EXHIBIT 13
Financial Report
Table of Contents
Management's Discussion and Consolidated Statements of
Analysis of Financial Comprehensive Income 86
Condition and
Results of Operations Notes to Consolidated Financial
Introduction 32 Statements
Certain Factors Affecting Note 1 Summary of Significant
Results of Operations 32 Accounting Policies 87
Forward-Looking Statements 33 Note 2 Fair Value of Financial
Executive Overview 33 Instruments 94
Results of Operations 36 Note 3 Financial Instruments 95
Liquidity, Funding and Capital 45 Note 4 Derivatives and Hedging
Off-Balance-Sheet Arrangements 60 Activities 98
Derivative Financial Instruments 61 Note 5 Transfers of Financial
Critical Accounting Policies 62 Assets and
Accounting and Reporting Liabilities 100
Developments 66 Note 6 Variable Interest Entities
Effects of Inflation 67 and Mortgage Loan
Risk Management Special Purpose
Overall 68 Entities 104
Market Risk 69 Note 7 Collateralized Financing
Credit Risk 74 Arrangements 105
Operational Risk 76 Note 8 Short-Term Borrowings 106
Legal Risk 77 Note 9 Long-Term Borrowings 107
Other Risks 77 Note 10 Preferred Stock 108
Note 11 Earnings Per Share 110
Management's Report on Internal Note 12 Employee Benefit Plan 110
Control over Financial Note 13 Stock Compensation Plans 110
Reporting 78 Note 14 Customer Activities 114
Report of Independent Registered Note 15 Income Taxes 116
Public Accounting Firm 79 Note 16 Regulations 117
Report of Independent Registered Note 17 Commitments and
Public Accounting Firm 80 Contingencies 118
Note 18 Guarantees 120
Consolidated Financial Statements Note 19 Segment and Geographic
Consolidated Statements of Income 81 Area Data 122
Consolidated Statements of Note 20 Acquisition of Minority
Financial Condition 82 Interest and
Consolidated Statements of Impairment of
Cash Flows 83 Intangible Assets 125
Consolidated Statements of Note 21 Asset Acquisition 126
Changes in Stockholders' Note 22 Quarterly Information
Equity 84 (Unaudited) 127
Corporate Information
Price Range of Common Stock and
Dividends 128
Performance Graph 129
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
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, and 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. ("BSFP"); Bear Stearns
Capital Markets Inc.; Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc.
("BS Forex"); EMC Mortgage Corporation; Bear Stearns Commercial Mortgage, Inc.;
Bear Stearns Investment Products Inc.; and Bear Energy L.P. 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 fiscal 2007, 2006 and
2005 refer to the twelve months ended November 30, 2007, 2006 and 2005,
respectively.
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 effects of many
factors, including, but not limited to, general economic conditions, securities
market conditions, the level and volatility of interest rates and equity prices,
competitive conditions, liquidity of global markets, international and regional
political conditions, regulatory and legislative developments, monetary and
fiscal policy, investor sentiment, availability and cost of capital,
technological changes and events, outcome of legal proceedings, changes in
currency values, inflation, credit ratings and the size, volume and timing of
transactions. For further discussion of these risks, see Part 1, Items 1A, "Risk
Factors," in Form 10-K.
These and other factors can affect the Company's volume of new securities
issuances; mergers and acquisitions and business restructurings; the stability
and liquidity of securities and futures markets; inventory valuations; and the
ability of issuers, other securities firms and counterparties to perform on
their obligations. A decrease in the volume of new securities issuances, mergers
and acquisitions or restructurings generally results in lower revenues from
investment banking and, to a lesser extent, reduced principal transactions. A
reduced volume of securities and futures transactions and reduced market
liquidity generally results in lower revenues from principal transactions and
commissions. Lower price levels for securities may result in a reduced volume of
transactions, and may also result in losses from declines in the market value of
securities held in proprietary trading and underwriting accounts. In periods of
reduced sales and trading or investment banking activity, profitability may be
adversely affected because certain expenses remain relatively fixed. The
Company's securities trading, derivatives, arbitrage, market-making, specialist,
leveraged lending, leveraged buyout and underwriting activities are conducted by
it on a principal basis and expose the Company to significant risk of loss. Such
risks include, but are not limited to, market, counterparty credit and liquidity
risks. For a further discussion of these risks and how the Company seeks to
manage risks, see the "Risk Management" and "Liquidity, Funding and Capital"
sections in this report.
Substantial legal liability or a significant regulatory action against the
Company could have a material adverse effect or cause significant reputational
harm to the Company, which in turn could seriously harm the Company's business
prospects. Firms in the financial services industry have been operating in a
stringent regulatory environment. The Company faces significant legal risks in
its businesses, and the volume of claims and amount of damages and penalties
claimed in litigation and regulatory proceedings against financial institutions
have been increasing.
32
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
FORWARD-LOOKING STATEMENTS
Certain statements contained in this report are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements include statements other than historical information
or statements of current condition and may relate to management's expectations,
strategic objectives, business prospects, anticipated economic performance and
financial condition and other similar matters. As a global investment bank,
there are a variety of factors, many of which are beyond the Company's control,
which affect the Company's operations, performance, business strategy and
results and could cause actual results to differ materially from the
expectations and objectives expressed in any forward-looking statements. These
factors include, but are not limited to, actions and initiations taken by
competitors, general economic conditions, the effects of current, pending, and
future legislation, regulation and regulatory actions, and other risks and
uncertainties disclosed in this report, including those described in Part 1,
Item 1A. Risk Factors of the Form 10-K. Readers are cautioned not to place undue
reliance on forward-looking statements, which speak only as of the date of the
document in which they are made. The Company disclaims any obligation or
undertaking to provide any updates or revisions to any forward-looking statement
to reflect any change in the Company's expectations or any change in events,
conditions or circumstances on which such forward-looking statement is based.
EXECUTIVE OVERVIEW
Summary of Results
The operating environment during the Company's fiscal year ended November 30,
2007, particularly during the second half of the fiscal year, was extremely
challenging as the global credit crisis adversely impacted global fixed income
markets. Weakness in the Company's fixed income and asset management areas more
than offset record years for the Company's institutional equities, global
clearing, and private client services ("PCS") businesses and resulted in
disappointing overall results. Revenues, net of interest expense ("net
revenues"), for the fiscal year ended November 30, 2007 decreased 36% to $5.95
billion from $9.23 billion for the fiscal year ended November 30, 2006, while
pre-tax earnings decreased 94% during the same period to $193 million. The
pre-tax profit margin for fiscal 2007 decreased to 3.2%, compared with 34.1% for
fiscal 2006. Return on average common equity was 1.8% for fiscal 2007, compared
with 19.1% for fiscal 2006.
Capital Markets net revenues decreased for fiscal 2007 compared with fiscal 2006
due to decreased net revenues from fixed income and investment banking,
partially offset by record net revenues from institutional equities.
Fixed income net revenues decreased significantly during fiscal 2007 from fiscal
2006, due to the extremely challenging U.S. mortgage and credit markets. As a
result of these market conditions, the Company recognized significant inventory
markdowns in both the mortgage-related and leveraged finance areas in fiscal
2007. Mortgage revenues for fiscal 2007 reflect inventory markdowns in both
whole loan collateral and residential and commercial mortgage-backed securities.
The Company's leveraged finance revenues reflect markdowns of the pipeline of
leveraged finance commitments and loans, as investor concerns served to reduce
liquidity and price levels in the leveraged finance market. Credit trading
revenues also decreased significantly in fiscal 2007 compared with fiscal 2006,
as credit spreads widened dramatically. Partially offsetting these decreases
were increases in the Company's interest rate derivatives and foreign exchange
revenues, as increased volatility served to increase customer volumes.
Institutional equities net revenues increased to record levels during fiscal
2007 compared with fiscal 2006. Revenues from our institutional equity sales and
trading reached record levels during fiscal 2007, reflecting continued strength
from European and Asian equities. Structured equity products net revenues also
increased during fiscal 2007, reflecting gains on the Company's structured notes
portfolio. In addition, revenues from the Company's risk arbitrage area
increased to record levels, reflecting favorable market conditions. Partially
offsetting these increases was a decrease in revenues from specialist activities
during fiscal 2007 compared with fiscal 2006, resulting from the implementation
of the NYSE Hybrid trading system. Energy-related revenues also decreased in
fiscal 2007 compared with fiscal 2006, as fiscal 2006 included significant gains
from the monetization of certain commodity assets.
33
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Investment banking net revenues decreased in fiscal 2007 compared with fiscal
2006, largely reflecting less favorable market conditions for fixed income
underwriting, resulting in decreased revenues from high yield and high grade
underwriting. However, strong U.S. equity market conditions served to increase
equity underwriting revenues. Merchant banking revenues decreased, reflecting
lower gains on the Company's portfolio of investments during fiscal 2007
compared with fiscal 2006.
Global Clearing Services net revenues increased to record levels in fiscal 2007
compared with fiscal 2006 due to higher average customer margin debt and
customer short balances.
Wealth Management net revenues decreased in fiscal 2007 compared with fiscal
2006, reflecting lower asset management revenues, partially offset by record net
revenues from the Company's PCS business. Fiscal 2007 results include
significant losses associated with the failure of the two Bear Stearns Asset
Management ("BSAM")-managed high grade funds. PCS revenues increased on higher
levels of fee-based income and commissions.
From a geographical perspective, net revenues from our international activities
increased by 41% to $1.73 billion in fiscal 2007 from $1.22 billion in fiscal
2006. Net revenues from international activities represented 29% of total net
revenues in fiscal 2007 compared with 13% in fiscal 2006.
Business Environment
Fiscal 2007
The business environment during the first half of the Company's fiscal year
ended November 30, 2007 was generally favorable due to a combination of factors,
including low unemployment, low corporate interest rates, and strong consumer
confidence. However, the second half of the Company's fiscal year ended November
30, 2007 was characterized by a global credit crisis that created extremely
difficult market conditions. These conditions resulted in greater volatility,
less liquidity, widening credit spreads, a lack of price transparency, and a
flight to quality.
The unemployment rate dropped to a low of 4.4% in March 2007, showing a strong
labor market, and ended fiscal 2007 at 4.7%. However, rising energy prices
continued to be a cause for concern throughout fiscal 2007, as the price of oil
increased from a low of approximately $52 a barrel in January 2007 to a high of
approximately $95 a barrel in November 2007.
Each of the major U.S. equity indices increased during the fiscal year ended
November 30, 2007. The Standard & Poor's 500 Index ("S&P 500"), the Dow Jones
Industrial Average ("DJIA") and the National Association of Securities Dealers
Automated Quotations ("NASDAQ") Composite Index ("NASDAQ Composite Index")
increased 5.7%, 9.4% and 7.6%, respectively. Average daily trading volume on the
New York Stock Exchange ("NYSE") decreased 3.0% compared with fiscal 2006, while
average daily trading volume on the NASDAQ increased 11.5% compared with fiscal
2006. Industry-wide U.S.-announced M&A volumes increased 12.3%, while
industry-wide U.S.-completed M&A volumes increased 42.0%, compared with fiscal
2006. Total industry-wide equity issuance volumes increased 15.1%, while
industry-wide initial public offering ("IPO") volumes increased 26.7%, compared
with the levels reached during fiscal 2006. Long-term rates, as measured by the
10-year Treasury bond, declined during fiscal 2007. At the close of fiscal 2007,
the 10-year Treasury bond yield was 3.94%, compared with 4.46% on November 30,
2006.
The Federal Reserve Board (the "Fed") met ten times (eight scheduled meetings
and two unscheduled meetings) during fiscal 2007 and kept the federal funds rate
unchanged at 5.25% at each of its first six scheduled meetings. At the Fed's
last two scheduled meetings of fiscal 2007, the Fed lowered the federal funds
rate by 50 basis points and 25 basis points, respectively, to 4.50%, citing the
potential of tightening credit conditions to intensify the housing correction
and restrain economic growth, and that such an action is intended to help
forestall some of the adverse effects on the broader economy that might
otherwise arise from the disruptions in the financial markets and to promote
moderate growth over time. In addition, in fiscal 2007, the Fed injected
$billions into the money supply for banks to borrow at a low rate in order to
try to alleviate the credit
34
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
crisis. At its two unscheduled meetings of fiscal 2007, the Fed mentioned that
it is continuing to monitor the situation of deteriorating market conditions,
tighter credit conditions, and increased uncertainty, and is prepared to act as
needed to mitigate the adverse effects on the economy arising from disruptions
in the financial markets.
The decline in home sales that began in 2006 continued into 2007 and represented
the first year-over-year decline in nationwide house prices since 1991. The
subprime mortgage industry began to collapse in early 2007, with more than 25
subprime lenders declaring bankruptcy, announcing significant losses, or putting
themselves up for sale. The mortgage lenders that retained credit risk (the risk
of payment default) were the first to be affected, as borrowers became unable or
unwilling to make payments. The significant increase in foreclosure activity and
rising interest rates in mid-2007 depressed housing prices further as problems
in the subprime markets spread to the near-prime and prime mortgage markets.
The widespread dispersion of credit risk related to mortgage delinquencies
through the securitization of mortgage-backed securities, sales of
collateralized debt obligations ("CDOs") and the creation of structured
investment vehicles ("SIVs") and the unclear impact on large banks of
mortgage-backed securities, CDOs and SIVs caused banks to reduce their loans to
each other or make them at higher interest rates. Similarly, the ability of
corporations to obtain funds through the issuance of commercial paper was
negatively impacted. In addition, many lenders stopped offering home equity
loans and "stated income" loans. As prices declined and delinquencies increased,
investors lost confidence in the rating system for structured products as rating
agencies moved to downgrade CDOs and other structured products. In addition,
investors lost confidence in commercial paper conduits and SIVs causing concerns
over large potential liquidations of AAA collateral. The lack of liquidity and
transparency regarding the underlying assets in securitizations, CDOs and SIVs
resulted in significant price declines across all mortgage-related products in
fiscal 2007. Price declines were further driven by forced sales of assets in
order to meet demands by investors for the return of their collateral and
collateral calls by lenders. During the second half of 2007, the economic impact
of these problems spread on a global basis and disrupted the broader financial
markets. The combination of these events caused a large number of mortgage
lenders and certain hedge funds to shut down or file for bankruptcy and resulted
in the downgrade of certain monoline insurers. In addition, banks and
institutional investors have recognized substantial losses as they revalued
their CDOs and other mortgage-related assets downward.
As a result of these issues and events, U.S. mortgage-backed securities
underwriting volumes decreased 7.5% in fiscal 2007 compared with fiscal 2006 as
a result of the more challenging market conditions. Agency collateralized
mortgage obligation ("CMO") volumes declined 12.6% industry-wide from the levels
reached during fiscal 2006 and non-agency mortgage-backed originations decreased
17.5%. The Mortgage Bankers Association Purchase Index increased approximately
3.8%, compared with fiscal 2006, as average 30-year fixed mortgage rates
decreased during fiscal 2007. The ABX subprime mortgage credit indices declined
dramatically, reflecting concern due to increased delinquencies in subprime
mortgages and the CMBX mortgage indices widened on broader recessionary
concerns.
Current Environment
The market conditions that result from, and many of the underlying causes of,
the subprime mortgage and global credit crisis discussed above continued in
December 2007 and January 2008. If these market conditions continue or worsen
during the remainder of fiscal 2008, the Company may continue to face a very
challenging business environment for its products and businesses.
Fiscal 2006
The business environment during the Company's fiscal year ended November 30,
2006 was generally favorable due to a combination of factors, including an
expanding U.S. economy, improved corporate profitability, low unemployment and
moderate inflation. Favorable labor reports provided ongoing support to economic
activity in fiscal 2006. The unemployment rate dropped to 4.4% in October 2006,
its lowest level since August 2001 and ended fiscal 2006 at 4.5%. However,
rising energy prices continued to be a cause for concern throughout fiscal 2006,
as the price of oil increased from approximately $57 a barrel in December 2005
to a high of approximately $77 a barrel in August 2006. A decline in oil prices
during the fourth quarter of fiscal 2006 helped fuel a year-end rally in the
equity markets. The Fed met eight times during fiscal 2006 and raised the
federal funds rate during each of its first five meetings, in 25 basis point
increments, from 4.00% to 5.25%, supported by gains in productivity, relatively
low core inflation and expansion in economic activity. However, during its last
three meetings of fiscal 2006, the Fed kept the federal funds rate unchanged at
5.25%, citing a cooling of the housing market and moderating economic growth
from its strong pace earlier in the year.
35
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Each of the major U.S. equity indices increased during the fiscal year ended
November 30, 2006. The S&P 500, the DJIA and the NASDAQ Composite Index
increased 12.1%, 13.1% and 8.9%, respectively. Average daily trading volume on
the NYSE and the NASDAQ increased 5.5% and 10.3%, respectively, compared with
fiscal 2005. Industry-wide U.S.-announced M&A volumes increased 22.0% while
industry-wide U.S.-completed M&A volumes increased 40.7%, compared with fiscal
2005. Total industry-wide equity issuance volumes increased 25.3%, while
industry-wide IPO volumes increased 3.4%, compared with the levels reached
during fiscal 2005.
Fixed income markets remained strong in fiscal 2006 despite challenges
associated with higher short-term interest rates and a flat yield curve.
Long-term rates, as measured by the 10-year Treasury bond, remained relatively
stable during fiscal 2006. At the close of fiscal 2006, the 10-year Treasury
bond yield was 4.46%, compared with 4.50% on November 30, 2005. U.S.
mortgage-backed securities underwriting volumes increased 10.9% in fiscal 2006
compared with fiscal 2005 and continued to benefit from favorable market
conditions. Agency CMO volumes declined 15.9% industry-wide from the levels
reached during fiscal 2005, reflecting declining refinancing activity. However,
non-agency mortgage-backed originations increased 27.3%. The Mortgage Bankers
Association Purchase Index decreased approximately 12.9%, compared with fiscal
2005, as average 30-year fixed mortgage rates increased and the home purchasing
market cooled in fiscal 2006 compared with fiscal 2005.
Results of Operations
Firmwide Results
The following table sets forth an overview of the Company's financial results
for the fiscal years ended November 30, 2007, 2006 and 2005:
% Increase (Decrease)
----------------------------------------------------------------------------
(in millions, except per share amounts, pre-
tax profit margin and return on average
common equity) 2007 2006 2005 2007/2006 2006/2005
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense $ 5,945 $ 9,227 $ 7,411 (36%) 25%
Income before provision for income taxes 193 3,147 2,207 (94%) 43%
Net income 233 2,054 1,462 (89%) 40%
Diluted earnings per share $ 1.52 $ 14.27 $ 10.31 (89%) 38%
Pre-tax profit margin 3.2% 34.1% 29.8%
Return on average common equity (annualized) 1.8% 19.1% 16.5%
- ------------------------------------------------------------------------------------------------------------------------------------
The Company reported net revenues of $5.9 billion for fiscal 2007, which
represented a decrease of 36% from $9.2 billion for fiscal 2006. The Company
reported net income of $233 million, or $1.52 per share (diluted) for fiscal
2007, which represented a decrease of 89% from $2.1 billion, and from $14.27 per
share (diluted), for fiscal 2006. Due to the extremely challenging market
environment, the Company recorded net inventory markdowns in the second half of
fiscal 2007 of approximately $2.6 billion on mortgage-related products and the
pipeline of leveraged finance commitments and loans. The third quarter results
also included approximately $200 million of losses associated with the failure
of the BSAM-managed high grade funds. In addition, the results for the fiscal
year ended 2007 includes a non-cash charge of $227 million related to the
write-off of intangible assets associated with the Company's NYSE specialist
activities and $108 million in severance charges related to headcount
reductions. The Company reported net revenues of $7.4 billion and net income of
$1.5 billion for fiscal 2005, or $10.31 per share (diluted).
36
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Fiscal 2007 versus Fiscal 2006
The Company's commission revenues by reporting category for the fiscal years
ended November 30, 2007, 2006 and 2005 were as follows:
% Increase (Decrease)
----------------------------------------------------------------------------
(in millions) 2007 2006 2005 2007/2006 2006/2005
- ------------------------------------------------------------------------------------------------------------------------------------
Institutional $ 891 $ 786 $ 776 13% 1%
Clearance 232 234 261 (1%) (10%)
Retail 146 143 163 2% (12%)
- ------------------------------------------------------------------------------------------------------------------------------------
Total commissions $ 1,269 $ 1,163 $ 1,200 9% (3%)
====================================================================================================================================
Institutional commissions increased 13% to $891 million in fiscal 2007 from $786
million in fiscal 2006 due to increased average daily trading volumes on the
NASDAQ. Clearance commissions decreased 1% to $232 million in fiscal 2007 from
$234 million in fiscal 2006, primarily reflecting lower average trading volumes
from prime brokerage and fully disclosed clients. Retail commissions increased
2% to $146 million in fiscal 2007 from $143 million in fiscal 2006 due to higher
average trading volumes on the NASDAQ.
The Company's principal transactions revenues by reporting category for the
fiscal years ended November 30, 2007, 2006 and 2005 were as follows:
% Increase (Decrease)
----------------------------------------------------------------------------
(in millions) 2007 2006 2005 2007/2006 2006/2005
- ------------------------------------------------------------------------------------------------------------------------------------
Fixed income $ (215) $ 3,617 $ 2,998 nm 21%
Equities 1,538 1,378 838 12% 64%
- ------------------------------------------------------------------------------------------------------------------------------------
Total principal transactions $ 1,323 $ 4,995 $ 3,836 (74%) 30%
====================================================================================================================================
nm - not meaningful
Fixed income principal transactions revenues decreased to a loss of $215 million
for fiscal 2007 from $3.62 billion for fiscal 2006, primarily attributable to a
decrease in revenues in the mortgage-backed securities, leveraged finance,
credit trading, and distressed trading areas. Revenues from the Company's
mortgage-backed securities and leveraged finance areas decreased significantly
as a result of $2.6 billion of valuation adjustments taken during the second
half of fiscal 2007. Additionally, revenues from credit trading decreased as
corporate credit spreads widened. Also contributing to the decline in fixed
income net revenues were losses associated with the BSAM-managed high grade
funds. Revenues derived from the Company's equities activities increased 12% to
$1.54 billion in fiscal 2007 from $1.38 billion in fiscal 2006 due to an
increase in net revenues from structured equity products, international equity
sales and trading, and risk arbitrage, partially offset by a decrease in NYSE
specialist activities and energy-related activities.
The Company's investment banking revenues by reporting category for the fiscal
years ended November 30, 2007, 2006 and 2005 were as follows:
% Increase (Decrease)
----------------------------------------------------------------------------
(in millions) 2007 2006 2005 2007/2006 2006/2005
- ------------------------------------------------------------------------------------------------------------------------------------
Underwriting $ 529 $ 515 $ 470 3% 10%
Advisory and other fees 828 707 413 17% 71%
Merchant banking 23 112 154 (79%) (27%)
- ------------------------------------------------------------------------------------------------------------------------------------
Total investment banking $ 1,380 $ 1,334 $ 1,037 3% 29%
====================================================================================================================================
37
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Underwriting revenues increased to $529 million in fiscal 2007 from $515 million
in fiscal 2006, primarily due to an increase in equity underwriting resulting
from improved global equity market conditions. Partially offsetting this
increase were lower levels of high yield and high grade underwriting activity
resulting from less favorable market conditions. Advisory and other fees
increased to $828 million in fiscal 2007 from $707 million in fiscal 2006,
reflecting an improved M&A environment and an increase in mortgage servicing
fees. Merchant banking revenues include net realized and unrealized investment
gains and performance fees on managed merchant banking funds. Merchant banking
revenues decreased to $23 million in fiscal 2007 from $112 million in fiscal
2006, reflecting lower net gains on the Company's portfolio of investments and
lower performance fees on managed merchant banking funds.
Net interest revenues (interest and dividends revenue less interest expense)
increased 12% to $1.35 billion in fiscal 2007 from $1.21 billion in fiscal 2006.
The increase in net interest revenues was primarily attributable to higher
average customer margin debt balances and customer short balances.
Asset management and other income revenues increased 19% to $623 million for
fiscal 2007 from $523 million for fiscal 2006, primarily reflecting an increase
in net revenues from PCS on higher levels of fee-based assets.
Fiscal 2006 versus Fiscal 2005
Institutional commissions increased 1% to $786 million from $776 million in
fiscal 2005 due to increased average daily trading volumes. Clearance
commissions decreased 10% to $234 million in fiscal 2006 from $261 million in
fiscal 2005, primarily reflecting lower average rates from prime brokerage and
fully disclosed clients. Retail commissions decreased 12% to $143 million in
fiscal 2006 from $163 million in fiscal 2005 due to the transition of certain
accounts from a commission-based to a fee-based platform.
Fixed income revenues increased 21% to $3.62 billion for fiscal 2006 from $3.00
billion for fiscal 2005, primarily attributable to an increase in net revenues
in the mortgage-backed securities, distressed trading and credit derivatives
areas. Mortgage-backed securities revenues increased during fiscal 2006 when
compared with fiscal 2005 on higher origination volumes as well as increased
secondary trading revenues. Revenues derived from distressed trading increased
as corporate credit spreads tightened and customer activity increased during
fiscal 2006. Revenues from the leveraged finance business increased
significantly, associated with increased acquisition finance activity.
Additionally, revenues from credit derivatives increased due to higher customer
activities reflecting favorable market conditions. Revenues derived from the
Company's equities activities increased 64% to $1.38 billion in fiscal 2006 from
$838 million in fiscal 2005 due to an increase in net revenues from equity
derivatives, international equity sales and trading and risk arbitrage. In
addition, fiscal 2006 included gains on the Company's sale of certain commodity
assets as well as gains on the Company's investment in the NYSE Group Inc.
Investment banking revenues increased 29% to $1.33 billion in fiscal 2006 from
$1.04 billion in fiscal 2005. Underwriting revenues increased primarily due to
higher levels of high yield and high grade underwriting activity. Partially
offsetting these increases was a decline in equity underwriting revenues
reflecting lower levels of equity underwriting activity. Advisory and other fees
for fiscal 2006 increased from fiscal 2005, reflecting a significant increase in
completed M&A assignments during fiscal 2006. Merchant banking revenues
decreased for fiscal 2006 from fiscal 2005, reflecting lower net gains on the
Company's portfolio of investments and lower performance fees on managed
merchant banking funds.
Net interest revenues increased 25% to $1.21 billion in fiscal 2006 from $965
million in fiscal 2005. The increase in net interest revenues was primarily
attributable to higher levels of customer interest-bearing balances and improved
net interest margins.
Asset management and other revenues increased 41% to $523 million for fiscal
2006 from $372 million for fiscal 2005, primarily reflecting increased
performance fees on proprietary hedge fund products and increased management
fees on higher levels of traditional assets under management. PCS fees also
increased due to higher levels of fee-based assets.
38
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Non-Interest Expenses
The Company's non-interest expenses for the fiscal years ended November 30,
2007, 2006 and 2005 were as follows:
% Increase (Decrease)
----------------------------------------------------------------------------
(in millions) 2007 2006 2005 2007/2006 2006/2005
- ------------------------------------------------------------------------------------------------------------------------------------
Employee compensation and benefits $ 3,425 $ 4,343 $ 3,553 (21%) 22%
Floor brokerage, exchange and clearance fees 279 227 222 23% 2%
Communications and technology 578 479 402 21% 19%
Occupancy 264 198 168 33% 18%
Advertising and market development 179 147 127 22% 16%
Professional fees 362 280 229 29% 22%
Impairment of goodwill and
specialist rights 227 -- -- nm --
Other expenses 438 406 503 8% (19%)
- ------------------------------------------------------------------------------------------------------------------------------------
Total non-interest expenses $ 5,752 $ 6,080 $ 5,204 (5%) 17%
====================================================================================================================================
nm- not meaningful
Fiscal 2007 versus Fiscal 2006 Employee compensation and benefits includes the
cost of salaries, benefits and incentive compensation, including Capital
Accumulation Plan ("CAP Plan") units, restricted stock units and option awards.
Employee compensation and benefits decreased 21% to $3.43 billion for fiscal
2007 from $4.34 billion for fiscal 2006, primarily due to lower compensation
associated with the decrease in net revenues. In addition, the Company changed
the requisite service period associated with its 2007 stock-based compensation
awards to align it with the vesting schedules, resulting in lower employee
compensation costs for fiscal 2007. See Note 13, "Stock Compensation Plans," in
the Notes to Consolidated Financial Statements. Employee compensation and
benefits as a percentage of net revenues was 57.6% for fiscal 2007, compared
with 47.1% for fiscal 2006. Full-time employees increased to 14,153 at November
30, 2007 from 13,566 at November 30, 2006.
Non-compensation expenses increased 34% to $2.33 billion for fiscal 2007 from
$1.74 billion for fiscal 2006. Non-compensation expenses as a percentage of net
revenues increased to 39.1% for fiscal 2007, compared with 18.8% for fiscal
2006. Included in the 2007 results was a non-cash charge of $227 million related
to the write-off of intangible assets, representing goodwill and specialist
rights, associated with the Company's NYSE specialist activities.
Non-compensation expenses, excluding the non-cash charge, were $2.11 billion for
the fiscal year ended November 30, 2007. Floor brokerage, exchange and clearance
fees increased 23% to $279 million in fiscal 2007 from $227 million in fiscal
2006, due to increased volumes and clearing house charges attributable to
international growth of the Company. Communications and technology costs
increased 21% to $578 million in fiscal 2007 from $479 million in fiscal 2006 as
increased headcount resulted in higher voice and market data-related costs as
well as information technology consulting expenses. Occupancy costs increased
33% to $264 million for fiscal 2007 from $198 million for fiscal 2006,
reflecting additional office space requirements and higher leasing costs
associated with the Company's headquarters building at 383 Madison Avenue and
other office locations in New York City, as well as several international
locations, reflecting the Company's growth globally. Advertising and market
development costs increased 22% to $179 million for fiscal 2007 from $147
million for fiscal 2006 primarily due to higher levels of client and deal
related expenses. Professional fees increased 29% to $362 million in fiscal 2007
from $280 million in fiscal 2006 attributable to higher levels of non-IT
consulting fees, employment agency fees, and legal bills. Other expenses
increased 8% to $438 million in fiscal 2007 from $406 million in fiscal 2006,
principally due to increased litigation associated with the BSAM-managed
high-grade funds and severance expenses of $108 million associated with a large
year end reduction in headcount. CAP Plan-related costs decreased to $18 million
for fiscal 2007 from $154 million in fiscal 2006 due to a lower level of
earnings. The Company's pre-tax profit margin was 3.2% for fiscal 2007, down
from 34.1% for fiscal 2006.
39
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
The Company's effective tax rate was a benefit of 21.0% for fiscal 2007,
compared with a provision of 34.7% for fiscal 2006, primarily due to lower
overall earnings, the majority of which was earned in lower tax jurisdictions,
which did not entirely offset losses in higher tax jurisdictions and the impact
of permanent differences.
Fiscal 2006 versus Fiscal 2005 Employee compensation and benefits increased 22%
to $4.34 billion for fiscal 2006 from $3.55 billion for fiscal 2005, primarily
due to higher discretionary compensation associated with the increase in net
revenues and increased headcount. Employee compensation and benefits as a
percentage of net revenues was 47.1% for fiscal 2006, compared with 47.9% for
fiscal 2005. Full-time employees increased to 13,566 at November 30, 2006 from
11,843 at November 30, 2005.
Non-compensation expenses increased 5% to $1.74 billion for fiscal 2006 from
$1.65 billion for fiscal 2005. Non-compensation expenses as a percentage of net
revenues decreased to 18.8% for fiscal 2006, compared with 22.3% for fiscal
2005. The increase in non-compensation-related costs compared with fiscal 2005
was principally related to increased communications and technology costs,
professional fees, occupancy costs and advertising and market development costs.
Communications and technology costs increased 19% to $479 million in fiscal 2006
from $402 million in fiscal 2005 as increased headcount resulted in higher voice
and market data-related costs as well as information technology consulting
costs. Professional fees increased 22% to $280 million in fiscal 2006 from $229
million in fiscal 2005 attributable to higher levels of non-IT consulting fees,
employment agency fees, and temporary staff. Occupancy costs increased 18% to
$198 million for fiscal 2006 from $168 million for fiscal 2005, reflecting
additional office space requirements and higher leasing costs associated with
the Company's headquarters building at 383 Madison Avenue in New York City.
Advertising and market development costs increased 16% to $147 million for
fiscal 2006 from $127 million for fiscal 2005 primarily due to higher levels of
business promotion expenses. Other expenses decreased 19% to $406 million in
fiscal 2006 from $503 million in fiscal 2005, principally due to a reduction in
legal and litigation-related costs. Partially offsetting this decrease was an
increase in costs related to the CAP Plan. CAP Plan-related costs increased to
$154 million for fiscal 2006 from $144 million in fiscal 2005 due to a higher
level of earnings. The Company achieved a pre-tax profit margin of 34.1% for
fiscal 2006, up from 29.8% for fiscal 2005.
The Company's effective tax rate increased to 34.7% for fiscal 2006, compared
with 33.75% for fiscal 2005, primarily due to an increase in the level of
earnings in fiscal 2006, as related to preference items.
BUSINESS SEGMENTS
The remainder of "Results of Operations" is presented on a business segment
basis. The Company's three business segments--Capital Markets, Global Clearing
Services and Wealth Management--are analyzed separately due to the distinct
nature of the products they provide and the clients they serve. Certain Capital
Markets products are distributed by the Wealth Management and Global Clearing
Services distribution networks, with the related revenues of such intersegment
services allocated to the respective segments. In fiscal 2006, the Company
changed its presentation of segments to allocate certain revenues (predominantly
interest) as well as certain corporate administrative expenses from "Other" to
its three business segments. These reclassifications were also made to fiscal
2005 amounts and are reflected in the following business segment discussion and
in Note 19, "Segment and Geographic Area Data" in the Notes to Consolidated
Financial Statements.
40
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Capital Markets
% Increase (Decrease)
----------------------------------------------------------------------------
(in millions) 2007 2006 2005 2007/2006 2006/2005
- ------------------------------------------------------------------------------------------------------------------------------------
Net revenues
Institutional equities $ 2,158 $ 1,961 $ 1,446 10% 36%
Fixed income 685 4,190 3,293 (84%) 27%
Investment banking 1,076 1,170 983 (8%) 19%
- ------------------------------------------------------------------------------------------------------------------------------------
Total net revenues $ 3,919 $ 7,321 $ 5,722 (46%) 28%
Pre-tax income $ (232) $ 2,801 $ 2,020 nm 39%
- ------------------------------------------------------------------------------------------------------------------------------------
nm - not meaningful
The Capital Markets segment comprises institutional equities, fixed income and
investment banking. The Capital Markets segment operates as a single integrated
unit that provides the sales, trading and origination effort for various fixed
income, equity and advisory products and services. Each of the three businesses
work in tandem to deliver these products and services to institutional and
corporate clients.
