UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended February 28, 2006
or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ___________ to ___________
Commission file number 1-8989
The Bear Stearns Companies Inc.
(Exact name of registrant as specified in its charter)
Delaware 13-3286161
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
383 Madison Avenue, New York, New York 10179
(Address of Principal Executive Offices) (Zip Code)
(212) 272-2000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer" and "large accelerated filer" in Rule 12b-2 of the Exchange
Act. Large Accelerated Filer [X] Accelerated Filer [ ] Non-Accelerated Filer [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of April 6, 2006, the latest practicable date, there were 120,607,046
shares of Common Stock, $1 par value, outstanding.
TABLE OF CONTENTS
Page
Available Information 3
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
Condensed Consolidated Statements of Income (Unaudited)
for the three months ended February 28, 2006 and
February 28, 2005 4
Condensed Consolidated Statements of Financial Condition
as of February 28, 2006 (Unaudited) and November 30, 2005
(Audited) 5
Condensed Consolidated Statements of Cash Flows (Unaudited)
for the three months ended February 28, 2006 and
February 28, 2005 6
Notes to Condensed Consolidated Financial Statements
(Unaudited) 7
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 29
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 30
Introduction 30
Certain Factors Affecting Results of Operations 30
Forward-Looking Statements 31
Executive Overview 31
Results of Operations 33
Liquidity and Capital Resources 38
Off-Balance-Sheet Arrangements 47
Derivative Financial Instruments 48
Critical Accounting Policies 49
Accounting and Reporting Developments 52
Effects of Inflation 52
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 53
Item 4. CONTROLS AND PROCEDURES 57
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS 58
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 59
Item 6 EXHIBITS 60
Signature 61
2
AVAILABLE INFORMATION
The Bear Stearns Companies Inc. and its subsidiaries ("Company") files current,
annual and quarterly reports, proxy statements and other information required by
the Securities Exchange Act of 1934, as amended ("Exchange Act"), with the
Securities and Exchange Commission ("SEC"). You may read and copy any document
the Company files at the SEC's public reference room located at 450 Fifth
Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for
further information on the public reference room. The Company's SEC filings are
also available to the public from the SEC's internet site at http://www.sec.gov.
Copies of these reports, proxy statements and other information can also be
inspected at the offices of the New York Stock Exchange, Inc., 20 Broad Street,
New York, New York 10005.
The Company's public internet site is http://www.bearstearns.com. The Company
makes available free of charge through its internet site, via a link to the
SEC's internet site at http://www.sec.gov, its annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements
and Forms 3, 4 and 5 filed on behalf of directors and executive officers and any
amendments to those reports filed or furnished pursuant to the Exchange Act, as
soon as reasonably practicable after it electronically files such material with,
or furnishes it to, the SEC.
In addition, the Company currently makes available on http://www.bearstearns.com
its most recent annual report on Form 10-K, its quarterly reports on Form 10-Q
for the current fiscal year and its most recent proxy statement, although in
some cases these documents are not available on that site as soon as they are
available on the SEC's internet site. Also posted on the Company's website, and
available in print upon request of any stockholder to the Investor Relations
Department, are charters for the Company's Audit Committee, Compensation
Committee, Corporate Governance Committee, Nominating Committee and Qualified
Legal Compliance Committee. Copies of the Corporate Governance Guidelines and
the Code of Business Conduct and Ethics governing our directors, officers and
employees are also posted on the Company's website within the "Corporate
Governance" section under the heading "About Bear Stearns." You will need to
have on your computer the Adobe Acrobat Reader software to view these documents,
which are in the .PDF format.
3
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Income
(Unaudited)
Three Months Ended
-----------------------------
(in thousands, except share and per February 28, February 28,
share data) 2006 2005
---------------------------------------------------------------------------
REVENUES
Commissions $ 286,071 $ 297,377
Principal transactions 1,150,432 978,633
Investment banking 337,853 233,710
Interest and dividends 1,723,989 1,021,619
Asset management and other income 140,073 91,030
------------------------------
Total revenues 3,638,418 2,622,369
Interest expense 1,453,215 784,709
------------------------------
Revenues, net of interest expense 2,185,203 1,837,660
------------------------------
NON-INTEREST EXPENSES
Employee compensation and benefits 1,046,850 906,775
Floor brokerage, exchange and clearance fees 51,243 57,318
Communications and technology 104,034 98,939
Occupancy 44,627 39,594
Advertising and market development 34,673 28,572
Professional fees 53,873 46,719
Other expenses 97,550 81,415
------------------------------
Total non-interest expenses 1,432,850 1,259,332
------------------------------
Income before provision for income taxes 752,353 578,328
Provision for income taxes 238,197 199,523
------------------------------
Net income $ 514,156 $ 378,805
==============================
Net income applicable to common shares $ 508,742 $ 372,327
=============================
Basic earnings per share $ 3.92 $ 2.94
Diluted earnings per share $ 3.54 $ 2.64
==============================
Weighted average common shares outstanding:
Basic 132,738,565 131,261,212
Diluted 149,417,369 149,193,402
=============================
Cash dividends declared per common share $ 0.28 $ 0.25
=============================
See Notes to Condensed Consolidated Financial Statements.
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
4
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Financial Condition
(Unaudited)
February 28, November 30,
(in thousands, except share data) 2006 2005
---------------------------------------------------------------------------
ASSETS
Cash and cash equivalents $ 5,051,418 $ 5,859,133
Cash and securities deposited with clearing
organizations segregated in compliance
with federal regulations 6,783,641 5,269,676
Securities purchased under agreements to
resell 39,192,568 42,647,603
Securities received as collateral 13,149,392 12,426,383
Securities borrowed 71,103,472 62,915,010
Receivables:
Customers 31,386,847 33,254,980
Brokers, dealers and others 2,010,823 3,544,806
Interest and dividends 414,313 433,305
Financial instruments owned, at fair value 97,657,432 93,364,088
Financial instruments owned and pledged as
collateral, at fair value 13,002,368 12,880,333
---------------------------
Total financial instruments owned, at
fair value 110,659,800 106,244,421
Assets of variable interest entities and
mortgage loan special purpose entities 15,184,187 15,151,699
Property, equipment and leasehold
improvements, net of accumulated
depreciation and amortization of
$1,045,098 and $1,011,036
as of February 28, 2006 and November 30,
2005, respectively 455,893 451,247
Other assets 4,630,336 4,436,970
--------------------------
Total Assets $300,022,690 $292,635,233
==========================
LIABILITIES AND STOCKHOLDERS' EQUITY
Short-term borrowings $ 21,578,993 $ 20,015,727
Securities sold under agreements to
repurchase 69,149,832 66,131,617
Obligation to return securities received
as collateral 13,149,392 12,426,383
Securities loaned 9,218,632 10,104,325
Payables:
Customers 73,426,323 73,231,067
Brokers, dealers and others 2,890,387 2,657,178
Interest and dividends 877,646 796,956
Financial instruments sold, but not yet
purchased, at fair value 35,007,009 35,004,333
Liabilities of variable interest entities
and mortgage loan special purpose entities 14,487,162 14,321,285
Accrued employee compensation and benefits 934,431 1,853,416
Other liabilities and accrued expenses 1,713,849 1,811,898
---------------------------
242,433,656 238,354,185
---------------------------
Commitments and contingencies (Note 10)
Long-term borrowings 46,423,442 43,489,616
--------------------------
STOCKHOLDERS' EQUITY
Preferred stock 366,906 372,326
Common stock, $1.00 par value; 500,000,000
shares authorized and 184,805 847
shares issued as of both February 28, 2006
and November 30, 2005 184,806 184,806
Paid-in capital 4,413,283 4,109,166
Retained earnings 7,966,674 7,492,951
Employee stock compensation plans 2,112,414 2,600,186
Unearned compensation (127,202) (143,302)
Treasury stock, at cost:
Common stock: 64,588,652 and 70,937,640
shares as of February 28, 2006 and
November 30, 2005, respectively (3,751,289) (3,824,701)
---------------------------
Total Stockholders' Equity 11,165,592 10,791,432
---------------------------
Total Liabilities and Stockholders' Equity $300,022,690 $292,635,233
===========================
See Notes to Condensed Consolidated Financial Statements.
5
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Cash Flows
(Unaudited)
Three Months Ended
----------------------------
February 28, February 28,
(in thousands) 2006 2005
----------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 514,156 $ 378,805
Adjustments to reconcile net income to cash
used in operating activities:
Non-cash items included in net income:
Depreciation and amortization 81,371 57,868
Deferred income taxes (2,253) (25,415)
Employee stock compensation plans 10,086 21,424
Changes in operating assets and liabilities:
Cash and securities deposited with clearing
organizations or segregated in compliance
with federal regulations (1,513,965) (1,473,114)
Securities borrowed, net of securities
loaned (9,074,155) (16,637)
Net receivables from customers 2,063,389 (423,551)
Net receivables from brokers, dealers and
others 1,767,192 1,466,956
Financial instruments owned (4,222,328) (4,516,795)
Other assets (87,210) (397,042)
Securities sold under agreements to
repurchase, net of securities purchased under
agreements to resell 6,473,250 (1,083,180)
Financial instruments sold, but not
yet purchased (71,924) (548,303)
Accrued employee compensation and benefits (932,053) (927,756)
Other liabilities and accrued expenses (17,358) 112,888
--------------------------
Cash used in operating activities (5,011,802) (7,373,852)
--------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and
leasehold improvements (39,234) (46,832)
--------------------------
Cash used in investing activities (39,234) (46,832)
--------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from short-term borrowings 1,563,266 2,957,677
Proceeds from issuance of long-term
borrowings 4,940,564 4,121,750
Payments for retirement/repurchase of
long-term borrowings (2,198,314) (1,858,338)
Proceeds from issuances of derivatives with
a financing element, net 74,600 110,344
Issuance of common stock 109,715 81,063
Cash retained resulting from tax
deductibility under share-based payment
arrangements 274,076 265,490
Redemption of preferred stock (5,393) (5,210)
Treasury stock purchases - common stock (476,427) (166,102)
Cash dividends paid (38,766) (35,802)
--------------------------
Cash provided by financing activities 4,243,321 5,470,872
--------------------------
Net decrease in cash and cash equivalents (807,715) (1,949,812)
Cash and cash equivalents, beginning of year 5,859,133 4,173,385
--------------------------
Cash and cash equivalents, end of period $ 5,051,418 $ 2,223,573
==========================
Supplemental Disclosure of Cash Flow Information:
Cash payments for interest were $1.51 billion and $819.3 million during the
three months ended February 28, 2006 and 2005, respectively.
Cash payments for income taxes were $88.4 million and $5.5 million for the
three months ended February 28, 2006 and 2005, respectively.
Cash payments for taxes would have been $362.5 and $271.0 for the three
months ended February 28, 2006 and 2005, respectively, if increases in
the value of equity instruments issued under share-based payment
arrangements had not been deductible in determining taxable income.
See Notes to Condensed Consolidated Financial Statements.
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
6
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
The Bear Stearns Companies Inc. (the "Company") is a holding company that,
through its broker-dealer and international bank subsidiaries, principally
Bear, Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp.
("BSSC"), Bear, Stearns International Limited ("BSIL") and Bear Stearns
Bank plc ("BSB"), is primarily engaged in business as a securities
broker-dealer and operates in three principal segments: Capital Markets,
Global Clearing Services and Wealth Management. Capital Markets comprises
the institutional equities, fixed income and investment banking areas.
Global Clearing Services provides clearance-related services for prime
brokerage clients and clearance on a fully disclosed basis for introducing
broker-dealers. Wealth Management comprises the private client services
("PCS") and asset management areas. See Note 12, "Segment Data," in the
Notes to Condensed Consolidated Financial Statements. The Company also
conducts significant activities through other wholly owned subsidiaries,
including: Bear Stearns Global Lending Limited; Custodial Trust Company;
Bear Stearns Financial Products Inc.; Bear Stearns Capital Markets Inc.;
Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc.; EMC Mortgage
Corporation; and Bear Stearns Commercial Mortgage, Inc. and through its
majority-owned subsidiary Bear Hunter Holdings LLC. As used in this
report, the "Company" refers (unless the context requires otherwise) to
The Bear Stearns Companies Inc. and its subsidiaries.
Basis of Presentation
The condensed consolidated financial statements include the accounts of
the Company, its wholly owned subsidiaries and other entities in which the
Company has a controlling interest. In accordance with Financial
Accounting Standards Board ("FASB") Interpretation ("FIN") No. 46 (R),
"Consolidation of Variable Interest Entities" ("FIN No. 46 (R)"), the
Company also consolidates any variable interest entities ("VIEs") for
which it is the primary beneficiary. The assets and related liabilities of
such variable interest entities have been shown in the Condensed
Consolidated Statements of Financial Condition in the captions "Assets of
variable interest entities and mortgage loan special purpose entities" and
"Liabilities of variable interest entities and mortgage loan special
purpose entities." See Note 5, "Variable Interest Entities and Mortgage
Loan Special Purpose Entities," in the Notes to Condensed Consolidated
Financial Statements.
When the Company does not have a controlling interest in an entity, but
exerts significant influence over the entity's operating and financial
decisions (generally defined as owning a voting or economic interest of
20% to 50%), the Company applies the equity method of accounting.
The Condensed Consolidated Statement of Financial Condition as of February
28, 2006, the Condensed Consolidated Statements of Income for the three
months ended February 28, 2006 and February 28, 2005 and the Condensed
Consolidated Statements of Cash Flows for the three months ended February
28, 2006 and February 28, 2005 are unaudited. The Condensed Consolidated
Statement of Financial Condition at November 30, 2005 and related
information was derived from the audited consolidated financial
statements.
The condensed consolidated financial statements are prepared in accordance
with the rules and regulations of the Securities and Exchange Commission
("SEC") with respect to the Form 10-Q and reflect all adjustments which,
in the opinion of management, are normal and recurring, which are
necessary for a fair statement of the results for the interim periods
presented. In accordance with such rules and regulations, certain
disclosures that are normally included in annual financial statements have
been omitted. These financial statements should be read together with the
Company's Annual Report on Form 10-K for the fiscal year ended November
30, 2005, as amended by Amendment No. 1 thereto on Form 10-K/A, each as
filed by the Company under the Securities Exchange Act of 1934, as amended
("Exchange Act") (together, the "Form 10-K").
The condensed consolidated financial statements are prepared in conformity
with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions, including those regarding inventory valuations, stock
compensation, certain accrued liabilities and the
7
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
potential outcome of litigation and tax matters, which may affect the
amounts reported in the condensed consolidated financial statements and
accompanying notes. Actual results could differ materially from these
estimates. The nature of the Company's business is such that the results
of any interim period may not be indicative of the results to be expected
for an entire fiscal year. All material intercompany transactions and
balances have been eliminated in consolidation. Certain prior period
amounts have been reclassified to conform to the current period's
presentation.
Financial Instruments
Proprietary securities, futures and other derivatives transactions are
recorded on a trade date basis. Financial instruments owned and financial
instruments sold, but not yet purchased, including contractual commitments
arising pursuant to futures, forward and option contracts, interest rate
swaps and other derivative contracts, are recorded at fair value with the
resulting net unrealized gains and losses reflected in "Principal
transactions" revenues in the Condensed Consolidated Statements of Income.
Fair value is generally based on quoted market prices. If quoted market
prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, fair value is determined
based on other relevant factors, including dealer price quotations, price
activity for equivalent instruments and valuation pricing models.
Valuation pricing models consider time value, yield curve and volatility
factors, prepayment speeds, default rates, loss severity, current market
and contractual prices for the underlying financial instruments, as well
as other measurements.
The Company follows Emerging Issues Task Force ("EITF") Statement No.
02-3, "Issues Involved in Accounting for Derivative Contracts Held for
Trading Purposes and Contracts Involved in Energy Trading and Risk
Management Activities." This guidance generally eliminates the practice of
recognizing profit at the inception of a derivative contract unless the
fair value of the derivative is obtained from a quoted market price in an
active market or is otherwise evidenced by comparison to other observable
current market transactions or based on a valuation technique that
incorporates observable market data.
Equity interests and securities acquired as a result of private equity and
merchant banking activities are reflected in the condensed consolidated
financial statements at their fair value. Fair value is generally defined
as an investment's initial cost until significant transactions or
developments indicate that a change in the carrying value of the
investment is appropriate. Generally, the carrying values of these
securities will be increased in those instances where market values are
readily ascertainable by reference to substantial transactions occurring
in the marketplace or quoted market prices. Reductions to the carrying
value of these securities are made when the Company's estimate of net
realizable value has declined below the carrying value.
Derivative Instruments and Hedging Activities
The Company follows Statement of Financial Accounting Standards ("SFAS")
No. 133, "Accounting for Derivative Instruments and Hedging Activities,"
as amended by SFAS No. 138, "Accounting for Certain Derivative Instruments
and Certain Hedging Activities," and SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities," which establishes
accounting and reporting standards for stand-alone derivative instruments,
derivatives embedded within other contracts or securities, and hedging
activities. Accordingly, all derivatives, whether stand-alone or embedded
within other contracts or securities (except in narrowly defined
circumstances), are carried in the Company's Condensed Consolidated
Statements of Financial Condition at fair value, with changes in fair
value recorded in current earnings in "Principal transactions" revenues.
Designated hedged items in fair value hedging relationships are marked for
the risk being hedged, with such changes recorded in current earnings.
Customer Transactions
Customer securities transactions are recorded on the Condensed
Consolidated Statements of Financial Condition on
8
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
a settlement date basis, which is generally three business days after
trade date, while the related commission revenues and expenses are
recorded on a trade date basis. Receivables from and payables to customers
include amounts related to both cash and margin transactions. Securities
owned by customers, including those that collateralize margin or other
similar transactions, are generally not reflected in the Condensed
Consolidated Statements of Financial Condition.
Mortgage Servicing Assets, Fees and Advances
Mortgage servicing rights ("MSRs"), which are included in "Other assets"
on the Condensed Consolidated Statements of Financial Condition, are
reported at the lower of amortized cost or market. MSRs are amortized in
proportion to and over the period of estimated net servicing income. MSRs
are periodically evaluated for impairment based on the fair value of those
rights determined by using market-based models that discount anticipated
future net cash flows considering loan prepayment estimates, interest
rates, default rates, servicing costs and other economic factors. For
purposes of impairment evaluation and measurement, the Company stratifies
MSRs by predominant risk characteristics. The excess of amortized cost
over market value is reflected as a valuation allowance at balance sheet
dates.
Contractual servicing fees, late fees and other ancillary servicing fees
earned for servicing mortgage loans are reflected net of MSR amortization
and impairment in "Investment banking" revenues in the Condensed
Consolidated Statements of Income. Contractual servicing fees are
recognized when earned based on the terms of a 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 or
from the proceeds received from the sales of the underlying properties. A
charge to expense is recognized to the extent that servicing advances are
estimated to be uncollectible.
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities--a Replacement of
FASB Statement No. 125," to account for securitizations and other
transfers of financial assets and collateral. SFAS No. 140 establishes
accounting and reporting standards with a financial-components approach
that focuses on control. Under this approach, financial assets or
liabilities are recognized when control is established and derecognized
when control has been surrendered or the liability has been extinguished.
Control is deemed to be relinquished only when all of the following
conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee
is a Qualifying Special Purpose Entity ("QSPE") or has the right to pledge
or exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. The Company derecognizes
financial assets transferred in securitizations provided that such
transfer meets all of these criteria.
Collateralized Securities Transactions
Transactions involving purchases of securities under agreements to resell
("reverse repurchase agreements") or sales of securities under agreements
to repurchase ("repurchase agreements") are treated as collateralized
financing transactions and are recorded at their contracted resale or
repurchase amounts plus accrued interest. Resulting interest income and
expense is generally included in "Principal transactions" revenues in the
Condensed Consolidated Statements of Income. Reverse repurchase agreements
and repurchase agreements are presented in the Condensed Consolidated
Statements of Financial Condition on a net-by-counterparty basis, where
permitted by generally accepted accounting principles. It is the Company's
general policy to take possession of securities with a market value in
excess of the principal amount loaned plus the accrued interest thereon,
in order to collateralize reverse repurchase agreements. Similarly, the
Company is generally required to provide securities to counterparties to
collateralize repurchase agreements. The Company's agreements with
counterparties generally contain contractual provisions allowing for
additional collateral to be obtained, or excess collateral returned. It is
the Company's policy to value collateral and to obtain additional
collateral, or to retrieve excess collateral from
9
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
counterparties, when deemed appropriate.
Securities borrowed and securities loaned are recorded based upon the
amount of cash collateral advanced or received. Securities borrowed
transactions facilitate the settlement process and require the Company to
deposit cash, letters of credit or other collateral with the lender. With
respect to securities loaned, the Company receives collateral in the form
of cash or other collateral. The amount of collateral required to be
deposited for securities borrowed, or received for securities loaned, is
an amount generally in excess of the market value of the applicable
securities borrowed or loaned. The Company monitors the market value of
securities borrowed and loaned, with excess collateral retrieved or
additional collateral obtained, when deemed appropriate.
Investment Banking and Advisory Services
Underwriting revenues and fees for mergers and acquisitions advisory
services are accrued when services for the transactions are substantially
completed. Transaction expenses are deferred until the related revenue is
recognized.
