Exhibit 99.4
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of The Bear Stearns Companies Inc.
We have reviewed the accompanying condensed consolidated statement of financial
condition of The Bear Stearns Companies Inc. and subsidiaries (the "Company") as
of February 29, 2008, and the related condensed consolidated statements of
income, comprehensive income and cash flows for the three-month periods ended
February 29, 2008 and February 28, 2007. These interim financial statements are
the responsibility of the Company's management.
We conducted our review in accordance with the standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board (United States), the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to such condensed consolidated interim financial statements for them to
be in conformity with accounting principles generally accepted in the United
States of America.
The accompanying condensed consolidated interim financial statements have been
prepared assuming that the Company will continue as a going concern. As
discussed in Notes 1 and 17 to the condensed consolidated interim financial
statements and Note 23 to the annual consolidated financial statements for the
year ended November 30, 2007 (included as Exhibit 99.1 in this Current Report on
Form 8-K), certain conditions raise substantial doubt about its ability to
continue as a going concern. Management's plans in regards to these matters are
also described in Notes 1, 17 and 23 to the respective consolidated financial
statements.
As discussed in Note 1 to the condensed consolidated interim financial
statements, effective December 1, 2007, the Company adopted the Financial
Accounting Standards Board Interpretation No. 48, "Accounting for Uncertainty in
Income Taxes - an interpretation of FASB Statement No. 109."
We have previously audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated statement
of financial condition of the Company as of November 30, 2007, and the related
consolidated statements of income, comprehensive income, cash flows and changes
in stockholders' equity for the year then ended (not presented herein); and in
our report dated January 28, 2008 (April 11, 2008 as to Note 23), we expressed
an unqualified opinion on those consolidated financial statements and included
an explanatory paragraph concerning matters that raise substantial doubt about
the Company's ability to continue as a going concern. In our opinion, the
information set forth in the accompanying condensed consolidated statement of
financial condition as of November 30, 2007 is fairly stated, in all material
respects, in relation to the consolidated statement of financial condition from
which it has been derived.
/s/ Deloitte & Touche LLP
New York, New York
April 14, 2008
1
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Income
(Unaudited)
Three Months Ended
---------------------------
February 29, February 28,
(in millions, except share and per share data) 2008 2007
- --------------------------------------------------------------------------------
REVENUES
Commissions $ 330 $ 281
Principal transactions 515 1,342
Investment banking 230 350
Interest and dividends 2,198 2,657
Asset management and other income 154 168
---------------------------
Total revenues 3,427 4,798
Interest expense 1,948 2,316
---------------------------
Revenues, net of interest expense 1,479 2,482
---------------------------
NON-INTEREST EXPENSES
Employee compensation and benefits 754 1,204
Floor brokerage, exchange and clearance fees 79 56
Communications and technology 154 128
Occupancy 73 57
Advertising and market development 40 37
Professional fees 100 72
Other expenses 126 93
---------------------------
Total non-interest expenses 1,326 1,647
---------------------------
Income before provision for income taxes 153 835
Provision for income taxes 38 281
---------------------------
Net income $ 115 $ 554
Preferred stock dividends 5 6
---------------------------
Net income applicable to common shares $ 110 $ 548
===========================
Basic earnings per share $ 0.89 $ 4.23
Diluted earnings per share $ 0.86 $ 3.82
===========================
Weighted average common shares outstanding:
Basic 129,128,281 133,094,747
Diluted 138,539,248 149,722,654
===========================
Cash dividends declared per common share $ 0.32 $ 0.32
===========================
See Notes to Condensed Consolidated Financial Statements.
2
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Financial Condition
(Unaudited)
---------------------------
February 29, November 30,
(in millions, except share data) 2008 2007
- ------------------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and cash equivalents $ 20,786 $ 21,406
Cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations 14,910 12,890
Securities received as collateral 15,371 15,599
Collateralized agreements:
Securities purchased under agreements to resell 26,888 27,878
Securities borrowed 87,143 82,245
Receivables:
Customers 41,990 41,115
Brokers, dealers and others 10,854 11,622
Interest and dividends 488 785
Financial instruments owned, at fair value 118,201 122,518
Financial instruments owned and pledged as collateral, at fair value 22,903 15,724
--------------------------
Total financial instruments owned, at fair value 141,104 138,242
Assets of variable interest entities and mortgage loan special purpose entities 29,991 33,553
Property, equipment and leasehold improvements, net of accumulated
depreciation and amortization of $1,196 and $1,149 as of February
29, 2008 and November 30, 2007, respectively 608 605
Other assets 8,862 9,422
--------------------------
Total Assets $ 398,995 $ 395,362
==========================
LIABILITIES AND STOCKHOLDERS' EQUITY
Unsecured short-term borrowings (includes $434 and $339 at fair value as of $ 8,538 $ 11,643
February 29, 2008 and November 30, 2007, respectively)
Obligation to return securities received as collateral 15,371 15,599
Collateralized financings:
Securities sold under agreements to repurchase 98,272 102,373
Securities loaned 4,874 3,935
Other secured borrowings 7,778 12,361
Payables:
Customers 91,632 83,204
Brokers, dealers and others 5,642 4,101
Interest and dividends 853 1,301
Financial instruments sold, but not yet purchased, at fair value 51,544 43,807
Liabilities of variable interest entities and mortgage loan special purpose entities 26,739 30,605
Accrued employee compensation and benefits 360 1,651
Other liabilities and accrued expenses 3,743 4,451
Long-term borrowings (includes $9,018 and $8,500 at fair value as of
February 29, 2008 and November 30, 2007, respectively) 71,753 68,538
--------------------------
Total Liabilities $ 387,099 $ 383,569
==========================
Commitments and contingencies (Note 12)
STOCKHOLDERS' EQUITY
Preferred stock 352 352
Common stock, $1.00 par value; 500,000,000 shares authorized and 184,805,847
shares issued as of both February 29, 2008 and November 30, 2007 185 185
Paid-in capital 5,619 4,986
Retained earnings 9,419 9,441
Employee stock compensation plans 2,164 2,478
Accumulated other comprehensive income (loss) 25 (8)
Shares held in RSU trust (2,955) --
Treasury stock, at cost:
Common stock: 39,135,671 and 71,807,227 shares as of February 29, 2008 and
November 30, 2007, respectively (2,913) (5,641)
--------------------------
Total Stockholders' Equity 11,896 11,793
--------------------------
Total Liabilities and Stockholders' Equity $ 398,995 $ 395,362
==========================
See Notes to Condensed Consolidated Financial Statements.
3
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Cash Flows
(Unaudited)
Three Months Ended
-------------------------------------
February 29, February 28,
(in millions) 2008 2007
- ------------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 115 $ 554
Adjustments to reconcile net income to cash used in operating activities:
Non-cash items included in net income:
Depreciation and amortization 53 42
Employee stock compensation plans 89 13
Changes in operating assets and liabilities:
Cash and securities deposited with clearing organizations or segregated
in compliance with federal regulations (2,020) (322)
Securities borrowed, securities loaned, net (3,959) (2,795)
Receivables from customers (875) (3,048)
Receivables from brokers, dealers and others 768 (1,188)
Financial instruments owned, at fair value (830) (22,958)
Other assets 908 (1,791)
Securities sold under agreements to repurchase, securities purchased under
agreements to resell, net (3,111) 20,409
Payables to customers 8,428 4,904
Payables to brokers, dealers and others 1,541 (305)
Financial instruments sold, but not yet purchased, at fair value 7,803 (54)
Accrued employee compensation and benefits (1,291) (1,144)
Other liabilities and accrued expenses (1,251) 1,525
-------------------------------------
Cash provided by (used in) operating activities 6,368 (6,158)
-------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements, net (51) (67)
-------------------------------------
Cash used in investing activities (51) (67)
-------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Payments for/proceeds from unsecured short-term borrowings, net (3,105) 4,924
Payments for other secured borrowings, net (4,583) (1,757)
Proceeds from issuance of long-term borrowings 4,396 8,082
Payments for retirement/repurchase of long-term borrowings (3,536) (3,554)
Payments for/proceeds from issuances of derivatives with a financing
element, net (66) 76
Issuance of common stock 25 62
Cash retained resulting from tax deductibility under share-based payment
arrangements 45 205
Treasury stock purchases - common stock (70) (473)
Cash dividends paid (43) (44)
-------------------------------------
Cash (used in) provided by financing activities (6,937) 7,521
-------------------------------------
Net (decrease) increase in cash and cash equivalents (620) 1,296
Cash and cash equivalents, beginning of year 21,406 4,595
-------------------------------------
Cash and cash equivalents, end of period $ 20,786 $ 5,891
=====================================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash payments for interest were $2.32 billion and $2.51 billion during the
three months ended February 29, 2008 and February 28, 2007, respectively.
