Exhibit 99.1
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.
We have not audited any financial statements of the Company for any period
subsequent to November 30, 2007, nor have we performed a review of interim
financial statements in conformity with the standards of the Public Company
Accounting Oversight Board (United States) for any period subsequent to November
30, 2007. However, as discussed in Note 23 to the consolidated financial
statements, during the end of the week of March 10, 2008, the Company
experienced a significant liquidity crisis which seriously jeopardized the
financial viability of the Company, and which raises substantial doubt about the
Company's ability to continue as a going concern. Management's plans in regards
to these matters are also discussed in Note 23. The consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
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
(April 11, 2008 as to Note 23)
1
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.
2
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.
3
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.
4
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Common Employee Treasury
Stock Stock Stock-
(in millions, except share Preferred $1 Par Paid-In Retained Compensation Common
and per share data) Stock Value Capital Earnings Plans Stock Total
- ---------------------------------------------------------------------------------------------------------------------------
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
(8,483,483 shares) (870)
Common stock issued out of treasury
(18,565,624 shares) 13 (729) 921
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
(10,582,214 shares) (1,374)
Common stock issued out of treasury
(14,122,978 shares) 91 (551) 754
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
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Common Employee
Stock Stock
(in millions, except share Preferred $1 Par Paid-In Retained Compensation
and per share data) Stock Value Capital Earnings Plans
- ------------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2006 $ 359 $ 185 $ 4,579 $ 9,385 $ 2,066
Net Income 233
Dividends declared--
Common ($1.28 per share) (159) 8
Preferred (21)
Treasury Stock--
Common stock purchased
(12,044,779 shares)
Common stock issued out of treasury 58 (370)
(7,634,428 shares)
Redemption of preferred stock (7)
Income tax benefit related to 254
distributions from employee stock
compensation plans
Unearned employee stock (31)
compensation, net
Employee stock compensation 96 805
awards, net
Amortization of preferred stock (1)
issue costs
Foreign currency translation,
net of tax
Net (losses) on cash flow
hedges, net of tax
Implementation of accounting principles 3
- ------------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2007 $ 352 $ 185 $ 4,986 $ 9,441 $ 2,478
========================================================================================================================
Accumulated Treasury
Other Stock-
(in millions, except share Comprehensive Common
and per share data) Income Stock Total
- ---------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2006 $ -- $ (4,445) $ 12,129
Net Income
Dividends declared--
Common ($1.28 per share)
Preferred
Treasury Stock--
Common stock purchased (1,670)
(12,044,779 shares)
Common stock issued out of treasury 474
(7,634,428 shares)
Redemption of preferred stock
Income tax benefit related to
distributions from employee stock
compensation plans
Unearned employee stock
compensation, net
Employee stock compensation
awards, net
Amortization of preferred stock
issue costs
Foreign currency translation, 2
net of tax
Net (losses) on cash flow
hedges, net of tax (10)
Implementation of accounting principles
- ---------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2007 $ (8) $ (5,641) $ 11,793
=======================================================================================
See Notes to Consolidated Financial Statements
5
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF 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.
6
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.
7
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.
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.
8
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.
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.
9
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.
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.
10
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.
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.
11
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 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
================================================================================
12
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.
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.
13
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 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.
14
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.
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.
15
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 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.
16
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.
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.
17
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.
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 a significant reduction in observable trading
activity for these instruments during the latter part of fiscal 2007.
18
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 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.
19
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.
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.
20
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.
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
================================================================================
21
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%
- --------------------------------------------------------------------------------
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)
- --------------------------------------------------------------------------------
22
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.
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)
- --------------------------------------------------------------------------------
23
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
================================================================================
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.
24
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
- -------------------------------------------------------------------------------------------------------------------
Maximum
Maximum Exposure
VIE Exposure VIE to Loss
(in millions) Assets to Loss (1) Assets (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.
25
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.
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.
26
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 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.
27
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.
28
The effective weighted average interest rates for long-term borrowings, after
giving effect to the swaps, were as follows:
- --------------------------------------------------------------------------------
As of November Fiscal Year Ended
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.
29
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.
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.
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.
30
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
outstanding and dilutive potential common shares 146 149 147
===============================================================================================================
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.
