UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[ X ] Quarterly Report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended February 29, 2008
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, a non-accelerated filer, or a smaller reporting
company. See the definitions of "large accelerated filer," "accelerated filer"
and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ]
Smaller reporting company [ ] (Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of April 8, 2008, the latest practicable date, there were 145,698,482
shares of Common Stock, $1 par value, outstanding.
TABLE OF CONTENTS
Page
----
Available Information 3
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS (UNAUDITED)
Condensed Consolidated Statements of Income for
the three months ended February 29,
2008 and February 28, 2007 4
Condensed Consolidated Statements of Financial Condition
as of February 29, 2008 and November 30, 2007 5
Condensed Consolidated Statements of Cash Flows
for the three months ended February 6
29, 2008 and February 28, 2007
Condensed Consolidated Statements of Comprehensive
Income
for the three months ended February
29, 2008 and February 28, 2007 7
Notes to Condensed Consolidated Financial Statements 8
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 46
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Introduction 47
Recent Developments 47
Certain Factors Affecting Results of Operations 48
Forward-Looking Statements 49
Executive Overview 49
Results of Operations 51
Liquidity, Funding and Capital 57
Off-Balance-Sheet Arrangements 68
Derivative Financial Instruments 69
Critical Accounting Policies 70
Accounting and Reporting Developments 74
Effects of Inflation 75
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 76
Item 4. CONTROLS AND PROCEDURES 80
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS 81
Item 1A. RISK FACTORS 84
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 86
Item 6 EXHIBITS 87
Signature 88
2
AVAILABLE INFORMATION
The Bear Stearns Companies Inc. and its subsidiaries ("Company") file current,
annual and quarterly reports, proxy statements and other information required by
the Securities Exchange Act of 1934, as amended ("Exchange Act"), with the
Securities and Exchange Commission ("SEC"). You may read and copy any document
the Company files at the SEC's public reference room located at 100 F Street,
NE, Room 1580, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for
further information on the public reference room. The Company's SEC filings are
also available to the public from the SEC's internet site at http://www.sec.gov.
Copies of these reports, proxy statements and other information can also be
inspected at the offices of the New York Stock Exchange, Inc., 20 Broad Street,
New York, New York 10005.
The Company's public internet site is http://www.bearstearns.com. The Company
makes available free of charge through its internet site, via a link to the
SEC's internet site at http://www.sec.gov, its annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements
and Forms 3, 4 and 5 filed on behalf of directors and executive officers and any
amendments to those reports filed or furnished pursuant to the Exchange Act, as
soon as reasonably practicable after it electronically files such material with,
or furnishes it to, the SEC.
In addition, the Company currently makes available on http://www.bearstearns.com
its most recent annual report on Form 10-K, its quarterly reports on Form 10-Q
for the current fiscal year and its most recent proxy statement, although in
some cases these documents are not available on that site as soon as they are
available on the SEC's internet site. Also posted on the Company's website, and
available in print upon request of any stockholder to the Investor Relations
Department, are charters for the Company's Audit Committee, Compensation
Committee, Corporate Governance, and Nominating Committee and Qualified Legal
Compliance Committee. Copies of the Corporate Governance Guidelines and the Code
of Business Conduct and Ethics governing our directors, officers and employees
are also posted on the Company's website within the "Corporate Governance"
section under the heading "About Bear Stearns." You will need to have the Adobe
Acrobat Reader software on your computer to view these documents, which are in
the .PDF format.
3
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Income
(Unaudited)
Three Months Ended
---------------------------
February 29, February 28,
(in millions, except share and per share data) 2008 2007
--------------------------------------------------------------------------------
REVENUES
Commissions $ 330 $ 281
Principal transactions 515 1,342
Investment banking 230 350
Interest and dividends 2,198 2,657
Asset management and other income 154 168
---------------------------
Total revenues 3,427 4,798
Interest expense 1,948 2,316
---------------------------
Revenues, net of interest expense 1,479 2,482
---------------------------
NON-INTEREST EXPENSES
Employee compensation and benefits 754 1,204
Floor brokerage, exchange and clearance fees 79 56
Communications and technology 154 128
Occupancy 73 57
Advertising and market development 40 37
Professional fees 100 72
Other expenses 126 93
---------------------------
Total non-interest expenses 1,326 1,647
---------------------------
Income before provision for income taxes 153 835
Provision for income taxes 38 281
---------------------------
Net income $ 115 $ 554
Preferred stock dividends 5 6
---------------------------
Net income applicable to common shares $ 110 $ 548
===========================
Basic earnings per share $ 0.89 $ 4.23
Diluted earnings per share $ 0.86 $ 3.82
===========================
Weighted average common shares outstanding:
Basic 129,128,281 133,094,747
Diluted 138,539,248 149,722,654
===========================
Cash dividends declared per common share $ 0.32 $ 0.32
===========================
See Notes to Condensed Consolidated Financial Statements.
4
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Financial Condition
(Unaudited)
---------------------------
February 29, November 30,
(in millions, except share data) 2008 2007
------------------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and cash equivalents $ 20,786 $ 21,406
Cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations 14,910 12,890
Securities received as collateral 15,371 15,599
Collateralized agreements:
Securities purchased under agreements to resell 26,888 27,878
Securities borrowed 87,143 82,245
Receivables:
Customers 41,990 41,115
Brokers, dealers and others 10,854 11,622
Interest and dividends 488 785
Financial instruments owned, at fair value 118,201 122,518
Financial instruments owned and pledged as collateral, at fair value 22,903 15,724
--------------------------
Total financial instruments owned, at fair value 141,104 138,242
Assets of variable interest entities and mortgage loan special purpose entities 29,991 33,553
Property, equipment and leasehold improvements, net of accumulated
depreciation and amortization of $1,196 and $1,149 as of February
29, 2008 and November 30, 2007, respectively 608 605
Other assets 8,862 9,422
--------------------------
Total Assets $ 398,995 $ 395,362
==========================
LIABILITIES AND STOCKHOLDERS' EQUITY
Unsecured short-term borrowings (includes $434 and $339 at fair value as of $ 8,538 $ 11,643
February 29, 2008 and November 30, 2007, respectively)
Obligation to return securities received as collateral 15,371 15,599
Collateralized financings:
Securities sold under agreements to repurchase 98,272 102,373
Securities loaned 4,874 3,935
Other secured borrowings 7,778 12,361
Payables:
Customers 91,632 83,204
Brokers, dealers and others 5,642 4,101
Interest and dividends 853 1,301
Financial instruments sold, but not yet purchased, at fair value 51,544 43,807
Liabilities of variable interest entities and mortgage loan special purpose entities 26,739 30,605
Accrued employee compensation and benefits 360 1,651
Other liabilities and accrued expenses 3,743 4,451
Long-term borrowings (includes $9,018 and $8,500 at fair value as of
February 29, 2008 and November 30, 2007, respectively) 71,753 68,538
--------------------------
Total Liabilities $ 387,099 $ 383,569
==========================
Commitments and contingencies (Note 12)
STOCKHOLDERS' EQUITY
Preferred stock 352 352
Common stock, $1.00 par value; 500,000,000 shares authorized and 184,805,847
shares issued as of both February 29, 2008 and November 30, 2007 185 185
Paid-in capital 5,619 4,986
Retained earnings 9,419 9,441
Employee stock compensation plans 2,164 2,478
Accumulated other comprehensive income (loss) 25 (8)
Shares held in RSU trust (2,955) --
Treasury stock, at cost:
Common stock: 39,135,671 and 71,807,227 shares as of February 29, 2008 and
November 30, 2007, respectively (2,913) (5,641)
--------------------------
Total Stockholders' Equity 11,896 11,793
--------------------------
Total Liabilities and Stockholders' Equity $ 398,995 $ 395,362
==========================
See Notes to Condensed Consolidated Financial Statements.
5
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Cash Flows
(Unaudited)
Three Months Ended
-------------------------------------
February 29, February 28,
(in millions) 2008 2007
------------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 115 $ 554
Adjustments to reconcile net income to cash used in operating activities:
Non-cash items included in net income:
Depreciation and amortization 53 42
Employee stock compensation plans 89 13
Changes in operating assets and liabilities:
Cash and securities deposited with clearing organizations or segregated
in compliance with federal regulations (2,020) (322)
Securities borrowed, securities loaned, net (3,959) (2,795)
Receivables from customers (875) (3,048)
Receivables from brokers, dealers and others 768 (1,188)
Financial instruments owned, at fair value (830) (22,958)
Other assets 908 (1,791)
Securities sold under agreements to repurchase, securities purchased under
agreements to resell, net (3,111) 20,409
Payables to customers 8,428 4,904
Payables to brokers, dealers and others 1,541 (305)
Financial instruments sold, but not yet purchased, at fair value 7,803 (54)
Accrued employee compensation and benefits (1,291) (1,144)
Other liabilities and accrued expenses (1,251) 1,525
-------------------------------------
Cash provided by (used in) operating activities 6,368 (6,158)
-------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements, net (51) (67)
-------------------------------------
Cash used in investing activities (51) (67)
-------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Payments for/proceeds from unsecured short-term borrowings, net (3,105) 4,924
Payments for other secured borrowings, net (4,583) (1,757)
Proceeds from issuance of long-term borrowings 4,396 8,082
Payments for retirement/repurchase of long-term borrowings (3,536) (3,554)
Payments for/proceeds from issuances of derivatives with a financing
element, net (66) 76
Issuance of common stock 25 62
Cash retained resulting from tax deductibility under share-based payment
arrangements 45 205
Treasury stock purchases - common stock (70) (473)
Cash dividends paid (43) (44)
-------------------------------------
Cash (used in) provided by financing activities (6,937) 7,521
-------------------------------------
Net (decrease) increase in cash and cash equivalents (620) 1,296
Cash and cash equivalents, beginning of year 21,406 4,595
-------------------------------------
Cash and cash equivalents, end of period $ 20,786 $ 5,891
=====================================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash payments for interest were $2.32 billion and $2.51 billion during the
three months ended February 29, 2008 and February 28, 2007, respectively.
Cash payments for income taxes, net of an approximate $325 million refund
of November 30, 2007 estimated Federal taxes, was ($294.0) million for the
three months ended February 29, 2008 and cash payments for income taxes,
net of refunds, was $108.8 million for the three months ended February 28,
2007. Cash payments for income taxes, net of an approximate $325 million
refund of November 30, 2007 estimated Federal taxes, would have been
($249.0) million for the three months ended February 29, 2008 if increases
in the value of equity instruments issued under share-based payment
arrangements had not been deductible in determining taxable income. Cash
payments for income taxes, net of refunds, would have been $313.9 million
for the three months ended February 28, 2007 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.
6
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Comprehensive Income
(Unaudited)
Three months ended
----------------------------
February 29, February 28,
(in millions) 2008 2007
--------------------------------------------------------------------------------
Net Income $ 115 $ 554
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment (2) --
Net gains on cash flow hedges 35 --
--------------------------------------------------------------------------------
Comprehensive income $ 148 $ 554
================================================================================
See Notes to Condensed Consolidated Financial Statements.
7
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 operating in three principal segments: Capital Markets,
Global Clearing Services and Wealth Management. Capital Markets is
comprised of the institutional equities, fixed income and investment
banking areas. Global Clearing Services provides clearance-related
services for prime brokerage clients and clearance on a fully disclosed
basis for introducing broker-dealers. Wealth Management is comprised of
the private client services ("PCS") and asset management areas. See Note
15, "Segment Data," in the Notes to Condensed Consolidated Financial
Statements for a complete description of the Company's principal segments.
The Company also conducts significant activities through other wholly
owned subsidiaries, including: Bear Stearns Global Lending Limited; Bear
Stearns Bank & Trust Company (formerly known as Custodial Trust Company);
Bear Stearns Financial Products Inc. ("BSFP"); Bear Stearns Capital
Markets Inc.; Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc.
("BS Forex"); EMC Mortgage Corporation; Bear Stearns Commercial Mortgage,
Inc.; Bear Stearns Investment Products Inc.; and Bear Energy L.P.
Subsequent Events
The Company experienced a significant liquidity crisis during the end of
the week of March 10, 2008 that seriously jeopardized its financial
viability and which raises substantial doubt about its ability to continue
as a going concern. As a result, on March 16, 2008, the Company and
JPMorgan Chase & Co. ("JPMorgan Chase") entered into an agreement and plan
of merger, and on March 24, 2008, entered into an amendment to the
agreement and plan of merger (as amended the "Merger Agreement'). Pursuant
to the Merger Agreement each share of the Company's common stock
outstanding immediately prior to the merger will be exchanged for 0.21753
shares of JPMorgan Chase common stock. A summary of the Merger Agreement,
related transaction documents and the accounting implications are
described in more detail in the Transaction Documents and Accounting
Implications sections of Note 17, "Subsequent Events," of Notes to
Condensed Consolidated Financial Statements.
In connection with the entry into the amendment to the Merger Agreement,
the Company and JPMorgan Chase entered into a share exchange agreement
under which JPMorgan Chase will purchase 95 million newly issued shares of
the Company's common stock, or 39.5% of the outstanding common stock of
the Company after giving effect to the issuance, in exchange for the
issuance of 20,665,350 shares of JPMorgan Chase common stock to the
Company and the entry by JPMorgan Chase into an amended and restated
guaranty agreement and the guaranty agreement with the Federal Reserve
Bank of New York ("New York Fed"). The share exchange was completed on
April 8, 2008.
Concurrent with the closing of the merger, the New York Fed will take,
through a limited liability company formed for this purpose, control of a
portfolio of $30 billion in assets of the Company based on the value of
the portfolio as of March 14, 2008. The assets will be funded by a $29
billion, 10-year term note from the New York Fed, and a $1 billion,
10-year subordinated note from JPMorgan Chase. The JPMorgan Chase note is
subordinated to the New York Fed loan and will bear the first $1 billion
of any losses associated with the assets. Any funds remaining after
payment of the New York Fed loan, the JPMorgan Chase note and other
expenses of the limited liability company, will be paid to the New York
Fed.
Since the liquidity crisis and the announcement of the merger, the Company
has experienced substantial deterioration of its earnings capacity. The
closing of the merger is expected to occur by June 30, 2008. The Company
believes that the termination of the JPMorgan Chase guaranties prior to
consummation of the merger or the parties' failure to consummate the
merger could seriously jeopardize the Company's financial viability. In
addition, absent the Guaranty, the Company could face the increased risk
of rapid loss of customers and counterparties. The lack of liquidity and
the loss of customers and counterparties would materially adversely affect
the Company's financial stability and its viability as a going concern.
Accordingly, the Company could be forced to file for bankruptcy protection
and need to liquidate. The accompanying Condensed Consolidated Financial
8
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Statements do not reflect any adjustments that might result if the Company
were unable to continue as a going concern.
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 financial interest. All material intercompany
transactions and balances have been eliminated in consolidation.
The Company determines whether it has a controlling financial interest in
an entity by evaluating whether an entity is a voting interest entity, a
variable interest entity ("VIE") or a qualifying special purpose entity
("QSPE") under generally accepted accounting principles.
Voting interest entities are consolidated in accordance with Accounting
Research Bulletin ("ARB") No. 51, "Consolidated Financial Statements," as
amended. ARB No. 51 states that the usual condition for a controlling
financial interest in an entity is ownership of a majority voting
interest. Accordingly, the Company consolidates voting interest entities
in which it has a majority voting interest. VIEs are entities that lack
one or more of the characteristics of a voting interest entity. A
controlling financial interest in a VIE occurs when an entity has a
variable interest that will absorb a majority of the VIEs expected losses,
receive a majority of the VIEs residual returns, or both. The entity with
the controlling financial interest, known as the primary beneficiary,
consolidates the VIE. In accordance with Financial Accounting Standards
Board ("FASB") Interpretation ("FIN") No. 46 (R), "Consolidation of
Variable Interest Entities (revised December 2003)--an interpretation of
Accounting Research Bulletin ("ARB") No. 51" ("FIN No. 46 (R)"), the
Company consolidates any variable interest entities 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.
QSPEs are passive entities that are commonly used in securitization
transactions. Statement of Financial Accounting Standards ("SFAS") No.
140, "Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities," sets forth the criteria an entity must satisfy to be a QSPE.
In accordance with SFAS No. 140, the Company does not consolidate QSPEs.
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 Company follows Emerging Issues Task Force ("EITF") Issue No. 04-5
"Determining Whether a General Partner, or the General Partners as a
Group, Controls a Limited Partnership or Similar Entity When the Limited
Partners Have Certain Rights." The EITF consensus requires a general
partner in a limited partnership to consolidate the limited partnership
unless the presumption of control is overcome. The general partner may
overcome this presumption of control and not consolidate the entity if the
limited partners have: (a) the substantive ability to dissolve or
liquidate the limited partnership or otherwise remove the general partner
without having to show cause; or (b) substantive participating rights in
managing the partnership.
The Condensed Consolidated Statement of Financial Condition as of February
29, 2008, the Condensed Consolidated Statements of Income, Cash Flows, and
Comprehensive Income for the three months ended February 29, 2008 and
February 28, 2007 are unaudited. The Condensed Consolidated Statement of
Financial Condition at November 30, 2007 and related information were
derived from the audited consolidated financial statements included in the
Company's Current Report on Form 8-K, which was filed with the Securities
and Exchange Commission ("SEC") on April 11, 2008 (the "Form 8-K").
9
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Condensed Consolidated Financial Statements are prepared in accordance
with the rules and regulations of the SEC with respect to the Quarterly
Report on 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 Condensed
Consolidated Financial Statements should be read together with the Form
8-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 fair value measurements,
stock-based compensation, certain accrued liabilities, the potential
outcome of litigation and tax matters, and the realizability of deferred
tax assets, 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.
Revenue Recognition Policies
Principal Transactions
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.
Investment Banking and Advisory Services
Underwriting revenues and fees for mergers and acquisitions advisory
services are accrued when services for the transactions are substantially
completed. Transaction expenses are deferred until the related revenue is
recognized. Investment banking and advisory services revenues are
presented net of transaction-related expenses.
Mortgage Servicing Fees and Advances
Contractual servicing fees, late fees and other ancillary servicing fees
earned for servicing mortgage loans are reflected in "Investment banking"
revenues in the Condensed Consolidated Statements of Income. Contractual
servicing fees are recognized when earned based on the terms of the
servicing agreement. All other fees are recognized when received. In the
normal course of its business, the Company makes principal, interest and
other servicing advances to external investors on mortgage loans serviced
for these investors. Such advances are generally recoverable from the
mortgagors, related securitization trusts or from the proceeds received
from the sales of the underlying properties. A charge to earnings is
recognized to the extent that servicing advances are estimated to be
uncollectible under the provisions of the servicing contracts.
Commissions
Commission revenues primarily include fees from executing and clearing
client transactions on stock, options and futures markets worldwide. These
fees are recognized on a trade date basis. The Company records its share
of the commission under certain clearing agreements where the Company is
acting as agent for another broker, in accordance with EITF Statement No.
99-19, "Reporting Revenue Gross as a Principal versus Net as an Agent."
Asset Management and Other Income
The Company receives advisory fees for investment management. In addition,
the Company receives performance incentive fees for managing certain
funds. Advisory fees are recognized over the period of advisory service.
Unearned advisory fees are treated as deferred revenues and are included
in "Other liabilities" in the accompanying Condensed Consolidated
Statements of Financial Condition. Performance incentive fees are accrued
throughout the year based on a fund's performance to date against
specified performance targets.
10
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Energy Trading
Energy trading revenues are reported, net of certain direct costs, in
"Principal transactions" revenues on the Condensed Consolidated Statements
of Income. Energy trading assets and liabilities that are derivatives are
reported at fair value with the corresponding changes recognized in
income. Non-derivative contracts are accounted for on an accrual basis and
recognized in income when the energy is delivered. See Note 16, "Asset
Acquisition" for a further discussion on the assets acquired from the
Williams Power Company, Inc.
Financial Instruments
The Company follows SFAS No. 157, "Fair Value Measurements." SFAS No. 157
defines fair value, establishes a framework for measuring fair value and
requires enhanced disclosures about fair value measurements. Additionally,
SFAS No. 157 disallows the use of block discounts on positions traded in
an active market as well as nullifies certain guidance in EITF No. 02-3
regarding the recognition of inception gains on certain derivative
transactions. See Note 2, "Financial Instruments" of Notes to Condensed
Consolidated Financial Statements for a complete discussion of SFAS No.
157.
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 on a trade-date basis at fair value.
Fair value is generally based on quoted market prices. If quoted market
prices are not available, fair value is determined based on other relevant
factors, including dealer price quotations, price activity for equivalent
instruments and valuation pricing models. Valuation pricing models
consider time value, yield curve and volatility factors, prepayment
speeds, default rates, loss severity, current market and contractual
prices for the underlying financial instruments, as well as other
measurements.
Equity interests and securities acquired as a result of private equity and
merchant banking activities are reflected in the Condensed Consolidated
Financial Statements at fair value, which is often represented at initial
cost until significant transactions or developments indicate that a change
in the carrying value of the securities is appropriate. This represents
the Company's best estimate of exit price as defined by SFAS No. 157.
Generally, the carrying values of these securities will be increased based
on company performance and in those instances where market values are
readily ascertainable by reference to substantial transactions occurring
in the marketplace or quoted market prices. Reductions to the carrying
value of these securities are made when the Company's estimate of fair
value has declined below the carrying value.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities - Including an amendment of
FASB Statement No. 115," which provides a fair value option election that
permits entities to irrevocably elect to measure financial assets and
liabilities (except for those that are specifically scoped out of the
Statement) at fair value as the initial and subsequent measurement
attribute, with changes in fair value recognized in earnings as they
occur. SFAS No. 159 permits the fair value option election on an
instrument-by-instrument basis at initial recognition of an asset or
liability or upon an event that gives rise to a new basis of accounting
for that instrument.
Effective December 1, 2007, the Company adopted SFAS No. 159 and elected
to apply the fair value option to liabilities of variable interest
entities and mortgage loan special purpose entities. The primary reason
for electing the fair value option is to simplify the accounting
requirements. The Company did not have a transition adjustment upon the
adoption of this Statement.
Derivative Instruments and Hedging Activities
The Company follows SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities," as amended by SFAS No. 138, "Accounting for
Certain Derivative Instruments and Certain Hedging Activities," and SFAS
No. 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
11
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
contracts or securities, and hedging activities. Accordingly, all
derivatives, whether stand-alone or embedded within other contracts or
securities, are carried in the Company's Condensed Consolidated Statements
of Financial Condition at fair value, with changes in fair value recorded
in "Principal transactions" revenues. Designated hedged items in fair
value hedging relationships are marked for the risk being hedged, with
such changes also recorded in "Principal transactions" revenues.
Derivatives designated as cash flow hedges are carried at fair value. The
effective portion of the change in fair value on a derivative designated
as a cash flow hedge is reported in "Accumulated other comprehensive
income (loss)." The ineffective portion is reported in "Principal
transactions" revenues in the Condensed Consolidated Statements of Income.
Amounts that are reported in "Accumulated other comprehensive income
(loss)" are reclassified into earnings in the same period or periods
during which the hedged transaction affects earnings.
The Company follows SFAS No. 155, "Accounting for Certain Hybrid Financial
Instruments an amendment of FASB Statements No. 133 and 140." SFAS No. 155
permits companies to elect on an instrument-by-instrument basis, to apply
a fair value measurement to hybrid financial instruments that contain an
embedded derivative that would otherwise require bifurcation under SFAS
No. 133. As permitted, on December 1, 2006, the Company elected to apply a
fair value measurement to all existing hybrid financial instruments that
met the SFAS No. 155 definition. The Company also elected the fair value
measurement for certain qualifying hybrid financial instruments issued on
or after December 1, 2006. The Company's reason for electing to carry
these instruments on a fair value basis was to enable the Company to more
efficiently hedge these instruments and to simplify the accounting
process. Changes in fair value are reflected in "Principal transactions"
revenues in the Condensed Consolidated Statements of Income.
The Company follows FIN No. 39, "Offsetting Amounts Related to Certain
Contracts," and offsets assets and liabilities in the Condensed
Consolidated Statements of Financial Condition provided that the legal
right of offset exists under a master netting agreement. This includes the
offsetting of payables or receivables relating to the fair value of cash
collateral received or paid associated with its derivative inventory, on a
counterparty by counterparty basis.
In April 2007, the FASB issued Staff Position ("FSP") FIN No. 39-1,
"Amendment of FASB Interpretation No. 39." FSP FIN No. 39-1 defines "right
of setoff" and specifies what conditions must be met for a derivative
contract to qualify for this right of setoff. It also addresses the
applicability of a right of setoff to derivative instruments and clarifies
the circumstances in which it is appropriate to offset amounts recognized
for those instruments in the Condensed Consolidated Statement of Financial
Condition. In addition, this FSP permits offsetting of fair value amounts
recognized for multiple derivative instruments executed with the same
counterparty under a master netting arrangement and fair value amounts
recognized for the right to reclaim cash collateral (a receivable) or the
obligation to return cash collateral (a payable) arising from the same
master netting arrangement as the derivative instruments. The provisions
of this FSP are consistent with the Company's current accounting practice.
The Company adopted the provisions of FSP FIN No. 39-1 on December 1,
2007. The adoption of FSP FIN No. 39-1 did not impact the condensed
consolidated financial statements of the Company.
Customer Transactions
Customer securities transactions are recorded on the Condensed
Consolidated Statements of Financial Condition on a settlement date basis,
which is generally three business days after trade date, while the related
commission revenues and expenses are recorded on a trade date basis.
Receivables from and payables to customers include amounts related to both
cash and margin transactions. Securities owned by customers, including
those that collateralize margin or other similar transactions, are
generally not reflected in the Condensed Consolidated Statements of
Financial Condition.
Mortgage Servicing Rights
Mortgage servicing rights ("MSRs") are included in "Other assets" on the
Condensed Consolidated Statements of Financial Condition. The Company
follows SFAS No. 156, "Accounting for Servicing of Financial Assets--an
amendment of FASB Statement No. 140," and measures servicing assets at
fair value. The fair value of MSRs is determined by using market-based
models that discount anticipated future net cash flows considering loan
12
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
prepayment predictions, interest rates, default rates, servicing costs,
current market data and other economic factors. Changes in the fair value
of MSRs are recorded in "Principal transactions" revenues in the Condensed
Consolidated Statements of Income.
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 QSPE or has the right to pledge or exchange the assets received; and
(3) the transferor has not maintained effective control over the
transferred assets. The Company derecognizes financial assets transferred
in securitizations provided that such transfer meets all of these
criteria.
Mortgage securitization transactions, net of certain direct costs, are
recorded in "Principal transactions" revenues in the Condensed
Consolidated Statements of Income.
Collateralized Securities Transactions
Transactions involving purchases of securities under agreements to resell
("reverse repurchase agreements") or sales of securities under agreements
to repurchase ("repurchase agreements") are treated as collateralized
financing transactions and are recorded at their contracted resale or
repurchase amounts plus accrued interest. Resulting interest income and
expense is generally included in "Principal transactions" revenues in the
Condensed Consolidated Statements of Income. Reverse repurchase agreements
and repurchase agreements are presented in the Condensed Consolidated
Statements of Financial Condition on a net-by-counterparty basis, where
permitted by generally accepted accounting principles. It is the Company's
general policy to take possession of securities or loans 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 or
loans to counterparties to collateralize repurchase agreements. The
Company's agreements with counterparties generally contain contractual
provisions allowing for additional collateral to be obtained, or excess
collateral returned. It is the Company's policy to value collateral and to
obtain additional collateral, or to retrieve excess collateral from
counterparties, when deemed appropriate.
Securities borrowed and securities loaned are recorded based upon the
amount of cash collateral advanced or received. Securities borrowed
transactions facilitate the settlement process and require the Company to
deposit cash, letters of credit or other collateral with the lender. With
respect to securities loaned, the Company receives collateral in the form
of cash or other collateral. The amount of collateral required to be
deposited for securities borrowed, or received for securities loaned, is
an amount generally in excess of the market value of the applicable
securities borrowed or loaned. The Company monitors the market value of
securities borrowed and loaned, with excess collateral retrieved or
additional collateral obtained, when deemed appropriate.
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
13
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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." See Note 17,
"Subsequent Events," of Notes to the Condensed Consolidated Financial
Statements for further discussion.
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 and restated ("CAP Plan"), as well as the effect of the redemption
of preferred stock, by the weighted average number of common shares
outstanding. Common shares outstanding includes vested units issued under
certain stock compensation plans, which will be distributed as shares of
common stock. Diluted EPS includes the determinants of basic EPS and, in
addition, gives effect to dilutive potential common shares related to
stock compensation plans.
Stock-Based Compensation
The Company follows SFAS No. 123 (R), "Share-Based Payment," to account
for its stock-based compensation plans. SFAS No. 123 (R) is a revision of
SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows."