Cash payments for income taxes, net of an approximate $325 million refund
of November 30, 2007 estimated Federal taxes, was ($294.0) million for the
three months ended February 29, 2008 and cash payments for income taxes,
net of refunds, was $108.8 million for the three months ended February 28,
2007. Cash payments for income taxes, net of an approximate $325 million
refund of November 30, 2007 estimated Federal taxes, would have been
($249.0) million for the three months ended February 29, 2008 if increases
in the value of equity instruments issued under share-based payment
arrangements had not been deductible in determining taxable income. Cash
payments for income taxes, net of refunds, would have been $313.9 million
for the three months ended February 28, 2007 if increases in the value of
equity instruments issued under share-based payment arrangements had not
been deductible in determining taxable income.
See Notes to Condensed Consolidated Financial Statements.
4
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Comprehensive Income
(Unaudited)
Three months ended
----------------------------
February 29, February 28,
(in millions) 2008 2007
- --------------------------------------------------------------------------------
Net Income $ 115 $ 554
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment (2) --
Net gains on cash flow hedges 35 --
- --------------------------------------------------------------------------------
Comprehensive income $ 148 $ 554
================================================================================
See Notes to Condensed Consolidated Financial Statements.
5
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
The Bear Stearns Companies Inc. (the "Company") is a holding company that,
through its broker-dealer and international bank subsidiaries, principally
Bear, Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp.
("BSSC"), Bear, Stearns International Limited ("BSIL") and Bear Stearns
Bank plc ("BSB"), is primarily engaged in business as a securities
broker-dealer operating in three principal segments: Capital Markets,
Global Clearing Services and Wealth Management. Capital Markets is
comprised of the institutional equities, fixed income and investment
banking areas. Global Clearing Services provides clearance-related
services for prime brokerage clients and clearance on a fully disclosed
basis for introducing broker-dealers. Wealth Management is comprised of
the private client services ("PCS") and asset management areas. See Note
15, "Segment Data," in the Notes to Condensed Consolidated Financial
Statements for a complete description of the Company's principal segments.
The Company also conducts significant activities through other wholly
owned subsidiaries, including: Bear Stearns Global Lending Limited; Bear
Stearns Bank & Trust Company (formerly known as Custodial Trust Company);
Bear Stearns Financial Products Inc. ("BSFP"); Bear Stearns Capital
Markets Inc.; Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc.
("BS Forex"); EMC Mortgage Corporation; Bear Stearns Commercial Mortgage,
Inc.; Bear Stearns Investment Products Inc.; and Bear Energy L.P.
Subsequent Events
The Company experienced a significant liquidity crisis during the end of
the week of March 10, 2008 that seriously jeopardized its financial
viability and which raises substantial doubt about its ability to continue
as a going concern. As a result, on March 16, 2008, the Company and
JPMorgan Chase & Co. ("JPMorgan Chase") entered into an agreement and plan
of merger, and on March 24, 2008, entered into an amendment to the
agreement and plan of merger (as amended the "Merger Agreement'). Pursuant
to the Merger Agreement each share of the Company's common stock
outstanding immediately prior to the merger will be exchanged for 0.21753
shares of JPMorgan Chase common stock. A summary of the Merger Agreement,
related transaction documents and the accounting implications are
described in more detail in the Transaction Documents and Accounting
Implications sections of Note 17, "Subsequent Events," of Notes to
Condensed Consolidated Financial Statements.
In connection with the entry into the amendment to the Merger Agreement,
the Company and JPMorgan Chase entered into a share exchange agreement
under which JPMorgan Chase will purchase 95 million newly issued shares of
the Company's common stock, or 39.5% of the outstanding common stock of
the Company after giving effect to the issuance, in exchange for the
issuance of 20,665,350 shares of JPMorgan Chase common stock to the
Company and the entry by JPMorgan Chase into an amended and restated
guaranty agreement and the guaranty agreement with the Federal Reserve
Bank of New York ("New York Fed"). The share exchange was completed on
April 8, 2008.
Concurrent with the closing of the merger, the New York Fed will take,
through a limited liability company formed for this purpose, control of a
portfolio of $30 billion in assets of the Company based on the value of
the portfolio as of March 14, 2008. The assets will be funded by a $29
billion, 10-year term note from the New York Fed, and a $1 billion,
10-year subordinated note from JPMorgan Chase. The JPMorgan Chase note is
subordinated to the New York Fed loan and will bear the first $1 billion
of any losses associated with the assets. Any funds remaining after
payment of the New York Fed loan, the JPMorgan Chase note and other
expenses of the limited liability company, will be paid to the New York
Fed.
Since the liquidity crisis and the announcement of the merger, the Company
has experienced substantial deterioration of its earnings capacity. The
closing of the merger is expected to occur by June 30, 2008. The Company
believes that the termination of the JPMorgan Chase guaranties prior to
consummation of the merger or the parties' failure to consummate the
merger could seriously jeopardize the Company's financial viability. In
addition, absent the Guaranty, the Company could face the increased risk
of rapid loss of customers and counterparties. The lack of liquidity and
the loss of customers and counterparties would materially adversely affect
the Company's financial stability and its viability as a going concern.
Accordingly, the Company could be forced to file for bankruptcy protection
and need to liquidate. The accompanying Condensed Consolidated Financial
6
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Statements do not reflect any adjustments that might result if the Company
were unable to continue as a going concern.
Basis of Presentation
The Condensed Consolidated Financial Statements include the accounts of
the Company, its wholly owned subsidiaries and other entities in which the
Company has a controlling financial interest. All material intercompany
transactions and balances have been eliminated in consolidation.
The Company determines whether it has a controlling financial interest in
an entity by evaluating whether an entity is a voting interest entity, a
variable interest entity ("VIE") or a qualifying special purpose entity
("QSPE") under generally accepted accounting principles.
Voting interest entities are consolidated in accordance with Accounting
Research Bulletin ("ARB") No. 51, "Consolidated Financial Statements," as
amended. ARB No. 51 states that the usual condition for a controlling
financial interest in an entity is ownership of a majority voting
interest. Accordingly, the Company consolidates voting interest entities
in which it has a majority voting interest. VIEs are entities that lack
one or more of the characteristics of a voting interest entity. A
controlling financial interest in a VIE occurs when an entity has a
variable interest that will absorb a majority of the VIEs expected losses,
receive a majority of the VIEs residual returns, or both. The entity with
the controlling financial interest, known as the primary beneficiary,
consolidates the VIE. In accordance with Financial Accounting Standards
Board ("FASB") Interpretation ("FIN") No. 46 (R), "Consolidation of
Variable Interest Entities (revised December 2003)--an interpretation of
Accounting Research Bulletin ("ARB") No. 51" ("FIN No. 46 (R)"), the
Company consolidates any variable interest entities for which it is the
primary beneficiary. The assets and related liabilities of such variable
interest entities have been shown in the Condensed Consolidated Statements
of Financial Condition in the captions "Assets of variable interest
entities and mortgage loan special purpose entities" and "Liabilities of
variable interest entities and mortgage loan special purpose entities."
See Note 5, "Variable Interest Entities and Mortgage Loan Special Purpose
Entities," in the Notes to Condensed Consolidated Financial Statements.
QSPEs are passive entities that are commonly used in securitization
transactions. Statement of Financial Accounting Standards ("SFAS") No.
140, "Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities," sets forth the criteria an entity must satisfy to be a QSPE.
In accordance with SFAS No. 140, the Company does not consolidate QSPEs.
When the Company does not have a controlling interest in an entity, but
exerts significant influence over the entity's operating and financial
decisions (generally defined as owning a voting or economic interest of
20% to 50%), the Company applies the equity method of accounting.