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.
31
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.
32
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.
33
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.
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.
34
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.
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
Range 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
35
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.
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.
36
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.
37
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.
38
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.
39
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 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.
40
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.
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:
(in millions)
- -------------------------------------------------
FISCAL YEAR
2008 $ 81
2009 82
2010 83
2011 258
2012 416
Thereafter 3,399
- -------------------------------------------------
Total 4,319
=================================================
41
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 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.
42
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.
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.
43
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.
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.
44
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
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.
45
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.
- -----------------------------------------------------------------------------------------------------------------------------------
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.
46
- --------------------------------------------------------------------------------
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
================================================================================
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
===================================================================================================================
47
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.
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
================================================================================
48
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.
49
23. SUBSEQUENT EVENTS
BACKGROUND OF THE MERGER
The Company experienced a significant liquidity crisis during the end of the
week of March 10, 2008 that seriously jeopardized its financial viability and
which raises substantial doubt about its ability to continue as a going concern.
As a result, on March 16, 2008, the Company and JPMorgan Chase & Co. ("JPMorgan
Chase") entered into an agreement and plan of merger, and on March 24, 2008,
entered into an amendment to the agreement and plan of merger (as amended, the
"Merger Agreement"). Pursuant to the Merger Agreement, each share of the
Company's common stock outstanding immediately prior to the merger will be
exchanged for 0.21753 of a share of JPMorgan Chase common stock. A summary of
the Merger Agreement, related transaction documents and the accounting
implications are described in more detail in the Transaction Documents and
Accounting Implications sections of this note.
In connection with the entry into the amendment to the Merger Agreement, the
Company and JPMorgan Chase entered into a share exchange agreement under which
JPMorgan Chase will purchase 95 million newly issued shares of the Company's
common stock, or 39.5% of the outstanding common stock of the Company after
giving effect to the issuance, in exchange for the issuance of 20,665,350 shares
of JPMorgan Chase common stock to the Company and the entry by JPMorgan Chase
into the amendment to the merger agreement, an amended and restated guaranty
agreement and the guaranty agreement with the Federal Reserve Bank of New York
(the "New York Fed"). The share exchange was completed on April 8, 2008.
Concurrent with the closing of the merger, the New York Fed will take through a
limited liability company formed for this purpose control of a portfolio of $30
billion in assets of the Company based on the value of the portfolio as of March
14, 2008. The assets will be funded by a $29 billion, 10-year term loan from the
New York Fed, and a $1 billion, 10-year subordinated note from JPMorgan Chase.
The JPMorgan Chase note is subordinated to the New York Fed loan and will bear
the first $1 billion of any losses associated with the assets. Any funds
remaining after payment of the New York Fed loan, the JPMorgan Chase note and
other expenses of the limited liability company, will be paid to the New York
Fed.
TRANSACTION DOCUMENTS
Agreement and Plan of Merger
Upon the terms and subject to the conditions set forth in the Merger Agreement,
a wholly-owned subsidiary of JPMorgan Chase will merge with and into the Company
with the Company continuing as the surviving corporation and as a wholly-owned
subsidiary of JPMorgan Chase (the "Merger"). At the effective time of the
Merger, each share of Company common stock will be converted into the right to
receive 0.21753 of a share of JPMorgan Chase common stock. Outstanding Company
stock options and phantom stock units will be converted into JPMorgan Chase
equity awards, adjusted to reflect the exchange ratio in the Merger.
The Company and JPMorgan Chase have agreed to consider providing holders of
restricted stock units and capital accumulation plan units with the right to
elect, prior to completion of the Merger, to have outstanding awards distributed
in cash (rather than stock) at the same time the units would have been settled
absent such election, and otherwise subject to the same terms and conditions in
the applicable plans and award agreements, as amended.
The Merger Agreement contains representations and warranties of Bear Stearns and
JPMorgan Chase relating to their respective businesses. Pursuant to the Merger
Agreement, the Company has agreed to operate within its existing credit,
principal, market and other risk limits and comply with existing risk-related
policies and procedures, subject to JPMorgan Chase's right to oversee the
Company's setting and changing of such policies, procedures and limits. Subject
to the continued effectiveness of the Guaranty (as defined below), the Company
has granted JPMorgan Chase the right to oversee the business, operations and
management of the Company in its reasonable discretion. The Company also granted
JPMorgan Chase the rights to custody of, and to manage, a scheduled collateral
pool and related hedges, which rights were delegated to the New York Fed.
