period from $64.3 billion for the 2005 period.
Asset management and other revenues decreased 12.1% to $77.0 million for the
2006 quarter from $87.6 million for the 2005 quarter, primarily reflecting
decreased performance fees on proprietary hedge fund products, partially offset
by increased management fees on private and traditional assets under management.
Private client services net revenues also increased due to higher levels of
fee-based assets.
Asset management and other revenues increased 21.5% to $217.1 million for the
six months ended May 31, 2006 from $178.6 million for the 2005 period, primarily
reflecting increased performance fees on proprietary hedge fund products,
increased management fees on higher levels of private and traditional assets
under management and an increase in private client services net revenues due to
higher levels of fee-based assets.
34
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Non-Interest Expenses
The Company's non-interest expenses were as follows:
Three Months Ended Six Months Ended
---------------------------------------------------------------------------------
May 31, May 31, % Increase May 31, May 31, %Increase
(in thousands) 2006 2005 (Decrease) 2006 2005 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Employee compensation and benefits $ 1,220,216 $ 922,908 32.2% $ 2,267,066 $ 1,829,683 23.9%
Floor brokerage, exchange and clearance fees 58,261 57,262 2.4% 109,864 114,580 (4.1%)
Communications and technology 118,169 100,343 17.8% 222,203 199,282 11.5%
Occupancy 45,422 40,756 11.4% 90,049 80,350 12.1%
Advertising and market development 35,093 34,577 1.5% 69,766 63,149 10.5%
Professional fees 65,468 61,278 6.8% 119,341 107,997 10.5%
Other expenses 122,254 193,989 (37.0%) 219,804 275,404 (20.2%)
------------------------------------------------------------------------------------------------------------------------------------
Total non-interest expenses $ 1,665,243 $ 1,411,113 18.0% $ 3,098,093 $ 2,670,445 16.0%
====================================================================================================================================
Employee compensation and benefits includes the cost of salaries, benefits and
incentive compensation, including CAP units, restricted stock units and option
awards. Employee compensation and benefits increased 32.2% to $1.22 billion for
the 2006 quarter from $922.9 million for the 2005 quarter, and increased 23.9%
to $2.27 billion for the six months ended May 31, 2006 from $1.83 billion for
the six months ended May 31, 2005, primarily due to higher discretionary
compensation associated with the increase in net revenues. Employee compensation
and benefits as a percentage of net revenues decreased to 48.8% for the 2006
quarter from 49.3% for the 2005 quarter, and decreased to 48.4% for the six
months ended May 31, 2006 from 49.3% for the six months ended May 31, 2005.
Full-time employees increased to 12,519 at May 31, 2006 from 11,141 at May 31,
2005. The growth in headcount is primarily due to the expansion of the Company's
fixed income, investment banking and wealth management areas, resulting from
increased business activities and growth initiatives.
Non-compensation expenses decreased 8.8% to $445.0 million for the 2006 quarter
from $488.2 million for the 2005 quarter and decreased 1.2% to $831.0 million
for the six months ended May 31, 2006 from $840.8 million for the six months
ended May 31, 2005. Non-compensation expenses as a percentage of net revenues
decreased to 17.8% for the 2006 quarter compared with 26.1% for the 2005
quarter, and decreased to 17.7% for the six months ended May 31, 2006 compared
with 22.7% for the six months ended May 31, 2005. Communications and technology
costs increased 17.8% and 11.5% for the three and six months ended May 31, 2006,
respectively, compared with the corresponding prior year periods, as increased
headcount resulted in higher voice and market data-related costs. Occupancy
costs increased 11.4% and 12.1% for the three and six months ended May 31, 2006,
respectively, compared with the corresponding prior year periods, 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 6.8% and 10.5% for the three and six months ended
May 31, 2006, respectively, compared with the corresponding prior year periods,
due to higher levels of employment agency and consulting fees. Other expenses
decreased 37.0% and 20.2% for the three and six months ended May 31, 2006,
respectively, compared with the corresponding prior year periods, primarily
reflecting a reduction in litigation related costs. CAP Plan related costs
increased 34.9% to $42.5 million for the 2006 quarter from $31.5 million in the
2005 quarter, and increased 12.9% to $78.5 million for the six months ended May
31, 2006 from $69.5 million for the six months ended May 31, 2005, reflecting
the higher level of earnings. Pre-tax profit margin was 33.4% and 33.9% for the
three and six months ended May 31, 2006, respectively, versus 24.7% and 28.0%
for the corresponding prior year periods.
The Company's effective tax rate decreased slightly to 35.3% for the 2006
quarter from 35.5% for the 2005 quarter. The Company's effective tax rate for
the six months ended May 31, 2006 decreased to 33.6% from 35.0% in the
comparable prior year period. During the six month period ended May 31, 2006,
the Company experienced favorable audit settlements which resulted in a
reduction in the consolidated tax rate.
35
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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.
The following segment operating results exclude certain unallocated revenues
(predominantly interest) as well as certain corporate administrative functions,
such as certain legal costs and costs related to the CAP Plan. See Note 12,
"Segment Data" in the Notes to Condensed Consolidated Financial Statements for
complete segment information.