Institutional equities consists of sales, trading and research, in areas such as
domestic and international equities, block trading, over-the counter equities,
equity derivatives, energy and commodity activities, risk and convertible
arbitrage and specialist activities on the NYSE, American Stock Exchange
("AMEX") and International Stock Exchange ("ISE"). Fixed income includes sales,
trading, origination and research provided to institutional clients across a
variety of products such as mortgage- and asset-backed securities, corporate and
government bonds, municipal bonds, high yield products, including bank and
bridge loans, foreign exchange and interest rate and credit derivatives.
Investment banking provides services in capital raising, strategic advice,
mergers and acquisitions and merchant banking. Capital raising encompasses the
Company's underwriting of equity, investment grade, municipal and high yield
debt products.
Fiscal 2007 versus Fiscal 2006 Net revenues for Capital Markets decreased 46% to
$3.92 billion for fiscal 2007, compared with $7.32 billion for fiscal 2006.
Institutional equities net revenues for fiscal 2007 increased 10% to $2.16
billion from $1.96 billion for fiscal 2006. Revenues from the Company's
structured equity products increased, reflecting gains from the Company's
structured notes business. Revenues from the Company's international equity
sales and trading area also increased substantially to a record level,
reflecting continued strength in both European and Asian equities. Additionally,
risk arbitrage revenues increased during fiscal 2007 on higher levels of global
announced M&A volumes. Partially offsetting these increases were decreases in
the Company's specialist activities, due to the implementation of the NYSE
Hybrid trading system, which automated certain tasks previously performed by
specialists and reduced the opportunity for specialists to participate in order
processing. Revenues from the Company's energy activities also decreased in
fiscal 2007, as fiscal 2006 included significant gains from the sale of certain
commodity assets. Fiscal 2007 was a significant build out year for the energy
business with significant investments made in the trading and power generation
areas, including the acquisition of all the power-related and natural gas assets
comprising the power trading business from Williams Power Company, Inc.
Fixed income net revenues decreased 84% to $685 million for fiscal 2007 from
$4.19 billion for fiscal 2006. Results for fiscal 2007 were heavily impacted by
the severe market conditions across the fixed income sector. The repricing of
credit led to significantly lower net revenue levels due to illiquidity in the
markets as trading levels deteriorated across the spectrum of fixed income
products. Mortgage-backed securities revenues decreased significantly during
fiscal 2007 when compared with fiscal
41
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
2006 due to weaker U.S. mortgage markets and challenges associated with the
subprime mortgage sector. Significant spread widening in the second half of
fiscal 2007 served to reduce inventory values and activity levels.
Mortgage-related revenues reflect approximately $2.3 billion in net inventory
write downs in the second half of fiscal 2007. A large component of these
writedowns were related to ABS CDOs and the unwinding of ABS CDO warehouse
facilities. As of November 30, 2007, all ABS CDO warehouse positions have been
unwound. The remaining writedowns were experienced across our U.S. and
international residential and commercial inventories. Leveraged finance revenues
also decreased significantly during fiscal 2007, reflecting challenging market
conditions, which resulted in valuation adjustments taken on the Company's
leveraged lending commitments and inventory. Leveraged finance revenues reflect
valuation adjustments of approximately $.26 billion. Widening credit spreads in
a more challenging credit environment during fiscal 2007 also resulted in a
decrease in the Company's credit trading revenues. Partially offsetting these
decreases were increased revenues from the Company's interest rate product
business, as global volatility and higher customer volumes served to increase
interest rate product net revenues compared to the prior year.
At November 30, 2007, the Company had approximately $46 billion of mortgages,
mortgage backed and asset backed securities including approximately $12 billion
of floating rate commercial loans and approximately $3 billion of fixed rate
commercial loans.
The Company's CDOs and subprime-related exposures (net of hedges) as of November
30, 2007 is presented below:
($ in millions)
AAA - Super Senior Exposure: November 30, 2007
High - Grade Collateral $ 167
Mezz Collateral 597
CDO^2 Collateral 1
-----------------
Total AAA - Super Senior Exposure 765
Total Below-AAA Exposure (10)
-----------------
Total ABS CDO-Related Exposure $ 755
=================
($ in millions)
U.S. Subprime Mortgage Exposure:
Subprime whole loans $ 496
Investment-grade Subprime securities 1,062
Non-investment-grade subprime securities 211
ABS CDS (2,351)
-----------------
Total U.S. Subprime Mortgage Exposure $ (582)
=================
Investment banking revenues decreased 8% to $1.08 billion for fiscal 2007 from
$1.17 billion for fiscal 2006. Underwriting revenues decreased 10% to $513
million for fiscal 2007 from $568 million for fiscal 2006, primarily reflecting
lower levels of high yield underwriting activity during fiscal 2007, partially
offset by increased equity underwriting revenues, reflecting higher volumes of
lead and co-managed and follow-on offerings as a result of strong global equity
market conditions. Advisory and other fees for fiscal 2007 increased 10% to $541
million from $490 million for fiscal 2006, due to higher M&A fees from increased
customer activity. Merchant banking revenues decreased 79% to $23 million for
fiscal 2007 from $112 million for fiscal 2006, reflecting lower gains on the
Company's portfolio of investments and lower performance fees on managed
merchant banking funds.
42
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Fiscal 2006 versus Fiscal 2005 Net revenues for Capital Markets increased 28% to
$7.32 billion for fiscal 2006, compared with $5.72 billion for fiscal 2005.
Institutional equities net revenues for fiscal 2006 increased 36% to $1.96
billion from $1.45 billion for fiscal 2005. Revenues from the Company's energy
and commodity activities increased, reflecting gains from the sale of certain
commodity assets and increased revenues from the Company's energy activities.
Equity derivatives revenues increased during fiscal 2006 to record levels
reflecting increased customer activity and favorable market conditions. Net
revenues from international institutional equities activities increased,
reflecting higher customer trading volumes and increased market share in both
the European and Asian equity markets. Risk arbitrage revenues also increased
during fiscal 2006 on higher announced M&A volumes and market share gains.
Fiscal 2006 also included gains on the Company's investment in the NYSE Group
Inc.
Fixed income net revenues increased 27% to $4.19 billion for fiscal 2006 from
$3.29 billion for fiscal 2005, primarily reflecting strong results from the
Company's mortgage-backed securities area as well as record net revenues from
the Company's credit businesses. Mortgage-backed securities revenues increased
during fiscal 2006 when compared with fiscal 2005 on higher origination volumes
from asset-backed securities, ARMs, and commercial mortgage-backed securities,
as well as increased secondary trading revenues. Credit products net revenues
reached record levels, reflecting a significant increase in revenues from the
Company's leveraged finance, distressed trading and credit derivatives areas.
Leveraged finance revenues achieved record levels, reflecting the surge in
acquisition related financing activity associated with higher M&A volumes and
increased market share. Revenues from the Company's interest rate product
business declined during fiscal 2006 when compared with fiscal 2005, primarily
due to a decrease in interest rate derivatives and foreign exchange revenues.
Investment banking revenues increased 19% to $1.17 billion for fiscal 2006 from
$983 million for fiscal 2005. Underwriting revenues increased 7% to $568 million
for fiscal 2006 from $532 million for fiscal 2005. Higher levels of high yield
and high grade underwriting activity during fiscal 2006 were partially offset by
lower levels of equity underwriting activity. Advisory and other fees for fiscal
2006 increased 65% to $490 million from $297 million for fiscal 2005, reflecting
an increase in M&A fees resulting from a significant increase in completed M&A
assignments. Merchant banking revenues include realized and unrealized
investment gains and performance fees on managed merchant banking funds.
Merchant banking revenues decreased 27% to $112 million for fiscal 2006 from
$154 million for fiscal 2005.
Global Clearing Services
% Increase (Decrease)
----------------------------------------------------------------------------
(in millions) 2007 2006 2005 2007/2006 2006/2005
- ------------------------------------------------------------------------------------------------------------------------------------
Net revenues $ 1,200 $ 1,077 $ 1,029 11% 5%
Pre-tax income $ 566 $ 465 $ 472 22% (1%)
- ------------------------------------------------------------------------------------------------------------------------------------
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.
Fiscal 2007 versus Fiscal 2006 Net revenues for Global Clearing Services
increased 11% to $1.20 billion for fiscal 2007 from $1.08 billion for fiscal
2006. Net interest revenues increased 15% to $923 million for fiscal 2007 from
$803 million for fiscal 2006, primarily reflecting increased average customer
margin balances and customer short balances. Commission and other revenues
essentially remained flat at $277 million for fiscal 2007 compared with $274
million for fiscal 2006. Pre-tax income increased 22% to $566 million for fiscal
2007 from $465 million for fiscal 2006. Pre-tax profit margin was 47.2% for
fiscal 2007, compared with 43.2% for fiscal 2006.
43
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
The following table presents the Company's interest-bearing balances for the
fiscal years ended November 30, 2007 and 2006:
- ----------------------------------------------------------------------
(in billions) 2007 2006
- ----------------------------------------------------------------------
Margin debt balances, average for period $ 90.3 $ 68.4
Margin debt balances, at period end 85.8 78.6
Customer short balances, average for period 95.6 82.6
Customer short balances, at period end 88.0 95.8
Securities borrowed, average for period 64.3 55.0
Securities borrowed, at period end 63.0 57.6
Free credit balances, average for period 36.6 32.8
Free credit balances, at period end 36.1 32.6
- ----------------------------------------------------------------------
During the third quarter of fiscal 2007, customer margin balances and short
balances declined, reflecting client deleveraging due to the challenging
environment and prime broker reallocations. During the fourth quarter of fiscal
2007, customer margin and short balances increased off their lows with margin
balances and customer short balances ending the period at $86 billion and $88
billion, respectively.
Fiscal 2006 versus Fiscal 2005 Net revenues for Global Clearing Services
increased 5% to $1.08 billion for fiscal 2006 from $1.03 billion for fiscal
2005. Net interest revenues increased 9% to $803 million for fiscal 2006 from
$736 million for fiscal 2005, primarily reflecting increased average customer
margin balances from prime brokerage clients. These results were partially
offset by a decline in commission and other revenues of 6% to $274 million for
fiscal 2006 from $293 million for fiscal 2005, reflecting reduced rates from
prime brokerage and fully disclosed clients. Pre-tax income decreased 1% to $465
million for fiscal 2006 from $472 million for fiscal 2005. Pre-tax profit margin
was 43.2% for fiscal 2006, compared with 45.9% for fiscal 2005.
Wealth Management
% Increase (Decrease)
----------------------------------------------------------------------------
(in millions) 2007 2006 2005 2007/2006 2006/2005
- ------------------------------------------------------------------------------------------------------------------------------------
Private client services revenues $ 710 $ 620 $ 547 15% 13%
Revenue transferred to Capital Markets
segment (108) (98) (94) 10% 4%
---------------------------------------------------------------------------------------------
Private client services net revenues 602 522 453 15% 15%
Asset management 228 336 228 (32%) 47%
---------------------------------------------------------------------------------------------
Total net revenues $ 830 $ 858 $ 681 (3%) 26%
Pre-tax income $ (45) $ 69 $ 37 nm 86%
- ------------------------------------------------------------------------------------------------------------------------------------
nm - not meaningful
The Wealth Management segment is comprised 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 November 30, 2007, PCS had approximately 500 account
executives in its principal office, six regional offices and two international
offices. Asset management manages equity, fixed income and alternative assets
for corporate pension plans, public systems, endowments, foundations,
multi-employer plans, insurance companies, corporations, families and
high-net-worth individuals in the United States and abroad.
44
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Fiscal 2007 versus Fiscal 2006 Net revenues for Wealth Management decreased 3%
to $830 million for fiscal 2007 from $858 million for fiscal 2006. Asset
management revenues decreased 32% to $228 million for fiscal 2007 compared to
$336 million for fiscal 2006. These results were due to losses associated with
the Bear Stearns High-Grade Structured Credit Strategies Fund ("High-Grade
Fund") and the Bear Stearns High-Grade Structured Credit Strategies Enhanced
Leveraged Fund (collectively the "Funds"). In the third quarter of fiscal 2007
the results included losses of approximately $200 million representing the
write-off of the Company's investment and fees receivable from the Funds, losses
from the closure of the $1.6 billion secured financing agreement provided to the
High-Grade Fund and other directly related expenses. Excluding the impact on net
revenues of losses in the Funds, asset management revenues were up 18% to $398
million for fiscal 2007 compared with fiscal 2006, reflecting growth in both
management and performance fees. PCS revenues increased 15% to $602 million for
fiscal 2007 from $522 million for fiscal 2006, reflecting higher levels of
fee-based revenues and commissions.
Assets under management were $44.6 billion at November 30, 2007, reflecting a
15% decrease from $52.5 billion in assets under management at November 30, 2006.
The decrease in assets under management primarily reflects an $8.8 billion
transfer of assets related to the spin-off of O'Shaughnessy Asset Management.
Under the terms of the agreement, the Company will maintain a continuing
interest in, and a sub advisory arrangement for $5.3 billion of assets under
management. Assets under management at November 30, 2007 include $8.3 billion of
assets from alternative investment products, a 6% increase from $7.8 billion at
November 30, 2006.
Fiscal 2006 versus Fiscal 2005 Net revenues for Wealth Management increased 26%
to $858 million for fiscal 2006 from $681 million for fiscal 2005. PCS revenues
increased 15% to $522 million for fiscal 2006 from $453 million for fiscal 2005,
reflecting increased fee income attributable to the Company's private client
advisory services products as well as an increase in broker productivity. Asset
management revenues increased 47% to $336 million for fiscal 2006 from $228
million for fiscal 2005, reflecting increased performance fees on proprietary
hedge fund products and increased management fees on higher levels of
traditional assets under management. Pre-tax income for Wealth Management
increased 86% to $69 million in fiscal 2006 from $37 million for fiscal 2005.
Assets under management were $52.5 billion at November 30, 2006, reflecting a
25% increase from $41.9 billion in assets under management at November 30, 2005.
The increase in assets under management primarily reflects an increase in
traditional equity assets attributable to both market appreciation and net
inflows. Assets under management at November 30, 2006 include $7.8 billion of
assets from alternative investment products, a 24% increase from $6.3 billion at
November 30, 2005.
LIQUIDITY, FUNDING AND CAPITAL
Liquidity Risk Management
- -------------------------
The Company maintains a rigorous framework and commits substantial time and
effort to the management of liquidity risk. The Global Finance Committee, in
consultation with the Chief Financial Officer, has established a funding
framework for the Company. This framework ensures flexibility to address
liquidity events, maintains stability and continuity of funding in all market
environments, and includes targets and guidelines around key liquidity measures.
A fundamental premise of the liquidity
45
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
risk management framework is that the firm is not reliant upon nor does it
contemplate forced balance sheet reduction to endure a period of constrained
funding availability. The Company's liquidity risk management framework is
centered on the following concepts and metrics:
o Unencumbered Collateral - The Company monitors the market value and
borrowing value of unencumbered, unhypothecated financial
instruments owned by the Company. These assets may be monetized to
generate liquidity for the repayment of debt obligations or meet
other cash outflows as required. Given that the unencumbered
collateral is held in both regulated and unregulated subsidiaries,
there may be limitations on availability of this liquidity to the
Parent Company.
o Liquidity Ratio - The ratio of cash plus the borrowing value of
unencumbered collateral in relation to total unsecured debt maturing
over the next twelve months. The firm strives to maintain this ratio
at 110% or greater.
o Excess Liquidity - The Company maintains cash and cash equivalents
to meet a broad array of potential cash outflows in a stressed
liquidity environment. This excess liquidity is maintained at the
Parent Company to ensure ready availability to meet cash outflows as
needed.
o Net Cash Capital - The measurement of cash capital sources (i.e.,
equity plus long-term debt maturing in more than 12 months) relative
to cash capital requirements. The Company strives to maintain
positive net cash capital of $2.0 billion or more. The cash capital
framework is discussed in more detail below.
o Stress Funding Action Plan - This plan details immediate and medium
term response to an event-driven liquidity stress. The plan
identifies the stress management group, details an external
communication constituency and specifies heightened information flow
needed to manage through the stress period.
Unencumbered Collateral and Liquidity Ratio
The Company's liquidity ratio is calculated using advance rates that are
considered readily available, reflecting what can be reliably realized in a
stressed liquidity environment. The cash capital model is calculated using
haircuts, which are consistent and symmetrical with the advance rates used in
the liquidity ratio in that the haircut is equal to one minus the advance rate.
In the vast majority of circumstances/asset classes, advance rates are derived
from committed secured bank facilities, whereby a bank or group of banks are
contractually obligated to lend to the Company at a pre-specified advance rate
on specific types of ("eligible") collateral regardless of "market environment."
As such, the advance rates/haircuts used in calculating the liquidity ratio and
in assessing cash capital requirements are typically more conservative than
those the Company realizes in normalized repo and secured lending markets.
As of November 30, 2007, the market value of eligible unencumbered,
unhypothecated financial instruments owned by the Company was approximately
$16.3 billion with a borrowing value of $14.0 billion. These eligible assets are
primarily comprised of U.S. equities and residential and commercial mortgage
whole loans, mortgage- and asset-backed securities, investment grade municipal
and corporate bonds. The vast majority of advance rates on these different asset
types are 70% or higher, and as described above, is based predominantly on
committed, secured facilities that the Company and its subsidiaries maintain in
different regions globally. The liquidity ratio, explained above, based solely
on Company-owned securities, has averaged 151% over the previous 12 months,
including the Company's $4.0 billion unused committed unsecured bank credit, and
138%, excluding the committed unsecured revolving credit facility. On this same
basis, as of November 30, 2007 the liquidity ratio was 171% and 152%,
respectively.
The Company monitors unrestricted liquidity available to the Parent Company via
the ability to monetize unencumbered assets held in unregulated and regulated
entities. As of November 30, 2007, approximately $5.1 billion of the market
value identified in the liquidity ratio data above was held in unregulated
entities and thus likely to be available to the Parent Company. The remaining
$11.2 billion market value of unencumbered securities was held in regulated
entities, a substantial portion of which is available to provide liquidity to
the Parent Company.
Excess Liquidity
46
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
The Company maintains cash and cash equivalents to meet a broad range of
potential cash outflows in a stressed liquidity environment. This excess
liquidity is maintained at the Parent Company to ensure ready availability to
meet cash outflows as needed. The size of the Parent Company Liquidity Pool is
determined from Company-specific stressed liquidity events that the firm could
face over the next 12 months. Specific events that are accounted for in sizing
the liquidity pool include, but are not limited to the following:
o Derivative collateral outflows that would be required if the firm
were to experience a 2-notch ratings downgrade;
o Derivative collateral outflows that could be required after a
variety of stress market moves;
o Potential draws on unfunded committed funding obligations;
o Widening of haircuts in secured financing transactions; and
o Financing haircuts for certain off-balance sheet financing
transactions.
The liquidity pool consists of liquidity immediately accessible by the Parent
Company at all times. This liquidity pool can take the form of cash deposits and
money market instruments that are held at the Parent Company level and
high-quality collateral (corporate bonds, municipal bonds, equity securities)
that is owned by subsidiaries and explicitly pledged to and segregated for the
benefit of the Parent Company and maintained at a third-party custodian. For
purposes of calculating the aggregate value of the Parent Company Liquidity
Pool, the contractually obligated advance rates described herein are used to
determine the borrowing value of collateral pledged. As of November 30, 2007 the
Parent Company Liquidity Pool was $17.4 billion comprised entirely of money
market funds, bank deposits and short-term high quality money market
investments.
Net Cash Capital
The cash capital framework is utilized to evaluate the Company's long-term
funding sources and requirements in their entirety. Cash capital required to
support all of the Company's assets is determined on a regular basis. The
Company holds cash capital to support longer-term funding requirements,
including, but not limited to, the following:
o That portion of financial instruments owned that cannot be funded on
a secured basis (i.e., the haircuts);
o Margin loans and resale principal in excess of the borrowing value
of collateral received;
o Operational cash deposits required to support the regular activities
of the Company (e.g., exchange initial margin);
o Unfunded committed funding obligations, such as leveraged loan
commitments;
o Less liquid and illiquid assets, such as restricted securities and
fixed assets;
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 November 30, 2007, the Company's net cash capital position, defined as the
surplus of long-term funding sources versus long-term funding requirements was
$8.2 billion. Fluctuations in net cash capital are common and are a function of
variability in total assets, balance sheet composition and total capital. The
Company attempts to maintain cash capital sources in excess of the aggregate
longer-term funding requirements of the firm with a target for positive net cash
capital of $2.0 billion or more. For fiscal year 2007, the Company's total cash
capital requirement, cash capital intensity ratio (average haircut), and net
cash capital position have averaged $66.0 billion, 16.5% and $1.8 billion,
respectively.
Three Year Quarterly End of Period Net Cash Capital Profile
[BAR CHART GRAPHIC OMITTTED - represented by chart data below]
Quarterly (in billions)
Data Date NCC
- --------- -------------
1Q05 3.3
2Q05 0.3
3Q05 2.1
4Q05 5.7
1Q06 4.6
2Q06 4.1
3Q06 1.4
4Q06 0.5
1Q07 5.6
2Q07 2.9
3Q07 2.8
4Q07 8.2
47
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Stress Funding Action Plan
The Company maintains a stress funding action plan to ensure the ability of The
Bear Stearns Companies Inc. and its affiliates to manage a liquidity crisis on a
consolidated basis. A liquidity crisis is defined as an event-driven loss of
uncommitted, unsecured, confidence-sensitive funding. The objective of the
stress funding plan is to allow Bear Stearns to meet its maturing obligations as
they occur over a 12-month period with minimal disruption to ongoing business
operations and without having to rely upon access to additional unsecured
financing.
The Stress Funding Action Plan addresses the following issues:
o Delegation of responsibility and authority to the working group;
o Definition of liquidity crisis and liquidity stress levels;
o Notification procedure;
o Working group meeting schedule;
o Management reporting requirements;
o Utilization of credit facilities; and
o Key internal/external contacts.
Funding Framework
- -----------------
Liquidity is of paramount importance for financial services firms in general and
for securities firms, such as the Company in particular, given reliance on
market confidence. With an eye toward stability and continuity of funding, the
firm's overall objective is to ensure sufficient diversity and reliability of
funding sources to meet its financing needs at all times and in all market
environments. With this objective at the forefront, the Company modified its
general funding structure, beginning in late 2006, consistent with the following
elements:
o Increased use of secured funding given the view that secured funding
is inherently less credit sensitive and thus more stable due to the
collateralized nature of the borrowing;
o Introduced substantially greater amounts of longer tenor secured
funding into the repo and bank loan portions of its secured funding
mix;
o Reduced reliance on short-term unsecured funding sources, thereby
lessening both exposure to rollover risk and dependence on any
large, single short-term unsecured creditor;
o Expanded the size and scope of the Parent Company Liquidity Pool,
which consists of cash and cash equivalents held at the parent
company for deployment as needed; and
o Increased the target for net cash capital, which measures the
surplus of longer-term funding sources versus longer-term funding
requirements.
48
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
In general, the Company funds its assets based on their liquidity
characteristics as measured by an asset's reliable self-funding ability. As
such, the firm's liability and capital structure is primarily a function of
asset composition. Most assets are funded with a mix of short-term
(predominantly secured) and longer-term funding (i.e., cash capital). The
relative funding mix is a function of the asset and is determined by the advance
rate that an asset warrants in currently active and utilized secured funding
markets. Secured funding with market driven haircuts is used wherever possible,
while the haircut portion plus a conservative add-on is funded with cash
capital. Illiquid assets are funded entirely with cash capital. Unfunded
commitments are pre-funded with cash capital, while the necessary amount of
which is determined by the haircut to be assigned to the asset once funded.
The Company's use of unsecured funding is dominated by the long-term unsecured
component. Long-term debt with the maturity greater than one year is a source of
cash capital and serves to provide stability to the firm's overall funding
profile. The firm accesses long-term debt in a number of currencies allowing it
to tap a broad and diverse investor base. Maturity concentration guidelines have
been established and are regularly monitored to both minimize rollover risk and
target prospective issuance. Long-term debt totaling $59.0 billion and $48.1
billion had remaining maturities beyond one year at November 30, 2007 and
November 30, 2006, respectively. As of November 30, 2007, the weighted average
maturity of the Company's long-term debt was 4.3 years. The Company accesses
funding in a variety of markets in the United States, Europe and Asia. The
Company issues debt through syndicated U.S.-registered offerings,
U.S.-registered and 144A medium-term note programs, other U.S. and non-U.S. bond
and note offerings.
With respect to short-term unsecured funding, the Company seeks to ensure
prudent usage thereof, as well as tapping a broad diverse base of credit
providers and funding markets. In aggregate, usage of short-term unsecured debt
has declined in recent periods given the emphasis on greater use of secured
funding with a significant term component. Diversification by product,
geography, maturity and creditor/investor facilitates management of related
funding risks. Reduced reliance over the last twelve months on more credit
sensitive, potentially less stable short-term unsecured funding is positive to
the firm's liquidity profile and was accomplished intentionally concurrent with
the desired shift in funding framework. In addition to the above considerations,
the Company:
o Regularly monitors and quantifies potential draws on its liquidity.
These include, but are not limited to, ratings downgrades,
commitments to extend credit, repo haircut widening and derivative
collateral outflows in a stressed market. The associated liquidity
risk is mitigated by inclusion in the Company's Parent Company
Liquidity Pool;
o Monitors and prudently funds illiquid and other hard to fund assets,
ensuring these are predominantly funded by 100% cash capital;
o Maintains ongoing dialogue and relationships with broad, diverse
base of debt investors and bank creditors, as these key creditor
constituents are crucial to the Company's liquidity and financial
health;
o Manages investor and maturity concentration risk via strict
adherence to short-term debt investor concentration limits and
regularly monitors the maturity profile of its unsecured debt; and
o Adheres to a general guideline of no more than 20% of its long-term
debt maturing in any one year, as well as no more than 10% maturing
in any one quarter over the next five years. The bar charts reflect
the actual position of long-term debt maturities vis-a-vis the
guidelines. In this context, maturity is based on earliest
redemption date for putable debt and earliest maturity date for
extendible debt.
49
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
YEARLY LONG-TERM DEBT MATURITY PROFILE
As of November 30, 2007
[BAR CHART GRAPHIC OMITTED - represented by chart data below]
(in millions)
0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 10+
- -----------------------------------------------------------------------------------------------------
Non-Extendibles 9,586 12,469 10,430 6,716 9,242 4,909 3,196 1,778 1,300 4,712 3,204
Extendibles 996
YEARS
FIVE YEAR QUARTERLY LONG-TERM DEBT MATURITY PROFILE
[BAR CHART GRAPHIC OMITTED - represented by chart data below]
(in millions)
1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11
- -----------------------------------------------------------------------------------------------------------------------------------
Non-Extendibles 2,134 2,580 3,325 1,547 2,748 3,140 3,075 3,506 3,358 2,019 2,913 2,140 2,879 792 1,768 1,277
Extendibles (1) 996
1Q12 2Q12 3Q12 4Q12
- ---------------------------------------
Non-Extendibles 2999 476 5582 185
Extendibles (1)
[_] Non-Extendibles [_] Extendibles(1)
(1) Extendibles are debt instruments with an extendible maturity
date and are included in long-term debt at the earliest maturity
date. Unless debt holders instruct the Company to redeem their debt,
the earliest maturity date of these instruments is automatically
extended. Based on past experience, the majority of the Company's
extendibles is expected to remain outstanding beyond their earliest
maturity date.
50
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Legal Entity Structure
- ----------------------
The Parent Company, operating as the centralized unsecured funding arm of the
Company, raises the vast majority of the Company's unsecured debt, including
both commercial paper and long-term debt. The Parent Company is thus the
"central bank" of the Company, where all capital is held and from which capital
is deployed. The benefits of a centralized funding approach include greater
control of issuance and flexibility to meet subsidiary funding needs, while the
legal entity structure can constrain liquidity available to the Company. The
Firm's inter-company funding approach mitigates this risk. The Parent Company
advances funds in the form of debt or equity to subsidiaries to meet their
operating funding needs and, in the case of regulated entities, regulatory
capital requirements. Primary regulated subsidiaries include Bear Stearns, BSSC,
BSIL, BSIT, BSB, and CTC. See Note 16, "Regulatory Requirements", in the Notes
to Consolidated Financial Statements. In addition to the primary regulated
subsidiaries, the Company also conducts significant activities through other
wholly owned subsidiaries, including: Bear Stearns Global Lending Limited, Bear
Stearns Financial Products Inc., Bear Stearns Capital Markets Inc., Bear Stearns
Credit Products Inc., Bear Stearns Forex Inc., EMC Mortgage Corporation, Bear
Stearns Commercial Mortgage, Inc., Bear Stearns Investment Products Inc., and
Bear Energy L.P. In connection with all of the Company's operating activities, a
substantial portion of the Company's long-term borrowings and equity has been
used to fund investments in, and advances to, these subsidiaries, including
subordinated debt advances.
Within this funding framework, the Company attempts to fund equity investments
in subsidiaries with equity from the Parent Company (i.e., utilize no equity
double leverage). At November 30, 2007, the Parent Company's equity investment
in subsidiaries was $8.1 billion versus common stockholders' equity and
preferred equity of $11.4 billion and $352 million, respectively. As such, at
November 30, 2007, the ratio of the equity investment in subsidiaries to Parent
Company equity (equity double leverage) was approximately 0.71 based on common
equity and 0.69 including preferred equity. At November 30, 2006, these measures
were 0.67 based on common equity and 0.65 including preferred equity.
Additionally, all subordinated debt advances to regulated subsidiaries for use
as regulatory capital, which totaled $12.9 billion at the end of fiscal 2007,
are funded with long-term debt issued by the Company, having a remaining
maturity equal to or greater than the maturity of the subordinated debt advance.
The Company regularly monitors the nature and significance of assets or
activities conducted in all subsidiaries and attempts to fund such assets with
both capital and/or borrowings having a maturity profile and relative mix
consistent with the nature and self-funding ability of the assets being
financed. The funding mix also takes into account regulatory capital
requirements for regulated subsidiaries.
Balance Sheet and Financial Leverage
- ------------------------------------
Asset Composition
The Company's actual level of balance sheet capital, capital requirements and
thereby the level of financial leverage, is a function of numerous variables,
including asset composition, rating agency/creditor perception, business
prospects, regulatory requirements, balance sheet liquidity, cost/availability
of capital and risk of loss. The Company consistently maintains a highly liquid
balance sheet, with the vast majority of the Company's assets consisting of
cash, marketable securities inventories and collateralized receivables arising
from customer-related and proprietary securities transactions.
Collateralized receivables consist of resale agreements secured predominantly by
U.S. government and agency securities, customer margin loans and securities
borrowed, which are typically secured by marketable corporate debt and equity
securities. The nature of the Company's business as a securities dealer requires
it to carry significant levels of securities inventories to meet its customer
and proprietary trading needs. Additionally, the Company's role as a financial
intermediary for customer activities, which it conducts on a principal basis,
together with its customer-related activities in its clearance business, results
in significant levels of customer-related balances, including customer margin
debt, securities borrowed and reverse repurchase activity. The Company's total
assets and financial leverage can and do fluctuate, depending largely on
economic and market conditions, volume of activity and customer demand.
51
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
The Company's total assets at November 30, 2007 increased to $395.4 billion from
$350.4 billion at November 30, 2006. The increase was primarily attributable to
increases in cash and cash equivalents, financial instruments owned, and
customer receivables, partially offset by a decrease in securities purchased
under agreements to resell.
Balance Sheet Size and Variability
Given the nature of the Company's market-making and customer-financing activity,
the overall size of the balance sheet fluctuates from time to time. The
Company's total assets at each quarter end are typically lower than would be
observed on an average basis. At the end of each quarter, the Company typically
uses excess cash to finance high-quality, highly liquid securities inventory
that otherwise would be funded via the repurchase agreement market. In addition,
the Company reduces its matched book repurchase and reverse repurchase
activities at quarter end. Finally, the Company may reduce the aggregate level
of inventories through ordinary course, open market activities in the most
liquid portions of the balance sheet, which are principally U.S. government and
agency securities and agency mortgage pass-through securities.
At November 30, 2007, total assets of $395.4 billion were approximately 12.2%
lower than the average of the month-end balances observed over the trailing
12-month period, while total assets at November 30, 2006 were approximately 0.5%
higher than the average of month-end balances over the trailing 12-months prior.
Despite fluctuations in total assets at each quarter end, the Company's overall
market, credit and liquidity risk profile does not change materially, since the
reduction in asset balances is predominantly in highly liquid, short-term
instruments that are financed on a secured basis. This periodic reduction
verifies the inherently liquid nature of the balance sheet and provides
consistency with respect to creditor constituents' evaluation of the Company's
financial condition.
Leverage Ratios
Balance sheet leverage measures are one approach to assessing the capital
adequacy of a securities firm, such as the Company. Gross leverage equals total
assets divided by stockholders' equity, inclusive of preferred and trust
preferred equity. The Company views its trust preferred equity as a component of
its equity capital base given the equity-like characteristics of the securities.
The Company also receives rating agency equity credit for these securities. Net
adjusted leverage equals net adjusted assets divided by tangible equity capital,
which excludes goodwill and intangible assets from both the numerator and the
denominator, as equity used to support goodwill and intangible assets is not
available to support the balance of the Company's net assets. With respect to a
comparative measure of financial risk and capital adequacy, the Company believes
that the low-risk, collateralized nature of the items excluded in deriving net
adjusted assets (see table) renders net adjusted leverage as the more relevant
measure.
52
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
The following table presents total assets and net adjusted assets with the
resultant leverage ratios at November 30, 2007 and 2006:
(in millions, except ratios) 2007 2006
- -----------------------------------------------------------------------------------------------------------------------------------
Total assets $ 395,362 $ 350,433
Deduct:
Cash and securities deposited with clearing organizations
or segregated in compliance with federal regulations 12,890 8,804
Securities purchased under agreements to resell 27,878 38,838
Securities received as collateral 15,599 19,648
Securties borrowed 82,245 80,523
Receivables from customers 41,115 29,482
Assets of variable interest entities and
Mortgage loan special purpose entities, net 30,605 29,080
Goodwill & intangible assets 952 383
- -----------------------------------------------------------------------------------------------------------------------------------
Subtotal 184,078 143,675
- -----------------------------------------------------------------------------------------------------------------------------------
Add:
Financial instruments sold, but not yet purchased 43,807 42,257
Deduct:
Derivative financial instruments 13,492 11,865
- -----------------------------------------------------------------------------------------------------------------------------------
Net adjusted assets $ 214,393 $ 174,067
===================================================================================================================================
Stockholders' equity
Common equity $ 11,441 $ 11,770
Preferred stock 352 359
Stock-based compensation --(2) 816(1)
- -----------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 11,793 12,945
- -----------------------------------------------------------------------------------------------------------------------------------
Add:
Trust preferred equity 263 263
- -----------------------------------------------------------------------------------------------------------------------------------
Subtotal - leverage equity 12,056 13,208
- -----------------------------------------------------------------------------------------------------------------------------------
Deduct:
Goodwill & intangible assets 952 383
- -----------------------------------------------------------------------------------------------------------------------------------
Tangible equity capital $ 11,104 $ 12,825
===================================================================================================================================
Gross leverage 32.8x 26.5x
Net adjusted leverage 19.3x 13.6x
- -----------------------------------------------------------------------------------------------------------------------------------
(1) Represents stock-based compensation associated with fiscal 2006
awards that was reflected in equity as of the grant date in December
2006, in accordance with SFAS No. 123(R), "Share-based Payment."