Asset Management and Other Income
The Company receives advisory fees for investment management. Advisory
fees are recognized over the period that the related service is provided
based upon the net asset value. Unearned advisory fees are treated as
deferred revenues and are included in "Other liabilities" in the
accompanying Condensed Consolidated Statements of Financial Condition. In
addition, the Company receives performance incentive fees for managing
certain funds based upon the achievement of specified performance targets.
These fees are accrued as earned during the period when the assets under
management exceed the applicable specific investment performance target.
Fixed Assets
Depreciation of property and equipment is provided by the Company on a
straight-line basis over the estimated useful life of the asset.
Amortization of leasehold improvements is provided on a straight-line
basis over the lesser of the estimated useful life of the asset or the
remaining life of the lease.
Goodwill and Identifiable Intangible Assets
The Company accounts for goodwill and identifiable intangible assets under
the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." In
accordance with this guidance, the Company does not amortize goodwill, but
amortizes identifiable intangible assets over their useful lives. Goodwill
is tested at least annually for impairment and identifiable intangible
assets are tested for potential impairment whenever events or changes in
circumstances suggest that the carrying value of an asset or asset group
may not be fully recoverable in accordance with SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets."
Earnings Per Share
Earnings per share ("EPS") is computed in accordance with SFAS No. 128,
"Earnings Per Share." Basic EPS is computed by dividing net income
applicable to common shares, adjusted for costs related to vested shares
under the Capital Accumulation Plan for Senior Managing Directors, as
amended ("CAP Plan"), as well as the effect of the redemption of preferred
stock, by the weighted average number of common shares outstanding. Common
shares outstanding includes vested units issued under certain stock
compensation plans, which will be distributed as shares of common stock.
Diluted EPS includes the determinants of basic EPS and, in addition, gives
effect to dilutive potential common shares related to stock compensation
plans.
Stock-Based Compensation
Effective December 1, 2002, the Company elected to adopt fair value
accounting for stock-based compensation
10
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
consistent with SFAS No. 123, "Accounting for Stock-Based Compensation,"
using the prospective method with guidance provided by SFAS No. 148,
"Accounting for Stock-Based Compensation--Transition and Disclosure." As a
result, commencing with options granted after November 30, 2002, the
Company expenses the fair value of stock options issued to employees over
the related vesting period. Prior to December 1, 2002, the Company had
elected to account for its stock-based compensation plans using the
intrinsic value method prescribed by Accounting Principles Board ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"),
as permitted by SFAS No. 123. Under the provisions of APB No. 25,
compensation cost for stock options is measured as the excess, if any, of
the quoted market price of the Company's common stock at the date of grant
over the amount an employee must pay to acquire the stock. Accordingly, no
compensation expense had been recognized for stock option awards granted
prior to December 1, 2002 because the exercise price was at the fair
market value of the Company's common stock on the grant date.
The cost related to stock-based compensation included in the determination
of net income for the three months ended February 28, 2006 has been fully
recognized under the fair value-based method, and for the three months
ended February 28, 2005 is less than that which would have been recognized
if the fair value-based method had been applied to stock option awards
since the original effective date of SFAS No. 123.
The following table illustrates the effect on net income and earnings per
share for the three months ended February 28, 2005 if the fair value-based
method under SFAS No. 123 had been applied to stock options granted for
the year ended November 30, 2002.
Three months ended
-------------------------------------------------------------------------
February 28,
(in millions, except per share amounts) 2005
-------------------------------------------------------------------------
Net income, as reported $ 378.8
Add:
Stock-based employee compensation plans expense
included in reported net income, net of related
tax effects 12.2
Deduct:
Total stock-based employee compensation plans expense
determined under the fair value basedonethod, net of
related tax effects (15.7)
-------------------------------------------------------------------------
Pro forma net income $ 375.3
=========================================================================
Earnings per share:
Basic - as reported $ 2.94
Basic - pro forma $ 2.92
Diluted - as reported $ 2.64
Diluted - pro forma $ 2.62
=========================================================================
In December 2004, the FASB issued SFAS No. 123 (R), "Share-Based Payment."
SFAS No. 123 (R) is a revision of SFAS No. 123 and supersedes APB No. 25,
and amends SFAS No. 95, "Statement of Cash Flows." SFAS No. 123 (R)
eliminates the ability to account for share-based compensation
transactions using APB No. 25 and requires all share-based payments to
employees, including grants of employee stock options, to be recognized in
the financial statements using a fair value-based method. The Company
adopted SFAS No. 123 (R), as required, on December 1, 2005, using the
modified prospective method with no material impact on the consolidated
financial statements of the Company. The Company does not expect a
material impact to the consolidated financial statements for fiscal 2006.
11
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Cash Equivalents
The Company has defined cash equivalents as liquid investments not held
for sale in the ordinary course of business with original maturities of
three months or less that are not part of the Company's trading inventory.
Income Taxes
The Company and certain of its subsidiaries file a US consolidated federal
income tax return. The Company accounts for income taxes under the
provisions of SFAS No. 109, "Accounting for Income Taxes." Under SFAS No.
109, deferred income taxes are based on the net tax effects of temporary
differences between the financial reporting and tax bases of assets and
liabilities. In addition, deferred income taxes are determined by the
enacted tax rates and laws expected to be in effect when the related
temporary differences are expected to be reversed.
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations.
The Company regularly evaluates the likelihood of additional assessments
in each of the tax jurisdictions resulting from these examinations. Tax
reserves have been established, which the Company believes to be adequate
in relation to the potential for additional assessments. Once established,
reserves are adjusted as information becomes available or when an event
requiring a change to the reserve occurs.
Translation of Foreign Currencies
Assets and liabilities denominated in foreign currencies are translated at
period end rates of exchange, while income statement items are translated
at daily average rates of exchange during the fiscal period. Gains or
losses resulting from foreign currency transactions are included in net
income.
Accounting and Reporting Developments
In June 2005, the EITF reached a consensus on EITF Issue No. 04-5,
"Determining Whether a General Partner, or the General Partners as a
Group, Controls a Limited Partnership or Similar Entity When the Limited
Partners Have Certain Rights." The EITF consensus requires a general
partner in a limited partnership to consolidate the limited partnership
unless the presumption of control is overcome. The general partner may
overcome this presumption of control and not consolidate the entity if the
limited partners have: (a) the substantive ability to dissolve or
liquidate the limited partnership or otherwise remove the general partner
without having to show cause; or (b) substantive participating rights in
managing the partnership. This guidance became effective upon ratification
by the FASB on June 29, 2005 for all newly formed limited partnerships and
for existing limited partnerships for which the partnership agreements
have been modified. For all other limited partnerships, the guidance is
effective no later than the beginning of the first reporting period in
fiscal years beginning after December 15, 2005. The Company does not
expect the EITF consensus on EITF issue No. 04-5 to have a material impact
on the consolidated financial statements of the Company.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments." SFAS No. 155 is an amendment of SFAS No.
133 and SFAS No. 140. SFAS No. 155 permits companies to elect, on a deal
by deal basis, to apply a fair value remeasurement for any hybrid
financial instrument that contains an embedded derivative that otherwise
would require bifurcation. SFAS No. 155 is effective for all financial
instruments acquired or issued after the beginning of an entity's first
fiscal year that begins after September 15, 2006. The impact of SFAS No.
155 on the Company's consolidated financial statements is currently being
evaluated.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets." SFAS No. 156 amends SFAS No. 140. SFAS No. 156 requires
that all separately recognized servicing assets and servicing liabilities
be initially measured at fair value. For subsequent measurements, SFAS No.
156 permits companies to choose between using an amortization method or a
fair value measurement method for reporting purposes. SFAS No. 156 is
effective as of the beginning of a company's first fiscal year that begins
after September 15, 2006. The Company does not expect SFAS No. 156 to have
a material impact on the consolidated financial statements of the Company.
12
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
2. FINANCIAL INSTRUMENTS
Financial instruments owned and financial instruments sold, but not yet
purchased, consisting of the Company's proprietary trading inventories, at
fair value, were as follows:
February 28, November 30,
(in thousands) 2006 2005
---------------------------------------------------------------------
FINANCIAL INSTRUMENTS OWNED:
U.S. government and agency $ 10,097,015 $9,914,866
Other sovereign governments 574,050 1,159,265
Corporate equity and convertible debt 20,598,372 18,601,132
Corporate debt and other 26,396,129 21,571,914
Mortgages, mortgage- and asset-backed 39,671,521 40,297,016
Derivative financial instruments 13,322,713 14,700,228
---------------------------------------------------------------------
$110,659,800 $106,244,421
=====================================================================
FINANCIAL INSTRUMENTS SOLD, BUT
NOT YET PURCHASED:
U.S. government and agency $10,108,694 $10,115,133
Other sovereign governments 653,165 1,617,998
Corporate equity and convertible debt 8,891,317 6,900,004
Corporate debt and other 3,077,780 3,274,034
Mortgages, mortgage- and asset-backed 47,074 139,988
Derivative financial instruments 12,228,979 12,957,176
---------------------------------------------------------------------
$35,007,009 $35,004,333
=====================================================================
As of February 28, 2006 and November 30, 2005, all financial instruments
owned that were pledged to counterparties where the counterparty has the
right, by contract or custom, to rehypothecate those securities are
classified as "Financial instruments owned and pledged as collateral" in
the Condensed Consolidated Statements of Financial Condition.
Financial instruments sold, but not yet purchased, represent obligations
of the Company to purchase the specified financial instrument at the then
current market price. Accordingly, these transactions result in
off-balance-sheet risk as the Company's ultimate obligation to repurchase
such securities may exceed the amount recognized in the Condensed
Consolidated Statements of Financial Condition.
Concentration Risk
The Company is subject to concentration risk by holding large positions or
committing to hold large positions in certain types of securities,
securities of a single issuer (including governments), issuers located in
a particular country or geographic area, or issuers engaged in a
particular industry. Positions taken and commitments made by the Company,
including underwritings, often involve substantial amounts and significant
exposure to individual issuers and businesses, including
non-investment-grade issuers. At February 28, 2006 and November 30, 2005,
the Company's most significant concentrations are related to US government
and agency inventory positions, including those of the Federal National
Mortgage Association and the Federal Home Loan Mortgage Corporation. In
addition, a substantial portion of the collateral held by the Company for
securities purchased under agreements to resell consists of securities
issued by the US government and agencies.
3. DERIVATIVES AND HEDGING ACTIVITIES
The Company, in its capacity as a dealer in over-the-counter derivative
financial instruments and its proprietary market-making and trading
activities, enters into transactions in a variety of cash and derivative
financial
13
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
instruments for proprietary trading and to manage its exposure to market
and credit risk. These risks include interest rate, exchange rate and
equity price risk. Derivative financial instruments represent contractual
commitments between counterparties that derive their value from changes in
an underlying interest rate, currency exchange rate, index (e.g., Standard
& Poor's 500 Index), reference rate (e.g., London Interbank Offered Rate,
or LIBOR), or asset value referenced in the related contract. Some
derivatives, such as futures contracts, certain options and
index-referenced warrants, can be traded on an exchange. Other
derivatives, such as interest rate and currency swaps, caps, floors,
collars, swaptions, equity swaps and options, credit derivatives,
structured notes and forward contracts, are negotiated in the
over-the-counter markets. Derivatives generate both on- and
off-balance-sheet risks depending on the nature of the contract.
Generally, these financial instruments represent commitments or rights to
exchange interest payment streams or currencies or to purchase or sell
other securities at specific terms at specified future dates. Option
contracts generally provide the holder with the right, but not the
obligation, to purchase or sell a financial instrument at a specific price
on or before an established date or dates. Financial instruments sold, but
not yet purchased may result in market and/or credit risk in excess of
amounts recorded in the Condensed Consolidated Statements of Financial
Condition.
Market Risk
Derivative financial instruments involve varying degrees of
off-balance-sheet market risk, whereby changes in the level or volatility
of interest rates, foreign currency exchange rates or market values of the
underlying financial instruments may result in changes in the value of a
particular financial instrument in excess of the amounts currently
reflected in the Condensed Consolidated Statements of Financial Condition.
The Company's exposure to market risk is influenced by a number of
factors, including the relationships among and between financial
instruments with off-balance-sheet risk, the Company's proprietary
securities, futures and derivatives inventories as well as the volatility
and liquidity in the markets in which the financial instruments are
traded. The Company attempts to mitigate its exposure to market risk by
entering into hedging transactions, which may include over-the-counter
derivative contracts or the purchase or sale of interest-bearing
securities, equity securities, financial futures and forward contracts. In
this regard, the utilization of derivative instruments is designed to
reduce or mitigate market risks associated with holding dealer inventories
or in connection with arbitrage-related trading activities.
Derivatives Credit Risk
Credit risk arises from the potential inability of counterparties to
perform in accordance with the terms of the contract. At any point in
time, the Company's exposure to credit risk associated with counterparty
non-performance is generally limited to the net replacement cost of
over-the-counter contracts, net of the value of collateral held. Such
financial instruments are reported at fair value on a net-by-counterparty
basis pursuant to enforceable netting agreements. Exchange-traded
financial instruments, such as futures and options, generally do not give
rise to significant unsecured counterparty exposure due to the Company's
margin requirements, which may be greater than those prescribed by the
individual exchanges. Options written generally do not give rise to
counterparty credit risk since they obligate the Company (not its
counterparty) to perform.
The Company has controls in place to monitor credit exposures by assessing
the future creditworthiness of counterparties and limiting transactions
with specific counterparties. The Company also seeks to control credit
risk by following an established credit approval process, monitoring
credit limits and requiring collateral where appropriate.
Non-Trading Derivatives Activity
To modify the interest rate characteristics of its long- and short-term
debt, the Company also engages in non-trading derivatives activities. The
Company has issued US dollar- and foreign currency-denominated debt with
both variable- and fixed-rate interest payment obligations. The Company
has entered into interest rate swaps, primarily based on LIBOR, to convert
fixed-rate interest payments on its debt obligations into variable-rate
payments. In addition, for foreign currency debt obligations that are not
used to fund assets in the same currency, the Company has entered into
currency swap agreements that effectively convert the debt into US dollar
obligations. Such
14
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
transactions are accounted for as fair value hedges.
These financial instruments are subject to the same market and credit
risks as those that are traded in connection with the Company's
market-making and trading activities. The Company has similar controls in
place to monitor these risks.
SFAS No. 133, as amended by SFAS No. 138 and SFAS No. 149, establishes
accounting and reporting standards for stand-alone derivative instruments,
derivatives embedded within other contracts or securities and for hedging
activities. It requires that all derivatives, whether stand-alone or
embedded within other contracts or securities (except in very defined
circumstances) be carried on the Company's Condensed Consolidated
Statement of Financial Condition at fair value. SFAS No. 133 also requires
items designated as being fair value hedged to be recorded at fair value,
as defined in SFAS No. 133, provided that the intent to hedge is fully
documented. Any resultant net change in value for both the hedging
derivative and the hedged item is recognized in earnings immediately, such
net effect being deemed the "ineffective" portion of the hedge. The gains
and losses associated with the ineffective portion of the fair value
hedges are included in "Principal transactions" revenues in the Condensed
Consolidated Statements of Income. These amounts were immaterial for the
three months ended February 28, 2006 and 2005.
4. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES
Securitizations
The Company is a market leader in mortgage-backed securitization and other
structured financing arrangements. In the normal course of business, the
Company regularly securitizes commercial and residential mortgages,
consumer receivables and other financial assets. Securitization
transactions are generally treated as sales, provided that control has
been relinquished. In connection with securitization transactions, the
Company establishes special-purpose entities ("SPEs"), in which
transferred assets, including commercial and residential mortgages,
consumer receivables and other financial assets are sold to an SPE and
repackaged into securities or similar beneficial interests. Transferred
assets are accounted for at fair value prior to securitization. The
majority of the Company's involvement with SPEs relates to securitization
transactions meeting the definition of a QSPE under the provisions of SFAS
No. 140. Provided it has relinquished control over such assets, the
Company derecognizes financial assets transferred in securitizations and
does not consolidate the financial statements of QSPEs. For SPEs that do
not meet the QSPE criteria, the Company uses the guidance in FIN No. 46
(R) to determine whether the SPE should be consolidated.
In connection with these securitization activities, the Company may retain
interests in securitized assets in the form of senior or subordinated
securities or as residual interests. Retained interests in securitizations
are generally not held to maturity and typically are sold shortly after
the settlement of a securitization. The weighted average holding period
for retained interest positions in inventory at February 28, 2006 and
November 30, 2005 was approximately 100 days and 90 days, respectively.
These retained interests are included in "Financial instruments owned" in
the Consolidated Statements of Financial Condition and are carried at fair
value. Consistent with the valuation of similar inventory, fair value is
determined by broker-dealer price quotations and internal valuation
pricing models that utilize variables such as yield curves, prepayment
speeds, default rates, loss severity, interest rate volatilities and
spreads. The assumptions used for pricing variables are based on
observable transactions in similar securities and are further verified by
external pricing sources, when available.
15
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company's securitization activities are detailed below:
Agency
Mortgage- Other Mortgage-
(in billions) Backed and Asset-Backed Total
---------------------------------------------------------------------------
Total securitizations
Three months ended February 28, 2006 $5.8 $24.8 $30.6
Three months ended February 28, 2005 $6.4 $21.2 $27.6
Retained interests
As of February 28, 2006 $3.0 $2.4 $5.4 (1)
As of November 30, 2005 $1.8 $3.7 $5.5 (2)
---------------------------------------------------------------------------
(1) Includes approximately $1.0 billion in non-investment-grade and
unrated retained interests.
(2) Includes approximately $0.8 billion in non-investment-grade and
unrated retained interests.
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the three months ended
February 28, 2006 and February 28, 2005:
Agency
Mortgage- Other Mortgage-
(in millions) Backed and Asset-Backed Total
---------------------------------------------------------------------------
Cash flows received from retained
interests
Three months ended February 28, 2006 $21.1 $109.3 $130.4
Three months ended February 28, 2005 $22.9 $34.0 $56.9
Cash flows from servicing
Three months ended February 28, 2006 $0.1 $6.0 $6.1
Three months ended February 28, 2005 $0.1 $3.0 $3.1
---------------------------------------------------------------------------
The Company is an active market maker in these securities and therefore
may retain interests in assets it securitizes, predominantly highly rated
or government agency-backed securities. The models employed in the
valuation of retained interests use discount rates that are based on the
Treasury curve plus a spread. Key points on the constant maturity Treasury
curve at February 28, 2006 were 4.68% for 2-year Treasuries and 4.64%
for 10-year Treasuries, and ranged from 4.57% to 4.76%. These models also
consider prepayment speeds as well as credit losses. Credit losses are
considered through option-adjusted spreads that also incorporate
additional factors such as liquidity and optionality.
Weighted average key economic assumptions used in measuring the fair value
of retained interests in assets the Company securitized at February 28,
2006 were as follows:
Agency
Mortgage- Other Mortgage-
Backed and Asset-Backed
---------------------------------------------------------------------------
Weighted average life (years) 7.4 3.8
Average prepayment speeds (annual rate) 7% - 27% 7% - 52%
Credit losses - 0% - 8%
---------------------------------------------------------------------------
16
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following hypothetical sensitivity analysis as of February 28, 2006
illustrates the potential adverse change in fair value of these retained
interests due to a specified change in the key valuation assumptions. The
interest rate changes represent a parallel shift in the Treasury curve.
This shift considers the effect of other variables, including prepayments.
The remaining valuation assumptions are changed independently. Retained
interests in securitizations are generally not held to maturity and are
typically sold shortly after the settlement of a securitization. The
Company considers the current and expected credit profile of the
underlying collateral in determining the fair value and periodically
updates the fair value for changes in credit, interest rate, prepayment
and other pertinent market factors. Actual credit losses on retained
interests have not been significant.
Agency
Mortgage- Other Mortgage-
(in millions) Backed and Asset-Backed
---------------------------------------------------------------------------
Interest rates
Impact of 50 basis point adverse
change $ (60.3) $ (75.1)
Impact of 100 basis point adverse
change (127.0) (155.5)
---------------------------------------------------------------------------
Prepayment speeds
Impact of 10% adverse change (1.9) (21.9)
Impact of 20% adverse change (3.4) (41.8)
---------------------------------------------------------------------------
Credit losses
Impact of 10% adverse change (5.3) (51.8)
Impact of 20% adverse change (10.6) (99.3)
---------------------------------------------------------------------------
In the normal course of business, the Company originates and purchases
conforming and non-conforming, conventional fixed-rate and adjustable-rate
residential mortgage loans and sells such loans to investors. In
connection with these activities, the Company may retain MSRs that entitle
the Company to a future stream of cash flows based on the contractual
servicing fee. In addition, the Company may purchase and sell MSRs. At
February 28, 2006, the key economic assumptions and the sensitivity of the
current fair value of MSRs to immediate changes in those assumptions were
as follows:
Adjustable-Rate
Fixed-Rate Prime Prime &
(in millions) Sub-Prime Loans & Alt-A Loans Alt-A Loans
-------------------------------------------------------------------------------------
Fair Value of MSRs $ 167.7 $ 109.1 $ 262.8
Constant prepayment rate (in CPR) 15% - 75% 12% - 37% 23% - 53%
Impact on fair value of:
5 CPR adverse change $ (12.7) $ (13.8) $ (11.8)
10 CPR adverse change (23.5) (20.6) (20.9)
Discount Rate 15% 13% 13%
Impact on fair value of:
5% adverse change $ (11.2) $ (16.1) $ (19.6)
10% adverse change (20.9) (24.9) (35.9)
-------------------------------------------------------------------------------------
The previous tables should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the tables. Changes in fair value based on a 10% adverse
variation in assumptions generally cannot be extrapolated because the
relationship of the change in assumptions to the change in fair value is
not usually linear. In addition, the tables do not consider the change in
fair value of hedging positions, which would generally offset the changes
detailed in the tables, nor do they consider any corrective action that
the Company may take in response to changes in these conditions. The
impact of hedges is not presented because hedging positions are
established on a portfolio level and allocating the impact would not be
practicable.