Capital Markets
Three Months Ended Six Months Ended
---------------------------------------------------------------------------------
May 31, May 31, % May 31, May 31,
(in thousands) 2006 2005 Increase 2006 2005 %Increase
------------------------------------------------------------------------------------------------------------------------------------
Net revenues
Institutional equities $ 554,469 $ 390,453 42.0% $ 1,042,963 $ 703,393 48.3%
Fixed income 1,167,308 808,013 44.5% 2,056,046 1,673,520 22.9%
Investment banking 278,405 231,935 20.0% 574,999 449,329 28.0%
------------------------------------------------------------------------------------------------------------------------------------
Total net revenues $ 2,000,182 $ 1,430,401 39.8% $ 3,674,008 $ 2,826,242 30.0%
Pre-tax income $ 702,005 $ 455,776 54.0% $ 1,336,756 $ 937,459 42.6%
------------------------------------------------------------------------------------------------------------------------------------
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, convertible bonds,
over-the-counter equities, equity derivatives, risk and convertible arbitrage
and through a majority-owned joint venture, specialist activities on the NYSE,
American Stock Exchange and International Securities Exchange. Fixed income
includes sales, trading and research provided to institutional clients across a
variety of products such as mortgage- and asset-backed securities, corporate,
government and municipal bonds, high yield products, 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 39.8% to $2.0 billion for the 2006
quarter compared to $1.43 billion for the 2005 quarter. Pre-tax income for
Capital Markets increased 54.0% to $702.0 million for the 2006 quarter from
$455.8 million for the comparable prior year quarter. Pre-tax profit margin was
35.1% for the 2006 quarter compared with 31.9% for the 2005 quarter.
Institutional equities net revenues for the 2006 quarter increased 42.0% to
$554.5 million from $390.5 million for the comparable prior year quarter. Equity
derivatives net revenues increased during the 2006 quarter due to increased
customer activities. Net revenues from the Company's international equity sales
and trading area rose, reflecting higher trading volumes as well as higher
volatility and strong international M&A activity. Institutional equities net
revenues achieved during the 2006 quarter also reflected increased net revenues
from the Company's energy and commodity activities as well as gains on the
Company's investment in NYSE Group Inc.
Fixed income net revenues increased 44.5% to $1.17 billion for the 2006 quarter
from $808.0 million for the 2005 quarter. Mortgage-backed securities revenues
increased in the 2006 quarter when compared to the 2005 quarter on increased
origination volumes and active secondary trading for non-agency mortgage-backed
securities. During the 2006 quarter, the Company ranked as the No. 1 underwriter
of US mortgage-backed securities, capturing nearly 11% of the overall US
mortgage-backed securities
36
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
market. An increase in interest rate volatility resulted in higher interest rate
derivatives revenues on active customer volumes. Distressed debt and leveraged
finance revenues increased as spreads tightened and acquisition related finance
activities increased.
Investment banking revenues increased 20.0% to $278.4 million for the 2006
quarter from $231.9 million for the 2005 quarter. Underwriting revenues
increased 27.0% to $149.3 million for the 2006 quarter from $117.6 million for
the corresponding prior year quarter, as equity underwriting revenues increased,
reflecting an increase in the volume of IPOs and follow-on offerings, partially
offset by a decrease in fixed income underwriting revenues. Advisory and other
fees for the 2006 quarter increased 93.0% to $133.6 million from $69.2 million
for the 2005 quarter reflecting a significant increase in completed M&A
assignments during the 2006 quarter. Merchant banking revenues decreased to a
$4.5 million loss in the 2006 quarter from a $45.2 million gain during the 2005
quarter. An unrealized loss on our remaining investment in portfolio company New
York & Company, Inc. offset other gains in the portfolio during the 2006
quarter.
Net revenues for Capital Markets increased 30.0% to $3.67 billion for the six
months ended May 31, 2006 compared to $2.83 billion for the 2005 period. Pre-tax
income for Capital Markets increased 42.6% to $1.34 billion for the 2006 period
from $937.5 million for the comparable prior year period. Pre-tax profit margin
was 36.4% for the 2006 period compared with 33.2% for the 2005 period.
Institutional equities net revenues for the 2006 period increased 48.3% to $1.04
billion from $703.4 million for the comparable prior year period. Equity
derivatives net revenues increased due to increased customer activities
resulting from rising equity markets. Net revenues from the Company's
international equity sales and trading area rose, reflecting higher trading
volumes as well as higher volatility and strong international M&A activity. In
addition, net revenues from the risk arbitrage business increased on higher
global announced M&A volumes. Revenues from the Company's energy and commodity
activities also increased, reflecting gains from the sale of certain commodity
assets and increased revenues from the Company's energy activities.
Fixed income net revenues increased 22.9% to $2.06 billion for the 2006 period
from $1.67 billion for the comparable prior year period. Mortgage-backed
securities revenues increased in the 2006 period, when compared to the prior
year period on increased origination volumes and active secondary trading
markets. Net revenues from non-agency fixed rate whole loans, ARMS and
commercial mortgage-backed securities all improved during the 2006 period,
reflecting increased securitization activity and generally tighter mortgage
spreads. Leverage finance net revenues also increased as acquisition related
financing activity rose. Partially offsetting these increases was a decline in
credit derivative revenues due to less favorable market conditions.
Investment banking revenues increased 28.0% to $575.0 million for the 2006
period from $449.3 million for the 2005 period. Underwriting revenues increased
5.8% to $285.5 million for the 2006 period from $269.8 million for the
corresponding prior year period, as equity underwriting revenues increased,
reflecting increased industry volume, partially offset by a decrease in fixed
income underwriting revenues. Advisory and other fees for the 2006 period
increased 78.4% to $222.6 million from $124.8 million for the prior year period
reflecting increased M&A fees due to a significant increase in completed M&A
assignments during the quarter. Merchant banking revenues increased to $67.0
million in the 2006 period from $54.7 million during the 2005 period
attributable to gains from the Company's principal investments as well as
increased performance fees on merchant banking funds.
Global Clearing Services
Three Months Ended Six Months Ended
---------------------------------------------------------------------------------
May 31, May 31, % Increase May 31, May 31, %Increase
(in thousands) 2006 2005 (Decrease) 2006 2005 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Net revenues $ 289,523 $ 276,160 4.8% $ 553,515 $ 546,552 1.3%
Pre-tax income $ 139,045 $ 142,989 (2.8%) $ 268,617 $ 280,763 (4.3%)
------------------------------------------------------------------------------------------------------------------------------------
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
37
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
institutional brokerage business. At May 31, 2006 and May 31, 2005, the Company
held approximately $274.6 billion and $252.5 billion, respectively, in equity in
Global Clearing Services client accounts.