Additionally, the Company has agreed not to (i) solicit proposals relating to
alternative business combination transactions or (ii) subject to certain
exceptions, enter into discussions, or enter into any agreement, concerning, or
provide confidential information in connection with, any proposals for
alternative business combination transactions.
50
Consummation of the Merger is subject to the satisfaction of certain conditions
including, among other things, (i) approval and adoption of the Merger Agreement
by the Company's stockholders; (ii) registration and NYSE listing of the common
stock to be issued by JPMorgan Chase in the Merger; (iii) absence of any order,
injunction or decree preventing or making illegal the consummation of the
Merger; and (iv) receipt of specified governmental and regulatory approvals.
The Merger Agreement contains certain termination rights for both the Company
and JPMorgan Chase. In the event the Company's stockholders do not approve and
adopt the Merger Agreement at the first stockholders meeting called for that
purpose, JPMorgan Chase will have the right to exercise an option to purchase
the Company's headquarters building for an amount equal to $1.1 billion less
assumed indebtedness and transfer costs. In addition, JPMorgan Chase will also
have the right to exercise such option following the termination of the Merger
Agreement under the following circumstances: (i) JPMorgan Chase terminates the
Merger Agreement because (A) the Company's board of directors made any change of
recommendation, (B) the Company breached its no-solicitation and related
obligations under the Merger Agreement, or (C) the Company breached its
obligations to hold a meeting of its stockholders to approve and adopt the
Merger Agreement, or (ii) (A) JPMorgan Chase or the Company terminate the Merger
Agreement because both (x) the approval and adoption of the Merger Agreement by
the Company's stockholders has not been obtained and (y) 120 days have elapsed
from the date of such stockholders meeting (provided that the parties may
mutually agree to extend the 120-day period); (B) JPMorgan Chase terminates the
Merger Agreement because there has been an uncured breach by the Company of any
of the covenants or agreements or any of the representations or warranties in
the Merger Agreement that would cause the failure of the closing conditions set
forth in the Merger Agreement to be satisfied; or (C) JPMorgan Chase or the
Company terminates the Merger Agreement because the merger has not been
consummated on or before the first anniversary of the date of the Merger
Agreement, and prior to any termination of the merger agreement described in
this clause (ii) an alternative proposal has been publicly announced or
otherwise communicated or made known to the Company and has not been irrevocably
withdrawn. Upon the exercise of the option to purchase the Company's
headquarters building, the Company will, upon the request of JPMorgan Chase,
exercise its option to purchase the headquarters building and take all action
required to acquire the building and simultaneously convey it to JPMorgan Chase.
The foregoing description of the Merger Agreement does not purport to be
complete and is qualified in its entirety by reference to the Merger Agreement,
which is filed as Exhibit 2.1 to the Company's Current Reports on Form 8-K filed
on March 20, 2008 and March 24, 2008 (Amendment No. 1).
Beginning March 17, 2008, various stockholders of the Company filed several
purported class action lawsuits against the Company, its board of directors and
certain of the Company's present and former executive officers. Among other
things, these actions allege that the individual defendants breached their
fiduciary duties and obligations to the Company's stockholders by agreeing to
the proposed merger. Five of these actions have been filed in the Supreme Court
of the State of New York and consolidated under the caption In re Bear Stearns
Litigation. Two actions have been filed in the Delaware Court of Chancery where
plaintiffs have filed a motion to consolidate their cases in Delaware. JPMorgan
Chase is named as a defendant in certain of these cases. In each of these
actions, plaintiffs seek to enjoin the proposed merger and enjoin JPMorgan Chase
from voting the 95 million shares acquired pursuant to the Share Exchange
Agreement (as defined below), other injunctive relief and an unspecified amount
of compensatory damages. On April 9, 2008, the Delaware Chancery Court granted
JPMorgan Chase's and the Company's motion to stay the Delaware action in favor
of the New York action, at least until the preliminary injunction motion is
resolved. The Delaware court also granted plaintiffs' motion to consolidate
their cases. Additionally, on April 10, 2008, an amended complaint was filed in
a previously-filed shareholder derivative suit naming the Company's directors
and certain former and present executive officers. This amended complaint seeks,
among other things, a declaration that the Merger Agreement is unlawful,
unenforceable, and seeks to enjoin the merger. Although the Company is unable at
this time to determine the ultimate outcome of these lawsuits, injunctive relief
or an adverse determination could affect the Company's ability to complete the
merger.