17
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
MSRs are included in "Other assets" on the Condensed Consolidated
Statements of Financial Condition. The Company's MSRs activities for the
three months ended February 28, 2006 and 2005 were as follows:
February 28, February 28,
(in millions) 2006 2005
----------------------------------------------------------
Balance, beginning of period $ 431.1 $ 230.2
Additions 119.6 59.9
Amortization (46.6) (24.8)
Recovery 1.8 2.6
----------------------------------------------------------
Balance, end of period $ 505.9 $ 267.9
==========================================================
Changes in the MSR valuation allowance for the three months ended February
28, 2006 and 2005 were as follows:
February 28, February 28,
(in millions) 2006 2005
----------------------------------------------------------
Balance, beginning of period $ (10.6) $ (33.7)
Recovery 1.8 2.6
----------------------------------------------------------
Balance, end of period $ (8.8) $ (31.1)
==========================================================
5. VARIABLE INTEREST ENTITIES AND MORTGAGE LOAN SPECIAL PURPOSE ENTITIES
The Company regularly creates or transacts with entities that may be VIEs.
These entities are an essential part of its securitization, asset
management and structured finance businesses. In addition, the Company
purchases and sells instruments that may be variable interests. The
Company adopted FIN No. 46 (R) for its variable interests in fiscal 2004.
The Company consolidates those VIEs in which the Company is the primary
beneficiary.
The Company may perform various functions, including being the seller,
servicer, investor, structurer or underwriter in securitization
transactions. These transactions typically involve entities that are
considered to be QSPEs as defined in SFAS No. 140. QSPEs are exempt from
the requirements of FIN No. 46 (R). For securitization vehicles that do
not qualify as QSPEs, the holders of the beneficial interests have no
recourse to the Company, only to the assets held by the related VIE. In
certain of these VIEs, the Company is the primary beneficiary often
through its ownership of certain beneficial interests, and is, therefore,
required to consolidate the assets and liabilities of the VIE.
The Company has a limited number of mortgage securitizations that did not
meet the criteria for sale treatment under SFAS No. 140 because the
securitization vehicles were not QSPEs. The assets in these mortgage
securitizations approximated $3.7 billion and $5.3 billion at February 28,
2006 and November 30, 2005, respectively.
The Company also acts as portfolio manager and/or underwriter in several
collateralized debt obligation transactions. In these transactions, the
Company establishes a trust that purchases a portfolio of assets and
issues trust certificates that represent interests in the portfolio of
assets. In addition to receiving variable compensation for managing the
portfolio, the Company may also retain certain trust certificates. In
certain of these transactions, these interests result in the Company
becoming the primary beneficiary of these entities. The holders of the
trust certificates have recourse only to the underlying assets of the
trusts and not to other assets of the Company.
Assets held by VIEs, which are currently consolidated because the Company
is the primary beneficiary, approximated $1.1 billion and $1.2 billion at
February 28, 2006 and November 30, 2005, respectively. At February 28,
2006 and November 30, 2005, the Company's maximum exposure to loss as a
result of its relationship with these VIEs is approximately $428.7 million
and $531.0 million, respectively, which represents the fair value of its
interests in the VIEs.
18
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company also owns significant variable interests in several VIEs
related to collateralized debt obligations or asset securitizations for
which the Company is not the primary beneficiary and therefore does not
consolidate these entities. In aggregate, these VIEs have assets
approximating $9.3 billion and $4.7 billion at February 28, 2006 and
November 30, 2005, respectively. At February 28, 2006 and November 30,
2005, the Company's maximum exposure to loss from these entities
approximates $72.6 million and $29.6 million, respectively, which
represents the fair value of its interests and is reflected in the
condensed consolidated financial statements.
The Company purchases and sells interests in entities that may be deemed
to be VIEs in its market-making capacity in the ordinary course of
business. As a result of these activities, it is reasonably possible that
such entities may be consolidated and deconsolidated at various points in
time. Therefore, the Company's variable interests included above may not
be held by the Company in future periods.
The Company has retained call options on a limited number of
securitization transactions that require the Company to continue
recognizing the assets subject to the call options, which assets
approximated $9.9 billion and $8.7 billion, at February 28, 2006 and
November 30, 2005, respectively.
The Company was the general partner of certain limited partnerships in
which the limited partners did not have sufficient voting or control
rights. Under EITF No. 04-5, the Company was required to consolidate the
limited partnerships. The assets held by the limited partnerships
approximated $378.2 million as of February 28, 2006. The Company's maximum
exposure to loss as a result of its relationship with these limited
partnerships is approximately $25.8 million as of February 28, 2006.
6. COLLATERALIZED FINANCING ARRANGEMENTS
The Company enters into secured borrowing and lending agreements to obtain
collateral necessary to effect settlements, finance inventory positions,
meet customer needs or re-lend as part of its dealer operations.
The Company receives collateral under reverse repurchase agreements,
securities borrowing transactions, derivative transactions, customer
margin loans and other secured money-lending activities. In many
instances, the Company is also permitted by contract or custom to
rehypothecate securities received as collateral. These securities may be
used to secure repurchase agreements, enter into securities lending or
derivative transactions or cover short positions.
At February 28, 2006 and November 30, 2005, the fair value of securities
received as collateral by the Company that can be repledged, delivered or
otherwise used was approximately $248.19 billion and $254.62 billion,
respectively. Of these securities received as collateral, those with a
fair value of approximately $178.37 billion and $184.25 billion were
delivered or repledged at February 28, 2006 and November 30, 2005,
respectively.
The Company also pledges financial instruments owned to collateralize
certain financing arrangements and permits the counterparty to pledge or
rehypothecate the securities. These securities are recorded as "Financial
instruments owned and pledged as collateral, at fair value" in the
Condensed Consolidated Statements of Financial Condition. The carrying
value of securities and other inventory positions owned that have been
pledged or otherwise encumbered to counterparties where those
counterparties do not have the right to sell or repledge was approximately
$22.23 billion and $20.83 billion at February 28, 2006 and November 30,
2005, respectively.
19
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
7. LONG-TERM BORROWINGS
The Company's long-term borrowings (which have original maturities of at
least 12 months) at February 28, 2006 and November 30, 2005 consisted of
the following:
February 28, November 30,
(in thousands) 2006 2005
--------------------------------------------------------------------------
Fixed rate notes due 2006 to 2036 $22,143,938 $21,973,171
Floating rate notes due 2006 to 2036 16,746,557 14,208,786
Index/equity/credit-linked notes 7,532,947 7,307,659
--------------------------------------------------------------------------
Total long-term borrowings $46,423,442 $43,489,616
==========================================================================
The Company's long-term borrowings include fair value adjustments
in accordance with SFAS No. 133. During the three months ended February
28, 2006, the Company issued and retired/repurchased $4.94 billion and
$2.20 billion of long-term borrowings, respectively. The weighted average
maturity of the Company's long-term borrowings, based upon stated maturity
dates, was approximately 4.4 years at February 28, 2006.
8. EARNINGS PER SHARE
Basic EPS is computed by dividing net income applicable to common shares,
adjusted for costs related to vested shares under the CAP Plan, as well as
the effect of the redemption of preferred stock, by the weighted average
number of common shares outstanding. Common shares outstanding includes
vested units issued under certain stock compensation plans, which will be
distributed as shares of common stock. Diluted EPS includes the
determinants of basic EPS and, in addition, gives effect to dilutive
potential common shares related to stock compensation plans.
The computations of basic and diluted EPS are set forth below:
Three Months Ended
--------------------------------------------------------------------------
February 28 February 28,
(in thousands, except per share amounts) 2006 2005
--------------------------------------------------------------------------
Net income $ 514,156 $ 378,805
Preferred stock dividends (5,414) (6,478)
Redemption of preferred stock 27 -
Income adjustment (net of tax) applicable
to deferred compensation arrangements-vested
shares 11,777 13,884
--------------------------------------------------------------------------
Net earnings used for basic EPS 520,546 386,211
Income adjustment (net of tax) applicable
to deferred compensation
arrangements-nonvested shares 8,786 7,821
--------------------------------------------------------------------------
Net earnings used for diluted EPS $ 529,332 $ 394,032
==========================================================================
Total basic weighted average common
shares outstanding (1) 132,739 131,261
--------------------------------------------------------------------------
Effect of dilutive securities:
Employee stock options 5,288 4,348
CAP and restricted units 11,390 13,584
--------------------------------------------------------------------------
Dilutive potential common shares 16,678 17,932
--------------------------------------------------------------------------
Weighted average number of common shares
outstanding and dilutive potential common shares 149,417 149,193
==========================================================================
Basic EPS $ 3.92 $ 2.94
Diluted EPS $ 3.54 $ 2.64
==========================================================================
(1) Includes 14,684,386 and 20,293,510 vested units for the three months
ended February 28, 2006 and February 28, 2005, respectively, issued
under stock compensation plans which will be distributed as shares
of common stock.
20
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
9. REGULATORY REQUIREMENTS
Effective December 1, 2005, the Company became regulated by the SEC as a
consolidated supervised entity ("CSE"). As a CSE, the Company is subject
to group-wide supervision and examination by the SEC and is required to
compute allowable capital and allowances for market, credit and
operational risk on a consolidated basis. As of February 28, 2006, the
Company was in compliance with the CSE capital requirements.
Bear Stearns and BSSC are registered broker-dealers and futures commission
merchants and, accordingly, are subject to Rule 15c3-1 under the
Securities Exchange Act of 1934 ("Net Capital Rule") and Rule 1.17 under
the Commodity Futures Trading Commission. Effective December 1, 2005 the
SEC approved Bear Stearns' use of Appendix E of the Net Capital Rule which
establishes alternative net capital requirements for broker-dealers that
are part of consolidated supervised entities. Appendix E allows Bear
Stearns to calculate net capital charges for market risk and
derivatives-related credit risk based on mathematical models provided that
Bear Stearns holds tentative net capital in excess of $1 billion and net
capital in excess of $500 million. At February 28, 2006, Bear Stearns' net
capital of $5.1 billion exceeded the minimum requirement by $4.5 billion.
Bear Stearns' net capital computation, as defined, includes $661 million,
which is net capital of BSSC in excess of 5.5% of aggregate debit items
arising from customer transactions.
BSIL and Bear Stearns International Trading Limited ("BSIT"), London-based
broker-dealer subsidiaries, are subject to the regulatory capital
requirements of the U.K.'s Financial Services Authority.
BSB, an Ireland-based bank principally involved in the trading and sales
of fixed income products, is registered in Ireland and is subject to the
regulatory capital requirements of the Irish Financial Services Regulatory
Authority.
At February 28, 2006, Bear Stearns, BSSC, BSIL, BSIT and BSB were in
compliance with their respective regulatory capital requirements.
10. COMMITMENTS AND CONTINGENCIES
In the ordinary course of business, the Company has commitments in
connection with various activities, the most significant of which are as
follows:
Leases
The Company occupies office space under leases that expire at various
dates through 2024. At February 28, 2006, future minimum aggregate annual
rentals payable under non-cancelable leases (net of subleases), including
383 Madison Avenue in New York City, for fiscal years 2006 through 2010
and the aggregate amount thereafter, are as follows:
(in thousands)
--------------------------------
FISCAL YEAR
2006 (remaining) $ 59,809
2007 80,328
2008 78,988
2009 74,861
2010 59,291
Thereafter 212,640
--------------------------------
Total $ 565,917
================================
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,
21
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 $2.97 billion and $2.37 billion at February 28,
2006 and November 30, 2005, respectively. Of this amount, approximately
$728.3 million and $652.5 million was hedged at February 28, 2006 and
November 30, 2005, respectively. Lending-related commitments to
non-investment-grade borrowers approximated $1.57 billion and $1.44
billion at February 28, 2006 and November 30, 2005, respectively.
The Company also had contingent commitments to investment grade and
non-investment-grade companies of approximately $5.06 billion and $3.89
billion as of February 28, 2006 and November 30, 2005, respectively.
Generally, these commitments are provided in connection with leveraged
acquisitions. These commitments are not indicative of the Company's actual
risk because the borrower may never draw upon the commitment. In fact, the
borrower may not be successful in the acquisition, the borrower may access
the capital markets instead of drawing on the commitment, or the Company's
portion of the commitment may be reduced through the syndication process.
Additionally, the borrower's ability to draw may be subject to there being
no material adverse change in either market conditions or the borrower's
financial condition, among other factors. These commitments generally
contain certain flexible pricing features to adjust for changing market
conditions prior to closing.
Private Equity-Related Investments and Partnerships
In connection with the Company's merchant banking activities, the Company
has commitments to invest in merchant banking and private equity-related
investment funds as well as commitments to invest directly in private
equity-related investments. At February 28, 2006 and November 30, 2005,
such commitments aggregated $183.3 million and $222.1 million,
respectively. These commitments will be funded, if called, through the end
of the respective investment periods, with the longest of such periods
ending in 2017.
Underwriting
In connection with the Company's mortgage-backed securitizations and fixed
income underwriting, the Company had commitments to purchase new issues of
securities aggregating $47.7 million and $943.1 million, respectively, at
February 28, 2006 and November 30, 2005.
Commercial and Residential Loans
The Company participates in the acquisition, securitization, servicing,
financing and disposition of commercial and residential loans. At February
28, 2006 and November 30, 2005, the Company had entered into commitments
to purchase or finance mortgage loans of $2.18 billion and $5.1 billion,
respectively.
Letters of Credit
At February 28, 2006 and November 30, 2005, the Company was contingently
liable for unsecured letters of credit of approximately $2.70 billion and
$2.50 billion, respectively, and letters of credit of $1.14 billion and
$985.6 million, respectively, secured by financial instruments, primarily
used to provide collateral for securities borrowed and to satisfy margin
requirements at option and commodity exchanges.
Other
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $106.8 million and $159.8 million respectively, at February
28, 2006 and November 30, 2005.
The Company has executed a set of contractual arrangements providing for
the extension of credit under certain limitations with a merchant power
generator through its Houston energy venture. This facility is limited to
$350
22
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
million and is subject to various operating limits and secured by various
forms of collateral. This facility terminated on March 31, 2006 and was
never utilized.
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
On March 16, 2006, the SEC and the New York Stock Exchange ("NYSE")
announced their acceptance of the Offer of Settlement previously submitted
by the Company in connection with the previously disclosed investigations
by the SEC and the NYSE relating to mutual fund trading. Pursuant to the
terms of the settlement, the Company will, among other things, pay an
amount equal to $250 million, composed of a $90 million penalty and $160
million as disgorgement and prejudgment interest, and retain an
Independent Compliance Consultant to review procedures at Bear Stearns and
BSSC. The Company is fully reserved for this settlement. This settlement
concludes the investigations by the SEC and the NYSE regarding the
Company.
In the normal course of business, the Company has been named as a
defendant in various legal actions, including arbitrations, class actions
and other litigation. Certain of the legal actions include claims for
substantial compensatory and/or punitive damages or claims for
indeterminate amounts of damages. The Company is also involved in other
reviews, investigations and proceedings by governmental and
self-regulatory agencies regarding the Company's business, certain of
which may result in adverse judgments, settlements, fines, penalties,
injunctions or other relief.
Because litigation is inherently unpredictable, particularly in cases
where claimants seek substantial or indeterminate damages or where
investigations and proceedings are in the early stages, the Company cannot
predict with certainty the loss or range of loss related to such matters,
how such matters will be resolved, when they will ultimately be resolved,
or what the eventual settlement, fine, penalty or other relief might be.
Consequently, the Company cannot estimate losses or ranges of losses for
matters where there is only a reasonable possibility that a loss may have
been incurred. Although the ultimate outcome of these matters cannot be
ascertained at this time, it is the opinion of management, after
consultation with counsel, that the resolution of the foregoing matters
will not have a material adverse effect on the financial condition of the
Company, taken as a whole; such resolution may, however, have a material
effect on the operating results in any future period, depending on the
level of income for such period.
The Company has provided reserves for such matters in accordance with SFAS
No. 5, "Accounting for Contingencies." The ultimate resolution may differ
materially from the amounts reserved.
Tax
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations.
The Company regularly evaluates the likelihood of additional assessments
in each of the tax jurisdictions resulting from these examinations. Tax
reserves have been established, which the Company believes to be adequate
in relation to the potential for additional assessments. Once established,
reserves are adjusted as information becomes available or when an event
requiring a change to the reserve occurs.
During the quarter, the Company achieved favorable audit settlements which
resulted in a reduction in the consolidated tax provision. The Company's
effective tax rate decreased to 31.7% for the 2006 quarter from 34.5% for
the 2005 quarter.
23
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
11. GUARANTEES
In the ordinary course of business, the Company issues various guarantees
to counterparties in connection with certain derivative, leasing,
securitization and other transactions. FIN No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees
of Indebtedness of Others," requires the Company to recognize a liability
at the inception of certain guarantees and to disclose information about
its obligations under certain guarantee arrangements.
The guarantees covered by FIN No. 45 include contracts that contingently
require the guarantor to make payments to the guaranteed party based on
changes related to an asset, a liability or an equity security of the
guaranteed party, contracts that contingently require the guarantor to
make payments to the guaranteed party based on another entity's failure to
perform under an agreement and indirect guarantees of the indebtedness of
others, even though the payment to the guaranteed party may not be based
on changes to an asset, liability or equity security of the guaranteed
party. In addition, FIN No. 45 covers certain indemnification agreements
that contingently require the guarantor to make payments to the
indemnified party, such as an adverse judgment in a lawsuit or the
imposition of additional taxes due to either a change in the tax law or an
adverse interpretation of the tax law.
The following table sets forth the maximum payout/notional amounts
associated with the Company's guarantees as of February 28, 2006:
Amount of Guarantee Expiration Per Period
------------------------------------------------------
Less Than One to Three Three to Five Greather than
(in millions) One Year Years Years Five Years Total
----------------------------------------------------------------------------------------------------------------
Certain derivative contracts (notional)(1) $ 148,492 $ 255,360 $ 226,893 $ 166,232 $ 796,977
Municipal securities 2,510 286 - - 2,796
Residual value guarantee - - 570 - 570
----------------------------------------------------------------------------------------------------------------
(1) The carrying value of these derivatives approximated $1.6 billion as
of February 28, 2006.
Derivative Contracts
The Company's dealer activities cause it to make markets and trade a
variety of derivative instruments. Certain derivatives contracts that the
Company has entered into meet the accounting definition of a guarantee
under FIN No. 45. Derivatives that meet the FIN No. 45 definition of
guarantees include credit default swaps (whereby a default or significant
change in the credit quality of the underlying financial instrument may
obligate the Company to make a payment), put options, as well as floors,
caps and collars. Since the Company does not track the counterparties'
purpose for entering into a derivative contract, it has disclosed
derivatives contracts that are likely to be used to protect against a
change in an underlying financial instrument, regardless of their actual
use.
On certain of these contracts, such as written interest rate caps and
foreign currency options, the maximum payout cannot be quantified since
the increase in interest rates and foreign exchange rates is not
contractually limited by the terms of the contracts. As such, the Company
has disclosed notional amounts as a measure of the extent of its
involvement in these classes of derivatives rather than maximum payout.
Notional amounts do not represent the maximum payout and generally
overstate the Company's exposure to these contracts. These derivatives
contracts are recorded at fair value, which approximated $1.6 billion at
February 28, 2006.
In connection with these activities, the Company attempts to mitigate its
exposure to market risk by entering into a variety of offsetting
derivatives contracts and security positions.
Municipal Securities
In 1997, the Company established a program whereby it created a series of
municipal securities trusts in which it has retained interests. These
trusts purchase fixed-rate, long-term, highly rated, insured or escrowed
municipal bonds
24
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
financed by the issuance of trust certificates. Certain of the trust
certificates entitle the holder to receive future payments of principal
and variable interest and to tender such certificates at the option of the
holder on a periodic basis. The Company acts as placement agent and as
liquidity provider. The purpose of the program is to allow the Company's
clients to purchase synthetic short-term, floating-rate municipal debt
that does not otherwise exist in the marketplace. In the Company's
capacity as liquidity provider to the trusts, the maximum exposure to loss
at February 28, 2006 was approximately $2.80 billion, which represents the
outstanding amount of all trust certificates. This exposure to loss is
mitigated by the underlying municipal bonds held by trusts. The underlying
municipal bonds in the trusts are either AAA or AA rated, insured or
escrowed to maturity. Such bonds had a market value, net of related
hedges, approximating $2.87 billion at February 28, 2006.
Residual Value Guarantee
The Company has entered into an operating lease arrangement for its world
headquarters at 383 Madison Avenue in New York City (the "Synthetic
Lease"). Under the terms of the Synthetic Lease, the Company is obligated
to make monthly payments based on the lessor's underlying interest costs.
The Synthetic Lease expires on August 14, 2009 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 28, 2006, there was no expected shortfall and
the maximum residual value guarantee approximated $570 million.