Net revenues for Global Clearing Services increased 4.8% to $289.5 million for
the 2006 quarter from $276.2 million in the 2005 quarter. Net interest revenues
increased 7.6% to $211.0 million for the 2006 quarter from $196.1 million for
the prior year quarter, on improved net interest margins. Commission revenues
decreased 7.2% to $62.6 million for the 2006 quarter from $67.5 million for the
comparable prior year quarter reflecting lower average rates from prime
brokerage clients. Pre-tax income decreased 2.8% to $139.0 million, from $143.0
million for the 2005 quarter. Pre-tax profit margin was 48.0% for the 2006
quarter compared to 51.8% for the 2005 quarter.
Net revenues for Global Clearing Services increased 1.3% to $553.5 million for
the six months ended May 31, 2006 from $546.6 million in the 2005 period. Net
interest revenues increased 4.2% to $410.6 million for the 2006 period from
$394.2 million for the prior year period, on improved net interest margins.
Commission revenues decreased 9.5% to $121.8 million for the 2006 period from
$134.6 million for the comparable prior year period reflecting lower trading
volumes and rates from prime brokerage clients. Pre-tax income decreased 4.3% to
$268.6 million, from $280.8 million for the 2005 period. Pre-tax profit margin
was 48.5% for the 2006 period compared to 51.4% for the 2005 period.
The following table presents the Company's interest-bearing balances for the
fiscal periods ended:
Three Months Ended Six Months Ended
----------------------------------------------------------------------------------------------
May 31, May 31, May 31, May 31
(in billions) 2006 2005 2006 2005
----------------------------------------------------------------------------------------------
Margin debt balances, average for period $ 68.4 $ 64.7 $ 66.5 $ 64.4
Margin debt balances, at period end 72.7 59.8 72.7 59.8
Customer short balances, average for period 80.2 86.8 79.2 87.7
Customer short balances, at period end 81.7 82.5 81.7 82.5
Securities borrowed, average for period 54.8 61.9 53.9 64.3
Securities borrowed, at period end 52.1 56.6 52.1 56.6
Free credit balances, average for period 30.8 30.6 30.4 30.9
Free credit balances, at period end 34.1 31.6 34.1 31.6
Equity held in client accounts, at period end 274.6 252.5 274.6 252.5
----------------------------------------------------------------------------------------------
Wealth Management
Three Months Ended Six Months Ended
---------------------------------------------------------------------------------
May 31, May 31, % Increase May 31, May 31, %Increase
(in thousands) 2006 2005 (Decrease) 2006 2005 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Private client services revenues $ 153,014 $ 130,284 17.4% $ 306,092 $ 263,579 16.1%
Revenue transferred to Capital Markets segment (24,125) (24,647) (2.1%) (48,409) (44,067) 9.9%
---------------------------------------------------------------------------------
Private client services net revenues 128,889 105,637 22.0% 257,683 219,512 17.4%
Asset management 22,182 50,148 (55.8%) 116,657 105,463 10.6%
---------------------------------------------------------------------------------
Total net revenues $ 151,071 $ 155,785 (3.0%) $ 374,340 $ 324,975 15.2%
Pre-tax income $ (13,317) $ 6,054 nm $ 18,856 $ 21,033 (10.4%)
------------------------------------------------------------------------------------------------------------------------------------
nm - not meaningful
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 May 31, 2006, 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 US and abroad.
38
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Net revenues for Wealth Management decreased 3.0% to $151.1 million for the 2006
quarter from $155.8 million for the 2005 quarter. PCS revenues increased 22.0%
to $128.9 million for the 2006 quarter from $105.6 million for the 2005 quarter
reflecting higher levels of fee-based income attributable to the Company's
private client advisory services products. Asset management revenues decreased
55.8% to $22.2 million for the 2006 quarter from $50.1 million for the 2005
quarter, primarily reflecting decreased performance fees on proprietary hedge
fund products, partially offset by increased management fees resulting from the
growth in assets under management.
Net revenues for Wealth Management increased 15.2% to $374.3 million for the six
months ended May 31, 2006 from $325.0 million for the 2005 period. PCS revenues
increased 17.4% to $257.7 million for the 2006 period from $219.5 million for
the 2005 period reflecting higher levels of fee-based income attributable to the
Company's private client advisory services products. Asset management revenues
increased 10.6% to $116.7 million for the 2006 period from $105.5 million for
the 2005 period. This increase reflects increased management fees resulting from
growth in assets under management and increased performance fees on proprietary
hedge fund products.
Assets under management were $47.9 billion at May 31, 2006, reflecting a 20.1%
increase from $39.9 billion in assets under management at May 31, 2005. The
increase in assets under management is due to the growth in traditional equity
assets attributable to market appreciation and net inflows. Assets under
management at May 31, 2006 include $6.8 billion of assets from alternative
investment products, an increase from $6.0 billion at May 31, 2005.
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 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 May 31, 2006 increased to $326.2 billion from
$292.6 billion at November 30, 2005. The increase was primarily attributable to
increases in securities borrowed, securities received as collateral, financial
instruments owned, at fair value and cash and securities deposited with clearing
organizations or segregated in compliance with federal regulations, 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 $58.4
billion at May 31, 2006 from $54.3 billion at November 30, 2005. This change was
primarily due to a net increase in long-term debt and an increase in
stockholders' equity due to earnings as well as income tax benefits attributable
to the distribution of common stock under the Company's deferred compensation
plans.
39
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's total capital base as of May 31, 2006 and November 30, 2005 was as
follows:
May 31, November 30,
(in millions) 2006 2005
--------------------------------------------------------------------------
Long-term borrowings:
Senior debt $ 46,384 $ 43,227
Subordinated debt (1) 263 263
--------------------------------------------------------------------------
Total long-term borrowings $ 46,647 $ 43,490
Stockholders' equity:
Preferred stockholders' equity $ 367 $ 372
Common stockholders' equity 11,341 10,419
--------------------------------------------------------------------------
Total stockholders' equity $ 11,708 $ 10,791
--------------------------------------------------------------------------
Total capital $ 58,355 $ 54,281
==========================================================================
(1) Represents junior subordinated deferrable interest debentures issued by the
Company, held by Bear Stearns Capital Trust III.