Excluding this adjustment for stock-based compensation, gross
leverage and net adjusted leverage would be 28.3x and 14.5x,
respectively.
(2) The Company changed the requisite service period associated with its
2007 stock-based compensation awards to align it with the vesting
schedules. As a result, an adjustment to stockholders' equity was
not applicable.
53
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Total Capital
The Company's total capital base, which consists of long-term debt, preferred
equity issued by subsidiaries and total stockholders' equity, increased to $80.3
billion at November 30, 2007 from $66.7 billion at November 30, 2006. This
change was primarily due to a net increase in long-term debt.
The Company's total capital base as of November 30, 2007 and 2006 was as
follows:
(in millions) 2007 2006
- ----------------------------------------------------------------------
Long-term borrowings:
Senior debt $ 67,275 $ 53,307
Subordinated debt (1) 1,263 1,263
- ----------------------------------------------------------------------
Total long-term borrowings $ 68,538 $ 54,570
Stockholders' equity:
Preferred stockholders' equity $ 352 $ 359
Common stockholders' equity 11,441 11,770
- ----------------------------------------------------------------------
Total stockholders' equity $ 11,793 $ 12,129
- ----------------------------------------------------------------------
Total capital $ 80,331 $ 66,699
======================================================================
(1) Includes $1.0 billion in subordinated debt issued by the Company and $263
million in junior subordinated deferrable interest debentures
("Debentures") issued by the Company and held by Bear Stearns Capital
Trust III ("Capital Trust III") at November 30, 2007 and 2006. See Note 9,
"Long-Term Borrowings," and Note 10, "Preferred Stock," in the Notes to
Consolidated Financial Statements for further information.
The amount of long-term debt as well as total capital that the Company maintains
is driven by a number of factors, with particular focus on asset composition.
The Company's ability to support increases in total assets is a function of its
ability to obtain short-term secured and unsecured funding, as well as its
access to longer-term sources of capital (i.e., long-term debt and equity). The
Company regularly measures and monitors its total capital requirements, which
are primarily a function of the self-funding ability of its assets. The equity
portion of total capital is primarily a function of on- and off-balance-sheet
risks (i.e., market, credit and liquidity) and regulatory capital requirements.
As such, the liquidity and risk characteristics of assets being held are
critical determinants of both total capital and the equity portion thereof, thus
significantly influencing the amount of leverage that the Company can employ.
Credit Ratings
- --------------
The Company's access to external sources of financing, as well as the cost of
that financing, is dependent on various factors and could be adversely affected
by a deterioration of the Company's long- and short-term debt ratings, which are
influenced by a number of factors. These include, but are not limited to:
o Material changes in operating margins;
o Earnings trends and volatility;
o The prudence of funding and liquidity management practices;
o Perceived changes in risk appetite;
o Financial leverage on an absolute basis or relative to peers;
o The composition of the balance sheet and/or capital structure;
o Geographic and business diversification; and
o The Company's market share and competitive position in the business
segments in which it operates.
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
54
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
credit ratings could also trigger incremental collateral requirements,
predominantly in the over-the-counter derivatives market. As of November 30,
2007, a downgrade by either Moody's Investors Service or Standard & Poor's in
the Company's long-term credit ratings to the level of A3 or A- would have
resulted in the Company being required to post $29.6 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 the
Company being required to post an additional $353.2 million in collateral.
At the date of filing, the Company's long-term/short-term debt ratings were as
follows:
Long-Term Rating Short-Term Rating
- ------------------------------------------------------------------------------
Dominion Bond Rating Service Limited A(high) R-1(middle)
Fitch Ratings A+ F1
Japan Credit Rating Agency, Ltd AA- NR
Moody's Investors Service A2 P-1
Rating & Investment Information, Inc. AA- NR
Standard & Poor's Ratings Services A A-1
- ------------------------------------------------------------------------------
NR - does not assign a short-term rating
Following the Company's announcement on November 14, 2007 of writedowns on
collateralized debt obligations ("CDOs") and subprime positions, Standard &
Poor's (S&P) lowered the Company's long-term senior unsecured debt from A+ to A
and left the outlook on "Negative." S&P stated that the writedown was
comparatively less than that of peers and they believe the exposure to be
manageable, but that the Company's concentration in fixed income may hinder
future revenue generation. Fitch Ratings (Fitch) affirmed the long-term rating
of A+ but revised the outlook to "Negative" from "Stable." At the same time,
Fitch lowered the short-term rating to F1 from F1+. Fitch acknowledged the
Company's strong businesses outside of fixed income and well-managed liquidity,
but cited pressure on near term profitability as a concern. Moody's Investors
Service (Moody's) revised the outlook on Bear Stearns' A1 rating to "Review for
Downgrade". Following the fourth quarter 2007 earnings release, Moody's lowered
the long-term senior unsecured debt rating to A2 from A1 and revised the outlook
to "Stable". Moody's cited weak performance in 2007 and challenging core
operating outlook in 2008 as reasoning for the downgrade, but a strong and
increasingly global franchise, historically stable earnings, and ample capital
position as support for the "Stable" outlook. Dominion Bond Rating Service
Limited (DBRS) had previously revised the outlook on its A (high) rating on the
Company to "Stable" from "Positive" in early November. Following the fourth
quarter 2007 earnings release, DBRS affirmed both the ratings and outlook.
Committed Credit Facilities
- ---------------------------
The Company has a committed revolving credit facility ("Facility") totaling $4.0
billion, which permits borrowing on a secured basis by the Parent Company, BSSC,
BSIL and certain other subsidiaries. The Facility also allows the Parent
Company, BSIL and Bear Stearns International Trading Limited ("BSIT") to borrow
up to $4.0 billion of the Facility on an unsecured basis. Secured borrowings can
be collateralized by both investment-grade and non-investment-grade financial
instruments as the Facility provides for defined advance rates on a wide range
of financial instruments eligible to be pledged. The Facility contains financial
covenants, the most significant of which require maintenance of specified levels
of stockholders' equity of the Company and net capital of BSSC. The Facility
terminates in February 2008, with all loans outstanding at that date payable no
later than February 2009. The Company intends to renew the Facility at market
available terms. There were no borrowings outstanding under the Facility at
November 30, 2007.
The Company has a $1.5 billion committed revolving securities repo facility
("Repo Facility"), which permits borrowings secured by a broad range of
collateral under a repurchase arrangement by the Parent Company, BSIL, BSIT and
BSB and BS Forex. The Repo Facility contains financial covenants that require,
among other things, maintenance of specified levels of
55
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
stockholders' equity of the Company. The Repo Facility terminates in August
2008, with all repos outstanding at that date payable no later than August 2009.
There were no borrowings outstanding under the Repo Facility at November 30,
2007.
The Company has a $350 million committed revolving credit facility ("Pan Asian
Facility"), which permits borrowing on a secured basis by the Parent Company,
BSSC, Bear Stearns Japan Limited ("BSJL"), and BSIL. The Pan Asian Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company and net capital of BSSC.
In December 2007, the Company renewed the Facility at a $350 million committed
level with substantially the same terms. The Pan Asian Facility terminates in
December 2008 with all loans outstanding at that date payable no later than
December 2009. There were no borrowings outstanding under the Pan Asian Facility
at November 30, 2007.
The Company has a $450 million committed revolving credit facility ("Tax Lien
Facility"), which permits borrowing on a secured basis by the Parent Company,
Plymouth Park Tax Services and Madison Tax Capital LLC. The Tax Lien Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company. The Tax Lien Facility
terminates in March 2008 with all loans outstanding at that date payable no
later than March 2009. There were no borrowings outstanding under the Tax Lien
Facility at November 30, 2007.
The Company also maintains a series of committed credit facilities, which permit
borrowing on a secured basis, to support liquidity needs for the financing of
investment-grade and non-investment-grade corporate loans, residential
mortgages, commercial mortgages, listed options and whole loans. The facilities
are expected to be drawn from time to time and expire at various dates, the
longest of such periods ending in fiscal 2008. All of these facilities contain a
term-out option of one year or more for borrowings outstanding at expiration.
The banks providing these facilities are committed to provide up to an aggregate
of approximately $6.7 billion. At November 30, 2007, the borrowings outstanding
under these committed credit facilities were $4.9 billion.
Stock Repurchase Program
- ------------------------
The Company has various employee stock compensation plans designed to increase
the emphasis on stock-based incentive compensation and align the compensation of
its key employees with the long-term interests of stockholders. Such plans
provide for annual grants of stock units and stock options. The Company intends
to offset the potentially dilutive impact of the annual grants by purchasing
common stock throughout the year in open market and private transactions.
On December 13, 2006, the Board of Directors of the Company approved an
amendment to the Stock Repurchase Program ("Repurchase Program") to replenish
the previous authorizations to allow the Company to purchase up to $2.0 billion
of common stock in fiscal 2007 and beyond. On September 18, 2007, the Board of
Directors approved an amendment to the Repurchase Program authorizing the
purchase of up to $2.5 billion of common stock in fiscal 2007 and beyond. The
amendment supersedes the previous $2.0 billion authorization. The Repurchase
Program will be used to acquire shares of common stock for the Company's
employee stock compensation plans and for up to $1.0 billion in corporate share
repurchases. During the fiscal year ended November 30, 2007, the Company
purchased under the current and previous authorizations a total of approximately
11.9 million shares at a cost of $1.56 billion of which 3.4 million shares at a
cost of $374 million were purchased pursuant to corporate share repurchases
beyond employee stock grants. Approximately $2.1 billion was available to be
purchased under the current authorization as of November 30, 2007.
Pursuant to a $200 million CAP Plan Earnings Purchase Authorization ("CAP
Authorization"), which was approved by the Compensation Committee of the Board
of Directors of the Company on December 12, 2006, during the fiscal year ended
November 30, 2007, the Company purchased a total of 711,557 shares of its common
stock at a total cost of $108 million. Approximately $92 million was available
to be purchased under the CAP Authorization as of November 30, 2007.
56
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Cash Flows
- ----------
Fiscal 2007
Cash and cash equivalents increased $16.81 billion to $21.41 billion at November
30, 2007 from $4.60 billion at November 30, 2006. Cash provided by operating
activities was $11.15 billion, primarily attributable to the increase in
securities sold under agreements to repurchase, securities purchased under
agreements to resell, net and payables to customers, partially offset by
increases in financial instruments owned, at fair value, receivables from
customers and securities borrowed, securities loaned, net, which occurred in the
normal course of business as a result of changes in customer needs, market
conditions and trading strategies. Cash used in investing activities of $295
million reflected purchases of property, equipment and leasehold improvements.
Cash provided by financing activities of $5.96 billion reflected net proceeds
from the issuance of long-term borrowings of $24.92 billion and net proceeds
relating to other secured borrowings of $9.09 billion, primarily to fund normal
operating activities. This was partially offset by net payments for unsecured
short-term borrowings of $14.14 billion and net payments for the
retirement/repurchase of long-term borrowings of $12.50 billion. Treasury stock
purchases of $1.67 billion were made to provide for the annual grant of CAP Plan
units, restricted stock units and stock options and other corporate purposes.
Fiscal 2006
Cash and cash equivalents decreased $1.26 billion to $4.60 billion at November
30, 2006 from $5.86 billion at November 30, 2005. Cash used in operating
activities was $19.22 billion, primarily attributable to increases in financial
instruments owned, at fair value and securities borrowed, securities loaned,
net, partially offset by increases in financial instruments sold, but not yet
purchased, at fair value, securities sold under agreements to repurchase,
securities purchased under agreements to resell, net and payables to customers,
which occurred in the normal course of business as a result of changes in
customer needs, market conditions and trading strategies. Cash used in investing
activities of $181 million reflected purchases of property, equipment and
leasehold improvements. Cash provided by financing activities of $18.14 billion
reflected net proceeds from the issuance of long-term borrowings of $19.89
billion, net proceeds relating to unsecured short-term borrowings of $6.03
billion and net proceeds from other secured borrowings of $3.02 billion,
primarily to fund normal operating activities. This was partially offset by net
payments for the retirement/repurchase of long-term borrowings of $10.25
billion. Treasury stock purchases of $1.37 billion were made to provide for the
annual grant of CAP Plan units, restricted stock units and stock options and
other corporate purposes.
Fiscal 2005
Cash and cash equivalents increased $1.69 billion to $5.86 billion at November
30, 2005 from $4.17 billion at November 30, 2004. Cash used in operating
activities was $14.44 billion, primarily attributable to an increase in
financial instruments owned, at fair value and a decrease in payables to
customers, partially offset by increases in securities sold under agreements to
repurchase, securities purchased under agreements to resell, net and financial
instruments sold, but not yet purchased, at fair value and a decrease in
securities borrowed, securities loaned, net, which occurred in the normal course
of business as a result of changes in customer needs, market conditions and
trading strategies. Cash used in investing activities of $203 million reflected
purchases of property, equipment and leasehold improvements. Cash provided by
financing activities of $16.33 billion reflected net proceeds from the issuance
of long-term borrowings of $16.00 billion and net proceeds relating to unsecured
short-term borrowings of $8.03 billion, primarily to fund normal operating
activities. This was partially offset by net payments for the
retirement/repurchase of long-term borrowings of $7.27 billion. Treasury stock
purchases of $870 million were made to provide for the annual grant of CAP Plan
units, restricted stock units and stock options.
57
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Regulations
- -----------
The Company is regulated by the Securities and Exchange Commission ("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 November 30, 2007, the Company was in compliance with
the CSE capital requirements.
As registered broker-dealers and futures commission merchants, Bear Stearns and
BSSC are subject to the net capital requirements of the Exchange Act and Rule
1.17 under the Commodity Futures Trading Commission. 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, the Company's London-based broker-dealer subsidiaries, are
subject to the regulatory capital requirements of the United Kingdom's Financial
Services Authority. Additionally, BSB is subject to the regulatory capital
requirements of the Financial Regulator. Custodial Trust Company ("CTC"), a
Federal Deposit Insurance Corporation ("FDIC") insured New Jersey state
chartered bank, is subject to the regulatory capital requirements of the FDIC.
At November 30, 2007, Bear Stearns, BSSC, BSIL, BSIT, BSB and CTC were in
compliance with their respective regulatory capital requirements. Certain other
subsidiaries are subject to various securities regulations and capital adequacy
requirements promulgated by the regulatory and exchange authorities of the
countries in which they operate. At November 30, 2007, these other subsidiaries
were in compliance with their applicable local capital adequacy requirements.
The Company's broker-dealer subsidiaries and other regulated subsidiaries are
subject to minimum capital requirements and may also be subject to certain
restrictions on the payment of dividends, which could limit the Company's
ability to withdraw capital from such regulated subsidiaries, which in turn
could limit the Company's ability to pay dividends. See Note 16, "Regulations,"
in the Notes to Consolidated Financial Statements.
Merchant Banking and Private Equity Investments
- -----------------------------------------------
In connection with the Company's merchant banking activities, the Company has
investments in merchant banking and private equity-related investment funds as
well as direct investments in private equity-related investments. At November
30, 2007, the Company held investments with an aggregate recorded value of $986
million, reflected in the Consolidated Statements of Financial Condition in
"Other Assets." At November 30, 2006, the Company held investments with an
aggregate recorded value of $822 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
non-investment-grade commercial and leveraged loans. The Company also invests
in, syndicates and trades in loans to 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 November 30, 2007 and 2006, the Company held high yield positions
approximating $8.84 billion and $10.73 billion, respectively, substantially all
of which are in "Financial Instruments Owned" in the Consolidated Statements of
Financial Condition, and $716 million and $605 million, respectively, reflected
in "Financial Instruments Sold, But Not Yet Purchased" in the Consolidated
Statements of Financial Condition. Included in the high yield positions are
extensions of credit to highly leveraged companies. At November 30, 2007 and
2006, the amount outstanding to highly leveraged borrowers totaled $6.27 billion
and $7.70 billion, respectively. At November 30, 2007, the largest industry
58
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
concentration to highly leveraged borrowers was the transportation industry,
which approximated 23.3% of these highly leveraged borrowers' positions. At
November 30, 2006, the largest industry concentration to highly leveraged
borrowers was the technology industry, which approximated 22.8% of these highly
leveraged borrowers' positions. 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 November 30, 2007, the
Company's contractual obligations by maturity, excluding derivative financial
instruments, were as follows:
Payments Due By Period
----------------------------------------------------
Fiscal Fiscal
(in millions) Fiscal 2008 2009- 2010 2011- 2012 Thereafter Total
- --------------------------------------------------------------------------------------------------
Long-term borrowings (1) (2) $ 9,586 $ 23,895 $ 15,958 $ 19,099 $ 68,538
Future minimum lease payments (3) 125 244 231 650 1,250
Bear Energy (4) 81 165 674 3,399 4,319
- --------------------------------------------------------------------------------------------------
(1) Amounts include fair value adjustments in accordance with SFAS No.
133 and hybrid instruments accounted for at fair value as elected
under SFAS No. 155, as well as $263 million of junior subordinated
deferrable interest debentures ("Debentures"). The Debentures will
mature on May 15, 2031; however, effective May 15, 2006, the
Company, at its option, may redeem the Debentures. The Debentures
are reflected in the table at their contractual maturity dates.
(2) Included in fiscal 2009-2010 are approximately $996 million of
floating-rate notes that are redeemable prior to maturity at the
option of the noteholder. These notes contain certain provisions
that effectively enable noteholders to put these notes back to the
Company and, therefore, are reflected in the table at the date such
notes first become redeemable. The final maturity dates of these
notes are during fiscal 2009, 2010 and 2011.
(3) See Note 17, "Commitments and Contingencies," in the Notes to
Consolidated Financial Statements.
(4) Primarily represents obligations under tolling agreements (net of
re-tolling agreements) associated with the Company's energy
business.
59
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Commitments
- -----------
The Company has commitments(1) under a variety of commercial arrangements. At
November 30, 2007, the Company's commitments associated with lending and
financing, private equity-related investments and partnerships, underwriting,
outstanding letters of credit and other commercial commitments summarized by
period of expiration were as follows:
Amount of Commitment Expiration Per Period
--------------------------------------------------------------------------------
Commitments
Fiscal Fiscal Fiscal with no stated
2008 2009-2010 2011-2012 Thereafter maturity Total
- ---------------------------------------------------------------------------------------------------------------------
(in millions)
- ---------------------------------------------------------------------------------------------------------------------
Lending-related commitments:
Investment-grade(2) $ 630 $ 937 $ 1,785 $ 69 $ -- $ 3,421
Non-investment-grade(2) 745 333 1,790 418 11 3,297
Contingent commitments 501 -- -- -- -- 501
Commitments to invest in
private equity-related
investments and partnerships(3) 101 45 130 425 28 729
Underwriting commitments 652 -- -- -- -- 652
Commercial and residential loans 2,229 418 125 56 -- 2,828
Letters of credit 2,714 -- 35 -- -- 2,749
Other commercial commitments 131 39 -- -- -- 170
- ---------------------------------------------------------------------------------------------------------------------
(1) See Note 17, "Commitments and Contingencies," in the Notes to Consolidated
Financial Statements.
(2) In order to mitigate the exposure to investment-grade and
non-investment-grade borrowings, the Company entered into credit default swaps
approximating $952 million and $220 million, respectively, in notional value, at
November 30, 2007.
(3) These commitments will be funded, if called, through the end of the
respective investment periods, the longest of such periods ending in 2020.
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 Statement of Financial Accounting Standards ("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 5, "Transfers of Financial Assets and Liabilities," in the Notes to
Consolidated Financial Statements for a more complete discussion of the
Company's securitization activities.
60
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
The Company regularly creates or transacts with entities that may be VIEs. These
entities are an essential part of its securitization, asset management and
structured finance businesses. In addition, the Company purchases and sells
instruments that may be variable interests. The Company consolidates those VIEs
in which the Company is the primary beneficiary. See Note 6, "Variable Interest
Entities and Mortgage Loan Special Purpose Entities," in the Notes to
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-backed and asset-backed securitization
businesses.
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)
"Consolidation of Variable Interest Entities," 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 18, "Guarantees," in
the Notes to Consolidated Financial Statements for a complete discussion on
guarantees.
In 1997, the Company established a program whereby it created a series of
municipal securities trusts in which it has retained interests. These trusts
purchase fixed-rate, long-term, highly rated, insured or escrowed municipal
bonds financed by the issuance of trust certificates. In the Company's capacity
as liquidity provider to the trusts, the maximum exposure to loss at November
30, 2007 was approximately $3.87 billion, which represents the outstanding
amount of all trust certificates. This exposure to loss is mitigated by the
underlying municipal bonds held by trusts. The underlying municipal bonds in the
trusts are either AAA- or AA-rated, insured or escrowed to maturity. Such bonds
had a market value, net of related offsetting positions, approximating $3.77
billion at November 30, 2007.
The Company does not sponsor any SIVs or Commercial Paper Conduits.
Additionally, the Company has no obligation to buy back subprime assets.
DERIVATIVE FINANCIAL INSTRUMENTS
Derivative financial instruments are contractual commitments between
counterparties that derive their values from changes in an underlying interest
rate, currency exchange rate, index (e.g., S&P 500), reference rate (e.g.,
LIBOR), or asset value referenced in the related contract. Some derivatives,
such as futures contracts, certain options and index-referenced warrants, can be
traded on an exchange. Other derivatives, such as interest rate and currency
swaps, caps, floors, collars, swaptions, equity swaps and options, structured
notes and forward contracts, are negotiated in the over-the-counter markets.
Derivatives generate both on- and off-balance-sheet risks depending on the
nature of the contract. The Company is engaged as a dealer in over-the-counter
derivatives and, accordingly, enters into transactions involving derivative
instruments as part of its customer-related and proprietary trading activities.
The Company's dealer activities require it to make markets and trade a variety
of derivative instruments. In connection with these activities, the Company
attempts to mitigate its exposure to market risk by entering into offsetting
transactions that may include over-the counter derivative contracts or the
purchase or sale of interest-bearing securities, equity securities, financial
futures and forward contracts. The Company also utilizes derivative instruments
to offset proprietary market-making and trading activities. In this regard, the
utilization of derivative instruments is designed to reduce or mitigate market
risks associated with holding dealer inventories or in connection with
arbitrage-related trading activities. The Company also utilizes interest rate
and currency swaps, futures contracts and U.S. Treasury positions to hedge
certain debt issuances as part of its asset and liability management. In
addition, the Company actively manages commodity price risks resulting from
exposures to changes in spot and forward prices in
61
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
electricity and natural gas with exchange traded futures, swaps, OTC swaps and
options.
In connection with the Company's dealer activities, the Company formed BSFP and
its wholly owned subsidiary, Bear Stearns Trading Risk Management Inc.
("BSTRM"). BSFP is a wholly owned subsidiary of the Company. BSFP and BSTRM were
established to provide clients with a AAA-rated counterparty that offers a wide
range of global derivative products. BSFP is structured so that if a specified
trigger event (including certain credit rating downgrades of the Company, the
failure of BSFP to maintain its credit rating and the occurrence of a bankruptcy
event with respect to the Company) occurs, BSFP will perform on all of its
contracts to their original maturities with the assistance of an independent
derivatives portfolio manager who would assume the active management of BSFP's
portfolio. BSTRM is structured so that, on the occurrence of a specified trigger
event, it will cash-settle all outstanding derivative contracts in a
predetermined manner. Clients can use either structure. The AAA/Aaa ratings that
BSFP and BSTRM have received are based on their ability to meet their respective
obligations without any additional capital from the Company. In the unlikely
occurrence of a trigger event, the Company does not expect any significant
incremental impact on the liquidity or financial condition of the Company. At
November 30, 2007, there was a potential cash settlement payable by BSTRM of
$210 million on the occurrence of a trigger event.
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 November 30, 2007 and 2006, the Company had notional/contract amounts of
approximately $13.40 trillion and $8.74 trillion, respectively, of derivative
financial instruments, of which $1.85 trillion and $1.25 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 Consolidated Statements of
Financial Condition. The Company's derivative financial instruments outstanding,
which either are used to offset trading positions, modify the interest rate
characteristics of its long- and short-term debt, or are part of its derivative
dealer activities, are marked to fair value.
The Company's derivatives had a notional weighted average maturity of
approximately 4.2 years at November 30, 2007 and 4.1 years at November 30, 2006.
The maturities of notional/contract amounts outstanding for derivative financial
instruments as of November 30, 2007 were as follows:
Less Than One to Three to Greater Than
(in billions) One Year Three Years Five Years Five Years Total
- -------------------------------------------------------------------------------------------------------
Swap agreements, including
options, swaptions, caps,
collars and floors $ 2,624.6 $ 2,795.7 $ 2,321.5 $ 3,250.2 $ 10,992.0
Futures contracts 707.4 387.2 49.1 -- 1,143.7
Forward contracts 164.6 -- -- -- 164.6
Options held 569.8 28.8 5.2 1.4 605.2
Options written 459.7 25.0 5.0 1.5 491.2
- -------------------------------------------------------------------------------------------------------
Total $ 4,526.1 $ 3,236.7 $ 2,380.8 $ 3,253.1 $ 13,396.7
=======================================================================================================
Percent of total 33.8% 24.1% 17.8% 24.3% 100.0%
=======================================================================================================
CRITICAL ACCOUNTING POLICIES
The 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 consolidated financial
statements (see Note 1, "Summary of Significant Accounting
62
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Policies," in the Notes to Consolidated Financial Statements). Critical
accounting policies are those policies that are the most important to the
consolidated financial statements and/or those that require significant
management judgment related to matters that are uncertain.
Valuation of Financial Instruments
The Company has identified the valuation of financial instruments as a critical
accounting policy due to the complex nature of certain of its products, the
degree of judgment required to appropriately value these products and the
pervasive impact of such valuation on the financial condition and earnings of
the Company.
The Company adopted SFAS No. 157, "Fair Value Measurements," in the first
quarter of 2007. SFAS No. 157 applies to all financial instruments that are
being measured and reported on a fair value basis. This includes those items
reported in "Financial instruments owned" and "Financial instruments sold, but
not yet purchased" as well as other assets and liabilities that are reported at
fair value.
As defined in SFAS No. 157, fair value is the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date. In determining fair value the
Company uses various methods including market, income and cost approaches. Based
on these approaches, the Company often utilizes certain assumptions that market
participants would use in pricing the asset or liability, including assumptions
about risk and or the risks inherent in the inputs to the valuation technique.
These inputs can be readily observable, market corroborated, or generally
unobservable firm inputs. The Company utilizes valuation techniques that
maximize the use of observable inputs and minimize the use of unobservable
inputs. Based on the observability of the inputs used in the valuation
techniques the Company is required to provide the following information
according to the fair value hierarchy. The fair value hierarchy ranks the
quality and reliability of the information used to determine fair values.
Financial assets and liabilities carried at fair value will be classified and
disclosed in one of the following three categories:
Level 1: Inputs based on quoted market prices for identical assets or
liabilities in active markets.
Level 2: Observable market based inputs or unobservable inputs that are
corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
(1) Financial Instruments Valued Based on Inputs Based on Quoted Market Prices
for Identical Assets or Liabilities in Active Markets
The Company's valuation policy is to use quoted market prices from securities
and derivatives exchanges where they are available and reliable. Financial
instruments valued based on quoted market prices are primarily exchange-traded
derivatives and listed equities. Financial instruments that are most typically
valued using alternative approaches but for which the Company typically receives
independent external valuation information include U.S. Treasuries, other U.S.
Government and agency securities, as well as certain corporate debt securities
and certain cash instruments such as money market funds and certificates of
deposit.
(2) Financial Instruments Whose Inputs are Observable Market Based or
Unobservable Inputs that are Corroborated By Market Data
The second broad category consists of financial instruments for which the
Company does not receive quoted prices; therefore, models or other methodologies
are utilized to value these financial instruments. Such models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates, loss
severity, current market and contractual prices for the underlying financial
instruments, as well as other relevant economic measures. Substantially all
these assumptions are observable in the marketplace, can be derived from
observable data or are
63
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
supported by observable levels at which transactions are executed in the
marketplace. A degree of subjectivity is required to determine appropriate
models or methodologies as well as appropriate underlying assumptions. This
subjectivity makes these valuations inherently less reliable than quoted market
prices. Financial instruments in this category include sovereign debt, certain
corporate equities and corporate debt, certain U.S. agency and non-agency
mortgage backed securities and non-exchange-traded derivatives such as interest
rate swaps. For an indication of the Company's involvement in derivatives,
including maturity terms, see the table setting forth notional/contract amounts
outstanding in the preceding "Derivative Financial Instruments" section.
(3) Financial Instruments Whose Inputs Used to Determine the Fair Value Is
Estimated Based on Internally Developed Models or Methodologies Utilizing
Significant Assumptions or Other Data That Are Generally Less Readily Observable
from Objective Sources
Certain complex financial instruments and other investments have significant
data inputs that cannot be validated by reference to readily observable data.
These instruments are typically illiquid, long dated or unique in nature and
therefore engender considerable judgment by traders and their management who, as
dealers in many of these instruments, have the appropriate knowledge to estimate
data inputs that are less readily observable. For certain instruments,
extrapolation or other methods are applied to observed market or other data to
estimate assumptions that are not observable.
The Company participates in the underwriting, securitization or trading of
non-performing mortgage-related assets, certain mortgage-backed securities and
residual interests. In addition, the Company has a portfolio of Chapter 13 and
other credit card receivables from individuals. Certain of these high yield
positions have limited price observability. In these instances, fair values are
determined by statistical analysis of historical cash flows, default
probabilities, recovery rates, time value of money and discount rates considered
appropriate given the level of risk in the instrument and associated investor
yield requirements.
The Company is also engaged in structuring and acting as principal in complex
derivative transactions. Complex derivatives include certain long-dated equity
derivatives, certain credit and municipal derivatives and other complex
derivative structures. These non-exchange-traded instruments may have immature
or limited markets and, by their nature, involve complex valuation methodologies
and models, which are often refined to correlate with the market risk of these
instruments.
See Note 3, "Financial Instruments" of Notes to Consolidated Financial
Statements for a description of the financial assets and liabilities carried at
fair value.
Controls Over Valuation of Financial Instruments
In recognition of the importance the Company places on the accuracy of its
valuation of financial instruments as described in the three categories above,
the Company engages in an ongoing internal review of its valuations. Members of
the Controllers and Risk Management Departments perform analysis of internal
valuations, typically on a monthly basis but often on an intra-month basis as
well. These departments are independent of the trading areas responsible for
valuing the positions. Results of the monthly validation process are reported to
the Mark-to-Market Committee ("MTMC"), which is composed of senior management
from the Risk Management and Controllers Departments. The MTMC is responsible
for ensuring that the approaches used to independently validate the Company's
valuations are robust, comprehensive and effective. Typical approaches include
valuation comparisons with external sources, comparisons with observed trading,
independent comparisons of key model valuation inputs, independent trade
modeling and a variety of other techniques.
Merchant Banking
As part of its merchant banking activities, the Company participates from time
to time in principal investments. As part of these activities, the Company
originates, structures and invests in merger, acquisition, restructuring and
leveraged capital transactions,
64
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
including leveraged buyouts. The Company's principal investments in these
transactions are generally made in the form of equity investments,
equity-related investments or subordinated loans and have not historically
required significant levels of capital investment.
Equity interests and securities acquired are reflected in the consolidated
financial statements at fair value, which are often represented as initial cost
until significant transactions or developments indicate that a change in the
carrying value of the securities is appropriate. This represents the Company's
best estimate of exit price as defined by SFAS No. 157. Generally, the carrying
values of these securities will be increased based on company performance and in
those instances where market values are readily ascertainable by reference to
substantial transactions occurring in the marketplace or quoted market prices.
Reductions to the carrying value of these securities are made in the event that
the Company's estimate of fair value has declined below the carrying value. See
"Merchant Banking and Private Equity Investments" in Management's Discussion and
Analysis for additional details.
Legal, Regulatory and Tax Contingencies
In the normal course of business, the Company has been named as a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental and self-regulatory agencies regarding the Company's
business, certain of which may result in adverse judgments, settlements, fines,
penalties, injunctions or other relief.
Reserves for litigation and regulatory proceedings are determined on a
case-by-case basis and represent an estimate of probable losses after
considering, among other factors, the progress of each case, prior experience
and the experience of others in similar cases, and the opinions and views of
internal and external legal counsel. Because litigation is inherently
unpredictable, particularly in cases where claimants seek substantial or
indeterminate damages or where investigations and proceedings are in the early
stages, the Company cannot predict with certainty the loss or range of loss
related to such matters, the ultimate resolution, the timing of resolution or
the amount of eventual settlement, fine, penalty or relief, if any.
The Company is subject to the income tax laws of the United States, its states
and municipalities and those of the foreign jurisdictions in which the Company
has significant business operations. These tax laws are complex and subject to
different interpretations by the taxpayer and the relevant governmental taxing
authorities. The Company must make judgments and interpretations about the
application of these inherently complex tax laws when determining the provision
for income taxes and must also make estimates about when in the future certain
items affect taxable income in the various tax jurisdictions. Disputes over
interpretations of the tax laws may be settled with the taxing authority upon
examination or audit. The Company regularly evaluates the likelihood of
assessments in each of the taxing jurisdictions resulting from current and
subsequent years' examinations and tax reserves are established as appropriate.
The Company establishes reserves for potential losses that may arise out of
litigation, regulatory proceedings and tax audits to the extent that such losses
are probable and can be estimated, in accordance with SFAS No. 5, "Accounting
for Contingencies." Once established, reserves are adjusted as additional
information becomes available or when an event requiring a change to the
reserves occurs. Significant judgment is required in making these estimates and
the ultimate resolution may differ materially from the amounts reserved.
65
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
ACCOUNTING AND REPORTING DEVELOPMENTS
During fiscal 2007, the Company adopted SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments--an amendment of FASB Statements No. 133 and 140,"
SFAS No. 156, "Accounting for Servicing of Financial Assets--an amendment of
FASB Statement No. 140," and SFAS No. 157, "Fair Value Measurements." As a
result of the adoption of these standards, the Company recorded a cumulative
effect adjustment to increase the opening retained earnings balance by
approximately $3.5 million (after tax).