Indemnifications
The Company provides representations and warranties to counterparties in
connection with a variety of commercial transactions, including certain
asset sales and securitizations and occasionally indemnifies them against
potential losses caused by the breach of those representations and
warranties. To mitigate these risks with respect to assets being
securitized that have been originated by third parties, the Company seeks
to obtain appropriate representations and warranties from such third-party
originators upon acquisition of such assets. The Company generally
performs due diligence on assets purchased and maintains underwriting
standards for assets originated. The Company may also provide
indemnifications to some counterparties to protect them in the event
additional taxes are owed or payments are withheld, due either to a change
in or adverse application of certain tax laws. These indemnifications
generally are standard contractual terms and are entered into in the
normal course of business. Generally, there are no stated or notional
amounts included in these indemnifications, and the contingencies
triggering the obligation to indemnify are not expected to occur.
Maximum payout information under these indemnifications is not readily
available because of the number, size and 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 the Company will have to make significant
payments under these arrangements.
Other Guarantees
The Company is a member of numerous exchanges and clearinghouses. Under
the membership agreements, members are generally required to guarantee the
performance of other members. Additionally, if a member becomes unable to
satisfy its obligations to the clearinghouse, other members would be
required to meet these shortfalls. To mitigate these performance risks,
the exchanges and clearinghouses often require members to post collateral.
The Company's maximum potential liability under these arrangements cannot
be quantified. However, the potential for the Company to be required to
make payments under these arrangements is remote. Accordingly, no
contingent liability is recorded in the consolidated financial statements
for these arrangements.
25
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
12. SEGMENT DATA
The Company operates in three principal segments -- Capital Markets,
Global Clearing Services and Wealth Management. These segments offer
different products and services and are managed separately as different
levels and types of expertise are required to effectively manage the
segments' transactions.
The Capital Markets segment comprises the institutional equities, fixed
income and investment banking areas. The Capital Markets segment operates
as a single integrated unit that provides the sales, trading and
origination effort for various fixed income, equity and advisory products
and services. Each of the three businesses work in tandem to deliver
these services to institutional and corporate clients.
Institutional equities consists of research, sales and trading in areas
such as domestic and international equities, block trading, convertible
bonds, over-the-counter equities, equity derivatives, risk and convertible
arbitrage and the NYSE, American Stock Exchange and International
Securities Exchange specialist activities. Fixed income includes sales,
trading and research provided to institutional clients across a variety of
products such as mortgage- and asset-backed securities, corporate and
government bonds, municipal bonds, high yield products, foreign exchange
and interest rate and credit derivatives. Investment banking provides
services in capital raising, strategic advice, mergers and acquisitions
and merchant banking. Capital raising encompasses the Company's
underwriting of equity, investment grade, municipal and high yield debt
products.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to
clearing clients worldwide. Prime brokerage clients include hedge funds
and clients of money managers, short sellers and other professional
investors. Fully disclosed clients engage in either the retail or
institutional brokerage business.
The Wealth Management segment is composed of the PCS and asset management
areas. PCS provides high-net-worth individuals with an institutional level
of investment service, including access to the Company's resources and
professionals. Asset management manages equity, fixed income and
alternative assets for leading corporate pension plans, public systems,
endowments, foundations, multi-employer plans, insurance companies,
corporations, families and high-net-worth individuals in the US and
abroad.
The three business segments comprise many business areas, with
interactions among each. Revenues and expenses include those that are
directly related to each segment. Revenues from intersegment transactions
are based upon specific criteria or agreed upon rates with such amounts
eliminated in consolidation. Individual segments also include revenues and
expenses relating to various items, including corporate overhead and
interest, which are internally allocated by the Company primarily based on
balance sheet usage or expense levels. The Company generally evaluates
performance of the segments based on net revenues and profit or loss
before provision for income taxes.
26
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Three Months Ended
--------------------------------
February 28, February 28,
(in thousands) 2006 2005
-----------------------------------------------------------------
NET REVENUES (1)
Capital Markets
Institutional Equities $ 488,494 $ 312,940
Fixed Income 888,738 865,507
Investment Banking 296,594 217,394
-----------------------------------------------------------------
Total Capital Markets 1,673,826 1,395,841
Global Clearing Services 263,992 270,392
Wealth Management
Private Client Services (2) 128,794 113,875
Asset Management 94,475 55,315
-----------------------------------------------------------------
Total Wealth Management 223,269 169,190
Other (3) 24,116 2,237
-----------------------------------------------------------------
Total net revenues $ 2,185,203 $ 1,837,660
=================================================================
PRE-TAX INCOME
Capital Markets $ 634,751 $ 481,683
Global Clearing Services 129,572 137,774
Wealth Management 32,173 14,979
Other (3) (44,143) (56,108)
-----------------------------------------------------------------
Total pre-tax income $ 752,353 $ 578,328
=================================================================
(1) Certain prior period items have been reclassified to conform to the
current period's presentation.
(2) Private Client Services detail:
Three Months Ended
--------------------------------
February 28, February 28,
2006 2005
------------------------------------------------------------------
Gross revenues, before transfer
to Capital Market segment $ 153,078 $ 133,295
Revenue transferred to Capital
Markets segment (24,284) (19,420)
------------ -----------
Private Client Services net
revenues $ 128,794 $ 113,875
============ ===========
(3) Includes consolidation and elimination entries, unallocated revenues
(predominantly interest), and certain corporate administrative
functions, including certain legal costs and costs related to the
CAP Plan. CAP Plan costs were $36.0 million and $38.0 million for
the three months ended February 28, 2006 and February 28, 2005,
respectively.
As of
------------------------------------------------
February 28, November 30, February 28,
(in thousands) 2006 2005 2005
-------------------------------------------------------------------------
SEGMENT ASSETS
Capital Markets $ 198,434,188 $ 195,292,625 $ 152,180,300
Global Clearing Services 91,375,573 85,625,396 106,753,628
Wealth Management 3,136,169 2,751,749 2,682,327
Other 7,076,760 8,965,463 6,812,819
-------------------------------------------------------------------------
Total segment assets $ 300,022,690 $ 292,635,233 $ 268,429,074
=========================================================================
27
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
13. SUBSEQUENT EVENT
On March 7, 2006, the NYSE and Archipelago Holdings, Inc. completed their
previously announced merger (the "Merger"). The Company no longer owns
membership interests in the NYSE. In their place, the Company acquired 20
trading licenses which will be effective for the remainder of 2006. The
price for each license for the calendar year 2006 is $49,290. The NYSE
will conduct an auction for such licenses each year thereafter, with the
price to be determined in accordance with that process. The Company opted
for the Cash Election, as defined, whereby the Company received $404,640
in cash and 78,601 shares of common stock of NYSE Group Inc. for each of
the fourteen seats owned. In addition, the Company also received $70,570
in dividends for each of the Company's previously owned seats.
In addition, a subsidiary of Bear Hunter Holdings LLC, the Company's
majority-owned joint venture, opted for the Standard Election, as defined,
and received $300,069 in cash and 80,177 shares of common stock of NYSE
Group Inc., together with $70,570 in dividends, for each of the eight
seats owned. A total of 62 trading licenses were also acquired by the
joint venture in January 2006.
The NYSE Group Inc. common stock issued to NYSE members in the Merger is
subject to certain transfer restrictions. The lock-up period will expire
in three equal installments on the first, second and third anniversaries
of the Merger.
28
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of The Bear Stearns Companies Inc.
We have reviewed the accompanying condensed consolidated statement of financial
condition of The Bear Stearns Companies Inc. and subsidiaries as of February 28,
2006, and the related condensed consolidated statements of income and cash flows
for the three month periods ended February 28, 2006 and February 28, 2005. These
interim financial statements are the responsibility of The Bear Stearns
Companies Inc.'s management.
We conducted our reviews in accordance with standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with standards
of the Public Company Accounting Oversight Board (United States), the objective
of which is the expression of an opinion regarding the financial statements
taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to such condensed consolidated interim financial statements for them to
be in conformity with accounting principles generally accepted in the United
States of America.
We have previously audited, in accordance with standards of the Public Company
Accounting Oversight Board (United States), the consolidated statement of
financial condition of The Bear Stearns Companies Inc. and subsidiaries as of
November 30, 2005, and the related consolidated statements of income, cash flows
and changes in stockholders' equity for the fiscal year then ended (not
presented herein) included in The Bear Stearns Companies Inc.'s Annual Report on
Form 10-K for the fiscal year ended November 30, 2005, as amended by Amendment
No. 1 thereto on Form 10-K/A; and in our report dated February 10, 2006, we
expressed an unqualified opinion on those consolidated financial statements. In
our opinion, the information set forth in the accompanying condensed
consolidated statement of financial condition as of November 30, 2005 is fairly
stated, in all material respects, in relation to the consolidated statement of
financial condition from which it has been derived.
/s/ Deloitte & Touche LLP
New York, New York
April 7, 2006
29
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The Bear Stearns Companies Inc. (the "Company") is a holding company that
through its broker-dealer and international bank subsidiaries, principally Bear,
Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp. ("BSSC"),
Bear, Stearns International Limited ("BSIL") and Bear Stearns Bank plc ("BSB"),
is a leading investment banking, securities and derivatives trading, clearance
and brokerage firm serving corporations, governments, institutional and
individual investors worldwide. BSSC, a subsidiary of Bear Stearns, provides
professional and correspondent clearing services in addition to clearing and
settling customer transactions and certain proprietary transactions of the
Company. The Company also conducts significant activities through other wholly
owned subsidiaries, including: Bear Stearns Global Lending Limited; Custodial
Trust Company; Bear Stearns Financial Products Inc.; Bear Stearns Capital
Markets Inc.; Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc.; EMC
Mortgage Corporation; and Bear Stearns Commercial Mortgage, Inc. and through its
majority owned subsidiary Bear Hunter Holdings LLC. The Company is primarily
engaged in business as a securities broker-dealer operating in three principal
segments: Capital Markets, Global Clearing Services and Wealth Management. As
used in this report, the "Company" refers (unless the context requires
otherwise) to The Bear Stearns Companies Inc. and its subsidiaries. Unless
specifically noted otherwise, all references to the three months of 2006 and
2005 refer to the three months ended February 28, 2006 and February 28, 2005,
respectively, and all references to quarters are to the Company's fiscal
quarters.
For a description of the Company's business, including its trading in cash
instruments and derivative products, its underwriting and trading policies, and
their respective risks, and the Company's risk management policies and
procedures, see the Company's Annual Report on Form 10-K for the fiscal year
ended November 30, 2005, as amended by Amendment No. 1 thereto on Form 10-K/A,
each as filed by the Company under the Securities Exchange Act of 1934, as
amended ("Exchange Act") (together, the "Form 10-K").
The Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read together with the Management's Discussion and Analysis
of Financial Condition and Results of Operations and the Consolidated Financial
Statements in the Form 10-K.
CERTAIN FACTORS AFFECTING RESULTS OF OPERATIONS
The Company's principal business activities--investment banking, securities and
derivatives sales and trading, clearance, brokerage and asset management--are,
by their nature, highly competitive and subject to various risks, including
volatile trading markets and fluctuations in the volume of market activity.
Consequently, the Company's net income and revenues have been, and are likely to
continue to be, subject to wide fluctuations, reflecting the effect of many
factors, including general economic conditions, securities market conditions,
the level and volatility of interest rates and equity prices, competitive
conditions, liquidity of global markets, international and regional political
conditions, regulatory and legislative developments, monetary and fiscal policy,
investor sentiment, availability and cost of capital, technological changes and
events, outcome of legal proceedings, changes in currency values, inflation,
credit ratings and the size, volume and timing of transactions.
These and other factors can affect the Company's volume of security new issues,
mergers and acquisitions and business restructurings; the stability and
liquidity of securities and futures markets; and ability of issuers, other
securities firms and counterparties to perform on their obligations. A decrease
in the volume of security new issues, mergers and acquisitions or restructurings
generally results in lower revenues from investment banking and, to a lesser
extent, reduced principal transactions. A reduced volume of securities and
futures transactions and reduced market liquidity generally results in lower
revenues from principal transactions and commissions. Lower price levels for
securities may result in a reduced volume of transactions, and may also result
in losses from declines in the market value of securities held in proprietary
trading and underwriting accounts. In periods of reduced sales and trading or
investment banking activity, profitability may be adversely affected because
certain expenses remain relatively fixed. The Company's securities trading,
derivatives, arbitrage, market-making, specialist, leveraged lending, leveraged
buyout and underwriting activities are conducted by it on a principal basis and
expose the Company to significant risk of loss. Such risks include market,
counterparty credit and liquidity risks. For a discussion of how the Company
seeks to manage risks, see the "Risk Management" and "Liquidity and Capital
Resources" sections of the Form 10-K.
30
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Substantial legal liability or a significant regulatory action against the
Company could have a material adverse effect or cause significant reputational
harm to the Company, which in turn could seriously harm the Company's business
prospects. Firms in the financial services industry have been operating in a
difficult regulatory environment. The Company faces significant legal risks in
its businesses, and the volume of claims and amount of damages and penalties
claimed in litigation and regulatory proceedings against financial institutions
have been increasing.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements concerning management's expectations, strategic
objectives, business prospects, anticipated economic performance and financial
condition and other similar matters are subject to risks and uncertainties,
including those described in the prior paragraphs, which could cause actual
results to differ materially from those discussed in the forward-looking
statements. Forward-looking statements speak only as of the date of the document
in which they are made. We disclaim any obligation or undertaking to provide any
updates or revisions to any forward-looking statement to reflect any change in
our expectations or any change in events, conditions or circumstances on which
the forward-looking statement is based.
EXECUTIVE OVERVIEW
Summary of Results
A favorable operating environment characterized by an expanding US economy,
improving US capital market conditions and active equity and fixed income
markets provided a healthy climate for the Company's businesses during the three
months ended February 28, 2006. Revenues, net of interest expense ("net
revenues") for the three months ended February 28, 2006 increased 18.9% to a
record $2.19 billion from $1.84 billion for the three months ended February 28,
2005, while pre-tax earnings increased 30.1% during the same period. Pre-tax
profit margins for the 2006 quarter increased to a record 34.4% when compared
with 31.5% in the 2005 quarter. Annualized return on average common equity was
20.1% for the quarter ended February 28, 2006 versus 17.8% in the prior year
quarter.
Capital Markets net revenues increased 19.9% to a record $1.67 billion for the
2006 quarter compared to $1.40 billion for the 2005 quarter. Within the Capital
Markets segment, institutional equities net revenues for the 2006 quarter
increased 56.1% to a record $488.5 million from $312.9 million for the
comparable prior year quarter. Equity derivatives net revenues increased
significantly on increased customer activity and improved market conditions.
Risk arbitrage revenues also increased on higher levels of global announced
mergers and acquisitions ("M&A") volumes during the 2006 quarter. Revenues from
the Company's energy and commodity activities increased as well, reflecting
gains from the sale of certain commodity assets and increased revenues from the
Company's energy activities. International equity sales and trading net revenues
also rose, reflecting the continued growth of the Company's European and Asian
equity activities. Fixed income net revenues increased 2.7% to a record $888.7
million for the 2006 quarter from $865.5 million for the comparable prior year
quarter. Mortgage-backed securities revenues increased in the 2006 quarter when
compared to the 2005 quarter as customer demand continued to be strong. Net
revenues from non-agency fixed rate whole loans, adjustable rate mortgages and
commercial mortgage-backed securities all improved, reflecting increased
securitization activity and tighter spreads on mortgage products due to
increased customer demand. Revenues derived from credit derivatives increased
significantly as a result of improved market share and robust customer demand
for credit products. Leveraged finance net revenues also increased as
acquisition related financing activity rose reflecting an improved M&A
environment. Investment banking revenues increased 36.4% to $296.6 million for
the 2006 quarter from $217.4 million for the 2005 quarter, as a result of
increased advisory fees and merchant banking revenues.
Global Clearing Services net revenues decreased 2.4% to $264.0 million from
$270.4 million in the 2005 quarter. Despite a 6.5% decline in average customer
interest bearing balances, net interest revenues increased 0.7% to $199.5
million from $198.1 million in the 2005 quarter on improved net interest
margins. Offsetting this increase, clearance commission revenues decreased 11.8%
to $59.2 million in the 2006 quarter from $67.1 million in the 2005 quarter
reflecting lower trading volumes and rates from prime brokerage clients.
31
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Wealth Management net revenues increased 32.0% to a record $223.3 million for
the 2006 quarter from $169.2 million in the fiscal quarter ended February 28,
2005. Revenues from private client services ("PCS") increased on higher
fee-based income derived from the Company's private client advisory services
products. Asset management revenues similarly increased due to increased
performance fees on proprietary hedge fund products and the growth in assets
under management.
Business Environment
Fiscal 2006 Quarter
The business environment during the Company's first quarter ended February 28,
2006 was favorable due to a combination of factors including an expanding US
economy, improved corporate profitability and low unemployment. The unemployment
rate dropped to 4.7% in January 2006, its lowest level in 4 1/2 years. Despite
these favorable factors, energy prices continued to be a concern during the 2006
quarter as the price of oil increased from approximately $57 a barrel at the
beginning of the quarter to approximately $68 in January 2006 and closed the
quarter at $61 at February 28, 2006. The Federal Reserve Board (the "Fed") met
twice during the quarter, raising the federal funds rate, in 25 basis point
increments, from 4.00% to 4.50%.
Each of the major US equity indices increased during the 2006 quarter. The
Standard & Poor's 500 Index ("S&P 500"), the Dow Jones Industrial Average
("DJIA"), and the Nasdaq Composite Index ("NASDAQ") increased 2.5%, 1.7% and
2.2%, respectively, during the quarter. Average daily trading volume on the New
York Stock Exchange ("NYSE") increased 9.2% while average daily trading volume
on the Nasdaq decreased 4.9% in the 2006 quarter, compared to the 2005 quarter.
Industry-wide US-announced M&A volumes decreased 15% while industry-wide
US-completed M&A volumes increased 89% compared to the first quarter of 2005.
Total equity issuance volumes increased 35% while initial public offering
("IPOs") volumes decreased 32% compared to the 2005 quarter.
Fixed income activity was robust during the 2006 quarter despite the increase in
short term interest rates and a flattening yield curve. While the Fed continued
to raise the federal funds rate during the 2006 quarter, long-term interest
rates, as measured by the 10-year Treasury bond, remained relatively stable
during the 2006 quarter. The 10-year Treasury bond yield was 4.56% at the end of
the 2006 quarter, up slightly from 4.50% at the beginning of the quarter. The
housing market experienced declines in refinancing and purchasing levels as
rates for 30-year fixed rate mortgages increased modestly during the 2006
quarter. The mortgage purchase index and mortgage refinance index decreased
approximately 2% and 25%, respectively, compared to the 2005 quarter. However,
overall US mortgage-backed securities new issue volume increased 25% during the
2006 quarter compared with the strong results achieved in the 2005 quarter.
Agency collateralized mortgage obligation ("CMO") volumes increased
approximately 5% industry-wide during the 2006 quarter from the levels reached
in the 2005 quarter while non-agency mortgage-backed originations volumes
increased approximately 33% industry-wide compared to the 2005 quarter.
Fiscal 2005 Quarter
The business environment during the Company's first quarter ended February 28,
2005 was generally favorable due to a combination of factors, including an
expanding US economy, improved corporate profitability and low interest rates.
Positive job growth reports served to boost consumer confidence during the
quarter. The Fed met twice during the quarter and raised the federal funds rate,
in 25 basis point increments, from 2.00% to 2.50% while maintaining its position
of taking a "measured" approach to monetary policy. The rate increases reflected
the Fed's concern that the US economy was showing signs of inflationary risk.
The major equity indices were mixed during the first quarter of 2005. The DJIA
and the S&P 500 increased 3.2% and 2.5%, respectively, while the NASDAQ
decreased 2.2% during the quarter. Average daily trading volume on the NYSE and
Nasdaq increased 6.4% and 5.0%, respectively, compared to the 2004 quarter.
Industry-wide announced M&A volumes increased 59% while industry-wide completed
M&A volumes decreased 15% in the 2005 quarter compared to the first quarter of
2004.
Fixed income activity was robust during the 2005 quarter, despite the increase
in short term interest rates and a flattening yield curve. Investment grade and
high yield origination volumes rose as issuers continued to take advantage of
low borrowing rates. However, higher interest rates on 30-year fixed rate
mortgages resulted in an industry-wide decline in
32
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
agency CMO activity. This decline was substantially offset by growth in
non-agency volumes. Long-term interest rates, as measured by the 10-year
Treasury bond, were flat during the 2005 quarter. At the close of the Company's
first quarter of 2005 the 10-year Treasury bond yield was 4.36%, exactly the
same rate as at the beginning of the quarter. The mortgage purchase index
increased approximately 3% during the first quarter of fiscal 2005, reflecting
the continued low level of interest rates and strong home purchasing market.
RESULTS OF OPERATIONS
Firmwide Results
The following table sets forth an overview of the Company's financial results:
Three Months Ended
-------------------------------------------
(in thousands, except per share amounts,
pre-tax profit margin and return on February 28, February 28,
average common equity) 2006 2005 % Increase
-----------------------------------------------------------------------------------------
Revenues, net of interest expense $ 2,185,203 $ 1,837,660 18.9%
Income before provision for income taxes $ 752,353 $ 578,328 30.1%
Net Income $ 514,156 $ 378,805 35.7%
Diluted earnings per share $ 3.54 $ 2.64 34.1%
Pre-tax profit margin 34.4% 31.5%
Return on average common equity (annualized) 20.1% 17.8%
-----------------------------------------------------------------------------------------
The Company reported record net income of $514.2 million, or $3.54 per share
(diluted), for the quarter ended 2006, which represented an increase of 35.7%
from $378.8 million, and 34.1% from $2.64 per share (diluted), for the quarter
ended 2005. Net revenues increased 18.9% to a record $2.19 billion for the
quarter ended 2006 from $1.84 billion for the quarter ended 2005, due to
increases in principal transactions revenues, investment banking revenues, asset
management and other revenues and net interest revenues, partially offset by a
decrease in commission revenues.