The amount of long-term debt and 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 quarter end are 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 May 31, 2006 and November 30, 2005,
total assets of $326.2 billion and $292.6 billion were approximately 0.8% and
5.6%, respectively, lower than the average of the month-end balances observed
over the trailing 12-month period. Despite reduced total assets at 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.
Leverage Ratios
Balance sheet leverage measures are one approach to assessing the capital
adequacy of securities firms. The following table presents total assets and net
adjusted assets with the resultant leverage ratios at May 31, 2006 and November
30, 2005. 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 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,
collateralized nature of its securities purchased under agreements to resell,
securities borrowed, securities received as collateral, customer receivables and
segregated cash assets renders net adjusted leverage as the relevant measure.
40
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
May 31, November 30,
(in millions, except ratios) 2006 2005
--------------------------------------------------------------------------------
Total assets $ 326,180 $ 292,635
Deduct:
Cash and securities deposited with
clearing organizations or segregated
in compliance with federal regulations 7,189 5,270
Securities purchased under agreements to
resell 39,605 42,648
Securities received as collateral 17,118 12,426
Securities borrowed 72,766 62,915
Receivables from customers 33,091 33,255
Goodwill & intangible assets 352 355
--------------------------------------------------------------------------------
Subtotal 156,059 135,766
--------------------------------------------------------------------------------
Add:
Financial instruments sold, but not yet
purchased 41,453 35,004
Deduct:
Derivative liabilities 15,179 12,957
--------------------------------------------------------------------------------
Net adjusted assets $ 182,333 $ 157,813
================================================================================
Stockholders' equity
Common equity $ 11,341 $ 10,419
Preferred stock 367 372
--------------------------------------------------------------------------------
Total stockholders' equity 11,708 10,791
--------------------------------------------------------------------------------
Add:
Trust preferred equity 263 263
--------------------------------------------------------------------------------
Subtotal - leverage equity 11,971 11,054
--------------------------------------------------------------------------------
Deduct:
Goodwill & intangible assets 352 355
--------------------------------------------------------------------------------
Tangible equity capital $ 11,619 $ 10,699
================================================================================
Gross leverage 27.2 x 26.5 x
Net adjusted leverage 15.7 x 14.8 x
--------------------------------------------------------------------------------
Funding Strategy & Liquidity Risk Management
General Funding Strategy
Liquidity is extraordinarily important for financial services firms in general
and for securities firms, given reliance on market confidence. Consequently, the
Company focuses on management of funding and liquidity risk. 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, bank loans and
other 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
41
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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
stressed environment. In the vast majority of circumstances/asset classes, they
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 the "market
environment." As such, the advance rates/haircuts in the alternative liquidity
models are 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 in the
liquidity ratio in that the haircut is equal to one minus the advance rate.
As of May 31, 2006, the market value of unencumbered, unhypothecated financial
instruments owned by the Company was approximately $39.8 billion with a
borrowing value of $31.3 billion. The assets are composed of primarily 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 64% to 96% 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 137% over the previous 12 months including unused committed unsecured
bank credit, and 128% excluding the unsecured portion of the Company's $4.0
billion committed revolving credit facility. On this same basis, the liquidity
ratio was 120% as of May 31, 2006 and 114% excluding committed unsecured bank
credit. In addition to Company-owned unencumbered financial instruments, as of
May 31, 2006, the Company held $66.9 billion of collateral owned by customers
and introducing brokers that could be repledged to raise secured funding. Of
this total, $2.3 billion was readily available to pledge to meet the Company's
liquidity needs given current reserve requirements. Inclusive of both the
readily available portion of customer and introducing broker collateral and
unused committed secured bank credit, the liquidity ratio at May 31, 2006 was
127%.
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 $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
42
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(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 May 31, 2006, approximately $26.0 billion of the
market value identified in the liquidity ratio data above was held in
unregulated entities and thus unrestricted as to parent availability, 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 $9.8 billion market value of unencumbered securities was held in
regulated entities, a portion of which may 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 May 31, 2006, the Company's net cash capital position was $4.1 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 net cash capital position has averaged $2.6 billion.
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. As of May 31, 2006, 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
43
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Company and BSIL to borrow up to $2.0 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 2007, with all loans
outstanding at that date payable no later than February 2008. There were no
borrowings outstanding under the Facility at May 31, 2006.
The Company has a $1.50 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, Bear
Stearns International Trading Limited ("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 2006, with all repos outstanding at that date payable no
later than August 2007. There were no borrowings outstanding under the Repo
Facility at May 31, 2006.
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 and BSJL. 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 2006 with all loans outstanding at that date payable no later than
December 2007. There were no borrowings outstanding under the Pan Asian Facility
at May 31, 2006.
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. The Tax Lien Facility
terminates in March 2007 with all loans outstanding at that date payable no
later than March 2008. There were no borrowings outstanding under the Tax Lien
Facility at May 31, 2006.
The Company also maintains a series of committed credit facilities to support
liquidity needs for the financing of investment-grade and non-investment-grade
corporate loans, residential mortgages, 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 2007. 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 $4.6 billion. At May 31, 2006, the
borrowings outstanding under these committed credit facilities were $163.7
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, Bear
Stearns Commercial Mortgage, Inc. and 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 May 31, 2006, the Parent Company's equity investment in
subsidiaries was $7.8 billion versus common stockholders' equity and preferred
equity of $11.3 billion and $366.9 million, respectively. As such, at May 31,
2006, the ratio of the equity investment in subsidiaries to Parent Company
equity (equity double leverage) was
44
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
approximately 0.69 based on common equity and 0.66 including preferred equity.