SFAS No. 123 (R) eliminated the ability to account for share-based
compensation transactions 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.
Cash Equivalents
The Company has defined cash equivalents as liquid investments not held
for sale in the ordinary course of business with original maturities of
three months or less that are not part of the Company's trading inventory.
Income Taxes
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109"
("FIN No. 48"). FIN No. 48 clarifies the accounting for uncertainty in
income taxes recognized in an enterprise's financial statements in
accordance with SFAS No. 109. FIN No. 48 prescribes a recognition
threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. The Company adopted the provisions of FIN No.
48 in the first quarter of 2008. See Note 13, "Income Taxes," of the Notes
to Condensed Consolidated Financial Statements for a further discussion.
The Company and certain of its subsidiaries file a U.S. 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 on translation of the financial statements of foreign subsidiaries
from their respective functional currency to the U.S. dollar are included,
net of tax, on the Condensed Consolidated Statements of Comprehensive
Income. Gains or losses resulting from foreign currency transactions are
included in current earnings.
14
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Accounting and Reporting Developments
In March 2008, the FASB issued Statement No. 161, "Disclosures about
Derivative Instruments and Hedging Activities - an amendment of FASB
Statement No. 133." The Statement requires companies to provide enhanced
disclosures regarding derivative instruments and hedging activities. It
requires companies to better convey the purpose of derivative use in terms
of the risks that such company is intending to manage. Disclosures about
(a) how and why an entity uses derivative instruments, (b) how derivative
instruments and related hedged items are accounted for under SFAS No. 133
and its related interpretations, and (c) how derivative instruments and
related hedged items affect a company's financial position, financial
performance, and cash flows are required. This Statement retains the same
scope as SFAS No. 133 and is effective for fiscal years and interim
periods beginning after November 15, 2008. The Company is currently
assessing implementation plans and does not expect the adoption of SFAS
No. 161 to have a material impact, if any, on the Condensed Consolidated
Financial Statements.
In February 2008, the FASB issued a FASB Staff Position ("FSP") on
Accounting for Transfers of Financial Assets and Repurchase Financing
Transactions "FSP FAS 140-3." This FSP addresses the issue of whether or
not these transactions should be viewed as two separate transactions or as
one "linked" transaction. The FSP includes a "rebuttable presumption" that
presumes linkage of the two transactions unless the presumption can be
overcome by meeting certain criteria. The FSP will be effective for fiscal
years beginning after November 15, 2008 and will apply only to original
transfers made after that date; early adoption will not be allowed. The
Company is currently evaluating the impact, if any, the adoption of this
interpretation will have on the Company's Condensed Consolidated Financial
Statements.
In December 2007, the FASB issued Statement No. 141R, "Business
Combinations (a revision of Statement No. 141)." This Statement applies to
all transactions or other events in which an entity obtains control of one
or more businesses, including those combinations achieved without the
transfer of consideration. This Statement retains the fundamental
requirements in Statement No. 141 that the acquisition method of
accounting be used for all business combinations. This Statement expands
the scope to include all business combinations and requires an acquirer to
recognize the assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree at their fair values as of the
acquisition date. Additionally, SFAS No. 141R changes the way entities
account for business combinations achieved in stages by requiring the
identifiable assets and liabilities to be measured at their full fair
values. Additionally, contractual contingencies and contingent
consideration shall be measured at fair value at the acquisition date.
This Statement is effective on a prospective basis to business
combinations for which the acquisition date is on or after the beginning
of the first annual reporting period beginning on or after December 15,
2008. The Company is currently evaluating the impact, if any, that the
adoption of this Statement will have on the Condensed Consolidated
Financial Statements of the Company.
In December 2007, the FASB issued Statement No. 160, "Noncontrolling
Interests in Consolidated Financial Statements - an amendment of ARB No.
51". This Statement amends ARB No. 51 to establish accounting and
reporting standards for the noncontrolling interest in a subsidiary and
for the deconsolidation of a subsidiary. It clarifies that a
noncontrolling interest in a subsidiary is an ownership interest in the
consolidated entity that should be reported as equity in the consolidated
financial statements. Additionally, this Statement requires that
consolidated net income include the amounts attributable to both the
parent and the noncontrolling interest. This Statement is effective for
interim periods beginning on or after December 15, 2008. The Company is
currently evaluating the impact, if any, that the adoption of this
Statement will have on the Condensed Consolidated Financial Statements of
the Company.
In June 2007, the EITF issued EITF Issue No. 06-11 "Accounting for Income
Tax Benefits of Dividends on Share-Based Payment Awards." This issue
requires that the tax benefits related to dividend equivalents paid on
restricted stock units, which are expected to vest, be recorded as an
increase to additional paid-in capital. EITF 06-11 is effective
prospectively to the income tax benefits on dividends declared in fiscal
years beginning after December 15, 2007. The Company is currently
evaluating the impact, if any, the adoption of this issue may have on the
Company's Condensed Consolidated Financial Statements and does not expect
that the adoption of this issue will have a material impact on the
Condensed Consolidated Financial Statements.
15
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
In December 2007, the American Securitization Forum published a
Streamlined Foreclosure and Loss Avoidance Framework (ASF Framework) to
enable mortgage servicers to streamline their loss avoidance and loan
modification practices. The framework is an industry-developed,
recommended methodology that servicers of securitized subprime ARMS held
in QSPEs can use to fulfill their existing obligations to service those
loans in a faster and more efficient manner while maximizing recoveries
for the benefit of securitization investors. The ASF Framework applies to
all first lien subprime residential ARMs that have an initial fixed rate
period of 36 months or less that were originated between January 1, 2005
and July 31, 2007, and that have an initial interest rate reset between
January 1, 2008 and July 31, 2010.
Under the ASF Framework, the covered loans are divided into three
segments:
Segment 1 - includes current loans where the borrower is likely to be able
to refinance into any available mortgage product, including FHA, FHA
Secure or readily available mortgage industry products;
Segment 2 - includes current loans where the borrower is unlikely to be
able to refinance into any readily available mortgage industry
product; and
Segment 3 - includes loans where the borrower is not current as defined
above, demonstrating difficulty meeting the introductory rate.
The methodology prescribed in the ASF Framework applies to those loans in
Segment 2, in advance of the initial reset date. Those loans would be
eligible for a "fast track" loan modification under which the interest
rate would be kept at the existing rate, generally for five years
following the upcoming reset. The ASF Framework provides a methodology
which complies with relevant tax regulations and off-balance-sheet
accounting standards for QSPEs. Moreover, the SEC's Office of Chief
Accountant has concluded that it will not object to continued status as a
QSPE if Segment 2 subprime ARM loans are modified pursuant to the specific
screening criteria in the ASF Framework. The Company adopted the ASF
screening criteria in the first quarter of 2008, and believes that the
modification of loans in accordance with the ASF Framework does not impact
the off-balance-sheet accounting treatment of QSPEs that hold subprime ARM
loans.
While a uniform definition of subprime mortgages does not exist in the
marketplace, the Company defines subprime primarily as loans issued to
higher risk borrowers who do not qualify for the best market interest
rates because of their deficient credit history. Although FICO credit
scores and prior mortgage or rent payment histories are the main drivers
of a subprime designation, subprime also includes borrowers that have had
a recent foreclosure or bankruptcy. Other considerations include
borrower's reserve funds, residual household income and debt to income
ratio. The Company has not yet modified a significant percentage of loans
using the ASF Framework; accordingly, the impact to the Company's retained
interest has been immaterial.
16
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:
February 29, November 30,
(in millions) 2008 2007
-------------------------------------------------------------------------
FINANCIAL INSTRUMENTS OWNED, AT FAIR VALUE:
U.S. government and agency $ 21,310 $ 12,920
Other sovereign governments 2,394 672
Corporate equity and convertible debt 26,975 32,454
Corporate debt and other 23,511 26,330
Mortgages, mortgage- and asset-backed 38,186 46,141
Derivative financial instruments 28,728 19,725
--------------------------------------------------------------------------
$ 141,104 $ 138,242
==========================================================================
FINANCIAL INSTRUMENTS SOLD, BUT NOT YET PURCHASED,
AT FAIR VALUE:
U.S. government and agency $ 9,718 $ 4,563
Other sovereign governments 1,189 2,473
Corporate equity and convertible debt 18,700 18,843
Corporate debt and other 5,079 4,373
Mortgages, mortgage- and asset-backed 348 63
Derivative financial instruments 16,510 13,492
--------------------------------------------------------------------------
$ 51,544 $ 43,807
==========================================================================
As of February 29, 2008 and November 30, 2007, 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, at
fair value" in the Condensed Consolidated Statements of Financial
Condition.
Financial instruments sold, but not yet purchased, at fair value represent
obligations of the Company to purchase the specified financial instrument
at the then current market price. Accordingly, these transactions result
in off-balance-sheet risk as the Company's ultimate obligation to
repurchase such securities may exceed the amount recognized in the
Condensed Consolidated Statements of Financial Condition.
Concentration Risk
The Company is subject to concentration risk by holding large positions or
committing to hold large positions in certain types of securities,
securities of a single issuer (including governments), issuers located in
a particular country or geographic area, or issuers engaged in a
particular industry. Positions taken and commitments made by the Company,
including underwritings, often involve substantial amounts and significant
exposure to individual issuers and businesses, including
non-investment-grade issuers. At February 29, 2008 and November 30, 2007,
the Company's most significant concentrations were related to United
States government securities, Federal National Mortgage Association and
Federal Home Loan Mortgage Corporation agency-backed securities, which are
included in the U.S. government and agency and Mortgages, mortgage-and
asset-backed inventory captions above. In addition, a substantial portion
of the collateral held by the Company for reverse repurchase agreements
consists of securities issued by the U.S. government and agencies.
Fair Value Measurements
The Company follows SFAS No. 157, "Fair Value Measurements." SFAS No. 157
applies to all financial instruments that are measured and reported on a
fair value basis. This includes those items currently reported in
"Financial instruments owned, at fair value" and "Financial instruments
sold, but not yet purchased, at fair value" on
17
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
the Condensed Consolidated Statements of Financial Condition as well as
financial instruments reported in "Other assets" and "Other liabilities"
captions that are reported at fair value below.
As defined in SFAS No. 157, fair value is the price that would be received
to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date. In determining fair
value, the Company uses various methods including market, income and cost
approaches. Based on these approaches, the Company often utilizes certain
assumptions that market participants would use in pricing the asset or
liability, including assumptions about risk and or the risks inherent in
the inputs to the valuation technique. These inputs can be readily
observable, market corroborated, or generally unobservable firm inputs.
The Company utilizes valuation techniques that maximize the use of
observable inputs and minimize the use of unobservable inputs. Based on
the observability of the inputs used in the valuation techniques the
Company is required to provide the following information according to the
fair value hierarchy. The fair value hierarchy ranks the quality and
reliability of the information used to determine fair values. Financial
assets and liabilities carried at fair value will be classified and
disclosed in one of the following three categories:
Level 1: Quoted market prices in active markets for identical assets or
liabilities.
Level 2: Observable market based inputs or unobservable inputs that are
corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
Level 1 primarily consists of financial instruments whose value is based
on quoted market prices such as exchange-traded derivatives and listed
equities. This category also includes financial instruments that are
valued using alternative approaches but for which the Company typically
receives independent external valuation information including U.S.
Treasuries, other U.S. Government and agency securities, and certain cash
instruments such as money market funds and certificates of deposit.
Level 2 includes financial instruments that are valued using models or
other valuation methodologies. These models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates,
loss severity, current market and contractual prices for the underlying
financial instruments, as well as other relevant economic measures.
Substantially all of these assumptions are observable in the marketplace,
can be derived from observable data or are supported by observable levels
at which transactions are executed in the marketplace. Financial
instruments in this category include sovereign debt, certain corporate
equities, corporate debt, certain U.S. agency and non-agency
mortgage-backed securities and non-exchange-traded derivatives such as
interest rate swaps.
Level 3 is comprised of financial instruments whose fair value is
estimated based on internally developed models or methodologies utilizing
significant inputs that are generally less readily observable. Included in
this category are distressed debt, non-performing mortgage-related assets,
certain performing residential and commercial mortgage loans, certain
mortgage- and asset-backed securities and residual interests, Chapter 13
and other credit card receivables from individuals, and complex derivative
structures including long-dated equity derivatives.
In determining the appropriate levels, the Company performs a detailed
analysis of the assets and liabilities that are subject to SFAS No. 157.
At each reporting period, all assets and liabilities for which the fair
value measurement is based on significant unobservable inputs are
classified as Level 3.
18
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Fair Value Measurements on a Recurring Basis as of February 29, 2008:
Balance as of
Impact of February 29,
(in millions) Level 1 Level 2 Level 3 Netting 2008
------------------------------------------------------------------------------------------------------------------------------
Financial Instruments Owned, at fair
value
U.S. government and agency $ 5,857 $ 15,453 $ -- $ -- $ 21,310
Other sovereign governments -- 2,394 -- -- 2,394
Corporate equity and convertible debt 19,798 6,830 347 -- 26,975
Corporate debt and other 14 18,373 5,124 -- 23,511
Mortgages, mortgage- and asset-backed -- 15,966 22,220 -- 38,186
-----------------------------------------------------------------------------------------------------------------------------
Total Non Derivative Trading Assets 25,669 59,016 27,691 -- 112,376
Derivative financial instruments (1) 202 272,356 6,276 (250,106 ) 28,728
-----------------------------------------------------------------------------------------------------------------------------
Total Financial Instruments
Owned, at fair value 25,871 331,372 33,967 (250,106 ) 141,104
-----------------------------------------------------------------------------------------------------------------------------
Other Assets(2) 391 1,607 3,383 -- 5,381
-----------------------------------------------------------------------------------------------------------------------------
Total Assets at fair value $ 26,262 $ 332,979 $ 37,350 $ (250,106 ) $ 146,485
=============================================================================================================================
Balance as of
Impact of February 29,
(in millions) Level 1 Level 2 Level 3 Netting 2008
------------------------------------------------------------------------------------------------------------------------------
Financial Instruments Sold But Not Yet
Purchased, at fair value
U.S. government and agency $ (9,718) $ -- $ -- $ -- $ (9,718)
Other sovereign governments -- (1,189) -- -- (1,189)
Corporate equity and convertible debt (16,554) (2,145) (1) -- (18,700)
Corporate debt and other -- (5,053) (26) -- (5,079)
Mortgages, mortgage- and asset-backed -- (348) -- -- (348)
------------------------------------------------------------------------------------------------------------------------------
Total Non Derivative Trading (26,272) (8,735) (27) -- (35,034)
Liabilities
Derivative financial instruments (1) (185) (254,426) (5,096) 243,197 (16,510)
------------------------------------------------------------------------------------------------------------------------------
Total Financial Instruments Sold But (26,457) (263,161) (5,123) 243,197 (51,544)
Not Yet Purchased, at fair value
------------------------------------------------------------------------------------------------------------------------------
Other Liabilities(3) (82) (7,715) (1,739) -- (9,536)
------------------------------------------------------------------------------------------------------------------------------
Total Liabilities at fair value $ (26,539) $ (270,876) $ (6,862) $ 243,197 $ (61,080)
==============================================================================================================================
(1) The derivatives trading inventory balances are reported on a gross
basis by level with a corresponding adjustment for netting.
(2) Other assets includes certain items such as alternative investments,
mortgage servicing rights, net assets of variable interest entities
and mortgage securitizations that did not meet the criteria for sale
treatment under SFAS No. 140.
(3) Other liabilities are primarily comprised of certain hybrid debt
issuances accounted for at fair value as elected in accordance with
SFAS No. 155.
As stated above SFAS No. 157 applies to all financial assets and
liabilities that are reported on a fair value basis. These valuations are
adjusted for various factors including credit risk. For applicable
financial assets carried at fair value, the credit standing of the
counterparties is analyzed and factored into the fair value measurement of
those assets. SFAS No. 157 states that the fair value measurement of a
liability must reflect the nonperformance risk of the entity. Therefore,
the impact of credit standing as well as any potential credit enhancements
(e.g. collateral) has been factored into the fair value measurement of
both financial assets and liabilities.
The non-derivative trading inventory category includes securities such as
U.S. Government and agency, other sovereign governments, corporate
equities, convertible debt, corporate debt, mortgages, mortgage- and
asset-backed, as well as certain other items. They are reported in
"Financial instruments owned, at fair value" and "Financial instruments
sold, but not yet purchased, at fair value" on the Condensed Consolidated
Statements of Financial Condition. The derivatives trading inventory
balances in the table above are reported on a gross basis by level with a
netting adjustment presented separately in the "Impact of Netting" column.
The Company often enters into different types of derivative contracts with
a single counterparty and these contracts are covered under one ISDA
master
19
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
netting agreement. The fair value of the individual derivative contracts
are reported gross in their respective levels based on the fair value
hierarchy.
Other assets and other liabilities represent those financial assets and
liabilities that the Company carries at fair value but are not included in
"Financial instruments owned, at fair value" and "Financial instruments
sold, but not yet purchased, at fair value" captions. Other assets
includes certain items such as alternative investments, mortgage servicing
rights, net assets of VIEs and mortgage securitizations that did not meet
the criteria for sale treatment under SFAS No. 140. Other liabilities is
primarily comprised of certain hybrid debt issuances accounted for at fair
value as elected in accordance with SFAS No. 155.
The following tables provide a reconciliation of the beginning and ending
balances for the major classes of assets and liabilities measured at fair
value using significant unobservable inputs (Level 3):
Level 3 Financial Assets and Liabilities
Three months ended February 29, 2008
Changes in
Unrealized
Gains/(Losses)
Ending relating to
Beginning Total Gains/ Purchases, Balance Assets and
Balance as of (Losses) Issuances, Transfers as of Liabilities
December 1, (Realized and Sales and In/Out of February held at the
(in millions) 2007 Unrealized) Settlements Level 3 29, 2008 reporting date
------------------------------------------------------------------------------------------------------------------------------
Non-Derivative Trading Assets $ 22,080 $ (1,435) $ 118 $ 6,928 $ 27,691 $ (1,527)
Non Derivative Trading Liabilities $ (58) $ (6) $ 23 $ 14 $ (27) $ 11
Derivative Trading Inventory (Net) $ (589) $ 763 $ 290 $ 716 $ 1,180 $ 812
Other Assets $ 3,758 $ (369) $ (165) $ 159 $ 3,383 $ (375)
Other Liabilities $ (1,254) $ 142 $ (47) $ (580) $ (1,739) $ 166
------------------------------------------------------------------------------------------------------------------------------
Non-Derivative Trading Assets and Liabilities
Realized and unrealized gains and losses on Level 3 assets and liabilities
are primarily reported in "Principal transactions" revenues in the
Condensed Consolidated Statements of Income. The Level 3 non-derivative
trading assets reflect an unrealized loss related to the mortgage related
inventory write-downs incurred during the first quarter of 2008. The
Company manages its exposure on a portfolio basis and regularly engages in
offsetting strategies in which financial instruments from one fair value
hierarchy level are used to economically offset the risk of financial
instruments in the same or different levels. Therefore, realized and
unrealized gains and losses reported as Level 3 may be offset by gains or
losses attributable to assets or liabilities classified in Level 1 or
Level 2.
Derivative Trading Inventory (Net)
The net derivative trading inventory resulted in a gain for the first
quarter of 2008. This gain was primarily driven by changes in interest
rates and credit spreads related to the Company's interest rate and credit
derivative products.
Transfers
The Company reviews the fair value hierarchy classifications on a monthly
basis. Changes in the observability of the valuation attributes may result
in a reclassification of certain financial assets or liabilities. Such
reclassifications are reported as transfers in/out of Level 3 at fair
value in the month in which the changes occur.
During the 2008 quarter, there were approximately $6.9 billion of
non-derivative trading assets transferred from level 2 to level 3. These
transfers were primarily related to mortgages and mortgage-backed
securities. The largest
20
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
contributors to the transfers were performing residential mortgages and
investment-grade mortgage-backed securities. Additionally, during the 2008
quarter, there were approximately $700 million of net derivative trading
assets which transferred from level 2 to level 3. These transfers were
primarily related to mortgage-related credit default swaps.
These transfers were driven by the continued market and liquidity
deterioration in the mortgage markets.
Fair Value Option
SFAS No. 159 provides a fair value option election that permits entities
to irrevocably elect to measure financial assets and liabilities (except
for those that are specifically scoped out of the Statement) at fair value
as the initial and subsequent measurement attribute, with changes in fair
value recognized in earnings as they occur. SFAS No. 159 permits the fair
value option election on an instrument-by-instrument basis at initial
recognition of an asset or liability or upon an event that gives rise to a
new basis of accounting for that instrument.
Effective December 1, 2007, the Company adopted SFAS No. 159 and elected
to apply the fair value option to liabilities of variable interest
entities and mortgage loan special purpose entities. Incorporated in the
SFAS No. 159 guidance are specific disclosure requirements related to the
hybrid financial instruments elected under SFAS No. 155.
In accordance with SFAS No. 155, the Company measures certain hybrid
financial instruments at fair value. These hybrid financial instruments
are recorded in "Long-term borrowings" and "Unsecured short-term
borrowings" in the Condensed Consolidated Statements of Financial
Condition. Changes in the fair value of these hybrid financial
instruments, including interest, are reflected in "Principal transactions"
revenues in the Condensed Consolidated Statements of Income. Gains
(losses) related to changes in the fair value of these hybrid financial
instruments classified as Long term borrowings amounted to $639 million
and $337 million for the three months ended February 29, 2008 and February
28, 2007 respectively, of which $305 million and $35 million were
attributable to the widening of the Company's credit spreads and were
derived from the Company's bond market spreads during the respective
periods. Gains (losses) related to changes in the fair value of these
hybrid financial instruments classified as Unsecured short-term borrowings
were not material for the three months ended February 29, 2008 and
February 28, 2007. As of February 29, 2008 and November 30, 2007, the
aggregate principal balance classified as Long term borrowings, exceeded
the aggregate fair value by $1.8 billion and $547 million, respectively.
As of February 29, 2008 and November 30, 2007, the aggregate principal
balance classified as Unsecured short-term borrowings, exceeded the
aggregate fair value by approximately $224 million and $203 million,
respectively. As a result of the events described in Note 17, "Subsequent
Events" of Notes to the Condensed Consolidated Financial Statements,
approximately $372 million in losses were recognized during the month
ended March 31, 2008, due to tightening of the Company's credit spreads.
3. DERIVATIVES AND HEDGING ACTIVITIES
The Company, in its capacity as a dealer in over-the-counter derivative
financial instruments and its proprietary market-making and trading
activities, enters into transactions in a variety of cash and derivative
financial instruments for proprietary trading and to manage its exposure
to market and credit risk. These risks include interest rate, exchange
rate, equity price, and commodity price risk. Derivative financial
instruments represent contractual commitments between counterparties that
derive their value from changes in an underlying interest rate, currency
exchange rate, index (e.g., Standard & Poor's 500 Index), reference rate
(e.g., London Interbank Offered Rate, or LIBOR), or asset value referenced
in the related contract. Some derivatives, such as futures contracts,
certain options and index-referenced warrants, can be traded on an
exchange. Other derivatives, such as interest rate and currency swaps,
caps, floors, collars, swaptions, equity swaps and options, credit
derivatives, structured notes and forward contracts, are negotiated in the
over-the-counter markets. Derivatives generate both on- and
off-balance-sheet risks depending on the nature of the contract.
Generally, these financial instruments represent commitments or rights to
exchange interest payment streams or currencies or to purchase or sell
other securities at specific terms at specified future dates. Option
contracts generally provide the holder with the right, but not the
obligation, to purchase or sell a financial instrument at a specific price
on or before an established date or dates. Financial
21
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
instruments sold, but not yet purchased may result in market and/or credit
risk in excess of amounts recorded in the Condensed Consolidated
Statements of Financial Condition.
Market Risk
Derivative financial instruments involve varying degrees of
off-balance-sheet market risk, whereby changes in the level or volatility
of interest rates, foreign currency exchange rates or market values of the
underlying financial instruments may result in changes in the value of a
particular financial instrument in excess of the amounts currently
reflected in the Condensed Consolidated Statements of Financial Condition.
The Company's exposure to market risk is influenced by a number of
factors, including the relationships among and between financial
instruments with off-balance-sheet risk, the Company's proprietary
securities, futures and derivatives inventories as well as the volatility
and liquidity in the markets in which the financial instruments are
traded. The Company mitigates its exposure to market risk by entering into
offsetting 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 margin
requirements of the exchanges, as well as the Company's internal 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.
Hedging 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 U.S. 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 U.S.
dollar obligations. Such transactions are accounted for as fair value
hedges.
These financial instruments are subject to the same market and credit
risks as those that are traded in connection with the Company's market
making and trading activities. The Company has similar controls in place
to monitor these risks.
SFAS No. 133, as amended by SFAS No. 138 and SFAS No. 149, establishes
accounting and reporting standards for stand-alone derivative instruments,
derivatives embedded within other contracts or securities and for hedging
activities. It requires that all derivatives, whether standalone or
embedded within other contracts or securities be carried on the Company's
Condensed Consolidated Statements of Financial Condition at fair value.
SFAS No. 133 also requires the value of items designated as being fair
value hedged to be adjusted for the risk being hedged, 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 for the risk being hedged is recognized in earnings
immediately,
22
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
such net effect being deemed the "ineffective" portion of the hedge. The
gains and losses associated with the ineffective portion of the fair value
hedges are included in "Principal transactions" revenues in the Condensed
Consolidated Statements of Income. These amounts were immaterial for the
three months ended February 29, 2008.
The Company also engages in non-trading derivative activities to manage
commodity price risks resulting from exposures to changes in spot and
forward prices in electricity and natural gas. The Company actively
manages these risks with exchange traded futures, swaps, OTC swaps and
options. Certain of these transactions are accounted for as cash flow
hedges as defined in SFAS No. 133 which requires the effective portion of
the unrealized gain or loss on a derivative designated as a cash flow
hedge, as defined in SFAS No. 133, to be reported in "Accumulated other
comprehensive income" ("OCI") with the ineffective portion reported in
"Principal transactions" revenues in the Condensed Consolidated Statements
of Income. Amounts that are reported in OCI are reclassified into earnings
in the same period or periods during which the hedged transaction affects
earnings. The ineffective portion of cash flow hedges was deemed
immaterial for the three months ended February 29, 2008.
The net gain on derivative instruments designated in cash flow hedging
relationships recorded in OCI, net of tax, was $25 million at February 29,
2008. The net increase in fair value recorded in OCI in the first quarter
of 2008 was $35 million. The net gain in OCI is expected to be
reclassified into earnings as follows: $6 million in fiscal 2008 and the
remaining $19 million of gains within five years.
4. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES
Securitizations
The Company is a market leader in mortgage-backed securitization and other
structured financing arrangements. In the normal course of business, the
Company regularly securitizes commercial and residential mortgages,
consumer receivables and other financial assets. Securitization
transactions are generally treated as sales, provided that control has
been relinquished. In connection with securitization transactions, the
Company establishes special-purpose entities ("SPEs"), in which
transferred assets, including commercial and residential mortgages,
consumer receivables and other financial assets are sold to an SPE and
repackaged into securities or similar beneficial interests. Transferred
assets are accounted for at fair value prior to securitization. The
majority of the Company's involvement with SPEs relates to securitization
transactions meeting the definition of a QSPE under the provisions of SFAS
No. 140. Provided it has relinquished control over such assets, the
Company derecognizes financial assets transferred in securitizations and
does not consolidate the financial statements of QSPEs. For SPEs that do
not meet the QSPE criteria, the Company uses the guidance in FIN No. 46
(R) to determine whether the SPE should be consolidated.
In connection with these securitization activities, the Company may retain
interests in securitized assets in the form of senior or subordinated
securities or as residual interests. Retained interests in securitizations
are generally not held to maturity and typically are sold shortly after
the settlement of a securitization. The weighted average holding period
for retained interest positions in inventory at February 29, 2008 and
November 30, 2007 was approximately 210 days and 180 days, respectively.
These retained interests are included in "Financial instruments owned, at
fair value" 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.