In December 2007, the FASB issued Statement No. 141 R, "Business Combinations (a
revision of Statement No. 141)." This Statement applies to all transactions or
other events in which an entity obtains control of one or more businesses,
including those combinations achieved without the transfer of consideration.
This Statement retains the fundamental requirements in Statement No. 141 that
the acquisition method of accounting be used for all business combinations. This
Statement expands the scope to include all business combinations and requires an
acquirer to recognize the assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree at their fair values as of the
acquisition date. Additionally, FASB No. 141R changes the way entities account
for business combinations achieved in stages by requiring the identifiable
assets and liabilities to be measured at their full fair values. Additionally,
contractual contingencies and contingent consideration shall be measured at fair
value at the acquisition date. This Statement is effective on a prospective
basis to business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after December
15, 2008. The Company is currently evaluating the impact, if any, that the
adoption of this Statement will have on the consolidated financial statements of
the Company.
In December 2007, the FASB issued Statement No. 160, "Noncontrolling Interests
in Consolidated Financial Statements - an amendment of ARB No.51." This
Statement amends ARB No. 51 to establish accounting and reporting standards for
the noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an
ownership interest in the consolidated entity that should be reported as equity
in the consolidated financial statements. Additionally, this Statement requires
that consolidated net income include the amounts attributable to both the parent
and the noncontrolling interest. This Statement is effective for interim periods
beginning on or after December 15, 2008. The Company is currently evaluating the
impact, if any, that the adoption of this Statement will have on the
consolidated financial statements of the Company.
In June 2007, the FASB's Emerging Issues Task Force (EITF) issued EITF Issue No.
06-11 "Accounting for Income Tax Benefits of Dividends on Share-Based Payment
Awards." This issue requires that the tax benefits related to dividend
equivalents paid on restricted stock units, which are expected to vest, be
recorded as an increase to additional paid-in capital. EITF 06-11 is effective
prospectively to the income tax benefits on dividends declared in fiscal years
beginning after December 15, 2007. The Company is currently evaluating the
impact, if any, the adoption of this issue may have on the Company's
consolidated financial statements and does not expect a material impact on the
consolidated financial statements.
In February 2007, the FASB issued Statement No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities" ("SFAS No. 159"). SFAS No. 159
permits entities to elect to measure financial assets and liabilities (except
for those that are specifically scoped out of the Statement) at fair value. The
election to measure a financial asset or liability at fair value can be made on
an instrument-by-instrument basis and is irrevocable. The difference between the
carrying value and the fair value at the election date is recorded as a
transition adjustment to opening retained earnings. Subsequent changes in fair
value are recognized in earnings. The Company adopted SFAS No. 159 effective
December 1, 2007. The adoption of SFAS No. 159 did not have a material impact on
the consolidated financial statements of the Company.
In June 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty
in Income Taxes--an interpretation of FASB Statement No. 109" ("FIN No. 48").
FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized
in an
66
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
enterprise's financial statements in accordance with SFAS No. 109. FIN No. 48
prescribes a recognition threshold and measurement attribute for the financial
statement recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. The Company will adopt the provisions of FIN No. 48
beginning in the first quarter of 2008. The adoption of FIN No. 48 will not have
a material impact on the consolidated financial statements of the Company.
In April 2007, the FASB issued a Staff Position ("FSP") FIN No. 39-1, "Amendment
of FASB Interpretation No. 39." FSP FIN No. 39-1 defines "right of setoff" and
specifies what conditions must be met for a derivative contract to qualify for
this right of setoff. It also addresses the applicability of a right of setoff
to derivative instruments and clarifies the circumstances in which it is
appropriate to offset amounts recognized for those instruments in the
Consolidated Statement of Financial Condition. In addition, this FSP permits
offsetting of fair value amounts recognized for multiple derivative instruments
executed with the same counterparty under a master netting arrangement and fair
value amounts recognized for the right to reclaim cash collateral (a receivable)
or the obligation to return cash collateral (a payable) arising from the same
master netting arrangement as the derivative instruments. The provisions of this
FSP are consistent with the Company's current accounting practice. The Company
will adopt the provisions of FSP FIN No. 39-1 on December 1, 2007. The adoption
of FSP FIN No. 39-1 did not impact 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.
67
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
OVERALL
The Company's principal business activities involve significant market and
credit risks. In addition, the Company is subject to operational, legal, funding
and other risks. Volatility and uncertainty in the global capital markets may
have a significant impact on our business, operations and reputation. Effective
identification, assessment and management of these risks are critical to the
success and stability of the Company. Comprehensive risk management procedures
have been established to identify, monitor and control each of these major
risks. Additionally, the Company's diverse business segments and practices
contribute to mitigating the risks of a downturn in any one of the global
capital markets. Management ensures that a strong internal control environment
exists to minimize the adverse impact these risks may create. The risk
management process encompasses many units independent of the trading desks,
including the Risk Management, Global Credit, Global Clearing Services,
Controllers, Operations, Compliance, Legal and Financial Analytics & Structured
Transactions ("F.A.S.T.") Departments. The Treasurer's Department is also
independent of trading units and is responsible for the Company's funding and
liquidity risk management. Funding and liquidity risk management are discussed
in Management's Discussion and Analysis of Financial Condition and Results of
Operations in the "Liquidity, Funding and Capital" section.
RISK MANAGEMENT STRUCTURE
The Company has established various management committees that have
responsibilities for monitoring and oversight of its activities and risk
exposures. The key risk management committees are described below.
The Risk Policy Committee is composed of several members of senior management,
including the chief risk officer, chief financial officer and trading division
heads. The Risk Policy Committee generally meets weekly and reviews firmwide
risk exposures, determines risk measures and limits, and provides a high level
of oversight to trading strategies.
The Global Finance Committee is composed of senior managers from Corporate
Treasury, Fixed Income Finance, Equity Finance, and Controllers. The Global
Finance Committee monitors the firm's liquidity, sets funding policies and
strategies, coordinates funding activities to ensure integrity with policies and
cost efficiency, and monitors balance sheet and capital usage.
The Credit Policy Committee is composed of senior risk, legal and business
managers. The Credit Policy Committee delegates credit approval authority to the
Global Credit Committee, approves exposure measurement standards, reviews
concentrations of credit risk, establishes documentation and credit support
standards, and considers new or unusual credit-related transactions.
The Global Credit Committee, which includes several members of the Credit Policy
Committee, implements policy through its review and approval of counterparty
credit limits.
The Operations Committee is composed of senior managing directors from various
departments, primarily representing key internal control functions. The
Operations Committee ensures the coordination of key operational, control and
regulatory issues across the Company.
The Model Review Committee is composed of senior members of the Risk Management,
Risk Analytics and F.A.S.T. Departments, as well as senior business unit
managers who have experience developing and using trading models. The Model
Review Committee works with staff of the Risk Management Department to ensure
that trading models are independently vetted and controlled.
The Principal Activities Committee is composed of senior investment banking,
capital markets, credit and risk management professionals. The Principal
Activities Committee reviews and approves loan underwriting proposals. Certain
leveraged loan commitments, as well as large or unusual credit extensions, are
referred by this committee for approval to the Company's Executive Committee.
68
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
The Mark-to-Market (MTM) Committee is composed of senior management from the
Risk Management and Controllers Departments. The MTM Committee is responsible
for ensuring that the approaches used to independently validate the Company's
valuations are robust, comprehensive and effective.
The New Products and Special Structured Transactions (New Products) Committee is
composed of senior management from various departments. The New Products
Committee is responsible for ensuring that identified new businesses and
products are reviewed in advance for legal, credit, operational, accounting,
market and reputational risk and related concerns. The New Products Committee
meets on a regular basis to review new business proposals and address related
issues.
MARKET RISK
Market risk generally represents the risk of loss that may result from the
potential change in the value of a financial instrument as a result of
fluctuations in interest and currency exchange rates, equity, futures and
commodity prices, changes in the implied volatility of interest rates, foreign
exchange rates, equity, futures and commodity prices, and price deterioration or
changes in value due to changes in market perception or actual credit quality of
either the issuer or its country of origin. Market risk can be exacerbated in
times of illiquidity where market participants refrain from transacting in
normal quantities and/or at normal bid-offer spreads. Market risk is inherent to
both cash and derivative financial instruments and, accordingly, the scope of
the Company's market risk management procedures includes all market
risk-sensitive financial instruments. The Company's exposure to market risk is
directly related to its role as a financial intermediary in customer trading
transactions and to its proprietary trading, investment and arbitrage
activities.
The Risk Management Department is independent of all trading areas and reports
to the chief risk officer. The goals of the department are to understand the
market risk profile of each trading area, to consolidate common risks on a
firmwide basis, to articulate large trading or position risks to senior
management, to provide traders with perspectives on their positions and to
better ensure accurate mark-to-market pricing. The department supplements the
communication between trading managers and senior management by providing its
independent perspective on the Company's market risk profile via a daily risk
highlights report that is distributed to a number of senior managers in the
Company and by regularly providing information on significant risk positions to
the Risk Policy Committee.
The Company believes that a clear understanding of how its positions generate
profit or loss on a daily basis is crucial to managing risk. Many of the
independent units are actively involved in ensuring the integrity and clarity of
the daily profit and loss statements. Activities include daily and monthly price
verification procedures, position reconciliation, review of pricing models and
review of recording of complex transactions.
In addition, trading desk management, senior management and independent units
also review the age and composition of proprietary accounts and review risk
reports appropriate to the risk profile of each trading activity. Risk limits
are established and monitored, market conditions are evaluated, certain
transactions are reviewed in detail, and quantitative methods such as
value-at-risk and stress testing are employed (see "Value-at-Risk"). These
procedures better ensure that trading strategies are followed within acceptable
risk parameters.
The Company is an active participant in over-the-counter markets, including
derivatives, commercial and residential mortgage loans, leveraged loans and
Chapter 13 and other credit card receivables. The nature of many of these
financial instruments is such that they are valued through the use of models.
The complexities and reduced transparency inherent in financial instruments that
are valued using models, as compared with exchange-traded prices or other quoted
market valuations, introduce a particular element of operational risk into the
Company's business. In most cases, internal valuation models are developed by
staff within the F.A.S.T. Department. Traders and trading management supplement
and review the development efforts. A further level of review is performed by
the independent model review team within the Risk Management Department. Results
of the independent
69
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
model review process are presented to the Model Review Committee. In certain
cases, the Company is also able to compare its model-based valuations with
counterparties in conjunction with collateral exchange agreements. Senior
trading managers and independent Risk Management also emphasize the importance
of two-way trading in financial instruments valued using models in order to
verify the accuracy of the models. While the Company believes these controls to
be effective, it is also important to note that the risk of model-based
valuations is inherent in a number of the Company's activities.
Following is a discussion of the Company's primary market risk exposures as of
November 30, 2007 and November 30, 2006, including a discussion of how those
exposures are managed. The following discussion of the Company's risk management
procedures for its principal risks and the estimated amounts of the Company's
market risk exposure generated by the Company's statistical analyses contains
forward-looking statements. The analyses used to assess such risks are not
predictions of future events, and actual results may vary significantly from
such analyses due to events in the markets in which the Company operates and
certain other factors as described herein.
Interest Rate Risk
Interest rate risk is a consequence of maintaining market-making and proprietary
inventory positions and trading in interest rate-sensitive financial
instruments. In connection with the Company's dealer and arbitrage activities,
including market-making in over-the-counter derivatives contracts, the Company
exposes itself to interest rate risk arising from changes in the level or
volatility of interest rates, mortgage prepayment speeds or the level and shape
of the yield curve. The Company's fixed income activities also expose it to the
risk of loss related to changes in credit spreads on debt instruments. Credit
spread risk arises from the potential that changes in an issuer's credit rating
or credit perception could affect the value of financial instruments. Credit
risk resulting from default on counterparty obligations is discussed in the
"Credit Risk" section. The Company attempts to hedge its exposure to interest
rate risk primarily through the use of interest rate swaps, options, eurodollar
and U.S. government securities, and futures and forward contracts designed to
reduce the Company's risk profile. Credit spread risk is hedged through the use
of credit derivatives such as credit default swaps, and by offsetting long or
short positions in various related securities.
Foreign Exchange Rate Risk
Foreign exchange rate risk arises from the possibility that changes in foreign
exchange rates will affect the value of financial instruments. When the Company
buys or sells a foreign currency or a financial instrument denominated in a
currency other than U.S. dollars, exposure exists from a net open currency
position. Until the position is covered by selling or buying the equivalent
amount of the same currency or by entering into a financing arrangement
denominated in the same currency, the Company is exposed to the risk that the
exchange rate may move against it. The Company attempts to hedge the risk
arising from its foreign exchange activities primarily through the use of
currency borrowing, swaps, options, forwards and futures.
Equity Price Risk
The Company is exposed to equity price risk through its market making activities
in equity securities, distressed debt, equity derivatives as well as specialist
activities. Equity price risk results from changes in the level or volatility of
equity prices, which affect the value of equity securities or instruments that
derive their value from a particular stock, a basket of stocks or a stock index.
The Company attempts to reduce the risk of loss inherent in its inventory of
equity securities by entering into hedging transactions, including equity
options and futures, designed to mitigate the Company's market risk profile.
Commodity Price Risk
Commodity price risk refers to the potential loss the Company could suffer from
adverse moves in the levels of commodity prices and derivatives linked to them.
The Company is exposed to commodity price risk through its energy trading
business, which transacts in both listed and over-the-counter energy derivatives
as well as the underlying physical commodities themselves, and through various
trading activities which make use of listed commodity futures and options on
futures. The Company attempts to
70
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
mitigate the risk of loss in these activities by using commodity derivatives to
limit its exposure to changes in the overall level of any given commodity price,
to changes in the volatility of that price, and to changes in the relative
levels of future prices for that commodity.
Value-at-Risk
An estimation of potential losses that could arise from changes in market
conditions is typically accomplished through the use of statistical models known
as value-at-risk ("VaR") that seek to predict risk of loss based on historical
and/or market-implied price and volatility patterns. VaR estimates the
probability of the value of a financial instrument rising above or falling below
a specified amount. The calculation uses the simulated changes in value of the
market risk-sensitive financial instruments to estimate the amount of change in
the current value that could occur at a specified probability level.
The Company has performed an entity-wide VaR analysis of the Company's financial
assets and liabilities, including financial instruments owned and sold,
repurchase and resale agreements and funding assets and liabilities. The Company
regularly evaluates and enhances such VaR models in an effort to more accurately
measure risk of loss. Certain equity-method investments and non-publicly traded
investments are not reflected in the VaR results. The VaR related to certain
non-trading financial instruments has been included in this analysis and is not
reported separately because the amounts are not material. The calculation is
based on a methodology that uses a one-day interval and a 95% confidence level.
The Company uses a historical simulation approach for VaR, which is supplemented
by statistical risk add-ons for risk factors that do not lend themselves readily
to historical simulation. Historical simulation involves the generation of price
movements in a portfolio using price sensitivities, and actual historical
movements of the underlying risk factors to which the securities are sensitive.
Risk factors incorporated via historical simulation include interest rate
movements, yield curve shape, general market credit spreads, equity price
movement, option volatility movement (for certain option types) and foreign
exchange movement, among others. Risk factors incorporated via add-on factors
include the risk of specific bond issuers, among others. The Company believes
that its VaR methodologies are consistent with industry practices for these
calculations.
VaR has inherent limitations, including reliance on historical data, which may
not accurately predict future market risk, and the quantitative risk information
generated is limited by the parameters established in creating the models. There
can be no assurance that actual losses occurring on any one day arising from
changes in market conditions will not exceed the VaR amounts shown below or that
such losses will not occur more than once in 20 trading days. VaR is not likely
to accurately predict exposures in markets that exhibit sudden fundamental
changes or shifts in market conditions or established trading relationships.
Many of the Company's hedging strategies are structured around likely
established trading relationships and, consequently, those hedges may not be
effective and VaR models may not accurately predict actual results. Furthermore,
VaR calculated for a one-day horizon does not fully capture the market risk of
positions that cannot be liquidated in a one-day period. However, the Company
believes VaR models are an established methodology for the quantification of
risk in the financial services industry despite these limitations. VaR is best
used in conjunction with other financial disclosures in order to assess the
Company's risk profile.
The aggregate VaR presented here is less than the sum of the individual
components (i.e., interest rate risk, foreign exchange rate risk, equity risk
and commodity price risk), due to the benefit of diversification among the
risks. Diversification benefit equals the difference between aggregate VaR and
the sum of the VaRs for the four risk categories. This benefit arises because
the simulated one-day losses for each of the four primary market risk categories
occur on different days and because of general diversification benefits
introduced when risk is measured across a larger set of specific risk factors
than exist in the respective categories; similar diversification benefits also
are taken into account across risk factors within each category.
71
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
The following table illustrates the VaR for each component of market risk as of
November 30, 2007 and 2006.
(in millions) 2007 2006
- -----------------------------------------------------
MARKET RISK
Interest rate $ 72.4 $ 29.9
Currency 1.4 0.8
Equity 6.5 3.0
Commodity/energy 12.5 0.0
Diversification
benefit (23.5) (4.9)
- -----------------------------------------------------
Aggregate VaR $ 69.3 $ 28.8
=====================================================
The table below illustrates the high, low and average VaR for each component of
market risk and aggregate market risk during fiscal 2007 and fiscal 2006
(calculated on a daily basis):
Fiscal 2007 Fiscal 2006
- ----------------------------------------------------------------------------------------------
(in millions) High Low Average High Low Average
- ----------------------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 72.4 22.5 34.1 $ 41.3 20.3 30.8
Currency 3.4 0.0 1.2 3.2 0.0 0.8
Equity 12.4 1.6 6.4 11.3 1.3 4.3
Commodity/Energy 20.3 0.0 2.8 1.2 0.0 0.2
Aggregate VaR 69.3 22.7 33.1 44.4 19.0 28.6
- ----------------------------------------------------------------------------------------------
The increase in VaR during 2007 was due to dramatic increases in volatility
across credit, interest rates, and asset backed markets, and to changes in the
Company's inventory positions.
The Company utilizes a wide variety of market risk management methods, including
trading limits; marking all positions to market on a daily basis; daily profit
and loss statements; position reports; daily risk highlight reports; aged
inventory position reports; and independent verification of inventory pricing.
The Company believes that these procedures, which stress timely communication
between traders, trading department management and senior management, are
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.
72
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
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 fiscal years ended November
30, 2007 and 2006. The chart represents a historical summary of the results
generated by the Company's trading activities as opposed to the probability
approach used by the VaR model. The average daily trading profit was $5 million
and $20 million for the fiscal years ended November 30, 2007 and 2006,
respectively. There were 62 daily trading losses for the fiscal year ended
November 30, 2007 and 13 daily trading losses for the fiscal year ended November
30, 2006. Daily trading losses exceeded the reported average aggregate VaR
amounts on 27 days during the fiscal year ended November 30, 2007 and never
exceeded the reported average aggregate VaR amounts during the fiscal year ended
November 30, 2006. Higher market volatility and reduced market liquidity
contributed to an increase in the number of trading days with losses, and to
higher magnitude daily losses, in 2007. The Firm uses historical simulation VaR,
which is driven by previously observed changes in market variables. During
periods in which volatility is increasing, VaR tends to lag since it does not
incorporate swings in the relevant markets until they have actually been
observed and are incorporated in the historical time series of market data being
used for the VaR calculation. This was the case in 2007, when volatility across
many markets rose sharply and continuously throughout the year. Substantial
trading losses were experienced in the mortgage-related and leveraged finance
areas. The number of days with trading losses and the number of days with
trading losses that exceeded the reported average aggregate VaR in fiscal 2007
was sharply higher than in fiscal 2006 as a result of increased volatility in
underlying markets.
DISTRIBUTION OF DAILY NET TRADING REVENUES
FISCAL YEARS ENDED NOVEMBER 30, 2007 AND NOVEMBER 30, 2006
[BAR CHART - GRAPHIC OMITTED -represented by the plot points below]
(20)+ (20)-(15) (15)-(10) (10)-(5) (5)-0 0-5 5-10 10-15 15-20 20-25 25-30 30-35 35-40 40+
38 5 6 7 6 21 20 15 43 21 22 16 8 24 2007
0 0 1 2 10 18 35 41 44 36 22 16 8 19 2006
73
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
CREDIT RISK
Credit risk arises from potential non-performance by counterparties, customers,
borrowers or debt security issuers. The Company is exposed to credit risk as
trading counterparty to dealers and customers, as direct lender, as holder of
securities and as member of exchanges and clearing organizations. The Company
has established policies and procedures to manage credit risk.
Dedicated professionals in several departments contribute to the administration
of the Company's credit policies and procedures. The responsible groups include
Global Credit, Operations and Administration (Margin), Risk Management, Global
Clearing Services (Prime Brokerage) and the Loan Portfolio Management Group.
Global Credit
The Global Credit Department monitors and controls extensions of credit to
customers and dealer counterparties and, in conjunction with the Credit Policy
Committee and its subcommittee, the Global Credit Committee, establishes and
reviews appropriate credit limits and collateral requirements for customers and
dealer counterparties. Credit limits are set to control potential exposure
arising from repurchase and resale agreements, stock borrowing or loan
facilities, derivative financial instruments and other products that may give
rise to secured and unsecured credit exposure.
Global Credit Department professionals assess the creditworthiness of the
Company's counterparties, assign an internal credit rating that reflects the
Global Credit Department's quantitative and qualitative assessment of each
counterparty's relative probability of default, and assign or recommend credit
limits and requirements. In addition, credit and quantitative analysts assess
the quality and acceptability of collateral, measure potential credit exposure
associated with certain transactions, monitor compliance with credit limits,
obtain appropriate legal documentation and provide comprehensive credit risk
reporting to senior management.
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 underwriting, often involve
substantial amounts and significant exposure to individual issuers and
businesses, including non-investment-grade issuers. At November 30, 2007, the
Company's most significant concentrations are related to U.S. government and
agency inventory positions, including those of the Federal National Mortgage
Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation
("Freddie Mac"). In addition, a substantial portion of the collateral held by
the Company for reverse repurchase agreements consists of securities issued by
the U.S. government and agencies. The Company seeks to limit concentration risk
through the use of the systems and procedures described in the preceding
discussions of market and credit risk.
The Company establishes potential exposure limits across a variety of financing
and trading products for all counterparties on a group and individual entity
basis. Potential exposure is the statistically estimated net credit exposure
associated with adverse market moves over the life of transactions at a 97.7%
confidence interval. The potential exposure is estimated daily, using
sophisticated, internally developed risk models that employ Monte Carlo
simulations. Potential exposure estimates consider the size and maturity of
contracts; the volatility of, and correlations among, the underlying assets,
indices and currencies; settlement mechanisms; rights to demand additional
collateral; and other legally enforceable credit mitigants such as third-party
guarantees or insurance.
The Company establishes country concentration limits and monitors actual and
potential exposures, including both position and counterparty exposures, in
emerging markets. Sovereign risk analysts evaluate international macroeconomic
conditions and recommend country concentration limits. The Company limits and
monitors its exposure to sovereign default, devaluation and inconvertibility of
local currencies.
74
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
OTC Derivatives Credit Exposure
- -------------------------------
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 derivatives contracts in a
gain position at November 30, 2007 and November 30, 2006 approximated $12.54
billion and $4.99 billion, respectively. Exchange-traded financial instruments,
which typically are guaranteed by a highly rated clearing organization, have
margin requirements that substantially mitigate risk of credit loss.
The following table summarizes the counterparty credit quality of the Company's
exposure with respect to over-the-counter derivatives (including foreign
exchange and forward-settling mortgage transactions) as of November 30, 2007:
Over-the-Counter Derivatives Credit Exposure(1)
($ in millions)
Percentage of
Exposure, Net Exposure, Net
Rating (2) Exposure Collateral (3) of Collateral(4) of Collateral
- ------------ -------- -------------- ---------------- -------------
AAA $ 5,794 90 5,732 46%
AA 11,416 8,304 3,342 27%
A 5,608 3,831 2,223 18%
BBB 724 360 429 3%
BB and lower 2,590 4,632 751 6%
Non-rated 155 382 62 0%
(1) Excluded are 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 derivatives 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.
Operations and Administration
The Margin Department is responsible for evaluating the risk of extending loans
to the Company's customers secured by certain marketable securities. The
department evaluates the acceptability of collateral and actively monitors to
ensure that collateral received meets regulatory and internal requirements.
Internal (or "house") margin requirements generally exceed minimum regulatory
requirements and may be adjusted for specific securities based on volatility or
liquidity. The Special Credit Services unit of the Global Credit Department
evaluates and sets terms for loans secured by restricted or control stock,
emerging markets securities and concentrated or less liquid securities.
Risk Management
The Risk Management Department is responsible for monitoring the market risk of
the Company's proprietary positions. As part of its duties, the group evaluates
the credit quality of securities positions held in inventory to quantify and
limit the risk to the Company of issuer default or changes in credit spreads. In
a similar manner, the department also evaluates the credit quality of reference
issuer obligations associated with derivatives contracts whose values are linked
to the credit quality or credit spread trading level of reference issuers. The
department monitors issuer credit exposures across the various cash and
derivatives trading desks that trade in securities or derivatives of the same or
related issuers to monitor aggregate exposures. This process also aggregates
counterparty credit exposures with issuer exposures to produce a more
comprehensive perspective on the Company's exposure to credit risks.
75
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
Global Clearing Services
Global Clearing Services carries the accounts of professional clients, including
floor traders and specialists, arbitrageurs, broker-dealers, hedge funds and
fund of funds groups. These clients employ a wide variety of trading styles,
including option hedging, market-neutral statistical arbitrage, risk arbitrage,
hedged convertible strategies and multiple fixed income strategies. Trading
strategies are employed in both domestic and international markets. The
extension of credit, via secured margin debt for a given customer, is determined
by the Risk Department of Global Clearing Services using a systematic analysis
of the securities held and trading strategy that such customer employs. Global
Clearing Services has established a risk-based margin lending policy under which
the minimum capital requirement for a portfolio may be greater than the
applicable regulatory capital requirement for the sum of the underlying
constituents of that portfolio.
Client portfolios are analyzed and evaluated daily through extensive stress
testing simulations designed to estimate market-related risk under different
scenarios. Using its internally developed risk management system, known as RACS
(Risk Analytic Control System), the Risk Department is able to analyze every
professional client's portfolio prior to each market opening and track that
portfolio on an intra-day basis. Client positions are simulated across more than
200 different scenarios, resulting in a wide variety of potential profit and
loss possibilities. Some basic assumptions used in the analysis are minimum
portfolio moves of 20% as well as minimum moves in individual securities of 25%
or more. Other scenarios include price movement tests of 1 and 2 standard
deviations, fixed percentage moves, beta-weighted and market
capitalization-driven extreme price moves. Scenarios are constructed in such a
way as to assess position and portfolio sensitivities to changes in underlying
prices, volatilities, interest rates, credit spreads, cross-currency rates and
forward time horizons. Experienced managers review the results of the stress
testing to determine whether additional margin is necessary. In addition to
client-level security and portfolio analysis, the system produces over 40
various reports that provide multi-dimensional views, which include industry
exposures, country/region exposures and security concentration and liquidity
risk.
Loan Portfolio Management Group
The Loan Portfolio Management Group is responsible for managing the credit risk
in the Company's loan portfolio. The group is responsible for evaluating
transactions originated by investment bankers and advising on pricing or other
considerations during the due diligence process. Specific portfolio limits have
been established for the various types of lending, and there are formally
approved guidelines for hedging the loan portfolio.
OPERATIONAL RISK
Operational risk is the potential for loss arising from inadequate or failed
internal processes, people or systems, or from external events. This includes,
but is not limited to, limitations in the Company's financial systems and
controls, deficiencies in legal documentation, non-compliance with the execution
of legal, regulatory and fiduciary responsibilities, deficiencies in technology
and the risk of loss attributable to operational problems. These risks are less
direct than credit and market risk, but managing them is critical, particularly
in a rapidly changing environment with increasing regulation and transaction
volumes. In an effort to reduce or mitigate these risks, the Company has
established and maintains an internal control environment that incorporates
various control mechanisms at different levels throughout the organization and
within such departments as Controllers, Operations, Legal, Risk Management,
Global Credit, Compliance and Internal Audit. These control mechanisms are
designed to better ensure that operational policies and procedures are being
followed and that the Company's various businesses are operating within
established corporate policies and limits.
Management of the Company has established and maintains effective internal
control over financial reporting. Internal control over financial reporting is a
process designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting principles. The
Company's internal control over financial reporting includes those policies and
procedures that: (i) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the
assets of the Company; (ii)
76
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of consolidated financial statements in accordance with
generally accepted accounting principles and that receipts and expenditures of
the Company are being made only in accordance with authorizations of management
and directors of the Company; and (iii) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use or disposition
of the Company's assets that could have a material effect on the consolidated
financial statements.
The Company has invested heavily in technology over the years to have the
ability to gather and process information efficiently and to handle the wide
variety of products and services the Company offers. In addition, the Company's
investment in technology allows the Company to communicate information
efficiently and securely to customers and to groups within the Company.
In addition to these existing control mechanisms, the Company has an Operational
Risk Management function, which focuses on facilitating internal communication,
disclosure, and supervisory review of operational risk management practices. The
Operational Risk Management function has responsibilities related to the
development, consistent application and oversight of operational risk policies,
processes and procedures firmwide. The function is independent of all business
units and formally reports to the chief risk officer.
LEGAL RISK
Legal risk includes the risk of non-compliance with applicable legal and
regulatory requirements and the risk that a counterparty will not perform on its
obligations due to non-credit-related conditions, including counterparty legal
authority and capacity. The Company is generally subject to extensive regulation
in the various jurisdictions in which it conducts its business. The Company has
established procedures based on legal and regulatory requirements on a worldwide
basis that are designed to ensure compliance with applicable statutory and
regulatory requirements. The Company has established policies and procedures in
an effort to mitigate the risk that counterparty performance obligations will be
unenforceable.
OTHER RISKS
Other risks encountered by the Company include, but are not limited to,
political, regulatory and tax risks. These risks reflect the potential impact
that changes in local and international laws, regulatory requirements or tax
statutes have on the economics and viability of current or future transactions.
In an effort to mitigate these risks, the Company seeks to continuously review
new and pending regulations and legislation and participates in various industry
interest groups.
77
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of The Bear Stearns Companies Inc. and subsidiaries (the "Company")
is responsible for establishing and maintaining adequate internal control over
financial reporting. Internal control over financial reporting is a process
designed under the supervision of the Company's principal executive and
principal financial officers to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of the Company's
financial statements for external purposes in accordance with generally accepted
accounting principles.
The Company's internal control over financial reporting includes those policies
and procedures that: (1) pertain to the maintenance of records that, in
reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the Company; (2) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles and that
receipts and expenditures of the Company are being made only in accordance with
authorizations of management and directors of the Company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use or disposition of the Company's assets that could have a
material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
The Company's management assessed the effectiveness of the Company's internal
control over financial reporting as of November 30, 2007. In making this
assessment, the Company's management used the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in
Internal Control-Integrated Framework. Based on its assessment, management
believes that, as of November 30, 2007, the Company's internal control over
financial reporting is effective based on those criteria.
The Company's independent registered public accounting firm has audited the
Company's internal control over financial reporting as of November 30, 2007, as
stated in their report.
78
THE BEAR STEARNS COMPANIES INC.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of The Bear Stearns Companies Inc.
We have audited the internal control over financial reporting of The Bear
Stearns Companies Inc. and subsidiaries (the "Company") as of November 30, 2007,
based on criteria established in "Internal Control-Integrated Framework" issued
by the Committee of Sponsoring Organizations of the Treadway Commission. The
Company's management is responsible for maintaining effective internal control
over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, testing
and evaluating the design and operating effectiveness of internal control based
on the assessed risk, and performing such other procedures as we considered
necessary in the circumstances. We believe that our audit provides a reasonable
basis for our opinion.
A company's internal control over financial reporting is a process designed by,
or under the supervision of, the company's principal executive and principal
financial officers, or persons performing similar functions, and effected by the
company's board of directors, management, and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial
reporting, including the possibility of collusion or improper management
override of controls, material misstatements due to error or fraud may not be
prevented or detected on a timely basis. Also, projections of any evaluation of
the effectiveness of the internal control over financial reporting to future
periods are subject to the risk that the controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective
internal control over financial reporting as of November 30, 2007, based on the
criteria established in "Internal Control-Integrated Framework" issued by the
Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated statement of
financial condition as of November 30, 2007 and the related consolidated
statements of income, comprehensive income, cash flows and changes in
stockholders' equity for the year ended November 30, 2007 of the Company and our
report dated January 28, 2008 expressed an unqualified opinion on those
financial statements and included an explanatory paragraph relating to the
adoption of Statement of Financial Accounting Standards ("SFAS") No. 155,
"Accounting for Certain Hybrid Instruments, an amendment of FASB Statements No.
133 and 140" and SFAS No. 157, "Fair Value Measurements."
/s/ Deloitte & Touche LLP
New York, New York
January 28, 2008
79
THE BEAR STEARNS COMPANIES INC.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of The Bear Stearns Companies Inc.
We have audited the accompanying consolidated statements of financial condition
of The Bear Stearns Companies Inc. and subsidiaries (the "Company") as of
November 30, 2007 and 2006, and the related consolidated statements of income,
comprehensive income, cash flows and changes in stockholders' equity for each of
the three years in the period ended November 30, 2007. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of The Bear Stearns Companies Inc. and
subsidiaries as of November 30, 2007 and 2006, and the results of their
operations and their cash flows for each of the three years in the period ended
November 30, 2007, in conformity with accounting principles generally accepted
in the United States of America.
As discussed in Note 1 and Note 3 to the consolidated financial statements,
effective December 1, 2006, the Company adopted Statement of Financial
Accounting Standards No. 155, "Accounting for Certain Hybrid Instruments, an
amendment of FASB Statements No. 133 and 140" and Statement of Financial
Accounting Standards No. 157, "Fair Value Measurements."
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the Company's internal control over
financial reporting as of November 30, 2007, based on the criteria established
in "Internal Control-Integrated Framework" issued by the Committee of Sponsoring
Organizations of the Treadway Commission and our report dated January 28, 2008
expressed an unqualified opinion on the Company's internal control over
financial reporting.