51
Share Exchange Agreement
On March 24, 2008, the Company and JPMorgan Chase, in connection with entering
into the amendment to the Merger Agreement, entered into a share exchange
agreement (the "Share Exchange Agreement"), under which JPMorgan Chase will
purchase 95 million newly issued shares of the Company's common stock, or 39.5%
of the outstanding shares of the Company's common stock after giving effect to
the issuance, in exchange for the issuance of 20,665,350 shares of JPMorgan
Chase common stock to the Company and the entry by JPMorgan Chase into the
amendment to the merger agreement, an amended and restated guaranty agreement
and the guaranty in favor of the New York Fed (each as described below). The
share exchange was completed on April 8, 2008.
The foregoing description of the Share Exchange Agreement does not purport to be
complete and is qualified in its entirety by reference to the Share Exchange
Agreement, which is filed as Exhibit 2.2 to the Company's Current Report on Form
8-K filed on March 24, 2008.
Amended and Restated Guaranty Agreement
On March 24, 2008, JPMorgan Chase, in connection with the amendment to the
Merger Agreement, entered into an amended and restated guaranty agreement (the
"Guaranty"), effective retroactively from March 16, 2008, which replaces the
guaranty agreement entered into on March 16, 2008 in connection with the Merger
Agreement. Pursuant to the Guaranty, JPMorgan Chase will guarantee certain
liabilities of the Company and certain of its operating subsidiaries (the
"Guaranteed Bear Entities") to the extent such liabilities arise prior to the
end of the specified "Guaranty Period", including (i) liabilities and
obligations under revolving credit facilities, letters of credit and letter of
credit facilities, term loan facilities, lines of credit or uncommitted loan
facilities, in each case whether secured or unsecured, of the Guaranteed Bear
Entities, (ii) brokerage and trading contract obligations of the Guaranteed Bear
Entities (including liabilities and obligations arising under prime brokerage
agreements and accounts, securities lending agreements, custodial and carrying
agreements, securities accounts and securities contracts, commodity contracts,
forward contracts, futures contracts, tolling agreements, energy management
agreements, repurchase or reverse repurchase agreements, swap agreements,
foreign exchange and currency contracts, options or other derivatives,
settlement or clearing agreements and arrangements, margin loan agreements,
other contracts or transactions similar to any of the foregoing, any customary
brokerage commission with respect to the foregoing, any contractual obligation
to provide collateral or margin in respect of any of the foregoing or any
obligation under a guaranty of any of the foregoing and (iii) obligations of the
Guaranteed Bear Entities to deliver cash, securities or other property to
customers pursuant to customary custody arrangements. The Guaranty Period will
end (subject to provision of further notice by JPMorgan Chase posted on its
website at least three days prior to the end of the Guaranty Period), no sooner
than the earliest to occur of (i) the date that is 120 days following the
failure of the Company's stockholders to approve and adopt the Merger Agreement
at a meeting of the Company's stockholders convened for that purpose, (ii) the
date that is 120 days following closing of the Merger and (iii) the date of
termination of the Merger Agreement.
The foregoing description of the Guaranty does not purport to be complete and is
qualified in its entirety by reference to the Guaranty, which is filed as
Exhibit 99.1 to the Company's Current Report on Form 8-K filed on March 24,
2008.
52
Guarantee and Collateral Agreement
On March 24, 2008, JPMorgan Chase, in connection with the amendment to the
Merger Agreement and the Guaranty, entered into a guarantee and collateral
agreement (the "Guarantee and Collateral Agreement") with the Company and
certain of its subsidiaries (collectively, the "Collateral Parties") pursuant to
which the Collateral Parties agreed to guarantee the obligations of each of them
to repay to JPMorgan Chase (1) any loans or other advances of credit by JPMorgan
Chase and its affiliates to the Company and its affiliates and (2) any amounts
paid by JPMorgan Chase to creditors of the Company and its affiliates under the
Guaranty and the Fed Guarantee (as defined below). Each of the Collateral
Parties secured their guarantee by granting a lien on substantially all of their
respective assets, subject to certain carve-outs.