23
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company's securitization activities are detailed below:
Agency Other Mortgage-
(in billions) Mortgage-Backed and Asset-Backed Total
------------------------------------------------------------------------------------------------------------------------
Total securitizations
Three months ended February 29, 2008 $5.4 $3.9 $9.3
Three months ended February 28, 2007 $4.7 $21.3 $26.0
------------------------------------------------------------------------------------------------------------------------
The following table summarizes the Company's retained interests by rating
as of February 29, 2008 and November 30, 2007:
February 29, November 30,
(in billions) 2008 2007
--------------------------------------------------------------------------
Retained Interests:
AAA rated Agency Mortgage-Backed $2.6 $2.4
AAA rated Other Mortgage and Asset-Backed 2.9 2.7
--------------------------------------------------------------------------
Total AAA rated $5.5 $5.1
Other investment grade 1.4 1.6
Non-investment grade 1.3 1.3
--------------------------------------------------------------------------
Total retained interests $8.2 $8.0
==========================================================================
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the three months ended
February 29, 2008 and February 28, 2007:
Other
Agency Mortgage-
Mortgage- and Asset-
(in millions) Backed Backed Total
--------------------------------------------------------------------------
Cash flows received from retained interests
Three months ended February 29, 2008 $10.1 $1.2 $11.3
Three months ended February 28, 2007 $13.5 $78.3 $91.8
Cash flows from servicing
Three months ended February 29, 2008 $ - $5.1 $5.1
Three months ended February 28, 2007 $ - $4.5 $4.5
--------------------------------------------------------------------------
The Company is an active market maker in mortgage-backed securities and
therefore may retain interests in assets it securitizes, predominantly
highly rated or government agency-backed securities. The models employed
in the valuation of retained interests consider possible changes in
prepayment speeds in response to changes in future interest rates, as well
as potential credit losses. Prepayment speed changes are incorporated by
calibrating the distribution of possible future interest rates to the
observed levels of implied volatility in the market for interest rate
options and generating the corresponding cash flows for the securities
using prepayment models. Credit losses are considered through explicit
loss models for positions exposed to significant default risk in the
underlying collateral, and through option-adjusted spreads that also
incorporate additional factors such as liquidity and model uncertainty for
all positions. The models use discount rates that are based on the
Treasury curve, plus the option-adjusted spread. Key points on the
constant maturity Treasury curve at February 29, 2008 were 1.63% for
2-year Treasuries and 3.78% for 10-year Treasuries, and ranged from 1.57%
to 4.44%. The weighted average spread was 207 basis points and 561 basis
points for agency mortgage-backed securities and other mortgage- and
asset-backed securities, respectively, at February 29, 2008.
24
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Weighted key economic assumptions used in measuring the fair value of
retained interests in assets the Company securitized at February 29, 2008
were as follows:
Other
Agency Mortgage-
Mortgage- and Asset-
Backed Backed
------------------------------------------------------------------
Weighted average life (years) 5.9 3.1
Average prepayment speeds (annual rate) 8% - 36% 8% - 40%
Credit losses - 0.9% - 53%
------------------------------------------------------------------
The following hypothetical sensitivity analysis as of February 29, 2008
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 corresponding 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 speeds and other pertinent market factors. Changes in portfolio
composition, updates to loss and prepayment models, and changes in the
level of interest rates and market prices for retained interests, can
combine to produce significant changes in the sensitivities reported even
if aggregate market values do not change significantly. Actual credit
losses on retained interests have not been significant.
Other
Agency Mortgage-
Mortgage- and Asset-
(in millions) Backed Backed
------------------------------------------------------------------
Interest rates
Impact of 50 basis point adverse change $ (78) (113)
Impact of 100 basis point adverse change (167) (232)
------------------------------------------------------------------
Prepayment speeds
Impact of 10% adverse change (5) (33)
Impact of 20% adverse change (10) (58)
------------------------------------------------------------------
Credit losses
Impact of 10% adverse change (18) (161)
Impact of 20% adverse change (36) (294)
------------------------------------------------------------------
The above table should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the table. Changes in fair value based on adverse variations
in assumptions generally cannot be extrapolated because the relationship
of the change in assumptions to the change in fair value is not usually
linear. In addition, the table does not consider the change in fair value
of offsetting positions, which would generally offset the changes detailed
in the table, nor does it consider any corrective action that the Company
may take in response to changes in these conditions. The impact of
offsetting positions is not presented because these positions are
established on a portfolio level and allocating the impact would not be
practicable.
Mortgage Servicing Rights
In the normal course of business, the Company originates and purchases
conforming and non-conforming, conventional fixed-rate and adjustable-rate
residential mortgage loans and sells such loans to investors. In
connection with these activities, the Company may retain MSRs that entitle
the Company to a future stream of cash flows based on the contractual
servicing fee. In addition, the Company may purchase and sell MSRs.
The Company follows SFAS No. 156 and carries its MSRs at fair value, with
changes in fair value reported in earnings.
25
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The determination of fair value of the Company's MSRs requires management
judgment because they are not actively traded. The determination of fair
value for MSRs requires valuation processes which combine the use of
discounted cash flow models and extensive analysis of current market data
to arrive at an estimate of fair value. The cash flow and prepayment
assumptions used in the Company's discounted cash flow model are based on
empirical data drawn from the historical performance of the Company's MSRs
adjusted to reflect current Market conditions, which the Company believes
are consistent with assumptions used by market participants valuing
similar MSRs. The key risks and therefore the key assumptions used in the
valuation of MSRs include mortgage prepayment speeds and the discount
rates. These variables can, and generally will, change from quarter to
quarter as market conditions and projected interest rates change. The
Company mitigates the income statement effect of changes in fair value of
MSRs by entering into economic offsetting transactions.
At February 29, 2008, the key economic assumptions and the sensitivity of
the current fair value of MSRs to immediate changes in those assumptions
were as follows:
February 29,
(in millions) 2008
--------------------------------------------------------------------------
Fair value of MSRs $ 771
Weighted average constant prepayment rate (CPR) 10.7%
Impact on fair value of:
10% adverse change $ (30)
20% adverse change (51)
Weighted average discount rate 13.3%
Impact on fair value of:
10% adverse change $ (24)
20% adverse change (46)
Weighted average constant default rate (CDR) 7.7%
Impact on fair value of:
10% adverse change $ (25)
20% adverse change (48)
--------------------------------------------------------------------------
The above table should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the table. Changes in fair value based on adverse variations
in assumptions generally cannot be extrapolated because the relationship
of the change in assumptions to the change in fair value is not usually
linear. In addition, the table does not consider the change in fair value
of offsetting positions, which would generally offset the changes detailed
in the table, nor does it consider any corrective action that the Company
may take in response to changes in these conditions. The impact of
offsetting positions is not presented because these positions are
established on a portfolio level and allocating the impact would not be
practicable.
MSRs are included in "Other assets" on the Condensed Consolidated
Statements of Financial Condition and are carried at fair value in
accordance with SFAS No. 156. The Company's MSRs activities for the three
months ended February 29, 2008 and February 28, 2007 were as follows:
--------------------------------------------------------------------------
February 29, February 28,
(in millions) 2008 2007
--------------------------------------------------------------------------
Balance, beginning of period $ 833 $ 502
Additions 2 112
Paydowns (23) (39)
Changes in fair value resulting from
changes in valuation inputs/assumptions (41) 5
--------------------------------------------------------------------------
Balance, end of period $ 771 $ 580
==========================================================================
26
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
5. VARIABLE INTEREST ENTITIES AND MORTGAGE LOAN SPECIAL PURPOSE ENTITIES
The Company regularly creates or transacts with entities that may be
variable interest entities (VIEs). These entities are an essential part of
the Company's securitization, asset management and structured finance
businesses. In addition, the Company purchases and sells financial
instruments that may be variable interests. The Company follows the
guidance in FIN No. 46(R) and consolidates those VIEs in which the Company
is the primary beneficiary.
The Company may perform various functions, including acting as the seller,
servicer, investor, structurer or underwriter in securitization
transactions. These transactions typically involve entities that are
considered to be QSPEs, as defined in SFAS No. 140. QSPEs are exempt from
the requirements of FIN No. 46 (R). For securitization vehicles that do
not qualify as QSPEs, the holders of the beneficial interests have no
recourse to the Company, only to the assets held by the related VIE. In
certain of these VIEs, the Company could be determined to be the primary
beneficiary through its ownership of certain beneficial interests, and
would, therefore, be required to consolidate the assets and liabilities of
the VIE.
The Company has mortgage securitizations that did not meet the criteria
for sale treatment under SFAS No. 140, including transactions where the
retained call option did not meet the definition of a clean up call under
SFAS No. 140. As such, the Company continues to carry the assets and
liabilities from these transactions on its Condensed Consolidated
Statements of Financial Condition.
The Company acts as portfolio manager and/or underwriter in several
collateralized debt obligation and collateralized loan obligation
transactions. In these transactions, the Company establishes a trust that
purchases a portfolio of assets and issues trust certificates that
represent interests in the portfolio of assets. The holders of the trust
certificates have recourse only to the underlying assets of the trusts and
not to the Company's other assets. In addition, the Company may receive
variable compensation for managing the portfolio and may also retain
certain trust certificates. In certain of these transactions, these
interests result in the Company becoming the primary beneficiary of these
entities.
The Company establishes and operates funds for the benefit of its
employees. These funds are considered to be VIEs of which the Company is
the primary beneficiary.
The Company has made investments in entities that own power plants.
Certain entities are VIEs of which the Company is the primary beneficiary.
The following table sets forth the Company's total assets and maximum
exposure to loss associated with its significant variable interests in
consolidated VIEs and securitizations that did not qualify for sale
treatment. This information is presented based on principal business
activity.
As of February 29, 2008 As of November 30, 2007
------------------------------------------------------------------------------------------------------------------------------
Maximum Maximum
Exposure Exposure
(in millions) VIE Assets to Loss (1) VIE Assets to Loss (1)
------------------------------------------------------------------------------------------------------------------------------
Mortgage Securitizations $ 27,322 $ 2,522 $ 30,313 $ 2,075
Collateralized Debt
and Loan Obligations 1,639 173 2,150 297
Employee Funds(2) 625 429 650 445
Energy Investments 405 128 440 131
------------------------------------------------------------------------------------------------------------------------------
Total $ 29,991 $ 3,252 $ 33,553 $ 2,948
------------------------------------------------------------------------------------------------------------------------------
(1) Represents the fair value of the Company's interest in these
entities.
(2) Maximum exposure to loss includes loans the Company has made
to employees who participate in the funds, for which the
Company is in a second loss position.
The Company also owns significant variable interests in several VIEs
related to collateralized debt obligations and collateralized loan
obligations for which the Company is not the primary beneficiary and
therefore does not consolidate these entities. In aggregate, these VIEs
had assets of approximately $5.8 billion and $11.5 billion at
27
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
February 29, 2008 and November 30, 2007, respectively. At February 29,
2008 and November 30, 2007, the Company's maximum exposure to loss from
these entities was approximately $61 million and $112 million,
respectively, which represents the fair value of its interests and are
included in "Financial instruments owned, at fair value" in the Condensed
Consolidated Statements of Financial Condition.
The Company purchases and sells interests in entities that may be deemed
to be VIEs in its market-making capacity in the ordinary course of
business. As a result of these activities, it is reasonably possible that
such entities may be consolidated or deconsolidated at various points in
time. Therefore, the Company's variable interests included above may not
be held by the Company in future periods.
6. COLLATERALIZED FINANCING ARRANGEMENTS
The Company enters into secured borrowing and lending agreements to obtain
collateral necessary to effect settlements, finance inventory positions,
meet customer needs or re-lend as part of its dealer operations.
The Company receives collateral under reverse repurchase agreements,
securities borrowing transactions, derivative transactions, customer
margin loans and other secured money-lending activities. In many
instances, the Company is also permitted by contract or custom to
rehypothecate securities received as collateral. These securities may be
used to secure repurchase agreements, enter into securities lending or
derivative transactions or cover short positions.
At February 29, 2008 and November 30, 2007, the fair value of securities
received as collateral by the Company that can be repledged, delivered or
otherwise used was approximately $303 billion and $280 billion,
respectively. Of these securities received as collateral, those with a
fair value of approximately $211 billion and $189 billion were delivered,
repledged or otherwise used at February 29, 2008 and November 30, 2007,
respectively.
The Company also pledges financial instruments owned to collateralize
certain financing arrangements and permits the counterparty to pledge or
rehypothecate the securities. These securities are recorded as "Financial
instruments owned and pledged as collateral, at fair value" in the
Condensed Consolidated Statements of Financial Condition. The carrying
value of securities and other inventory positions owned that have been
pledged or otherwise encumbered to counterparties where those
counterparties do not have the right to sell or repledge was approximately
$54 billion and $65 billion at February 29, 2008 and November 30, 2007,
respectively.
7. SHORT-TERM BORROWINGS
The Company obtains unsecured short-term borrowings through the issuance
of commercial paper, bank loans, medium term notes and other borrowings.
In addition, the Company obtains secured short-term borrowings primarily
through master notes and secured bank loans. A master note is an agreement
under which a lender may make one or more loans to a borrower, the
repayment obligation of which is reflected in a promissory note to the
lender. In the case of secured master notes, these agreements are secured
by collateral. The interest rates on such short-term borrowings reflect
market rates of interest at the time of the transactions.
The Company's short-term borrowings at February 29, 2008 and November 30,
2007 consisted of the following:
February 29, November 30,
(in billions) 2008 2007
-------------------------------------------------------------------------
Commercial paper $ 3.9 $ 3.9
Bank loans 1.7 3.1
Medium term notes 0.5 1.9
Other borrowings 2.4 2.7
-------------------------------------------------------------------------
Total unsecured short-term borrowings 8.5 11.6
-------------------------------------------------------------------------
Secured borrowings 7.8 12.4
-------------------------------------------------------------------------
Total short-term borrowings $ 16.3 $ 24.0
=========================================================================
28
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Committed Credit Facilities
As of February 29, 2008, the Company had a committed revolving credit
facility ("Facility") totaling $2.9 billion, which permitted borrowing on
a secured basis by the Parent Company, BSSC, BSIL and certain other
subsidiaries. The Facility terminated on April 7, 2008. There were no
borrowings outstanding under the Facility at February 29, 2008 or on the
date of termination.
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, BSIT and BSB and BS Forex. 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 2008, with all repos outstanding at that date payable
no later than August 2009. There were no borrowings outstanding under the
Repo Facility at February 29, 2008.
The Company has a $350 million committed revolving credit facility ("Pan
Asian Facility"), which permits borrowing on a secured basis by the Parent
Company, BSSC, Bear Stearns Japan Limited ("BSJL"), and BSIL. The Pan
Asian Facility contains financial covenants that require, among other
things, maintenance of specified levels of stockholders' equity of the
Company and net capital of BSSC. The Pan Asian Facility terminates in
December 2008 with all loans outstanding at that date payable no later
than December 2009. There were no borrowings outstanding under the Pan
Asian Facility at February 29, 2008.
As of February 29, 2008, the Company had a $450 million committed
revolving credit facility ("Tax Lien Facility"), which permitted borrowing
on a secured basis by the Parent Company, Plymouth Park Tax Services and
Madison Tax Capital LLC. The Tax Lien Facility terminated in March 2008.
There were no borrowings outstanding under the Tax Lien Facility at
February 29, 2008 or on the date of termination.
As of February 29, 2008, the Company had a committed revolving credit
facility ("AAA Facility") totaling $750 million, which permits borrowing
on an unsecured basis by Bear Stearns Financial Products ("BSFP"). Under
the AAA Facility, BSFP may borrow up to the committed amount in the event
of: (i) a Bankruptcy Event, as defined, at The Bear Stearns Companies
Inc.; (ii) the downgrade of The Bear Stearns Companies Inc.'s short term
debt rating to A-2 by S&P or to P-2 by Moody's; (iii) the failure of Bear
Stearns Capital Markets to post collateral with or make payments to BSFP
in accordance with BSFP's Operating Guidelines; (iv) the failure of BSFP
to meet the capital requirements required by its Operating Guidelines; or
(v) the downgrade of BSFP's counterparty credit rating below A by S&P or
below A2 by Moody's. The AAA Facility terminates on April 25, 2008, with
all loans outstanding at that date payable no later than April 2009. There
were no borrowings outstanding under the AAA Facility at February 29,
2008.
The Company also maintains a series of committed credit facilities, which
permit borrowing on a secured basis, to support liquidity needs for the
financing of investment-grade and non-investment-grade corporate loans,
residential mortgages, commercial mortgages, listed options and whole
loans. The facilities are expected to be drawn from time to time and
expire at various dates, the longest of such periods ending in fiscal
2008. All of these facilities contain a term-out option of one year or
more for borrowings outstanding at expiration. The banks providing these
facilities are committed to provide up to an aggregate of approximately
$6.7 billion. At February 29, 2008, the borrowings outstanding under these
committed credit facilities were $3.3 billion.
29
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
8. LONG-TERM BORROWINGS
The Company's long-term borrowings (which have original maturities of at
least 12 months) at February 29, 2008 and November 30, 2007 consisted of
the following:
February 29, November 30,
(in billions) 2008 2007
--------------------------------------------------------------------------
Fixed rate notes due 2008 to 2047 $ 32.5 $ 28.7
Floating rate notes due 2008 to 2046 30.3 31.3
Index/equity/credit-linked notes 9.0 8.5
--------------------------------------------------------------------------
Total long-term borrowings $ 71.8 $ 68.5
==========================================================================
The Company's long-term borrowings include fair value adjustments in
accordance with SFAS No. 133, hybrid financial instruments accounted for
at fair value as elected under SFAS No. 155, as well as $263 million of
junior subordinated deferrable interest debentures ("Debentures"). The
Debentures will mature on May 15, 2031; however, effective May 15, 2006,
the Company, at its option, may redeem the Debentures. The Debentures are
reflected in the table at their contractual maturity dates. During the
three months ended February 29, 2008, the Company issued and
retired/repurchased $4.4 billion and $3.5 billion of long-term borrowings,
respectively. The weighted average maturity of the Company's long-term
borrowings, based upon stated maturity dates, was approximately 4.6 years
and 4.3 years at February 29, 2008 and November 30, 2007, respectively.
9. STOCKHOLDERS' EQUITY - RSU TRUST
In connection with the Company's deferred compensation plans, during the
first quarter of fiscal 2008, the Company established an irrevocable
grantor trust (the "RSU Trust") for the purpose of holding shares of
common stock of the Company underlying awards granted to selected
employees and certain key executives under The Bear Stearns Companies Inc.
Capital Accumulation Plan for Senior Managing Directors and The Bear
Stearns Companies Inc. Restricted Stock Unit Plan. During the first
quarter, the company transferred 27.3 million treasury shares to the RSU
Trust. In accordance with EITF Issue No. 97-14, "Accounting for Deferred
Compensation Arrangements where Amounts Earned Are Held in a Rabbi Trust
and Invested," assets of the RSU Trust are consolidated and both the
shares held by the RSU Trust and the related deferred compensation
obligation are recorded in equity. Shares issued to the RSU Trust are
recorded in "Shares held in RSU trust" and obligations under deferred
compensation plans are recorded in "Employee stock compensation plans,"
both at an amount equal to the original amount of the compensation
deferred (fair value of the deferred stock award at the date of grant) in
the Condensed Consolidated Statements of Financial Condition. Changes in
fair value of amounts owed to employees are not recognized. Shares
transferred to the RSU Trust do not affect the total number of shares used
in the calculation of basic and diluted earnings per share. Accordingly,
the RSU Trust has no effect on total equity, net income, book value per
share or earnings per share.
30
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
10. 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
--------------------------------------------------------------------------------------------------
February 29, February 28,
(in millions, except per share amounts) 2008 2007
--------------------------------------------------------------------------------------------------
Net income $ 115 $ 554
Preferred stock dividends (5) (6)
Income adjustment (net of tax) applicable to deferred
compensation arrangements-vested shares 5 15
--------------------------------------------------------------------------------------------------
Net earnings used for basic EPS 115 563
Income adjustment (net of tax) applicable to deferred
compensation arrangements-nonvested shares 4 9
--------------------------------------------------------------------------------------------------
Net earnings used for diluted EPS $ 119 $ 572
==================================================================================================
Total basic weighted average common
shares outstanding (1) 129 133
--------------------------------------------------------------------------------------------------
Effect of dilutive securities:
Employee stock options 2 7
CAP and restricted units 8 10
--------------------------------------------------------------------------------------------------
Dilutive potential common shares 10 17
--------------------------------------------------------------------------------------------------
Weighted average number of common shares 139 150
outstanding and dilutive potential common shares
==================================================================================================
Basic EPS $ 0.89 $ 4.23
Diluted EPS $ 0.86 $ 3.82
==================================================================================================
(1) Includes approximately 12 million and 13 million vested units for
the three months ended February 29, 2008 and February 28, 2007,
respectively, issued under stock compensation plans which will be
distributed as shares of common stock.
(2) Options to purchase approximately 8 million shares of common stock
at prices ranging from $87.68 to $165.32 were outstanding but were
not included in the computation of diluted EPS because the exercise
price was greater than the average market price of the common stock.
11. REGULATIONS
The Company is regulated by the SEC as a consolidated supervised entity
("CSE"). As a CSE, the Company is subject to group-wide supervision and
examination by the SEC and is required to compute allowable capital and
allowances for market, credit and operational risk on a consolidated
basis. As of February 29, 2008, 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 Exchange
Act ("Net Capital Rule") and Rule 1.17 under the Commodity Futures Trading
Commission. Bear Stearns uses Appendix E of the Net Capital Rule
("Appendix E"), which establishes alternative net capital requirements for
broker-dealers that are part of consolidated supervised entities. Appendix
E allows Bear Stearns to calculate net capital charges for market risk and
derivatives-related credit risk based on mathematical models provided that
Bear Stearns holds tentative net capital in excess of $1 billion and net
capital in excess of $500 million. At February 29, 2008, Bear Stearns' net
capital of $2.89 billion exceeded the minimum requirement by $2.34
billion. Bear Stearns' net capital computation, as defined, includes $545
million, which is net capital of BSSC in excess of 5.5% of aggregate debit
items arising from customer transactions.
31
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
BSIL and BSIT, London-based broker-dealer subsidiaries, are subject to the
regulatory capital requirements of the United Kingdom's Financial Services
Authority.
BSB, an Ireland-based bank principally involved in the trading and sales
of fixed income products, is registered in Ireland and is subject to the
regulatory capital requirements of the Financial Regulator.
Bear Stearns Bank & Trust Company ("BSBTC") (formerly known as Custodial
Trust Company), a Federal Deposit Insurance Corporation ("FDIC") insured
New Jersey state chartered bank, offers a range of trust, lending,
deposit, and securities-clearing products and services. BSBTC provides the
Company with banking powers, including access to the securities and
funds-wire services of the Federal Reserve System. BSBTC is subject to the
regulatory capital requirements of the FDIC.
At February 29, 2008, Bear Stearns, BSSC, BSIL, BSIT, BSB and BSBTC were
in compliance with their respective regulatory capital requirements.
Certain other subsidiaries are subject to various securities regulations
and capital adequacy requirements promulgated by the regulatory and
exchange authorities of the countries in which they operate. At February
29, 2008, these other subsidiaries were in compliance with their
applicable local capital adequacy requirements.
12. COMMITMENTS AND CONTINGENCIES
In the ordinary course of business, the Company has commitments in
connection with various activities, the most significant of which are as
follows:
Leases
The Company occupies office space under leases that expire at various
dates through 2024. At February 29, 2008, future minimum aggregate annual
rentals payable under non-cancelable leases (net of subleases), including
383 Madison Avenue in New York City, for fiscal years ended 2008 through
2012 and the aggregate amount thereafter, are as follows:
(in millions)
-----------------------------------------
FISCAL YEAR
2008 (remaining) $ 91
2009 117
2010 118
2011 128
2012 95
Thereafter 640
-----------------------------------------
Total $ 1,189
=========================================
Lending - Related Commitments
In connection with certain of the Company's business activities, the
Company provides financing or financing commitments to investment-grade
and non-investment-grade companies in the form of senior and subordinated
debt, including bridge financing. Commitments have varying maturity dates
and are generally contingent on the accuracy and validity of certain
representations, warranties and contractual conditions applicable to the
borrower. Lending-related commitments to investment-grade borrowers
aggregated approximately $2.59 billion and $3.42 billion at February 29,
2008 and November 30, 2007, respectively. Of these amounts, approximately
$841 million and $952 million of the credit risk was offset at February
29, 2008 and November 30, 2007, respectively. Lending-related commitments
to non-investment-grade borrowers approximated $2.77 billion and $3.30
billion at February 29, 2008 and November 30, 2007, respectively. Of these
amounts, approximately $267 million and $220 million of the credit risk
was offset at February 29, 2008 and November 30, 2007, respectively.
32
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company also had contingent commitments to non-investment-grade
companies of approximately $110 million and $501 million as of February
29, 2008 and November 30, 2007, 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
not be successful in the acquisition, the borrower may access the capital
markets instead of drawing on the commitment, or the Company's portion of
the commitment may be reduced through the syndication process.
Additionally, the borrower's ability to draw may be subject to there being
no material adverse change in either market conditions or the borrower's
financial condition, among other factors. These commitments generally
contain certain flexible pricing features to adjust for changing market
conditions prior to closing.
Private Equity-Related Investments and Partnerships
In connection with the Company's merchant banking activities, the Company
has commitments to invest in merchant banking and private equity-related
investment funds as well as commitments to invest directly in private
equity-related investments. At February 29, 2008 and November 30, 2007,
such commitments aggregated $667 million and $729 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
2020.
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 $248 million and $652 million,
respectively, at February 29, 2008 and November 30, 2007.
Commercial and Residential Loans
The Company participates in the origination, acquisition, securitization,
servicing, financing and disposition of commercial and residential loans.
At February 29, 2008 and November 30, 2007, the Company had entered into
commitments to purchase or finance mortgage loans of $1.33 billion and
$2.83 billion, respectively.
Letters of Credit
At February 29, 2008 and November 30, 2007, the Company was contingently
liable for unsecured letters of credit of approximately $1.71 billion and
$1.42 billion, respectively, and secured (by financial instruments)
letters of credit of $1.55 billion and $1.33 billion, respectively. These
letters of credit are primarily used to provide collateral for securities
borrowed and to satisfy margin requirements at commodity/futures
exchanges.
Energy
In connection with its energy activities, the Company has entered into
contractual obligations (primarily obligations under tolling agreements,
net of re-tolling agreements) that require future cash payments. At
February 29, 2008 those contractual obligations, by maturity, were as
follows:
(in millions)
-----------------------------------------
FISCAL YEAR
2008 (remaining) $ 65
2009 91
2010 90
2011 260
2012 417
Thereafter 3,403
-----------------------------------------
Total $ 4,326
=========================================
33
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Other
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $189 million and $170 million, respectively, at February
29, 2008 and November 30, 2007.
With respect to certain of the commitments outlined above, the Company
utilizes various hedging strategies to actively manage its market, credit
and liquidity exposures. Additionally, since these commitments may expire
unused, the total commitment amount may not necessarily reflect the actual
future cash funding requirements.
Litigation
The Company is the sole defendant in an action commenced in the United
States Bankruptcy court for the Southern District of New York by the
Chapter 11 Trustee for Manhattan Investment Fund Limited ("MIFL"). The
complaint seeks to recover from the Company, among other things, certain
allegedly fraudulent transfers made by MIFL in the amount of $141 million
plus pre-judgment interest. The Company provided prime brokerage services
to MIFL prior to its bankruptcy. In January 2007, the Bankruptcy Court
granted the Trustee's motion for summary judgment on the fraudulent
transfer claims against the Company.
On appeal, the District Court affirmed the Bankruptcy Court's findings in
part, but also reversed in part, the Bankruptcy's Court's grant of summary
judgment to the Trustee, finding that a trial is necessary to make a
factual finding as to whether the Company acted in good faith with respect
to its receipt of the alleged fraudulent transfers. The Company believes
it has substantial defenses to the Trustee's claims.
The Company and certain subsidiaries have been named as defendants in
various investor lawsuits and FINRA arbitrations relating to the failure
of the Bear Stearns High Grade Structured Credit Strategies Master Fund,
Ltd (the "High Grade Fund") and the Enhanced Leverage Master Fund, Ltd.
(the "Enhanced Leverage Fund"), which were managed by Bear Stearns Asset
Management. Also, the Company and certain subsidiaries have been named as
defendants in a lawsuit by the Joint Voluntary Liquidators of the overseas
"feeder funds" of the High Grade Fund and Enhanced Leverage Fund. The High
Grade Fund had net investor contributions of approximately $775 million.
The Enhanced Fund had net investor contributions of approximately $1.08
billion. The relief being sought by the plaintiffs in these matters
includes specified and unspecified damages, costs and fees. The Company
believes it has substantial defenses to the claims asserted against it in
these proceedings. Additionally, the Company and its subsidiaries have
been the subject of various state and federal regulatory and law
enforcement inquiries, and a state administrative proceeding relating to
the Funds.
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.
See also Note 17, "Subsequent Events," of the Notes to Condensed
Consolidated Financial Statements.
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.
34
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
13. INCOME TAXES
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109"
("FIN No. 48"). FIN No. 48 clarifies the accounting for uncertainty in
income taxes recognized in an enterprise's financial statements in
accordance with SFAS No. 109. FIN No. 48 prescribes a recognition
threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition
The Company adopted FIN No. 48 effective December 1, 2007 and recognized a
decrease to beginning retained earnings of approximately $90.7 million.