The Company follows Emerging Issues Task Force ("EITF") Issue No. 04-5
"Determining Whether a General Partner, or the General Partners as a
Group, Controls a Limited Partnership or Similar Entity When the Limited
Partners Have Certain Rights." The EITF consensus requires a general
partner in a limited partnership to consolidate the limited partnership
unless the presumption of control is overcome. The general partner may
overcome this presumption of control and not consolidate the entity if the
limited partners have: (a) the substantive ability to dissolve or
liquidate the limited partnership or otherwise remove the general partner
without having to show cause; or (b) substantive participating rights in
managing the partnership.
The Condensed Consolidated Statement of Financial Condition as of February
29, 2008, the Condensed Consolidated Statements of Income, Cash Flows, and
Comprehensive Income for the three months ended February 29, 2008 and
February 28, 2007 are unaudited. The Condensed Consolidated Statement of
Financial Condition at November 30, 2007 and related information were
derived from the audited consolidated financial statements included in the
Company's Current Report on Form 8-K, which was filed with the Securities
and Exchange Commission ("SEC") on April 11, 2008 (the "Form 8-K").
7
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Condensed Consolidated Financial Statements are prepared in accordance
with the rules and regulations of the SEC with respect to the Quarterly
Report on Form 10-Q and reflect all adjustments which, in the opinion of
management, are normal and recurring, and which are necessary for a fair
statement of the results for the interim periods presented. In accordance
with such rules and regulations, certain disclosures that are normally
included in annual financial statements have been omitted. These Condensed
Consolidated Financial Statements should be read together with the Form
8-K.
The Condensed Consolidated Financial Statements are prepared in conformity
with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions, including those regarding fair value measurements,
stock-based compensation, certain accrued liabilities, the potential
outcome of litigation and tax matters, and the realizability of deferred
tax assets, which may affect the amounts reported in the Condensed
Consolidated Financial Statements and accompanying notes. Actual results
could differ materially from these estimates. The nature of the Company's
business is such that the results of any interim period may not be
indicative of the results to be expected for an entire fiscal year.
Revenue Recognition Policies
Principal Transactions
Financial instruments owned and financial instruments sold, but not yet
purchased, including contractual commitments arising pursuant to futures,
forward and option contracts, interest rate swaps and other derivative
contracts, are recorded at fair value with the resulting net unrealized
gains and losses reflected in "Principal transactions" revenues in the
Condensed Consolidated Statements of Income.
Investment Banking and Advisory Services
Underwriting revenues and fees for mergers and acquisitions advisory
services are accrued when services for the transactions are substantially
completed. Transaction expenses are deferred until the related revenue is
recognized. Investment banking and advisory services revenues are
presented net of transaction-related expenses.
Mortgage Servicing Fees and Advances
Contractual servicing fees, late fees and other ancillary servicing fees
earned for servicing mortgage loans are reflected in "Investment banking"
revenues in the Condensed Consolidated Statements of Income. Contractual
servicing fees are recognized when earned based on the terms of the
servicing agreement. All other fees are recognized when received. In the
normal course of its business, the Company makes principal, interest and
other servicing advances to external investors on mortgage loans serviced
for these investors. Such advances are generally recoverable from the
mortgagors, related securitization trusts or from the proceeds received
from the sales of the underlying properties. A charge to earnings is
recognized to the extent that servicing advances are estimated to be
uncollectible under the provisions of the servicing contracts.
Commissions
Commission revenues primarily include fees from executing and clearing
client transactions on stock, options and futures markets worldwide. These
fees are recognized on a trade date basis. The Company records its share
of the commission under certain clearing agreements where the Company is
acting as agent for another broker, in accordance with EITF Statement No.
99-19, "Reporting Revenue Gross as a Principal versus Net as an Agent."
Asset Management and Other Income
The Company receives advisory fees for investment management. In addition,
the Company receives performance incentive fees for managing certain
funds. Advisory fees are recognized over the period of advisory service.
Unearned advisory fees are treated as deferred revenues and are included
in "Other liabilities" in the accompanying Condensed Consolidated
Statements of Financial Condition. Performance incentive fees are accrued
throughout the year based on a fund's performance to date against
specified performance targets.
8
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Energy Trading
Energy trading revenues are reported, net of certain direct costs, in
"Principal transactions" revenues on the Condensed Consolidated Statements
of Income. Energy trading assets and liabilities that are derivatives are
reported at fair value with the corresponding changes recognized in
income. Non-derivative contracts are accounted for on an accrual basis and
recognized in income when the energy is delivered. See Note 16, "Asset
Acquisition" for a further discussion on the assets acquired from the
Williams Power Company, Inc.
Financial Instruments
The Company follows SFAS No. 157, "Fair Value Measurements." SFAS No. 157
defines fair value, establishes a framework for measuring fair value and
requires enhanced disclosures about fair value measurements. Additionally,
SFAS No. 157 disallows the use of block discounts on positions traded in
an active market as well as nullifies certain guidance in EITF No. 02-3
regarding the recognition of inception gains on certain derivative
transactions. See Note 2, "Financial Instruments" of Notes to Condensed
Consolidated Financial Statements for a complete discussion of SFAS No.
157.
Financial instruments owned and financial instruments sold, but not yet
purchased, including contractual commitments arising pursuant to futures,
forward and option contracts, interest rate swaps and other derivative
contracts, are recorded on a trade-date basis at fair value.
Fair value is generally based on quoted market prices. If quoted market
prices are not available, fair value is determined based on other relevant
factors, including dealer price quotations, price activity for equivalent
instruments and valuation pricing models. Valuation pricing models
consider time value, yield curve and volatility factors, prepayment
speeds, default rates, loss severity, current market and contractual
prices for the underlying financial instruments, as well as other
measurements.
Equity interests and securities acquired as a result of private equity and
merchant banking activities are reflected in the Condensed Consolidated
Financial Statements at fair value, which is often represented at initial
cost until significant transactions or developments indicate that a change
in the carrying value of the securities is appropriate. This represents
the Company's best estimate of exit price as defined by SFAS No. 157.
Generally, the carrying values of these securities will be increased based
on company performance and in those instances where market values are
readily ascertainable by reference to substantial transactions occurring
in the marketplace or quoted market prices. Reductions to the carrying
value of these securities are made when the Company's estimate of fair
value has declined below the carrying value.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities - Including an amendment of
FASB Statement No. 115," which provides a fair value option election that
permits entities to irrevocably elect to measure financial assets and
liabilities (except for those that are specifically scoped out of the
Statement) at fair value as the initial and subsequent measurement
attribute, with changes in fair value recognized in earnings as they
occur. SFAS No. 159 permits the fair value option election on an
instrument-by-instrument basis at initial recognition of an asset or
liability or upon an event that gives rise to a new basis of accounting
for that instrument.
Effective December 1, 2007, the Company adopted SFAS No. 159 and elected
to apply the fair value option to liabilities of variable interest
entities and mortgage loan special purpose entities. The primary reason
for electing the fair value option is to simplify the accounting
requirements. The Company did not have a transition adjustment upon the
adoption of this Statement.
Derivative Instruments and Hedging Activities
The Company follows SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities," as amended by SFAS No. 138, "Accounting for
Certain Derivative Instruments and Certain Hedging Activities," and SFAS
No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging
Activities," which establishes accounting and reporting standards for
stand-alone derivative instruments, derivatives embedded within other
9
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
contracts or securities, and hedging activities. Accordingly, all
derivatives, whether stand-alone or embedded within other contracts or
securities, are carried in the Company's Condensed Consolidated Statements
of Financial Condition at fair value, with changes in fair value recorded
in "Principal transactions" revenues. Designated hedged items in fair
value hedging relationships are marked for the risk being hedged, with
such changes also recorded in "Principal transactions" revenues.
Derivatives designated as cash flow hedges are carried at fair value. The
effective portion of the change in fair value on a derivative designated
as a cash flow hedge is reported in "Accumulated other comprehensive
income (loss)." The ineffective portion is reported in "Principal
transactions" revenues in the Condensed Consolidated Statements of Income.
Amounts that are reported in "Accumulated other comprehensive income
(loss)" are reclassified into earnings in the same period or periods
during which the hedged transaction affects earnings.