/s/ Deloitte & Touche LLP
New York, New York
January 28, 2008
80
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF INCOME
- ------------------------------------------------------------------------------------------------------------------------------------
Fiscal Years Ended November 30, 2007 2006 2005
- ------------------------------------------------------------------------------------------------------------------------------------
(in millions, except share and per share data)
REVENUES
Commissions $ 1,269 $ 1,163 $ 1,200
Principal transactions 1,323 4,995 3,836
Investment banking 1,380 1,334 1,037
Interest and dividends 11,556 8,536 5,107
Asset management and other income 623 523 372
- ------------------------------------------------------------------------------------------------------------------------------------
Total revenues 16,151 16,551 11,552
Interest expense 10,206 7,324 4,141
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense 5,945 9,227 7,411
- ------------------------------------------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSES
Employee compensation and benefits 3,425 4,343 3,553
Floor brokerage, exchange and clearance fees 279 227 222
Communications and technology 578 479 402
Occupancy 264 198 168
Advertising and market development 179 147 127
Professional fees 362 280 229
Impairment of goodwill and specialist rights 227 -- --
Other expenses 438 406 503
- ------------------------------------------------------------------------------------------------------------------------------------
Total non-interest expenses 5,752 6,080 5,204
- ------------------------------------------------------------------------------------------------------------------------------------
Income before provision for income taxes $ 193 $ 3,147 $ 2,207
(Benefit from)/provision for income taxes (40) 1,093 745
- ------------------------------------------------------------------------------------------------------------------------------------
Net income $ 233 $ 2,054 $ 1,462
Preferred stock dividends (21) (21) (24)
- ------------------------------------------------------------------------------------------------------------------------------------
Net income applicable to common shares $ 212 $ 2,033 $ 1,438
====================================================================================================================================
Basic earnings per share $ 1.68 $ 15.79 $ 11.42
Diluted earnings per share $ 1.52 $ 14.27 $ 10.31
====================================================================================================================================
Weighted average common shares outstanding:
Basic 130,208,999 131,711,382 130,326,947
Diluted 146,442,842 148,575,469 147,467,992
====================================================================================================================================
See Notes to Consolidated Financial Statements.
81
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
- --------------------------------------------------------------------------------------------------------------------------------
As of November 30, 2007 2006
- --------------------------------------------------------------------------------------------------------------------------------
(in millions, except share data)
ASSETS
Cash and cash equivalents $ 21,406 $ 4,595
Cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations 12,890 8,804
Securities received as collateral 15,599 19,648
Collateralized agreements:
Securities purchased under agreements to resell 27,878 38,838
Securities borrowed 82,245 80,523
Receivables:
Customers 41,115 29,482
Brokers, dealers and others 11,622 6,119
Interest and dividends 785 745
Financial instruments owned, at fair value 122,518 109,200
Financial instruments owned and pledged as collateral, at fair value 15,724 15,968
-----------------------------------
Total financial instruments owned, at fair value 138,242 125,168
Assets of variable interest entities and mortgage loan special purpose entities 33,553 30,245
Property, equipment and leasehold improvements, net of accumulated depreciation
and amortization of $1,149 and $1,152 in 2007 and 2006, respectively 605 480
Other assets 9,422 5,786
- --------------------------------------------------------------------------------------------------------------------------------
Total Assets $ 395,362 $ 350,433
================================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Unsecured short-term borrowings $ 11,643 $ 25,787
Obligation to return securities received as collateral 15,599 19,648
Collateralized financings:
Securities sold under agreements to repurchase 102,373 69,750
Securities loaned 3,935 11,451
Other secured borrowings 12,361 3,275
Payables:
Customers 83,204 72,989
Brokers, dealers and others 4,101 3,397
Interest and dividends 1,301 1,123
Financial instruments sold, but not yet purchased, at fair value 43,807 42,257
Liabilities of variable interest entities and mortgage loan special purpose entities 30,605 29,080
Accrued employee compensation and benefits 1,651 2,895
Other liabilities and accrued expenses 4,451 2,082
Long-term borrowings 68,538 54,570
- --------------------------------------------------------------------------------------------------------------------------------
Total Liabilities $ 383,569 $ 338,304
- --------------------------------------------------------------------------------------------------------------------------------
Commitments and contingencies (Note 17)
STOCKHOLDERS' EQUITY 352 359
Preferred stock
Common stock, $1.00 par value; 500,000,000 shares authorized as of November 30, 2007 and
2006; 184,805,847 shares issued as of November 30, 2007 and 2006 185 185
Paid-in capital 4,986 4,579
Retained earnings 9,441 9,385
Employee stock compensation plans 2,478 2,066
Accumulated other comprehensive (loss) income (8) --
Treasury stock, at cost:
Common stock: 71,807,227 and 67,396,876 shares as of November 30, 2007 and 2006,
respectively (5,641) (4,445)
- --------------------------------------------------------------------------------------------------------------------------------
Total Stockholders' Equity 11,793 12,129
- --------------------------------------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 395,362 $ 350,433
================================================================================================================================
See Notes to Consolidated Financial Statements.
82
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------------------------------------------------------
Fiscal Years Ended November 30, 2007 2006 2005
- --------------------------------------------------------------------------------------------------------------------------------
(in millions)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 233 $ 2,054 $ 1,462
Adjustments to reconcile net income to cash used in operating activities:
Non-cash items included in net income:
Impairment of goodwill and specialist rights 227 -- --
Depreciation and amortization 186 350 277
Deferred income taxes (33) (85) 113
Employee stock compensation plans 31 1,010 801
Changes in operating assets and liabilities:
Cash and securities deposited with clearing organizations or segregated
in compliance with federal regulations (4,086) (3,534) (847)
Securities borrowed, securities loaned, net (9,238) (16,261) 6,264
Receivables from customers (11,633) 1,791 841
Receivables from brokers, dealers and others (5,503) (2,575) (610)
Financial instruments owned, at fair value (13,111) (21,357) (26,938)
Other assets (4,111) (1,597) (831)
Securities sold under agreements to repurchase, securities purchased under
agreements to resell, net 43,583 7,427 10,275
Payables to customers 10,215 3,118 (9,513)
Payables to brokers, dealers and others 704 740 57
Financial instruments sold, but not yet purchased, at fair value 1,539 8,895 3,546
Accrued employee compensation and benefits (405) 207 171
Other liabilities and accrued expenses 2,548 596 494
- --------------------------------------------------------------------------------------------------------------------------------
Cash provided by (used in) operating activities 11,146 (19,221) (14,438)
- --------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements, net (295) (181) (203)
- --------------------------------------------------------------------------------------------------------------------------------
Cash used in investing activities (295) (181) (203)
- --------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Payments for/proceeds from unsecured short-term borrowings, net (14,144) 6,026 8,030
Proceeds from/payments for other secured borrowings, net 9,086 3,021 (225)
Proceeds from issuance of long-term borrowings 24,923 19,892 15,997
Payments for retirement/repurchase of long-term borrowings (12,495) (10,250) (7,273)
Proceeds from issuances of derivatives with a financing element, net 23 339 255
Issuance of common stock 162 289 202
Cash retained resulting from tax deductibility under
share-based payment arrangements 254 363 426
Redemption of preferred stock (7) (13) (76)
Treasury stock purchases - common stock (1,670) (1,374) (870)
Cash dividends paid (172) (155) (139)
- --------------------------------------------------------------------------------------------------------------------------------
Cash provided by financing activities 5,960 18,138 16,327
- --------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 16,811 (1,264) 1,686
Cash and cash equivalents, beginning of year 4,595 5,859 4,173
- --------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of period $ 21,406 $ 4,595 $ 5,859
================================================================================================================================
Supplemental Disclosure of Cash Flow Information:
Cash payments for interest were $10.86 billion, $7.93 billion and $4.30 billion
during the fiscal years ended November 30, 2007, 2006 and 2005 respectively.
Cash payments for income taxes, net of refunds, were $561 million, $709 million
and $146 million for the fiscal years ended November 30, 2007, 2006 and 2005,
respectively. Cash payments for income taxes, net of refunds, would have been
$815 million, $1.07 billion and $572 million for the fiscal years ended November
30, 2007, 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 Consolidated Financial Statements.
83
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Employee Treasury
Common Stock Stock -
Preferred Stock $1 Paid-in Retained Compensation Common
in millions, except share Stock Par Value Capital Earnings Plans Stock Total
and per share data)
- ---------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2004 $ 448 $ 185 $ 3,548 $ 6,177 $ 2,509 $ (3,876) $ 8,991
Net income 1,462
Dividends declared--
Common ($1.00 per share) (121) 7
Preferred (25)
Treasury Stock--
Common stock purchased (870)
(8,483,483 shares)
Common stock issued out
of treasury 13 (729) 921
(18,565,624 shares)
Redemption of preferred stock (76)
Income tax benefit related
to distributions from
employee stock
compensation plans 426
Unearned employee stock
compensation, net 15
Employee stock compensation
awards, net 123 655
Amortization of preferred
stock issue costs (1)
- ---------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2005 $ 372 $ 185 $ 4,109 $ 7,493 $ 2,457 $ (3,825) $ 10,791
Net Income 2,054
Dividends declared--
Common ($1.12 per share) (141) 7
Preferred (21)
Treasury Stock--
Common stock purchased (1,374)
(10,582,214 shares)
Common stock issued out
of treasury 91 (551) 754
(14,122,978 shares)
Redemption of preferred stock (13) --
Income tax benefit related
to distributions from
employee stock
compensation plans 363
Unearned employee stock
compensation, net (13)
Employee stock compensation
awards, net 17 166
Amortization of preferred
stock issue costs (1)
- ---------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2006 $ 359 $ 185 $ 4,579 $ 9,385 $ 2,066 $ (4,445) $ 12,129
=====================================================================================================================
See Notes to Consolidated Financial Statements
84
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Common Employee Accumulated Treasury
Stock Stock Other Stock -
Preferred $1 Par Paid-in Retained Compensation Comprehensive Common
Stock Value Capital Earnings Plans Income Stock Total
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2006 $ 359 $ 185 $ 4,579 $ 9,385 $ 2,066 $ -- $ (4,445) $ 12,129
Net Income 233
Dividends declared--
Common ($1.28 per share) (159) 8
Preferred (21)
Treasury Stock--
Common stock purchased (1,670)
(12,044,779 shares)
Common stock issued out of
treasury 58 (370) 474
(7,634,428 shares)
Redemption of preferred stock (7)
Income tax benefit related 254
to distributions from
employee stock compensation
plans
Unearned employee stock (31)
compensation, net
Employee stock compensation 96 805
awards, net
Amortization of preferred (1)
stock issue costs
Foreign currency translation, 2
net of tax
Net (losses) on cash flow (10)
hedges, net of tax
Implementation of 3
accounting principles
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2007 $ 352 $ 185 $ 4,986 $ 9,441 $ 2,478 $ (8) $ ( 5,641) $ 11,793
====================================================================================================================================
See Notes to Consolidated Financial Statements
85
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
- --------------------------------------------------------------------------------------------------------
Fiscal Years Ended November 30, 2007 2006 2005
- --------------------------------------------------------------------------------------------------------
(in millions)
Net Income $ 233 $ 2,054 $ 1,462
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment 2 -- --
Net gains (losses) on cash flow hedges (10) -- --
- --------------------------------------------------------------------------------------------------------
Comprehensive income $ 225 $ 2,054 $ 1,462
========================================================================================================
See Notes to Consolidated Financial Statements.
86
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
The Bear Stearns Companies Inc. (the "Company") is a holding company that,
through its broker-dealer and international bank subsidiaries, principally Bear,
Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp. ("BSSC"),
Bear, Stearns International Limited ("BSIL") and Bear Stearns Bank plc ("BSB"),
is primarily engaged in business as a securities broker-dealer and operates in
three principal segments: Capital Markets, Global Clearing Services and Wealth
Management. Capital Markets is comprised of the institutional equities, fixed
income and investment banking areas. Global Clearing Services provides
clearance-related services for prime brokerage clients and clearance on a fully
disclosed basis for introducing broker-dealers. Wealth Management is comprised
of the private client services ("PCS") and asset management areas. See Note 19,
"Segment and Geographic Area Data," in the Notes to Consolidated Financial
Statements for a complete description of the Company's principal segments. The
Company also conducts significant activities through other wholly owned
subsidiaries, including: Bear Stearns Global Lending Limited; Custodial Trust
Company; Bear Stearns Financial Products Inc. ("BSFP"); Bear Stearns Capital
Markets Inc.; Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc. ("BS
Forex"); EMC Mortgage Corporation; Bear Stearns Commercial Mortgage, Inc.; Bear
Stearns Investment Products Inc.; and Bear Energy L.P.
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company, its
wholly owned subsidiaries and other entities in which the Company has a
controlling financial interest. All material intercompany transactions and
balances have been eliminated in consolidation.
The Company determines whether it has a controlling financial interest in an
entity by evaluating whether an entity is a voting interest entity, a variable
interest entity ("VIE") or a qualifying special purpose entity ("QSPE") under
generally accepted accounting principles.
Voting interest entities are consolidated in accordance with Accounting Research
Bulletin ("ARB") No. 51, "Consolidated Financial Statements," as amended. ARB
No. 51 states that the usual condition for a controlling financial interest in
an entity is ownership of a majority voting interest. Accordingly, the Company
consolidates voting interest entities in which is has a majority voting
interest. VIEs are entities that lack one or more of the characteristics of a
voting interest entity. A controlling financial interest in a VIE occurs when an
entity has a variable interest that will absorb a majority of the VIEs expected
losses, receive a majority of the VIEs residual returns, or both. The entity
with the controlling financial interest, known as the primary beneficiary,
consolidates the VIE. In accordance with Financial Accounting Standards Board
("FASB") Interpretation ("FIN") No. 46 (R), "Consolidation of Variable Interest
Entities (revised December 2003)--an interpretation of Accounting Research
Bulletin ("ARB") No. 51" ("FIN No. 46 (R)"), the Company consolidates any
variable interest entities for which it is the primary beneficiary. The assets
and related liabilities of such variable interest entities have been shown in
the 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 6, "Variable Interest Entities and Mortgage Loan Special
Purpose Entities," in the Notes to Consolidated Financial Statements. QSPEs are
passive entities that are commonly used in securitization transactions.
Statement of Financial Accounting Standards ("SFAS") No. 140, "Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities," sets forth
the criteria an entity must satisfy to be a QSPE. In accordance with SFAS No.
140, the Company does not consolidate QSPEs.
When the Company does not have a controlling interest in an entity, but exerts
significant influence over the entity's operating and financial decisions
(generally defined as owning a voting or economic interest of 20% to 50%), the
Company applies the equity method of accounting.
As of December 1, 2006, the Company has adopted Emerging Issues Task Force
("EITF") Issue No. 04-5 "Determining Whether a General Partner, or the General
Partners as a Group, Controls a Limited Partnership or Similar Entity When the
Limited Partners Have Certain Rights." The EITF consensus requires a general
partner in a limited partnership to consolidate the limited partnership unless
the presumption of control is overcome. The general partner may overcome this
presumption of control and not consolidate the entity if the limited partners
have: (a) the substantive ability to dissolve or liquidate the limited
partnership or otherwise remove the general partner without having to show
cause; or (b) substantive participating rights in managing the partnership.
87
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The consolidated financial statements are prepared in conformity with accounting
principles generally accepted in the United States of America. These principles
require management to make certain estimates and assumptions, including those
regarding fair value measurements, stock-based compensation, certain accrued
liabilities and the potential outcome of litigation and tax matters, which may
affect the amounts reported in the consolidated financial statements and
accompanying notes. Actual results could differ materially from these estimates.
REVENUE RECOGNITION POLICIES
Principal Transactions
Financial instruments owned and financial instruments sold, but not yet
purchased, including contractual commitments arising pursuant to futures,
forward and option contracts, interest rate swaps and other derivative
contracts, are recorded at fair value with the resulting net unrealized gains
and losses reflected in "Principal transactions" revenues in the Consolidated
Statements of Income.
Investment Banking and Advisory Services
Underwriting revenues and fees for mergers and acquisitions advisory services
are accrued when services for the transactions are substantially completed.
Transaction expenses are deferred until the related revenue is recognized.
Investment banking and advisory services revenues are presented net of
transaction-related expenses.
Mortgage Servicing Fees and Advances
Contractual servicing fees, late fees and other ancillary servicing fees earned
for servicing mortgage loans are reflected in "Investment banking" revenues in
the Consolidated Statements of Income. Contractual servicing fees are recognized
when earned based on the terms of the servicing agreement. All other fees are
recognized when received. In the normal course of its business, the Company
makes principal, interest and other servicing advances to external investors on
mortgage loans serviced for these investors. Such advances are generally
recoverable from the mortgagors, related securitization trusts or from the
proceeds received from the sales of the underlying properties. A charge to
earnings is recognized to the extent that servicing advances are estimated to be
uncollectible under the provisions of the servicing contracts.
Commissions
Commission revenues primarily include fees from executing and clearing client
transactions on stock, options and futures markets worldwide. These fees are
recognized on a trade date basis. The Company records its share of the
commission under certain clearing agreements where the Company is acting as
agent for another broker, in accordance with EITF Statement No. 99-19,
"Reporting Revenue Gross as a Principal versus Net as an Agent."
Asset Management and Other Income
The Company receives advisory fees for investment management. In addition, the
Company receives performance incentive fees for managing certain funds. Advisory
fees are recognized over the period of advisory service. Unearned advisory fees
are treated as deferred revenues and are included in "Other liabilities" in the
accompanying Consolidated Statements of Financial Condition. Performance
incentive fees are accrued throughout the year based on a fund's performance to
date against specified performance targets.
Energy Trading
Energy trading revenues are reported, net of certain direct costs, in "Principal
transactions" on the Consolidated Statement of Income. Energy trading assets and
liabilities that are derivatives are reported at fair value with the
corresponding changes recognized in income. Non-derivative contracts are
accounted for on an accrual basis and recognized in income when the energy is
delivered. See Note 21, "Asset Acquisition" for a further discussion on the
assets acquired from the Williams Power Company, Inc.
88
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
FINANCIAL INSTRUMENTS
On December 1, 2006, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 157, "Fair Value Measurements." SFAS No. 157 defines fair
value, establishes a framework for measuring fair value and requires enhanced
disclosures about fair value measurements. Additionally, SFAS No. 157 disallows
the use of block discounts on positions traded in an active market as well as
nullifies certain guidance in EITF No. 02-3 regarding the recognition of
inception gains on certain derivative transactions. See Note 3, "Financial
Instruments" of Notes to Consolidated Financial Statements for a complete
discussion of SFAS No. 157.
Financial instruments owned and financial instruments sold, but not yet
purchased, including contractual commitments arising pursuant to futures,
forward and option contracts, interest rate swaps and other derivative
contracts, are recorded on a trade-date basis at fair value.
Fair value is generally based on quoted market prices. If quoted market prices
are not available, fair value is determined based on other relevant factors,
including dealer price quotations, price activity for equivalent instruments and
valuation pricing models. Valuation pricing models consider time value, yield
curve and volatility factors, prepayment speeds, default rates, loss severity,
current market and contractual prices for the underlying financial instruments,
as well as other measurements.
Equity interests and securities acquired as a result of private equity and
merchant banking activities are reflected in the consolidated financial
statements at fair value, which is often represented at initial cost until
significant transactions or developments indicate that a change in the carrying
value of the securities is appropriate. This represents the Company's best
estimate of exit price as defined by SFAS No. 157. Generally, the carrying
values of these securities will be increased based on company performance and in
those instances where market values are readily ascertainable by reference to
substantial transactions occurring in the marketplace or quoted market prices.
Reductions to the carrying value of these securities are made when the Company's
estimate of fair value has declined below the carrying value.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company follows SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities," as amended by SFAS No. 138, "Accounting for Certain
Derivative Instruments and Certain Hedging Activities," and SFAS No. 149,
"Amendment of Statement 133 on Derivative Instruments and Hedging Activities,"
which establishes accounting and reporting standards for stand-alone derivative
instruments, derivatives embedded within other contracts or securities, and
hedging activities. Accordingly, all derivatives, whether stand-alone or
embedded within other contracts or securities, are carried in the Company's
Consolidated Statements of Financial Condition at fair value, with changes in
fair value recorded in "Principal transactions" revenues. Designated hedged
items in fair value hedging relationships are marked for the risk being hedged,
with such changes also recorded in "Principal transactions" revenues.
Derivatives designated as cash flow hedges are carried at fair value. The
effective portion of the change in fair value on a derivative designated as a
cash flow hedge is reported in "Accumulated other comprehensive (loss) income."
The ineffective portion is reported in "Principal transactions" revenues in the
Consolidated Statements of Income. Amounts that are reported in "Accumulated
other comprehensive (loss) income" are reclassified into earnings in the same
period or periods during which the hedged transaction affects earnings.
On December 1, 2006, the Company adopted SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140."
SFAS No. 155 permits companies to elect on an instrument-by-instrument basis, to
apply a fair value measurement to hybrid financial instruments that contain an
embedded derivative that would otherwise require bifurcation under SFAS No. 133.
As permitted, on December 1, 2006, the Company elected to apply a fair value
measurement to all existing hybrid financial instruments that met the SFAS No.
155 definition. The Company has elected the fair value measurement for certain
qualifying hybrid financial instruments issued on or after December 1, 2006. The
Company's reason for electing to carry these instruments on a fair value basis
was to enable the Company to more efficiently hedge these instruments and to
simplify the accounting process. Changes in fair value are reflected in
"Principal transactions" revenues in the Consolidated Statements of Income. For
fiscal 2007, the increase to revenues due to changes in fair value pursuant to
the election of SFAS No. 155 was $664 million.
89
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The Company follows FIN No. 39, "Offsetting Amounts Related to Certain
Contracts," and offsets assets and liabilities in the Consolidated Statements of
Financial Condition provided that the legal right of offset exists under a
master netting agreement. This includes the offsetting of payables or
receivables relating to the fair value of cash collateral received or paid
associated with its derivative inventory, on a counterparty by counterparty
basis. The amounts netted reduced Financial Instruments Owned and Payable to
Customers, by $12.5 billion as of November 30, 2007 and $6.3 billion as of
November 30, 2006, and reduced Financial Instruments Sold, But Not Yet Purchased
and Receivable From Customers by $9.6 billion as of November 30, 2007 and $3.2
billion as of November 30, 2006.
CUSTOMER TRANSACTIONS
Customer securities transactions are recorded on the Consolidated Statements of
Financial Condition on a settlement date basis, which is generally three
business days after trade date, while the related commission revenues and
expenses are recorded on a trade-date basis. Receivables from and payables to
customers include amounts related to both cash and margin transactions.
Securities owned by customers, including those that collateralize margin or
other similar transactions, are generally not reflected in the Consolidated
Statements of Financial Condition.
MORTGAGE SERVICING RIGHTS
Mortgage servicing rights ("MSRs") are included in "Other assets" on the
Consolidated Statements of Financial Condition. On December 1, 2006, the Company
adopted SFAS No. 156, "Accounting for Servicing of Financial Assets--an
amendment of FASB Statement No. 140," and elected to measure servicing assets at
fair value. The fair value of MSRs is determined by using market-based models
that discount anticipated future net cash flows considering loan prepayment
predictions, interest rates, default rates, servicing costs, current market data
and other economic factors. Changes in the fair value of MSRs are recorded in
"Principal transactions" revenues in the Consolidated Statements of Income.
TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities--a replacement of FASB
Statement No. 125," to account for securitizations and other transfers of
financial assets and collateral. SFAS No. 140 establishes accounting and
reporting standards with a financial-components approach that focuses on
control. Under this approach, financial assets or liabilities are recognized
when control is established and derecognized when control has been surrendered
or the liability has been extinguished. Control is deemed to be relinquished
only when all of the following conditions have been met: (1) the assets have
been isolated from the transferor, even in bankruptcy or other receivership; (2)
the transferee is a QSPE or has the right to pledge or exchange the assets
received; and (3) the transferor has not maintained effective control over the
transferred assets. The Company derecognizes financial assets transferred in
securitizations provided that such transfer meets all of these criteria.
Mortgage securitization transactions, net of certain direct costs, are recorded
in "Principal transactions" revenues in the Consolidated Statements of Income.
COLLATERALIZED SECURITIES TRANSACTIONS
Transactions involving purchases of securities under agreements to resell
("reverse repurchase agreements") or sales of securities under agreements to
repurchase ("repurchase agreements") are treated as collateralized financing
transactions and are recorded at their contracted resale or repurchase amounts
plus accrued interest. Resulting interest income and expense is generally
included in "Principal transactions" revenues in the Consolidated Statements of
Income. Reverse repurchase agreements and repurchase agreements are presented in
the Consolidated Statements of Financial Condition on a net-by-counterparty
basis, where permitted by generally accepted accounting principles. It is the
Company's general policy to take possession of securities or loans with a market
value in excess of the principal amount loaned plus the accrued interest
thereon, in order to collateralize reverse repurchase agreements. Similarly, the
Company is generally required to provide securities or loans to counterparties
to collateralize repurchase agreements. The Company's agreements with
counterparties generally contain contractual provisions allowing for additional
collateral to be obtained, or excess collateral returned. It is the Company's
policy to value collateral and to obtain additional collateral, or to retrieve
excess collateral from counterparties, when deemed appropriate.
90
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Securities borrowed and securities loaned are recorded based upon the amount of
cash collateral advanced or received. Securities borrowed transactions
facilitate the settlement process and require the Company to deposit cash,
letters of credit or other collateral with the lender. With respect to
securities loaned, the Company receives collateral in the form of cash or other
collateral. The amount of collateral required to be deposited for securities
borrowed, or received for securities loaned, is an amount generally in excess of
the market value of the applicable securities borrowed or loaned. The Company
monitors the market value of securities borrowed and loaned, with excess
collateral retrieved or additional collateral obtained, when deemed appropriate.
FIXED ASSETS
Depreciation of property and equipment is calculated 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." See Note 20, "Acquisition of Minority Interest
and Impairment of Intangible Assets."
EARNINGS PER SHARE
Earnings per share ("EPS") is computed in accordance with SFAS No. 128,
"Earnings Per Share." Basic EPS is computed by dividing net income applicable to
common shares, adjusted for costs related to vested shares under the Capital
Accumulation Plan for Senior Managing Directors, as amended ("CAP Plan"), as
well as the effect of the redemption of preferred stock, by the weighted average
number of common shares outstanding. Common shares outstanding includes vested
units issued under certain stock compensation plans, which will be distributed
as shares of common stock. Diluted EPS includes the determinants of basic EPS
and, in addition, gives effect to dilutive potential common shares related to
stock compensation plans.
STOCK-BASED COMPENSATION
The Company follows the provisions of SFAS No. 123 (R), "Share-Based Payment,"
to account for its stock-based compensation plans. SFAS No. 123 (R) is a
revision of SFAS No. 123, "Accounting for Stock-Based Compensation," and
supersedes Accounting Principles Board ("APB") Opinion No. 25, "Accounting for
Stock Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows."
SFAS No. 123 (R) eliminated the ability to account for share-based compensation
transactions using APB No. 25 and requires all share-based payments to
employees, including grants of employee stock options, to be recognized in the
financial statements using a fair value-based method. The Company adopted SFAS
No. 123 (R) effective December 1, 2005, using the modified prospective method.
Because the fair value recognition provisions of SFAS No. 123 and SFAS No. 123
(R) were materially consistent under the Company's equity plans, the adoption of
SFAS No. 123 (R) did not have a material impact on the Company's financial
position or results of operations.
Prior to the Company's adoption of SFAS No. 123 (R), tax benefits in excess of
recognized compensation costs were reported as operating cash flows. SFAS No.
123 (R) requires excess tax benefits to be reported as a financing cash inflow.
The Company previously elected to adopt fair value accounting for stock-based
compensation consistent with SFAS No. 123, using the prospective method with
guidance provided by SFAS No. 148, "Accounting for Stock-Based
Compensation--Transition and Disclosure," effective December 1, 2002. As a
result, commencing with options granted after November 30, 2002, the Company
expenses the fair value of stock options issued to
91
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
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 APB No. 25, as permitted by SFAS No. 123.
Under the provisions of APB No. 25, compensation cost for stock options was
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 was recognized for stock
option awards granted prior to December 1, 2002 because the exercise price was
equal to the fair market value of the Company's common stock on the grant date.
The cost related to stock-based compensation included in net income for the
fiscal years ended November 30, 2007 and 2006 has been fully determined under
the fair value-based method, and for the fiscal year ended November 30, 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
if the fair value-based method had been applied to all outstanding awards in
fiscal year ended November 30, 2005.
- --------------------------------------------------------------------------------
Fiscal Year Ended November 30, 2005
- --------------------------------------------------------------------------------
(in millions, except per share amounts)
Net income, as reported $ 1,462
Add: Stock-based employee compensation plan expense
included in reported net income, net of related
tax effect 375
Deduct: Total stock-based employee compensation plan expense
determined under the fair value-based method, net of
related tax effect (387)
- --------------------------------------------------------------------------------
Pro forma net income $ 1,450
================================================================================
Earnings per share:
Basic-as reported $ 11.42
Basic-pro forma $ 11.33
Diluted-as reported $ 10.31
Diluted-pro forma $ 10.23
================================================================================
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 U.S. consolidated federal
income tax return. The Company accounts for income taxes under the provisions of
SFAS No. 109, "Accounting for Income Taxes." Under SFAS No. 109, deferred income
taxes are based on the net tax effects of temporary differences between the
financial reporting and tax bases of assets and liabilities. In addition,
deferred income taxes are determined by the enacted tax rates and laws expected
to be in effect when the related temporary differences are expected to be
reversed.
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations. The
Company regularly evaluates the likelihood of additional assessments in each of
the tax jurisdictions resulting from these examinations. Tax reserves have been
established, which the Company believes to be adequate in relation to the
probability for additional assessments. Once established, reserves are adjusted
as information becomes available or when an event requiring a change to the
reserve occurs.
92
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
TRANSLATION OF FOREIGN CURRENCIES
Assets and liabilities denominated in foreign currencies are translated at
fiscal year-end rates of exchange, while income statement items are translated
at daily average rates of exchange during the fiscal year. Gains or losses on
translation of the financial statements of foreign subsidiaries from their
respective functional currency to the U.S. dollar are included, net of tax, on
the Consolidated Statements of Comprehensive Income. Gains or losses resulting
from foreign currency transactions are included in current earnings.
ACCOUNTING AND REPORTING DEVELOPMENTS
During fiscal 2007, the Company adopted SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments--an amendment of FASB Statements No. 133 and 140,"
SFAS No. 156, "Accounting for Servicing of Financial Assets--an amendment of
FASB Statement No. 140," and SFAS No. 157, "Fair Value Measurements." As a
result of the adoption of these standards, the Company recorded a cumulative
effect adjustment to increase the opening retained earnings balance by
approximately $3.5 million (after tax).
In December 2007, the FASB issued Statement No. 141 R, "Business Combinations (a
revision of Statement No. 141)." This Statement applies to all transactions or
other events in which an entity obtains control of one or more businesses,
including those combinations achieved without the transfer of consideration.
This Statement retains the fundamental requirements in Statement No. 141 that
the acquisition method of accounting be used for all business combinations. This
Statement expands the scope to include all business combinations and requires an
acquirer to recognize the assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree at their fair values as of the
acquisition date. Additionally, FASB No. 141R changes the way entities account
for business combinations achieved in stages by requiring the identifiable
assets and liabilities to be measured at their full fair values. Additionally,
contractual contingencies and contingent consideration shall be measured at fair
value at the acquisition date. This Statement is effective on a prospective
basis to business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after December
15, 2008. The Company is currently evaluating the impact, if any, that the
adoption of this Statement will have on the consolidated financial statements of
the Company.
In December 2007, the FASB issued Statement No. 160, "Noncontrolling Interests
in Consolidated Financial Statements - an amendment of ARB No.51". This
Statement amends ARB No. 51 to establish accounting and reporting standards for
the noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an
ownership interest in the consolidated entity that should be reported as equity
in the consolidated financial statements. Additionally, this Statement requires
that consolidated net income include the amounts attributable to both the parent
and the noncontrolling interest. This Statement is effective for interim periods
beginning on or after December 15, 2008. The Company is currently evaluating the
impact, if any, that the adoption of this Statement will have on the
consolidated financial statements of the Company.
In June 2007, the FASB's Emerging Issues Task Force (EITF) issued EITF Issue No.
06-11 "Accounting for Income Tax Benefits of Dividends on Share-Based Payment
Awards." This issue requires that the tax benefits related to dividend
equivalents paid on restricted stock units, which are expected to vest, be
recorded as an increase to additional paid-in capital. EITF 06-11 is effective
prospectively to the income tax benefits on dividends declared in fiscal years
beginning after December 15, 2007. The Company is currently evaluating the
impact, if any, the adoption of this issue may have on the Company's
consolidated financial statements and does not expect a material impact on the
consolidated financial statements.
In February 2007, the FASB issued Statement No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities" ("SFAS No. 159"). SFAS No. 159
permits entities to elect to measure financial assets and liabilities (except
for those that are specifically scoped out of the Statement) at fair value. The
election to measure a financial asset or liability at fair value can be made on
an instrument-by-instrument basis and is irrevocable. The difference between the
carrying value and the fair value at the election date is recorded as a
transition adjustment to opening retained earnings. Subsequent changes in fair
value are recognized in earnings. The Company adopted SFAS No. 159 effective
December 1, 2007. The adoption of SFAS No. 159 did not have a material impact on
the consolidated financial statements of the Company.
93
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
In June 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty
in Income Taxes--an interpretation of FASB Statement No. 109" ("FIN No. 48").
FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized
in an enterprise's financial statements in accordance with SFAS No. 109. FIN No.
48 prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. FIN No. 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure, and transition. The Company will adopt the provisions of
FIN No. 48 beginning in the first quarter of 2008. The adoption of FIN No. 48
will not have a material impact on the consolidated financial statements of the
Company.
In April 2007, the FASB issued a Staff Position ("FSP") FIN No. 39-1, "Amendment
of FASB Interpretation No. 39." FSP FIN No. 39-1 defines "right of setoff" and
specifies what conditions must be met for a derivative contract to qualify for
this right of setoff. It also addresses the applicability of a right of setoff
to derivative instruments and clarifies the circumstances in which it is
appropriate to offset amounts recognized for those instruments in the
Consolidated Statement of Financial Condition. In addition, this FSP permits
offsetting of fair value amounts recognized for multiple derivative instruments
executed with the same counterparty under a master netting arrangement and fair
value amounts recognized for the right to reclaim cash collateral (a receivable)
or the obligation to return cash collateral (a payable) arising from the same
master netting arrangement as the derivative instruments. The provisions of this
FSP are consistent with the Company's current accounting practice. The Company
adopted the provisions of FSP FIN No. 39-1 on December 1, 2007. The adoption of
FSP FIN No. 39-1 did not impact the consolidated financial statements of the
Company.
2. FAIR VALUE OF FINANCIAL INSTRUMENTS
Substantially all of the Company's assets and liabilities are carried at fair
value or contracted amounts that approximate fair value. Assets that are
recorded at contracted amounts approximating fair value consist largely of
short-term secured receivables, including reverse repurchase agreements,
securities borrowed, customer receivables and certain other receivables.
Similarly, the Company's short-term liabilities, such as bank loans, commercial
paper, medium-term notes, structured notes, repurchase agreements, securities
loaned, customer payables and certain other payables, are recorded at contracted
amounts approximating fair value. These instruments generally have variable
interest rates and/or short-term maturities, in many cases overnight, and
accordingly, their fair values are not materially affected by changes in
interest rates.