The gross amount of unrecognized tax benefits ("UTB") as of the date of
adoption of FIN No. 48 was approximately $578.4 million. Of this total,
approximately $371.4 million (net of federal benefit of state issues,
Competent Authority and foreign tax credit offsets) represents the amount
that, if recognized, would favorably affect the effective tax rate in
future periods.
The Company recognizes the accrual of interest and penalties, if any, to
UTB's in income tax expense. Interest accrued on UTB's as of December 1,
2007 was approximately $108.9 million.
The Company is under examination by the Internal Revenue Service ("IRS")
and other tax authorities. The other major exams include Japan, the United
Kingdom, and locations in which it has significant business operations,
such as New York State and City. The tax years under examination vary by
jurisdiction as follows:
Open Tax Years Open Tax Years
Examination Examination
Jurisdiction in progress not yet initiated
United States 2003-2005 2006-2007
United Kingdom 1999-2005 2006-2007
Japan 2000-2003 2004-2007
New York State 1999-2002 2003-2007
New York City 1997-2000 2001-2007
It is reasonably possible that these tax examinations will be completed
within the next 12 months. Based on the status of these examinations and
the protocol of finalizing audits by the relevant tax authorities, which
could include formal appeal and/or legal proceedings, it is not possible
to estimate the impact of any amount of such changes, if any, to
previously recorded uncertain tax positions.
The tax benefit associated with employee stock plans reduced taxes payable
by $254 million, $363 million and $426 million for 2007, 2006 and 2005,
respectively. These benefits have been reflected as additional
paid-in-capital in the accompanying Condensed Consolidated Statements of
Financial Condition, except for certain 2007, 2006 and 2005 stock awards.
On December 1, 2005, the Company adopted SFAS No. 123 (R). Under SFAS No.
123 (R) all share-based compensation is required to be recognized as an
expense in the year of grant with a corresponding tax benefit recorded to
the tax provision. See Note 17, "Subsequent Events," in the Notes to
Condensed Consolidated Financial Statements for a discussion of the impact
the merger agreement between the Company and JPMorgan Chase will have on
the realization of the deferred tax asset recorded in prior years.
14. 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.
35
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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.
The following table sets forth the maximum payout/notional amounts
associated with the Company's guarantees as of February 29, 2008:
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) $ 537,763 $ 515,993 $ 859,651 $ 742,403 $ 2,655,810
Municipal securities 3,131 58 - - 3,189
Residual value guarantee - - 570 - 570
------------------------------------------------------------------------------------------------------------------------------
(1) The gross carrying value of these derivatives approximated $130.9
billion as of February 29, 2008.
Derivative Contracts
The Company's dealer activities cause it to make markets and trade a
variety of derivative instruments. Certain derivative contracts that the
Company has entered into meet the accounting definition of a guarantee
under FIN No. 45. Derivatives that meet the FIN No. 45 definition of
guarantees include credit default swaps (whereby a default or significant
change in the credit quality of the underlying financial instrument may
obligate the Company to make a payment), put options, as well as floors,
caps and collars. Since the Company does not track the counterparties'
purpose for entering into a derivative contract, it has disclosed
derivative contracts that are likely to be used to protect against a
change in an underlying financial instrument, regardless of their actual
use.
On certain of these contracts, such as written interest rate caps and
foreign currency options, the maximum payout cannot be quantified since
the increase in interest rates and foreign exchange rates is not
contractually limited by the terms of the contracts. As such, the Company
has disclosed notional amounts as a measure of the extent of its
involvement in these classes of derivatives rather than maximum payout.
Notional amounts do not represent the maximum payout and generally
overstate the Company's exposure to these contracts.
In connection with these activities, the Company mitigates its exposure to
market risk by entering into a variety of offsetting derivative contracts
and security positions.
Municipal Securities
In 1997, the Company established a program whereby it created a series of
municipal securities trusts in which it has retained interests. These
trusts purchase fixed-rate, long-term, highly rated, insured or escrowed
municipal bonds financed by the issuance of trust certificates. Certain of
the trust certificates entitle the holder to receive future payments of
principal and variable interest and to tender such certificates at the
option of the holder on a periodic basis. The Company acts as placement
agent and as liquidity provider. The purpose of the program is to allow
the Company's clients to purchase synthetic short-term, floating-rate
municipal debt that does not otherwise exist in the marketplace. In the
Company's capacity as liquidity provider to the trusts, the maximum
exposure to loss at February 29, 2008 was approximately $3.2 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 offsetting positions, approximating $2.9 billion at February
29, 2008. See Note 17, "Subsequent Events," of the Notes to Condensed
Consolidated Financial Statements for a further discussion.
36
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 10, 2012 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 for the
sale of the property with the proceeds of the sale to be used to satisfy
the lessor's debt obligation. If the sale of the property does not
generate sufficient proceeds to satisfy the lessor's debt obligation, the
Company is required to fund the shortfall up to a maximum residual value
guarantee. As of February 29, 2008, there was no expected shortfall and
the maximum residual value guarantee was approximately $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 certain counterparties to protect them in the event
additional taxes are owed or payments are withheld, due either to a change
in or adverse application of certain tax laws. These indemnifications
generally are standard contractual terms and are entered into in the
normal course of business. Generally, there are no stated or notional
amounts included in these indemnifications.
Maximum payout information under these indemnifications is not readily
available because of the number, size and lives of these transactions. In
implementing this accounting interpretation, the Company reviewed its
experience with the indemnifications on these structures. Based on such
experience, it is unlikely that these arrangements will have a material
impact on the Condensed Consolidated Financial Statements of the Company.
Other Guarantees
The Company is a member of numerous exchanges and clearinghouses. Under
the membership agreements, members are generally required to guarantee the
performance of other members. Therefore, 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 Condensed Consolidated Financial
Statements for these arrangements.
37
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
15. 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 is comprised of the institutional equities,
fixed income and investment banking areas. The Capital Markets segment
operates as a single integrated unit that provides the sales, trading and
origination effort for various fixed income, equity and advisory products
and services. Each of the three businesses work in tandem to deliver these
services to institutional and corporate clients.
Institutional equities consists of sales, trading and research, in areas
such as domestic and international equities, block trading,
over-the-counter equities, equity derivatives, energy and commodity
activities, risk and convertible arbitrage and specialist activities on
the New York Stock Exchange, American Stock Exchange and International
Securities Exchange. Fixed income includes sales, trading, origination and
research provided to institutional clients across a variety of products
such as mortgage- and asset-backed securities, corporate and government
bonds, municipal bonds, high yield products, including bank and bridge
loans, foreign exchange and interest rate and credit derivatives.
Investment banking provides services in capital raising, strategic advice,
mergers and acquisitions and merchant banking. Capital raising encompasses
the Company's underwriting of equity, investment grade, municipal and high
yield debt products.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to
clearing clients worldwide. Prime brokerage clients include hedge funds
and clients of money managers, short sellers and other professional
investors. Fully disclosed clients engage in either the retail or
institutional brokerage business.
The Wealth Management segment is composed of the PCS and asset management
areas. PCS provides high-net-worth individuals with an institutional level
of investment service, including access to the Company's resources and
professionals. Asset management manages equity, fixed income and
alternative assets for leading corporate pension plans, public systems,
endowments, foundations, multi-employer plans, insurance companies,
corporations, families and high-net-worth individuals in the United States
and abroad.
The three business segments comprise many business areas, with
interactions among each. Revenues and expenses include those that are
directly related to each segment. Revenues from intersegment transactions
are based upon specific criteria or agreed upon rates with such amounts
eliminated in consolidation. Individual segments also include revenues and
expenses relating to various items, including corporate overhead and
interest, which are internally allocated by the Company primarily based on
balance sheet usage or expense levels. The Company generally evaluates
performance of the segments based on net revenues and profit or loss
before provision for income taxes.
38
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Three Months ended
-----------------------------------------------
(in millions) February 29, 2008 February 28, 2007
--------------------------------------------------------------------------------
NET REVENUES
Capital Markets
Institutional Equities $ 811 $ 513
Fixed Income 66 1,149
Investment Banking 159 303
--------------------------------------------------------------------------------
Total Capital Markets 1,036 1,965
Global Clearing Services 253 276
Wealth Management
Private Client Services (1) 161 136
Asset Management 39 119
--------------------------------------------------------------------------------
Total Wealth Management 200 255
Other (2) (10) (14)
--------------------------------------------------------------------------------
Total net revenues $ 1,479 $ 2,482
================================================================================
PRE-TAX INCOME
Capital Markets $ 171 $ 736
Global Clearing Services 86 113
Wealth Management (42) 44
Other (3) (62) (58)
--------------------------------------------------------------------------------
Total pre-tax income $ 153 $ 835
================================================================================
Three Months ended
-------------------------------------
February 29, 2008 February 28, 2007
-------------------------------------
(1) Private Client Services detail:
Gross revenues, before
transfer to Capital
Markets segment $ 183 $ 166
Revenue transferred
to Capital Markets segment (22) (30)
-------------------------------------
Private Client Services net
revenues $ 161 $ 136
=====================================
(2) Includes consolidation and elimination entries.
(3) Includes certain legal costs and costs related to the CAP Plan.
39
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
As of
------------------------------------------------------------------------
February 29, February 28,
(in billions) 2008 2007
------------------------------------------------------------------------
SEGMENT ASSETS
Capital Markets $ 244 $ 278
Global Clearing Services 124 101
Wealth Management 4 4
Other 27 12
------------------------------------------------------------------------
Total segment assets $ 399 $ 395
========================================================================
40
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
16. ASSET ACQUISITION
In connection with the acquisition of substantially all of the
power-related and natural gas assets comprising the power trading business
of Williams Power Company, Inc., an energy trading and marketing
subsidiary of The Williams Companies, Inc., which closed on November 8,
2007, the Company recorded intangible assets and intangible liabilities
based on contractual arrangements, at their estimated fair values. As of
February 29, 2008, the weighted average amortization period for intangible
assets and intangible liabilities was approximately 10.6 years and 13.3
years, respectively. The results of operations of the power-related assets
and liabilities acquired are included in the Company's Capital Markets
segment.
The estimated aggregate amortization expense for each of the five
succeeding fiscal years for intangible assets and intangible liabilities
were as follows:
------------------------------------------------------
(in millions) Intangible Intangible
Assets Liabilities
------------------------------------------------------
FISCAL YEAR
2008 (remaining) $ 83 $ 171
2009 98 129
2010 96 98
2011 64 74
2012 50 47
Thereafter 456 359
------------------------------------------------------
Total $ 847 $ 878
======================================================
17. SUBSEQUENT EVENTS
BACKGROUND OF THE MERGER
The Company experienced a significant liquidity crisis during the end of
the week of March 10, 2008 that seriously jeopardized its financial
viability and which raises substantial doubt about its ability to continue
as a going concern. As a result, on March 16, 2008, the Company and
JPMorgan Chase & Co. ("JPMorgan Chase") entered into an agreement and plan
of merger, and on March 24, 2008, entered into an amendment to the
agreement and plan of merger (as amended, the "Merger Agreement").
Pursuant to the Merger Agreement, each share of the Company's common stock
outstanding immediately prior to the merger will be exchanged for 0.21753
shares of JPMorgan Chase common stock. A summary of the Merger Agreement,
related transaction documents and the accounting implications are
described in more detail in the Transaction Documents and Accounting
Implications sections of this note.
In connection with the entry into the amendment to the Merger Agreement,
the Company and JPMorgan Chase entered into a share exchange agreement
under which JPMorgan Chase will purchase 95 million newly issued shares of
the Company's common stock, or 39.5% of the outstanding common stock of
the Company after giving effect to the issuance, in exchange for the
issuance of 20,665,350 shares of JPMorgan Chase common stock to the
Company and the entry by JPMorgan Chase into the amendment to the merger
agreement, an amended and restated guaranty agreement and the guaranty
agreement with the Federal Reserve Bank of New York ("New York Fed"). The
share exchange was completed on April 8, 2008.
Concurrent with the closing of the merger, the New York Fed will take,
through a limited liability company formed for this purpose, control of a
portfolio of $30 billion in assets of the Company based on the value of
the portfolio as of March 14, 2008. The assets will be funded by a $29
billion, 10-year term note from the New York Fed, and a $1
41
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
billion, 10-year subordinated note from JPMorgan Chase. The JPMorgan Chase
note is subordinated to the New York Fed loan and will bear the first $1
billion of any losses associated with the assets. Any funds remaining
after payment of the New York Fed loan, the JPMorgan Chase note and other
expenses of the limited liability company, will be paid to the New York
Fed.
TRANSACTION DOCUMENTS
Agreement and Plan of Merger
Upon the terms and subject to the conditions set forth in the Merger
Agreement, a wholly-owned subsidiary of JPMorgan Chase will merge with and
into the Company with the Company continuing as the surviving corporation
and as a wholly-owned subsidiary of JPMorgan Chase (the "Merger"). At the
effective time of the Merger, each share of Company common stock will be
converted into the right to receive 0.21753 of a share of JPMorgan Chase
common stock. Outstanding Company stock options and phantom stock units
will be converted into JPMorgan Chase equity awards, adjusted to reflect
the exchange ratio in the Merger. The Company and JPMorgan Chase have
agreed to consider providing holders of restricted stock units and capital
accumulation plan units with the right to elect, prior to completion of
the Merger, to have outstanding awards distributed in cash (rather than
stock) at the same time the units would have been settled absent such
election, and otherwise subject to the same terms and conditions in the
applicable plans and award agreements, as amended.
The Merger Agreement contains representations and warranties of Bear
Stearns and JPMorgan Chase relating to their respective businesses.
Pursuant to the Merger Agreement, the Company has agreed to operate within
its existing credit, principal, market and other risk limits and comply
with existing risk-related policies and procedures, subject to JPMorgan
Chase's right to oversee the Company's setting and changing of such
policies, procedures and limits. Subject to the continued effectiveness of
the Guaranty (as defined below), the Company has granted JPMorgan Chase
the right to oversee the business, operations and management of the
Company in its reasonable discretion. The Company also granted JPMorgan
Chase the rights to custody of, and to manage, a scheduled collateral pool
and related hedges, which rights were delegated to the New York Fed.
Additionally, the Company has agreed not to (i) solicit proposals relating
to alternative business combination transactions or (ii) subject to
certain exceptions, enter into discussions, or enter into any agreement,
concerning, or provide confidential information in connection with, any
proposals for alternative business combination transactions.
Consummation of the Merger is subject to the satisfaction of certain
conditions including, among other things, (i) approval and adoption of the
Merger Agreement by the Company's stockholders; (ii) registration and NYSE
listing of the common stock to be issued by JPMorgan Chase in the Merger;
(iii) absence of any order, injunction or decree preventing or making
illegal the consummation of the Merger; and (iv) receipt of specified
governmental and regulatory approvals.
The Merger Agreement contains certain termination rights for both the
Company and JPMorgan Chase. In the event the Company's stockholders do not
approve and adopt the Merger Agreement at the first stockholders meeting
called for that purpose, JPMorgan Chase will have the right to exercise an
option to purchase the Company's headquarters building for an amount equal
to $1.1 billion less assumed indebtedness and transfer costs. In addition,
JPMorgan Chase will also have the right to exercise such option following
the termination of the Merger Agreement under the following circumstances:
(i) JPMorgan Chase terminates the Merger Agreement because (A) the
Company's board of directors made any change of recommendation, (B) the
Company breached its no-solicitation and related obligations under the
Merger Agreement, or (C) the Company breached its obligations to hold a
meeting of its stockholders to approve and adopt the Merger Agreement, or
(ii) (A) JPMorgan Chase or the Company terminate the Merger Agreement
because both (x) the approval and adoption of the Merger Agreement by the
Company's stockholders has not been obtained and (y) 120 days have elapsed
from the date of such stockholders meeting (provided that the parties may
mutually agree to extend the 120-day period); (B) JPMorgan Chase
terminates the Merger Agreement because there has been an uncured breach
by the Company of any of the covenants or agreements or any of the
representations or warranties in the Merger Agreement that would cause the
failure of the closing conditions set forth in the Merger Agreement to be
satisfied; or (C) JPMorgan Chase or the Company terminates the Merger
Agreement because the merger has not been consummated on or before the
first anniversary of the date of the Merger Agreement, and prior to any
termination of the merger agreement described in this clause (ii) an
alternative proposal has been publicly announced or otherwise communicated
or made known to the
42
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Company and has not been irrevocably withdrawn. Upon the exercise of the
option to purchase the Company's headquarters building, the Company will,
upon the request of JPMorgan Chase, exercise its option to purchase the
headquarters building and take all action required to acquire the building
and simultaneously convey it to JPMorgan Chase.
The foregoing description of the Merger Agreement does not purport to be
complete and is qualified in its entirety by reference to the Merger
Agreement, which is filed as Exhibit 2.1 to the Company's Current Report
on Form 8-K filed on March 20, 2008 and March 24, 2008 (Amendment No. 1).
Beginning March 17, 2008, various stockholders of the Company filed
several purported class action lawsuits against the Company, its board of
directors and certain of the Company's present and former executive
officers. Among other things, these actions allege that the individual
defendants breached their fiduciary duties and obligations to the
Company's stockholders by agreeing to the proposed merger. Five of these
actions have been filed in the Supreme Court of the State of New York and
consolidated under the caption In re Bear Stearns Litigation. Two actions
have been filed in the Delaware Court of Chancery where plaintiffs have
filed a motion to consolidate their cases in Delaware. JPMorgan Chase is
named as a defendant in certain of these cases. In each of these actions,
plaintiffs seek to enjoin the proposed merger and enjoin JPMorgan Chase
from voting the 95 million shares acquired pursuant to the Share Exchange
Agreement (as defined below), other injunctive relief and an unspecified
amount of compensatory damages. On April 9, 2008, the Delaware Chancery
Court granted JPMorgan Chase's and the Company's motion to stay the
Delaware action in favor of the New York action, at least until the
preliminary injunction motion is resolved. The Delaware court also granted
plaintiffs' motion to consolidate their cases. Additionally, on April 10,
2008, an amended complaint was filed in a previously-filed shareholder
derivative suit naming the Company's directors and certain former and
present executive officers. This amended complaint seeks, among other
things, a declaration that the Merger Agreement is unlawful,
unenforceable, and seeks to enjoin the merger.
Share Exchange Agreement
On March 24, 2008, the Company and JPMorgan Chase, in connection with
entering into the amendment to the Merger Agreement, entered into a share
exchange agreement (the "Share Exchange Agreement"), under which JPMorgan
Chase will purchase 95 million newly issued shares of the Company's common
stock, or 39.5% of the outstanding shares of the Company's common stock
after giving effect to the issuance, in exchange for the issuance of
20,665,350 shares of JPMorgan Chase common stock to the Company and the
entry by JPMorgan Chase into the amendment to the merger agreement, an
amended and restated guaranty agreement and the guaranty in favor of the
New York Fed (each as described below). The share exchange was completed
on April 8, 2008.
The foregoing description of the Share Exchange Agreement does not purport
to be complete and is qualified in its entirety by reference to the Share
Exchange Agreement, which is filed as Exhibit 2.2 to the Company's Current
Report on Form 8-K filed on March 24, 2008.
Amended and Restated Guaranty Agreement
On March 24, 2008, JPMorgan Chase, in connection with the amendment to the
Merger Agreement, entered into an amended and restated guaranty agreement
(the "Guaranty"), effective retroactively from March 16, 2008, which
replaces the guaranty agreement entered into on March 16, 2008 in
connection with the Merger Agreement. Pursuant to the Guaranty, JPMorgan
Chase will guarantee certain liabilities of the Company and certain of its
operating subsidiaries (the "Guaranteed Bear Entities") to the extent such
liabilities arise prior to the end of the specified "Guaranty Period",
including (i) liabilities and obligations under revolving credit
facilities, letters of credit and letter of credit facilities, term loan
facilities, lines of credit or uncommitted loan facilities, in each case
whether secured or unsecured, of the Guaranteed Bear Entities, (ii)
brokerage and trading contract obligations of the Guaranteed Bear Entities
(including liabilities and obligations arising under prime brokerage
agreements and accounts, securities lending agreements, custodial and
carrying agreements, securities accounts and securities contracts,
commodity contracts, forward contracts, futures contracts, tolling
agreements, energy management agreements, repurchase or reverse repurchase
agreements, swap agreements, foreign exchange and currency contracts,
options or other derivatives, settlement or clearing agreements and
arrangements, margin loan agreements, other contracts or transactions
similar to any of the foregoing, any customary brokerage commission with
respect to
43
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
the foregoing, any contractual obligation to provide collateral or margin
in respect of any of the foregoing or any obligation under a guaranty of
any of the foregoing and (iii) obligations of the Guaranteed Bear Entities
to deliver cash, securities or other property to customers pursuant to
customary custody arrangements. The Guaranty Period will end (subject to
provision of further notice by JPMorgan Chase posted on its website at
least three days prior to the end of the Guaranty Period), no sooner than
the earliest to occur of (i) the date that is 120 days following the
failure of the Company's stockholders to approve and adopt the Merger
Agreement at a meeting of the Company's stockholders convened for that
purpose, (ii) the date that is 120 days following closing of the Merger
and (iii) the date of termination of the Merger Agreement.
The foregoing description of the Guaranty does not purport to be complete
and is qualified in its entirety by reference to the Guaranty, which is
filed as Exhibit 99.1 to the Company's Current Report on Form 8-K filed on
March 24, 2008.
Guarantee and Collateral Agreement
On March 24, 2008, JPMorgan Chase, in connection with the amendment to the
Merger Agreement and the Guaranty, entered into a guarantee and collateral
agreement (the "Guarantee and Collateral Agreement") with the Company and
certain of its subsidiaries (collectively, the "Collateral Parties")
pursuant to which the Collateral Parties agreed to guarantee the
obligations of each of them to repay to JPMorgan Chase (1) any loans or
other advances of credit by JPMorgan Chase and its affiliates to the
Company and its affiliates and (2) any amounts paid by JPMorgan Chase to
creditors of the Company and its affiliates under the Guaranty and the Fed
Guarantee (as defined below). Each of the Collateral Parties secured their
guarantee by granting a lien on substantially all of their respective
assets, subject to certain carve-outs.
The foregoing description of the Guarantee and Collateral Agreement does
not purport to be complete and is qualified in its entirety by reference
to the Guarantee and Collateral Agreement, which is filed as Exhibit 99.1
to the Company's Current Report on Form 8-K filed on March 28, 2008.
Fed Guaranty Agreement
On March 24, 2008, JPMorgan Chase, in connection with the amendment to the
Merger Agreement, entered into a guarantee in favor of the New York Fed
(the "Fed Guarantee"), pursuant to which JPMorgan Chase guaranteed certain
obligations of the Company and certain of its affiliates to the New York
Fed. Such guarantee will apply with respect to transactions entered into
prior to the termination of the Merger Agreement and may be terminated by
JPMorgan Chase with respect to transactions thereafter.
The foregoing description of the Fed Guaranty does not purport to be
complete and is qualified in its entirety by reference to the Fed
Guarantee, which is filed as Exhibit 99.2 to the Company's Current Report
on Form 8-K filed on March 24, 2008.
ACCOUNTING IMPLICATIONS
Based on the activities discussed above, the following accounting impacts
on the Condensed Consolidated Financial Statements have occurred or are
expected to occur for periods ending after March 10, 2008:
Municipal Securities
The Company acts as placement agent and as liquidity provider under a
municipal tender option bond program as described in Note 14, "Guarantees"
in Notes to the Condensed Consolidated Financial Statements of the
Company. Under the program, the Company has created a series of municipal
securities trusts which purchase fixed-rate, long-term, highly rated,
insured or escrowed municipal bonds financed by the issuance of trust
certificates. The trust certificates entitle the holder to tender such
certificates at the option of the holder on a periodic basis. Subsequent
to March 10, 2008, holders of all the Class A trust certificates had
tendered such certificates to the Company, resulting in the Company owning
100% of the trusts and consolidation of the trusts. As a result, the
Company recognized losses of approximately $200 million in the second
quarter of 2008.
44
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Deferred Tax Asset
As of February 29, 2008, the Company had approximately $1.5 billion in net
deferred tax assets (approximately $1.3 billion was associated with its
stock-based compensation plans). In accordance with SFAS No. 109, the
gross deferred tax assets of $1.7 billion will be evaluated for future
realization and be reduced by a valuation allowance if, based on available
evidence, it is more likely than not that some portion or all of the
deferred tax asset will not be realized. Management will be required to
make certain estimates and assumptions in order to assess the
realizability of the deferred tax assets. Further full realization of the
deferred tax asset for stock-based compensation requires the shares for
RSUs and CAP units to be distributed at a price equaling or exceeding the
fair value at the grant date. The provisions of SFAS No. 123 (R), however,
do not allow a valuation allowance to be recorded based on the current
fair value of the Company's shares. Accordingly, given the activities
discussed above, the Company believes it is likely that a significant
portion of this deferred tax asset will not be realized in the future.
Goodwill and Intangibles
As of February 29, 2008, the Company had goodwill and intangible assets.
Based on the proposed merger agreement, the Company believes an impairment
loss for the $88 million is probable, and would be recorded in the second
quarter of 2008.
Since the liquidity crisis and the announcement of the merger, the Company
has experienced substantial deterioration of its earnings capacity. The
closing of the merger is expected to occur by June 30, 2008. The Company
believes that the termination of the JPMorgan Chase guaranties prior to
consummation of the merger or the parties' failure to consummate the
merger could seriously jeopardize the Company's financial viability. In
addition, absent the Guaranty, the Company could face the increased risk
of rapid loss of customers and counterparties. The lack of liquidity and
the loss of customers and counterparties would materially adversely affect
the Company's financial stability and its viability as a going concern.
Accordingly, the Company could be forced to file for bankruptcy protection
and need to liquidate. The accompanying Condensed Consolidated Financial
Statements do not reflect any adjustments that might result if the Company
were unable to continue as a going concern.
45
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 (the "Company") as
of February 29, 2008, and the related condensed consolidated statements of
income, comprehensive income and cash flows for the three-month periods ended
February 29, 2008 and February 28, 2007. These interim financial statements are
the responsibility of the Company's management.
We conducted our review in accordance with the standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board (United States), the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to such condensed consolidated interim financial statements for them to
be in conformity with accounting principles generally accepted in the United
States of America.
The accompanying condensed consolidated interim financial statements have been
prepared assuming that the Company will continue as a going concern. As
discussed in Notes 1 and 17 to the condensed consolidated interim financial
statements and Note 23 to the annual consolidated financial statements for the
year ended November 30, 2007 (not presented herein), certain conditions raise
substantial doubt about its ability to continue as a going concern. Management's
plans in regards to these matters are also described in Notes 1, 17 and 23 to
the respective consolidated financial statements.
As discussed in Note 1 to the condensed consolidated interim financial
statements, effective December 1, 2007, the Company adopted the Financial
Accounting Standards Board Interpretation No. 48, "Accounting for Uncertainty in
Income Taxes - an interpretation of FASB Statement No. 109."
We have previously audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated statement
of financial condition of the Company as of November 30, 2007, and the related
consolidated statements of income, comprehensive income, cash flows and changes
in stockholders' equity for the year then ended (not presented herein); and in
our report dated January 28, 2008 (April 11, 2008 as to Note 23), we expressed
an unqualified opinion on those consolidated financial statements and included
an explanatory paragraph concerning matters that raise substantial doubt about
the Company's ability to continue as a going concern. In our opinion, the
information set forth in the accompanying condensed consolidated statement of
financial condition as of November 30, 2007 is fairly stated, in all material
respects, in relation to the consolidated statement of financial condition from
which it has been derived.
/s/ Deloitte & Touche LLP
New York, New York
April 14, 2008
46
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The Bear Stearns Companies Inc. (the "Company" or the "Firm") 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; Bear Stearns Bank & Trust Company ("BSBTC") (formerly Custodial Trust
Company); Bear Stearns Financial Products Inc.; Bear Stearns Capital Markets
Inc.; Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc. ("BS Forex");
EMC Mortgage Corporation; Bear Stearns Commercial Mortgage, Inc.; Bear Stearns
Investment Products Inc.; and Bear Energy L.P. The Company is primarily engaged
in business as a securities broker-dealer operating in three principal segments:
Capital Markets, Global Clearing Services and Wealth Management. As used in this
report, the "Company" refers (unless the context requires otherwise) to The Bear
Stearns Companies Inc. and its subsidiaries. Unless specifically noted
otherwise, all references to the three months of 2008 and 2007 refer to the
three months ended February 29, 2008 and February 28, 2007, 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 Current Report on Form 8-K filed on April 11, 2008
(the "Form 8-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 8-K.