The Company follows SFAS No. 155, "Accounting for Certain Hybrid Financial
Instruments an amendment of FASB Statements No. 133 and 140." SFAS No. 155
permits companies to elect on an instrument-by-instrument basis, to apply
a fair value measurement to hybrid financial instruments that contain an
embedded derivative that would otherwise require bifurcation under SFAS
No. 133. As permitted, on December 1, 2006, the Company elected to apply a
fair value measurement to all existing hybrid financial instruments that
met the SFAS No. 155 definition. The Company also elected the fair value
measurement for certain qualifying hybrid financial instruments issued on
or after December 1, 2006. The Company's reason for electing to carry
these instruments on a fair value basis was to enable the Company to more
efficiently hedge these instruments and to simplify the accounting
process. Changes in fair value are reflected in "Principal transactions"
revenues in the Condensed Consolidated Statements of Income.
The Company follows FIN No. 39, "Offsetting Amounts Related to Certain
Contracts," and offsets assets and liabilities in the Condensed
Consolidated Statements of Financial Condition provided that the legal
right of offset exists under a master netting agreement. This includes the
offsetting of payables or receivables relating to the fair value of cash
collateral received or paid associated with its derivative inventory, on a
counterparty by counterparty basis.
In April 2007, the FASB issued Staff Position ("FSP") FIN No. 39-1,
"Amendment of FASB Interpretation No. 39." FSP FIN No. 39-1 defines "right
of setoff" and specifies what conditions must be met for a derivative
contract to qualify for this right of setoff. It also addresses the
applicability of a right of setoff to derivative instruments and clarifies
the circumstances in which it is appropriate to offset amounts recognized
for those instruments in the Condensed Consolidated Statement of Financial
Condition. In addition, this FSP permits offsetting of fair value amounts
recognized for multiple derivative instruments executed with the same
counterparty under a master netting arrangement and fair value amounts
recognized for the right to reclaim cash collateral (a receivable) or the
obligation to return cash collateral (a payable) arising from the same
master netting arrangement as the derivative instruments. The provisions
of this FSP are consistent with the Company's current accounting practice.
The Company adopted the provisions of FSP FIN No. 39-1 on December 1,
2007. The adoption of FSP FIN No. 39-1 did not impact the condensed
consolidated financial statements of the Company.
Customer Transactions
Customer securities transactions are recorded on the Condensed
Consolidated Statements of Financial Condition on a settlement date basis,
which is generally three business days after trade date, while the related
commission revenues and expenses are recorded on a trade date basis.
Receivables from and payables to customers include amounts related to both
cash and margin transactions. Securities owned by customers, including
those that collateralize margin or other similar transactions, are
generally not reflected in the Condensed Consolidated Statements of
Financial Condition.
Mortgage Servicing Rights
Mortgage servicing rights ("MSRs") are included in "Other assets" on the
Condensed Consolidated Statements of Financial Condition. The Company
follows SFAS No. 156, "Accounting for Servicing of Financial Assets--an
amendment of FASB Statement No. 140," and measures servicing assets at
fair value. The fair value of MSRs is determined by using market-based
models that discount anticipated future net cash flows considering loan
10
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
prepayment predictions, interest rates, default rates, servicing costs,
current market data and other economic factors. Changes in the fair value
of MSRs are recorded in "Principal transactions" revenues in the Condensed
Consolidated Statements of Income.
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities--a replacement of
FASB Statement No. 125," to account for securitizations and other
transfers of financial assets and collateral. SFAS No. 140 establishes
accounting and reporting standards with a financial-components approach
that focuses on control. Under this approach, financial assets or
liabilities are recognized when control is established and derecognized
when control has been surrendered or the liability has been extinguished.
Control is deemed to be relinquished only when all of the following
conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee
is a QSPE or has the right to pledge or exchange the assets received; and
(3) the transferor has not maintained effective control over the
transferred assets. The Company derecognizes financial assets transferred
in securitizations provided that such transfer meets all of these
criteria.
Mortgage securitization transactions, net of certain direct costs, are
recorded in "Principal transactions" revenues in the Condensed
Consolidated Statements of Income.
Collateralized Securities Transactions
Transactions involving purchases of securities under agreements to resell
("reverse repurchase agreements") or sales of securities under agreements
to repurchase ("repurchase agreements") are treated as collateralized
financing transactions and are recorded at their contracted resale or
repurchase amounts plus accrued interest. Resulting interest income and
expense is generally included in "Principal transactions" revenues in the
Condensed Consolidated Statements of Income. Reverse repurchase agreements
and repurchase agreements are presented in the Condensed Consolidated
Statements of Financial Condition on a net-by-counterparty basis, where
permitted by generally accepted accounting principles. It is the Company's
general policy to take possession of securities or loans with a market
value in excess of the principal amount loaned plus the accrued interest
thereon, in order to collateralize reverse repurchase agreements.
Similarly, the Company is generally required to provide securities or
loans to counterparties to collateralize repurchase agreements. The
Company's agreements with counterparties generally contain contractual
provisions allowing for additional collateral to be obtained, or excess
collateral returned. It is the Company's policy to value collateral and to
obtain additional collateral, or to retrieve excess collateral from
counterparties, when deemed appropriate.
Securities borrowed and securities loaned are recorded based upon the
amount of cash collateral advanced or received. Securities borrowed
transactions facilitate the settlement process and require the Company to
deposit cash, letters of credit or other collateral with the lender. With
respect to securities loaned, the Company receives collateral in the form
of cash or other collateral. The amount of collateral required to be
deposited for securities borrowed, or received for securities loaned, is
an amount generally in excess of the market value of the applicable
securities borrowed or loaned. The Company monitors the market value of
securities borrowed and loaned, with excess collateral retrieved or
additional collateral obtained, when deemed appropriate.
Fixed Assets
Depreciation of property and equipment is provided by the Company on a
straight-line basis over the estimated useful life of the asset.
Amortization of leasehold improvements is provided on a straight-line
basis over the lesser of the estimated useful life of the asset or the
remaining life of the lease.
Goodwill and Identifiable Intangible Assets
The Company accounts for goodwill and identifiable intangible assets under
the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." In
accordance with this guidance, the Company does not amortize goodwill, but
amortizes identifiable intangible assets over their useful lives. Goodwill
is tested at least annually for impairment and identifiable intangible
assets are tested for potential impairment whenever events or changes in
11
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
circumstances suggest that the carrying value of an asset or asset group
may not be fully recoverable in accordance with SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets." See Note 17,
"Subsequent Events," of Notes to the Condensed Consolidated Financial
Statements for further discussion.
Earnings Per Share
Earnings per share ("EPS") is computed in accordance with SFAS No. 128,
"Earnings Per Share." Basic EPS is computed by dividing net income
applicable to common shares, adjusted for costs related to vested shares
under the Capital Accumulation Plan for Senior Managing Directors, as
amended and restated ("CAP Plan"), as well as the effect of the redemption
of preferred stock, by the weighted average number of common shares
outstanding. Common shares outstanding includes vested units issued under
certain stock compensation plans, which will be distributed as shares of
common stock. Diluted EPS includes the determinants of basic EPS and, in
addition, gives effect to dilutive potential common shares related to
stock compensation plans.
Stock-Based Compensation
The Company follows SFAS No. 123 (R), "Share-Based Payment," to account
for its stock-based compensation plans. SFAS No. 123 (R) is a revision of
SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows."
SFAS No. 123 (R) eliminated the ability to account for share-based
compensation transactions using APB No. 25, and requires all share-based
payments to employees, including grants of employee stock options, to be
recognized in the financial statements using a fair value-based method.
Cash Equivalents
The Company has defined cash equivalents as liquid investments not held
for sale in the ordinary course of business with original maturities of
three months or less that are not part of the Company's trading inventory.
Income Taxes
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109"
("FIN No. 48"). FIN No. 48 clarifies the accounting for uncertainty in
income taxes recognized in an enterprise's financial statements in
accordance with SFAS No. 109. FIN No. 48 prescribes a recognition
threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. The Company adopted the provisions of FIN No.
48 in the first quarter of 2008. See Note 13, "Income Taxes," of the Notes
to Condensed Consolidated Financial Statements for a further discussion.
The Company and certain of its subsidiaries file a U.S. consolidated
federal income tax return. The Company accounts for income taxes under the
provisions of SFAS No. 109, "Accounting for Income Taxes." Under SFAS No.