At November 30, 2005, these measures were 0.69 based on common equity and 0.67
including preferred equity. Additionally, all subordinated debt advances to
regulated subsidiaries for use as regulatory capital, which totaled $10.4
billion at May 31, 2006, 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 $41.4 billion and $37.0 billion had remaining maturities
beyond one year at May 31, 2006 and November 30, 2005, 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 May 31, 2006, a
downgrade by either Moody's Investors Service or Standard & Poor's in the
Company's long-term credit ratings to the level of A3 or A- would have resulted
in the Company needing to post $43.0 million in additional collateral pursuant
to contractual arrangements for outstanding over-the-counter derivatives
contracts. A downgrade to Baa1 or BBB+ would have resulted in needing to post an
additional $362.3 million in collateral.
At May 31, 2006, the Company's long-term/short-term debt ratings were as
follows:
Rating
-------------------------------------------------------------------
Dominion Bond Rating Service Limited A(high)/R-1 (middle)
Fitch Ratings A+/F1+
Moody's Investors Service A1/P-1
Rating & Investment Information, Inc. A+/NR
Standard & Poor's Ratings
Services A/A-1
-------------------------------------------------------------------
NR - does not assign a short-term rating
In October 2005, Standard & Poor's Ratings Services changed the outlook on The
Bear Stearns Companies Inc. from stable to positive. Simultaneously, the A/A-1
ratings were affirmed. Standard & Poor's cited the outlook change reflects the
Company's high profitability with low earnings volatility during the past
several years. Standard & Poor's also cited the strength of the Company's
various franchises, conservative management team and low tolerance for risk.
Standard & Poor's cited the outlook change indicates that the rating could be
raised during the next one to two years if the Company continues to perform
well.
In June 2006, Japan Credit Rating Agency, Ltd. assigned a rating of AA to The
Bear Stearns Companies Inc. senior long-term debt 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
45
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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.
The Company has two authorizations to purchase its common stock in fiscal 2006.
On December 12, 2005, the Board of Directors of the Company approved an
amendment to the Stock Repurchase Program ("Repurchase Program") to replenish
the previous authorization to allow the Company to purchase up to $1.5 billion
of common stock in fiscal 2006 and beyond. During the quarter ended May 31,
2006, the Company purchased under the current authorization a total of 24,295
shares at a cost of approximately $3.2 million. The Company may, depending upon
price and other factors, acquire additional shares in excess of that required
for annual share awards. Approximately $1.05 billion was available to be
purchased under the current authorization as of May 31, 2006.
Under the second stock repurchase authorization, during the quarter ended May
31, 2006, the Company purchased a total of 363,473 shares of its common stock at
a total cost of $50.0 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 9, 2005. Approximately $120.5
million is available to be purchased under the current authorization as of May
31, 2006.
Cash Flows
Cash and cash equivalents increased $132.2 million to $5.99 billion at May 31,
2006 from $5.86 billion at November 30, 2005. Cash used in operating activities
was $15.16 billion, primarily attributable to increases in financial instruments
owned and securities borrowed, net of securities loaned, partially offset by an
increase in financial instruments owned, but not yet purchased and 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 $91.5 million reflected purchases of
property, equipment and leasehold improvements. Cash provided by financing
activities of $15.39 billion reflected proceeds from the issuance of long-term
borrowings of $8.81 billion and net proceeds relating to short-term borrowings
of $12.89 billion, primarily to fund normal operating activities. This was
partially offset by payments for the retirement/repurchase of long-term
borrowings of $6.42 billion. Treasury stock purchases of $529.6 million were
made to provide for the annual grant of CAP Plan units, RSUs and stock options.
Regulated Subsidiaries
Effective December 1, 2005, the Company became 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 May 31, 2006, 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. Effective December 1, 2005
the SEC approved Bear Stearns' use of 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, London-based broker-dealer subsidiaries, are subject to the regulatory
capital requirements of the U.K.'s Financial Services Authority. Additionally,
BSB is subject to the regulatory capital requirements of the Financial
Regulator. At May 31, 2006, Bear Stearns, BSSC, BSIL, BSIT and BSB were in
compliance with their respective regulatory capital 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.
46
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 May 31,
2006, the Company held investments with an aggregate recorded value of
approximately $720.5 million, reflected in the Condensed Consolidated Statements
of Financial Condition, primarily in "Other assets." At November 30, 2005, the
Company held investments with an aggregate recorded value of approximately
$658.8 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 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 May 31, 2006 and November 30,
2005, the Company held high yield positions approximating $8.61 billion and
$6.71 billion, respectively, substantially all of which are in "Financial
instruments owned" in the Condensed Consolidated Statements of Financial
Condition, and $1.50 billion and $1.72 billion, 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 May 31,
2006 and November 30, 2005, the amount outstanding to highly leveraged borrowers
totaled $4.95 billion and $4.24 billion, respectively. The largest industry
concentration was the telecommunications industry, which approximated 14.3% and
17.2% of these highly leveraged borrowers' positions at May 31, 2006 and
November 30, 2005, 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 May 31, 2006, the Company's
contractual obligations by maturity, excluding derivative financial instruments,
were as follows:
Payments Due By Period
---------------------------------------------------
Remaining Fiscal Fiscal
(in millions) Fiscal 2006 2007- 2008 2009- 2010 Thereafter Total
----------------------------------------------------------------------------------------------
Long-term borrowings (1)(2) $1,777 $16,104 $13,316 $15,450 $46,647
Future minimum lease payments(3)(4) 42 171 146 229 588
----------------------------------------------------------------------------------------------
(1) Amounts include fair value adjustments in accordance with Statement of
Financial Accounting Standards ("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 2007 and fiscal 2008 are approximately $2.2 billion and
$0.1 billion, respectively, 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 2009, fiscal 2010 and thereafter.
(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.