RECENT DEVELOPMENTS
The Company experienced a significant liquidity crisis during the end of the
week of March 10, 2008 that seriously jeopardized its financial viability. On
March 16, 2008, the Company and JPMorgan Chase & Co. ("JPMorgan Chase") entered
into an agreement and plan of merger, and on March 24, 2008, entered into an
amendment to the agreement and plan of merger (as amended the "Merger
Agreement"). The liquidity crisis and the transaction documents are described in
detail in Note 17, "Subsequent Events," in the Notes to Condensed Consolidated
Financial Statements. As a result of the liquidity crisis and the events that
followed, the Company's earnings capacity has declined significantly. While the
decline in the business outlook has occurred overwhelmingly since the end of the
week of March 10, 2008, the information to follow will compare balances and
activity as of March 24, 2008 with that as of and for the period ended February
29, 2008. A substantial number of prime brokerage clients have moved accounts to
other clearing brokers. Customer margin balances were $66 billion at March 24,
2008, down 23% from $86 billion at February 29, 2008. Customer shorts at March
24, 2008 were $66 billion, down from $88 billion at February 29, 2008.
Institutional equity and fixed income commission and sales activity has declined
precipitously to well less than 50% of activity levels in the first quarter of
2008. Assets under management for the Company have declined to approximately $36
billion at March 24, 2008, down 8% from $39 billion at February 29, 2008. The
extremely challenging market environment and the unique issues associated with
the operating environment of the Company have adversely affected the Company's
day-to-day business operations. As a result, the franchise has experienced
substantial deterioration of its earnings capacity.
At the time of the anticipated merger with JPMorgan Chase (which is expected to
occur by June 30, 2008), the merger will be accounted for by JPMorgan Chase as a
"purchase" for accounting and financial reporting purposes, as that term is used
under accounting principles generally accepted in the United States. Under
purchase accounting, there may be adjustments as of the closing date. Our
financial statements as of and for the period ended February 29, 2008 do not
reflect these adjustments. Such adjustments will reflect the effect on inventory
valuations of market disruptions and the liquidity crisis encountered by the
Company subsequent to February 29, 2008, merger integration costs and
restructuring actions that may be necessary as a result of the merger, or costs
likely to be incurred by the Company to delever its balance sheet prior to the
closing of the merger.
Note 17, "Subsequent Events," in the Notes to Condensed Consolidated Financial
Statements also provides the current status of the Company's funding (in
particular, the Company's reliance on JPMorgan Chase and the Federal Reserve
Bank of New
47
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
York). Such arrangements have changed substantially from the funding plan as
disclosed in "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Liquidity, Funding and Capital."
Beginning March 17, 2008, various stockholders of the Company filed several
purported class action lawsuits against the Company, its board of directors and
certain of the Company's present and former executive officers, alleging, among
other things, that the individual defendants breached their fiduciary duties and
obligations to the Company's stockholders by agreeing to the proposed merger. In
each of these actions, plaintiffs seek, among other things, to enjoin the
proposed merger and enjoin JPMorgan Chase from voting the 95 million shares
acquired pursuant to the share exchange agreement. Additionally, on April 10,
2008, an amended complaint was filed in a previously-filed shareholder
derivative suit naming the Company's directors and certain present and former
executive officers. This amended complaint seeks, among other things, a
declaration that the Merger Agreement is unlawful, unenforceable, and seeks to
enjoin the merger. In addition, following the announcement of the merger,
various Bear Stearns stockholders filed purported class action lawsuits against
Bear Stearns, members of Bear Stearns' executive committee and certain of Bear
Stearns' present and former executive officers. Two of the complaints allege
violations of the federal securities laws; several other complaints allege
violations of the Employee Retirement Income Security Act. In these cases,
plaintiffs seek, among other things, an unspecified amount of compensatory
damages and attorneys fees. The Company and its directors each plan to defend
themselves against the claims made in these lawsuits, which the Company believes
to be without merit. Although the Company is unable at this time to determine
the ultimate outcome of these lawsuits, injunctive relief or an adverse
determination could affect the Company's ability to complete the merger.
The Company believes that the termination of the JPMorgan Chase guaranties prior
to the consummation of the merger or the parties failure to consummate the
merger could seriously jeopardize the Company's financial viability. In
addition, absent the Guaranty (as defined in Note 17), the Company could face
the increased risk of rapid loss of customers and counterparties. The lack of
liquidity and the loss of customers and counterparties would materially and
adversely affect the Company's financial stability and its viability as a going
concern. Accordingly, the Company could be forced to file for bankruptcy
protection and need to liquidate.
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, but not limited to, 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.
In addition, the Company's net income and revenues will be adversely impacted in
the event JP Morgan Chase terminates its operating guaranty in respect of
certain trading and other obligations of the Company and certain of the
Company's subsidiaries or its guaranty to the Federal Reserve Bank of New York
of the Company's borrowings from the Federal Reserve Bank of New York at the
Prime Dealer Discount Window.
These and other factors can affect the Company's volume of new securities
issuances, mergers and acquisitions and business restructurings; the stability
and liquidity of securities and futures markets; and the ability of issuers,
other securities firms and counterparties to perform on their obligations. A
decrease in the volume of new securities issuances, mergers and acquisitions or
restructurings generally results in lower revenues from investment banking and,
to a lesser extent, reduced principal transactions. A reduced volume of
securities and futures transactions and reduced market liquidity generally
results in lower revenues from principal transactions and commissions. Lower
price levels for securities may result in a reduced volume of transactions, and
may also result in losses from declines in the market value of securities held
in proprietary trading and underwriting accounts. In periods of reduced sales
and trading or investment banking activity, profitability may be adversely
affected because certain expenses remain relatively fixed. The Company's
securities trading, derivatives, arbitrage, market-making, specialist, leveraged
lending, leveraged buyout and underwriting activities are conducted by it on a
principal basis and expose the Company to significant risk of loss. Such risks
include market, counterparty credit and liquidity risks. For a further
discussion of these risks and how the Company seeks to manage risks, see the
"Risk Factors," "Risk Management" and "Liquidity Funding and Capital" sections
of the Form 8-K and the "Liquidity, Funding and Capital" and "Risk Factors"
sections in this Quarterly Report on Form 10-Q.
48
Item 2. 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
stringent regulatory environment. The Company faces significant legal risks in
its businesses, and the volume of claims and amount of damages and penalties
claimed in litigation and regulatory proceedings against financial institutions
have been increasing.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this report are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements include statements other than historical information
or statements of current condition and may relate to management's expectations,
strategic objectives, business prospects, anticipated economic performance and
financial condition and other similar matters. As a global investment bank,
there are a variety of factors, many of which are beyond the Company's control,
which affect the Company's operations, performance, business strategy and
results and could cause actual results to differ materially from the
expectations and objectives expressed in any forward-looking statements. These
factors include, but are not limited to, actions and initiations taken by
competitors, general economic conditions, the effects of current, pending, and
future legislation, regulation and regulatory actions, the ability to obtain
governmental and self-regulatory organization approvals of the merger with
JPMorgan Chase on the proposed terms and schedule and any changes to regulatory
agencies' outlook on, responses to and actions and commitments taken in
connection with the merger with JPMorgan Chase and the agreements and
arrangements related thereto and other risks and uncertainties disclosed in this
report, including those described in Part 1, Item 1A. Risk Factors of the Form
10-K, as amended. Readers are cautioned not to place undue reliance on
forward-looking statements, which speak only as of the date of the document in
which they are made. The Company disclaims any obligation or undertaking to
provide any updates or revisions to any forward-looking statement to reflect any
change in the Company's expectations or any change in events, conditions or
circumstances on which such forward-looking statement is based.
EXECUTIVE OVERVIEW
Summary of Results - Quarter Ended February 29, 2008 Compared with Quarter Ended
February 28, 2007
The continuation of the global liquidity crisis coupled with a further repricing
of credit risk created a difficult operating environment during the Company's
quarter ended February 29, 2008. Weakness in the Company's fixed income,
investment banking and asset management businesses more than offset a record
quarter for the Company's institutional equities and strong results for the
Private Client Services ("PCS") business. The Company's revenues, net of
interest expense ("net revenues") for the three months ended February 29, 2008
decreased 40% to $1.48 billion from $2.48 billion for the three months ended
February 28, 2007, while pre-tax earnings decreased 82% during the same period.
Pre-tax profit margins for the 2008 quarter decreased to 10.3% when compared
with 33.7% in the 2007 quarter. Annualized return on average common equity was
4.2% for the quarter ended February 29, 2008 compared with 18.3% in the 2007
quarter.
Capital Markets net revenues for the 2008 quarter decreased compared with the
2007 quarter due to decreased net revenues from fixed income and investment
banking, partially offset by record net revenues from institutional equities.
Fixed income net revenues decreased significantly in the 2008 quarter from the
2007 quarter, due to extremely challenging U.S. mortgage and credit markets. The
Company recognized approximately $0.6 billion in net inventory markdowns during
the 2008 quarter primarily related to losses experienced in the mortgage-related
and leveraged finance areas. Mortgage revenues for the 2008 quarter reflected
inventory markdowns in both Alt-A and commercial mortgage-backed securities. In
addition, the large supply of pending leverage finance activity, together with
investor concerns, served to reduce liquidity and price in the leverage finance
market during the 2008 quarter. Credit and distressed trading revenues also
decreased significantly in the 2008 quarter, as credit spreads widened
dramatically as investors were concerned with the higher probability of
corporate defaults. Interest rate derivatives and foreign exchange revenues
increased during the 2008 quarter, reflecting favorable market conditions and
increased customer volumes.
Institutional equities net revenues increased to record levels in the 2008
quarter from the 2007 quarter. Revenues from our international equity sales and
trading increased, reflecting continued strength in both European and Asian
equities. Additionally, revenues from domestic equity sales rose due to higher
average trading volumes on the New York Stock Exchange ("NYSE"). In addition,
structured equity net revenues increased during the 2008 quarter compared with
the 2007 quarter principally reflecting gains on the Company's structured notes
portfolio. Energy related revenues also increased in the
49
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
2008 quarter compared with the 2007 quarter, principally reflecting revenues
generated from the Williams transaction and certain proprietary trading gains.
Investment banking net revenues decreased in the 2008 quarter compared with the
2007 quarter, reflecting less favorable market conditions for equity and fixed
income underwriting. Equity underwriting revenues decreased in the 2008 quarter
compared with the 2007 quarter on lower volumes of equity follow-on offerings
and convertible new issue activity. Fixed income underwriting revenues decreased
in the 2008 quarter compared with the 2007 quarter as a result of decreased
revenues from high yield and high grade underwriting revenues. Mergers and
acquisitions ("M&A") and advisory revenues also decreased during the 2008
quarter compared with the 2007 quarter due to more challenging market
conditions. Merchant banking revenues decreased, reflecting lower gains on the
Company's portfolio of investments in the 2008 quarter compared with the 2007
quarter.
Global Clearing Services net revenues decreased in the 2008 quarter compared
with the 2007 quarter due to lower net interest revenues, partially offset by
increased commission revenues. Average prime broker margin debt increased while
average customer short balances decreased during the 2008 quarter compared with
the 2007 quarter.
Wealth Management net revenues decreased during the 2008 quarter driven by a
decrease in asset management net revenues, partially offset by an increase in
PCS net revenues. Asset management revenues decreased for the 2008 quarter
compared with the 2007 quarter primarily due to lower performance fees due to
challenging market conditions. PCS revenues increased on growth in fee-based
assets.
From a geographical perspective, net revenues from our international activities
increased by 50% to $671 million in the 2008 quarter from $448 million in the
2007 quarter. Net revenues from international activities represented 45% of
total net revenues in the 2008 quarter compared with 18% in the 2007 quarter.
Business Environment
Fiscal 2008 Quarter
The business environment during the Company's first fiscal quarter ended
February 29, 2008 was characterized by a global credit crisis resulting
primarily from concerns about sub-prime mortgages which created extremely
difficult market conditions. These conditions resulted in greater volatility,
less liquidity, widening credit spreads, a lack of price transparency, and a
flight to quality. The Federal Reserve Board (the "Fed") met five times (two
scheduled meetings and three unscheduled meetings) during the February 2008
quarter. The Fed lowered the federal funds rate by 150 basis points to 3.00%
during the 2008 quarter, citing slowing economic growth and deterioration in the
financial markets.
Each of the major U.S. equity indices decreased during the 2008 quarter. The
Standard & Poor's 500 Index ("S&P 500"), the Dow Jones Industrial Average
("DJIA"), and the National Association of Securities Dealers Automated
Quotations ("NASDAQ") Composite Index ("NASDAQ Composite Index") decreased
10.2%, 8.3% and 13.2%, respectively, during the 2008 quarter. Average daily
trading volume on the NYSE and the NASDAQ increased 4.5% and 4.8%, respectively
in the 2008 quarter, compared to the 2007 quarter. Industry-wide U.S.-announced
M&A volumes decreased 37.8% while industry-wide U.S.-completed M&A volumes
decreased 83.5% compared to the 2007 quarter. Total equity issuance volumes
decreased 18.4% while initial public offering ("IPO") volumes decreased 73.4%
compared to the 2007 quarter.
Fixed income activity continued to be adversely affected by the global credit
crisis and significantly weaker U.S. mortgage markets during the 2008 quarter.
Long-term interest rates, as measured by the 10-year Treasury bond, decreased
during the 2008 quarter. The 10-year Treasury bond yield was 3.51% at the end of
the 2008 quarter, down from 3.94% at the beginning of the quarter. Overall U.S.
mortgage-backed securities new issue volume decreased 72.5% during the 2008
quarter compared with the results achieved in the 2007 quarter. Agency
collateralized mortgage obligation ("CMO") security volumes decreased
approximately 9.9% industry-wide during the 2008 quarter from the levels reached
in the 2007 quarter, while non-agency mortgage-backed origination volumes
decreased approximately 90.0% industry-wide compared to the 2007 quarter.
50
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Fiscal 2007 Quarter
The business environment during the Company's first quarter ended February 28,
2007 was generally favorable due to a combination of factors including low
unemployment, low corporate interest rates, and strong consumer confidence. The
unemployment rate dropped to 4.5% at the end of February 2007, reflecting a
strong labor market. Additionally, the price of oil decreased from approximately
$63 a barrel at the beginning of the quarter and closed the quarter at
approximately $62 on February 28, 2007. The Fed met twice during the 2007
quarter, leaving the federal funds rate unchanged at 5.25%, citing cooling of
the housing market and moderate economic expansion.
Each of the major U.S. equity indices increased during the 2007 quarter. The S&P
500, the DJIA, and the NASDAQ Composite Index increased 9.9%, 11.6% and 5.9%,
respectively, during the 2007 quarter. Average daily trading volume on the NYSE
decreased 7.7% while average daily trading volume on the NASDAQ increased 13.6%
in the 2007 quarter, compared to the 2006 quarter. Industry-wide U.S.-announced
M&A volumes increased 196.2% while industry-wide U.S.-completed M&A volumes
increased 22.4% compared to the first quarter of 2006. Total equity issuance
volumes increased 9.2% while IPO volumes increased 27.1% compared to the 2006
quarter.
Fixed income activity remained strong during the 2007 quarter as corporate
credit spreads tightened and trading volumes increased. Long-term interest
rates, as measured by the 10-year Treasury bond, remained relatively stable
during the 2007 quarter. The 10-year Treasury bond yield was 4.57% at the end of
the 2007 quarter, up from 4.46% at the beginning of the quarter. Overall US
mortgage-backed securities new issue volume decreased 11.9% during the 2007
quarter compared with the strong results achieved in the 2006 quarter. Agency
CMO volumes decreased approximately 35.1% industry-wide during the 2007 quarter
from the levels reached in the 2006 quarter, while non-agency mortgage-backed
originations volumes decreased approximately 8.5% industry-wide compared to the
2006 quarter. During February 2007, the ABX subprime mortgage credit indices
widened dramatically, reflecting investor concern due to increased delinquencies
in subprime mortgages. Through quarter end, problems in the subprime market had
not spread to the broader mortgage market.
RESULTS OF OPERATIONS
Firmwide Results
The following table sets forth an overview of the Company's financial results:
Three Months Ended
------------------------------------------------------
(in millions, except per share amounts, pre-
tax profit margin and return on average February 29, February 28, %
common equity) 2008 2007 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense $ 1,479 $ 2,482 (40%)
Income before provision for income taxes $ 153 $ 835 (82%)
Net income $ 115 $ 554 (79%)
Diluted earnings per share $ 0.86 $ 3.82 (77%)
Pre-tax profit margin 10.3% 33.7%
Return on average common equity (annualized) 4.2% 18.3%
------------------------------------------------------------------------------------------------------------------------------------
The results for the three months ended February 29, 2008 includes approximately
$0.6 billion in net inventory markdowns during the 2008 quarter primarily
related to losses experienced in the mortgage-related and leveraged finance
areas, as a result of extremely challenging market conditions.
51
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's commission revenues by reporting category were as follows:
Three Months Ended
------------------------------------------------------
February 29, February 28,
(in millions) 2008 2007 % Increase
------------------------------------------------------------------------------------------------------------------------------------
Institutional $ 232 $ 193 20%
Clearance 63 54 17%
Retail 35 34 3%
------------------------------------------------------------------------------------------------------------------------------------
Total commissions $ 330 $ 281 17%
====================================================================================================================================
Institutional commissions increased 20% to $232 million for the 2008 quarter
from $193 million for the comparable prior year quarter due to higher average
trading volumes on both the NASDAQ and the NYSE. Clearance commissions increased
17% to $63 million for the 2008 quarter from $54 million for the comparable
prior year quarter due to higher average trading volumes from prime broker
clients. Retail commissions were $35 million in the 2008 quarter, up from $34
million in the 2007 quarter due to higher average trading volumes.
The Company's principal transactions revenues by reporting category were as
follows:
Three Months Ended
------------------------------------------------------
February 29, February 28, % Increase
(in millions) 2008 2007 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Fixed income $ (117) $ 970 nm
Equities 632 372 70%
------------------------------------------------------------------------------------------------------------------------------------
Total principal transactions $ 515 $ 1,342 (62%)
====================================================================================================================================
nm - not meaningful
Fixed income revenues decreased to a loss of $117 million for the 2008 quarter
from $970 million for the 2007 quarter, primarily reflecting a decrease in
revenues in the mortgage-backed securities, leveraged finance, credit trading,
and distressed trading areas. Revenues from the Company's mortgage-backed
securities and leveraged finance areas decreased significantly as a result of
inventory markdowns, partially offset by gains on various derivative hedges.
Revenues from the Company's credit and distressed trading decreased on
significant widening of corporate credit spreads. Revenues derived from equities
activities increased 70% to $632 million during the 2008 quarter from $372
million in the 2007 quarter primarily due to an increase in institutional equity
sales and trading, structured equity products, and energy-related revenues.
The Company's investment banking revenues by reporting category were as follows:
Three Months Ended
------------------------------------------------------
February 29, February 28, %
(in millions) 2008 2007 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Underwriting $ 72 $ 155 (54%)
Advisory and other fees 144 161 (11%)
Merchant banking 14 34 (59%)
------------------------------------------------------------------------------------------------------------------------------------
Total investment banking $ 230 $ 350 (34%)
====================================================================================================================================
Equity, high yield and high grade underwriting revenues decreased for the 2008
quarter due to lower volumes, reflecting a more difficult capital markets
environment. Advisory and other fees decreased on lower levels of M&A fees,
partially offset by higher mortgage servicing fees. Merchant banking revenues
decreased in the 2008 quarter compared with the 2007 quarter, reflecting lower
gains on the Company's portfolio of investments and lower performance fees on
managed merchant banking funds.
Net interest revenues (interest and dividends revenue less interest expense)
decreased 27% to $250 million for the 2008 quarter from $341 million for the
2007 quarter. The decrease in net interest revenues was primarily attributable
to lower average customer short balances.
52
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Asset management and other income revenues decreased 8% to $154 million for the
2008 quarter from $168 million for the 2007 quarter reflecting lower performance
fees and management fees on lower levels of traditional and alternative assets
under management. This decrease was partially offset by increased PCS net
revenues resulting from higher levels of fee-based assets.
Non-Interest Expenses
The Company's non-interest expenses were as follows:
Three Months Ended
------------------------------------------------------
February 29, February 28, % Increase
(in millions) 2008 2007 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Employee compensation and benefits $ 754 $ 1,204 (37%)
Floor brokerage, exchange and clearance fees 79 56 41%
Communications and technology 154 128 20%
Occupancy 73 57 28%
Advertising and market development 40 37 8%
Professional fees 100 72 39%
Other expenses 126 93 35%
------------------------------------------------------------------------------------------------------------------------------------
Total non-interest expenses $ 1,326 $ 1,647 (19%)
====================================================================================================================================
Employee compensation and benefits includes the cost of salaries, benefits and
incentive compensation, including Capital Accumulation Plan ("CAP Plan") units,
restricted stock units and option awards. Employee compensation and benefits
decreased 37% to $754 million for the 2008 quarter from $1.20 billion for the
2007 quarter, primarily due to lower compensation associated with the decrease
in net revenues and headcount. Employee compensation and benefits as a
percentage of net revenues increased to 51.0% for the 2008 quarter from 48.5%
for the 2007 quarter. Full-time employees decreased to 13,834 at February 29,
2008 from 14,409 at February 28, 2007.
Non-compensation expenses increased 29% to $572 million for the 2008 quarter
from $443 million for the 2007 quarter. Non-compensation expenses as a
percentage of net revenues increased to 38.7% for the 2008 quarter compared with
17.8% for the 2007 quarter. Floor brokerage, exchange and clearance fees
increased 41% to $79 million in the 2008 quarter from $56 million in the 2007
quarter, due to increased volumes and clearing house charges attributable to
international growth of the Company. Communications and technology costs
increased 20% to $154 million 2008 quarter from $128 million in the 2007
quarter, reflecting higher voice and market data-related costs as well as higher
information technology consulting expenses. Occupancy costs increased 28% to $73
million in the 2008 quarter from $57 million in the 2007 quarter, reflecting
additional office space requirements and higher leasing costs associated with
the Company's headquarters building at 383 Madison Avenue and other office
locations in New York City, as well as several international locations,
reflecting the Company's growth globally. Advertising and market development
costs increased 8% to $40 million for the 2008 quarter from $37 million from the
2007 quarter, due to higher levels of client and deal related expenses.
Professional fees increased 39% to $100 million for the 2008 quarter from $72
million in the 2007 quarter, due to higher levels of non-information technology
consulting fees and legal bills. Other expenses increased 35% to $126 million in
the 2008 quarter from $93 million in the 2007 quarter, primarily due to
increased litigation costs associated with the Bear Stearns Asset Management
("BSAM")-managed high-grade funds. CAP Plan related costs decreased 60% to $17
million for the 2008 quarter from $42 million in the 2007 quarter, reflecting
the lower level of earnings. Pre-tax profit margin was 10.3% for the 2008
quarter versus 33.7% for the 2007 quarter.
The Company's effective tax rate decreased to 25.0% for the 2008 quarter from
33.7% for the 2007 quarter reflecting the significant decline in pre-tax
earnings and relatively fixed level of tax preference items.
53
Item 2. 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. See Note 15, "Segment Data" in
the Notes to Condensed Consolidated Financial Statements for complete segment
information.
Capital Markets
Three Months Ended
------------------------------------------------------
February 29, February 28, % Increase
(in millions) 2008 2007 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Net revenues
Institutional equities $ 811 $ 513 58%
Fixed income 66 1,149 (94%)
Investment banking 159 303 (48%)
------------------------------------------------------------------------------------------------------------------------------------
Total net revenues $ 1,036 $ 1,965 (47%)
Pre-tax income $ 171 $ 736 (77%)
------------------------------------------------------------------------------------------------------------------------------------
The Capital Markets segment comprises institutional equities, fixed income and
investment banking. 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 to institutional and corporate
clients.
Institutional equities consists of sales, trading and research, in areas such as
domestic and international equities, block trading, over-the-counter equities,
equity derivatives, energy and commodity activities, risk and convertible
arbitrage and specialist activities on the NYSE, American Stock Exchange
("AMEX") and International Securities Exchange ("ISE"). Fixed income includes
sales, trading, origination and research provided to institutional clients
across a variety of products such as mortgage- and asset-backed securities,
corporate and government bonds, municipal bonds, high yield products, including
bank and bridge loans, foreign exchange and interest rate and credit
derivatives. Investment banking provides services in capital raising, strategic
advice, mergers and acquisitions and merchant banking. Capital raising
encompasses the Company's underwriting of equity, investment grade, municipal
and high yield debt products.
Net revenues for Capital Markets decreased 47% to $1.04 billion for the 2008
quarter compared with $1.97 billion for the 2007 quarter.
Institutional equities net revenues for the 2008 quarter increased 58% to $811
million from $513 million for the comparable prior year quarter. International
equity sales and trading revenues increased, representing continued strength in
our European and Asian equities. Domestic equity sales revenues also increased
on higher average trading volumes on the NYSE. Additionally, structured equity
products net revenues increased approximately $227 million in the 2008 quarter
from the 2007 quarter primarily reflecting gains from the Company's structured
notes portfolio. The Company's energy-related revenues also increased, primarily
reflecting revenues from the Williams transaction and certain proprietary gains.
Fixed income net revenues decreased 94% to $66 million for the 2008 quarter from
$1.15 billion for the 2007 quarter. The Company recognized approximately $0.6
billion in net inventory markdowns during the 2008 quarter related to losses in
the mortgage-related and leveraged finance areas. The exceptionally weak capital
markets conditions experienced in the residential mortgage markets served to
decrease origination volumes in the 2008 quarter compared with the 2007 quarter.
The inability to securitize and distribute mortgage assets served to exacerbate
the impact of inventory markdowns on mortgage revenues. Additionally, the large
supply of pending leveraged finance activity, together with investor concerns
served to dramatically reduce liquidity and pricing in the leveraged finance
market. Distressed trading and credit trading revenues also decreased, as credit
spreads widened during the 2008 quarter. Partially offsetting these decreases
were record revenues from interest rates products, as higher volatility
increased customer activity compared with the 2007 quarter.
Investment banking revenues decreased 48% to $159 million for the 2008 quarter
from $303 million for the 2007 quarter. Underwriting revenues decreased 56% to
$77 million for the 2008 quarter from $176 million for the 2007 quarter. Equity
54
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
underwriting revenues decreased, reflecting lower volumes of equity follow-on
and convertible new issue offerings. Additionally, high yield and high grade
underwriting revenues decreased, reflecting challenging market conditions.
Advisory and other fees for the 2008 quarter decreased 27% to $68 million from
$93 million for the prior year quarter reflecting decreased M&A fees due to a
decrease in customer activity. Merchant banking revenues decreased 59% to $14
million in the 2008 quarter from $34 million during the 2007 quarter, reflecting
lower gains in the Company's portfolio of investments compared to the prior year
quarter.
Global Clearing Services
Three Months Ended
------------------------------------------------------
February 29, February 28, %
(in millions) 2008 2007 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Net revenues $ 253 $ 276 (8%)
Pre-tax income $ 86 $ 113 (24%)
------------------------------------------------------------------------------------------------------------------------------------
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to clearing
clients worldwide. Prime brokerage clients include hedge funds and clients of
money managers, short sellers, arbitrageurs and other professional investors.
Fully disclosed clients engage in either the retail or institutional brokerage
business. At February 29, 2008 and February 28, 2007, the Company held
approximately $274 billion and $298 billion, respectively, in equity in Global
Clearing Services client accounts.
Net revenues for Global Clearing Services decreased 8% to $253 million for the
2008 quarter from $276 million in the 2007 quarter. Net interest revenues
decreased 15% to $180 million for the 2008 quarter from $212 million for the
2007 quarter, primarily reflecting decreased average customer short balances.
Commissions and other revenues increased 14% to $73 million for the 2008 quarter
from $64 million for the 2007 quarter reflecting higher trading volumes from
both prime brokerage and fully-disclosed clients. Pre-tax income decreased 24%
to $86 million for the 2008 quarter from $113 million for the 2007 quarter.
Pre-tax profit margin was 34.0% for the 2008 quarter compared with 40.9% for the
2007 quarter.