109, deferred income taxes are based on the net tax effects of temporary
differences between the financial reporting and tax bases of assets and
liabilities. In addition, deferred income taxes are determined by the
enacted tax rates and laws expected to be in effect when the related
temporary differences are expected to be reversed.
Translation of Foreign Currencies
Assets and liabilities denominated in foreign currencies are translated at
period end rates of exchange, while income statement items are translated
at daily average rates of exchange during the fiscal period. Gains or
losses on translation of the financial statements of foreign subsidiaries
from their respective functional currency to the U.S. dollar are included,
net of tax, on the Condensed Consolidated Statements of Comprehensive
Income. Gains or losses resulting from foreign currency transactions are
included in current earnings.
12
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Accounting and Reporting Developments
In March 2008, the FASB issued Statement No. 161, "Disclosures about
Derivative Instruments and Hedging Activities - an amendment of FASB
Statement No. 133." The Statement requires companies to provide enhanced
disclosures regarding derivative instruments and hedging activities. It
requires companies to better convey the purpose of derivative use in terms
of the risks that such company is intending to manage. Disclosures about
(a) how and why an entity uses derivative instruments, (b) how derivative
instruments and related hedged items are accounted for under SFAS No. 133
and its related interpretations, and (c) how derivative instruments and
related hedged items affect a company's financial position, financial
performance, and cash flows are required. This Statement retains the same
scope as SFAS No. 133 and is effective for fiscal years and interim
periods beginning after November 15, 2008. The Company is currently
assessing implementation plans and does not expect the adoption of SFAS
No. 161 to have a material impact, if any, on the Condensed Consolidated
Financial Statements.
In February 2008, the FASB issued a FASB Staff Position ("FSP") on
Accounting for Transfers of Financial Assets and Repurchase Financing
Transactions "FSP FAS 140-3." This FSP addresses the issue of whether or
not these transactions should be viewed as two separate transactions or as
one "linked" transaction. The FSP includes a "rebuttable presumption" that
presumes linkage of the two transactions unless the presumption can be
overcome by meeting certain criteria. The FSP will be effective for fiscal
years beginning after November 15, 2008 and will apply only to original
transfers made after that date; early adoption will not be allowed. The
Company is currently evaluating the impact, if any, the adoption of this
interpretation will have on the Company's Condensed Consolidated Financial
Statements.
In December 2007, the FASB issued Statement No. 141R, "Business
Combinations (a revision of Statement No. 141)." This Statement applies to
all transactions or other events in which an entity obtains control of one
or more businesses, including those combinations achieved without the
transfer of consideration. This Statement retains the fundamental
requirements in Statement No. 141 that the acquisition method of
accounting be used for all business combinations. This Statement expands
the scope to include all business combinations and requires an acquirer to
recognize the assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree at their fair values as of the
acquisition date. Additionally, SFAS No. 141R changes the way entities
account for business combinations achieved in stages by requiring the
identifiable assets and liabilities to be measured at their full fair
values. Additionally, contractual contingencies and contingent
consideration shall be measured at fair value at the acquisition date.
This Statement is effective on a prospective basis to business
combinations for which the acquisition date is on or after the beginning
of the first annual reporting period beginning on or after December 15,
2008. The Company is currently evaluating the impact, if any, that the
adoption of this Statement will have on the Condensed Consolidated
Financial Statements of the Company.
In December 2007, the FASB issued Statement No. 160, "Noncontrolling
Interests in Consolidated Financial Statements - an amendment of ARB No.
51". This Statement amends ARB No. 51 to establish accounting and
reporting standards for the noncontrolling interest in a subsidiary and
for the deconsolidation of a subsidiary. It clarifies that a
noncontrolling interest in a subsidiary is an ownership interest in the
consolidated entity that should be reported as equity in the consolidated
financial statements. Additionally, this Statement requires that
consolidated net income include the amounts attributable to both the
parent and the noncontrolling interest. This Statement is effective for
interim periods beginning on or after December 15, 2008. The Company is
currently evaluating the impact, if any, that the adoption of this
Statement will have on the Condensed Consolidated Financial Statements of
the Company.
In June 2007, the EITF issued EITF Issue No. 06-11 "Accounting for Income
Tax Benefits of Dividends on Share-Based Payment Awards." This issue
requires that the tax benefits related to dividend equivalents paid on
restricted stock units, which are expected to vest, be recorded as an
increase to additional paid-in capital. EITF 06-11 is effective
prospectively to the income tax benefits on dividends declared in fiscal
years beginning after December 15, 2007. The Company is currently
evaluating the impact, if any, the adoption of this issue may have on the
Company's Condensed Consolidated Financial Statements and does not expect
that the adoption of this issue will have a material impact on the
Condensed Consolidated Financial Statements.
13
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
In December 2007, the American Securitization Forum published a
Streamlined Foreclosure and Loss Avoidance Framework (ASF Framework) to
enable mortgage servicers to streamline their loss avoidance and loan
modification practices. The framework is an industry-developed,
recommended methodology that servicers of securitized subprime ARMS held
in QSPEs can use to fulfill their existing obligations to service those
loans in a faster and more efficient manner while maximizing recoveries
for the benefit of securitization investors. The ASF Framework applies to
all first lien subprime residential ARMs that have an initial fixed rate
period of 36 months or less that were originated between January 1, 2005
and July 31, 2007, and that have an initial interest rate reset between
January 1, 2008 and July 31, 2010.
Under the ASF Framework, the covered loans are divided into three
segments:
Segment 1 - includes current loans where the borrower is likely to be able
to refinance into any available mortgage product, including FHA, FHA
Secure or readily available mortgage industry products;
Segment 2 - includes current loans where the borrower is unlikely to be
able to refinance into any readily available mortgage industry
product; and
Segment 3 - includes loans where the borrower is not current as defined
above, demonstrating difficulty meeting the introductory rate.
The methodology prescribed in the ASF Framework applies to those loans in
Segment 2, in advance of the initial reset date. Those loans would be
eligible for a "fast track" loan modification under which the interest
rate would be kept at the existing rate, generally for five years
following the upcoming reset. The ASF Framework provides a methodology
which complies with relevant tax regulations and off-balance-sheet
accounting standards for QSPEs. Moreover, the SEC's Office of Chief
Accountant has concluded that it will not object to continued status as a
QSPE if Segment 2 subprime ARM loans are modified pursuant to the specific
screening criteria in the ASF Framework. The Company adopted the ASF
screening criteria in the first quarter of 2008, and believes that the
modification of loans in accordance with the ASF Framework does not impact
the off-balance-sheet accounting treatment of QSPEs that hold subprime ARM
loans.
While a uniform definition of subprime mortgages does not exist in the
marketplace, the Company defines subprime primarily as loans issued to
higher risk borrowers who do not qualify for the best market interest
rates because of their deficient credit history. Although FICO credit
scores and prior mortgage or rent payment histories are the main drivers
of a subprime designation, subprime also includes borrowers that have had
a recent foreclosure or bankruptcy. Other considerations include
borrower's reserve funds, residual household income and debt to income
ratio. The Company has not yet modified a significant percentage of loans
using the ASF Framework; accordingly, the impact to the Company's retained
interest has been immaterial.
14
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
2. FINANCIAL INSTRUMENTS
Financial instruments owned and financial instruments sold, but not yet
purchased, consisting of the Company's proprietary trading inventories, at
fair value, were as follows:
February 29, November 30,
(in millions) 2008 2007
-------------------------------------------------------------------------
FINANCIAL INSTRUMENTS OWNED, AT FAIR VALUE:
U.S. government and agency $ 21,310 $ 12,920
Other sovereign governments 2,394 672
Corporate equity and convertible debt 26,975 32,454
Corporate debt and other 23,511 26,330
Mortgages, mortgage- and asset-backed 38,186 46,141
Derivative financial instruments 28,728 19,725
--------------------------------------------------------------------------
$ 141,104 $ 138,242
==========================================================================
FINANCIAL INSTRUMENTS SOLD, BUT NOT YET PURCHASED,
AT FAIR VALUE:
U.S. government and agency $ 9,718 $ 4,563
Other sovereign governments 1,189 2,473
Corporate equity and convertible debt 18,700 18,843
Corporate debt and other 5,079 4,373
Mortgages, mortgage- and asset-backed 348 63
Derivative financial instruments 16,510 13,492
--------------------------------------------------------------------------
$ 51,544 $ 43,807
==========================================================================
As of February 29, 2008 and November 30, 2007, all financial instruments
owned that were pledged to counterparties where the counterparty has the
right, by contract or custom, to rehypothecate those securities are
classified as "Financial instruments owned and pledged as collateral, at
fair value" in the Condensed Consolidated Statements of Financial
Condition.