47
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
May 31, 2006 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
(in millions) Fiscal 2006 2007-2008 2009-2010 Thereafter stated maturity Total
------------------------------------------------------------------------------------------------------------------------------------
Lending-related commitments:
Investment-grade (2) $ 1,126 $ 490 $ 1,053 $ 484 $ - $ 3,153
Non-investment-grade 339 504 614 506 - 1,963
Contingent commitments 3,408 411 - - 1,087 4,906
Commitments to invest in private
equity-related investments
and partnerships (3) - - - - 192 192
Underwriting commitments 439 - - - - 439
Commercial and residential loans 2,129 320 47 - - 2,496
Letters of credit 3,654 174 35 - - 3,863
Other commercial commitments 31 56 - - - 87
------------------------------------------------------------------------------------------------------------------------------------
(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 borrowings, the
Company entered into credit default swaps aggregating $736 million at May
31, 2006.
(3) At May 31, 2006, commitments to invest in private equity-related
investments and partnerships aggregated $191.6 million. 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.
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
48
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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. Certain 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 derivatives 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 economically
hedge its 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 May 31, 2006 and November 30, 2005, the Company had notional/contract
amounts of approximately $7.59 trillion and $5.45 trillion, respectively, of
derivative financial instruments, of which $1.27 trillion and $1.13 trillion,
respectively, were listed futures and option contracts. The aggregate
notional/contract value of derivative contracts is a 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.
49
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's derivatives had a notional weighted average maturity of
approximately 4.6 years and 4.1 years at May 31, 2006 and November 30, 2005,
respectively. The maturities of notional/contract amounts outstanding for
derivative financial instruments as of May 31, 2006 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, $ 740.9 $ 1,593.1 $ 1,154.2 $ 2,667.6 $ 6,155.8
swaptions, caps, collars and floors
Futures contracts 380.3 191.4 24.1 - 595.8
Forward contracts 117.3 - - - 117.3
Options held 448.7 31.5 0.8 0.1 481.1
Options written 209.8 25.2 1.0 0.2 236.2
------------------------------------------------------------------------------------------------------------------------------------
Total $ 1,897.0 $ 1,841.2 $ 1,180.1 $ 2,667.9 $ 7,586.2
====================================================================================================================================
Percent of total 25.0% 24.3% 15.5% 35.2% 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's financial instruments can be aggregated in three broad categories:
(1) those whose fair value is based on quoted market prices or for which the
Company has independent external valuations, (2) those whose fair value is
determined based on readily observable price levels for similar instruments
and/or models or methodologies that employ data that are observable from
objective sources, and (3) those whose 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.
(1) Financial Instruments Valued Based on Quoted Market Prices or for Which the
Company Has Independent External Valuations
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, most
mortgage-backed securities and corporate, emerging market, high yield and
municipal bonds. Unlike most equities, which tend to be traded on exchanges, the
vast majority of fixed income trading (including US Treasuries) occurs in
over-the-counter markets, and, accordingly, the Company's valuation policy is
based on its best estimate of the prices at which these financial instruments
trade in those markets. The Company is an active dealer in most of the
over-the-counter markets for these financial instruments, and typically has
considerable insight into the trading level of financial instruments held in
inventory and/or related financial instruments that it uses as a basis for its
valuation.
50
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(2) Financial Instruments Whose Fair Value Is Determined Based on Internally
Developed Models or Methodologies That Employ Data That Are Readily Observable
from Objective Sources
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 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 follows Emerging Issues Task Force ("EITF") Statement No. 02-3,
"Issues Involved in Accounting for Derivative Contracts Held for Trading
Purposes and Contracts Involved in Energy Trading and Risk Management
Activities." This guidance prohibits recognizing profit at the inception of a
derivative contract unless the fair value of the derivative is obtained from a
quoted market price in an active market or is otherwise evidenced by comparison
to other observable current market transactions or based on a valuation
technique that incorporates observable market data.
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.
At May 31, 2006 and November 30, 2005, the total value of all financial
instruments whose 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 (primarily fixed income
cash positions) aggregated approximately $9.3 billion and $7.1 billion,
respectively, in "Financial instruments owned" and $5.2 billion and $3.5
billion, respectively, in "Financial instruments sold, but not yet purchased" in
the Condensed Consolidated Statements of Financial Condition.
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.
51
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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. Generally, the
carrying values of these securities will be increased only in those instances
where market values are readily ascertainable by reference to substantial
transactions occurring in the marketplace or quoted market prices. If quoted
market prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, fair value is determined based on
other relevant factors. 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, how such matters will be resolved, when they will
ultimately be resolved, or what the eventual settlement, fine, penalty or other
relief might be.
The Company is subject to the income tax laws of the US, 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.
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.
52
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ACCOUNTING AND REPORTING DEVELOPMENTS
In June 2005, the EITF reached a consensus on 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. This guidance became effective upon ratification by
the FASB on June 29, 2005 for all newly formed limited partnerships and for
existing limited partnerships for which the partnership agreements have been
modified. For all other limited partnerships, the guidance is effective no later
than the beginning of the first reporting period in fiscal years beginning after
December 15, 2005. For new and modified limited partnerships, the adoption of
the EITF did not have a material impact on the consolidated financial statements
of the Company. For the previously existing limited partnerships, the Company
does not expect the EITF consensus to have a material impact on the consolidated
financial statements of the Company.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid
Financial Instruments." SFAS No. 155 is an amendment of SFAS No. 133 and SFAS
No. 140. SFAS No. 155 permits companies to elect, on a deal by deal basis, to
apply a fair value remeasurement for any hybrid financial instrument that
contains an embedded derivative that otherwise would require bifurcation. SFAS
No. 155 is effective for all financial instruments acquired or issued after the
beginning of an entity's first fiscal year that begins after September 15, 2006.