The following table presents the Company's interest-bearing balances for the
fiscal periods ended:
Three Months Ended
------------------------------------------------------
February 29, February 28,
(in billions) 2008 2007
------------------------------------------------------------------------------------------------------------------------------------
Margin debt balances, average for period $ 84.0 $ 81.3
Margin debt balances, at period end 85.5 86.6
Customer short balances, average for period 86.1 94.0
Customer short balances, at period end 88.0 95.1
Securities borrowed, average for period 64.5 59.9
Securities borrowed, at period end 70.8 59.4
Free credit balances, average for period 37.3 33.8
Free credit balances, at period end 43.2 37.1
Equity held in client accounts, at period end 274.1 298.0
------------------------------------------------------------------------------------------------------------------------------------
55
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Wealth Management
Three Months Ended
------------------------------------------------------
February 29, February 28, % Increase
(in millions) 2008 2007 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Private client services revenues $ 183 $ 166 10%
Revenue transferred to Capital Markets segment (22) (30) (27%)
------------------------------------------------------------------------------------------------------------------------------------
Private client services net revenues 161 136 18%
Asset management 39 119 (67%)
------------------------------------------------------------------------------------------------------------------------------------
Total net revenues $ 200 $ 255 (22%)
Pre-tax income $ (42) $ 44 nm
------------------------------------------------------------------------------------------------------------------------------------
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 February 29, 2008, PCS had approximately 500 account
executives in its principal office, six regional offices and two international
offices. Asset management manages equity, fixed income and alternative assets
for corporate pension plans, public systems, endowments, foundations,
multi-employer plans, insurance companies, corporations, families and
high-net-worth individuals in the United States and abroad.
Net revenues for Wealth Management decreased 22% in the 2008 quarter to $200
million from $255 million for the 2007 quarter. Asset management revenues
decreased 67% to $39 million for the 2008 quarter compared to $119 million for
the 2007 quarter, primarily due to lower performance fees, reflecting declines
in alternative investment fund performances and proprietary investments, as a
result of the difficult market environment. Management fees also declined due to
lower assets under management. PCS net revenues increased 18% to $161 million
for the 2008 quarter from $136 million for the 2007 quarter, reflecting higher
levels of fee-based income and commissions.
Total assets under management were $39.3 billion at February 29, 2008,
reflecting a 27% decrease from $54.1 billion in assets under management at
February 28, 2007. The decrease in assets under management reflects $8.8 billion
transfer of assets related to the spin-off of O'Shaughnessy Asset Management.
Assets under management at February 29, 2008 include $7.6 billion of assets from
alternative investment products, a decrease from $8.7 billion at February 28,
2007.
56
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
LIQUIDITY, FUNDING AND CAPITAL
Recent Developments
On February 29, 2008, the Company had available liquidity at the parent company
equal to $17.3 billion. However, over the course of the week of March 10, market
speculation was that Bear Stearns was experiencing a serious liquidity problem.
On the evening of March 10, 2008, the Company issued a press release denying the
market rumors. On Wednesday, March 12, 2008, the Company disclosed that its
liquidity position was largely unchanged since the beginning of the year as
contrasted with the unsubstantiated market rumor and speculation. During the
course of the day on March 12, 2008, however, an increased volume of customers
expressed a desire to withdraw funds from and certain counterparties expressed
increased concern regarding maintaining their ordinary course exposure to Bear
Stearns. Over the course of the day on March 13, 2008, an unusually high number
of customers withdrew funds and a significant number of counterparties and
lenders were unwilling to make secured financing available on customary terms,
which resulted in a sharp deterioration in the Company's liquidity position. As
of the evening of March 13, 2008, available liquidity declined materially and
expected funding requirements on March 14, 2008 were significantly in excess of
available liquidity. The inability to borrow against high quality collateral and
rapid withdrawal of customer funds contributed to the liquidity issues. On the
morning of March 14, 2008, the Company issued a press release announcing that it
had obtained a secured lending facility from JPMorgan Chase and that it was
discussing permanent financing and other alternatives with JPMorgan Chase.
Despite this announcement, throughout the day on March 14, 2008, customers
continued to withdraw funds at an increasing rate and counterparties continued
to seek to reduce their exposure to the Company also at an increasing rate. On
the evening of March 14, 2008, the Company was informed that the secured lending
facility that had been entered into earlier that day would not be available on
March 17, 2008. On March 16, 2008, the Company and JPMorgan Chase entered into
the agreement and plan of merger. JPMorgan Chase issued the Guaranty (as defined
in Note 17) of the Company's trading and certain other obligations.
Despite the financial support from the merger agreement and the Guaranty, the
Company's liquidity position continued to deteriorate, customers continued to
withdraw funds and funding (other than from JPMorgan Chase and the New York Fed)
was not available. As of March 21, 2007, management estimated that Bear Stearns
had little to no available liquidity. On March 24, 2008, the Company and
JPMorgan Chase entered into the amendment to the agreement and plan of merger,
the share exchange agreement and certain other ancillary transaction documents
and JPMorgan Chase issued the guaranty to the New York Fed and the amended and
restated operating guaranty, which clarified and enhanced the terms of the
guaranty.
The closing of the merger is expected to occur by the end of the calendar second
quarter 2008. The Company believes that the termination of the Guaranty prior to
closing of the merger or the parties' failure to close the merger could
seriously jeopardize its financial viability. In addition, absent the Guaranty,
the Company could face the increased risk of rapid loss of customers and
counterparties. The lack of liquidity and the loss of customers and
counterparties would materially and adversely affect the Company's financial
stability and its viability as a going concern. Accordingly, the Company could
be forced to file for bankruptcy protection and need to liquidate. See Note 17,
"Subsequent Events," of Notes to Condensed Consolidated Financial Statements.
General
The discussion below reflects data as of February 29, 2008 and the qualitative
process that was employed in the management of funding and liquidity risk. Prior
to February 29, 2008 and during prior periods, the liquidity risk and funding
framework was predicated on access to secured funding versus fixed income and
equities securities as collateral.
Liquidity Risk Management
The Global Finance Committee, in consultation with the Chief Financial Officer,
has established a funding framework for the Firm. A fundamental premise of the
liquidity risk management framework is that the Firm is not reliant upon nor
does it contemplate forced balance sheet reduction to endure a period of
constrained funding availability. The Company's liquidity risk management
framework is centered on the following concepts and metrics:
o Unencumbered Collateral - The Company monitors the market value and
borrowing value of unencumbered, unhypothecated financial
instruments owned by the Company. These assets may be monetized to
generate liquidity for the repayment of debt obligations or meet
other cash outflows as required. Given that the unencumbered
collateral is held in both regulated and unregulated subsidiaries,
there may be limitations on availability of this liquidity to the
Parent Company.
o Liquidity Ratio - The ratio of cash plus the borrowing value of
unencumbered collateral in relation to total unsecured debt maturing
over the next twelve months. The firm strives to maintain this ratio
at 110% or greater.
o Excess Liquidity - The Company maintains cash and cash equivalents
to meet a broad array of potential cash outflows in a stressed
liquidity environment. This excess liquidity is maintained at the
Parent Company to ensure ready availability to meet cash outflows as
needed.
o Net Cash Capital - The measurement of cash capital sources (i.e.,
equity plus long-term debt maturing in more than 12 months) relative
to cash capital requirements. The Company strives to maintain
positive net cash capital of $2.0 billion or more. The cash capital
framework is discussed in more detail below.
Unencumbered Collateral and Liquidity Ratio
The Company's liquidity ratio is calculated using advance rates that are
considered readily available, reflecting what can be reliably realized in a
stressed liquidity environment. The cash capital model is calculated using
haircuts, which are consistent and symmetrical with the advance rates used in
the liquidity ratio in that the haircut is equal to one minus the advance rate.
In the vast majority of circumstances/asset classes, advance rates are derived
from committed secured bank facilities, whereby a bank or group of banks are
contractually obligated to lend to the Company at a pre-specified advance rate
on specific types of ("eligible") collateral regardless of "market environment."
As such, the advance rates/haircuts used in calculating the liquidity ratio and
in assessing cash capital requirements are typically more conservative than
those the Company realizes in normalized repo and secured lending markets.
57
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
As of February 29, 2008, the market value of eligible unencumbered,
unhypothecated financial instruments owned by the Company was approximately
$14.4 billion with a borrowing value of $12.3 billion. These eligible assets are
primarily comprised of U.S. equities and residential and commercial mortgage
whole loans, mortgage- and asset-backed securities, investment grade municipal
and corporate bonds. The vast majority of advance rates on these different asset
types are 70% or higher, 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 161% over the previous 12 months,
including the Company's $2.9 billion unused committed unsecured bank credit, and
145%, excluding the committed unsecured revolving credit facility. On this same
basis, as of February 29, 2008 the liquidity ratio was 183% and 167%,
respectively.
The Company monitors unrestricted liquidity available to the Parent Company via
the ability to monetize unencumbered assets held in unregulated and regulated
entities. As of February 29, 2008, approximately $4.5 billion of the market
value identified in the liquidity ratio data above was held in unregulated
entities and thus likely to be available to the Parent Company. The remaining
$9.9 billion market value of unencumbered securities was held in regulated
entities, a portion of which may not be available to provide liquidity to the
Parent Company.
Excess Liquidity
The Company maintains cash and cash equivalents to meet a broad range of
potential cash outflows in a stressed liquidity environment. This excess
liquidity is maintained at the Parent Company to ensure ready availability to
meet cash outflows as needed. The size of the Parent Company Liquidity Pool is
determined from Company-specific stressed liquidity events that the firm could
face over the next 12 months. Specific events that are accounted for in sizing
the liquidity pool include, but are not limited to the following:
o Derivative collateral outflows that would be required if the firm
were to experience a 2-notch ratings downgrade;
o Derivative collateral outflows that could be required after a
variety of stress market moves;
o Potential draws on unfunded committed funding obligations;
o Widening of haircuts in secured financing transactions; and
o Financing haircuts for certain off-balance sheet-financing
transactions.
The liquidity pool consists of liquidity immediately accessible by the Parent
Company at all times. This liquidity pool can take the form of cash deposits and
money market instruments that are held at the Parent Company level and
high-quality collateral (corporate bonds, municipal bonds, equity securities)
that is owned by subsidiaries and explicitly pledged to and segregated for the
benefit of the Parent Company and maintained at a third-party custodian. For
purposes of calculating the aggregate value of the Parent Company Liquidity
Pool, the contractually obligated advance rates described herein are used to
determine the borrowing value of collateral pledged. As of February 29, 2008 the
Parent Company Liquidity Pool was $17.3 billion comprised entirely of money
market funds, bank deposits and short-term high quality money market
investments.
Net Cash Capital
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. 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 leveraged loan
commitments;
o Less liquid and illiquid assets, such as restricted securities and
fixed assets;
58
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
o Uncollateralized funded loans and funded loans secured by illiquid
and/or collateral that cannot be rehypothecated;
o Merchant banking assets and other long-term investments; and
o Regulatory capital in excess of a regulated entity's cash capital
based longer-term funding requirements.
At February 29, 2008, the Company's net cash capital position, defined as the
surplus of long-term funding sources versus long-term funding requirements was
$3.6 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 with a target for positive net cash
capital of $2.0 billion or more. For fiscal year 2008, the Company's total cash
capital requirement, cash capital intensity ratio (average haircut), and net
cash capital position have averaged $65.9 billion, 16.1% and $3.1 billion,
respectively.
Funding Framework
The firm's overall objective is to ensure sufficient diversity and reliability
of funding sources to meet its financing needs at all times and in all market
environments. With this objective at the forefront, the Company modified its
general funding structure, beginning in late 2006, consistent with the following
elements:
o Increased use of secured funding given the view that secured funding
is inherently less credit sensitive and thus more stable due to the
collateralized nature of the borrowing;
o Introduced substantially greater amounts of longer tenor secured
funding into the repo and bank loan portions of its secured funding
mix;
o Reduced reliance on short-term unsecured funding sources, thereby
lessening both exposure to rollover risk and dependence on any
large, single short-term unsecured creditor;
o Expanded the size and scope of the Parent Company Liquidity Pool,
which consists of cash and cash equivalents held at the parent
company for deployment as needed; and
o Increased the target for net cash capital, which measures the
surplus of longer-term funding sources versus longer-term funding
requirements.
In general, the Company funds its assets based on their liquidity
characteristics as measured by an asset's reliable self-funding ability. As
such, the firm's liability and capital structure is primarily a function of
asset composition. Most assets are funded with a mix of short-term
(predominantly secured) and longer-term funding (i.e, cash capital). The
relative funding mix is a function of the asset and is determined by the advance
rate that an asset warrants in currently active and utilized secured funding
markets. Secured funding with market driven haircuts is used wherever possible,
while the haircut portion plus a conservative add-on is funded with cash
capital. Illiquid assets are funded entirely with cash capital. Unfunded
commitments are pre-funded with cash capital, while the necessary amount of
which is determined by the haircut to be assigned to the asset once funded.
The Company's use of unsecured funding is dominated by the long-term unsecured
component. Long-term debt with the maturity greater than one year is a source of
cash capital and serves to provide stability to the firm's overall funding
profile. The firm accesses long-term debt in a number of currencies allowing it
to tap a broad and diverse investor base. Maturity concentration guidelines have
been established and are regularly monitored to both minimize rollover risk and
target prospective issuance. Long-term debt totaling $60.8 billion and $59.0
billion had remaining maturities beyond one year at February 29, 2008 and
November 30, 2007, respectively. As of February 29, 2008, the weighted average
maturity of the Company's long-term debt was 4.6 years. The Company accesses
funding in a variety of markets in the United States, Europe and Asia. The
Company issues debt through syndicated U.S.-registered offerings,
U.S.-registered and 144A medium-term note programs, other U.S. and non-U.S. bond
and note offerings.
With respect to short-term unsecured funding, the Company seeks to ensure
prudent usage thereof, as well as tapping a broad diverse base of credit
providers and funding markets. In aggregate, usage of short-term unsecured debt
has declined in recent periods given the emphasis on greater use of secured
funding with a significant term component. Diversification by product,
geography, maturity and creditor/investor facilitates management of related
funding risks. Reduced reliance over the last
59
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
twelve months on more credit sensitive, potentially less stable short-term
unsecured funding is positive to the firm's liquidity profile and was
accomplished intentionally concurrent with the desired shift in funding
framework. In addition to the above considerations, the Company:
o Regularly monitors and quantifies potential draws on its liquidity.
These include, but are not limited to, ratings downgrades,
commitments to extend credit, repo haircut widening and stressed
market derivative collateral outflows. The associated liquidity risk
is mitigated by inclusion in the Company's Parent Company Liquidity
Pool;
o Monitors and prudently funds illiquid and other hard to fund assets,
ensuring these are predominantly funded by 100% cash capital;
o Maintains ongoing dialogue and relationships with broad, diverse
base of debt investors and bank creditors, as these key creditor
constituents are crucial to the Company's liquidity and financial
health;
o Manages investor and maturity concentration risk via strict
adherence to short-term debt investor concentration limits and
regularly monitors the maturity profile of its unsecured debt; and
o Adheres to a general guideline of no more than 20% of its long-term
debt maturing in any one year, as well as no more than 10% maturing
in any one quarter over the next five years. As of February 29,
2008, the Company was in compliance with these guidelines.
Legal Entity Structure
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 benefits of a centralized funding approach include greater
control of issuance and flexibility to meet subsidiary funding needs, while the
legal entity structure can constrain liquidity available to the Company. The
Firm's inter-company funding approach mitigates this risk. The Parent Company
advances funds in the form of debt or equity to subsidiaries to meet their
operating funding needs and, in the case of regulated entities, regulatory
capital requirements. Primary regulated subsidiaries include Bear Stearns, BSSC,
BSIL, BSIT, BSB, and BSBTC. See Note 11, "Regulations," in the Notes to
Condensed Consolidated Financial Statements. In addition to the primary
regulated subsidiaries, the Company also conducts significant activities through
other wholly owned subsidiaries, including: Bear Stearns Global Lending Limited,
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., Bear Stearns Investment Products Inc.,
and Bear Energy L.P. In connection with all of the Company's operating
activities, a substantial portion of the Company's long-term borrowings and
equity has been used to fund investments in, and advances to, these
subsidiaries, including subordinated debt advances.
Within this funding framework, the Company attempts to fund equity investments
in subsidiaries with equity from the Parent Company (i.e., utilize no equity
double leverage). At February 29, 2008, the Parent Company's equity investment
in subsidiaries was $8.5 billion versus common stockholders' equity and
preferred equity of $11.5 billion and $352 million, respectively. As such, at
February 29, 2008, the ratio of the equity investment in subsidiaries to Parent
Company equity (equity double leverage) was approximately 0.73 based on common
equity and 0.71 including preferred equity. At November 30, 2007, these measures
were 0.71 based on common equity and 0.69 including preferred equity.
Additionally, all subordinated debt advances to regulated subsidiaries for use
as regulatory capital, which totaled $14.0 billion at the first quarter of
fiscal 2008, 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.
60
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Balance Sheet and Financial Leverage
------------------------------------
Asset Composition
The Company's actual level of balance sheet 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
U.S. 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 reverse repurchase activity. The Company's total
assets and financial leverage can and do fluctuate, depending largely on
economic and market conditions, volume of activity and customer demand.
The Company's total assets at February 29, 2008 increased to $399.0 billion from
$395.4 billion at November 30, 2007. The increase was primarily attributable to
increases in cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations, securities borrowed, and
financial instruments owned, at fair value, partially offset by a decrease in
assets of variable interest entities and mortgage loan special purpose entities.
Balance Sheet Size and Variability
Given the nature of the Company's market-making and customer-financing activity,
the overall size of the balance sheet fluctuates from time to time. The
Company's total assets at each quarter end are typically lower than would be
observed on an average basis. At the end of each quarter, the Company typically
uses excess cash to finance high-quality, highly liquid securities inventory
that otherwise would be funded via the repurchase agreement market. In addition,
the Company reduces its matched book repurchase and reverse repurchase
activities at quarter end. Finally, the Company may reduce the aggregate level
of inventories through ordinary course, open market activities in the most
liquid portions of the balance sheet, which are principally U.S. government and
agency securities and agency mortgage pass-through securities.
At February 29, 2008 and November 30, 2007, total assets of $399.0 billion and
$395.4 billion were approximately 12.4% and 12.2%, respectively, lower than the
average of the month-end balances observed over the trailing 12-month period.
Despite fluctuations in total assets at each quarter end, the Company's overall
market, credit and liquidity risk profile does not change materially, since the
reduction in asset balances is predominantly in highly liquid, short-term
instruments that are financed on a secured basis. This periodic reduction
verifies the inherently liquid nature of the balance sheet and provides
consistency with respect to creditor constituents' evaluation of the Company's
financial condition.
Leverage Ratios
Balance sheet leverage measures are one approach to assessing the capital
adequacy of a securities firm, such as the Company. Gross leverage equals total
assets divided by stockholders' equity, inclusive of preferred and trust
preferred equity. The Company views its trust preferred equity as a component of
its equity capital base given the equity-like characteristics of the securities.
The Company also receives rating agency equity credit for these securities. Net
adjusted leverage equals net adjusted assets divided by tangible equity capital,
which excludes goodwill and intangible assets from both the numerator and the
denominator, as equity used to support goodwill and intangible assets is not
available to support
61
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 the items excluded in deriving net adjusted assets (see
table below) renders net adjusted leverage as the more relevant measure.
The following table presents total assets and net adjusted assets with the
resultant leverage ratios at February 29, 2008 and November 30, 2007:
February 29, November 30,
(in millions, except ratios) 2008 2007
------------------------------------------------------------------------------------------------------------------------------------
Total assets $ 398,995 $ 395,362
Deduct:
Cash and securities deposited with clearing
organizations or segregated in compliance with federal
regulations 14,910 12,890
Securities purchased under agreements to resell 26,888 27,878
Securities received as collateral 15,371 15,599
Securities borrowed 87,143 82,245
Receivables from customers 41,990 41,115
Assets of variable interest entities and
Mortgage loan special purpose entities, net 26,739 30,605
Goodwill & intangible assets 935 952
------------------------------------------------------------------------------------------------------------------------------------
Subtotal 185,019 184,078
------------------------------------------------------------------------------------------------------------------------------------
Add:
Financial instruments sold, but not yet purchased 51,544 43,807
Deduct:
Derivative financial instruments 16,510 13,492
------------------------------------------------------------------------------------------------------------------------------------
Net adjusted assets $ 220,053 $ 214,393
====================================================================================================================================
Stockholders' equity
Common equity $ 11,544 $ 11,441
Preferred stock 352 352
------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 11,896 11,793
------------------------------------------------------------------------------------------------------------------------------------
Add:
Trust preferred equity 263 263
------------------------------------------------------------------------------------------------------------------------------------
Subtotal - leverage equity 12,159 12,056
------------------------------------------------------------------------------------------------------------------------------------
Deduct:
Goodwill & intangible assets 935 952
------------------------------------------------------------------------------------------------------------------------------------
Tangible equity capital $ 11,224 $ 11,104
====================================================================================================================================
Gross leverage 32.8 x 32.8x
Net adjusted leverage 19.6 x 19.3x
------------------------------------------------------------------------------------------------------------------------------------
62
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Total Capital
The Company's total capital base, which consists of long-term debt, preferred
equity issued by subsidiaries and total stockholders' equity, increased to $83.7
billion at February 29, 2008 from $80.3 billion at November 30, 2007. This
change was primarily due to a net increase in long-term debt.
The Company's total capital base as of February 29, 2008 and November 30, 2007
was as follows:
February 29, November 30,
(in millions) 2008 2007
---------------------------------------------------------------------------
Long-term borrowings:
Senior debt $ 70,490 $ 67,275
Subordinated debt (1) 1,263 1,263
---------------------------------------------------------------------------
Total long-term borrowings $ 71,753 $ 68,538
Stockholders' equity:
Preferred stockholders' equity $ 352 $ 352
Common stockholders' equity 11,544 11,441
---------------------------------------------------------------------------
Total stockholders' equity $ 11,896 $ 11,793
---------------------------------------------------------------------------
Total capital $ 83,649 $ 80,331
===========================================================================
(1) Includes $1.0 billion in subordinated debt issued by the Company and $263
million in junior subordinated deferrable interest debentures
("Debentures") issued by the Company and held by Bear Stearns Capital
Trust III ("Capital Trust III") at February 29, 2008 and November 30,
2007.
The amount of long-term debt as well as total capital that the Company maintains
is driven by a number of factors, with particular focus on asset composition.
The Company's ability to support increases in total assets is a function of its
ability to obtain short-term secured and unsecured funding, as well as its
access to longer-term sources of capital (i.e., long-term debt and equity). The
Company regularly measures and monitors its total capital requirements, which
are primarily a function of the self-funding ability of its assets. The equity
portion of total capital is primarily a function of on- and off-balance-sheet
risks (i.e., market, credit and liquidity) and regulatory capital requirements.
As such, the liquidity and risk characteristics of assets being held are
critical determinants of both total capital and the equity portion thereof, thus
significantly influencing the amount of leverage that the Company can employ.
Credit Ratings
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:
o Material changes in operating margins;
o Earnings trends and volatility;
o The prudence of funding and liquidity management practices;
o Significant reductions in available liquidity;
o Perceived changes in risk appetite;
o Financial leverage on an absolute basis or relative to peers;
o The composition of the balance sheet and/or capital structure;
o Geographic and business diversification; and
o The Company's market share and competitive position in the business
segments in which it operates.
63
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
At the date of filing, the Company's long-term/short-term debt ratings were as
follows:
Long-Term Short-Term
Rating Rating
-------------------------------------------------------------------------
Dominion Bond Rating Service Limited A R-1(low)
Fitch Ratings A- F2
Japan Credit Rating Agency, Ltd AA- NR
Moody's Investors Service (1) Baa1 P-2
Rating & Investment Information, Inc. A- NR
Standard & Poor's Ratings
Services AA- A-1+
-------------------------------------------------------------------------
NR - does not assign a short-term rating
(1) On March 25, 2008, Moody's assigned Aa2 Backed Long-term and Prime-1
Backed Short-term Issuer ratings to Bear Stearns and certain rated
subsidiaries that explicitly benefit from the Amended and Restated
Guaranty Agreement from JPMorgan Chase & Co.
The above ratings and/or associated outlooks, to varying degrees, are positively
influenced by the proposed merger with and guarantee by JPMorgan Chase. In the
absence of the guarantee and merger, the ratings and/or outlook assigned to the
Company by all agencies would be lower and/or negative. Following the March 24,
2008 amendment to the merger agreement and execution of the amended and restated
guarantee (See Note 17, "Subsequent Events," of Notes to Condensed Consolidated
Financial Statements), all rating agencies listed above took favorable rating
actions.
Committed Credit Facilities
---------------------------
As of February 29, 2008, the Company had a committed revolving credit facility
("Facility") totaling $2.9 billion, which permitted borrowing on a secured basis
by the Parent Company, BSSC, BSIL and certain other subsidiaries. The Facility
terminated on April 7, 2008. There were no borrowings outstanding under the
Facility at February 29, 2008 or on the termination date.
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, BSIT and
BSB and BS Forex. 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 2008, with all repos
outstanding at that date payable no later than August 2009. There were no
borrowings outstanding under the Repo Facility at February 29, 2008.
The Company has a $350 million committed revolving credit facility ("Pan Asian
Facility"), which permits borrowing on a secured basis by the Parent Company,
BSSC, Bear Stearns Japan Limited ("BSJL"), and BSIL. The Pan Asian Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company and net capital of BSSC.
The Pan Asian Facility terminates in December 2008 with all loans outstanding at
that date payable no later than December 2009. There were no borrowings
outstanding under the Pan Asian Facility at February 29, 2008.
As of February 29, 2008, the Company had a $450 million committed revolving
credit facility ("Tax Lien Facility"), which permitted borrowing on a secured
basis by the Parent Company, Plymouth Park Tax Services and Madison Tax Capital
LLC. The Tax Lien Facility terminated in March 2008. There were no borrowings
outstanding under the Tax Lien Facility at February 29, 2008 or on the date of
termination.
As of February 29, 2008, the Company had a committed revolving credit facility
("AAA Facility") totaling $750 million, which permits borrowing on an unsecured
basis by Bear Stearns Financial Products ("BSFP"). Under the AAA Facility, BSFP
may borrow up to the committed amount in the event of: (i) a Bankruptcy Event,
as defined, at The Bear Stearns Companies Inc.; (ii) the downgrade of The Bear
Stearns Companies Inc.'s short term debt rating to A-2 by S&P or to P-2 by
Moody's; (iii) the failure of Bear Stearns Capital Markets to post collateral
with or make payments to BSFP in accordance with BSFP's Operating Guidelines;
(iv) the failure of BSFP to meet the capital requirements required by its
Operating Guidelines; or (v) the downgrade of BSFP's counterparty credit rating
below A by S&P or below A2 by Moody's. The AAA Facility terminates on April 25,
2008, with all loans outstanding at that date payable no later than April 2009.
There were no borrowings outstanding under the AAA Facility at February 29,
2008.
64
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company also maintains a series of committed credit facilities, which permit
borrowing on a secured basis, to support liquidity needs for the financing of
investment-grade and non-investment-grade corporate loans, residential
mortgages, commercial mortgages, listed options and whole loans. The facilities
are expected to be drawn from time to time and expire at various dates, the
longest of such periods ending in fiscal 2008. All of these facilities contain a
term-out option of one year or more for borrowings outstanding at expiration.
The banks providing these facilities are committed to provide up to an aggregate
of approximately $6.7 billion. At February 29, 2008 the borrowings outstanding
under these committed credit facilities were $3.3 billion.
Stock Repurchase Program
------------------------
The Company has various employee stock compensation plans designed to increase
the emphasis on stock-based incentive compensation and align the compensation of
its key employees with the long-term interests of stockholders. Such plans
provide for annual grants of stock units and stock options. The Company intends
to offset the potentially dilutive impact of the annual grants by purchasing
common stock throughout the year in open market and private transactions.
On September 18, 2007, the Board of Directors approved an amendment to the
Repurchase Program authorizing the purchase of up to $2.5 billion of common
stock in fiscal 2007 and beyond. During the quarter ended February 29, 2008, the
Company purchased under the current authorization a total of 710,549 shares at a
cost of $69.9 million. The Repurchase Program will be used to acquire shares of
common stock for the Company's employee stock compensation plans and for up to
$1.0 billion in corporate share repurchases. Approximately $2.0 billion was
available to be purchased under the current authorization as of February 29,
2008.
Pursuant to a $200 million CAP Plan Earnings Purchase Authorization ("CAP
Authorization"), which was approved by the Compensation Committee of the Board
of Directors of the Company on December 12, 2006, during the quarter ended
February 29, 2008, the Company purchased no shares of its common stock.
Approximately $92 million was available to be purchased under the CAP
Authorization as of February 29, 2008.
Cash Flows
----------
Cash and cash equivalents decreased $620 million to $20.79 billion at February
29, 2008 from $21.41 billion at November 30, 2007. Cash provided by operating
activities was $6.37 billion, primarily attributable to increases in payables to
customers and financial instruments sold, but not yet purchased, at fair value,
partially offset by an increase in securities borrowed, securities loaned, net
and a decrease in securities sold under agreements to repurchase, securities
purchased under agreements to resell, net, 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 $51 million reflected
purchases of property, equipment and leasehold improvements. Cash used in
financing activities of $6.94 billion reflected net payments for other secured
borrowings of $4.58 billion, net payments for the retirement/repurchase of
long-term borrowings of $3.54 billion, and net payments for unsecured short-term
borrowings of $3.11 billion. This was partially offset by net proceeds from the
issuance of long-term borrowings of $4.40 billion, primarily to fund normal
operating activities. Treasury stock purchases of $70 million were made to
provide for the annual grant of CAP Plan units, restricted stock and stock
options.