Financial instruments sold, but not yet purchased, at fair value represent
obligations of the Company to purchase the specified financial instrument
at the then current market price. Accordingly, these transactions result
in off-balance-sheet risk as the Company's ultimate obligation to
repurchase such securities may exceed the amount recognized in the
Condensed Consolidated Statements of Financial Condition.
Concentration Risk
The Company is subject to concentration risk by holding large positions or
committing to hold large positions in certain types of securities,
securities of a single issuer (including governments), issuers located in
a particular country or geographic area, or issuers engaged in a
particular industry. Positions taken and commitments made by the Company,
including underwritings, often involve substantial amounts and significant
exposure to individual issuers and businesses, including
non-investment-grade issuers. At February 29, 2008 and November 30, 2007,
the Company's most significant concentrations were related to United
States government securities, Federal National Mortgage Association and
Federal Home Loan Mortgage Corporation agency-backed securities, which are
included in the U.S. government and agency and Mortgages, mortgage-and
asset-backed inventory captions above. In addition, a substantial portion
of the collateral held by the Company for reverse repurchase agreements
consists of securities issued by the U.S. government and agencies.
Fair Value Measurements
The Company follows SFAS No. 157, "Fair Value Measurements." SFAS No. 157
applies to all financial instruments that are measured and reported on a
fair value basis. This includes those items currently reported in
"Financial instruments owned, at fair value" and "Financial instruments
sold, but not yet purchased, at fair value" on
15
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
the Condensed Consolidated Statements of Financial Condition as well as
financial instruments reported in "Other assets" and "Other liabilities"
captions that are reported at fair value below.
As defined in SFAS No. 157, fair value is the price that would be received
to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date. In determining fair
value, the Company uses various methods including market, income and cost
approaches. Based on these approaches, the Company often utilizes certain
assumptions that market participants would use in pricing the asset or
liability, including assumptions about risk and or the risks inherent in
the inputs to the valuation technique. These inputs can be readily
observable, market corroborated, or generally unobservable firm inputs.
The Company utilizes valuation techniques that maximize the use of
observable inputs and minimize the use of unobservable inputs. Based on
the observability of the inputs used in the valuation techniques the
Company is required to provide the following information according to the
fair value hierarchy. The fair value hierarchy ranks the quality and
reliability of the information used to determine fair values. Financial
assets and liabilities carried at fair value will be classified and
disclosed in one of the following three categories:
Level 1: Quoted market prices in active markets for identical assets or
liabilities.
Level 2: Observable market based inputs or unobservable inputs that are
corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
Level 1 primarily consists of financial instruments whose value is based
on quoted market prices such as exchange-traded derivatives and listed
equities. This category also includes financial instruments that are
valued using alternative approaches but for which the Company typically
receives independent external valuation information including U.S.
Treasuries, other U.S. Government and agency securities, and certain cash
instruments such as money market funds and certificates of deposit.
Level 2 includes financial instruments that are valued using models or
other valuation methodologies. These models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates,
loss severity, current market and contractual prices for the underlying
financial instruments, as well as other relevant economic measures.
Substantially all of these assumptions are observable in the marketplace,
can be derived from observable data or are supported by observable levels
at which transactions are executed in the marketplace. Financial
instruments in this category include sovereign debt, certain corporate
equities, corporate debt, certain U.S. agency and non-agency
mortgage-backed securities and non-exchange-traded derivatives such as
interest rate swaps.
Level 3 is comprised of financial instruments whose fair value is
estimated based on internally developed models or methodologies utilizing
significant inputs that are generally less readily observable. Included in
this category are distressed debt, non-performing mortgage-related assets,
certain performing residential and commercial mortgage loans, certain
mortgage- and asset-backed securities and residual interests, Chapter 13
and other credit card receivables from individuals, and complex derivative
structures including long-dated equity derivatives.
In determining the appropriate levels, the Company performs a detailed
analysis of the assets and liabilities that are subject to SFAS No. 157.
At each reporting period, all assets and liabilities for which the fair
value measurement is based on significant unobservable inputs are
classified as Level 3.
16
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Fair Value Measurements on a Recurring Basis as of February 29, 2008:
Balance as of
Impact of February 29,
(in millions) Level 1 Level 2 Level 3 Netting 2008
------------------------------------------------------------------------------------------------------------------------------
Financial Instruments Owned, at fair
value
U.S. government and agency $ 5,857 $ 15,453 $ -- $ -- $ 21,310
Other sovereign governments -- 2,394 -- -- 2,394
Corporate equity and convertible debt 19,798 6,830 347 -- 26,975
Corporate debt and other 14 18,373 5,124 -- 23,511
Mortgages, mortgage- and asset-backed -- 15,966 22,220 -- 38,186
-----------------------------------------------------------------------------------------------------------------------------
Total Non Derivative Trading Assets 25,669 59,016 27,691 -- 112,376
Derivative financial instruments (1) 202 272,356 6,276 (250,106 ) 28,728
-----------------------------------------------------------------------------------------------------------------------------
Total Financial Instruments
Owned, at fair value 25,871 331,372 33,967 (250,106 ) 141,104
-----------------------------------------------------------------------------------------------------------------------------
Other Assets(2) 391 1,607 3,383 -- 5,381
-----------------------------------------------------------------------------------------------------------------------------
Total Assets at fair value $ 26,262 $ 332,979 $ 37,350 $ (250,106 ) $ 146,485
=============================================================================================================================
Balance as of
Impact of February 29,
(in millions) Level 1 Level 2 Level 3 Netting 2008
------------------------------------------------------------------------------------------------------------------------------
Financial Instruments Sold But Not Yet
Purchased, at fair value
U.S. government and agency $ (9,718) $ -- $ -- $ -- $ (9,718)
Other sovereign governments -- (1,189) -- -- (1,189)
Corporate equity and convertible debt (16,554) (2,145) (1) -- (18,700)
Corporate debt and other -- (5,053) (26) -- (5,079)
Mortgages, mortgage- and asset-backed -- (348) -- -- (348)
------------------------------------------------------------------------------------------------------------------------------
Total Non Derivative Trading (26,272) (8,735) (27) -- (35,034)
Liabilities
Derivative financial instruments (1) (185) (254,426) (5,096) 243,197 (16,510)
------------------------------------------------------------------------------------------------------------------------------
Total Financial Instruments Sold But (26,457) (263,161) (5,123) 243,197 (51,544)
Not Yet Purchased, at fair value
------------------------------------------------------------------------------------------------------------------------------
Other Liabilities(3) (82) (7,715) (1,739) -- (9,536)
------------------------------------------------------------------------------------------------------------------------------
Total Liabilities at fair value $ (26,539) $ (270,876) $ (6,862) $ 243,197 $ (61,080)
==============================================================================================================================
(1) The derivatives trading inventory balances are reported on a gross
basis by level with a corresponding adjustment for netting.
(2) Other assets includes certain items such as alternative investments,
mortgage servicing rights, net assets of variable interest entities
and mortgage securitizations that did not meet the criteria for sale
treatment under SFAS No. 140.
(3) Other liabilities are primarily comprised of certain hybrid debt
issuances accounted for at fair value as elected in accordance with
SFAS No. 155.
As stated above SFAS No. 157 applies to all financial assets and
liabilities that are reported on a fair value basis. These valuations are
adjusted for various factors including credit risk. For applicable
financial assets carried at fair value, the credit standing of the
counterparties is analyzed and factored into the fair value measurement of
those assets. SFAS No. 157 states that the fair value measurement of a
liability must reflect the nonperformance risk of the entity. Therefore,
the impact of credit standing as well as any potential credit enhancements
(e.g. collateral) has been factored into the fair value measurement of
both financial assets and liabilities.