The Company uses derivatives to modify the interest rate characteristics of its
long- and short-term debt. The Company generally enters into interest rate swaps
and other transactions designed to either convert its fixed-rate debt into
floating-rate debt or otherwise hedge its exposure to changes in interest rates.
94
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
3. FINANCIAL INSTRUMENTS
Financial instruments owned and financial instruments sold, but not yet
purchased, consisting of the Company's proprietary trading inventories, at fair
value, as of November 30, 2007 and 2006, were as follows:
(in millions) 2007 2006
- ---------------------------------------------------------------------------------------------------------------------
FINANCIAL INSTRUMENTS OWNED, AT FAIR VALUE:
U.S. government and agency $ 12,920 $ 10,842
Other sovereign governments 672 1,372
Corporate equity and convertible debt 32,454 28,893
Corporate debt and other 26,330 32,551
Mortgages, mortgage- and asset-backed 46,141 39,893
Derivative financial instruments 19,725 11,617
- ---------------------------------------------------------------------------------------------------------------------
$ 138,242 $ 125,168
=====================================================================================================================
FINANCIAL INSTRUMENTS SOLD, BUT NOT YET PURCHASED, AT FAIR VALUE:
U.S. government and agency $ 4,563 $ 11,724
Other sovereign governments 2,473 1,275
Corporate equity and convertible debt 18,843 12,623
Corporate debt and other 4,373 4,451
Mortgages, mortgage- and asset-backed 63 319
Derivative financial instruments 13,492 11,865
- ---------------------------------------------------------------------------------------------------------------------
$ 43,807 $ 42,257
=====================================================================================================================
As of November 30, 2007 and 2006, all financial instruments owned that were
pledged to counterparties where the counterparty has the right, by contract or
custom, to rehypothecate those securities are classified as "Financial
Instruments Owned and Pledged as Collateral, at Fair Value" in the 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 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 November 30, 2007, the
Company's most significant concentrations are related to United States
government securities, Federal National Mortgage Association and Federal Home
Loan Mortgage Corporation agency mortgage-backed securities, which are included
in the U.S. government and agency and mortgages, mortgage- and asset-backed
inventory captions above. In addition, a substantial portion of the collateral
held by the Company for reverse repurchase agreements consists of securities
issued by the U.S. government and agencies.
FAIR VALUE MEASUREMENTS
On December 1, 2006, the Company adopted SFAS No. 157, "Fair Value
Measurements." SFAS No. 157 applies to all financial instruments that are
measured and reported on a fair value basis. This includes items currently
reported in "Financial instruments owned, at fair value" and "Financial
instruments sold, but not yet purchased, at fair value" on the Consolidated
Statements of Financial Condition as well as financial
95
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
instruments reported in "Other assets" and "Other liabilities" that are reported
at fair value.
As defined in SFAS No. 157, fair value is the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date. In determining fair value, the
Company uses various methods including market, income and cost approaches. Based
on these approaches, the Company often utilizes certain assumptions that market
participants would use in pricing the asset or liability, including assumptions
about risk and or the risks inherent in the inputs to the valuation technique.
These inputs can be readily observable, market corroborated, or generally
unobservable firm inputs. The Company utilizes valuation techniques that
maximize the use of observable inputs and minimize the use of unobservable
inputs. Based on the observability of the inputs used in the valuation
techniques the Company is required to provide the following information
according to the fair value hierarchy. The fair value hierarchy ranks the
quality and reliability of the information used to determine fair values.
Financial assets and liabilities carried at fair value will be classified and
disclosed in one of the following three categories:
Level 1: Quoted market prices in active markets for identical assets or
liabilities.
Level 2: Observable market based inputs or unobservable inputs that are
corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
Level 1 primarily consists of financial instruments whose value is based on
quoted market prices such as exchange-traded derivatives and listed equities.
This category also includes financial instruments that are valued using
alternative approaches but for which the Company typically receives independent
external valuation information including U.S. Treasuries, other U.S. Government
and agency securities and certain cash instruments such as money market funds
and certificates of deposit.
Level 2 includes financial instruments that are valued using models or other
valuation methodologies. These models are primarily industry-standard models
that consider various assumptions, including time value, yield curve, volatility
factors, prepayment speeds, default rates, loss severity, current market and
contractual prices for the underlying financial instruments, as well as other
relevant economic measures. Substantially all of these assumptions are
observable in the marketplace, can be derived from observable data or are
supported by observable levels at which transactions are executed in the
marketplace. Financial instruments in this category include sovereign debt,
certain corporate equities, corporate debt, certain U.S. agency and non-agency
mortgage-backed securities and non-exchange-traded derivatives such as interest
rate swaps.
Level 3 is comprised of financial instruments whose fair value is estimated
based on internally developed models or methodologies utilizing significant
inputs that are generally less readily observable. Included in this category are
distressed debt, non-performing mortgage-related assets, certain performing
residential and commercial mortgage loans, certain mortgage- and asset-backed
securities and residual interests, Chapter 13 and other credit card receivables
from individuals, and complex derivative structures including long-dated equity
derivatives.
In determining the appropriate levels, the Company performs a detailed analysis
of the assets and liabilities that are subject to SFAS No. 157. At each
reporting period, all assets and liabilities for which the fair value
measurement is based on significant unobservable inputs are classified as Level
3.
96
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Fair Value Measurements on a Recurring Basis as of November 30, 2007:
Balance as of
Impact of November 30,
(in millions) Level 1 Level 2 Level 3 Netting 2007
- ------------------------------------------------------------------------------------------------------------------------------------
Financial Instruments Owned, at fair value
U.S. government and agency $ 3,680 $ 9,240 $ -- $ -- $ 12,920
Other sovereign governments -- 672 -- -- 672
Corporate equity and convertible debt 23,984 8,208 262 -- 32,454
Corporate debt and other 447 21,315 4,568 -- 26,330
Mortgages, mortgage- and asset-backed -- 28,891 17,250 -- 46,141
- ------------------------------------------------------------------------------------------------------------------------------------
Total Non Derivative Trading Assets 28,111 68,326 22,080 -- 118,517
Derivative financial instruments (1) 928 157,370 2,331 (140,904) 19,725
- ------------------------------------------------------------------------------------------------------------------------------------
Total Financial Instruments Owned,
at fair value 29,039 225,696 24,411 (140,904) 138,242
Other Assets (2) 428 1,450 3,758 -- 5,636
- ------------------------------------------------------------------------------------------------------------------------------------
Total Assets at fair value $ 29,467 $ 227,146 $ 28,169 $ (140,904) $ 143,878
====================================================================================================================================
Balance as of
Impact of November 30,
(in millions) Level 1 Level 2 Level 3 Netting 2007
- ------------------------------------------------------------------------------------------------------------------------------------
Financial Instruments Sold But Not Yet
Purchased, at fair value
U.S. government and agency $ (4,563) $ -- $ -- $ -- $ (4,563)
Other sovereign governments -- (2,473) -- -- (2,473)
Corporate equity and convertible debt (18,327) (516) -- -- (18,843)
Corporate debt and other -- (4,367) (6) -- (4,373)
Mortgages, mortgage- and asset-backed -- (11) (52) -- (63)
- ------------------------------------------------------------------------------------------------------------------------------------
Total Non Derivative Trading Liabilities (22,890) (7,367) (58) -- (30,315)
Derivative financial instruments (1) (110) (148,481) (2,920) 138,019 (13,492)
- ------------------------------------------------------------------------------------------------------------------------------------
Total Financial Instruments Sold But
Not Yet Purchased, at fair value (23,000) (155,848) (2,978) 138,019 (43,807)
Other Liabilities (3) (96) (7,588) (1,254) -- (8,938)
- ------------------------------------------------------------------------------------------------------------------------------------
Total Liabilities at fair value $ (23,096) $ (163,436) $ (4,232) $ 138,019 $ (52,745)
====================================================================================================================================
(1) The derivatives trading inventory balances are reported on a gross basis by
level with a corresponding adjustment for netting.
(2) Other assets includes certain items such as alternative investments,
mortgage servicing rights, net assets of variable interest entities and
mortgage securitizations that did not meet the criteria for sale treatment
under SFAS No. 140.
(3) Other liabilities are primarily comprised of certain hybrid debt issuances
accounted for at fair value as elected in accordance with SFAS No. 155.
As stated above SFAS No. 157 applies to all financial assets and liabilities
that are reported on a fair value basis. These valuations are adjusted for
various factors including credit risk. For applicable financial assets carried
at fair value, the credit standing of the counterparties is analyzed and
factored into the fair value measurement of those assets. SFAS No. 157 states
that the fair value measurement of a liability must reflect the nonperformance
risk of the entity. Therefore, the impact of credit standing as well as any
potential credit enhancements (e.g. collateral) has been factored into the fair
value measurement of both financial assets and liabilities.
The derivative financial instruments balances in the table above are reported on
a gross basis by level with a netting adjustment presented separately in the
"Impact of Netting" column. The Company often enters into different types of
derivative contracts with a single counterparty and these contracts are covered
under one ISDA master netting agreement. The fair value of the individual
derivative contracts are reported gross in their respective levels based on the
fair value hierarchy.
97
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The following table provides a reconciliation of the beginning and ending
balances for the major classes of assets and liabilities measured at fair value
using significant unobservable inputs (Level 3):
Level 3 Financial Assets and Liabilities
Year Ended November 30, 2007
Changes in
Unrealized
Gains/(Losses)
relating to
Beginning Total Gains/ Purchases, Assets and
Balance as of (Losses) Issuances, Transfers Ending Balance Liabilities held
December 1, (Realized and Sales and In/Out of as of November at the reporting
(in millions) 2006 Unrealized) Settlements Level 3 30, 2007 date
- ------------------------------------------------------------------------------------------------------------------------------------
Non-Derivative Trading Assets $ 9,000 $ (1,891) $ 10,606 $ 4,365 $ 22,080 $ (1,016)
Non Derivative Trading Liabilities $ (190) $ (19) $ 451 $ (300) $ (58) $ 2
Derivative Trading Inventory (Net) $ (2,223) $ 375 $ 1,435 $ (176) $ (589) $ 584
Other Assets $ 2,836 $ (391) $ 783 $ 530 $ 3,758 $ (934)
Other Liabilities $ (3,515) $ 201 $ 1,603 $ 457 $ (1,254) $ 43
- ------------------------------------------------------------------------------------------------------------------------------------
Non-Derivative Trading Assets and Liabilities
Realized and unrealized gains and losses on Level 3 assets and liabilities are
primarily reported in "Principal transactions" revenues in the Consolidated
Statements of Income. The Level 3 non-derivative trading assets reflect an
unrealized loss related to the mortgage related inventory write-downs incurred
during the fourth quarter of 2007. The Company manages its exposure on a
portfolio basis and regularly engages in offsetting strategies in which
financial instruments from one fair value hierarchy level are used to
economically offset the risk of financial instruments in the same or different
levels. Therefore, realized and unrealized gains and losses reported as Level 3
may be offset by gains or losses attributable to assets or liabilities
classified in Level 1 or Level 2.
Derivative Trading Inventory (Net)
The net derivative trading inventory resulted in a gain for fiscal 2007. This
gain was primarily driven by changes in interest rates and credit spreads
related to the Company's interest rate and credit derivative products.
Transfers
The Company reviews the fair value hierarchy classifications on a monthly basis.
Changes in the observability of the valuation attributes may result in a
reclassification of certain financial assets or liabilities. Such
reclassifications are reported as transfers in/out of Level 3 at fair value in
the month in which the changes occur.
During fiscal 2007, there were significant transfers into Level 3. The majority
of these transfers related to mortgage and mortgage-related securities. The
largest contributors to the transfers were to commercial loans, performing
residential loans and investment grade CDOs. These transfers were primarily
driven by the fact that there was a significent reduction in observable trading
activity for these instruments during the latter part of fiscal 2007.
4. DERIVATIVES AND HEDGING ACTIVITIES
The Company, in its capacity as a dealer in over-the-counter derivative
financial instruments and its proprietary market-making and trading activities,
enters into transactions in a variety of cash and derivative financial
instruments for proprietary trading and to manage its exposure to market and
credit risk. These risks include interest rate, exchange rate, equity price and
commodity price risk. Derivative financial instruments represent contractual
commitments between counterparties that derive their value from changes in an
underlying interest rate, currency exchange rate, index (e.g., Standard & Poor's
500 Index), reference rate (e.g., London Interbank Offered Rate, or LIBOR), or
asset value referenced in the related contract. Some derivatives, such as
futures contracts, certain options and index-referenced warrants, can be traded
on an exchange. Other
98
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
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 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 Consolidated
Statements of Financial Condition. The Company's exposure to market risk is
influenced by a number of factors, including the relationships among and between
financial instruments with off-balance-sheet risk, the Company's proprietary
securities, futures and derivatives inventories as well as the volatility and
liquidity in the markets in which the financial instruments are traded. The
Company mitigates its exposure to market risk by entering into offsetting
transactions, which may include over-the-counter derivative contracts or the
purchase or sale of interest-bearing securities, equity securities, financial
futures and forward contracts. In this regard, the utilization of derivative
instruments is designed to reduce or mitigate market risks associated with
holding dealer inventories or in connection with arbitrage-related trading
activities.
DERIVATIVES CREDIT RISK
Credit risk arises from the potential inability of counterparties to perform in
accordance with the terms of the contract. At any point in time, the Company's
exposure to credit risk associated with counterparty non-performance is
generally limited to the net replacement cost of over-the-counter contracts, net
of the value of collateral held. Such financial instruments are reported at fair
value on a net-by-counterparty basis pursuant to enforceable netting agreements.
Exchange-traded financial instruments, such as futures and options, generally do
not give rise to significant unsecured counterparty exposure due to margin
requirements of the exchanges, as well as the Company's internal margin
requirements, which may be greater than those prescribed by the individual
exchanges. Options written by the Company generally do not give rise to
counterparty credit risk since they obligate the Company (not its counterparty)
to perform.
The Company has controls in place to monitor credit exposures by assessing the
future creditworthiness of counterparties and limiting transactions with
specific counterparties. The Company also seeks to control credit risk by
following an established credit approval process, monitoring credit limits and
requiring collateral where appropriate.
HEDGING ACTIVITY
To modify the interest rate characteristics of its long- and short-term debt,
the Company also engages in non-trading derivatives activities. The Company has
issued U.S. dollar-and foreign currency-denominated debt with both variable- and
fixed-rate interest payment obligations. The Company has entered into interest
rate swaps, primarily based on LIBOR, to convert fixed-rate interest payments on
its debt obligations into variable-rate payments. In addition, for foreign
currency debt obligations that are not used to fund assets in the same currency,
the Company has entered into currency swap agreements that effectively convert
the debt into U.S. dollar obligations. Such transactions are accounted for as
fair value hedges.
These financial instruments are subject to the same market and credit risks as
those that are traded in connection with the Company's market-making and trading
activities. The Company has similar controls in place to monitor these risks.
Interest rate swap agreements increased interest expense on the Company's long-
and short-term debt obligations by $506 million and $376 million during the
fiscal years ended November 30, 2007 and 2006, respectively and reduced interest
expense on the Company's long- and short-term debt obligations by $115 million
during the fiscal year ended November 30, 2005.
99
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
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 be carried on the Company's Consolidated
Statements of Financial Condition at fair value. SFAS No. 133 also requires the
value of items designated as being fair value hedged to be adjusted for the risk
being hedged, as defined in SFAS No. 133, provided that the intent to hedge is
fully documented. Any resultant net change in value for both the hedging
derivative and the hedged item for the risk being hedged is recognized in
earnings immediately, 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
Consolidated Statements of Income. These amounts were immaterial for fiscal
2007, 2006 and 2005.
The Company also engages in non-trading derivative activities to manage
commodity price risks resulting from exposures to changes in spot and forward
prices in electricity and natural gas. The company actively manages these risks
with exchange traded futures, swaps, OTC swaps and options. Certain of these
transactions are accounted for as cash flow hedges as defined in SFAS No. 133
which requires the effective portion of the unrealized gain or loss on a
derivative designated as a cash flow hedge, as defined in SFAS No. 133, to be
reported in "Accumulated other comprehensive income" ("OCI") with the
ineffective portion reported in `Principal transactions" revenues in the
Consolidated Statements of Income. Amounts that are reported in OCI are
reclassified into earnings in the same period or periods during which the hedged
transaction affects earnings. The ineffective portion of cash flow hedges was
deemed immaterial for fiscal 2007.
The net loss on derivative instruments designated in cash flow hedging
relationships recorded in OCI, net of tax, was $10 million at November 30, 2007,
which represents the net change in fair value recorded in OCI in fiscal 2007.
The net loss in OCI is expected to be reclassified into earnings as follows: $4
million in fiscal 2008 and the remaining $6 million of losses within five years.
5. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES
SECURITIZATIONS
The Company is a market leader in mortgage-backed securitizations 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 recorded 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 November 30, 2007 and 2006 was approximately 180 days
and 150 days, respectively. These retained interests are included in "Financial
instruments owned, at fair value" 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.
100
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The Company's securitization activities are detailed below:
Agency Other Mortgage-
(in billions) Mortgage-Backed and Asset-Backed Total
- ------------------------------------------------------------------------------------------------------------------------------------
Total securitizations
Fiscal 2007 $ 23.0 $ 73.8 $ 96.8
Fiscal 2006 $ 21.8 $ 99.3 $ 121.1
- ------------------------------------------------------------------------------------------------------------------------------------
The following table summarizes the Company's retained interests by rating as of
November 30, 2007 and 2006:
November 30, November 30,
(in billions) 2007 2006
- ------------------------------------------------------------------------------------------------------------------------------------
Retained Interests:
AAA rated Agency Mortgage-Backed $2.4 $1.5
AAA rated Other Mortgage-and Asset-Backed 2.7 1.5
- ------------------------------------------------------------------------------------------------------------------------------------
Total AAA rated $5.1 $3.0
Other investment grade 1.6 1.3
Non-investment grade 1.3 1.3
- ------------------------------------------------------------------------------------------------------------------------------------
Total retained interests $8.0 $5.6
====================================================================================================================================
The following table summarizes cash flows from securitization trusts related to
securitization transactions during the fiscal years ended November 30, 2007 and
2006:
Agency Other Mortgage-
(in millions) Mortgage-Backed and Asset-Backed Total
- ------------------------------------------------------------------------------------------------------------------------------------
Cash flows received from retained interests
Fiscal 2007 $ 254 $ 748 $ 1,002
Fiscal 2006 $ 296 $ 760 $ 1,056
Cash flows from servicing
Fiscal 2007 $ 1 $ 68 $ 69
Fiscal 2006 $-- $ 90 $ 90
- ------------------------------------------------------------------------------------------------------------------------------------
The Company is an active market maker in mortgage-backed securities and
therefore may retain interests in assets it securitizes, predominantly highly
rated or government agency-backed securities. The models employed in the
valuation of retained interests consider possible changes in prepayment speeds
in response to changes in future interest rates, as well as potential credit
losses. Prepayment speed changes are incorporated by calibrating the
distribution of possible future interest rates to the observed levels of implied
volatility in the market for interest rate options and generating the
corresponding cash flows for the securities using prepayment models. Credit
losses are considered through explicit loss models for positions exposed to
significant default risk in the underlying collateral, and through
option-adjusted spreads that also incorporate additional factors such as
liquidity and model uncertainty for all positions. The models use discount rates
that are based on the Treasury curve, plus the option-adjusted spread. Key
points on the constant maturity Treasury curve at November 30, 2007 were 3.03%
for 2-year Treasuries and 4.14% for 10-year Treasuries, and ranged from 3.03% to
4.47%. The weighted average spread was 116 basis points and 411 basis points for
agency mortgage-backed securities and other mortgage- and asset-backed
securities, respectively, at November 30, 2007.
Weighted average key economic assumptions used in measuring the fair value of
retained interests in assets the Company securitized at November 30, 2007 were
as follows:
Agency Other Mortgage-
Mortgage-Backed and Asset-Backed
- ------------------------------------------------------------------------------------------------------------------------------------
Weighted average life (years) 5.7 2.8
Average prepayment speeds (annual rate) 7% - 39% 6% - 39%
Credit losses -- 0.5% - 49%
- ------------------------------------------------------------------------------------------------------------------------------------
101
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The following hypothetical sensitivity analysis as of November 30, 2007
illustrates the potential adverse change in fair value of these retained
interests due to a specified change in the key valuation assumptions. The
interest rate changes represent a parallel shift in the Treasury curve. This
shift considers the corresponding effect of other variables, including
prepayments. The remaining valuation assumptions are changed independently.
Retained interests in securitizations are generally not held to maturity and are
typically sold shortly after the settlement of a securitization. The Company
considers the current and expected credit profile of the underlying collateral
in determining the fair value and periodically updates the fair value for
changes in credit, interest rate, prepayment speeds and other pertinent market
factors. Changes in portfolio composition, updates to loss and prepayment
models, and changes in the level of interest rates and market prices for
retained interests, can combine to produce significant changes in the
sensitivities reported even if aggregate market values do not change
significantly. Actual credit losses on retained interests have not been
significant.
Agency Other Mortgage-
(in millions) Mortgage-Backed and Asset-Backed
- ------------------------------------------------------------------------------------------------------------------------------------
Interest rates
Impact of 50 basis point adverse change $ (66) $ (144)
Impact of 100 basis point adverse change (143) (284)
- ------------------------------------------------------------------------------------------------------------------------------------
Prepayment speeds
Impact of 10% adverse change (5) (31)
Impact of 20% adverse change (8) (54)
- ------------------------------------------------------------------------------------------------------------------------------------
Credit losses
Impact of 10% adverse change (10) (222)
Impact of 20% adverse change (19) (408)
- ------------------------------------------------------------------------------------------------------------------------------------
The above table should be viewed with caution since the changes in a single
variable generally cannot occur without changes in other variables or conditions
that may counteract or amplify the effect of the changes outlined in the table.
Changes in fair value based on adverse variations in assumptions generally
cannot be extrapolated because the relationship of the change in assumptions to
the change in fair value is not usually linear. In addition, the table does not
consider the change in fair value of offsetting positions, which would generally
offset the changes detailed in the table, nor does it consider any corrective
action that the Company may take in response to changes in these conditions. The
impact of offsetting positions is not presented because these positions are
established on a portfolio level and allocating the impact would not be
practicable.
MORTGAGE SERVICING RIGHTS
In the normal course of business, the Company originates and purchases
conforming and non-conforming, conventional fixed-rate and adjustable-rate
residential mortgage loans and sells such loans to investors. In connection with
these activities, the Company may retain MSRs that entitle the Company to a
future stream of cash flows based on the contractual servicing fee. In addition,
the Company may purchase and sell MSRs.
As of December 1, 2006, the Company adopted SFAS No. 156 and elected to carry
its MSRs at fair value, with changes in fair value reported in earnings. Prior
to December 1, 2006, the Company reported the MSRs on a lower of cost or market
basis.
The determination of fair value of the Company's MSRs requires management
judgment because they are not actively traded. The determination of fair value
for MSRs requires valuation processes which combine the use of discounted cash
flow models and extensive analysis of current market data to arrive at an
estimate of fair value. The cash flow and prepayment assumptions used in the
Company's discounted cash flow model are based on empirical data drawn from the
historical performance of the Company's MSRs adjusted to reflect current Market
conditions, which the Company believes are consistent with assumptions used by
market participants valuing similar MSRs. The key risks and therefore the key
assumptions used in the valuation of MSRs include mortgage prepayment speeds,
discount rates and constant default rates. These variables can, and generally
will, change from quarter to quarter as market conditions and projected interest
rates change. The Company mitigates the income statement effect of changes in
fair value of MSRs by entering into offsetting economic transactions.
102
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
At November 30, 2007, the key economic assumptions and the sensitivity of the
current fair value of MSRs to immediate changes in those assumptions were as
follows:
(in millions)
- --------------------------------------------------------------------------------
Fair value of MSRs $ 833
Weighted average constant prepayment rate (CPR) 14%
Impact on fair value of:
10% adverse change $ (33)
20% adverse change (70)
Weighted average discount rate 13%
Impact on fair value of:
10% adverse change $ (26)
20% adverse change (51)
Weighted average constant default rate (CDR) 5%
Impact on fair value of:
10% adverse change $ (29)
20% adverse change (58)
- --------------------------------------------------------------------------------
The above table should be viewed with caution since the changes in a single
variable generally cannot occur without changes in other variables or conditions
that may counteract or amplify the effect of the changes outlined in the table.
Changes in fair value based on adverse variations in assumptions generally
cannot be extrapolated because the relationship of the change in assumptions to
the change in fair value is not usually linear. In addition, the table does not
consider the change in fair value of offsetting positions, which would generally
offset the changes detailed in the table, nor does it consider any corrective
action that the Company may take in response to changes in these conditions. The
impact of offsetting positions is not presented because these positions are
established on a portfolio level and allocating the impact would not be
practicable.
MSRs are included in "Other assets" on the Consolidated Statements of Financial
Condition and are carried at fair value as of December 1, 2006, in accordance
with SFAS No. 156. The Company's MSR activities for the fiscal year ended
November 30, 2007 were as follows:
(in millions) 2007
- --------------------------------------------------------------------
Balance, beginning of year $ 502
Additions 351
Paydowns (153)
Changes in fair value resulting from changes
in valuation inputs/assumptions 133
- --------------------------------------------------------------------
Balance, end of year $ 833
====================================================================
The Company's MSR activities for the fiscal year ended November 30, 2006,
carried at the lower of amortized cost or market, were as follows:
(in millions) 2006
- --------------------------------------------------------------------
Balance, beginning of year $ 431
Additions 366
Sales, net (109)
Amortization (188)
Recovery 2
- --------------------------------------------------------------------
Balance, end of year $ 502
====================================================================
103
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Changes in the MSR valuation allowance for the fiscal year ended November 30,
2006 were as follows:
(in millions) 2006
- --------------------------------------------------------------------
Balance, beginning of year $ (11)
Recovery 2
- --------------------------------------------------------------------
Balance, end of year $ (9)
====================================================================
6. 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 the Company's securitization, asset management
and structured finance businesses. In addition, the Company purchases and sells
financial instruments that may be variable interests. The Company follows the
guidance in FIN No. 46 (R) and consolidates VIEs in which the Company is the
primary beneficiary.
The Company may perform various functions, including acting as the seller,
servicer, investor, structurer or underwriter in securitization transactions.
These transactions typically involve entities that are considered to be QSPEs as
defined in SFAS No. 140. QSPEs are exempt from the requirements of FIN No. 46
(R). For securitization vehicles that do not qualify as QSPEs, the holders of
the beneficial interests have no recourse to the Company, only to the assets
held by the related VIE. In certain of these VIEs, the Company could be
determined to be the primary beneficiary through its ownership of certain
beneficial interests, and would, therefore, be required to consolidate the
assets and liabilities of the VIE.
The Company has mortgage securitizations that did not meet the criteria for sale
treatment under SFAS No. 140, including transactions where the retained call
option did not meet the definition of a clean up call under SFAS No. 140. As
such, the Company continues to carry the assets and liabilities from these
transactions on its Consolidated Statements of Financial Condition.
The Company acts as portfolio manager and/or underwriter in several
collateralized debt obligation and collateralized loan obligation transactions.
In these transactions, the Company establishes a trust that purchases a
portfolio of assets and issues trust certificates that represent interests in
the portfolio of assets. The holders of the trust certificates have recourse
only to the underlying assets of the trusts and not to the Company's other
assets. In addition, the Company may receive variable compensation for managing
the portfolio and may also retain certain trust certificates. In certain of
these transactions, these interests result in the Company becoming the primary
beneficiary of these entities.
The Company establishes and operates funds for the benefit of its employees.
These funds are considered to be VIEs of which the Company is the primary
beneficiary.
The Company has made investments in entities that own power plants. Certain
entities are VIEs of which the Company is the primary beneficiary.
The following table sets forth the Company's total assets and maximum exposure
to loss associated with its significant variable interests in consolidated VIEs
and securitizations that did not qualify for sale treatment. This information is
presented based on principal business activity.
As of November 30, 2007 As of November 30, 2006
- -------------------------------------------------------------------------------------------------------------------
(in millions) Maximum Maximum
VIE Exposure VIE Exposure
Assets to Loss (1) Assets to Loss (1)
- -------------------------------------------------------------------------------------------------------------------
Mortgage Securitizations $ 30,313 $ 2,075 $ 28,985 $ 762
Collateralized Debt and Loan Obligations 2,150 297 685 48
Employee Funds(2) 650 445 575 355
Energy Investments 440 131 -- --
- -------------------------------------------------------------------------------------------------------------------
Total $ 33,553 $ 2,948 $ 30,245 $ 1,165
- -------------------------------------------------------------------------------------------------------------------
(1) Represents the fair value of the Company's interest in these entities.
(2) Maximum exposure to loss includes loans the Company has made to employees
who participate in the funds, for which the Company is in a second loss
position.
104
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The Company also owns significant variable interests in several VIEs related to
collateralized debt obligations and collateralized loan obligations for which
the Company is not the primary beneficiary and therefore does not consolidate
these entities. In aggregate, these VIEs had assets of approximately $11.5
billion and $14.8 billion at November 30, 2007 and 2006, respectively. At
November 30, 2007 and 2006, the Company's maximum exposure to loss from these
entities was approximately $112 million and $163 million, respectively, which
represents the fair value of its interests and are included in "Financial
instruments owned, at fair value" in the Consolidated Statements of Financial
Condition.
The Company purchases and sells interests in entities that may be deemed to be
VIEs in its market-making capacity in the ordinary course of business. As a
result of these activities, it is reasonably possible that such entities may be
consolidated or deconsolidated at various points in time. Therefore, the
Company's variable interests included above may not be held by the Company in
future periods.
7. 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 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 November 30, 2007 and 2006, the fair value of securities received as
collateral by the Company that can be repledged, delivered or otherwise used was
$280 billion and $286 billion, respectively. Of these securities received as
collateral, those with a fair value of approximately $189 billion and $190
billion were delivered, repledged or otherwise used at November 30, 2007 and
2006, respectively.
The Company also pledges financial instruments owned to collateralize certain
financing arrangements and permits the counterparty to pledge or rehypothecate
the securities. These securities are recorded as "Financial instruments owned
and pledged as collateral, at fair value" in the 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 $65
billion and $42 billion at November 30, 2007 and 2006, respectively.
105
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
8. SHORT-TERM BORROWINGS
The Company obtains unsecured short-term borrowings through the issuance of
commercial paper, bank loans, medium term notes and other borrowings. In
addition, the Company obtains secured short-term borrowings primarily through
master notes and secured bank loans. A master note is an agreement under which a
lender may make one or more loans to a borrower, the repayment obligation of
which is reflected in a promissory note to the lender. In the case of secured
master notes, these agreements are secured by collateral. The interest rates on
such short-term borrowings reflect market rates of interest at the time of the
transactions.
The Company's short-term borrowings at November 30, 2007 and 2006 consisted of
the following:
(in billions) 2007 2006
- ------------------------------------------------------------------------------------------------------
Unsecured borrowings:
Commercial paper $ 3.9 $ 20.7
Bank loans 3.1 1.7
Medium term notes 1.9 0.3
Other unsecured borrowings 2.7 3.1
- ------------------------------------------------------------------------------------------------------
Total unsecured borrowings 11.6 25.8
Secured borrowings 12.4 3.3
- ------------------------------------------------------------------------------------------------------
Total short-term borrowings $ 24.0 $ 29.1
======================================================================================================
The effective weighted average interest rates for short-term borrowings were as
follows:
Fiscal Years Ended
As of November 30, November 30,
- ----------------------------------------------------------------------------------------------------------------------------
2007 2006 2007 2006 2005
- ----------------------------------------------------------------------------------------------------------------------------
Commercial paper 4.67% 5.25% 5.34% 4.92% 3.28%
Bank loans and other borrowings 4.90% 5.23% 5.19% 4.74% 3.33%
- ----------------------------------------------------------------------------------------------------------------------------
Committed Credit Facilities
- ---------------------------
The Company has a committed revolving credit facility ("Facility") totaling $4.0
billion, which permits borrowing on a secured basis by the Parent Company, BSSC,
BSIL and certain other subsidiaries. The Facility also allows the Parent
Company, BSIL and Bear Stearns International Trading Limited ("BSIT") to borrow
up to $4.0 billion of the Facility on an unsecured basis. Secured borrowings can
be collateralized by both investment-grade and non-investment-grade financial
instruments as the Facility provides for defined advance rates on a wide range
of financial instruments eligible to be pledged. The Facility contains financial
covenants, the most significant of which require maintenance of specified levels
of stockholders' equity of the Company and net capital of BSSC. The Facility
terminates in February 2008, with all loans outstanding at that date payable no
later than February 2009. The Company intends to renew the Facility at market
available terms. There were no borrowings outstanding under the Facility at
November 30, 2007.
The Company has a $1.5 billion committed revolving securities repo facility
("Repo Facility"), which permits borrowings secured by a broad range of
collateral under a repurchase arrangement by the Parent Company, BSIL, BSIT and
BSB and BS Forex. The Repo Facility contains financial covenants that require,
among other things, maintenance of specified levels of stockholders' equity of
the Company. The Repo Facility terminates in August 2008, with all repos
outstanding at that date payable no later than August 2009. There were no
borrowings outstanding under the Repo Facility at November 30, 2007.
The Company has a $350 million committed revolving credit facility ("Pan Asian
Facility"), which permits borrowing on a secured basis by the Parent Company,
BSSC, Bear Stearns Japan Limited ("BSJL"), and BSIL. The Pan Asian Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company and net capital of BSSC.
In December 2007, the Company renewed the Facility at a $350 million committed
level with substantially the same terms. The Pan Asian Facility terminates in
December 2008 with
106
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
all loans outstanding at that date payable no later than December 2009. There
were no borrowings outstanding under the Pan Asian Facility at November 30,
2007.
The Company has a $450 million committed revolving credit facility ("Tax Lien
Facility"), which permits borrowing on a secured basis by the Parent Company,
Plymouth Park Tax Services and Madison Tax Capital LLC. The Tax Lien Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company. The Tax Lien Facility
terminates in March 2008 with all loans outstanding at that date payable no
later than March 2009. There were no borrowings outstanding under the Tax Lien
Facility at November 30, 2007.
The Company also maintains a series of committed credit facilities, which permit
borrowing on a secured basis, to support liquidity needs for the financing of
investment-grade and non-investment-grade corporate loans, residential
mortgages, commercial mortgages, listed options and whole loans. The facilities
are expected to be drawn from time to time and expire at various dates, the
longest of such periods ending in fiscal 2008. All of these facilities contain a
term-out option of one year or more for borrowings outstanding at expiration.
The banks providing these facilities are committed to provide up to an aggregate
of approximately $6.7 billion. At November 30, 2007, the borrowings outstanding
under these committed credit facilities were $4.9 billion.