Cash and cash equivalents increased $1.30 billion to $5.89 billion at February
28, 2007 from $4.60 billion at November 30, 2006. Cash used in operating
activities was $6.16 billion, primarily attributable to increases in financial
instruments owned, at fair value, receivables from customers and securities
borrowed, securities loaned, net, partially offset by increases in securities
sold under agreements to repurchase, securities purchased under agreements to
resell, net and payables to customers which occurred in the normal course of
business as a result of changes in customer needs, market conditions and trading
strategies. Cash used in investing activities of $67 million reflected purchases
of property, equipment and leasehold improvements. Cash provided by financing
activities of $7.52 billion reflected net proceeds from the issuance of
long-term borrowings of $8.08 billion and net proceeds relating to unsecured
short-term borrowings of $4.92 billion, primarily to fund normal operating
activities. This was partially offset by net payments for the
retirement/repurchase of long-term borrowings of $3.55 billion and net payments
for other secured borrowings of $1.76 billion. Treasury stock purchases of $473
million were made to provide for the annual grant of CAP Plan units, restricted
stock and stock options.
65
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Regulations
-----------
The Company is regulated by the SEC as a consolidated supervised entity ("CSE").
As a CSE, the Company is subject to group-wide supervision and examination by
the SEC and is required to compute allowable capital and allowances for market,
credit and operational risk on a consolidated basis. As of February 29, 2008,
the Company was in compliance with the CSE capital requirements.
As registered broker-dealers and futures commission merchants, Bear Stearns and
BSSC are subject to the net capital requirements of the Exchange Act and Rule
1.17 under the Commodity Futures Trading Commission. Bear Stearns uses Appendix
E of the Net Capital Rule which establishes alternative net capital requirements
for broker-dealers that are part of consolidated supervised entities. Appendix E
allows Bear Stearns to calculate net capital charges for market risk and
derivatives-related credit risk based on mathematical models provided that Bear
Stearns holds tentative net capital in excess of $1 billion and net capital in
excess of $500 million. BSIL and BSIT, the Company's London-based broker-dealer
subsidiaries, are subject to the regulatory capital requirements of the United
Kingdom's Financial Services Authority. Additionally, BSB is subject to the
regulatory capital requirements of the Financial Regulator. BSBTC, a Federal
Deposit Insurance Corporation ("FDIC") insured New Jersey state chartered bank,
is subject to the regulatory capital requirements of the FDIC. At February 29,
2008, Bear Stearns, BSSC, BSIL, BSIT, BSB and BSBTC were in compliance with
their respective regulatory capital requirements. Certain other subsidiaries are
subject to various securities regulations and capital adequacy requirements
promulgated by the regulatory and exchange authorities of the countries in which
they operate. At February 29, 2008, these other subsidiaries were in compliance
with their applicable local capital adequacy requirements.
The Company's broker-dealer subsidiaries and other regulated subsidiaries are
subject to minimum capital requirements and may also be subject to certain
restrictions on the payment of dividends, which could limit the Company's
ability to withdraw capital from such regulated subsidiaries, which in turn
could limit the Company's ability to pay dividends. See Note 11, "Regulations,"
in the Notes to Condensed Consolidated Financial Statements.
Merchant Banking and Private Equity Investments
-----------------------------------------------
In connection with the Company's merchant banking activities, the Company had
investments in merchant banking and private equity-related investment funds as
well as direct investments in private equity-related investments. At February
29, 2008, the Company held investments with an aggregate recorded fair value of
approximately $1.04 billion, reflected in the Condensed Consolidated Statements
of Financial Condition in "Other assets." At November 30, 2007, the Company held
investments with an aggregate recorded value of approximately $986 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 February 29, 2008 and November
30, 2007, the Company held high yield positions approximating $7.13 billion and
$8.84 billion, respectively, substantially all of which are in "Financial
instruments owned, at fair value" in the Condensed Consolidated Statements of
Financial Condition, and $765 million and $716 million, respectively, reflected
in "Financial instruments sold, but not yet purchased, at fair value" in the
Condensed Consolidated Statements of Financial Condition. Included in the high
yield positions are extensions of credit to highly leveraged companies. At
February 29, 2008 and November 30, 2007, the amount outstanding to highly
leveraged borrowers totaled $4.95 billion and $6.27 billion, respectively. The
largest industry concentration to highly leveraged borrowers was the
transportation industry which approximated 27.1% of these highly leveraged
borrowers' positions at February 29, 2008. The largest industry concentration to
highly leveraged borrowers was the technology industry which approximated 23.3%
of these highly leveraged borrowers' positions at November 30, 2007.
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
overall limits and concentration limits of risk by individual issuer. High yield
positions generally involve greater risk than investment grade debt securities
due to credit considerations, liquidity of secondary
66
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
trading markets and increased vulnerability to changes in general economic
conditions. The level of the Company's high yield positions, and the impact of
such activities on the Company's results of operations, can fluctuate from
period to period as a result of customer demand, economic conditions and market
considerations.
Contractual Obligations
In connection with its operating activities, the Company enters into contractual
obligations that require future cash payments. At February 29, 2008, the
Company's contractual obligations by maturity, excluding derivative financial
instruments, were as follows:
Payments Due By Period
--------------------------------------------------------
Remaining Fiscal Fiscal
(in millions) Fiscal 2008 2009- 2010 2011- 2012 Thereafter Total
----------------------------------------------------------------------------------------------------------
Long-term borrowings (1) (2) $ 7,166 $ 24,166 $ 16,352 $ 24,069 $ 71,753
Future minimum lease payments (3) 91 235 223 640 1,189
Bear Energy(4) 65 181 677 3,403 4,326
----------------------------------------------------------------------------------------------------------
(1) Amounts include hybrid debt issuances accounted for at fair value as
elected under SFAS No. 155 and fair value adjustments in accordance with
SFAS No. 133 as well as $263 million of junior subordinated deferrable
interest debentures ("Debentures"). The Debentures will mature on August
15, 2031; however, the Company, at its option, may redeem the Debentures.
The Debentures are reflected in the table at their contractual maturity
dates.
(2) Included in fiscal 2009-2010 are approximately $113 million 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, 2010 and
2011.
(3) See Note 12, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
(4) Primarily represents obligations under tolling agreements (net of
re-tolling agreements) associated with the Company's energy business.
Commitments
-----------
The Company has commitments(1) under a variety of commercial arrangements. At
February 29, 2008, the Company's commitments associated with lending and
financing, private equity-related investments and partnerships, outstanding
letters of credit, underwriting and other commercial commitments summarized by
period of expiration were as follows:
Amount of Commitment Expiration Per Period
----------------------------------------------------------------------------------------
Commitments
Remaining Fiscal Fiscal with no stated
(in millions) Fiscal 2008 2009- 2010 2011- 2012 Thereafter Maturity Total
--------------------------------------------------------------------------------------------------------------------------------
Lending-related commitments:
Investment-grade (2) $ 749 $ 643 $ 1,194 $ -- $ 4 $ 2,590
Non-investment-grade(2) 534 282 1,402 406 145 2,769
Contingent commitments 110 -- -- -- -- 110
Commitments to invest in private
equity-related investments
and partnerships (3) 60 30 127 422 28 667
Underwriting commitments 248 -- -- -- -- 248
Commercial and residential loans 906 407 -- 16 -- 1,329
Letters of credit 2,926 300 35 -- -- 3,261
Other commercial commitments 57 132 -- -- -- 189
--------------------------------------------------------------------------------------------------------------------------------
(1) See Note 12, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
(2) In order to mitigate the exposure to investment-grade and
non-investment-grade borrowings the Company entered into credit default
swaps approximating $841 million and $267 million, respectively, in
notional value, at February 29, 2008.
(3) These commitments will be funded, if called, through the end of the
respective investment periods, the longest of such periods ending in 2020.
67
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 that may be variable interests. 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 14, "Guarantees," in
the Notes to Condensed Consolidated Financial Statements for a complete
discussion on guarantees.
In 1997, the Company established a program whereby it created a series of
municipal securities trusts in which is has retained interests. These trusts
purchase fixed-rate, long-term, highly rated, insured or escrowed municipal
bonds financed by the issuance of trust certificates. In the Company's capacity
as liquidity provider to the trusts, the maximum exposure to loss at February
29, 2008 was approximately $3.2 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 offsetting positions, approximating $2.9 billion at
February 29, 2008. See Note 17, "Subsequent Events," of the Notes to the
Condensed Consolidated Financial Statements for a further discussion.
The Company does not sponsor any SIV's or Commercial Paper Conduits.
Additionally, the Company has no obligation to buy back subprime assets or CDO's
collateralized by subprime assets.
68
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
DERIVATIVE FINANCIAL INSTRUMENTS
Derivative financial instruments are contractual commitments between
counterparties that derive their values from changes in an underlying interest
rate, currency exchange rate, index (e.g., S&P 500), reference rate (e.g.,
LIBOR), or asset value referenced in the related contract. Some derivatives,
such as futures contracts, certain options and index-referenced warrants, can be
traded on an exchange. Other derivatives, such as interest rate and currency
swaps, caps, floors, collars, swaptions, equity swaps and options, structured
notes and forward contracts, are negotiated in the over-the-counter markets.
Derivatives generate both on- and off-balance-sheet risks depending on the
nature of the contract. The Company is engaged as a dealer in over-the-counter
derivatives and, accordingly, enters into transactions involving derivative
instruments as part of its customer-related and proprietary trading activities.
The Company's dealer activities require it to make markets and trade a variety
of derivative instruments. In connection with these activities, the Company
attempts to mitigate its exposure to market risk by entering into offsetting
transactions that may include over-the-counter derivative contracts or the
purchase or sale of interest-bearing securities, equity securities, financial
futures and forward contracts. The Company also utilizes derivative instruments
to offset 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 U.S. Treasury positions to hedge
certain debt issuances as part of its asset and liability management. In
addition, the Company actively manages commodity price risks resulting from
exposures to changes in spot and forward prices in electricity and natural gas
with exchange traded futures, swaps, OTC swaps and options.
To measure derivative activity, notional or contract amounts are frequently
used. Notional/contract amounts are used to calculate contractual cash flows to
be exchanged and are generally not actually paid or received, with the exception
of currency swaps, foreign exchange forwards and mortgage-backed securities
forwards. The notional/contract amounts of financial instruments that give rise
to off-balance-sheet market risk are indicative only to the extent of
involvement in the particular class of financial instruments and are not
necessarily an indication of overall market risk.
As of February 29, 2008 and November 30, 2007, the Company had notional/contract
amounts of approximately $14.2 trillion and $13.4 trillion, respectively, of
derivative financial instruments, of which $1.6 trillion and $1.9 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 offset trading
positions, modify the interest rate characteristics of its long- and short-term
debt, or are part of its derivative dealer activities, are marked to fair value.
The Company's derivatives had a notional weighted average maturity of
approximately 4.2 years at February 29, 2008 and November 30, 2007. The
maturities of notional/contract amounts outstanding for derivative financial
instruments as of February 29, 2008 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, $ 3,219.8 $ 2,767.0 $ 2,736.9 $ 3,301.9 $ 12,025.6
swaptions, caps, collars and floors
Futures contracts 644.6 355.6 53.6 - 1,053.8
Forward contracts 180.7 - - - 180.7
Options held 519.7 21.3 3.3 0.7 545.0
Options written 374.6 19.7 6.4 0.7 401.4
----------------------------------------------------------------------------------------------------------------------------------
Total $ 4,939.4 $ 3,163.6 $ 2,800.2 $ 3,303.3 $ 14,206.5
==================================================================================================================================
Percent of total 34.8% 22.3% 19.7% 23.2% 100.0%
==================================================================================================================================
69
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 adopted SFAS No. 157, "Fair Value Measurements," in the first
quarter of 2007. SFAS No. 157 applies to all financial instruments that are
being measured and reported on a fair value basis. This includes those items
reported in "Financial instruments owned" and "Financial instruments sold, but
not yet purchased" as well as other assets and liabilities that are reported at
fair value.
As defined in SFAS No. 157, fair value is the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date. In determining fair value the
Company uses various methods including market, income and cost approaches. Based
on these approaches, the Company often utilizes certain assumptions that market
participants would use in pricing the asset or liability, including assumptions
about risk and or the risks inherent in the inputs to the valuation technique.
These inputs can be readily observable, market corroborated, or generally
unobservable firm inputs. The Company utilizes valuation techniques that
maximize the use of observable inputs and minimize the use of unobservable
inputs. Based on the observability of the inputs used in the valuation
techniques the Company is required to provide the following information
according to the fair value hierarchy. The fair value hierarchy ranks the
quality and reliability of the information used to determine fair values.
Financial assets and liabilities carried at fair value will be classified and
disclosed in one of the following three categories:
Level 1: Inputs based on quoted market prices for identical assets or
liabilities in active markets.
Level 2: Observable market based inputs or unobservable inputs that are
corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
(1) Financial Instruments Valued Based on Inputs Based on Quoted Market Prices
for Identical Assets or Liabilities in Active Markets
The Company's valuation policy is to use quoted market prices from securities
and derivatives exchanges where they are available and reliable. Financial
instruments valued based on quoted market prices are primarily exchange-traded
derivatives and listed equities. Financial instruments that are most typically
valued using alternative approaches but for which the Company typically receives
independent external valuation information include U.S. Treasuries, other U.S.
Government and agency securities, as well as certain corporate debt securities.
(2) Financial Instruments Whose Inputs are Observable Market Based or
Unobservable Inputs that are Corroborated By Market Data
The second broad category consists of financial instruments for which the
Company does not receive quoted prices; therefore, models or other methodologies
are utilized to value these financial instruments. Such models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates, loss
severity, current market and contractual prices for the underlying financial
instruments, as well as other relevant economic measures. Substantially all
these assumptions are observable in the marketplace, can be derived from
observable data or are supported by observable levels at which transactions are
executed in the marketplace. A degree of subjectivity is required to determine
appropriate models or methodologies as well as appropriate underlying
assumptions. This subjectivity makes these valuations inherently less reliable
than quoted market prices. Financial instruments in this category include
sovereign debt, certain corporate equities and corporate debt, certain mortgage
backed securities and non-exchange-traded derivatives such as interest rate
swaps. For an indication of the Company's involvement in derivatives,
70
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
including maturity terms, see the table setting forth notional/contract amounts
outstanding in the preceding "Derivative Financial Instruments" section.
(3) Financial Instruments Whose Inputs Used to Determine the Fair Value Is
Estimated Based on Internally Developed Models or Methodologies Utilizing
Significant Assumptions or Other Data That Are Generally Less Readily Observable
from Objective Sources
Certain complex financial instruments and other investments have significant
data inputs that cannot be validated by reference to readily observable data.
These instruments are typically illiquid, long dated or unique in nature and
therefore engender considerable judgment by traders and their management who, as
dealers in many of these instruments, have the appropriate knowledge to estimate
data inputs that are less readily observable. For certain instruments,
extrapolation or other methods are applied to observed market or other data to
estimate assumptions that are not observable.
The Company participates in the underwriting, securitization or trading of
non-performing mortgage-related assets, certain mortgage-backed securities and
residual interests. 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 complex
derivative structures. These non-exchange-traded instruments may have immature
or limited markets and, by their nature, involve complex valuation methodologies
and models, which are often refined to correlate with the market risk of these
instruments.
See Note 2, "Financial Instruments" of Notes to Condensed Consolidated Financial
Statements for a description of the financial assets and liabilities carried at
fair value.
Level 3 Activity
With Level 3, the fair value of the Level 3 assets represents approximately
25.9% of the total assets measured at fair value. The fair value of the Level 3
liabilities represents approximately 11.4% of the total liabilities measured at
fair value.
Transfers
During the 2008 quarter, there were approximately $6.9 billion of non-derivative
trading assets transferred from level 2 to level 3. These transfers were
primarily related to mortgages and mortgage-backed securities. The largest
contributors to the transfers were performing residential mortgages and
investment-grade mortgage-backed securities. Additionally, during the 2008
quarter, there were approximately $700 million of net derivative trading assets
which transferred from level 2 to level 3. These transfers were primarily
related to mortgage-related credit default swaps.
These transfers were driven by the continued market and liquidity deterioration
in the mortgage markets.
Any gains or losses that resulted from these transfers are reported in the
changes in unrealized column in the Level 3 Financial Assets and Liabilities
table of Note 2, "Financial Instruments," of Notes to Condensed Consolidated
Financial Statements.
The fair value of the instruments classified in level 3 declined during the
quarter as a result of the continued deterioration in the mortgage and credit
markets.
Fair Value Option
SFAS No. 159 provides a fair value option election that permits entities to
irrevocably elect to measure financial assets and liabilities (except for those
that are specifically scoped out of the Statement) at fair value as the initial
and subsequent measurement attribute, with changes in fair value recognized in
earnings as they occur. SFAS No. 159 permits the fair value option election on
an instrument-by-instrument basis at initial recognition of an asset or
liability or upon an event that gives rise to a new basis of accounting for that
instrument.
71
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Effective December 1, 2007, the Company adopted SFAS No. 159 and elected to
apply the fair value option to liabilities that resulted from the consolidation
of variable interest entities as well as certain transactions that were
accounted for as financings under SFAS No. 140. As a result of the adoption of
SFAS No. 159, there was no transition adjustment.
Controls Over Valuation of Financial Instruments
In recognition of the importance the Company places on the accuracy of its
valuation of financial instruments as described in the three categories above,
the Company engages in an ongoing internal review of its valuations. Members of
the Controllers and Risk Management Departments perform analysis of internal
valuations, typically on a monthly basis but often on an intra-month basis as
well. These departments are independent of the trading areas responsible for
valuing the positions. Results of the monthly validation process are reported to
the Mark-to-Market Committee ("MTMC"), which is composed of senior management
from the Risk Management and Controllers Departments. The MTMC is responsible
for ensuring that the approaches used to independently validate the Company's
valuations are robust, comprehensive and effective. Typical approaches include
valuation comparisons with external sources, comparisons with observed trading,
independent comparisons of key model valuation inputs, independent trade
modeling and a variety of other techniques.
Merchant Banking
As part of its merchant banking activities, the Company participates from time
to time in principal investments. 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 are reflected in the condensed
consolidated financial statements at fair value, which are often represented as
initial cost until significant transactions or developments indicate that a
change in the carrying value of the securities is appropriate. This represents
the Company's best estimate of exit price as defined by SFAS No. 157. Generally,
the carrying values of these securities will be increased based on company
performance and in those instances where market values are readily ascertainable
by reference to substantial transactions occurring in the marketplace or quoted
market prices. Reductions to the carrying value of these securities are made 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 determined on a
case-by-case basis and represent an estimate of probable losses after
considering, among other factors, the progress of each case, prior experience
and the experience of others in similar cases, and the opinions and views of
internal and external legal counsel. Because litigation is inherently
unpredictable, particularly in cases where claimants seek substantial or
indeterminate damages or where investigations and proceedings are in the early
stages, the Company cannot predict with certainty the loss or range of loss
related to such matters, the ultimate resolution, the timing of resolution or
the amount of eventual settlement, fine, penalty or relief, if any.
The Company is subject to the income tax laws of the United States, its states
and municipalities and those of the foreign jurisdictions in which the Company
has significant business operations. These tax laws are complex and subject to
different interpretations by the taxpayer and the relevant governmental taxing
authorities. The Company must make judgments and interpretations about the
application of these inherently complex tax laws when determining the provision
for income taxes and must also make estimates about when in the future certain
items affect taxable income in the various tax jurisdictions. Disputes over
interpretations of the tax laws may be settled with the taxing authority upon
examination or audit. The Company regularly evaluates the likelihood of
assessments in each of the taxing jurisdictions resulting from current and
72
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
subsequent years' examinations and tax reserves are established as appropriate.
See Note 13, "Income Taxes," of Notes to Condensed Consolidated Financial
Statements for a discussion for the Company's adoption of FIN No. 48.
The Company establishes reserves for potential losses that may arise out of
litigation, regulatory proceedings, and certain tax items 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.
Loan Modification - Streamlined Foreclosure and Loss Avoidance Framework
In December 2007, the American Securitization Forum published a Streamlined
Foreclosure and Loss Avoidance Framework (ASF Framework) to enable mortgage
servicers to streamline their loss avoidance and loan modification practices.
The framework is an industry-developed, recommended methodology that servicers
of securitized subprime ARMS held in Qualifying Special Purpose Entities (QSPEs)
can use to fulfill their existing obligations to service those loans in a faster
and more efficient manner while maximizing recoveries for the benefit of
securitization investors. The ASF Framework applies to all first lien subprime
residential ARMs that have an initial fixed rate period of 36 months or less
that were originated between January 1, 2005 and July 31, 2007, and that have an
initial interest rate reset between January 1, 2008 and July 31, 2010.
Under the ASF Framework, the covered loans are divided into three segments:
Segment 1 - includes current loans where the borrower is likely to be able to
refinance into any available mortgage product, including FHA,
FHA Secure or readily available mortgage industry products;
Segment 2 - includes current loans where the borrower is unlikely to be able
to refinance into any readily available mortgage industry
product; and
Segment 3 - includes loans where the borrower is not current as defined
above, demonstrating difficulty meeting the introductory rate.
The methodology prescribed in the ASF Framework applies to those loans in
Segment 2, in advance of the initial reset date. Those loans would be eligible
for a "fast track" loan modification under which the interest rate would be kept
at the existing rate, generally for five years following the upcoming reset. The
ASF Framework provides a methodology which complies with relevant tax
regulations and off-balance sheet accounting standards for QSPEs. Moreover, the
SEC's Office of Chief Accountant has concluded that it will not object to
continued status as a QSPE if Segment 2 subprime ARM loans are modified pursuant
to the specific screening criteria in the ASF Framework. The Company adopted the
ASF screening criteria in the first quarter of 2008, and believes that the
modification of loans in accordance with the ASF Framework does not impact the
off-balance-sheet accounting treatment of QSPEs that hold subprime ARM loans.
While a uniform definition of subprime mortgages does not exist in the
marketplace, the Company defines subprime primarily as loans issued to higher
risk borrowers who do not qualify for the best market interest rates because of
their deficient credit history. Although FICO credit scores and prior mortgage
or rent payment histories are the main drivers of a subprime designation,
subprime also includes borrowers that have had a recent foreclosure or
bankruptcy. Other considerations include borrower's reserve funds, residual
household income and debt to income ratio.
The total amount of assets owned by Company sponsored QSPEs that hold subprime
ARM loans as of February 29, 2008 was approximately $17.0 billion, which
included $860 million of real estate owned. These subprime ARM loans are
serviced by the Company. The retained interests in Company sponsored QSPEs that
hold subprime ARM loans totaled approximately $16 billion of which the Company
has retained $2 billion as of February 29, 2008.
Of the loans that meet the ASF Framework criteria, the unpaid principal balance
of loans that are included in these segments are $1.4 billion for Segment 1,
$1.8 billion for Segment 2, and $3 billion for Segment 3. The Company has not
yet modified a significant percentage of loans using the ASF Framework;
accordingly, the impact to the Company's retained interest has been immaterial.
73
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ACCOUNTING AND REPORTING DEVELOPMENTS
In March 2008, the FASB issued Statement No. 161, "Disclosures about Derivative
Instruments and Hedging Activities - an amendment of FASB Statement No. 133."
The Statement requires companies to provide enhanced disclosures regarding
derivative instruments and hedging activities. It requires companies to better
convey the purpose of derivative use in terms of the risks that such company is
intending to manage. Disclosures about (a) how and why an entity uses derivative
instruments, (b) how derivative instruments and related hedged items are
accounted for under SFAS No. 133 and its related interpretations, and (c) how
derivative instruments and related hedged items affect a company's financial
position, financial performance, and cash flows are required. This Statement
retains the same scope as SFAS No. 133 and is effective for fiscal years and
interim periods beginning after November 15, 2008. The Company is currently
assessing implementation plans and does not expect the adoption of SFAS No. 161
to have a material impact, if any, on the Condensed Consolidated Financial
Statements.
In February 2008, the FASB issued a FASB Staff Position ("FSP") on Accounting
for Transfers of Financial Assets and Repurchase Financing Transactions "FSP FAS
140-3". This FSP addresses the issue of whether or not these transactions should
be viewed as two separate transactions or as one "linked" transaction. The FSP
includes a "rebuttable presumption" that presumes linkage of the two
transactions unless the presumption can be overcome by meeting certain criteria.
The FSP will be effective for fiscal years beginning after November 15, 2008 and
will apply only to original transfers made after that date; early adoption will
not be allowed. The Company is currently evaluating the impact, if any, the
adoption of this interpretation will have on the Company's Condensed
Consolidated Financial Statements.
In December 2007, the FASB issued Statement No. 141R, "Business Combinations (a
revision of Statement No. 141)." This Statement applies to all transactions or
other events in which an entity obtains control of one or more businesses,
including those combinations achieved without the transfer of consideration.
This Statement retains the fundamental requirements in Statement No. 141 that
the acquisition method of accounting be used for all business combinations. This
Statement expands the scope to include all business combinations and requires an
acquirer to recognize the assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree at their fair values as of the
acquisition date. Additionally, SFAS No. 141R changes the way entities account
for business combinations achieved in stages by requiring the identifiable
assets and liabilities to be measured at their full fair values. Additionally,
contractual contingencies and contingent consideration shall be measured at fair
value at the acquisition date. This Statement is effective on a prospective
basis to business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after December
15, 2008. The Company is currently evaluating the impact, if any, that the
adoption of this Statement will have on the Condensed Consolidated Financial
Statements of the Company.
In December 2007, the FASB issued Statement No. 160, "Noncontrolling Interests
in Consolidated Financial Statements - an amendment of ARB No. 51". This
Statement amends ARB No. 51 to establish accounting and reporting standards for
the noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an
ownership interest in the consolidated entity that should be reported as equity
in the consolidated financial statements. Additionally, this Statement requires
that consolidated net income include the amounts attributable to both the parent
and the noncontrolling interest. This Statement is effective for interim periods
beginning on or after December 15, 2008. The Company is currently evaluating the
impact, if any, that the adoption of this Statement will have on the Condensed
Consolidated Financial Statements of the Company.
In June 2007, the EITF issued EITF Issue No. 06-11 "Accounting for Income Tax
Benefits of Dividends on Share-Based Payment Awards." This issue requires that
the tax benefits related to dividend equivalents paid on restricted stock units,
which are expected to vest, be recorded as an increase to additional paid-in
capital. EITF 06-11 is effective prospectively to the income tax benefits on
dividends declared in fiscal years beginning after December 15, 2007. The
Company is currently evaluating the impact, if any, the adoption of this issue
may have on the Company's Condensed Consolidated Financial Statements and does
not expect that the adoption of this issue will have a material impact on the
Condensed Consolidated Financial Statements.
74
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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.
75
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, equity price risk and commodity
price risk, as well as a discussion of the Company's credit risk and a
discussion of how those exposures are managed, refer to the Company's Form 8-K.
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 potential
change in value of a financial instrument at a specific probability level over a
specified time interval. 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 and time
interval.
The Company has performed an entity-wide VaR analysis of the Company's financial
assets and liabilities, including financial instruments owned and sold,
repurchase and resale agreements and funding assets and liabilities. The Company
regularly evaluates and enhances such VaR models in an effort to more accurately
measure risk of loss. Certain equity-method investments and non-publicly traded
investments are not reflected in the VaR results. The VaR related to certain
non-trading financial instruments has been included in this analysis and is not
reported separately because the amounts are not material. The calculation is
based on a methodology that uses a one-day interval and a 95% confidence level.
The Company uses a historical simulation approach for VaR, which is supplemented
by statistical risk add-ons for risk factors that do not lend themselves readily
to historical simulation. Historical simulation involves the generation of price
movements in a portfolio using price sensitivities, and actual historical
movements of the underlying risk factors to which the securities are sensitive.
Risk factors incorporated via historical simulation include interest rate
movements, yield curve shape, general market credit spreads, equity price
movement, option volatility movement (for certain option types) and foreign
exchange movement, among others. Risk factors incorporated via add-on factors
include the risk of specific bond issuers, among others. The Company believes
that its VaR methodologies are consistent with industry practices for these
calculations.
VaR has inherent limitations, including reliance on historical data, which may
not accurately predict future market risk, and the quantitative risk information
generated is limited by the parameters established in creating the models. There
can be no assurance that actual losses occurring on any one day arising from
changes in market conditions will not exceed the VaR amounts shown below or that
such losses will not occur more than once in 20 trading days. VaR is not likely
to accurately predict exposures in markets that exhibit sudden fundamental
changes or shifts in market conditions or established trading relationships.