The non-derivative trading inventory category includes securities such as
U.S. Government and agency, other sovereign governments, corporate
equities, convertible debt, corporate debt, mortgages, mortgage- and
asset-backed, as well as certain other items. They are reported in
"Financial instruments owned, at fair value" and "Financial instruments
sold, but not yet purchased, at fair value" on the Condensed Consolidated
Statements of Financial Condition. The derivatives trading inventory
balances in the table above are reported on a gross basis by level with a
netting adjustment presented separately in the "Impact of Netting" column.
The Company often enters into different types of derivative contracts with
a single counterparty and these contracts are covered under one ISDA
master
17
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
netting agreement. The fair value of the individual derivative contracts
are reported gross in their respective levels based on the fair value
hierarchy.
Other assets and other liabilities represent those financial assets and
liabilities that the Company carries at fair value but are not included in
"Financial instruments owned, at fair value" and "Financial instruments
sold, but not yet purchased, at fair value" captions. Other assets
includes certain items such as alternative investments, mortgage servicing
rights, net assets of VIEs and mortgage securitizations that did not meet
the criteria for sale treatment under SFAS No. 140. Other liabilities is
primarily comprised of certain hybrid debt issuances accounted for at fair
value as elected in accordance with SFAS No. 155.
The following tables provide a reconciliation of the beginning and ending
balances for the major classes of assets and liabilities measured at fair
value using significant unobservable inputs (Level 3):
Level 3 Financial Assets and Liabilities
Three months ended February 29, 2008
Changes in
Unrealized
Gains/(Losses)
Ending relating to
Beginning Total Gains/ Purchases, Balance Assets and
Balance as of (Losses) Issuances, Transfers as of Liabilities
December 1, (Realized and Sales and In/Out of February held at the
(in millions) 2007 Unrealized) Settlements Level 3 29, 2008 reporting date
------------------------------------------------------------------------------------------------------------------------------
Non-Derivative Trading Assets $ 22,080 $ (1,435) $ 118 $ 6,928 $ 27,691 $ (1,527)
Non Derivative Trading Liabilities $ (58) $ (6) $ 23 $ 14 $ (27) $ 11
Derivative Trading Inventory (Net) $ (589) $ 763 $ 290 $ 716 $ 1,180 $ 812
Other Assets $ 3,758 $ (369) $ (165) $ 159 $ 3,383 $ (375)
Other Liabilities $ (1,254) $ 142 $ (47) $ (580) $ (1,739) $ 166
------------------------------------------------------------------------------------------------------------------------------
Non-Derivative Trading Assets and Liabilities
Realized and unrealized gains and losses on Level 3 assets and liabilities
are primarily reported in "Principal transactions" revenues in the
Condensed Consolidated Statements of Income. The Level 3 non-derivative
trading assets reflect an unrealized loss related to the mortgage related
inventory write-downs incurred during the first quarter of 2008. The
Company manages its exposure on a portfolio basis and regularly engages in
offsetting strategies in which financial instruments from one fair value
hierarchy level are used to economically offset the risk of financial
instruments in the same or different levels. Therefore, realized and
unrealized gains and losses reported as Level 3 may be offset by gains or
losses attributable to assets or liabilities classified in Level 1 or
Level 2.
Derivative Trading Inventory (Net)
The net derivative trading inventory resulted in a gain for the first
quarter of 2008. This gain was primarily driven by changes in interest
rates and credit spreads related to the Company's interest rate and credit
derivative products.
Transfers
The Company reviews the fair value hierarchy classifications on a monthly
basis. Changes in the observability of the valuation attributes may result
in a reclassification of certain financial assets or liabilities. Such
reclassifications are reported as transfers in/out of Level 3 at fair
value in the month in which the changes occur.
During the 2008 quarter, there were approximately $6.9 billion of
non-derivative trading assets transferred from level 2 to level 3. These
transfers were primarily related to mortgages and mortgage-backed
securities. The largest
18
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
contributors to the transfers were performing residential mortgages and
investment-grade mortgage-backed securities. Additionally, during the 2008
quarter, there were approximately $700 million of net derivative trading
assets which transferred from level 2 to level 3. These transfers were
primarily related to mortgage-related credit default swaps.
These transfers were driven by the continued market and liquidity
deterioration in the mortgage markets.
Fair Value Option
SFAS No. 159 provides a fair value option election that permits entities
to irrevocably elect to measure financial assets and liabilities (except
for those that are specifically scoped out of the Statement) at fair value
as the initial and subsequent measurement attribute, with changes in fair
value recognized in earnings as they occur. SFAS No. 159 permits the fair
value option election on an instrument-by-instrument basis at initial
recognition of an asset or liability or upon an event that gives rise to a
new basis of accounting for that instrument.
Effective December 1, 2007, the Company adopted SFAS No. 159 and elected
to apply the fair value option to liabilities of variable interest
entities and mortgage loan special purpose entities. Incorporated in the
SFAS No. 159 guidance are specific disclosure requirements related to the
hybrid financial instruments elected under SFAS No. 155.
In accordance with SFAS No. 155, the Company measures certain hybrid
financial instruments at fair value. These hybrid financial instruments
are recorded in "Long-term borrowings" and "Unsecured short-term
borrowings" in the Condensed Consolidated Statements of Financial
Condition. Changes in the fair value of these hybrid financial
instruments, including interest, are reflected in "Principal transactions"
revenues in the Condensed Consolidated Statements of Income. Gains
(losses) related to changes in the fair value of these hybrid financial
instruments classified as Long term borrowings amounted to $639 million
and $337 million for the three months ended February 29, 2008 and February
28, 2007 respectively, of which $305 million and $35 million were
attributable to the widening of the Company's credit spreads and were
derived from the Company's bond market spreads during the respective
periods. Gains (losses) related to changes in the fair value of these
hybrid financial instruments classified as Unsecured short-term borrowings
were not material for the three months ended February 29, 2008 and
February 28, 2007. As of February 29, 2008 and November 30, 2007, the
aggregate principal balance classified as Long term borrowings, exceeded
the aggregate fair value by $1.8 billion and $547 million, respectively.
As of February 29, 2008 and November 30, 2007, the aggregate principal
balance classified as Unsecured short-term borrowings, exceeded the
aggregate fair value by approximately $224 million and $203 million,
respectively. As a result of the events described in Note 17, "Subsequent
Events" of Notes to the Condensed Consolidated Financial Statements,
approximately $372 million in losses were recognized during the month
ended March 31, 2008, due to tightening of the Company's credit spreads.
3. DERIVATIVES AND HEDGING ACTIVITIES
The Company, in its capacity as a dealer in over-the-counter derivative
financial instruments and its proprietary market-making and trading
activities, enters into transactions in a variety of cash and derivative
financial instruments for proprietary trading and to manage its exposure
to market and credit risk. These risks include interest rate, exchange
rate, equity price, and commodity price risk. Derivative financial
instruments represent contractual commitments between counterparties that
derive their value from changes in an underlying interest rate, currency
exchange rate, index (e.g., Standard & Poor's 500 Index), reference rate
(e.g., London Interbank Offered Rate, or LIBOR), or asset value referenced
in the related contract. Some derivatives, such as futures contracts,
certain options and index-referenced warrants, can be traded on an
exchange. Other derivatives, such as interest rate and currency swaps,
caps, floors, collars, swaptions, equity swaps and options, credit
derivatives, structured notes and forward contracts, are negotiated in the
over-the-counter markets. Derivatives generate both on- and
off-balance-sheet risks depending on the nature of the contract.
Generally, these financial instruments represent commitments or rights to
exchange interest payment streams or currencies or to purchase or sell
other securities at specific terms at specified future dates. Option
contracts generally provide the holder with the right, but not the
obligation, to purchase or sell a financial instrument at a specific price
on or before an established date or dates. Financial
19
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
instruments sold, but not yet purchased may result in market and/or credit
risk in excess of amounts recorded in the Condensed Consolidated
Statements of Financial Condition.
Market Risk
Derivative financial instruments involve varying degrees of
off-balance-sheet market risk, whereby changes in the level or volatility
of interest rates, foreign currency exchange rates or market values of the
underlying financial instruments may result in changes in the value of a
particular financial instrument in excess of the amounts currently
reflected in the Condensed Consolidated Statements of Financial Condition.