9. LONG-TERM BORROWINGS
The Company's long-term borrowings (which have original maturities of at least
12 months) at November 30, 2007 and 2006 consisted of the following:
(in billions) 2007 2006
- ------------------------------------------------------------------------
Fixed-rate notes due 2008 to 2047:
U.S. dollar-denominated (1) (2) $ 19.8 $ 15.3
Non-U.S. dollar-denominated 8.9 7.3
Floating rate notes due 2008 to 2046:
U.S. dollar-denominated 21.9 16.5
Non-U.S. dollar-denominated 9.4 6.7
Index/equity/credit-linked notes:
U.S. dollar-denominated 2.5 2.8
Non-U.S. dollar-denominated 6.0 6.0
- ------------------------------------------------------------------------
Total long-term borrowings $ 68.5 $ 54.6
========================================================================
Amounts include fair value adjustments in accordance with SFAS No. 133, hybrid
financial instruments accounted for at fair value as elected under SFAS No. 155,
as well as $263 million of junior subordinated deferrable interest debentures
("Debentures"). The Debentures will mature on May 15, 2031; however, effective
May 15, 2006, the Company, at its option, may redeem the Debentures. The
Debentures are reflected in the table at their contractual maturity dates.
(1) At November 30, 2007 and 2006, U.S. dollar-denominated fixed-rate notes were
at interest rates ranging from 2.7% to 7.7% and from 1.0% to 7.5%, respectively.
(2) Included in U.S. dollar-denominated fixed rate notes at November 30, 2007
and 2006 were $1.0 billion of Subordinated Global Notes due January 22, 2017
that have an annual interest rate of 5.5%, which rank junior in right of payment
to all of the Company's senior indebtedness.
The Company has entered into interest rate swaps and other transactions to
convert its fixed-rate notes into floating rates based on LIBOR. For
floating-rate notes that are not based on LIBOR, the Company has generally
entered into interest rate swaps and other transactions to convert them into
floating rates based on LIBOR. Index/equity-linked borrowings include various
structured instruments whose payments and redemption values are linked to the
performance of a specific index (e.g., Dow Jones Industrial Average), a basket
of stocks or a specific equity security. To minimize the exposure resulting from
movements in the underlying equity position or index, the Company has entered
into various equity swap contracts. Credit-linked notes include various
structured instruments whose payments and redemption values are linked to the
performance of a basket of credit products, an index or an individual security.
To minimize exposure to these instruments, the Company has entered into swaps
that pay the performance of the underlying security or index.
107
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The effective weighted average interest rates for long-term borrowings, after
giving effect to the swaps, were as follows:
- --------------------------------------------------------------------------------
As of Fiscal Year Ended
November 30, November 30,
- --------------------------------------------------------------------------------
2007 2006 2007 2006 2005
- --------------------------------------------------------------------------------
Fixed-rate notes 5.51% 5.77% 5.89% 5.47% 3.59%
Floating-rate notes 5.14% 5.50% 5.57% 5.19% 3.56%
- --------------------------------------------------------------------------------
The Company's long-term borrowings at November 30, 2007 mature as follows:
U.S. Dollar Non-U.S. Dollar
---------------------------------- ---------------------------------------
Index/ Index/
Equity/ Equity/
Fixed Floating Credit Fixed Floating Credit
(in millions) Rate Rate Linked Rate Rate Linked Total
- ---------------------------------------------------------------------------------------------------------------------
FISCAL YEAR
2008 $ 2,367 $ 5,376 $ 622 $ 389 $ 253 $ 579 $ 9,586
2009 799 7,239 794 976 2,258 1,399 13,465
2010 2,976 4,083 321 1,622 395 1,033 10,430
2011 931 2,420 365 1,327 245 1,428 6,716
2012 4,152 1,138 253 1,903 1,446 350 9,242
Thereafter 8,587 1,631 138 2,730 4,852 1,161 19,099
- ---------------------------------------------------------------------------------------------------------------------
Total $ 19,812 $ 21,887 $ 2,493 $ 8,947 $ 9,449 $ 5,950 $ 68,538
=====================================================================================================================
Included in fiscal 2009 are approximately $996 million of floating-rate notes
that are redeemable prior to maturity at the option of the noteholder. These
notes contain certain provisions that effectively enable noteholders to put
these notes back to the Company and, therefore, are reflected in the table at
the date such notes first become redeemable. The final maturity dates of these
notes are during fiscal 2009, 2010 and 2011.
Instruments governing certain indebtedness of the Company contain various
financial covenants, including maintenance of minimum levels of stockholders'
equity of the Company. At November 30, 2007, the Company was in compliance with
all covenants contained in these debt agreements.
10. PREFERRED STOCK
PREFERRED STOCK ISSUED BY THE BEAR STEARNS COMPANIES INC.
The Company is authorized to issue a total of 10 million shares of preferred
stock at par value of $1.00 per share. At November 30, 2007, the Company has
1,758,106 shares issued and outstanding under various series as described below.
All preferred stock has a dividend preference over the Company's common stock in
the paying of dividends and a preference in the liquidation of assets.
The Company has outstanding 3,272,450 depositary shares representing 818,113
shares of Cumulative Preferred Stock, Series E ("Series E Preferred Stock"),
having an aggregate liquidation preference of $164 million as of November 30,
2007. Each depositary share represents a one-fourth interest in a share of
Series E Preferred Stock. Dividends on the Series E Preferred Stock are payable
at an annual rate of 6.15%. Series E Preferred Stock is redeemable at the option
of the Company at any time on or after January 15, 2008, in whole or in part, at
a redemption price of $200 per share (equivalent to $50 per depositary share),
plus accrued but unpaid dividends to the redemption date. During the fiscal year
ended November 30, 2007, the Company redeemed and retired 75,800 depositary
shares.
The Company has outstanding 1,715,300 depositary shares representing 428,825
shares of Cumulative Preferred Stock, Series F ("Series F Preferred Stock"),
having an aggregate liquidation preference of $86 million as of November 30,
2007. Each depositary share represents a one-fourth interest in a share of
Series F Preferred Stock. Dividends on the Series F Preferred Stock are payable
at an annual rate of 5.72%. Series F Preferred Stock is redeemable at the option
of the Company at any time on or after April 15, 2008, in whole or in part, at a
redemption price of $200 per share (equivalent to $50 per depositary share),
plus accrued but unpaid dividends to the redemption date. During the fiscal year
ended November 30, 2007, the Company redeemed and retired 74,900 depositary
shares.
108
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The Company has outstanding 2,044,675 depositary shares representing 511,169
shares of Cumulative Preferred Stock, Series G ("Series G Preferred Stock"),
having an aggregate liquidation preference of $102 million as of November 30,
2007. Each depositary share represents a one-fourth interest in a share of
Series G Preferred Stock. Dividends on the Series G Preferred Stock are payable
at an annual rate of 5.49%. Series G Preferred Stock is redeemable at the option
of the Company at any time on or after July 15, 2008, in whole or in part, at a
redemption price of $200 per share (equivalent to $50 per depositary share),
plus accrued but unpaid dividends to the redemption date. During the fiscal year
ended November 30, 2007, the Company did not redeem or retire depositary shares.
PREFERRED STOCK ISSUED BY SUBSIDIARIES
Bear Stearns Capital Trust III ("Capital Trust III"), a wholly owned subsidiary
of the Company, has issued $263 million (10,500,000 shares) of Guaranteed
Preferred Beneficial Interests in Company Subordinated Debt Securities
("Preferred Securities"). The Preferred Securities are fixed-rate securities,
which have a liquidation value of $25 per security. Holders of the Preferred
Securities are entitled to receive quarterly preferential cash distributions at
an annual rate of 7.8% through May 15, 2031. The proceeds of the issuance of the
Preferred Securities were used to acquire junior subordinated deferrable
interest debentures ("Debentures") issued by the Company. The Debentures have
terms that correspond to the terms of the Preferred Securities and are the sole
assets of Capital Trust III. The Preferred Securities will mature on May 15,
2031. Effective May 15, 2006, the Preferred Securities became redeemable at the
Company's option at their principal amounts plus accrued distributions.
In accordance with FIN No. 46 (R), the Company has deconsolidated Capital Trust
III. As a result, the Debentures issued by the Company to Capital Trust III are
included within long-term borrowings at November 30, 2007 and 2006. The $263
million of Preferred Securities issued by Capital Trust III are still
outstanding, providing the funding for such Debentures. The Preferred Securities
issued by Capital Trust III are no longer included in the Company's Consolidated
Statements of Financial Condition.
109
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
11. 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 for the fiscal years ended November
30, 2007, 2006 and 2005 are set forth below:
- ---------------------------------------------------------------------------------------------------------------
(in millions, except per share amounts) 2007 2006 2005
- ---------------------------------------------------------------------------------------------------------------
Net income $ 233 $ 2,054 $ 1,462
Preferred stock dividends (21) (21) (24)
Income adjustment (net of tax) applicable to deferred
compensation arrangements-vested shares 7 47 50
- ---------------------------------------------------------------------------------------------------------------
Net earnings used for basic EPS 219 2,080 1,488
Income adjustment (net of tax) applicable to deferred
compensation arrangements-non-vested shares 4 41 32
- ---------------------------------------------------------------------------------------------------------------
Net earnings used for diluted EPS $ 223 $ 2,121 $ 1,520
===============================================================================================================
Total basic weighted average common
shares outstanding (1) 130 132 130
- ---------------------------------------------------------------------------------------------------------------
Effect of dilutive securities:
Employee stock options 5 6 4
CAP and restricted units 11 11 13
- ---------------------------------------------------------------------------------------------------------------
Dilutive potential common shares 16 17 17
- ---------------------------------------------------------------------------------------------------------------
Weighted average number of common shares 146 149 147
outstanding and dilutive potential common shares
===============================================================================================================
Basic EPS $ 1.68 $ 15.79 $ 11.42
Diluted EPS $ 1.52 $ 14.27 $ 10.31
===============================================================================================================
(1) Includes approximately 13 million, 13 million and 18 million vested units
for the fiscal years ended November 30, 2007, 2006 and 2005, respectively,
issued under certain employee stock compensation plans, which will be
distributed as shares of common stock.
12. EMPLOYEE BENEFIT PLAN
The Company has a qualified non-contributory profit sharing plan covering
substantially all employees. Contributions are made at the discretion of
management in amounts that relate to the Company's level of income before
provision for income taxes. The Company's expense related to the profit sharing
plan for the fiscal years ended November 30, 2007, 2006 and 2005 was $3 million,
$45 million and $37 million, respectively.
13. STOCK COMPENSATION PLANS
The Company has various 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. As discussed in Note
1, "Summary of Significant Accounting Policies," effective December 1, 2005, the
Company adopted SFAS No. 123 (R) using the modified prospective application
method. Stock-based compensation cost is measured at grant date, based on the
fair value of the award and is recognized as expense over the requisite service
period. Beginning in fiscal 2007, the requisite service period was changed to
align with the vesting schedule for the Company's stock-based incentive plans
(in line with industry practice and the Company's retention strategy). As a
result of this change, compensation cost for fiscal 2007 was less than the
amount that would have been recognized had the Company not changed the requisite
service period. The compensation cost that has been charged against income for
the Company's stock compensation plans was $30 million, $848 million and $650
million for the fiscal years ended November 30, 2007, 2006 and 2005,
respectively. The total income tax benefit recognized in the income statement
for stock-based compensation arrangements was $13 million, $357 million and $273
million for fiscal years ended November 30, 2007, 2006 and 2005, respectively.
110
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The Company concluded that under SFAS No. 123 (R), the grant date for
stock-based compensation awards is the date the awards are approved by the
Company's Compensation Committee. The Compensation Committee approved the 2007
stock-based compensation awards in December 2007 following the end of the
Company's 2007 fiscal year. In years prior to fiscal 2006, stock-based
compensation granted in December was included in stockholders' equity at
November year end. The Company's stock-based compensation plans are summarized
below.
STOCK REPURCHASE PROGRAM
The Company intends to offset the potentially dilutive impact of the annual
grants by purchasing common stock throughout the year in open market and private
transactions. On December 13, 2006, the Board of Directors of the Company
approved an amendment to the Stock Repurchase Program ("Repurchase Program") to
replenish the previous authorization in order to allow the Company to purchase
up to $2.0 billion of common stock in fiscal 2007 and beyond. In addition, on
September 18, 2007, the Board of Directors approved an amendment to the
Repurchase Program authorizing the purchase of up to $2.5 billion of common
stock in fiscal 2007 and beyond. The amendment supersedes the previous $2.0
billion authorization. The Company expects to utilize the repurchase
authorization to offset the dilutive impact of annual share awards. The Company
may, depending upon price and other factors, repurchase additional shares in
excess of that required for annual share awards. The Company's policy is to
issue shares out of treasury upon share option exercise or share unit
conversion.
CAPITAL ACCUMULATION PLAN
Pursuant to the CAP Plan, certain key executives receive a portion of their
total annual compensation in the form of CAP units. The number of CAP units
credited is a function of the dollar amount awarded to each participant and the
closing fair market value of the Company's common stock on the date the award is
granted. The CAP units awarded under the CAP Plan are subject to vesting and
convert to common stock after five years. CAP units granted in each of the
periods presented contain selling restrictions subsequent to the vesting date.
Holders of CAP units may forfeit ownership of a portion of their award if
employment is terminated before the end of the vesting period. The total number
of CAP units that may be issued under the CAP Plan during any fiscal year may
not exceed 15% of the sum of issued and outstanding shares of common stock and
CAP units outstanding determined as of the last day of the current fiscal year.
Beginning with the December 2007 grant, the Company measured compensation cost
based on the market price of the Company's common stock on grant date less a
discount for post-vesting restrictions. The discount of approximately 5% - 6%
per year, was derived based on short forward hedging models and market based
pricing as well as academic research. For CAP units granted prior to December
2007, the Company measured compensation cost based on the market value of the
Company's common stock at the grant date.
Each CAP unit gives the participant an unsecured right to receive, on an annual
basis, an amount equal to the Company's pre-tax income per share, as defined by
the CAP Plan, less net income per share, as defined by the CAP Plan, plus
dividends per share ("earnings adjustment"), subject to certain limitations. The
earnings adjustment will be credited to each participant's deferred compensation
account in the form of additional CAP units, based on the number of CAP units in
such account at the end of each fiscal year. The number of CAP units credited
depends on the amount awarded to each participant and the average per share cost
of common stock acquired by the Company. On completion of the five-year deferral
period, participants are entitled to receive shares of common stock equal to the
number of CAP units then credited to their respective deferred compensation
accounts. Amounts recognized attributable to CAP units with respect to the
earnings adjustment are recorded in "Other Expenses" in the Consolidated
Statements of Income.
Beginning with the December 2007 grant, the requisite service period was changed
to align with the vesting schedule for the CAP units and, as a result, there was
no expense associated with the 2007 grants. During the fiscal years ended
November 30, 2006 and 2005, the Company expensed $545 million and $363 million,
respectively, attributable to CAP units granted to participants for each of
those years. In addition, during the fiscal years ended November 30, 2007, 2006
and 2005, the Company recognized expense of $18 million, $154 million and $144
million, respectively, attributable to CAP units with respect to the earnings
adjustment. Awards allocated pursuant to the CAP Plan are credited to
participants' deferred compensation accounts in the form of CAP units and are
included in stockholders' equity. During the fiscal years ended November 30,
2007, 2006 and 2005, the Company recognized total compensation expense, net of
forfeitures, related to the CAP plan, of ($25) million, $528 million and $353
million, respectively.
111
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
For awards granted in December 2007, there was $426 million of total
unrecognized compensation cost related to these awards, which is expected to be
amortized over a weighted average period of approximately 2.3 years.
RESTRICTED STOCK UNIT PLAN
The Restricted Stock Unit Plan ("RSU Plan") provides for a portion of certain
key employees' compensation to be granted in the form of restricted stock units
("RSUs"), with allocations made to participants' deferred compensation accounts.
Under the RSU Plan, RSUs granted to employees generally vest over three years
and generally convert to common stock within four years. Such units are
restricted from sale, transfer or assignment until the end of the restriction
period. RSU's granted in each of the periods presented contain selling
restrictions subsequent to the vesting date. Holders of RSUs generally may
forfeit ownership of a portion of their award if employment is terminated before
the end of the vesting period. Holders of RSUs are entitled to receive a
dividend in the form of additional RSUs, based on dividends declared on the
Company's common stock. The total number of RSUs that may be granted under the
RSU Plan may not exceed 25,000,000. As of November 30, 2007, the total number of
RSUs outstanding was 6,725,447.
Beginning with the December 2007 grant, the Company measured the compensation
cost based on the market price of the Company's common stock on grant date less
a discount for post-vesting restrictions. The discount of approximately 5% - 6%
per year, was derived based on short forward hedging models and market based
pricing as well as academic research. For RSUs granted prior to December 2007,
the Company measured compensation cost based on the market value of the
Company's common stock at the grant date.
During the fiscal years ended November 30, 2007, 2006 and 2005, the Company
recognized compensation expense of $19 million, $201 million and $135 million,
respectively, related to awards granted to participants in each of those years.
During the fiscal years ended November 30, 2007, 2006 and 2005, the Company
recognized total compensation expense related to the RSU Plan of $46 million,
$218 million and $174 million, respectively.
As of November 30, 2007, there was $186 million of total unrecognized
compensation cost related to stock-based compensation granted under the RSU Plan
which is expected to be recognized over a weighted average period of
approximately 3.3 years. For awards granted in December 2007, $176 million of
unrecognized compensation cost related to these awards is expected to be
recognized over a weighted average period of approximately 3.1 years.
STOCK AWARD PLAN
Pursuant to the Stock Award Plan, certain key employees are given the
opportunity to acquire common stock through the grant of options. Stock options
generally have a 10-year expiration. The total number of stock options that may
be issued under the Stock Award Plan may not exceed 45,000,000. As of November
30, 2007, the total number of stock options under the Stock Award Plan
outstanding was 19,390,856.
The Company awarded approximately $3 million, $89 million and $108 million of
employee stock options in fiscal 2007, 2006 and 2005, respectively, of which
approximately $1 million, $89 million and $99 million were expensed in fiscal
2007, 2006 and 2005, respectively. Unvested awards granted are expensed over the
future vesting periods, generally over three years. In fiscal 2007, 2006 and
2005, the Company recognized total compensation expense related to stock options
of $10 million, $102 million and $123 million, respectively.
Fair value was estimated at grant date based on a modified Black-Scholes
option-pricing model. The weighted average fair value of options granted
relating to the fiscal years ended November 30, 2007, 2006 and 2005 was $24.03,
$45.83 and $26.50 per option, respectively. These amounts reflect adjustments
for vesting requirements and potential maturity shortening. Estimates of fair
value are not intended to predict the value ultimately realized by employees who
receive equity awards and subsequent events are not indicative of the
reasonableness of the original estimates of fair value made by the Company.
The total intrinsic value of options exercised during the years ended November
30, 2007, 2006 and 2005 was $151 million, $247 million and $149 million,
respectively. The total cash received from employees as a result of stock option
exercises for the years ended November 30, 2007, 2006 and 2005 was approximately
$162 million, $290 million and $202 million, respectively. In connection with
these exercises, the tax benefits realized by the Company for the years ended
November 30, 2007, 2006 and 2005 were $55 million, $90 million and $59 million,
respectively.
112
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The grant date fair value was estimated based on a modified Black-Scholes option
pricing model using the following assumptions:
- --------------------------------------------------------------------------------------------------------------
2007 2006 2005
- --------------------------------------------------------------------------------------------------------------
Risk-free interest rate(1) 3.58% 4.57% 4.46%
Expected option life(2) 5 years 5 years 5 years
Expected stock price volatility(3) 28% 26% 21%
Dividend yield 1.42% 0.68% 0.90%
- --------------------------------------------------------------------------------------------------------------
(1) Represents the interest rate of the five-year U.S. Treasury note.
(2) The expected option life is the number of years that the Company estimates,
based on history, that options will be outstanding prior to exercise or
forfeiture.
(3) The Company's estimates of expected volatility are principally based on
implied volatility of the Company's common stock and other relevant factors.
NON-EMPLOYEE DIRECTORS' STOCK OPTION AND STOCK UNIT PLAN
Pursuant to the Non-Employee Directors' Stock Option and Stock Unit Plan
("Directors' Plan"), members of the Board of Directors of the Company who are
not employees of the Company or any of its subsidiaries ("Non-Employee
Directors") may be granted stock options or RSUs. Non-Employee Directors may
elect to exchange a portion of their annual cash retainer paid by the Company
for services rendered as a director, for stock options or RSUs. Stock options
and RSUs issued under the plan generally vest six months after the date of
issuance and stock options have a 10-year expiration. The total number of stock
options and RSUs combined that may be issued under the Directors' Plan may not
exceed 300,000. As of November 30, 2007, the total number of stock options and
RSUs outstanding was 101,580, and 24,674, respectively. During the fiscal years
ended November 30, 2007, 2006 and 2005, the Company recognized expense of $0.3
million, $2 million and $1 million, respectively, related to these awards.
SUMMARY OF ALL STOCK UNIT AND OPTION ACTIVITY
The following is a summary of CAP units and RSUs outstanding:
- ------------------------------------------------------------------------------------------------------------------------------------
Weighted Average Fair Weighted Average
CAP Units Value RSUs Fair Value
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, November 30, 2006 18,525,655 $ 86.49 6,976,588 $ 87.63
Granted(1) 3,412,043 $ 164.82 2,041,497 157.21
Forfeited (190,910) $ 139.91 (368,660) 110.37
Distributed (3,557,908) $ 67.68 (1,899,304) 68.30
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, November 30, 2007 18,188,880 $ 104.34 6,750,121 112.53
====================================================================================================================================
(1) The weighted average grant-date fair value for CAP units and RSUs combined
was $161.87, $132.01 and $112.01 for fiscal years ended November 30, 2007, 2006
and 2005.
Note: In December 2007, the Company granted 6,093,917 and 1,992,257 CAP units
and RSUs, respectively, at an average market price of $89.95. In addition, in
December 2007, 3,996,173 and 1,497,992 CAP units and RSUs, respectively, were
converted into common shares and distributed to participants. The award grants
and distributions made in December 2007 are not reflected in the table above.
113
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Activity with respect to stock options for the fiscal year ended November 30,
2007 is presented below:
- -------------------------------------------------------------------------------------------------------------------
2007
- -------------------------------------------------------------------------------------------------------------------
Weighted Average
Number of Shares Exercise Price
- -------------------------------------------------------------------------------------------------------------------
Beginning balance 19,840,381 $ 78.39
Granted 1,907,803 $ 164.92
Exercised (2,153,989) $ 74.42
Forfeited (101,759) $ 134.22
Ending balance 19,492,436(1) $ 86.75
===================================================================================================================
Note: In December 2007, the Company granted 34,807 options with an
exercise price of $89.95. These option grants are not reflected in the
table above.
(1) At November 30, 2007, 18,303,886 stock options were exercisable with
a weighted average exercise price of $85.22 and had an average
remaining contractual life of 5.9 years. The aggregate intrinsic
value for options outstanding and options exercisable as of November
30, 2007 was $432.0 million and $431.9 million respectively.
Information for the Company's stock options as of November 30, 2007 is presented
in the following table:
Options Outstanding
- ----------------------------------------------------------------
Average
Weighted Remaining
Average Contractual
Number Exercise Life
Rang of Exercise Prices Outstanding Price (Years)
- ----------------------------------------------------------------
$35.00-$49.99 3,271,833 $47.17 2.8
$50.00-$64.99 4,415,195 $60.40 4.5
$65.00-$79.99 3,325,440 $73.73 6.0
$80.00-$94.99 19,764 $87.82 6.6
$95.00-$109.99 3,486,580 $102.63 7.1
$110.00-$124.99 3,082,553 $116.50 8.1
$125.00-$139.99 30,886 $136.23 6.5
$140.00-$166.00 1,860,185 $164.94 8.9
- ----------------------------------------------------------------
Total 19,492,436 $86.75 5.9
14. CUSTOMER ACTIVITIES
CUSTOMER CREDIT RISKS
The Company's clearance activities for both clearing clients and customers
(collectively, "customers"), involve the execution, settlement and financing of
customers' securities and futures transactions. Customers' securities activities
are transacted on either a cash or margin basis, while customers' futures
transactions are generally transacted on a margin basis subject to exchange
regulations.
In connection with the customer clearance activities, the Company executes and
clears customer transactions involving the short sale of securities ("short
sales"), entering into futures transactions and the writing of option contracts.
Short sales require the Company to borrow securities to settle customer short
sale transactions and, as such, these transactions may expose the Company to
loss if customers are unable to fulfill their contractual obligations and
customers' collateral balances are insufficient to fully cover their losses. In
the event customers fail to satisfy their obligations, the Company may be
required to purchase financial instruments at prevailing market prices in order
to fulfill the customers' obligations.
114
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The Company seeks to control the risks associated with its customers' activities
by requiring customers to maintain margin collateral in compliance with various
regulatory and internal guidelines. The Company monitors required margin levels
and, pursuant to such guidelines, may require customers to deposit additional
cash or collateral, or to reduce positions, when deemed necessary. The Company
also establishes credit limits for customers engaged in futures activities and
monitors credit compliance. Additionally, with respect to the Company's
correspondent clearing activities, introducing correspondent firms generally
guarantee the contractual obligations of their customers. Further, the Company
seeks to reduce credit risk by entering into netting agreements with customers,
which permit receivables and payables with such customers to be offset in the
event of a customer default.
In connection with the Company's customer financing and securities settlement
activities, the Company may pledge customers' securities as collateral to
satisfy the Company's exchange margin deposit requirements or to support its
various secured financing sources such as bank loans, securities loaned and
repurchase agreements. In the event counterparties are unable to meet their
contractual obligations to return customers' securities pledged as collateral,
the Company may be exposed to the risk of acquiring the securities at prevailing
market prices to satisfy its obligations to such customers. The Company seeks to
control this risk by monitoring the market value of securities pledged and by
requiring adjustments of collateral levels in the event of excess exposure.
Moreover, the Company establishes credit limits for such activities and monitors
credit compliance.
CONCENTRATIONS OF CREDIT RISKS
The Company is engaged in providing securities processing services to a diverse
group of individuals and institutional investors, including affiliates. A
substantial portion of the Company's transactions is collateralized and is
executed with, or made on behalf of, institutional investors, including other
brokers and dealers, commercial banks, insurance companies, pension plans,
mutual funds, hedge funds and other financial institutions. The Company's
exposure to credit risk, associated with the nonperformance of customers in
fulfilling their contractual obligations pursuant to securities and futures
transactions, can be directly affected by volatile or illiquid trading markets,
which may impair customers' ability to satisfy their obligations to the Company.
The Company attempts to minimize credit risk associated with these activities by
monitoring customers' credit exposure and collateral values and requiring, when
deemed necessary, additional collateral to be deposited with the Company.
From time to time, the Company enters into large financing commitments. During
fiscal 2007, the Company led a syndicate that underwrote a large commercial
mortgage loan to finance the acquisition of Hilton Hotels Corporation by certain
affiliates of The Blackstone Group L.P. including Blackstone Real Estate
Partners VI, L.P. as well as certain minority investors. As of November 30,
2007, the Company had advanced approximately $4.6 billion. The Company has sold
a portion of the loan and intends to further reduce its remaining position.
In the ordinary course of business, the company manages the risk of derivatives
and other businesses through dealer-to-dealer transactions with other large,
highly rated global financial institutions. As a result, the Company is exposed
to risk of non-performance on counterparty contracts with such dealers. The
Company seeks to mitigate risk of loss through independent assessment of the
financial condition of dealers and the collection of collateral to fully or
partially secure exposure on a mark-to-market basis. Nonetheless, periods of
severe volatility and illiquidity expose the market to potential systemic stress
and heightened exposure and risk of default of one or more counterparties.
The Company has entered into a variety of transactions and acquired inventory
positions that rely in part on financial guaranties provided by monoline credit
insurance entities. The Company's exposure to one such entity, resulting from
the purchase of credit default protection on structured asset-backed and
corporate credit positions, was fully reserved as of November 30, 2007. In
general, the Company has limited its unsecured credit extensions to monoline
insurance counterparties. As a result, the Company's direct exposure to
non-performance by any of the remaining large monoline insurance companies is
not material.
A significant portion of the Company's securities processing activities includes
clearing transactions for hedge funds, brokers and dealers and other
professional traders, including affiliates. Due to the nature of these
operations, which may include significant levels of credit extension such as
leveraged purchases, short selling and option writing, the Company may incur
credit exposure should these customers be unable to meet their commitments. In
addition, the Company may be subject to concentration risk through providing
margin to those customers holding large positions in certain types of
securities, securities of a single issuer, including sovereign governments,
issuers located in a particular country or geographic area or issuers engaged in
a particular industry, where the Company receives such large positions as
collateral. The Company seeks to control these risks by monitoring margin
collateral levels for compliance with both regulatory and internal guidelines.
Additional collateral is obtained when necessary. To further control these
risks, the Company has developed automated risk control systems that analyze the
customers' sensitivity to major market movements. The Company will require
customers to deposit additional margin collateral, or to reduce positions if it
is determined that customers' activities may be subject to above-normal market
risk.
The Company acts as a clearing broker for substantially all of the customer and
proprietary securities and futures activities of its affiliates on either a
fully disclosed or omnibus basis. Such activities are conducted on either a cash
or margin basis. The Company requires its affiliates to maintain margin
collateral in compliance with various regulatory guidelines. The Company
monitors required margin levels and requests additional collateral when deemed
appropriate.
115
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
15. INCOME TAXES
The Company and certain of its subsidiaries file a U.S. consolidated federal
income tax return. The (benefit) provision for income taxes for the fiscal years
ended November 30, 2007, 2006 and 2005 consisted of the following:
- --------------------------------------------------------------------------------
(in millions) 2007 2006 2005
- --------------------------------------------------------------------------------
CURRENT:
Federal $ (72) $ 806 $ 449
State and local (6) 182 59
Foreign 71 190 124
- --------------------------------------------------------------------------------
Total current (7) 1,178 632
- --------------------------------------------------------------------------------
DEFERRED:
Federal (81) (47) 94
State and local 28 (1) 35
Foreign 20 (37) (16)
- --------------------------------------------------------------------------------
Total deferred (33) (85) 113
- --------------------------------------------------------------------------------
Total (benefit) provision for income taxes $ (40) $ 1,093 $ 745
================================================================================
As of November 30, 2007, the Company had approximately $1.5 billion in
accumulated earnings permanently reinvested overseas. If such income were
repatriated, additional federal income tax (net of available tax credits) at
current tax rates would be approximately $303 million.
Significant components of the Company's deferred tax assets (liabilities) as of
November 30, 2007 and 2006 were as follows:
- --------------------------------------------------------------------------------
(in millions) 2007 2006
- --------------------------------------------------------------------------------
DEFERRED TAX ASSETS:
Deferred compensation $ 1,276 $ 1,213
Liability reserves and valuation adjustments 83 108
Unrealized loss 17 36
Partnerships 202 61
Other 171 170
- --------------------------------------------------------------------------------
Total deferred tax assets 1,749 1,588
- --------------------------------------------------------------------------------
DEFERRED TAX LIABILITIES:
Unrealized appreciation (142) (43)
Depreciation/amortization (70) (67)
Other (73) (47)
- --------------------------------------------------------------------------------
Total deferred tax liabilities (285) (157)
- --------------------------------------------------------------------------------
Net deferred tax assets $ 1,464 $ 1,431
===============================================================================
At November 30, 2007 and 2006, no valuation allowance has been established
against deferred tax assets since it is more likely than not that the deferred
tax assets will be realized. Net deferred tax assets are included in "Other
Assets" in the Consolidated Statements of Financial Condition.
The Company is estimating state and local net operating loss carryforwards of
$1.18 billion as of November 30, 2007. These carryforwards can be used through
November 30, 2028.
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations. The
Company regularly assesses 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. The resolution of tax matters could have a material impact on the
Company's effective tax rate.
116
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
A reconciliation of the statutory federal income tax rates to the Company's
effective tax rates for the fiscal years ended November 30, 2007, 2006 and 2005
was as follows:
- ------------------------------------------------------------------------- -------------- ------------ --------------
2007 2006 2005
- ------------------------------------------------------------------------- -------------- ------------ --------------
Statutory rate 35.0% 35.0% 35.0%
State and local income taxes, exclusive of effect of
legislative changes, net of federal benefit (9.8) 3.7 2.2
Dividend received deduction (10.1) (0.3) (0.6)
Tax-exempt interest income, net (14.2) (0.8) (1.5)
Lower tax rates applicable to non-U.S. earnings (31.3) (1.0) (0.6)
Domestic tax credits (17.6) (0.4) (0.5)
Effect of legislative changes, net of federal benefit 25.7 -- 0.5
Other, net 1.3 (1.5) (0.7)
- ------------------------------------------------------------------------- -------------- ------------ --------------
Effective tax rate (21.0)% 34.7% 33.8%
========================================================================= ============== ============ ==============
Not included in the effective tax rate is the effect of approximately $254
million, $363 million and $426 million in income tax benefits attributable to
the distribution of common stock under the CAP Plan and other deferred
compensation plans as well as the exercise of options, credited directly to
paid-in capital, for fiscal 2007, 2006 and 2005, respectively.
16. REGULATIONS
The Company is regulated by the Securities and Exchange Commission ("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 November 30, 2007, the Company was in compliance with
the CSE capital requirements.
Bear Stearns and BSSC are registered broker-dealers and futures commission
merchants and, accordingly, are subject to Rule 15c3-1 under the Securities
Exchange Act of 1934 ("Net Capital Rule") and Rule 1.17 under the Commodity
Futures Trading Commission. Bear Stearns uses Appendix E of the Net Capital Rule
("Appendix E"), which establishes alternative net capital requirements for
broker-dealers that are part of consolidated supervised entities. Appendix E
allows Bear Stearns to calculate net capital charges for market risk and
derivatives-related credit risk based on mathematical models, provided that Bear
Stearns holds tentative net capital in excess of $1 billion and net capital in
excess of $500 million. At November 30, 2007, Bear Stearns' net capital of $3.60
billion exceeded the minimum requirement by $3.05 billion. Bear Stearns' net
capital computation, as defined, includes $1.16 billion, which represents net
capital of BSSC in excess of 5.5% of aggregate debit items arising from customer
transactions.
BSIL and BSIT, London-based broker-dealer subsidiaries, are subject to the
regulatory capital requirements of the United Kingdom's Financial Services
Authority.
BSB, an Ireland-based bank principally involved in the trading and sales of
fixed income products, is registered in Ireland and is subject to the regulatory
capital requirements of the Financial Regulator.