The Company's commission revenues by reporting category were as follows:
Three Months Ended
---------------------------------------------------
February 28, February 28, % (Decrease)
(in thousands) 2006 2005 Increase
--------------------------------------------------------------------------------
Institutional $ 162,459 $ 165,803 (2.0%)
Clearance 59,196 67,143 (11.8%)
Retail & other 64,416 64,431 0.0%
--------------------------------------------------------------------------------
Total commissions $ 286,071 $ 297,377 (3.8%)
================================================================================
Commission revenues for the 2006 quarter decreased 3.8% to $286.1 million from
$297.4 million for the comparable prior year quarter. Institutional commissions
decreased 2.0% to $162.5 million for the 2006 quarter from $165.8 million for
the comparable prior year quarter due to a slight decline in market share in
listed trading compared with the 2005 quarter. Clearance commissions decreased
11.8% to $59.2 million for the 2006 quarter from $67.1 million for the
comparable prior year quarter reflecting lower trading volumes and rates from
prime brokerage clients. Retail and other commissions were $64.4 million in the
2006 quarter, flat compared to the 2005 quarter.
33
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's principal transactions revenues by reporting category were as
follows:
Three Months Ended
---------------------------------------------
February 28, February 28,
(in thousands) 2006 2005 % Increase
--------------------------------------------------------------------------------
Fixed income $ 658,477 $ 615,314 7.0%
Equities 208,719 97,141 114.9%
Derivative financial instruments 283,236 266,178 6.4%
--------------------------------------------------------------------------------
Total principal transactions $ 1,150,432 $ 978,633 17.6%
================================================================================
Revenues from principal transactions for the 2006 quarter increased 17.6% to
$1.15 billion from $978.6 million for the corresponding prior year quarter due
to increases in fixed income revenues, equities revenues and derivative
financial instruments revenues. Fixed income revenues increased 7.0% to $658.5
million for the 2006 quarter from $615.3 million for the prior year quarter.
Mortgage-backed securities revenues increased when compared to the prior year
quarter as origination volumes rose on increased investor demand. During the
2006 quarter the Company ranked as the No. 1 underwriter of US mortgage-backed
securities, capturing nearly 12% of the overall US mortgage-backed securities
market. Net revenues from non-agency fixed-rate whole loans, adjustable rate
mortgages and commercial mortgage-backed securities all improved, reflecting
increased securitization activity and generally tighter mortgage spreads. In
addition, leveraged finance revenues increased as acquisition related financing
activity rose reflecting an increase in completed M&A transactions. Revenues
derived from equities activities increased 114.9% to $208.7 million during the
2006 quarter from $97.1 million in the corresponding prior year quarter. Net
revenues from the Company's international equity sales and trading area rose,
reflecting higher trading volumes resulting from rising international equity
markets as well as market share gains. In addition, net revenues from the risk
arbitrage business increased on increased global announced M&A volumes. Revenues
from the Company's energy and commodity activities also increased, reflecting
gains from the sale of certain commodity assets and increased revenues from the
Company's energy activities. Revenues from derivative financial instruments
increased 6.4% to $283.2 million in the 2006 quarter from $266.2 million in the
2005 quarter. Equity derivatives net revenues increased to record levels on
increased customer activities and favorable market conditions. Increased
customer demand for structured credit products and credit default swaps resulted
in a sharp increase in credit derivatives net revenues. These increases were
partially offset by a decline in interest rate derivatives revenues resulting
from less favorable market conditions.
The Company's investment banking revenues by reporting category were as follows:
Three Months Ended
---------------------------------------------
February 28, February 28, % (Decrease)
(in thousands) 2006 2005 Increase
--------------------------------------------------------------------------------
Underwriting $ 131,400 $ 143,989 (8.7%)
Advisory and other fees 134,992 80,130 68.5%
Merchant banking 71,461 9,591 645.1%
--------------------------------------------------------------------------------
Total investment banking $ 337,853 $ 233,710 44.6%
================================================================================
Investment banking revenues increased 44.6% to $337.9 million for the 2006
quarter from $233.7 million for the 2005 quarter. Underwriting revenues
decreased 8.7% to $131.4 million for the 2006 quarter from $144.0 million for
the corresponding prior year quarter, as high grade and equity underwriting
revenues decreased, reflecting reduced new issue volumes, partially offset by an
increase in high yield new issue activity. Advisory and other fees for the 2006
quarter increased 68.5% to $135.0 million from $80.1 million for the prior year
quarter reflecting increased M&A fees due to a significant increase in completed
M&A assignments during the 2006 quarter as well as an increase in mortgage
servicing fees. Merchant banking revenues increased to $71.5 million in the 2006
quarter from $9.6 million during the 2005 quarter attributable to gains from the
Company's principal investments as well as improved performance fees on merchant
banking funds.
Net interest revenues (interest and dividend revenue less interest expense)
increased 14.3% to $270.8 million for the 2006 quarter from $236.9 million for
the 2005 quarter. The increase in net interest revenues was primarily
attributable to improved net interest margins. Average customer margin debt
balances increased 0.8% to $64.5 billion for the 2006 quarter from $64.0 billion
for the prior year quarter. Average customer short balances decreased 11.6% to
$78.2 billion for the 2006 quarter from
34
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
$88.5 billion for the 2005 quarter and average securities borrowed balances
decreased 20.6% to $52.9 billion for the 2006 quarter from $66.6 billion for the
2005 quarter.
Asset management and other revenues increased 53.9% to $140.1 million for the
2006 quarter from $91.0 million for the 2005 quarter, primarily reflecting
increased performance fees on proprietary hedge fund products. Management fees
also increased during the 2006 quarter on higher levels of traditional assets
under management. Private client services net revenues also increased due to
higher levels of fee-based assets.
Non-Interest Expenses
The Company's non-interest expenses were as follows:
Three Months Ended
------------------------------------
February 28, February 28, % Increase
(in thousands) 2006 2005 (Decrease)
--------------------------------------------------------------------------------
Employee compensation and benefits $ 1,046,850 $ 906,775 15.4%
Floor brokerage, exchange and clearance fees 51,243 57,318 (10.6%)
Communications and technology 104,034 98,939 5.1%
Occupancy 44,627 39,594 12.7%
Advertising and market development 34,673 28,572 21.4%
Professional fees 53,873 46,719 15.3%
Other expenses 97,550 81,415 19.8%
--------------------------------------------------------------------------------
Total non-interest expenses $ 1,432,850 $ 1,259,332 13.8%
================================================================================
Employee compensation and benefits includes the cost of salaries, benefits
and incentive compensation, including restricted stock and option awards.
Employee compensation and benefits increased 15.4% to $1.05 billion for the 2006
quarter from $906.8 million for the 2005 quarter, primarily due to higher
discretionary compensation associated with the increase in net revenues.
Employee compensation and benefits as a percentage of net revenues decreased to
47.9% for the 2006 quarter from 49.3% for the 2005 quarter primarily due to the
increased level of merchant banking net revenues. Full-time employees increased
to 12,061 at February 28, 2006 from 11,019 at February 28, 2005. The growth in
headcount is primarily due to the expansion of the Company's fixed income,
investment banking and wealth management areas, resulting from increased
business activities and growth initiatives.
Non-compensation expenses increased 9.5% to $386.0 million for the 2006 quarter
from $352.6 million for the 2005 quarter. Non-compensation expenses as a
percentage of net revenues decreased to 17.7% for the 2006 quarter compared with
19.2% for the corresponding prior year quarter. Communications and technology
costs increased 5.1% as increased headcount resulted in higher voice and market
data-related costs. Occupancy costs increased 12.7% reflecting additional office
space requirements and higher leasing costs associated with the Company's
headquarters building at 383 Madison Avenue in New York City. Professional fees
increased 15.3% due to higher levels of employment agency and consulting fees.
Other expenses increased 19.8% due to increased legal and miscellaneous
expenses. CAP Plan related costs decreased slightly to $36.0 million for the
2006 quarter from $38.0 million in the comparable prior year quarter. The
increase in net revenues resulted in a pre-tax profit margin of 34.4% for the
2006 quarter versus 31.5% for the 2005 quarter.
The Company's effective tax rate decreased to 31.7% for the 2006 quarter from
34.5% for the 2005 quarter. During the quarter, the Company achieved favorable
audit settlements which resulted in a reduction in the consolidated tax
provision.
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
35
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
and Global Clearing Services distribution networks, with the related revenues of
such intersegment services allocated to the respective segments. Certain prior
period items have been reclassified between the Capital Markets and Global
Clearing Services segments to conform to the current period's presentation.
The following segment operating results exclude certain unallocated revenues
(predominantly interest) as well as certain corporate administrative functions,
such as certain legal costs and costs related to the CAP Plan. See Note 12,
"Segment Data" in the Notes to Condensed Consolidated Financial Statements for
complete segment information.
Capital Markets
Three Months Ended
-----------------------------------------------
February 28, February 28, % Increase
(in thousands) 2006 2005
------------------------------------------------------------------------------
Net revenues
Institutional equities $ 488,494 $ 312,940 56.1%
Fixed income 888,738 865,507 2.7%
Investment banking 296,594 217,394 36.4%
-------------------------------------------------------------------------------
Total net revenues $ 1,673,826 $ 1,395,841 19.9%
Pre-tax income $ 634,751 $ 481,683 31.8%
-------------------------------------------------------------------------------
The Capital Markets segment comprises the institutional equities, fixed income
and investment banking areas. The Capital Markets segment operates as a single
integrated unit that provides the sales, trading and origination effort for
various fixed income, equity and advisory products and services. Each of the
three businesses work in tandem to deliver these services to institutional and
corporate clients.
Institutional equities consists of sales, trading and research, in areas such as
domestic and international equities, block trading, convertible bonds,
over-the-counter equities, equity derivatives, risk and convertible arbitrage
and through a majority-owned joint venture, specialist activities on the NYSE,
American Stock Exchange and International Securities Exchange. Fixed income
includes sales, trading and research provided to institutional clients across a
variety of products such as mortgage- and asset-backed securities, corporate,
government and municipal bonds, high yield products, foreign exchange and
interest rate and credit derivatives. Investment banking provides services in
capital raising, strategic advice, mergers and acquisitions and merchant
banking. Capital raising encompasses the Company's underwriting of equity,
investment grade, municipal and high yield debt products.
Net revenues for Capital Markets increased 19.9% to a record $1.67 billion for
the 2006 quarter compared to $1.40 billion for the 2005 quarter. Pre-tax income
for Capital Markets increased 31.8% to $634.8 million for the 2006 quarter from
$481.7 million for the comparable prior year quarter. Pre-tax profit margin was
37.9% for the 2006 quarter compared with 34.5% for the 2005 quarter.
Institutional equities net revenues for the 2006 quarter increased 56.1% to a
record $488.5 million from $312.9 million for the comparable prior year quarter.
Equity derivatives net revenues increased to record levels due to increased
customer activities resulting from rising equity markets. Net revenues from the
Company's international equity sales and trading area rose, reflecting higher
trading volumes resulting from rising international equity markets as well as
market share gains. In addition, net revenues from the risk arbitrage business
increased on higher global announced M&A volumes. Revenues from the Company's
energy and commodity activities also increased, reflecting gains from the sale
of certain commodity assets and increased revenues from the Company's energy
activities.
Fixed income net revenues increased 2.7% to a record $888.7 million for the 2006
quarter from $865.5 million for the comparable prior year quarter.
Mortgage-backed securities revenues increased in the 2006 quarter when compared
to the prior year quarter as origination volumes rose on increased investor
demand. Net revenues from non-agency fixed-rate whole loans, adjustable rate
mortgages and commercial mortgage-backed securities all improved, reflecting
increased securitization activity and generally tighter mortgage spreads.
Leveraged finance net revenues also increased as acquisition related financing
activity rose reflecting an increase in completed M&A transactions. Credit
derivative activity also experienced strong results on
36
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
increased customer demand for credit products. Partially offsetting these
increases was a decrease in revenues from interest rate derivatives resulting
from less favorable market conditions.
Investment banking revenues increased 36.4% to $296.6 million for the 2006
quarter from $217.4 million for the 2005 quarter. Underwriting revenues
decreased 10.6% to $136.1 million for the 2006 quarter from $152.2 million for
the corresponding prior year quarter, as high grade and equity underwriting
revenues decreased, reflecting reduced new issue volumes, partially offset by an
increase in high yield underwriting. Advisory and other fees for the 2006
quarter increased 60.1% to $89.0 million from $55.6 million for the prior year
quarter reflecting increased M&A fees due to a significant increase in completed
M&A assignments during the quarter. Merchant banking revenues increased to $71.5
million in the 2006 quarter from $9.6 million during the 2005 quarter
attributable to gains from the Company's principal investments as well as
performance fees on merchant banking funds.
Global Clearing Services
Three Months Ended
---------------------------------------------------
February 28, February 28,
(in thousands) 2006 2005 % Decrease
--------------------------------------------------------------------------------
Net revenues $ 263,992 $ 270,392 (2.4%)
Pre-tax income $ 129,572 $ 137,774 (6.0%)
--------------------------------------------------------------------------------
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to clearing
clients worldwide. Prime brokerage clients include hedge funds and clients of
money managers, short sellers, arbitrageurs and other professional investors.
Fully disclosed clients engage in either the retail or institutional brokerage
business. At February 28, 2006 and February 28, 2005, the Company held
approximately $281.3 billion and $259.2 billion, respectively, in equity in
Global Clearing Services client accounts.
Net revenues for Global Clearing Services decreased 2.4% to $264.0 million for
the 2006 quarter from $270.4 million in the 2005 quarter. Despite a decline in
average customer interest bearing balances, net interest revenues increased 0.7%
to $199.5 million for the 2006 quarter from $198.1 million for the prior year
quarter, on improved net interest margins. Commission revenues decreased 11.8%
to $59.2 million for the 2006 quarter from $67.1 million for the comparable
prior year quarter reflecting lower trading volumes and rates from prime
brokerage clients. Pre-tax income decreased 6.0% to $129.6 million, from $137.8
million for the 2005 quarter, reflecting lower net revenues. Pre-tax profit
margin was 49.1% for the 2006 quarter compared to 51.0% for the 2005 quarter.
The following table presents the Company's interest-bearing balances for the
fiscal periods ended:
------------------------------------------------------------------------------
February 28, February 28,
(in billions) 2006 2005
------------------------------------------------------------------------------
Margin debt balances, average for period $ 64.5 $ 64.0
Margin debt balances, at period end 64.5 67.3
Customer short balances, average for period 78.2 88.5
Customer short balances, at period end 78.1 93.9
Securities borrowed, average for period 52.9 66.6
Securities borrowed, at period end 52.4 64.6
Free credit balances, average for period 29.9 31.1
Free credit balances, at period end 30.6 30.2
Equity held in client accounts 281.3 259.2
------------------------------------------------------------------------------
37
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Wealth Management
Three Months Ended
----------------------------------------
February 28, February 28, % Increase
(in thousands) 2006 2005 (Decrease)
--------------------------------------------------------------------------------
Private client services revenues $ 153,078 $ 133,295 14.8%
Revenue transferred to Capital Markets
segment (24,284) (19,420) (25.0%)
-----------------------------------------
Private client services net 128,794 113,875 13.1%
revenues
Asset management 94,475 55,315 70.8%
-----------------------------------------
Total net revenues $ 223,269 $ 169,190 32.0%
Pre-tax income $ 32,173 $ 14,979 114.8%
--------------------------------------------------------------------------------
The Wealth Management segment is composed of the PCS and asset management areas.
PCS provides high-net-worth individuals with an institutional level of
investment service, including access to the Company's resources and
professionals. At February 28, 2006, PCS has approximately 500 account
executives in its principal office, six regional offices and two international
offices. Asset management manages equity, fixed income and alternative assets
for corporate pension plans, public systems, endowments, foundations,
multi-employer plans, insurance companies, corporations, families and
high-net-worth individuals in the US and abroad.
Net revenues for Wealth Management increased 32.0% to a record $223.3 million
for the 2006 quarter from $169.2 million for the 2005 quarter. PCS revenues
increased 13.1% to $128.8 million for the 2006 quarter from $113.9 million for
the 2005 quarter reflecting higher levels of fee-based income attributable to
the Company's private client advisory services products. Gross revenues per
broker for brokers with the Company for more than one year were $269,630 in the
2006 quarter compared with $246,022 in the 2005 quarter. Asset management
revenues increased 70.8% to a record $94.5 million for the 2006 quarter from
$55.3 million for the 2005 quarter. This increase reflects increased performance
fees on proprietary hedge fund products and growth in assets under management.
Pre-tax income for Wealth Management increased 114.8% to $32.2 million in the
2006 quarter from $15.0 million for the 2005 quarter.
Assets under management were $45.4 billion at February 28, 2006, reflecting a
13.5% increase from $40.0 billion in assets under management at February 28,
2005. The increase in assets under management is due to the growth in
traditional equity assets. Assets under management at February 28, 2006 include
$7.0 billion of assets from alternative investment products, an increase from
$6.2 billion at February 28, 2005.
LIQUIDITY AND CAPITAL RESOURCES
Financial Leverage
Asset Composition
The Company's actual level of capital, capital requirements and thereby the
level of financial leverage, is a function of numerous variables, including
asset composition, rating agency/creditor perception, business prospects,
regulatory requirements, balance sheet liquidity, cost/availability of capital
and risk of loss. The Company consistently maintains a highly liquid balance
sheet, with the vast majority of the Company's assets consisting of cash,
marketable securities inventories and collateralized receivables arising from
customer-related and proprietary securities transactions.
Collateralized receivables consist of resale agreements secured predominantly by
US government and agency securities, customer margin loans and securities
borrowed, which are typically secured by marketable corporate debt and equity
securities. The nature of the Company's business as a securities dealer requires
it to carry significant levels of securities inventories to meet its customer
and proprietary trading needs. Additionally, the Company's role as a financial
intermediary for customer activities, which it conducts on a principal basis,
together with its customer-related activities in its clearance business, results
in significant levels of customer-related balances, including customer margin
debt, securities borrowed and repurchase activity. The Company's total assets
and financial leverage can and do fluctuate, depending largely on economic and
market conditions, volume of activity and customer demand.
38
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's total assets at February 28, 2006 increased to $300.0 billion from
$292.6 billion at November 30, 2005. The increase was primarily attributable to
increases in securities borrowed, financial instruments owned, at fair value and
cash and securities deposited with clearing organizations or segregated in
compliance with federal regulations, partially offset by a decrease in
securities purchased under agreements to resell, receivables from customers and
receivables from brokers, dealers and others. The Company's total capital base,
which consists of long-term debt, preferred equity issued by subsidiaries and
total stockholders' equity, increased to $57.6 billion at February 28, 2006 from
$54.3 billion at November 30, 2005. This change was primarily due to a net
increase in long-term debt and an increase in stockholders' equity due to
earnings as well as income tax benefits attributable to the distribution of
common stock under the Company's deferred compensation plans.
The Company's total capital base as of February 28, 2006 and November 30, 2005
was as follows:
February 28, November 30,
(in millions) 2006 2005
---------------------------------------------------------------
Long-term borrowings:
Senior debt $ 46,160 $ 43,227
Subordinated debt (1) 263 263
---------------------------------------------------------------
Total long-term borrowings $ 46,423 $ 43,490
Stockholders' equity:
Preferred stockholders' equity $ 367 $ 372
Common stockholders' equity 10,799 10,419
---------------------------------------------------------------
Total stockholders' equity $ 11,166 $ 10,791
---------------------------------------------------------------
Total capital $ 57,589 $ 54,281
===============================================================
(1) Represents junior subordinated deferrable interest debentures issued by
the Company, held by Bear Stearns Capital Trust III.
The amount of long-term debt as well as total capital that the Company maintains
is driven by a number of factors, with particular focus on asset composition.
The Company's ability to support increases in total assets is a function of its
ability to obtain short-term secured and unsecured funding, as well as its
access to longer-term sources of capital (i.e., long-term debt and equity). The
Company regularly measures and monitors its total capital requirements, which
are primarily a function of the self-funding ability of its assets. The equity
portion of total capital is primarily a function of on- and off-balance-sheet
risks (i.e., market, credit and liquidity) and regulatory capital requirements.
As such, the liquidity and risk characteristics of assets being held are
critical determinants of both total capital and the equity portion thereof, thus
significantly influencing the amount of leverage that the Company can employ.