The Company does not expect SFAS No. 155 to have a material impact on the
consolidated financial statements of the Company.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets." SFAS No. 156 amends SFAS No. 140. SFAS No. 156 requires that
all separately recognized servicing assets and servicing liabilities be
initially measured at fair value. For subsequent measurements, SFAS No. 156
permits companies to choose between using an amortization method or a fair value
measurement method for reporting purposes. SFAS No. 156 is effective as of the
beginning of a company's first fiscal year that begins after September 15, 2006.
The Company does not expect SFAS No. 156 to have a material impact on the
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.
53
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
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 and equity price risk, as well as
a discussion of the Company's credit risk including how those exposures are
managed, refer to the Company's Annual Report on Form 10-K for the fiscal year
ended November 30, 2005.
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.
54
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
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),
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
three 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 May 31, 2006, February 28, 2006, November
30, 2005 and August 31, 2005. Commodity risk has been excluded due to
immateriality for each period presented.
(in millions) May 31, February 28, November 30, August 31,
2006 2006 2005 2005
--------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 32.5 $ 25.6 $ 22.1 $ 25.8
Currency 1.0 0.4 0.3 0.5
Equity 5.4 3.4 3.6 1.1
Diversification benefit (8.1) (4.5) (4.6) (3.1)
--------------------------------------------------------------------------------
Aggregate VaR $ 30.8 $ 24.9 $ 21.4 $ 24.3
================================================================================
The table below illustrates the high, low and average VaR for each component of
market risk and aggregate market risk during the quarters ended May 31, 2006 and
February 28, 2006:
Quarter Ended May 31, 2006 Quarter Ended February 28, 2006
--------------------------------------------------------------------------------
(in millions) High Low Average High Low Average
--------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 40.6 $ 26.5 $ 33.6 $ 30.5 $ 20.3 $ 24.8
Currency 2.4 0.0 0.7 1.6 0.0 0.6
Equity 9.3 2.5 6.2 5.6 2.5 3.8
Aggregate VaR 44.4 24.0 33.7 30.1 19.0 23.8
================================================================================
As previously discussed, 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.
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 May 31, 2006
and 2005. 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 $23.3 million and $15.3
million for the
55
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
quarters ended May 31, 2006 and 2005, respectively. There were four daily
trading losses for both the quarters ended May 31, 2006 and May 31, 2005. Daily
trading losses never exceeded the reported average VaR amounts during the fiscal
quarters ended May 31, 2006 and 2005. 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 May 31, 2006 and 2005. 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 May 31, 2006 and May 31, 2005
[GRAPHIC OMITTED - BAR CHART]
[DAILY NET TRADING REVENUES]
May 31, 2006 May 31, 2005
--------------------- ---------------------
(10)+ - (10)+ -
(10)-(5) - (10)-(5) 3
(5)-0 4 (5)-0 1
0-5 2 0-5 6
5-10 4 5-10 7
10-15 6 10-15 22
15-20 14 15-20 9
20-25 13 20-25 7
25-30 9 25-30 5
30+ 12 30+ 4
---------- ---------
Total 64 Total 64
56
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 May 31, 2006 and November 30, 2005 approximated $4.36 billion
and $4.41 billion, respectively. Exchange-traded financial instruments, which
typically are guaranteed by a highly rated clearing organization, have margin
requirements that substantially mitigate the risk of credit loss.
The following table summarizes the counterparty credit quality of the Company's
exposure with respect to over-the-counter derivatives (including foreign
exchange and forward-settling mortgage transactions) as of May 31, 2006:
Over-the-Counter Derivative Credit Exposure (1)
($ in millions)
Exposure Percentage of
Net of Exposure, Net
Rating (2) Exposure Collateral(3) Collateral(4) of Collateral
----------------------------------------------------------------------------
AAA $ 901 $ 31 $ 871 20%
AA 5,762 3,966 1,880 43%
A 2,880 1,884 1,086 25%
BBB 330 241 222 5%
BB and lower 1,321 2,851 281 6%
Non-rated 21 6 21 1%
----------------------------------------------------------------------------
(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.
57
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. 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.
58
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 2005
Financial Report; Part I, Item 3, of the Company's Annual Report on Form 10-K
for the fiscal year ended November 30, 2005, as amended by Amendment No. 1
thereto on Form 10-K/A (together the "Form 10-K"); and Note 10 to the
consolidated financial statements and Part II, Item 1, included in the Company's
Form 10-Q for the quarterly period ended February 28, 2006. The following
discussion is limited to recent developments concerning our legal proceedings
and should be read in conjunction with those earlier Reports.
Enron Corp. v. International Finance Corp., et al.:
---------------------------------------------------
As previously reported in the Company's Form 10-K, Bear Stearns, along with
other parties, has been named as a defendant in an adversary proceeding
commenced by Enron in the United States Bankruptcy Court for the Southern
District of New York. The matter involves allegations that certain alleged
payments by Enron to defendants relating to a purchase of notes issued by ENA
CLO Trust constituted fraudulent transfers in violation of Section 548(a)(1) of
the United States Bankruptcy Code. By Order and Opinion dated May 2, 2006, the
Bankruptcy Court granted defendants' motions to dismiss the complaint in this
action.
Enron Corp., et ano. v. Bear, Stearns International Ltd., et ano.:
------------------------------------------------------------------
As previously reported in the Company's Form 10-K, BSIL and BSSC were named as
defendants in an adversary proceeding commenced by Enron and Enron North America
Corp. in the United States Bankruptcy Court for the Southern District of New
York. Plaintiffs seek, inter alia, to recover payments totaling approximately
$26 million that were allegedly made to defendants during August 2001 in
connection with an equity forward derivative contract between BSIL and Enron. By
Order dated June 3, 2005, the Bankruptcy Court denied the motion to dismiss
filed by BSIL and BSSC, and defendants subsequently filed a motion with United
States District Court for the Southern District of New York for leave to take an
interlocutory appeal from the Bankruptcy Court's decision. By Order dated May 2,
2006, the District Court denied defendants' motion for leave to take an
interlocutory appeal from the Bankruptcy Court's decision.