The foregoing description of the Guarantee and Collateral Agreement does not
purport to be complete and is qualified in its entirety by reference to the
Guarantee and Collateral Agreement, which is filed as Exhibit 99.1 to the
Company's Current Report on Form 8-K filed on March 28, 2008.
Fed Guaranty Agreement
On March 24, 2008, JPMorgan Chase, in connection with the amendment to the
Merger Agreement, entered into a guarantee in favor of the New York Fed (the
"Fed Guarantee"), pursuant to which JPMorgan Chase guaranteed certain
obligations of the Company and certain of its affiliates to the New York Fed.
Such guarantee will apply with respect to transactions entered into prior to the
termination of the Merger Agreement and may be terminated by JPMorgan Chase with
respect to transactions thereafter.
The foregoing description of the Fed Guaranty does not purport to be complete
and is qualified in its entirety by reference to the Fed Guarantee, which is
filed as Exhibit 99.2 to the Company's Current Report on Form 8-K filed on March
24, 2008.
ACCOUNTING IMPLICATIONS
Based on the activities discussed above, the following accounting impacts on the
consolidated financial statements have occurred or are expected to occur for
periods ending after March 10, 2008:
Municipal Securities
The Company acts as placement agent and as liquidity provider under a municipal
tender option bond program as described in Note 18, "Guarantees" to the
Consolidated Financial Statements of the Company. Under the program, the Company
has created a series of municipal securities trusts which purchase fixed-rate,
long-term, highly rated, insured or escrowed municipal bonds financed by the
issuance of trust certificates. The trust certificates entitle the holder to
tender such certificates at the option of the holder on a periodic basis.
Subsequent to March 10, 2008, holders of all the Class A trust certificates had
tendered such certificates to the Company, resulting in the Company owning 100%
of the trusts and consolidation of the trusts. As a result, the Company
recognized losses of approximately $200 million in the second quarter of 2008.
Deferred Tax Asset
As of February 29, 2008, the Company had approximately $1.5 billion in net
deferred tax assets (approximately $1.3 billion was associated with its
stock-based compensation plans). In accordance with SFAS No. 109, the gross
deferred tax assets of $1.7 billion will be evaluated for future realization and
be reduced by a valuation allowance if, based on available evidence, it is more
likely than not that some portion or all of the deferred tax asset will not be
realized. Management will be required to make certain estimates and assumptions
in order to assess the realizability of the deferred tax assets. Further, full
realization of the deferred tax asset for stock-based compensation requires the
shares for RSUs and CAP units to be distributed at a price equaling or exceeding
the fair value at the grant date. The provisions of SFAS No. 123(R), however, do
not allow a valuation allowance to be recorded based on the current fair value
of the Company's shares. Accordingly, given the activities discussed above, the
Company believes it is likely that a significant portion of this deferred tax
asset will not be realized in the future.
53
Goodwill and Intangibles
As of February 29, 2008, the Company had goodwill and intangible assets. Based
on the proposed merger agreement, the Company believes an impairment loss for
$88 million is probable, and would be recorded in the second quarter of 2008.
Since the liquidity crisis and the announcement of the merger, the Company has
experienced substantial deterioration of its earnings capacity. The closing of
the merger is expected to occur by June 30, 2008. The Company believes that the
termination of the JPMorgan Chase guaranties prior to consummation of the merger
or the parties' failure to consummate the merger could seriously jeopardize the
Company's financial viability. In addition, absent the Guaranty, the Company
could face the increased risk of rapid loss of customers and counterparties. The
lack of liquidity and the loss of customers and counterparties would materially
adversely affect the Company's financial stability and its viability as a going
concern. Accordingly, the Company could be forced to file for bankruptcy
protection and need to liquidate. The accompanying consolidated financial
statements do not reflect any adjustments that might result if the Company were
unable to continue as a going concern.
54