Given the nature of the Company's market-making and customer-financing activity,
the overall size of the balance sheet fluctuates from time to time. The
Company's total assets at quarter end are lower than would be observed on an
average basis. At the end of each quarter, the Company typically uses excess
cash to finance high-quality, highly liquid securities inventory that otherwise
would be funded via the repurchase agreement market. In addition, the Company
reduces its matched book repurchase and reverse repurchase activities at quarter
end. Finally, the Company may reduce the aggregate level of inventories through
ordinary course, open market activities in the most liquid portions of the
balance sheet, which are principally US government and agency securities and
agency mortgage pass-through securities. At February 28, 2006 and November 30,
2005, total assets of $300.0 billion and $292.6 billion were approximately 5.7%
and 5.6%, respectively, lower than the average of the month-end balances
observed over the trailing 12-month period. Despite reduced total assets at
quarter end, the Company's overall market, credit and liquidity risk profile
does not change materially, since the reduction in asset balances is
predominantly in highly liquid, short-term instruments that are financed on a
secured basis. This periodic reduction verifies the inherently liquid nature of
the balance sheet and provides consistency with respect to creditor
constituents' evaluation of the Company's financial condition.
Leverage Ratios
Balance sheet leverage measures are one approach to assessing the capital
adequacy of a securities firm, such as the Company. The following table presents
total assets and net adjusted assets with the resultant leverage ratios at
February 28, 2006 and November 30, 2005. Gross leverage equals total assets
divided by stockholders' equity, inclusive of preferred and
39
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
trust preferred equity. The Company views its trust preferred equity as a
component of its equity capital base given the equity-like characteristics of
the securities. The Company also receives rating agency equity credit for these
securities. Net adjusted leverage equals net adjusted assets divided by tangible
equity capital, which excludes goodwill and intangible assets from both the
numerator and denominator, as equity used to support goodwill and intangible
assets is not available to support the balance of the Company's net assets. With
respect to a comparative measure of financial risk and capital adequacy, the
Company believes that the low-risk, collateralized nature of its securities
purchased under agreements to resell, securities borrowed, securities received
as collateral, customer receivables and segregated cash assets renders net
adjusted leverage as the relevant measure.
(in millions, except ratios) February 28, 2006 November 30, 2005
-------------------------------------------------------------------------------------------
Total assets $ 300,023 $ 292,635
Deduct:
Cash and securities deposited with clearing
organizations or segregated in compliance
with federal regulations 6,784 5,270
Securities purchased under agreements to resell 39,193 42,648
Securities received as collateral 13,149 12,426
Securities borrowed 71,103 62,915
Receivables from customers 31,387 33,255
Goodwill & intangible assets 354 355
---------------------------------------------------------------------------------------------
Subtotal 138,053 135,766
---------------------------------------------------------------------------------------------
Add:
Financial instruments sold, but not yet purchased 35,007 35,004
Deduct:
Derivative financial instruments sold,
but not yet purchased 12,229 12,957
---------------------------------------------------------------------------------------------
Net adjusted assets $ 160,831 $ 157,813
=============================================================================================
Stockholders' equity
Common equity $ 10,799 $ 10,419
Preferred stock 367 372
---------------------------------------------------------------------------------------------
Total stockholders' equity 11,166 10,791
---------------------------------------------------------------------------------------------
Add:
Trust preferred equity 263 263
---------------------------------------------------------------------------------------------
Subtotal - leverage equity 11,429 11,054
---------------------------------------------------------------------------------------------
Deduct:
Goodwill & intangible assets 354 355
---------------------------------------------------------------------------------------------
Tangible equity capital $ 11,075 $ 10,699
=============================================================================================
Gross leverage 26.3 x 26.5 x
Net adjusted leverage 14.5 x 14.8 x
---------------------------------------------------------------------------------------------
Funding Strategy & Liquidity Risk Management
General Funding Strategy
Liquidity is extraordinarily important for financial services firms in general
and for securities firms such as the Company in particular, given reliance on
market confidence. Consequently, the Company focuses on management of funding
and liquidity risk. The Company's overall objective and general funding strategy
seeks to ensure liquidity and diversity of funding sources to meet the Company's
financing needs at all times and under all market environments. In financing its
balance sheet, the Company attempts to maximize its use of secured funding where
economically competitive. Short-term sources of cash consist principally of
collateralized borrowings, including repurchase transactions, sell/buy
arrangements, securities lending arrangements and customer free credit balances.
Short-term unsecured funding sources expose the Company to rollover risk, as
providers of credit are not obligated to refinance the instruments at maturity.
For this reason, the Company seeks to
40
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
prudently manage its reliance on short-term unsecured borrowings by maintaining
an adequate total capital base and extensive use of secured funding. In addition
to this strategy, the Company places emphasis on diversification by product,
geography, maturity and instrument in order to further ensure prudent, moderate
usage of more credit-sensitive, potentially less stable, funding. Short-term
unsecured funding sources include commercial paper, bank loans and other
borrowings, which generally have maturities ranging from overnight to one year.
The Company views its secured funding as inherently less credit sensitive and
therefore a more stable source of funding due to the collateralized nature of
the borrowing.
In addition to short-term funding sources, the Company utilizes equity and
long-term debt, including floating- and fixed-rate notes, as longer-term sources
of unsecured financing. The Company regularly monitors and analyzes the size,
composition and liquidity characteristics of its asset base in the context of
each asset's ability to be used to obtain secured financing. This analysis helps
the Company in determining its aggregate need for longer-term funding sources
(i.e., long-term debt and equity). The Company views long-term debt as a stable
source of funding, which effectively strengthens its overall liquidity profile
and mitigates liquidity risk.
Alternative Funding Strategy
The Company maintains an alternative funding strategy focused on the liquidity
and self-funding ability of the underlying assets. The objective of this
strategy is to maintain sufficient cash capital (i.e., equity plus long-term
debt maturing in more than 12 months) and funding sources to enable the Company
to refinance short-term, unsecured borrowings with fully secured borrowings. As
such, the Company is not reliant upon nor does it contemplate forced balance
sheet reduction to endure a period of constrained funding availability. This
underlying approach is supported by maintenance of a formal contingency funding
plan, which includes a detailed delegation of authority and precise action steps
for managing an event-driven liquidity crisis. The plan identifies the crisis
management team, details an effective internal and external communication
strategy, and facilitates the greater information flow required to effect a
rapid and efficient transition to a secured funding environment.
As it relates to the alternative funding strategy discussed above, the Company
prepares an analysis that focuses on a 12-month time period and assumes that the
Company does not liquidate assets and cannot issue any new unsecured debt,
including commercial paper. Under these assumptions, the Company monitors its
cash position and the borrowing value of unencumbered, unhypothecated financial
instruments in relation to its unsecured debt maturing over the next 12 months,
striving to maintain the ratio of liquidity sources to maturing debt at 110% or
greater. Also within this strategy, the Company seeks to maintain cash capital
in excess of that portion of its assets that cannot be funded on a secured basis
(i.e., positive net cash capital). These two measures, liquidity ratio and net
cash capital, are complementary and constitute the core elements of the
Company's alternative funding strategy and, consequently, its approach to
funding and liquidity risk management.
The borrowing value advance rates used in the Company's liquidity ratio
calculation and the haircuts incorporated in the cash capital model are
symmetrical. These advance rates are considered readily available, even in a
stress environment. In the vast majority of circumstances/asset classes, they
are derived from committed secured bank facilities, whereby a bank or group of
banks are contractually obligated to lend to the Company at a pre-specified
advance rate on specific types of collateral regardless of "market environment."
As such, the advance rates/haircuts in the alternative liquidity models are
typically worse than those the Company realizes in normalized repo and secured
lending markets. The advance rates in the liquidity ratio reflect what can be
reliably realized in a stressed liquidity environment. The haircuts used in the
cash capital model are consistent with the advance rates in the liquidity ratio
in that the haircut is equal to one minus the advance rate.
As of February 28, 2006, the market value of unencumbered, unhypothecated
financial instruments owned by the Company was approximately $35.4 billion with
a borrowing value of $27.7 billion. The assets are composed of primarily
mortgage- and asset-backed securities, investment grade municipal and corporate
bonds, US equities and residential and commercial mortgage whole loans. The
average advance rate on these different asset types ranges from 74% to 98% and,
as described above, is based predominantly on committed, secured facilities that
the Company and its subsidiaries maintain in different regions globally. The
liquidity ratio, explained above, based solely on Company owned securities, has
averaged 147% over the previous 12 months including unused committed unsecured
bank credit, and 137% excluding the unsecured portion of the Company's $4.0
billion committed revolving credit facility. On this same basis, the liquidity
ratio was 128% as of February 28, 2006 and 121% excluding committed unsecured
bank credit. In addition to Company-owned unencumbered financial instruments, as
of February 28, 2006, the Company held $63.9 billion of collateral owned by
customers and introducing brokers that
41
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
could be repledged to raise secured funding. Of this total, $2.7 billion was
readily available to pledge to meet the Company's liquidity needs given current
reserve requirements. Inclusive of both the readily available portion of
customer and introducing broker collateral and unused committed secured bank
credit, the liquidity ratio at February 28, 2006 was 139%.
While The Bear Stearns Companies Inc. ("Parent Company") is the primary issuer
of unsecured debt in the marketplace, the collateral referred to in the
preceding paragraph is held in various subsidiaries, both regulated and
unregulated. A subsidiary's legal entity status and the Company's intercompany
funding structure may constrain liquidity available to the Parent Company, as
regulators may prevent the flow of funds and/or securities from a regulated
subsidiary to its parent company or other subsidiaries. In recognition of this
potential for liquidity to be trapped in subsidiaries, the Company maintains a
minimum $5.0 billion of liquidity immediately accessible by the Parent Company
at all times. This liquidity reserve takes the form of cash deposits and money
market instruments that are held at the Parent Company and high-quality
collateral (corporate bonds, municipal bonds, equity securities) that is owned
by subsidiaries and explicitly pledged to and segregated for the benefit of the
Parent Company and maintained at a third-party custodian. For purposes of
calculating the aggregate value of the liquidity reserve, the contractually
obligated advance rates described herein are used to determine the borrowing
value of collateral pledged. In addition to this immediately available
liquidity, the Company monitors unrestricted liquidity available to the Parent
Company via the ability to monetize unencumbered assets held in unregulated and
regulated entities. As of February 28, 2006, approximately $21.6 billion of the
market value identified in the liquidity ratio data above was held in
unregulated entities and thus unrestricted as to parent availability, while an
additional $4.0 billion market value had been pledged to the Parent Company as
collateral for inter-company borrowings and was thus readily available. The
remaining $9.8 billion market value of unencumbered securities was held in
regulated entities, a portion of which may be available to provide liquidity to
the Parent Company.
The cash capital framework is utilized to evaluate the Company's long-term
funding sources and requirements in their entirety. Cash capital required to
support all of the Company's assets is determined on a regular basis. For
purposes of broadly classifying the drivers of cash capital requirements, cash
capital usage can be delineated across two very broad categories as (1) firmwide
haircuts and (2) illiquid assets/long-term investments. More precisely, the
Company holds cash capital to support longer-term funding requirements,
including, but not limited to, the following:
o That portion of financial instruments owned that cannot be funded on
a secured basis (i.e., the haircuts);
o Margin loans and resale principal in excess of the borrowing value
of collateral received;
o Operational cash deposits required to support the regular activities
of the Company (e.g., exchange initial margin);
o Unfunded committed funding obligations, such as corporate loan
commitments;
o Less liquid and illiquid assets, such as goodwill and fixed assets;
o Uncollateralized funded loans and funded loans secured by illiquid
and/or non-rehypothecatable collateral;
o Merchant banking assets and other long-term investments; and
o Regulatory capital in excess of a regulated entity's cash capital
based longer-term funding requirements.
At February 28, 2006, the Company's net cash capital position was $4.6 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 (i.e., positive net cash capital). Over the previous 12
months, the Company's net cash capital position has averaged $1.7 billion.
In addition to the alternative funding measures above, the Company monitors the
maturity profile of its unsecured debt to minimize refinancing risk, maintains
relationships with a broad global base of debt investors and bank creditors,
establishes and adheres to strict short-term debt investor concentration limits,
and periodically tests its secured and unsecured committed credit facilities. An
important component of the Company's funding and liquidity risk management
efforts involves ongoing dialogues with a large number of creditor constituents.
Strong relationships with a diverse base of creditors and debt investors are
crucial to the Company's liquidity. The Company also maintains available sources
of short-term funding that exceed actual utilization, thus allowing it to endure
changes in investor appetite and credit capacity to hold the Company's debt
obligations.
With respect to the management of refinancing risk, the maturity profile of the
long-term debt portfolio of the Company is monitored on an ongoing basis and
structured within the context of two diversification guidelines. The Company has
a
42
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
general guideline of no more than 20% of its long-term debt portfolio maturing
in any one year, as well as no more than 10% maturing in any one quarter over
the next five years. The Company continued to meet these guidelines at the end
of the quarter ended February 28, 2006. As of February 28, 2006, the weighted
average maturity of the Company's long-term debt was 4.4 years.
Committed Credit Facilities
The Company has a committed revolving credit facility ("Facility") totaling $4.0
billion, which permits borrowing on a secured basis by the Parent Company, BSSC,
BSIL and certain other subsidiaries. The Facility also allows the Parent Company
and BSIL to borrow up to $2.0 billion of the Facility on an unsecured basis.
Secured borrowings can be collateralized by both investment grade and
non-investment-grade financial instruments as the Facility provides for defined
advance rates on a wide range of financial instruments eligible to be pledged.
The Facility contains financial covenants, the most significant of which require
maintenance of specified levels of stockholders' equity of the Company and net
capital of BSSC. The facility terminates in February 2007, with all loans
outstanding at that date payable no later than February 2008. The Company was in
compliance with all covenants and there were no borrowings outstanding under the
Facility at February 28, 2006.
The Company has a $1.50 billion committed revolving securities repo facility
("Repo Facility"), which permits borrowings secured by a broad range of
collateral under a repurchase arrangement by the Parent Company, BSIL, Bear
Stearns International Trading Limited ("BSIT") and BSB. The Repo Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company. The Repo Facility
terminates in August 2006, with all repos outstanding at that date payable no
later than August 2007. The Company was in compliance with all covenants and
there were no borrowings outstanding under the Repo Facility at February 28,
2006.
The Company has a $350 million committed revolving credit facility ("Pan Asian
Facility"), which permits borrowing on a secured basis by the Parent Company,
BSSC and BSJL. The Pan Asian Facility contains financial covenants that require,
among other things, maintenance of specified levels of stockholders' equity of
the Company and net capital of BSSC. The Pan Asian Facility terminates in
December 2006 with all loans outstanding at that date payable no later than
December 2007. The Company was in compliance with all covenants and there were
no borrowings outstanding under the Pan Asian Facility at February 28, 2006.
The Company also maintains a series of committed credit facilities to support
liquidity needs for the financing of investment grade and non-investment-grade
corporate loans, residential mortgages, commercial mortgages and listed options.
The facilities are expected to be drawn from time to time and expire at various
dates, the longest of such periods ending in fiscal 2007. All of these
facilities contain a term-out option of one year or more for borrowings
outstanding at expiration. The banks providing these facilities are committed to
provide up to an aggregate of approximately $2.9 billion. At February 28, 2006,
the borrowings outstanding under these committed credit facilities were $258.7
million.
Capital Resources
The Parent Company, operating as the centralized unsecured funding arm of the
Company, raises the vast majority of the Company's unsecured debt, including
both commercial paper and long-term debt. The Parent Company is thus the
"central bank" of the Company, where all capital is held and from which capital
is deployed. The Parent Company advances funds in the form of debt or equity to
subsidiaries to meet their operating funding needs and regulatory capital
requirements. In addition to the primary regulated subsidiaries, the Company
also conducts significant activities through other wholly owned subsidiaries,
including: Bear Stearns Global Lending Limited, Custodial Trust Company, Bear
Stearns Financial Products Inc., Bear Stearns Capital Markets Inc., Bear Stearns
Credit Products Inc., Bear Stearns Forex Inc., EMC Mortgage Corporation, Bear
Stearns Commercial Mortgage, Inc. and Bear Hunter Holdings LLC. In connection
with all of the Company's operating activities, a substantial portion of the
Company's long-term borrowings and equity has been used to fund investments in,
and advances to, these subsidiaries, including subordinated debt advances.
Within this funding framework, the Company attempts to fund equity investments
in subsidiaries with equity from the Parent Company (i.e., utilize no equity
double leverage). At February 28, 2006, the Parent Company's equity investment
in subsidiaries
43
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
was $7.6 billion versus common stockholders' equity and preferred equity of
$10.8 billion and $366.9 million, respectively. As such, at February 28, 2006,
the ratio of the equity investment in subsidiaries to Parent Company equity
(equity double leverage) was approximately 0.70 based on common equity and 0.68
including preferred equity. At November 30, 2005, these measures were 0.69 based
on common equity and 0.67 including preferred equity. Additionally, all
subordinated debt advances to regulated subsidiaries for use as regulatory
capital, which totaled $10.3 billion at February 28, 2006, are funded with
long-term debt issued by the Company having a remaining maturity equal to or
greater than the maturity of the subordinated debt advance. The Company
regularly monitors the nature and significance of assets or activities conducted
in all subsidiaries and attempts to fund such assets with both capital and/or
borrowings having a maturity profile and relative mix consistent with the nature
and self-funding ability of the assets being financed. The funding mix also
takes into account regulatory capital requirements for regulated subsidiaries.
Long-term debt totaling $39.1 billion and $37.0 billion had remaining maturities
beyond one year at February 28, 2006 and November 30, 2005, respectively. The
Company accesses funding in a variety of markets in the United States, Europe
and Asia. The Company issues debt through syndicated US registered offerings, US
registered and 144A medium-term note programs, other US and non-US bond and note
offerings and other methods. The Company's access to external sources of
financing, as well as the cost of that financing, is dependent on various
factors and could be adversely affected by a deterioration of the Company's
long- and short-term debt ratings, which are influenced by a number of factors.
These include, but are not limited to: material changes in operating margins;
earnings trends and volatility; the prudence of funding and liquidity management
practices; financial leverage on an absolute basis or relative to peers; the
composition of the balance sheet and/or capital structure; geographic and
business diversification; and the Company's market share and competitive
position in the business segments in which it operates. Material deterioration
in any one or a combination of these factors could result in a downgrade of the
Company's credit ratings, thus increasing the cost of and/or limiting the
availability of unsecured financing. Additionally, a reduction in the Company's
credit ratings could also trigger incremental collateral requirements,
predominantly in the over-the-counter derivatives market. As of February 28,
2006, a downgrade by either Moody's Investors Service or Standard & Poor's in
the Company's long-term credit ratings to the level of A3 or A- would have
resulted in the Company needing to post $54.2 million in additional collateral
pursuant to contractual arrangements for outstanding over-the-counter
derivatives contracts. A downgrade to Baa1 or BBB+ would have resulted in
needing to post an additional $329.9 million in collateral.
At February 28, 2006, the Company's long-term/short-term debt ratings were as
follows:
Rating
-------------------------------------------------------------
Dominion Bond Rating Service Limited A(high)/R-1 (middle)
Fitch Ratings A+/F1+
Moody's Investors Service A1/P-1
Rating & Investment Information, Inc. A+/NR
Standard & Poor's Ratings Services A/A-1
-------------------------------------------------------------
NR - does not assign a short-term rating
In October 2005, Standard & Poor's Ratings Services changed the outlook on The
Bear Stearns Companies Inc. from stable to positive. Simultaneously, the A/A-1
ratings were affirmed. Standard & Poor's cited the outlook change reflects the
Company's high profitability with low earnings volatility during the past
several years. Standard & Poor's also cited the strength of the Company's
various franchises, conservative management team and low tolerance for risk.
Standard & Poor's cited the outlook change indicates that the rating could be
raised during the next one to two years if the Company continues to perform
well.
Stock Repurchase Program
The Company has various employee stock compensation plans designed to increase
the emphasis on stock-based incentive compensation and align the compensation of
its key employees with the long-term interests of stockholders. Such plans
provide for annual grants of stock units and stock options. The Company intends
to offset the potentially dilutive impact of the annual grants by purchasing
common stock throughout the year in open market and private transactions. On
December
44
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
12, 2005, the Board of Directors of the Company approved an amendment to the
Stock Repurchase Program ("Repurchase Program") to replenish the previous
authorization to allow the Company to purchase up to $1.5 billion of common
stock in fiscal 2006 and beyond. During the quarter ended February 28, 2006, the
Company purchased under the current authorization a total of 3,836,329 shares at
a cost of approximately $446.9 million. The Company may, depending upon price
and other factors, acquire additional shares in excess of that required for
annual share awards. Approximately $1.05 billion was available to be purchased
under the current authorization as of February 28, 2006.
During the quarter ended February 28, 2006, the Company purchased a total of
236,116 shares of its common stock at a total cost of $29.5 million pursuant to
a $200 million CAP Plan Earnings Purchase Authorization, which was approved by
the Compensation Committee of the Board of Directors of the Company on December
9, 2005. Approximately $170.5 million is available to be purchased under the
current authorization as of February 28, 2006.
Cash Flows
Cash and cash equivalents decreased $807.7 million to $5.05 billion at February
28, 2006 from $5.86 billion at November 30, 2005. Cash used in operating
activities was $5.01 billion, primarily attributable to increases in securities
borrowed, net of securities loaned, financial instruments owned and cash and
securities deposited with clearing organizations or segregated in compliance
with federal regulations, partially offset by an increase in securities sold
under agreements to repurchase, net of securities purchased under agreements to
resell and a decrease in net receivables from customers and net receivables from
brokers, dealers and others, which occurred in the normal course of business as
a result of changes in customer needs, market conditions and trading strategies.