Sterling Foster & Co., Inc. Litigation:
---------------------------------------
As previously reported in the Company's Form 10-K, Bear Stearns and BSSC have
been named as defendants in two purported class actions arising out of Bear
Stearns' role as clearing broker for Sterling Foster & Co., Inc. A former
officer of BSSC is also a defendant in one of the actions. Bear Stearns, BSSC,
and the former officer of BSSC have entered into a settlement agreement with the
plaintiffs and certain other defendants that would resolve all claims against
them as defendants in both class actions. This settlement is subject to approval
by the United States District Court for the Eastern District of New York, which
has scheduled a hearing on the fairness of the proposed settlement's terms.
IPO Underwriting Fee Antitrust Litigation:
------------------------------------------
As previously reported in the Company's Form 10-K, Bear Stearns, along with
numerous other financial services firms, is a defendant in several consolidated
antitrust-related class actions currently pending in the United States District
Court for the Southern District of New York. The first consolidated action
purports to be brought on behalf of a putative class of purchasers of stock in
initial public offerings (the "Purchaser Action"). The second consolidated
action purports to be brought on behalf of a putative class of issuers of stock
in initial public offerings
59
LEGAL PROCEEDINGS
(the "Issuer Action"). Each suit alleges that Bear Stearns violated federal
antitrust laws by fixing underwriting fees at 7% for initial public offerings
with an aggregate issuance value of $20-$80 million for the time period 1994 to
the present. The Purchaser Action currently involves only claims for declaratory
relief, while the Issuer Action asserts claims for treble damages.
On September 16, 2005, plaintiffs in the Purchaser Action and the Issuer Action
moved for class certification. By Order dated April 18, 2006, the District Court
denied the Issuer Action plaintiffs' motion for class certification and
postponed a ruling on the class certification motion in the Purchaser Action
pending resolution of whether, in light of the Court's ruling in the Issuer
Action, the Purchaser Action plaintiffs nonetheless want to proceed with their
action.
60
Item 2. UNREGISTRERED 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 second quarter of fiscal 2006:
Approximate Dollar
Total Number of Shares Value of Shares that
Purchased as Part of May Yet Be Purchased
Total Number of Shares Average Price Paid Publicly Announced Under the Plans or
Period Purchased per Share Plans or Programs (1) Programs (1)
----------------------------------- ------------------------- ------------------- ----------------------- ----------------------
3/1/06 - 3/31/06 142,270 $ 135.00 142,270 $ 1,204,367,245
4/1/06 - 4/30/06 107,096 143.29 107,096 1,189,021,797
5/1/06 - 5/31/06 138,402 134.86 138,402 1,170,357,122
------------------------- -----------------------
Total 387,768 137.24 387,768
========================= =======================
(1) On December 12, 2005, the Board of Directors of the Company approved an
amendment to the Repurchase Program to replenish the previous authorization in
order to allow the Company to purchase up to $1.5 billion of common stock in
fiscal 2006 and beyond. The Repurchase Program has no set expiration or
termination date. On December 9, 2005, the Compensation Committee of the Board
of Directors approved a $200 million CAP Plan Earnings Purchase Authorization to
allow the Company to purchase up to $200 million of common stock in fiscal 2006.
61
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Annual Meeting of the Company held on April 11, 2006 (the "Annual
Meeting"), the stockholders of the Company approved an amendment to the
Company's Capital Accumulation Plan to expand the definition of Eligible
Employees to include all Senior Managing Directors employed by the Company and
all employees of subsidiaries and affiliates who are deemed by the Compensation
Committee of the Board of Directors to be equivalent to the grade of Senior
Managing Director. In addition, at the Annual Meeting the stockholders of the
Company elected twelve directors to serve until the next Annual Meeting of
Stockholders or until successors are duly elected and qualified and ratified the
appointment of Deloitte & Touche LLP as the independent registered public
accounting firm for the fiscal year ending November 30, 2006.
The affirmative vote of a majority of the shares of common stock represented at
the Annual Meeting and entitled to vote was required for the approval of the
amendment to the Capital Accumulation Plan and ratification of the independent
registered public accounting firm, while the affirmative vote of a plurality of
the votes cast by holders of shares of common stock was required to elect the
directors.
With respect to the approval of the amendment to the Capital Accumulation Plan
and ratification of the independent registered public accounting firm, set forth
below is information on the results of the votes cast at the Annual Meeting.
For Against Abstained Broker Non-Votes
----------- --------- --------- ----------------
Amendment to the Capital Accumulation Plan 81,388,485 3,579,464 1,175,271 25,476,664
Ratification of the independent
registered public accounting firm 109,095,483 1,654,729 869,672 N/A
With respect to the election of directors, set forth below is information with
respect to the nominees elected as directors of the Company at the Annual
Meeting and the votes cast for and withheld with respect to each such nominee.
Nominees For Withheld
--------------------------- ----------------- ----------------
James E. Cayne 108,922,901 2,696,983
Henry S. Bienen 106,929,001 4,690,883
Carl D. Glickman 105,877,644 5,742,240
Alan C. Greenberg 108,515,862 3,104,022
Donald J. Harrington 102,672,778 8,947,106
Frank T. Nickell 102,694,951 8,924,933
Paul A. Novelly 106,643,922 4,975,962
Frederic V. Salerno 105,812,653 5,807,231
Alan D. Schwartz 108,366,231 3,253,653
Warren J. Spector 108,364,437 3,255,447
Vincent Tese 105,267,483 6,352,401
Wesley S. Williams Jr. 110,359,451 1,260,433
--------------------------------------------------------------
62
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
63
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: July 10, 2006 By: /s/ Jeffrey M. Farber
--------------------------------
Jeffrey M. Farber
Controller
(Principal Accounting Officer)
64
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 66
Fixed Charges and Preferred Stock Dividends
(15) Letter re: Unaudited Interim Financial Information 67
(31.1) Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) 68
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) 69
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. 70
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. 71
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
65