Many of the Company's hedging strategies are structured around likely
established trading relationships and, consequently, those hedges may not be
effective and VaR models may not accurately predict actual results. Furthermore,
VaR calculated for a one-day horizon does not fully capture the market risk of
positions that cannot be liquidated in a one-day period. However, the Company
believes VaR models are an established methodology for the quantification of
risk in the financial services industry despite these limitations. VaR is best
used in conjunction with other financial disclosures in order to assess the
Company's risk profile.
The aggregate VaR presented here is less than the sum of the individual
components (i.e., interest rate risk, foreign exchange rate risk, equity risk,
and commodity risk), due to the benefit of diversification among the risks.
Diversification benefit equals the difference between aggregate VaR and the sum
of the VaRs for the four risk categories. This benefit arises because the
simulated one-day losses for each of the four primary market risk categories
occur on different days and because of general diversification benefits
introduced when risk is measured across a larger set of specific risk factors
than exist in the respective categories; similar diversification benefits also
are taken into account across risk factors within each category. The following
table illustrates the VaR for each component of market risk as of February 29,
2008, November 30, 2007, August 31, 2007 and May 31, 2007.
76
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
February 29, November 30, August 31, May 31,
(in millions) 2008 2007 2007 2007
---------------------------------------------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 51.3 $ 72.4 $ 41.6 $ 30.5
Currency 1.7 1.4 1.3 2.5
Equity 6.2 6.5 6.8 4.8
Commodity/energy 28.4 12.5 3.1 2.4
Diversification benefit (25.2) (23.5) (17.8) (11.5)
---------------------------------------------------------------------------------------------------------------------
Aggregate VaR $ 62.4 $ 69.3 35.0 28.7
=====================================================================================================================
The table below illustrates the high, low and average VaR for each component of
market risk and aggregate market risk during the quarters ended February 29,
2008 and November 30, 2007:
Quarter Ended February 29, 2008 Quarter Ended November 30, 2007
-----------------------------------------------------------------------------------------------------------------------------------
(in millions) High Low Average High Low Average
-----------------------------------------------------------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 74.8 43.8 56.9 $ 72.4 31.5 47.2
Currency 7.4 0.6 2.7 2.4 0.6 1.4
Equity 12.6 3.7 7.5 7.4 4.0 5.8
Commodity/Energy 28.4 6.4 14.5 20.3 1.6 6.0
Aggregate VaR 72.5 49.5 59.2 69.3 31.0 45.5
-----------------------------------------------------------------------------------------------------------------------------------
Aggregate average VaR increased to $59.2 million for the 2008 quarter from $45.5
for the quarter ended November 30, 2007. The increase was primarily due to
higher levels of exposure to interest rates and commodities, and increased
volatility for many of the underlying risk factors.
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.
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.
77
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The following chart represents a summary of the daily principal transactions
revenues and reflects a combination of trading revenues, net interest revenues
for certain trading areas and other revenues for the quarters ended February 29,
2008 and February 28, 2007. 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
$8.4 million and $22.4 million for the quarters ended February 29, 2008 and
February 28, 2007, respectively. There were 18 daily trading losses for the
quarter ended February 29, 2008 and 4 daily trading losses for the quarter ended
February 28, 2007. Daily trading losses exceeded the reported average aggregate
VaR amounts on 8 days during the fiscal quarter ended February 29, 2008 and 1
day greater than the reported average aggregate VaR amounts during the fiscal
quarter ended February 28, 2007. Trading losses experienced in the
mortgage-related and leveraged finance areas contributed to the number of daily
trading losses for the 2008 quarter. The Company uses historical simulation VaR,
which is driven by previously observed changes in market variables. During
periods in which volatility is increasing, VaR tends to lag since it does not
incorporate swings in the relevant markets until they have actually been
observed and are incorporated in the historical time series of market data being
used for the VaR calculation. This was the case in the fiscal 2008 quarter, when
volatility across many markets rose sharply and continuously throughout the
quarter. Substantial trading losses were experienced in the mortgage-related and
leveraged finance areas. The number of days with trading losses and the number
of days with trading losses that exceeded the reported average aggregate VaR in
quarter ended February 29, 2008 was sharply higher than in quarter ended
February 28, 2007 as a result of increased volatility in underlying markets.
DISTRIBUTION OF DAILY NET TRADING REVENUES
Quarters Ended February 29, 2008 and February 28, 2007
[BAR CHART - GRAPHIC OMITTED REPRESENTED BY THE PLOT POINTS BELOW]
2008 2007
---------------------------------
(20)+ 12 2
(20)-(15) 3 2
(15)-(10) 1 0
(10)-(5) 0 0
(5)-0 2 0
0-5 3 5
5-10 6 2
10-15 2 5
15-20 2 12
20-25 3 8
25-30 3 10
30-35 2 6
35-40 4 2
40+ 18 6
---------------------------------
78
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Credit Risk
The Company measures its actual credit exposure (the replacement cost of
counterparty contracts) on a daily basis. Master netting agreements, collateral
and credit insurance are used to mitigate counterparty credit risk. The credit
exposures reflect these risk-reducing features to the extent they are legally
enforceable. The Company's net replacement cost of derivative contracts in a
gain position at February 29, 2008 and November 30, 2007 approximated $20.02
billion and $12.54 billion, respectively. Exchange-traded financial instruments,
which typically are guaranteed by a highly rated clearing organization, have
margin requirements that substantially mitigate the risk of credit loss.
The following table summarizes the counterparty credit quality of the Company's
exposure with respect to over-the-counter derivatives (including foreign
exchange and forward-settling mortgage transactions) as of February 29, 2008:
Over-the-Counter Derivative Credit Exposure (1)
($ in millions)
Percentage of
Exposure, Net of Exposure, Net
Rating (2) Exposure Collateral (3) Collateral (4) of Collateral
----------------------------------------------------------------------------------------------------------------------------------
AAA $ 8,581 538 8,188 41%
AA 19,247 12,973 6,555 33%
A 9,402 6,615 3,430 17%
BBB 1,191 358 878 4%
BB and lower 3,670 5,045 887 5%
Non-rated 138 225 84 0%
----------------------------------------------------------------------------------------------------------------------------------
(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.
79
Item 4. CONTROLS AND PROCEDURES
As required by Rule 13a-15(b) of the Exchange Act, the Company's management,
including the Company's Chief Executive Officer and Chief Financial Officer, has
evaluated the effectiveness of its disclosure controls and procedures as of the
end of the period covered by this quarterly report. Based on that evaluation,
the Chief Executive Officer and Chief Financial Officer have concluded that the
Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under
the Exchange Act) were effective as of the end of the period covered by this
quarterly report (i) to ensure that information required to be disclosed by the
Company in the reports that it files or submits under the Exchange Act is
recorded, processed, summarized and reported, within the time periods specified
in the SEC's rules and forms and (ii) to ensure that information required to be
disclosed by the Company in the reports that the Company submits under the
Exchange Act is accumulated and communicated to the Company's management,
including the Company's principal executive and principal financial officers, or
persons performing similar functions, as appropriate, to allow timely decisions
regarding required disclosure. As required by Rule 13a-15(d) under the Exchange
Act, the Company's management, including the Company's Chief Executive Officer
and Chief Financial Officer, has evaluated the Company's internal control over
financial reporting to determine whether any changes occurred during the quarter
covered by this quarterly report that have materially affected, or are
reasonably likely to materially affect, the Company's internal control over
financial reporting. Based on that evaluation, there have been no such changes
during the quarter covered by this quarterly report. Without qualifying the
foregoing, reference is made to the matters discussed in the last paragraph of
this Item 4.
The Company's system of controls is designed to provide reasonable, not
absolute, assurance regarding the reliability and integrity of accounting and
financial reporting. Management does not expect that the Company's disclosure
controls and procedures or the Company's internal control over financial
reporting will prevent or detect all errors and all fraud. A control system, no
matter how well designed and operated, can provide only reasonable, not
absolute, assurance that the objectives of the control system will be met. These
inherent limitations include the following:
o Judgments in decision-making can be faulty, and control and process
breakdowns can occur because of simple errors or mistakes.
o Controls can be circumvented by individuals, acting alone or in
collusion with each other, or by management override.
o The design of any system of controls is based in part on certain
assumptions about the likelihood of future events, and there can be
no assurance that any design will succeed in achieving its stated
goals under all potential future conditions.
o Over time, controls may become inadequate because of changes in
conditions or deterioration in the degree of compliance with
associated policies or procedures.
o The design of a control system must reflect the fact that resources
are constrained, and the benefits of controls must be considered
relative to their costs.
Because of the inherent limitations in all control systems, no evaluation of
controls can provide absolute assurance that all control issues and instances of
fraud, if any, have been detected.
Events that occurred commencing late in the week of March 10, 2008, including
the deterioration of the Company's liquidity position, the subsequent merger
agreement with JPMorgan Chase and other developments described in "Management's
Discussion and Analysis of Results of Operations and Financial Condition--Recent
Developments" highlight the impact that extraordinary events could have on the
Company's system of controls described above. Human error in times of extreme
difficulty and turmoil, such as the Company recently experienced and continues
to experience, can occur. Moreover, control and process breakdowns may be more
frequent when a company is operating under duress and its employees become
distracted by crisis management and the uncertainty surrounding the viability of
the enterprise. These events and potential impacts may have had and may have an
adverse impact on the efficacy of our disclosure controls and procedures and our
internal controls over financial reporting. However, management has concluded
that the Company's disclosure controls and procedures and our internal controls
over financial reporting were effective as of February 29, 2008 to accomplish
their objectives and believes that such controls and procedures were effective
for purposes of preparing this Quarterly Report including the financial
statements contained herein.
80
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 2007
Financial Report; Part I, Item 3, of the Company's Annual Report on Form 10-K
for the fiscal year ended November 30, 2007, as amended, ("Form 10-K") and in
Note 12 to the Condensed Consolidated Financial statements included herein. The
following discussion is limited to recent developments concerning our legal
proceedings and should be read in conjunction with those earlier Reports.
Shareholder Litigation and Related Matters
------------------------------------------
Litigation Relating To Proposed Merger with J.P. Morgan Chase & Co.
("JPMC")
-------------------------------------------------------------------
Beginning March 17, 2008, various shareholders of the Company filed a number of
purported class action lawsuits against the Company, its Board of Directors and
certain of the Company's present and former executive officers. Among other
things, these actions allege that the individual defendants breached their
fiduciary duties and obligations to the Company's shareholders by agreeing to
the proposed acquisition of the Company by JPMC. Five of these actions have been
filed in the Supreme Court of the State of New York and have been consolidated
under the caption In re Bear Stearns Litigation; two of these actions have been
filed in the Delaware Court of Chancery where plaintiffs filed a motion to
consolidate their cases in Delaware. JPMC is named as a defendant in certain of
these cases. In each of these actions, plaintiff seeks to enjoin the proposed
merger, other injunctive relief and an unspecified amount of compensatory
damages. On April 9, 2008, the Delaware Court of Chancery granted the Company's
and JPMC's motion to stay the Delaware action in favor of the New York action,
at least until the preliminary injunction motion is resolved. The Delaware court
also granted plaintiffs' motion to consolidate their cases.
As previously reported in the Company's Form 10-K, the Company's Board of
Directors and certain of the Company's present and former executive officers
have been named as defendants in two purported shareholder derivative suits,
respectively captioned Cohen v. Cayne, et al. and Birn v. Cayne, et al., each of
which was commenced in the U.S. District Court for the Southern District of New
York. The Company was named as a nominal defendant in both actions. By Court
Order dated February 14, 2008, the Birn action was consolidated with the Cohen
action. A consolidated amended complaint was filed on March 3, 2008, and a
second amended complaint was filed on April 10, 2008. The second amended
complaint asserts claims against the Board of Directors for breach of fiduciary
duty in connection with the proposed merger with JPMC; it also asserts claims
for violations of federal securities laws, waste of corporate assets and gross
mismanagement, unjust enrichment, abuse of control and indemnification and
contribution, in connection with the losses sustained by the Company as a result
of its purchases of sub-prime loans and certain repurchases of its own common
shares. Certain individual defendants are also alleged to have sold their
holdings of the Company's common shares while in possession of material
non-public information. The second amended complaint seeks a declaration that
the merger agreement with JPMC is unlawful and unenforceable, to enjoin the
merger, compensatory damages in an unspecified amount and an order directing the
Company to improve its corporate governance procedures.
81
Part II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
ERISA Litigation
----------------
The Company and certain of its current and former officers and/or directors have
also been named as defendants in several putative class actions commenced in the
U.S. District Court for the Southern District of New York purporting to
represent the interests of participants in the Company's Employee Stock
Ownership Plan ("ESOP") during the time period of December 2006 through the
present (the "Class Period"). These actions allege defendants breached their
fiduciary duties to plaintiffs and to the other participants and beneficiaries
of the ESOP by (a) failing to prudently manage the ESOP's investment in Company
securities; (b) failing to communicate fully and accurately about the risks of
the ESOP's investment in the Company's stock; (c) failing to to avoid or address
alleged conflicts of interest; and (d) failing to monitor those who managed and
administered the ESOP. In connection with these allegations each Plaintiff
asserts claims for violations under various sections of the Employee Retirement
Income Security Act ("ERISA") and seeks reimbursement to the ESOP for all
losses, an unspecified amount of monetary damages and imposition of a
constructive trust.
Other Shareholder Litigation
----------------------------
In addition to the foregoing, various shareholders of the Company have commenced
purported class actions against the Company and certain of its current and
former officers and/or directors on behalf of all persons who purchased or
otherwise acquired common stock of the Company between December 14, 2006 and
March 14, 2008 (the "Class Period"). These three actions, commenced in the U.S.
District Court for the Southern District of New York, allege that defendants
issued materially false and misleading statements regarding the Company's
business and financial results and that as a result of those false statements,
the Company's common stock traded at artificially inflated prices during the
Class Period. In connection with these allegations, the Complaint asserts claims
for violations of Sections 10(b) and 20(a) of the Securities Exchange Act of
1934, as amended.
Requests for Information and Documents
--------------------------------------
The Company has been contacted by and received requests for information and
documents from federal regulatory and law enforcement authorities relating to
events surrounding the Company's liquidity crisis and its proposed merger with
JPMC.
Mortgage-Related Matters
------------------------
The Company's subsidiary EMC Mortgage Corporation (EMC) has been cooperating
with a civil investigative demand (CID) from the Federal Trade Commission (FTC)
seeking documents and data relating to EMC's business and servicing practices.
In March 2008, the Company received notice from the Staff of the FTC that the
Staff believes EMC and the Company have violated certain Federal consumer
protection statutes in connection with EMC's servicing activities. The Staff has
requested an opportunity to resolve the matter though consent negotiations
before it seeks approval from the FTC to proceed with the filing of a complaint
against EMC and the Company. EMC expects to engage in such discussions with the
Staff.
Municipal Derivatives Matters
-----------------------------
The Antitrust Division of the U.S. Department of Justice ("DOJ") and the
Securities and Exchange Commission ("SEC") are investigating possible
anti-competitive bidding practices in the municipal derivatives industry
involving various parties, including Bear Stearns, from the early 1990s to date.
The activities at issue in these industry-wide government investigations
generally concern the bidding process for municipal derivatives that are offered
to states, municipalities and other issuers of tax-exempt bonds. Bear Stearns
has cooperated, and continues to cooperate, with the DOJ and the SEC. In
February 2008, Bear Stearns received a "Wells Notice" advising that the SEC
Staff is considering recommending that the SEC bring a civil injunctive action
and/or an administrative proceeding in connection with the bidding for various
financial instruments associated with municipal securities. Bear Stearns
understands that it will have an opportunity to respond to the Wells Notice and
to discuss the matter with the Staff before any recommendation is made to the
Commission.
BSAM-Managed Hedge Fund Matters
-------------------------------
The Company, Bear Stearns, Bear Stearns Asset Management ("BSAM"), and certain
former BSAM employees have been named as defendants in a lawsuit filed on April
4, 2008 in the United States District Court for the Southern District of New
York by the Joint Voluntary Liquidators of Bear Stearns High Grade Structured
Credit Strategies (Overseas) Ltd. and Bear Stearns High Grade Structured Credit
Strategies Enhanced Leverage (Overseas) Ltd. (collectively, the "Overseas Feeder
Funds"). The Overseas Feeder Funds are two of the "feeder funds" that invested
substantially all their assets in the Bear Stearns High Grade Structured Credit
Strategies Master Fund, Ltd. or the Bear
82
Part II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
Stearns High Grade Structured Credit Strategies Enhanced Leverage Master Fund,
Ltd., for which BSAM served as investment manager. The complaint asserts claims
for, among other things, fraud, breach of fiduciary duty, breach of contract,
recklessness, gross negligence, negligence, and unjust enrichment. Plaintiffs
seek damages of not less than $1 billion, unspecified punitive damages, costs,
and fees. The Company believes it has substantial defenses to the claims.
83
Part II - OTHER INFORMATION
Item 1A. RISK FACTORS
You should carefully consider the risk factors disclosed in our Form 10-K, in
Part I, Item 1A, Risk Factors. Our business, financial condition or results of
operations or cash flows could be materially adversely affected by any of those
risks. The following are additional risk factors that were not disclosed in our
Form 10-K. Also, additional risks not presently known to us or that we currently
deem immaterial may also adversely affect our business, financial condition, or
results of operations.
The merger is subject to closing conditions, including stockholder approval,
that, if not satisfied or waived, will result in the merger not being completed,
which may result in material adverse consequences to our business and operations
and significant risk to our ability to continue as a going concern. The merger
is subject to closing conditions, including the approval of our stockholders
that, if not satisfied, will prevent the merger from being completed. The
closing condition that our stockholders approve and adopt the merger agreement
may not be waived under applicable law and must be satisfied for the merger to
be completed. If our stockholders do not approve and adopt the merger agreement
and the merger is not completed, our financial viability could be seriously
jeopardized, which would raise substantial doubt as to our ability to continue
as a going concern. JPMorgan Chase has provided an operating guaranty in respect
of certain trading and other obligations of Bear Stearns and certain of its
subsidiaries. In addition, JPMorgan Chase has provided a guaranty to the New
York Fed of our borrowings from the New York Fed at the Prime Dealer Discount
Window. The two guaranties have provided liquidity and the support necessary for
our financial stability and viability. In the event our stockholders do not vote
in favor of the merger, the operating guaranty would, by its terms, terminate
120 days following such a "no" vote. JPMorgan Chase would also terminate the
guaranty to the New York Fed under those circumstances. Absent the operating
guaranty, we could face the increased risk of rapid loss of clients, customers
and counterparties, and absent the guaranty to the New York Fed, we could be
unable to obtain necessary funding. The lack of liquidity and the loss of
clients, customers and counterparties could seriously jeopardize our financial
viability, which would raise substantial doubt as to our ability to continue as
a going concern. Accordingly, we could be forced to file for bankruptcy
protection and to liquidate our assets, resulting in material adverse
consequences for our stockholders, creditors and employees.
If the merger is not completed the $29 billion special funding facility to be
provided by the New York Fed with respect to a pool of collateral currently
owned by us would not take effect and any losses related thereto would remain
with us. In connection with our entry into the merger agreement with JPMorgan
Chase, the New York Fed announced that it would provide to JPMorgan Chase
special funding facility secured by a pool of collateral consisting of
investment grade securities (largely mortgage-related), residential and
commercial mortgage loans classified as performing and related hedges held by
us. Under this financing facility, JPMorgan Chase would bear the first $1
billion in losses associated with the collateral pool, and the New York Fed
would provide $29 billion of funding on a non-recourse basis. This financing,
and the New York Fed's assumption of the collateral pool are contingent upon the
completion of the merger. If the merger is not completed for any reason,
including due to the failure to obtain stockholder approval, the New York Fed's
announced financing would not take effect and the related pool of collateral and
any losses related thereto would remain with us.
The merger is subject to the receipt of consents and approvals from regulatory
authorities that may impose conditions that could have an adverse effect on
JPMorgan Chase or, if not obtained, could prevent completion of the merger.
Before the merger may be completed, various approvals or consents must be
obtained from regulatory entities. These regulators may impose conditions on the
completion of the merger or require changes to the terms of the merger. Although
we do not currently expect that any such conditions or changes would be imposed,
there can be no assurance that they will not be, and such conditions or changes
could have the effect of delaying completion of the merger or imposing
additional costs on or limiting the revenues of JPMorgan Chase following the
merger.
Because the market price of JPMorgan Chase common stock will fluctuate, our
stockholders cannot be sure of the market value of the merger consideration they
will receive. Upon completion of the merger, each share of our common stock will
be converted into 0.21753 of a share of JPMorgan Chase common stock. Any change
in the market price of JPMorgan Chase common stock prior to completion of the
merger will affect the market value of the merger consideration that our
stockholders will receive upon completion of the merger. Accordingly, at the
time of the special meeting, our stockholders will not know or be able to
calculate the market value of the merger consideration they would receive upon
completion of the merger. Neither company is permitted to terminate the merger
agreement or resolicit the vote of our stockholders solely because of changes in
the market prices of either company's stock. There will be no adjustment to the
merger consideration for changes in the market price of either shares of
JPMorgan Chase common stock or shares of our common stock. Stock price changes
may result from a variety of factors, including general market and economic
conditions, changes in our respective businesses, operations and prospects, and
regulatory considerations. Many of these factors are beyond our control.
84
Part II - OTHER INFORMATION
Item 1A. RISK FACTORS
JPMorgan Chase may fail to realize all of the anticipated benefits of the
merger. The success of the merger will depend, in part, on JPMorgan Chase's
ability to successfully combine the businesses of JPMorgan Chase and Bear
Stearns. To realize these anticipated benefits, after the completion of the
merger, JPMorgan Chase expects to integrate Bear Stearns' business into its own.
It is possible that the integration process could result in the loss of key
employees, the disruption of each company's ongoing businesses or
inconsistencies in standards, controls, procedures and policies that adversely
affect our ability to maintain relationships with clients, customers, depositors
and employees or to achieve the anticipated benefits of the merger. The loss of
key employees could adversely affect JPMorgan Chase's ability to successfully
conduct its business in the markets in which we now operate, which could have an
adverse effect on JPMorgan Chase's financial results and the value of its common
stock. If JPMorgan Chase experiences difficulties with the integration process,
the anticipated benefits of the merger may not be realized fully or at all, or
may take longer to realize than expected. As with any merger of financial
institutions, there also may be business disruptions that cause us to lose
customers or cause customers to remove their accounts from us and move their
business to competing financial institutions. Integration efforts between the
two companies will also divert management attention and resources. These
integration matters could have an adverse effect on each of Bear Stearns and
JPMorgan Chase during this transition period and for an undetermined period
after consummation of the merger.
The market price of JPMorgan Chase common stock after the merger may be affected
by factors different from those affecting the shares of Bear Stearns or JPMorgan
Chase currently. The businesses of JPMorgan Chase and Bear Stearns differ in
material respects and, accordingly, the results of operations of the combined
company and the market price of the combined company's shares of common stock
may be affected by factors different from those currently affecting the
independent results of operations of each of JPMorgan Chase and Bear Stearns.
The fairness opinion obtained by us from our financial advisor in connection
with the merger will not reflect changes in circumstances between signing the
merger agreement and the completion of the merger. Changes in the operations and
prospects of Bear Stearns or JPMorgan Chase, general market and economic
conditions and other factors that may be beyond the control of Bear Stearns and
JPMorgan Chase, and on which the fairness opinion was based, may alter the value
of Bear Stearns or JPMorgan Chase or the prices of shares our common stock or
JPMorgan Chase common stock by the time the merger is completed. The opinion
does not speak as of the time the merger will be completed or as of any date
other than the date of such opinion. Because we do not anticipate asking our
financial advisor to update its opinion, the opinion will not address the
fairness of the merger consideration, from a financial point of view, at the
time the merger is completed.
Bear Stearns, Bear Stearns' directors and officers, and JPMorgan Chase are named
parties to a number of actions relating to the merger. A number of actions are
pending in New York and Delaware state and federal courts relating to the
merger. These include securities and ERISA class actions against us and our
current and former directors and officers, and class-action complaints on behalf
of a putative Bear Stearns shareholder class against us, our current directors
and officers and JPMorgan Chase. Depending on the outcome, these actions could
result in a court enjoining the merger or enjoining JPMorgan Chase from voting
the 95 million shares of our common stock acquired pursuant to the share
exchange agreement, or could otherwise impede the closing of the merger and
could have adverse financial effects or cause reputational harm to us and
JPMorgan Chase.
At the time of the anticipated merger with JPMorgan Chase (which is expected to
occur by June 30, 2008), the merger will be accounted for by JPMorgan Chase as a
"purchase" for accounting and financial reporting purposes, as that term is used
under accounting principles generally accepted in the United States. Under
purchase accounting, there may be adjustments as of the closing date. Our
financial statements as of and for the period ended February 29, 2008 do not
reflect these adjustments. Such adjustments will reflect the effect on inventory
valuations of market disruptions and the liquidity crisis encountered by the
Company subsequent to February 29, 2008, merger integration costs and
restructuring actions that may be necessary as a result of the merger, or costs
likely to be incurred by us to delever our balance sheet prior to the closing of
the merger.
Our system of controls could be negatively impacted by the events that occurred
commencing late in the week of March 10, 2008. As described above under
"Controls and Procedures" the Company's Chief Executive Officer and Chief
Financial Officer have concluded that the Company's disclosure controls and
procedures were effective as of February 29, 2008 to accomplish their
objectives. However, events that occurred commencing late in the week of March
10, 2008, including the deterioration of the Company's liquidity position, the
subsequent merger agreement with JPMorgan Chase and other developments described
in "Management's Discussion and Analysis of Results of Operations and Financial
Condition--Recent Developments" highlight the impact that extraordinary events
could have on the Company's system of controls described above under "Controls
and Procedures." Human error in times of extreme difficulty and turmoil, such as
the Company recently experienced and continues to experience, can occur.
Moreover, control and process breakdowns may be more frequent when a company is
operating under duress and its employees become distracted by crisis management
and the uncertainty surrounding the viability of the enterprise. These events
and potential impacts may have had and may have an adverse impact on the
efficacy of our disclosure controls and procedures and our internal controls
over financial reporting. However, management has concluded that the Company's
disclosure controls and procedures and our internal controls over financial
reporting were effective as of February 29, 2008 to accomplish their objectives
and believes that such controls and procedures were effective for purposes of
preparing this Quarterly Report including the financial statements contained
herein.
85
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The table below sets forth the information with respect to purchases made by the
Company of the Company's common stock during the first quarter of fiscal 2008:
Approximate Dollar
Total Number of Shares Value of Shares that
Average Price Paid Purchased as Part of May Yet Be Purchased
Total Number of Shares per Publicly Announced Under the Plans or
Period Purchased Share Plans or Programs (1) Programs (1)
------------------ ------------------------- -------------------- --------------------------------- ------------------------
12/1/07 - 12/31/07 705,803 $ 98.40 705,803 $ 2,148,780,233
1/1/08 - 1/31/08 3,407 88.41 3,407 2,148,479,037
2/1/08 - 2/29/08 1,339 90.60 1,339 2,148,357,727
------------------------- ---------------------------------
Total 710,549 98.33 710,549
------------------------- ---------------------------------
(1) On September 18, 2007, the Board of Directors approved an amendment to the
Repurchase Program authorizing the purchase of up to $2.5 billion of common
stock in fiscal 2007 and beyond. During the quarter ended February 29, 2008, the
Company purchased under the current authorization a total of 710,549 shares at a
cost of approximately of $69.9 million. Approximately $2.0 billion was available
to be purchased under the current authorization as of February 29, 2008.
During the quarter ended February 29, 2008, the Company did not purchase any
shares of its common stock pursuant to a $200 million CAP Plan Earnings Purchase
Authorization, which was approved by the Compensation Committee of the Board of
Directors of the Company on December 12, 2006. Approximately $92 million was
available to be purchased under the CAP Plan Earnings Purchase Authorization as
of February 29, 2008.
86
Item 6. EXHIBITS
Exhibits
(3.1) Restated By-Laws of The Bear Stearns Companies Inc., as
amended
(11) Computation of Per Share Earnings. (The calculation of per
share earnings is in Note 9, "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
87
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
The Bear Stearns Companies Inc.
-------------------------------
(Registrant)
Date: April 14, 2008 By: /s/ Jeffrey M. Farber
Jeffrey M. Farber
Senior Vice President - Finance,
Controller
(Principal Accounting Officer)
88
THE BEAR STEARNS COMPANIES INC.
FORM 10-Q
EXHIBIT INDEX
Exhibit No. Description
----------- -----------
(3.1) Restated By-Laws of The Bear Stearns Companies Inc., as amended
(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
89