Cash used in investing activities of $39.2 million reflected purchases of
property, equipment and leasehold improvements. Cash provided by financing
activities of $4.24 billion reflected net proceeds from the issuance of
long-term borrowings of $4.94 billion and net proceeds relating to short-term
borrowings of $1.56 billion, primarily to fund normal operating activities. This
was partially offset by net payments for the retirement/repurchase of long-term
borrowings of $2.20 billion. Treasury stock purchases of $476.4 million were
made to provide for the annual grant of CAP Plan units, restricted stock and
stock options.
Regulated Subsidiaries
Effective December 1, 2005, the Company became regulated by the SEC as a
consolidated supervised entity ("CSE"). As a CSE, the Company is subject to
group-wide supervision and examination by the SEC and is required to compute
allowable capital and allowances for market, credit and operational risk on a
consolidated basis. As of February 28, 2006, the Company was in compliance with
the CSE capital requirements.
As registered broker-dealers and futures commission merchants, Bear Stearns and
BSSC are subject to the net capital requirements of the Exchange Act and Rule
1.17 under the Commodity Futures Trading Commission. Effective December 1, 2005
the SEC approved Bear Stearns' use of Appendix E of the Net Capital Rule which
establishes alternative net capital requirements for broker-dealers that are
part of consolidated supervised entities. Appendix E allows Bear Stearns to
calculate net capital charges for market risk and derivatives-related credit
risk based on mathematical models provided that Bear Stearns holds tentative net
capital in excess of $1 billion and net capital in excess of $500 million. BSIL
and BSIT, London-based broker-dealer subsidiaries, are subject to the regulatory
capital requirements of the U.K.'s Financial Services Authority. Additionally,
BSB is subject to the regulatory capital requirements of the Irish Financial
Services Regulatory Authority. At February 28, 2006, Bear Stearns, BSSC, BSIL,
BSIT and BSB were in compliance with their respective regulatory capital
requirements.
The Company's broker-dealer subsidiaries and other regulated subsidiaries are
subject to minimum capital requirements and may also be subject to certain
restrictions on the payment of dividends, which could limit the Company's
ability to withdraw capital from such regulated subsidiaries, which in turn
could limit the Company's ability to pay dividends. See Note 9, "Regulatory
Requirements," in the Notes to Condensed Consolidated Financial Statements.
Merchant Banking and Private Equity Investments
In connection with the Company's merchant banking activities, the Company had
investments in merchant banking and
45
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
private equity-related investment funds as well as direct investments in private
equity-related investments. At February 28, 2006, the Company held investments
with an aggregate recorded value of approximately $700.6 million, reflected in
the Condensed Consolidated Statements of Financial Condition in "Other assets."
At November 30, 2005, the Company held investments with an aggregate recorded
value of approximately $658.8 million. In addition to these various direct and
indirect principal investments, the Company has made commitments to invest in
private equity-related investments and partnerships (see the summary table under
"Commitments").
High Yield Positions
As part of its fixed income activities, the Company participates in the
underwriting and trading of non-investment-grade corporate debt securities and
also invests in, syndicates and trades in loans to highly leveraged, below
investment grade rated companies (collectively, "high yield positions").
Non-investment-grade debt securities have been defined as non-investment-grade
corporate debt and emerging market debt rated BB+ or lower, or equivalent
ratings recognized by credit rating agencies. At February 28, 2006 and November
30, 2005, the Company held high yield positions approximating $8.60 billion and
$6.71 billion, respectively, substantially all of which are in "Financial
instruments owned" in the Condensed Consolidated Statements of Financial
Condition, and $1.65 billion and $1.72 billion, respectively, reflected in
"Financial instruments sold, but not yet purchased" in the Condensed
Consolidated Statements of Financial Condition. Included in the high yield
positions are extensions of credit to highly leveraged companies. At February
28, 2006 and November 30, 2005, the amount outstanding to highly leveraged
borrowers totaled $5.94 billion and $4.24 billion, respectively. The largest
industry concentration was the telecommunications industry, which approximated
14.2% and 17.2% of these highly leveraged borrowers' positions at February 28,
2006 and November 30, 2005, respectively. Additionally, the Company has lending
commitments with highly leveraged borrowers (see the summary table under
"Commitments").
The Company's Risk Management Department and senior trading managers monitor
exposure to market and credit risk for high yield positions and establish limits
and concentrations of risk by individual issuer. High yield positions generally
involve greater risk than investment grade debt securities due to credit
considerations, liquidity of secondary trading markets and increased
vulnerability to changes in general economic conditions. The level of the
Company's high yield positions, and the impact of such activities on the
Company's results of operations, can fluctuate from period to period as a result
of customer demand, economic conditions and market considerations.
Contractual Obligations
In connection with its operating activities, the Company enters into contractual
obligations that require future cash payments. At February 28, 2006, the
Company's contractual obligations by maturity, excluding derivative financial
instruments, were as follows:
Payments Due By Period
------------------------------------------------------
Remaining Fiscal Fiscal
(in millions) Fiscal 2006 2007- 2008 2009- 2010 Thereafter Total
-------------------------------------------------------------------------------------------------------
Long-term borrowings (1) (2) $ 4,979 $ 14,929 $ 11,907 $ 14,608 $ 46,423
Future minimum lease payments (3) (4) 60 159 134 213 566
-------------------------------------------------------------------------------------------------------
(1) Amounts include fair value adjustments in accordance with Statement of
Financial Accounting Standards (`SFAS") No. 133 as well as $262.5 million
of junior subordinated deferrable interest debentures ("Debentures"). The
Debentures will mature on May 15, 2031; however, the Company, at its
option, may redeem the Debentures beginning May 15, 2006. The Debentures
are reflected in the table at their contractual maturity dates.
(2) Included in fiscal 2007 and fiscal 2008 are approximately $2.1 billion
and $0.1 billion, respectively, of floating-rate notes that are
redeemable prior to maturity at the option of the noteholder. These notes
contain certain provisions that effectively enable noteholders to put
these notes back to the Company and, therefore, are reflected in the
table at the date such notes first become redeemable. The final maturity
dates of these notes are during fiscal 2009 and fiscal 2010.
(3) Includes 383 Madison Avenue Headquarters in New York City.
(4) See Note 10, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
46
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Commitments
The Company has commitments(1) under a variety of commercial arrangements. At
February 28, 2006 the Company's commitments associated with lending and
financing, private equity-related investments and partnerships, outstanding
letters of credit, underwriting and other commercial commitments summarized by
period of expiration were as follows:
Amount of Commitment Expiration Per Period
------------------------------------------------------------
Remaining Fiscal Fiscal
(in millions) Fiscal 2006 2007- 2008 2009- 2010 Thereafter Total
-----------------------------------------------------------------------------------------------
Lending-related commitments:
Investment-grade (2) $ 1,243 $ 313 $ 1,052 $ 366 $ 2,974
Non-investment-grade 337 228 630 373 1,568
Contingent commitments (3) 314 -- -- -- 5,057
Commitments to invest in private
equity-related investments
and partnerships (4) 183
Underwriting commitments 48 -- -- -- 48
Commercial and residential loans 1,906 225 49 -- 2,180
Letters of credit 3,720 83 35 -- 3,838
Other commercial commitments 401 56 -- -- 457
-----------------------------------------------------------------------------------------------
(1) See Note 10, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
(2) In order to mitigate the exposure to investment-grade borrowings, the
Company entered into credit default swaps aggregating $728 million at
February 28, 2006.
(3) Includes $4,743 million in commitments with no stated maturity.
(4) At February 28, 2006, commitments to invest in private equity-related
investments and partnerships aggregated $183 million. These commitments
will be funded, if called, through the end of the respective investment
periods, the longest of such periods ending in 2017.
OFF-BALANCE-SHEET ARRANGEMENTS
In the normal course of business, the Company enters into arrangements with
special purpose entities ("SPEs"), also known as variable interest entities
("VIEs"). SPEs are corporations, trusts or partnerships that are established for
a limited purpose. SPEs, by their nature, are generally not controlled by their
equity owners, as the establishing documents govern all material decisions. The
Company's primary involvement with SPEs relates to securitization transactions
in which transferred assets, including commercial and residential mortgages,
consumer receivables, securities and other financial assets are sold to an SPE
and repackaged into securities or similar beneficial interests. SPEs may also be
used to create securities with a unique risk profile desired by investors and as
a means of intermediating financial risk. The Company, in the normal course of
business, may establish SPEs, sell assets to SPEs, underwrite, distribute and
make a market in securities or other beneficial interests issued by SPEs,
transact derivatives with SPEs, own securities or other beneficial interests,
including residuals, in SPEs, and provide liquidity or other guarantees for
SPEs.
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities--a Replacement of FASB
Statement No. 125," to account for securitizations and other transfers of
financial assets. In accordance with SFAS No. 140, the Company accounts for
transfers of financial assets as sales provided that control has been
relinquished. Control is deemed to be relinquished only when all of the
following conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee is a
Qualifying Special Purpose Entity ("QSPE") or has the right to pledge or
exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. Therefore, the Company
derecognizes financial assets transferred in securitizations, provided that such
transfer meets all of these criteria. See Note 4, "Transfers of Financial Assets
and Liabilities," in the Notes to Condensed Consolidated Financial Statements
for a more complete discussion of the Company's securitization activities.
47
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company regularly creates or transacts with entities that may be VIEs. These
entities are an essential part of its securitization, asset management and
structured finance businesses. In addition, the Company purchases and sells
instruments that may be variable interests. The Company adopted FIN No. 46 (R)
for its variable interests in fiscal 2004. The Company consolidates those VIEs
in which the Company is the primary beneficiary. See Note 5, "Variable Interest
Entities and Mortgage Loan Special Purpose Entities," in the Notes to Condensed
Consolidated Financial Statements for a complete discussion of the consolidation
of VIEs.
The majority of the SPEs that the Company sponsors or transacts with are QSPEs,
which the Company does not consolidate in accordance with this guidance. QSPEs
are entities that have little or no discretionary activities and may only
passively hold assets and distribute cash generated by the assets they hold. The
Company reflects the fair value of its interests in QSPEs on its balance sheet
but does not recognize the assets or liabilities of QSPEs. QSPEs are employed
extensively in the Company's mortgage and asset securitization business.
Certain other SPEs do not meet the requirements of a QSPE, because their
activities are not sufficiently limited or they have entered into certain
non-qualifying transactions. The Company follows the criteria in FIN No. 46 (R)
in determining whether it should consolidate such entities. These SPEs are
commonly employed in collateralized debt obligation transactions where portfolio
managers require the ability to buy and sell assets or in synthetic credit
transactions.
In addition to the above, in the ordinary course of business the Company issues
various guarantees to counterparties in connection with certain derivatives,
leasing, securitization and other transactions. See Note 11, "Guarantees," in
the Notes to Condensed Consolidated Financial Statements for a complete
discussion on guarantees.
DERIVATIVE FINANCIAL INSTRUMENTS
Derivative financial instruments are contractual commitments between
counterparties that derive their values from changes in an underlying interest
rate, currency exchange rate, index (e.g., S&P 500), reference rate (e.g.,
LIBOR), or asset value referenced in the related contract. Some derivatives,
such as futures contracts, certain options and index-referenced warrants, can be
traded on an exchange. Other derivatives, such as interest rate and currency
swaps, caps, floors, collars, swaptions, equity swaps and options, structured
notes and forward contracts, are negotiated in the over-the-counter markets.
Derivatives generate both on- and off-balance-sheet risks depending on the
nature of the contract. The Company is engaged as a dealer in over-the-counter
derivatives and, accordingly, enters into transactions involving derivative
instruments as part of its customer-related and proprietary trading activities.
The Company's dealer activities require it to make markets and trade a variety
of derivative instruments. In connection with these activities, the Company
attempts to mitigate its exposure to market risk by entering into hedging
transactions that may include over-the-counter derivatives contracts or the
purchase or sale of interest-bearing securities, equity securities, financial
futures and forward contracts. The Company also utilizes derivative instruments
to hedge proprietary market-making and trading activities. In this regard, the
utilization of derivative instruments is designed to reduce or mitigate market
risks associated with holding dealer inventories or in connection with
arbitrage-related trading activities. The Company also utilizes interest rate
and currency swaps, futures contracts and US Treasury positions to hedge its
debt issuances as part of its asset and liability management.
To measure derivative activity, notional or contract amounts are frequently
used. Notional/contract amounts are used to calculate contractual cash flows to
be exchanged and are generally not actually paid or received, with the exception
of currency swaps, foreign exchange forwards and mortgage-backed securities
forwards. The notional/contract amounts of financial instruments that give rise
to off-balance-sheet market risk are indicative only to the extent of
involvement in the particular class of financial instruments and are not
necessarily an indication of overall market risk.
As of February 28, 2006 and November 30, 2005, the Company had notional/contract
amounts of approximately $5.89 trillion and $5.45 trillion, respectively, of
derivative financial instruments, of which $1.21 trillion and $1.13 trillion,
respectively, were listed futures and option contracts. The aggregate
notional/contract value of derivative contracts is a reflection of the level of
activity and does not represent the amounts that are recorded in the Condensed
Consolidated Statements of Financial Condition. The Company's derivative
financial instruments outstanding, which either are used to hedge trading
positions, modify the interest rate characteristics of its long- and short-term
debt, or are part of its derivative
48
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
dealer activities, are marked to fair value.
The Company's derivatives had a notional weighted average maturity of
approximately 4.2 years and 4.1 years at February 28, 2006 and November 30,
2005, respectively. The maturities of notional/contract amounts outstanding for
derivative financial instruments as of February 28, 2006 were as follows:
Less Than One to Three to Greater Than
(in billions) One Year Three Years Five Years Five Years Total
-------------------------------------------------------------------------------------------------------------
Swap agreements, including
options, swaptions, caps,
collars and floors $ 817.2 $ 1,228.3 $ 1,045.6 $ 1,465.2 $ 4,556.3
Futures contracts 370.5 178.0 21.9 - 570.4
Forward contracts 103.6 - - - 103.6
Options held 360.4 68.0 0.7 0.1 429.2
Options written 209.4 23.9 0.8 0.2 234.3
-------------------------------------------------------------------------------------------------------------
Total $ 1,861.1 $ 1,498.2 $ 1,069.0 $ 1,465.5 $ 5,893.8
=============================================================================================================
Percent of total 31.6% 25.4% 18.1% 24.9% 100.0%
=============================================================================================================
CRITICAL ACCOUNTING POLICIES
The condensed consolidated financial statements of the Company are prepared in
conformity with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions that could materially affect reported amounts in the financial
statements (see Note 1, "Summary of Significant Accounting Policies," in the
Notes to Condensed Consolidated Financial Statements). Critical accounting
policies are those policies that are the most important to the financial
statements and/or those that require significant management judgment related to
matters that are uncertain.
Valuation of Financial Instruments
The Company has identified the valuation of financial instruments as a critical
accounting policy due to the complex nature of certain of its products, the
degree of judgment required to appropriately value these products and the
pervasive impact of such valuation on the financial condition and earnings of
the Company.
The Company's financial instruments can be aggregated in three broad categories:
(1) those whose fair value is based on quoted market prices or for which the
Company has independent external valuations, (2) those whose fair value is
determined based on readily observable price levels for similar instruments
and/or models or methodologies that employ data that are observable from
objective sources, and (3) those whose fair value is estimated based on
internally developed models or methodologies utilizing significant assumptions
or other data that are generally less readily observable from objective sources.
(1) Financial Instruments Valued Based on Quoted Market Prices or for Which the
Company Has Independent External Valuations
The Company's valuation policy is to use quoted market prices from securities
and derivatives exchanges where they are available and reliable. Financial
instruments valued based on quoted market prices are primarily exchange-traded
derivatives and listed equities. Financial instruments that are most typically
valued using alternative approaches but for which the Company typically receives
independent external valuation information include US Treasuries, most
mortgage-backed securities and corporate, emerging market, high yield and
municipal bonds. Unlike most equities, which tend to be traded on exchanges, the
vast majority of fixed income trading (including US Treasuries) occurs in
over-the-counter markets, and, accordingly, the Company's valuation policy is
based on its best estimate of the prices at which these financial instruments
trade in those markets. The Company is an active dealer in most of the
over-the-counter markets for these financial instruments, and typically has
considerable insight into the trading level of financial instruments held in
inventory and/or
49
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
related financial instruments that it uses as a basis for its valuation.
(2) Financial Instruments Whose Fair Value Is Determined Based on Internally
Developed Models or Methodologies That Employ Data That Are Readily Observable
from Objective Sources
The second broad category consists of financial instruments for which the
Company does not receive quoted prices; therefore, models or other methodologies
are utilized to value these financial instruments. Such models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates, loss
severity, current market and contractual prices for the underlying financial
instruments, as well as other relevant economic measures. Substantially all
these assumptions are observable in the marketplace, can be derived from
observable data or are supported by observable levels at which transactions are
executed in the marketplace. A degree of subjectivity is required to determine
appropriate models or methodologies as well as appropriate underlying
assumptions. This subjectivity makes these valuations inherently less reliable
than quoted market prices. Financial instruments in this category include
non-exchange-traded derivatives such as interest rate swaps, certain
mortgage-backed securities and certain other cash instruments. For an indication
of the Company's involvement in derivatives, including maturity terms, see the
table setting forth notional/contract amounts outstanding in the preceding
"Derivative Financial Instruments" section.
(3) Financial Instruments Whose Fair Value Is Estimated Based on Internally
Developed Models or Methodologies Utilizing Significant Assumptions or Other
Data That Are Generally Less Readily Observable from Objective Sources
Certain complex financial instruments and other investments have significant
data inputs that cannot be validated by reference to readily observable data.
These instruments are typically illiquid, long dated or unique in nature and
therefore engender considerable judgment by traders and their management who, as
dealers in many of these instruments, have the appropriate knowledge to estimate
data inputs that are less readily observable. For certain instruments,
extrapolation or other methods are applied to observed market or other data to
estimate assumptions that are not observable.
The Company follows Emerging Issues Task Force ("EITF") Statement No. 02-3,
"Issues Involved in Accounting for Derivative Contracts Held for Trading
Purposes and Contracts Involved in Energy Trading and Risk Management
Activities." This guidance generally eliminates the practice of recognizing
profit at the inception of a derivative contract unless the fair value of the
derivative is obtained from a quoted market price in an active market or is
otherwise evidenced by comparison to other observable current market
transactions or based on a valuation technique that incorporates observable
market data.
The Company participates in the underwriting, securitization or trading of
non-performing mortgage-related assets, real estate assets and certain
residuals. In addition, the Company has a portfolio of Chapter 13 and other
credit card receivables from individuals. Certain of these high yield positions
have limited price observability. In these instances, fair values are determined
by statistical analysis of historical cash flows, default probabilities,
recovery rates, time value of money and discount rates considered appropriate
given the level of risk in the instrument and associated investor yield
requirements.
The Company is also engaged in structuring and acting as principal in complex
derivative transactions. Complex derivatives include certain long-dated equity
derivatives, certain credit and municipal derivatives and other exotic
derivative structures. These non-exchange-traded instruments may have immature
or limited markets and, by their nature, involve complex valuation methodologies
and models, which are often refined to correlate with the market risk of these
instruments.
At February 28, 2006 and November 30, 2005, the total value of all financial
instruments whose fair value is estimated based on internally developed models
or methodologies utilizing significant assumptions or other data that are
generally less readily observable from objective sources (primarily fixed income
cash positions) aggregated approximately $8.9 billion and $7.1 billion,
respectively, in "Financial instruments owned" and $4.1 billion and $3.5
billion, respectively, in "Financial instruments sold, but not yet purchased" in
the Condensed Consolidated Statements of Financial Condition.
Controls Over Valuation of Financial Instruments
In recognition of the importance the Company places on the accuracy of its
valuation of financial instruments as described in the three categories above,
the Company engages in an ongoing internal review of its valuations. Members of
the Controllers
50
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
and Risk Management Departments perform analysis of internal valuations,
typically on a monthly basis but often on an intra-month basis as well. These
departments are independent of the trading areas responsible for valuing the
positions. Results of the monthly validation process are reported to the
Mark-to-Market Committee ("MTMC"), which is composed of senior management from
the Risk Management and Controllers Departments. The MTMC is responsible for
ensuring that the approaches used to independently validate the Company's
valuations are robust, comprehensive and effective. Typical approaches include
valuation comparisons with external sources, comparisons with observed trading,
independent comparisons of key model valuation inputs, independent trade
modeling and a variety of other techniques.
Merchant Banking
As part of its merchant banking activities, the Company participates from time
to time in principal investments in leveraged transactions. As part of these
activities, the Company originates, structures and invests in merger,
acquisition, restructuring and leveraged capital transactions, including
leveraged buyouts. The Company's principal investments in these transactions are
generally made in the form of equity investments, equity-related investments or
subordinated loans and have not historically required significant levels of
capital investment.
Equity interests and securities acquired as a result of leveraged acquisition
transactions are reflected in the condensed consolidated financial statements at
their initial cost until significant transactions or developments indicate that
a change in the carrying value of the securities is appropriate. Generally, the
carrying values of these securities will be increased only in those instances
where market values are readily ascertainable by reference to substantial
transactions occurring in the marketplace or quoted market prices. If quoted
market prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, fair value is determined based on
other relevant factors. Reductions to the carrying value of these securities are
made in the event that the Company's estimate of net realizable value has
declined below the carrying value. See "Merchant Banking and Private Equity
Investments" in Management's Discussion and Analysis for additional details.