Custodial Trust Company ("CTC"), a Federal Deposit Insurance Corporation
("FDIC") insured New Jersey state chartered bank, offers a range of trust,
lending, deposit and securities-clearing products and services. CTC provides the
Company with banking powers, including access to the securities and funds-wire
services of the Federal Reserve System. CTC is subject to the regulatory capital
requirements of the FDIC.
At November 30, 2007, Bear Stearns, BSSC, BSIL, BSIT, BSB and CTC were in
compliance with their respective regulatory capital requirements. Certain other
subsidiaries are subject to various securities regulations and capital adequacy
requirements promulgated by the regulatory and exchange authorities of the
countries in which they operate. At November 30, 2007, these other subsidiaries
were in compliance with their applicable local capital adequacy requirements.
Regulatory rules, as well as certain covenants contained in various instruments
governing indebtedness of the Company, Bear Stearns and other regulated
subsidiaries, may restrict the Company's ability to withdraw capital from its
regulated subsidiaries, which in turn could limit the
117
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Company's ability to pay dividends. Also, the Company's broker-dealer
subsidiaries and other regulated subsidiaries are subject to minimum capital
requirements that may restrict the Company's ability to withdraw capital from
its regulated subsidiaries, which in turn could limit the Company's ability to
pay dividends. At November 30, 2007, approximately $5.04 billion in equity
capital of Bear Stearns, BSSC, BSIL, BSIT, BSB and CTC was restricted as to the
payment of cash dividends and advances to the Company.
17. 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 November 30, 2007, future minimum aggregate annual rentals
payable under non-cancelable leases (net of subleases), including 383 Madison
Avenue in New York City, for fiscal years ended November 30, 2008 through 2012
and the aggregate amount thereafter, are as follows:
(in millions)
- -------------------------------------------------
FISCAL YEAR
2008 $ 125
2009 122
2010 122
2011 133
2012 98
Thereafter 650
- -------------------------------------------------
Total 1,250
=================================================
The various leases contain provisions for periodic escalations resulting from
increased operating and other costs. Rental expense, including escalations and
net of sublease rental income, under these leases was $218 million, $164 million
and $134 million for the fiscal years ended November 30, 2007, 2006 and 2005,
respectively.
LENDING-RELATED COMMITMENTS
In connection with certain of the Company's business activities, the Company
provides financing or financing commitments to investment-grade and
non-investment-grade companies in the form of senior and subordinated debt,
including bridge financing. Commitments have varying maturity dates and are
generally contingent on the accuracy and validity of certain representations,
warranties and contractual conditions applicable to the borrower.
Lending-related commitments to investment-grade borrowers aggregated
approximately $3.42 billion and $3.83 billion at November 30, 2007 and 2006,
respectively. Of these amounts, approximately $952 million and $698 million of
the credit risk was offset at November 30, 2007 and 2006, respectively.
Lending-related commitments to non-investment-grade borrowers approximated $3.30
billion and $2.04 billion at November 30, 2007 and 2006, respectively. Of these
amounts, approximately $220 million and $89 million of the credit risk was
offset at November 30, 2007 and 2006, respectively.
The Company also had contingent commitments to non-investment-grade companies of
$501 million as of November 30, 2007 and contingent commitments to investment
grade and non-investment grade companies of $17.5 billion as of November 30,
2006. Generally, these commitments are provided in connection with leveraged
acquisitions. These commitments are not indicative of the Company's actual risk
because the borrower may not be successful in the acquisition, the borrower may
access the capital markets instead of drawing on the commitment, or the
Company's portion of the commitment may be reduced through the syndication
process. Additionally, the borrower's ability to draw may be subject to there
being no material adverse change in either market conditions or the borrower's
financial condition, among other factors. These commitments generally contain
certain flexible pricing features to adjust for changing market conditions prior
to closing.
118
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
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 November 30, 2007 and 2006, such commitments aggregated $729
million and $788 million, respectively. These commitments will be funded, if
called, through the end of the respective investment periods, with the longest
of such periods ending in 2020.
UNDERWRITING
In connection with the Company's mortgage-backed securitizations and fixed
income and equity underwriting, the Company had commitments to purchase new
issues of securities aggregating $652 million and $205 million, respectively, at
November 30, 2007 and 2006.
COMMERCIAL AND RESIDENTIAL LOANS
The Company participates in the origination, acquisition, securitization,
servicing, financing and disposition of commercial and residential loans. At
November 30, 2007 and 2006, the Company had entered into commitments to purchase
or finance mortgage loans of $2.83 billion and $4.23 billion, respectively.
LETTERS OF CREDIT
At November 30, 2007 and 2006, the Company was contingently liable for unsecured
letters of credit of approximately $1.42 billion and $3.30 billion,
respectively, and secured (by financial instruments) letters of credit of $1.33
billion and $1.25 billion, respectively. These letters of credit are primarily
used to provide collateral for securities borrowed and to satisfy margin
requirements at commodity/futures exchanges.
ENERGY
In connection with its energy activities, the Company has entered into
contractual obligations (primarily obligations under tolling agreements, net of
re-tolling agreements) that require future cash payments. At November 30, 2007,
those contractual obligations, by maturity, were as follows:
(millions)
- ----------------------------------
Fiscal Year
2008 $ 81
2009 82
2010 83
2011 258
2012 416
Thereafter 3,399
- ----------------------------------
Total 4,319
==================================
Strategic Alliance
In October 2007, the Company announced an agreement in principle to form a
strategic alliance with CITIC Securities Co. Limited ("CITIC"). The companies
will work together to develop new financial products and services to meet the
evolving needs of the Chinese market. This alliance will include sharing
management expertise and technology to develop new capital markets products and
businesses in China, establishing an exclusive joint venture combining the
existing businesses of both companies in the rest of Asia, and cross-investments
of approximately $1 billion in each firm by the other. The Company and CITIC
have agreed to negotiate with each other on an exclusive basis. The proposed
transactions are subject to the negotiation of definitive agreements, the
approval by the respective boards of directors of the Company and CITIC, and
various governmental and regulatory approvals. There can be no assurances that
the Company and CITIC will be able to successfully complete negotiations or
consummate the transaction.
OTHER
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $170 million and $96 million respectively, at November 30, 2007
and 2006.
With respect to certain of the commitments outlined above, the Company utilizes
various hedging strategies to actively manage its market, credit and liquidity
exposures. Additionally, since these commitments may expire unused, the total
commitment amount may not necessarily reflect the actual future cash funding
requirements.
LITIGATION
The Company is the sole defendant in an action commenced in the United States
Bankruptcy court for the Southern District of New York by the Chapter 11 Trustee
for Manhattan Investment Fund Limited ("MIFL"). The complaint seeks to recover
from the Company, among other things, certain allegedly fraudulent transfers
made by MIFL in the amount of $141 million plus pre-judgment interest. The
Company provided prime brokerage services to MIFL prior to its bankruptcy. In
January 2007, the Bankruptcy Court granted the Trustee's motion for summary
judgment on the fraudulent transfer claims against the Company. The Company
believes it has substantial defenses to the Trustee's claims and intends to
appeal the decision of the Bankruptcy Court.
On appeal, the District Court affirmed the Bankruptcy Court's findings in part,
but also reversed in part, the Bankruptcy's Court's grant of summary judgment to
the Trustee, finding that a trial is necessary to make a factual finding as to
whether the Company acted in good faith with respect to its receipt of the
alleged fraudulent transfers.
The Company and certain subsidiaries have been named as defendants in various
investor lawsuits and FINRA arbitrations relating to the failure of the Bear
Stearns High Grade Structured Credit Strategies Master Fund, Ltd (the "High
Grade Fund") and the Enhanced Leverage Master Fund, Ltd. (the "Enhanced Leverage
Fund"), which were managed by Bear Stearns Asset Management. The High Grade Fund
had net investor contributions of approximately $775 million. The Enhanced Fund
had net investor contributions of approximately $1.08 billion. The relief being
sought by the plaintiffs
119
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
in these matters includes specified and unspecified damages, costs and fees. The
Company believes it has substantial defenses to the claims asserted against it
in these proceedings. Additionally, the Company and its subsidiaries have been
the subject of various state and federal regulatory and law enforcement
inquiries, and a state administrative proceeding relating to the Funds.
In the normal course of business, the Company has been named as a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental and self-regulatory agencies regarding the Company's
business, certain of which may result in adverse judgments, settlements, fines,
penalties, injunctions or other relief. Because litigation is inherently
unpredictable, particularly in cases where claimants seek substantial or
indeterminate damages or where investigations and proceedings are in the early
stages, the Company cannot predict with certainty the loss or range of loss
related to such matters, how such matters will be resolved, when they will
ultimately be resolved, or what the eventual settlement, fine, penalty or other
relief might be. Consequently, the Company cannot estimate losses or ranges of
losses for matters where there is only a reasonable possibility that a loss may
have been incurred. Although the ultimate outcome of these matters cannot be
ascertained at this time, it is the opinion of management, after consultation
with counsel, that the resolution of the foregoing matters will not have a
material adverse effect on the financial condition of the Company, taken as a
whole; such resolution may, however, have a material effect on the operating
results in any future period, depending on the level of income for such period.
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.
18. 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.
120
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The following table sets forth the maximum payout/notional amounts associated
with the Company's guarantees as of November 30, 2007:
Amount of Guarantee Expiration Per Period
---------------------------------------------------------------------------
Less Than One to Three Three to Five Greater than
(in millions) One Year Years Years Five Years Total
- ------------------------------------------------------------------------------------------------------------------------------------
Certain derivative contracts
(notional) (1) $ 495,124 $ 472,384 $ 742,138 $ 806,319 $ 2,515,965
Municipal securities 3,370 502 -- -- 3,872
Residual value guarantee -- -- 570 -- 570
- ------------------------------------------------------------------------------------------------------------------------------------
(1) The gross carrying value of these derivatives approximated $59.6 billion as
of November 30, 2007.
DERIVATIVE CONTRACTS
The Company's dealer activities cause it to make markets and trade a variety of
derivative instruments. Certain derivative contracts that the Company has
entered into meet the accounting definition of a guarantee under FIN No. 45.
Derivatives that meet the FIN No. 45 definition of guarantees include credit
default swaps (whereby a default or significant change in the credit quality of
the underlying financial instrument may obligate the Company to make a payment),
put options, as well as floors, caps and collars. Since the Company does not
track the counterparties' purpose for entering into a derivative contract, it
has disclosed derivative contracts that are likely to be used to protect against
a change in an underlying financial instrument, regardless of their actual use.
On certain of these contracts, such as written interest rate caps and foreign
currency options, the maximum payout cannot be quantified since the increase in
interest rates and foreign exchange rates is not contractually limited by the
terms of the contracts. As such, the Company has disclosed notional amounts as a
measure of the extent of its involvement in these classes of derivatives rather
than maximum payout. Notional amounts do not represent the maximum payout and
generally overstate the Company's exposure to these contracts.
In connection with these activities, the Company mitigates its exposure to
market risk by entering into a variety of offsetting derivative contracts and
security positions.
MUNICIPAL SECURITIES
In 1997, the Company established a program whereby it created a series of
municipal securities trusts in which it has retained interests. These trusts
purchase fixed-rate, long-term, highly rated, insured or escrowed municipal
bonds financed by the issuance of trust certificates. Certain of the trust
certificates entitle the holder to receive future payments of principal and
variable interest and to tender such certificates at the option of the holder on
a periodic basis. The Company acts as placement agent and as liquidity provider.
The purpose of the program is to allow the Company's clients to purchase
synthetic short-term, floating-rate municipal debt that does not otherwise exist
in the marketplace. In the Company's capacity as liquidity provider to the
trusts, the maximum exposure to loss at November 30, 2007 was approximately
$3.87 billion, which represents the outstanding amount of all trust
certificates. This exposure to loss is mitigated by the underlying municipal
bonds held by trusts. The underlying municipal bonds in the trusts are either
AAA- or AA-rated, insured or escrowed to maturity. Such bonds had a market
value, net of related offsetting positions, approximating $3.77 billion at
November 30, 2007.
121
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
RESIDUAL VALUE GUARANTEE
The Company has entered into an operating lease arrangement for its world
headquarters at 383 Madison Avenue in New York City (the "Synthetic Lease").
Under the terms of the Synthetic Lease, the Company is obligated to make monthly
payments based on the lessor's underlying interest costs. The Synthetic Lease
expires on August 10, 2012 unless both parties agree to a renewal prior to
expiration. At the expiration date of the Synthetic Lease, the Company has the
right to purchase the building for the amount of the then outstanding
indebtedness of the lessor or to arrange for the sale of the property with the
proceeds of the sale to be used to satisfy the lessor's debt obligation. If the
sale of the property does not generate sufficient proceeds to satisfy the
lessor's debt obligation, the Company is required to fund the shortfall up to a
maximum residual value guarantee. As of November 30, 2007, there was no expected
shortfall and the maximum residual value guarantee was approximately $570
million.
INDEMNIFICATIONS
The Company provides representations and warranties to counterparties in
connection with a variety of commercial transactions, including certain asset
sales and securitizations and occasionally indemnifies them against potential
losses caused by the breach of those representations and warranties. To mitigate
these risks with respect to assets being securitized that have been originated
by third parties, the Company seeks to obtain appropriate representations and
warranties from such third-party originators upon acquisition of such assets.
The Company generally performs due diligence on assets purchased and maintains
underwriting standards for assets originated. The Company may also provide
indemnifications to certain counterparties to protect them in the event
additional taxes are owed or payments are withheld, due either to a change in or
adverse application of certain tax laws. These indemnifications generally are
standard contractual terms and are entered into in the normal course of
business. Generally, there are no stated or notional amounts included in these
indemnifications.
Maximum payout information under these indemnifications is not readily available
because of the number, size and lives of these transactions. In implementing
this accounting interpretation, the Company reviewed its experience with the
indemnifications on these structures. Based on such experience, it is unlikely
that these arrangements will have a material impact on the Consolidated
Financial Statements of the Company.
OTHER GUARANTEES
The Company is a member of numerous exchanges and clearinghouses. Under the
membership agreements, members are generally required to guarantee the
performance of other members. Therefore, if a member becomes unable to satisfy
its obligations to the clearinghouse, other members would be required to meet
these shortfalls. To mitigate these performance risks, the exchanges and
clearinghouses often require members to post collateral. The Company's maximum
potential liability under these arrangements cannot be quantified. However, the
potential for the Company to be required to make payments under these
arrangements is remote. Accordingly, no contingent liability is recorded in the
Consolidated Financial Statements for these arrangements.
19. SEGMENT AND GEOGRAPHIC AREA DATA
The Company operates in three principal segments -- Capital Markets, Global
Clearing Services and Wealth Management. These segments offer different products
and services and are managed separately as different levels and types of
expertise are required to effectively manage the segments' transactions.
The Capital Markets segment is comprised of the institutional equities, fixed
income and investment banking areas. The Capital Markets segment operates as a
single integrated unit that provides the sales, trading and origination effort
for various fixed income, equity and advisory products and services. Each of the
three businesses work in tandem to deliver these services to institutional and
corporate clients.
Institutional equities consists of sales, trading and research, in areas such as
domestic and international equities, block trading, over-the-counter equities,
equity derivatives, energy and commodity activities, risk and convertible
arbitrage and specialist activities on the NYSE, AMEX and International Stock
Exchange. Fixed income includes sales, trading, origination and research
provided to institutional clients across a variety of products such as mortgage-
and asset-backed securities, corporate and government bonds, municipal bonds,
high yield products, including bank and
122
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
bridge loans, foreign exchange and interest rate and credit derivatives.
Investment banking provides services in capital raising, strategic advice,
mergers and acquisitions and merchant banking. Capital raising encompasses the
Company's underwriting of equity, investment grade, municipal and high yield
debt products.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to clearing
clients worldwide. Prime brokerage clients include hedge funds and clients of
money managers, short sellers and other professional investors. Fully disclosed
clients engage in either the retail or institutional brokerage business.
The Wealth Management segment is composed of the PCS and asset management areas.
PCS provides high-net-worth individuals with an institutional level of
investment service, including access to the Company's resources and
professionals. Asset management manages equity, fixed income and alternative
assets for leading corporate pension plans, public systems, endowments,
foundations, multi-employer plans, insurance companies, corporations, families
and high-net-worth individuals in the United States and abroad.
The three business segments comprise many business areas, with interactions
among each. Revenues and expenses include those that are directly related to
each segment. Revenues from intersegment transactions are allocated 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.
123
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
- -------------------------------------------------------------------------------------------------------------------------------
Fiscal Years Ended November 30, 2007 2006 2005
- -------------------------------------------------------------------------------------------------------------------------------
(in millions)
NET REVENUES
Capital Markets
Institutional Equities $ 2,158 $ 1,961 $ 1,446
Fixed Income 685 4,190 3,293
Investment Banking 1,076 1,170 983
- -------------------------------------------------------------------------------------------------------------------------------
Total Capital Markets 3,919 7,321 5,722
Global Clearing Services 1,200 1,077 1,029
Wealth Management
Private Client Services (1) 602 522 453
Asset Management 228 336 228
- -------------------------------------------------------------------------------------------------------------------------------
Total Wealth Management 830 858 681
Other (2) (4) (29) (21)
- -------------------------------------------------------------------------------------------------------------------------------
Total net revenues $ 5,945 $ 9,227 $ 7,411
===============================================================================================================================
PRE-TAX INCOME
Capital Markets $ (232)(4) $ 2,801 $ 2,020
Global Clearing Services 566 465 472
Wealth Management (45) 69 37
Other (3) (96) (188) (322)
- -------------------------------------------------------------------------------------------------------------------------------
Total pre-tax income $ 193 $ 3,147 $ 2,207
===============================================================================================================================
NET INTEREST REVENUES
Capital Markets $ 382 $ 350 $ 172
Global Clearing Services 923 803 736
Wealth Management 39 59 57
Other 6 - -
- -------------------------------------------------------------------------------------------------------------------------------
Total net interest revenues $ 1,350 $ 1,212 $ 965
===============================================================================================================================
(1) Private Client Services detail:
Gross revenues, before transfer to Capital Markets segment $ 710 $ 620 $ 547
Revenue transferred to Capital Markets segment (108) (98) (94)
-------------------------------------------------------------------------------------------------------------------------------
Private Client Services net revenues $ 602 $ 522 $ 453
===============================================================================================================================
(2) Includes consolidation and elimination entries.
(3) Includes certain legal costs and costs related to the CAP Plan, which
approximate $18 million, $154 million and $144 million for the fiscal years
ended November 30, 2007, 2006, 2005, respectively.
(4) Includes a non-cash charge of $227 million related to the write-off of
intangible assets, representing goodwill and specialist rights associated
with our NYSE specialist activities.
- -------------------------------------------------------------------------------
As of November 30, 2007 2006 2005
- -------------------------------------------------------------------------------
(in billions)
SEGMENT ASSETS
Capital Markets $ 247 $ 230 $ 183
Global Clearing Services 118 109 93
Wealth Management 4 3 3
Other 26 8 8
- -------------------------------------------------------------------------------
Total segment assets $ 395 $ 350 $ 287
===============================================================================
124
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The operations of the Company are conducted primarily in the United States of
America. The Company also maintains offices in Europe, Asia and Latin America.
The following are net revenues, income before provision for income taxes and
assets by geographic region for the fiscal years ended November 30, 2007, 2006
and 2005:
(in millions) 2007 2006 2005
Net Revenues-U.S. $ 4,219 $ 8,006 $ 6,488
Non-U.S. 1,726 1,221 923
- -------------------------------------------------------------------------------------------------------------------
Total net revenues $ 5,945 $ 9,227 $ 7,411
===================================================================================================================
(Loss) Income before provision for income taxes-U.S. $ (561) $ 2,669 $ 1,868
Non-U.S. 754 478 339
- -------------------------------------------------------------------------------------------------------------------
Total income before provision for income taxes $ 193 $ 3,147 $ 2,207
===================================================================================================================
Total Assets-U.S. $ 480,824 $ 437,419 $ 344,758
Non-U.S. 126,507 92,836 70,436
Eliminations (211,969) (179,822) (127,901)
- -------------------------------------------------------------------------------------------------------------------
Total assets $ 395,362 $ 350,433 $ 287,293
===================================================================================================================
Because of the international nature of the financial markets and the resultant
integration of U.S. and non-U.S. services, it is difficult to precisely separate
foreign operations. The Company conducts and manages these activities with a
view toward the profitability of the Company as a whole. Accordingly, the
foreign operations information is, of necessity, based on management judgments
and internal allocations.
20. ACQUISITION OF MINORITY INTEREST AND IMPAIRMENT OF INTANGIBLE ASSETS
At the close of business on April 30, 2007, the Company completed an acquisition
of the outstanding minority interest in Bear Hunter Holdings LLC (the parent of
Bear Wagner Specialists) from its partner, Hunter Partners LLC.
The Company tests goodwill at least annually for impairment in accordance with
SFAS No. 142 by comparing the fair value of a reporting unit with the carrying
amount, including goodwill. In addition, the Company amortizes identifiable
intangible assets over their estimated useful lives in accordance with SFAS No.
142 and tests for potential impairment whenever events or changes in
circumstances suggest that an asset's carrying value may not be fully
recoverable in accordance with SFAS No. 144. An impairment loss, calculated as
the difference between the estimated fair value and the carrying value of an
asset, is recognized if the expected undiscounted cash flows relating to the
asset are less than the corresponding carrying value.
During the fourth quarter of fiscal 2006, the New York Stock Exchange introduced
its Hybrid trading system, a new electronic trading system designed to make it
more competitive. The Hybrid trading system automated certain of the tasks
previously performed by specialists and dramatically reduced the opportunity for
specialists to participate in the order process. The Company monitored the
impact of the introduction of the Hybrid trading system on its specialist
business. As a result, during the May 2007 quarter, the Company tested its
goodwill and specialist rights associated with its NYSE specialist activities
and recognized a non-cash impairment charge of $227 million relating to the
original purchase of Wagner Stott Mercator, LLC in April 2001. The impairment
charge is included on a separate line item on the Consolidated Statements of
Income and within the Company's Capital Markets segment for the fiscal year
ended November 30, 2007.
125
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
21. ASSET ACQUISITION
On May 20, 2007, Bear Energy L.P., a Houston-based, wholly owned subsidiary of
the Company, signed a definitive agreement to acquire substantially all of the
power-related and natural gas assets comprising the power trading business of
Williams Power Company, Inc., an energy trading and marketing subsidiary of The
Williams Companies, Inc. The transaction closed on November 8, 2007 for cash
consideration of $496 million. The purchase price allocation resulted in
recording trading assets of $548 million, intangible assets of $863 million, and
intangible liabilities of $915 million based on contractual arrangements, at
their estimated fair values. As of November 30, 2007, the weighted average
amortization period for intangible assets and intangible liabilities was
approximately 10.8 years and 13.4 years, respectively. As of November 8, 2007,
the results of operations of the power-related assets and liabilities acquired
were included in the Company's Capital Markets segment.
The estimated aggregate amortization expense for each of the five succeeding
fiscal years for intangible assets and intangible liabilities were as follows:
(in millions) Intangible Assets Intangible Liabilities
- -------------------------------------------------------------------------------
FISCAL YEAR
2008 $ 99 $ 208
2009 98 129
2010 96 98
2011 64 74
2012 50 47
Thereafter 456 359
- -------------------------------------------------------------------------------
Total 863 915
===============================================================================
126
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
22. QUARTERLY INFORMATION (UNAUDITED)
The unaudited quarterly results of operations of the Company for the fiscal
years ended November 30, 2007 and 2006 are prepared in conformity with
accounting principles generally accepted in the United States of America, which
include industry practices, and reflect all adjustments that are, in the opinion
of management, necessary for a fair presentation of the results of operations
for the periods presented. Results of any interim period are not necessarily
indicative of results for a full year.
- ------------------------------------------------------------------------------------------------------------------------------------
Quarters Ended, Fiscal Year,
- ------------------------------------------------------------------------------------------------------------------------------------
February 28, May 31, August 31, November 30, November 30,
(in millions, except per share data) 2007 2007 2007 2007 2007 (1)
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues $ 4,798 $ 4,976 $ 4,340 $ 2,038 $ 16,151
Interest expense 2,316 2,464 3,009 2,417 10,206
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense 2,482 2,512 1,331 (379) 5,945
====================================================================================================================================
Non-interest expenses
Employee compensation and benefits 1,204 1,231 664 326 3,425
Other 443 727 492 666 2,327
- ------------------------------------------------------------------------------------------------------------------------------------
Total non-interest expenses 1,647 1,958 1,156 992 5,752
- ------------------------------------------------------------------------------------------------------------------------------------
Income (loss) before provision (benefit)
for income taxes 835 554 175 (1,371) 193
Provision (benefit) for income taxes 281 192 4 (517) (40)
- ------------------------------------------------------------------------------------------------------------------------------------
Net income (loss) 554 362 171 (854) 233
====================================================================================================================================
Basic earnings per share $ 4.23 $ 2.78 $ 1.30 $ (6.90) $ 1.68
Diluted earnings (loss) per share $ 3.82 $ 2.52 $ 1.16 $ (6.90)(2) $ 1.52
====================================================================================================================================
Cash dividends declared per common share $ 0.32 $ 0.32 $ 0.32 $ 0.32 $ 1.28
====================================================================================================================================
- ------------------------------------------------------------------------------------------------------------------------------------
Quarters Ended, Fiscal Year,
- ------------------------------------------------------------------------------------------------------------------------------------
February 28, May 31, August 31, November 30, November 30,
(in millions, except per share data) 2006 2006 2006 2006 2006 (1)
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues $ 3,638 $ 4,304 $ 4,136 $ 4,474 $ 16,551
Interest expense 1,453 1,805 2,007 2,061 7,324
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense 2,185 2,499 2,129 2,413 9,227
====================================================================================================================================
Non-interest expenses
Employee compensation and benefits 1,047 1,220 1,025 1,052 4,343
Other 386 445 437 468 1,737
- ------------------------------------------------------------------------------------------------------------------------------------
Total non-interest expenses 1,433 1,665 1,462 1,520 6,080
- ------------------------------------------------------------------------------------------------------------------------------------
Income before provision for income taxes 752 834 667 893 3,147
Provision for income taxes 238 295 229 330 1,093
- ------------------------------------------------------------------------------------------------------------------------------------
Net income 514 539 438 563 2,054
====================================================================================================================================
Basic earnings per share $ 3.92 $ 4.12 $ 3.34 $ 4.42 $ 15.79
Diluted earnings per share $ 3.54 $ 3.72 $ 3.02 $ 4.00 $ 14.27
====================================================================================================================================
Cash dividends declared per common share $ 0.28 $ 0.28 $ 0.28 $ 0.28 $ 1.12
====================================================================================================================================
(1) Beginning with the fourth quarter of 2007, the Company's results of
operations were rounded in $ millions. Quarterly results prior to the fourth
quarter are rounded based on previously disclosed figures. As a result, the sum
of the quarterly results of operations may differ from the full fiscal year
amounts disclosed on the Company's Consolidated Statement of Income.
(2) Due to the net loss in the fourth quarter of 2007, the diluted earnings per
share calculation excludes 15.1 million dilutive potential common shares, as
they were anti-dilutive.
127
PRICE RANGE OF COMMON STOCK AND DIVIDENDS
The common stock of the Company is traded on the NYSE under the symbol BSC. The
table below sets forth for the periods indicated the closing high and low prices
for the common stock and the cash dividends declared on the common stock.
As of January 28, 2008, there were 1,390 holders of record of the Company's
common stock. On January 28, 2008, the last reported sales price of the
Company's common stock was $91.10.
Dividends are payable on January 15, April 15, July 15 and October 15 in each
year on the Company's outstanding Cumulative Preferred Stock, Series E;
Cumulative Preferred Stock, Series F; and Cumulative Preferred Stock, Series G
(collectively, the "Preferred Stock"). The terms of the Preferred Stock require
that all accrued dividends in arrears be paid prior to the payment of any
dividends on the common stock.
Since the Company is a holding company, its ability to pay dividends is limited
by the ability of its subsidiaries to pay dividends and to make advances to the
Company. See Note 16, "Regulations," in the Notes to Consolidated Financial
Statements for a further description of the restrictions on dividends.
Cash Dividends
Declared Per
High Low Common Share
- -----------------------------------------------------------------------------------------------------------------
FISCAL YEAR ENDED NOVEMBER 30, 2007
First Quarter (through February 28, 2007) $ 171.51 $ 151.49 $ 0.32
Second Quarter (through May 31, 2007) 158.39 142.97 0.32
Third Quarter (through August 31, 2007) 153.50 103.15 0.32
Fourth Quarter (through November 30, 2007) 131.58 91.04 0.32
FISCAL YEAR ENDED NOVEMBER 30, 2006
First Quarter (through February 28, 2006) $ 136.40 $ 110.50 $ 0.28
Second Quarter (through May 31, 2006) 147.07 127.28 0.28
Third Quarter (through August 31, 2006) 145.49 123.43 0.28
Fourth Quarter (through November 30, 2006) 158.60 128.07 0.28
128
PERFORMANCE GRAPH
The following graph compares the performance of an investment in the
Company's Common Stock over the last five fiscal years with its Peer Group, the
S&P 500 Investment Banking & Brokerage Index and the S&P 500 Index. The entities
included in the Company's peer group consist of Merrill Lynch & Co., Inc.,
Morgan Stanley, The Goldman Sachs Group, Inc. and Lehman Brothers Holdings Inc.
The performance graph assumes the value of the investment in the Company's
Common Stock and each index was $100 on November 30, 2002, and that all
dividends have been reinvested. The performance shown in the graph represents
past performance and should not be considered an indication of future
performance.
COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN
[LINE CHART - GRAPHIC OMITTED]
Assumes $100 invested on November 30, 2002 in the Company's Common Stock, Peer
Group, S&P 500 Investment Banking & Brokerage Index and the S&P 500 Index and
that all dividends have been reinvested.
2002 2003 2004 2005 2006 2007
---- ---- ---- ---- ---- ----
The Bear Stearns Companies Inc. $ 100.00 $ 114.46 $ 155.68 $ 178.84 $ 247.68 $ 163.46
Peer Group 100.00 125.88 129.21 161.5 223.50 206.38
S&P 500 Investment Banking & Brokerage Index 100.00 122.94 126.50 154.16 213.14 191.06
S&P 500 Index 100.00 115.09 129.89 140.85 160.90 173.32
129
FINANCIAL HIGHLIGHTS
Fiscal years ended November 30, 2007 2006 2005 2004 2003
- --------------------------------------------------------------------------------------------------------------------------------
(in millions, except common share
Data, financial ratios and other data)
- --------------------------------------------------------------------------------------------------------------------------------
RESULTS
- --------------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense $ 5,945 $ 9,227 $ 7,411 $ 6,813 $ 5,994
Employee compensation and benefits 3,425 4,343 3,553 3,254 2,881
Non-compensation expenses 2,327 1,737 1,651 1,537 1,342
Total expenses 5,752 6,080 5,204 4,791 4,222
Net income $ 233 $ 2,054 $ 1,462 $ 1,345 $ 1,156
Net income applicable to common shares $ 212 $ 2,033 $ 1,438 $ 1,317 $ 1,125
- --------------------------------------------------------------------------------------------------------------------------------
FINANCIAL POSITION
- --------------------------------------------------------------------------------------------------------------------------------
Total assets (1) $ 395,362 $ 350,433 $ 287,293 $ 252,113 $ 209,181
Long-term borrowings $ 68,538 $ 54,570 $ 43,490 $ 36,843 $ 29,430
Guaranteed Preferred Beneficial Interest
in Company Subordinated Debt Securities(2) $ -- $ -- $ -- $ -- $ 563
Stockholders' equity $ 11,793 $ 12,129 $ 10,791 $ 8,991 $ 7,470
- --------------------------------------------------------------------------------------------------------------------------------
COMMON SHARE DATA
- --------------------------------------------------------------------------------------------------------------------------------
Basic earnings per share $ 1.68 $ 15.79 $ 11.42 $ 10.88 $ 9.44
Diluted earnings per share $ 1.52 $ 14.27 $ 10.31 $ 9.76 $ 8.52
Cash dividends declared per common share $ 1.28 $ 1.12 $ 1.00 $ 0.85 $ 0.74
Book value per common share $ 84.09 $ 86.39(3) $ 71.08 $ 59.13 $ 48.69
Common shares outstanding(4) 136,155,586 145,693,021 146,431,767 144,484,099 142,369,836
- --------------------------------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
- --------------------------------------------------------------------------------------------------------------------------------
Return on average common equity 1.8% 19.1% 16.5% 19.1% 20.2%
Profit margin(5) 3.2% 34.1% 29.8% 29.7% 29.6%
- --------------------------------------------------------------------------------------------------------------------------------
OTHER DATA
- --------------------------------------------------------------------------------------------------------------------------------
Assets under management (in billions) $ 44.6 $ 52.5 $ 41.9 $ 37.8 $ 29.2
Average value-at-risk (in millions) $ 33.1 $ 28.6 $ 20.5 $ 15.8 $ 15.8
Employees (end of year) 14,153 13,566 11,843 10,961 10,532
(1) As of November 30, 2006, the Company elected, under FIN No. 39,
"Offsetting Amounts Related to Certain Contracts," to net cash
collateral received or paid against its derivatives inventory, on a
counterparty basis, provided that the legal right of offset exists.
The Consolidated Statements of Financial Condition as of November
30, 2005, 2004, and 2003 have been adjusted to conform to the
current year's presentation.
(2) In accordance with FIN No. 46 (R) the Company has deconsolidated
Bear Stearns Capital Trust III effective beginning with the quarter
ended February 29, 2004. As a result, the Debentures issued by the
Company to Bear Stearns Capital Trust III are included within
long-term borrowings. The $263 million of Preferred Securities
issued by Capital Trust III is still outstanding, providing the
funding for such Debentures. The Preferred Securities issued by
Capital Trust III are no longer included in the Company's
Consolidated Statements of Financial Condition. As of November 30,
2003, Guaranteed Preferred Beneficial Interests in Company
Subordinated Debt Securities consists of $300 million of Preferred
Securities issued by Bear Stearns Capital Trust II and $263 million
of Preferred Securities issued by Bear Stearns Capital Trust III.
(3) For book value purposes, at November 30, 2006, common stockholders'
equity was adjusted by $816 million and common stock outstanding was
adjusted by 4.6 million units, which represents stock-based
compensation associated with fiscal 2006 awards that was reflected
in stockholders' equity as of the grant date in December 2006, in
accordance with SFAS No. 123 (R), "Share-based Payment." In years
prior to fiscal 2006, stock-based compensation granted in December
was included in stockholders' equity at November year-end. The
Company changed the requisite service period associated with its
2007 stock-based compensation awards to align it with the vesting
schedules. As a result, an adjustment to stockholders' equity was
not applicable.
(4) Common shares outstanding include units issued under certain stock
compensation plans, which will be distributed as shares of common
stock.
(5) Represents the ratio of income before provision for income taxes to
revenues, net of interest expense.
130