Legal, Regulatory and Tax Contingencies
In the normal course of business, the Company has been named as a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental and self-regulatory agencies regarding the Company's
business, certain of which may result in adverse judgments, settlements, fines,
penalties, injunctions or other relief.
Reserves for litigation and regulatory proceedings are generally determined on a
case-by-case basis and represent an estimate of probable losses after
considering, among other factors, the progress of each case, prior experience,
and the experience of others in similar cases, and the opinions and views of
internal and external legal counsel. Because litigation is inherently
unpredictable, particularly in cases where claimants seek substantial or
indeterminate damages or where investigations and proceedings are in the early
stages, the Company cannot predict with certainty the loss or range of loss
related to such matters, how such matters will be resolved, when they will
ultimately be resolved, or what the eventual settlement, fine, penalty or other
relief might be.
The Company is subject to the income tax laws of the US, its states and
municipalities and those of the foreign jurisdictions in which the Company has
significant business operations. These tax laws are complex and subject to
different interpretations by the taxpayer and the relevant governmental taxing
authorities. The Company must make judgments and interpretations about the
application of these inherently complex tax laws when determining the provision
for income taxes and must also make estimates about when in the future certain
items affect taxable income in the various tax jurisdictions. Disputes over
interpretations of the tax laws may be settled with the taxing authority upon
examination or audit. The Company regularly evaluates the likelihood of
assessments in each of the taxing jurisdictions resulting from current and
subsequent years' examinations and tax reserves are established as appropriate.
The Company establishes reserves for potential losses that may arise out of
litigation, regulatory proceedings and tax audits to the extent that such losses
are probable and can be estimated, in accordance with SFAS No. 5, "Accounting
for Contingencies." Once established, reserves are adjusted as additional
information becomes available or when an event
51
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
requiring a change to the reserves occurs. Significant judgment is required in
making these estimates and the ultimate resolution may differ materially from
the amounts reserved.
ACCOUNTING AND REPORTING DEVELOPMENTS
In June 2005, the EITF reached a consensus on EITF Issue No. 04-5, "Determining
Whether a General Partner, or the General Partners as a Group, Controls a
Limited Partnership or Similar Entity When the Limited Partners Have Certain
Rights." The EITF consensus requires a general partner in a limited partnership
to consolidate the limited partnership unless the presumption of control is
overcome. The general partner may overcome this presumption of control and not
consolidate the entity if the limited partners have: (a) the substantive ability
to dissolve or liquidate the limited partnership or otherwise remove the general
partner without having to show cause; or (b) substantive participating rights in
managing the partnership. This guidance became effective upon ratification by
the FASB on June 29, 2005 for all newly formed limited partnerships and for
existing limited partnerships for which the partnership agreements have been
modified. For all other limited partnerships, the guidance is effective no later
than the beginning of the first reporting period in fiscal years beginning after
December 15, 2005. The Company does not expect the EITF consensus on EITF issue
No. 04-5 to have a material impact on the consolidated financial statements of
the Company.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid
Financial Instruments." SFAS No. 155 is an amendment of SFAS No. 133 and SFAS
No. 140. SFAS No. 155 permits companies to elect, on a deal by deal basis, to
apply a fair value remeasurement for any hybrid financial instrument that
contains an embedded derivative that otherwise would require bifurcation. SFAS
No. 155 is effective for all financial instruments acquired or issued after the
beginning of an entity's first fiscal year that begins after September 15, 2006.
The impact of SFAS No. 155 on the Company's consolidated financial statements is
currently being evaluated.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets." SFAS No. 156 amends SFAS No. 140. SFAS No. 156 requires that
all separately recognized servicing assets and servicing liabilities be
initially measured at fair value. For subsequent measurements, SFAS No. 156
permits companies to choose between using an amortization method or a fair value
measurement method for reporting purposes. SFAS No. 156 is effective as of the
beginning of a company's first fiscal year that begins after September 15, 2006.
The Company does not expect SFAS No. 156 to have a material impact on the
consolidated financial statements of the Company.
EFFECTS OF INFLATION
The Company's assets are primarily recorded at their current market value and,
to a large extent, are liquid in nature. The rate of inflation affects the
Company's expenses, such as employee compensation, office leasing costs,
information technology and communications charges, which may not be readily
recoverable in the price of services offered by the Company. In addition, to the
extent that inflation causes interest rates to rise and has other adverse
effects on the securities markets and on the value of securities held in
inventory, it may adversely affect the Company's financial position and results
of operations.
52
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
For a description of the Company's risk management policies, including a
discussion of the Company's primary market risk exposures, which include
interest rate risk, foreign exchange rate risk and equity price risk, as well as
a discussion of the Company's credit risk and a discussion of how those
exposures are managed, refer to the Company's Annual Report on Form 10-K for the
fiscal year ended November 30, 2005.
Value-at-Risk
An estimation of potential losses that could arise from changes in market
conditions is typically accomplished through the use of statistical models known
as value-at-risk ("VaR") that seek to predict risk of loss based on historical
and/or market-implied price and volatility patterns. VaR estimates the
probability of the value of a financial instrument rising above or falling below
a specified amount. The calculation uses the simulated changes in value of the
market risk-sensitive financial instruments to estimate the amount of change in
the current value that could occur at a specified probability level.
The Company has performed an entity-wide VaR analysis of the Company's financial
assets and liabilities, including financial instruments owned and sold,
repurchase and resale agreements and funding assets and liabilities. The Company
regularly evaluates and enhances such VaR models in an effort to more accurately
measure risk of loss. Certain equity-method investments and non-publicly traded
investments are not reflected in the VaR results. The VaR related to certain
non-trading financial instruments has been included in this analysis and is not
reported separately because the amounts are not material. The calculation is
based on a methodology that uses a one-day interval and a 95% confidence level.
The Company uses a historical simulation approach for VaR, which is supplemented
by statistical risk add-ons for risk factors that do not lend themselves readily
to historical simulation. Historical simulation involves the generation of price
movements in a portfolio using price sensitivities, and actual historical
movements of the underlying risk factors to which the securities are sensitive.
Risk factors incorporated via historical simulation include interest rate
movements, yield curve shape, general market credit spreads, equity price
movement, option volatility movement (for certain option types) and foreign
exchange movement, among others. Risk factors incorporated via add-on factors
include the risk of specific bond issuers, among others. The Company believes
that its VaR methodologies are consistent with industry practices for these
calculations.
VaR has inherent limitations, including reliance on historical data, which may
not accurately predict future market risk, and the quantitative risk information
generated is limited by the parameters established in creating the models. There
can be no assurance that actual losses occurring on any one day arising from
changes in market conditions will not exceed the VaR amounts shown below or that
such losses will not occur more than once in 20 trading days. VaR is not likely
to accurately predict exposures in markets that exhibit sudden fundamental
changes or shifts in market conditions or established trading relationships.
Many of the Company's hedging strategies are structured around likely
established trading relationships and, consequently, those hedges may not be
effective and VaR models may not accurately predict actual results. Furthermore,
VaR calculated for a one-day horizon does not fully capture the market risk of
positions that cannot be liquidated in a one-day period. However, the Company
believes VaR models are an established methodology for the quantification of
risk in the financial services industry despite these limitations. VaR is best
used in conjunction with other financial disclosures in order to assess the
Company's risk profile.
53
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The aggregate VaR presented here is less than the sum of the individual
components (i.e., interest rate risk, foreign exchange rate risk, equity risk),
due to the benefit of diversification among the risks. Diversification benefit
equals the difference between aggregate VaR and the sum of the VaRs for the
three risk categories. This benefit arises because the simulated one-day losses
for each of the three primary market risk categories occur on different days and
because of general diversification benefits introduced when risk is measured
across a larger set of specific risk factors than exist in the respective
categories; similar diversification benefits also are taken into account across
risk factors within each category. The following table illustrates the VaR for
each component of market risk as of February 28, 2006, November 30, 2005, August
31, 2005 and May 31, 2005. Commodity risk has been excluded due to immateriality
for each period presented.
February 28, November 30, August 31, May 31,
(in millions) 2006 2005 2005 2005
--------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 25.6 $ 22.1 $ 25.8 $ 23.9
Currency 0.4 0.3 0.5 3.4
Equity 3.4 3.6 1.1 2.5
Diversification benefit (4.5) (4.6) (3.1) (6.9)
--------------------------------------------------------------------------------
Aggregate VaR $ 24.9 $ 21.4 $ 24.3 $ 22.9
================================================================================
The table below illustrates the high, low and average VaR for each component of
market risk and aggregate market risk during the quarters ended February 28,
2006 and November 30, 2005:
Quarter Ended February 28, 2006 Quarter Ended November 30, 2005
--------------------------------------------------------------------------------------
(in millions) High Low Average High Low Average
--------------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 30.5 $ 20.3 $ 24.8 $ 28.5 $ 20.0 $ 23.5
Currency 1.6 0.0 0.6 3.4 0.1 0.9
Equity 5.6 2.5 3.8 4.6 1.0 2.7
Aggregate VaR 30.1 19.0 23.8 28.8 18.1 22.9
--------------------------------------------------------------------------------------
As previously discussed, the Company utilizes a wide variety of market risk
management methods, including trading limits; marking all positions to market on
a daily basis; daily profit and loss statements; position reports; daily risk
highlight reports; aged inventory position reports; and independent verification
of inventory pricing. Additionally, management of each trading department
reports positions, profits and losses and notable trading strategies to the Risk
Committee on a weekly basis. The Company believes that these procedures, which
stress timely communication between traders, trading department management and
senior management, are the most important elements of the risk management
process.
Stress testing (also referred to as scenario analysis) measures the risk of loss
over a variety of extreme market conditions that are defined in advance. Stress
testing is a key methodology used in the management of market risk as well as
counterparty credit risk (see "Credit Risk"). Stress tests are calculated at the
firmwide level for particular trading books, customer accounts and individual
positions. Stress tests are performed on a regular basis as well as on an ad hoc
basis, as deemed appropriate. The ongoing evaluation process of trading risks as
well as the consideration of new trading positions commonly incorporates an ad
hoc discussion of "what-if" stressed market conditions and their impact on
profitability. This analysis varies in its degree of formality based on the
judgment of trading department management, risk management and senior managers.
While the Company recognizes that no methodology can perfectly predict future
market conditions, it believes that these tools are an important supplement to
the Company's risk management process. The Company expects to continue to
develop and refine its formal stress testing methodologies.
The following chart represents a summary of the daily principal transactions
revenues and reflects a combination of trading revenues, net interest revenues
for certain trading areas and other revenues for the quarters ended February 28,
2006 and 2005. The chart represents a historical summary of the results
generated by the Company's trading activities as opposed to the probability
approach used by the VaR model. The average daily trading profit was $19.2
million and $16.0 million for the
54
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
quarters ended February 28, 2006 and 2005, respectively. There were three daily
trading losses for the quarter ended February 28, 2006 and no daily trading
losses for the quarter ended February 28, 2005. Daily trading losses never
exceeded the reported average VaR amounts during the fiscal quarters ended
February 28, 2006 and 2005. The frequency distribution of the Company's daily
net trading revenues reflects the Company's historical ability to manage its
exposure to market risk and the diversified nature of its trading activities.
Market conditions were favorable for the Company's trading activity in both its
quarters ending February 28, 2006 and 2005. Hedging strategies were generally
effective as established trading relationships remained substantially intact and
volatility tended to be lower than historical norms. No guarantee can be given
regarding future net trading revenues or future earnings volatility. However,
the Company believes that these results are indicative of its commitment to the
management of market trading risk.
DISTRIBUTION OF DAILY NET TRADING REVENUES
Quarters Ended February 28, 2006 and February 28, 2005
Daily Trading Plot Points
TBSCI
Quarters ended 2/28/06 & 2/28/05
February 28, 2006 February 28, 2005
----------------------------- -------------------------
(10)+ - (10)+ -
(10)-(5) - (10)-(5) -
(5)-0 3 (5)-0 -
0-5 6 0-5 4
5-10 6 5-10 11
10-15 9 10-15 11
15-20 11 15-20 22
20-25 9 20-25 9
25-30 6 25-30 3
30+ 10 30+ 1
--------------- -------------
Total 60 Total 61
55
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Credit Risk
The Company measures its actual credit exposure (the replacement cost of
counterparty contracts) on a daily basis. Master netting agreements, collateral
and credit insurance are used to mitigate counterparty credit risk. The credit
exposures reflect these risk-reducing features to the extent they are legally
enforceable. The Company's net replacement cost of derivative contracts in a
gain position at February 28, 2006 and November 30, 2005 approximated $3.56
billion and $4.41 billion, respectively. Exchange-traded financial instruments,
which typically are guaranteed by a highly rated clearing organization, have
margin requirements that substantially mitigate the risk of credit loss.
The following table summarizes the counterparty credit quality of the Company's
exposure with respect to over-the-counter derivatives (including foreign
exchange and forward-settling mortgage transactions) as of February 28, 2006:
Over-the-Counter Derivative Credit Exposure (1)
($ in millions)
Percentage of
Exposure, Net of Exposure, Net
Rating (2) Exposure Collateral (3) Collateral (4) of Collateral
------------------------------------------------------------------------------------------------
AAA $ 1,037 $ 54 $ 984 28%
AA 3,541 2,323 1,366 38%
A 2,033 1,271 829 23%
BBB 312 370 169 5%
BB and lower 863 2,373 189 5%
Non-rated 24 7 23 1%
------------------------------------------------------------------------------------------------
(1) Excluded are covered transactions structured to ensure that the
market values of collateral will at all times equal or exceed the
related exposures. The net exposure for these transactions will,
under all circumstances, be zero.
(2) Internal counterparty credit ratings, as assigned by the Company's
Credit Department, converted to rating agency equivalents.
(3) For lower-rated counterparties, the Company generally receives
collateral in excess of the current market value of derivative
contracts.
(4) In calculating exposure net of collateral, collateral amounts are
limited to the amount of current exposure for each counterparty.
Excess collateral is not applied to reduce exposure because such
excess in one counterparty portfolio cannot be applied to deficient
collateral in a different counterparty portfolio.
56
Item 4. CONTROLS AND PROCEDURES
As required by Rule 13a-15(b) of the Exchange Act, the Company's management,
including the Company's Chief Executive Officer and Chief Financial Officer, has
evaluated the effectiveness of its disclosure controls and procedures as of the
end of the period covered by this quarterly report. Based on that evaluation,
the Chief Executive Officer and Chief Financial Officer have concluded that the
Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under
the Exchange Act) were effective as of the end of the period covered by this
quarterly report. As required by Rule 13a-15(d) under the Exchange Act, the
Company's management, including the Company's Chief Executive Officer and Chief
Financial Officer, has evaluated the Company's internal control over financial
reporting to determine whether any changes occurred during the quarter covered
by this quarterly report that have materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting. Based on
that evaluation, there have been no such changes during the quarter covered by
this quarterly report.
57
Part II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
In the normal course of business, the Company has been named a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental and self-regulatory organizations regarding the
Company's business. Certain of the foregoing could result in adverse judgments,
settlements, fines, penalties or other relief.
Because litigation is inherently unpredictable, particularly in cases where
claimants seek substantial or indeterminate damages or where investigations and
proceedings are in the early stages, the Company cannot predict with certainty
the loss or range of loss related to such matters, how such matters will be
resolved, when they will be ultimately resolved, or what the eventual
settlement, fine, penalty or other relief might be. Consequently, the Company
cannot estimate losses or ranges of losses for matters where there is only a
reasonable possibility that a loss may have been incurred. Although the ultimate
outcome of these matters cannot be ascertained at this time, it is the opinion
of management, that the resolution of the foregoing matters will not have a
material adverse effect on the financial condition of the Company, taken as a
whole; such resolution may, however, have a material effect on the operating
results in any future period, depending on the level of income for such period.
The Company has provided reserves for such matters in accordance with Statement
of Financial Accounting Standards No. 5, "Accounting for Contingencies". The
ultimate resolution may differ from the amounts reserved.
Certain legal proceedings in which the Company is involved are discussed in Note
17 to the consolidated financial statements included in the Company's 2005
Financial Report; Part I, Item 3, of the Company's Annual Report on Form 10-K
for the fiscal year ended November 30, 2005, as amended by Amendment No. 1
thereto on Form 10-K/A (together the "Form 10-K"). The following discussion is
limited to recent developments concerning our legal proceedings and should be
read in conjunction with those earlier Reports.
In re McKesson HBOC, Inc. Securities Litigation: This matter arises out of a
merger between McKesson Corporation ("McKesson") and HBO & Company ("HBOC")
resulting in an entity called McKesson HBOC, Inc. ("McKesson HBOC"). As
previously reported in the Form 10-K, on September 8, 2005, the court granted
preliminary approval of the revised proposed settlement between McKesson HBOC
and the plaintiff class. On February 24, 2006, the court granted final approval
of the revised proposed settlement. On March 23, 2006, Bear Stearns filed notice
with the court of its intent to appeal the final approval order to the United
States Circuit Court of Appeals for the Ninth Circuit. Bear Stearns intends to
seek reversal of the final approval order and the settlement by the Ninth
Circuit on the grounds it raised in opposition to final approval.
Purported Securities Actions Related to Enron Corp.: As previously reported in
the Form 10-K, Bear Stearns has been defending an Enron-related litigation
pending against it in the United States District Court for the Southern District
of Texas. Bear Stearns and the plaintiffs in that litigation have reached an
agreement to settle this action. By Order dated April 4, 2006, the court
dismissed Bear Stearns from this action with prejudice.
Mutual Fund Matters: As previously reported in the Form 10-K, Bear Stearns and
BSSC had submitted an Offer of Settlement to the U.S. Securities and Exchange
Commission (the "SEC") and the New York Stock Exchange (the "NYSE") to resolve
investigations by these agencies relating to mutual fund trading. On March 16,
2006, the SEC and the NYSE announced their acceptance of the Offer of Settlement
submitted by Bear Stearns and BSSC. Pursuant to the terms of the settlement,
Bear Stearns and BSSC are required, among other things, to pay an amount equal
to $250 million, composed of a $90 million penalty and $160 million as
disgorgement and to retain an Independent Compliance Consultant to review
procedures at Bear Stearns and BSSC. This settlement concludes the
investigations by the SEC and the NYSE regarding the Company.
In re Prime Hospitality, Inc. Shareholders Litigation: As previously reported in
the Form 10-K, shareholders of Prime Hospitality Corporation ("Prime") had filed
a consolidated amended class action complaint in the Delaware Chancery Court
against the directors of Prime, the Blackstone Group and certain of its
affiliates, and Bear Stearns. The parties have reached an agreement in principle
to settle the action against all defendants, including Bear Stearns, subject to
confirmatory discovery. Under the agreement in principle, Bear Stearns will not
make any financial contribution to the settlement.
58
Item 2. UNREGISTRERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The table below sets forth the information with respect to purchases made by the
Company of the Company's common stock during the first quarter of fiscal 2006:
Approximate Dollar
Total Number of Shares Value of Shares that
Total Number of Average Price Purchased as Part of May Yet Be Purchased
Shares Paid per Publicly Announced Under the Plans or
Period Purchased Share Plans or Programs (1) Programs (1)
---------------------------------------------------------------------------------------------------------
12/1/05 - 12/31/05 3,703,483 $ 116.23 3,703,483 $ 1,269,528,309
1/1/06 - 1/31/06 231,664 121.39 231,664 1,241,407,178
2/1/06 - 2/28/06 137,298 129.89 137,298 1,223,573,190
-------------- -------------
Total 4,072,445 116.99 4,072,445
============== =============
(1) On December 12, 2005, the Board of Directors of the Company approved an
amendment to the Repurchase Program to replenish the previous authorization in
order to allow the Company to purchase up to $1.5 billion of common stock in
fiscal 2006 and beyond. The Repurchase Program has no set expiration or
termination date. On December 9, 2005, the Compensation Committee of the Board
of Directors approved a $200 million CAP Plan Earnings Purchase Authorization to
allow the Company to purchase up to $200 million of common stock in fiscal 2006.
59
Item 6. EXHIBITS
Exhibits
(11) Computation of Per Share Earnings. (The
calculation of per share earnings is in Note 8,
"Earnings Per Share," of Notes to Condensed
Consolidated Financial Statements (Earnings Per
Share) and is omitted here in accordance with
Section (b) (11) of Item 601 of Regulation S-K)
(12) Computation of Ratio of Earnings to Fixed Charges
and to Combined Fixed Charges and Preferred Stock
Dividends
(15) Letter re: Unaudited Interim Financial Information
(31.1) Certification of Chief Executive Officer Pursuant
to Rule 13a-14(a) or 15d -14(a) of the Securities
Exchange Act of 1934, as Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
(31.2) Certification of Chief Financial Officer Pursuant
to Rule 13a-14(a) or 15d-14(a) of the Securities
Exchange Act of 1934, as Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
(32.1) Certification of Chief Executive Officer Pursuant
to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
(32.2) Certification of Chief Financial Officer Pursuant
to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
60
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 10, 2006 By: /s/ Jeffrey M. Farber
Jeffrey M. Farber
Controller
(Principal Accounting Officer)
61
THE BEAR STEARNS COMPANIES INC.
FORM 10-Q
EXHIBIT INDEX
Description Page
Exhibit No.
(12) Computation of Ratio of Earnings to Fixed Charges 63
and to Combined Fixed Charges and Preferred
Stock Dividends
(15) Letter re: Unaudited Interim Financial Information 64
(31.1) Certification of Chief Executive Officer Pursuant to 65
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 66
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 67
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 68
18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
63