The Company's exposure to market risk is influenced by a number of
factors, including the relationships among and between financial
instruments with off-balance-sheet risk, the Company's proprietary
securities, futures and derivatives inventories as well as the volatility
and liquidity in the markets in which the financial instruments are
traded. The Company mitigates its exposure to market risk by entering into
offsetting transactions, which may include over-the-counter derivative
contracts or the purchase or sale of interest-bearing securities, equity
securities, financial futures and forward contracts. In this regard, the
utilization of derivative instruments is designed to reduce or mitigate
market risks associated with holding dealer inventories or in connection
with arbitrage-related trading activities.
Derivatives Credit Risk
Credit risk arises from the potential inability of counterparties to
perform in accordance with the terms of the contract. At any point in
time, the Company's exposure to credit risk associated with counterparty
non-performance is generally limited to the net replacement cost of
over-the-counter contracts, net of the value of collateral held. Such
financial instruments are reported at fair value on a net-by-counterparty
basis pursuant to enforceable netting agreements. Exchange-traded
financial instruments, such as futures and options, generally do not give
rise to significant unsecured counterparty exposure due to margin
requirements of the exchanges, as well as the Company's internal margin
requirements, which may be greater than those prescribed by the individual
exchanges. Options written by the Company generally do not give rise to
counterparty credit risk since they obligate the Company (not its
counterparty) to perform.
The Company has controls in place to monitor credit exposures by assessing
the future creditworthiness of counterparties and limiting transactions
with specific counterparties. The Company also seeks to control credit
risk by following an established credit approval process, monitoring
credit limits and requiring collateral where appropriate.
Hedging Activity
To modify the interest rate characteristics of its long- and short-term
debt, the Company also engages in non-trading derivatives activities. The
Company has issued U.S. dollar- and foreign currency-denominated debt with
both variable- and fixed-rate interest payment obligations. The Company
has entered into interest rate swaps, primarily based on LIBOR, to convert
fixed-rate interest payments on its debt obligations into variable-rate
payments. In addition, for foreign currency debt obligations that are not
used to fund assets in the same currency, the Company has entered into
currency swap agreements that effectively convert the debt into U.S.
dollar obligations. Such transactions are accounted for as fair value
hedges.
These financial instruments are subject to the same market and credit
risks as those that are traded in connection with the Company's market
making and trading activities. The Company has similar controls in place
to monitor these risks.
SFAS No. 133, as amended by SFAS No. 138 and SFAS No. 149, establishes
accounting and reporting standards for stand-alone derivative instruments,
derivatives embedded within other contracts or securities and for hedging
activities. It requires that all derivatives, whether standalone or
embedded within other contracts or securities be carried on the Company's
Condensed Consolidated Statements of Financial Condition at fair value.
SFAS No. 133 also requires the value of items designated as being fair
value hedged to be adjusted for the risk being hedged, as defined in SFAS
No. 133, provided that the intent to hedge is fully documented. Any
resultant net change in value for both the hedging derivative and the
hedged item for the risk being hedged is recognized in earnings
immediately,
20
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
such net effect being deemed the "ineffective" portion of the hedge. The
gains and losses associated with the ineffective portion of the fair value
hedges are included in "Principal transactions" revenues in the Condensed
Consolidated Statements of Income. These amounts were immaterial for the
three months ended February 29, 2008.
The Company also engages in non-trading derivative activities to manage
commodity price risks resulting from exposures to changes in spot and
forward prices in electricity and natural gas. The Company actively
manages these risks with exchange traded futures, swaps, OTC swaps and
options. Certain of these transactions are accounted for as cash flow
hedges as defined in SFAS No. 133 which requires the effective portion of
the unrealized gain or loss on a derivative designated as a cash flow
hedge, as defined in SFAS No. 133, to be reported in "Accumulated other
comprehensive income" ("OCI") with the ineffective portion reported in
"Principal transactions" revenues in the Condensed Consolidated Statements
of Income. Amounts that are reported in OCI are reclassified into earnings
in the same period or periods during which the hedged transaction affects
earnings. The ineffective portion of cash flow hedges was deemed
immaterial for the three months ended February 29, 2008.
The net gain on derivative instruments designated in cash flow hedging
relationships recorded in OCI, net of tax, was $25 million at February 29,
2008. The net increase in fair value recorded in OCI in the first quarter
of 2008 was $35 million. The net gain in OCI is expected to be
reclassified into earnings as follows: $6 million in fiscal 2008 and the
remaining $19 million of gains within five years.
4. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES
Securitizations
The Company is a market leader in mortgage-backed securitization and other
structured financing arrangements. In the normal course of business, the
Company regularly securitizes commercial and residential mortgages,
consumer receivables and other financial assets. Securitization
transactions are generally treated as sales, provided that control has
been relinquished. In connection with securitization transactions, the
Company establishes special-purpose entities ("SPEs"), in which
transferred assets, including commercial and residential mortgages,
consumer receivables and other financial assets are sold to an SPE and
repackaged into securities or similar beneficial interests. Transferred
assets are accounted for at fair value prior to securitization. The
majority of the Company's involvement with SPEs relates to securitization
transactions meeting the definition of a QSPE under the provisions of SFAS
No. 140. Provided it has relinquished control over such assets, the
Company derecognizes financial assets transferred in securitizations and
does not consolidate the financial statements of QSPEs. For SPEs that do
not meet the QSPE criteria, the Company uses the guidance in FIN No. 46
(R) to determine whether the SPE should be consolidated.
In connection with these securitization activities, the Company may retain
interests in securitized assets in the form of senior or subordinated
securities or as residual interests. Retained interests in securitizations
are generally not held to maturity and typically are sold shortly after
the settlement of a securitization. The weighted average holding period
for retained interest positions in inventory at February 29, 2008 and
November 30, 2007 was approximately 210 days and 180 days, respectively.
These retained interests are included in "Financial instruments owned, at
fair value" in the Condensed Consolidated Statements of Financial
Condition and are carried at fair value. Consistent with the valuation of
similar inventory, fair value is determined by broker-dealer price
quotations and internal valuation pricing models that utilize variables
such as yield curves, prepayment speeds, default rates, loss severity,
interest rate volatilities and spreads. The assumptions used for pricing
variables are based on observable transactions in similar securities and
are further verified by external pricing sources, when available.
21
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company's securitization activities are detailed below:
Agency Other Mortgage-
(in billions) Mortgage-Backed and Asset-Backed Total
------------------------------------------------------------------------------------------------------------------------
Total securitizations
Three months ended February 29, 2008 $5.4 $3.9 $9.3
Three months ended February 28, 2007 $4.7 $21.3 $26.0
------------------------------------------------------------------------------------------------------------------------
The following table summarizes the Company's retained interests by rating as of
February 29, 2008 and November 30, 2007:
February 29, November 30,
(in billions) 2008 2007
--------------------------------------------------------------------------
Retained Interests:
AAA rated Agency Mortgage-Backed $2.6 $2.4
AAA rated Other Mortgage and Asset-Backed 2.9 2.7
--------------------------------------------------------------------------
Total AAA rated $5.5 $5.1
Other investment grade 1.4 1.6
Non-investment grade 1.3 1.3
--------------------------------------------------------------------------
Total retained interests $8.2 $8.0
==========================================================================
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the three months ended
February 29, 2008 and February 28, 2007:
Other
Agency Mortgage-
Mortgage- and Asset-
(in millions) Backed Backed Total
--------------------------------------------------------------------------
Cash flows received from retained interests
Three months ended February 29, 2008 $10.1 $1.2 $11.3
Three months ended February 28, 2007 $13.5 $78.3 $91.8
Cash flows from servicing
Three months ended February 29, 2008 $ - $5.1 $5.1
Three months ended February 28, 2007 $ - $4.5 $4.5
--------------------------------------------------------------------------
The Company is an active market maker in mortgage-backed securities and
therefore may retain interests in assets it securitizes, predominantly
highly rated or government agency-backed securities. The models employed
in the valuation of retained interests consider possible changes in
prepayment speeds in response to changes in future interest rates, as well
as potential credit losses. Prepayment speed changes are incorporated by
calibrating the distribution of possible future interest rates to the
observed levels of implied volatility in the market for interest rate
options and generating the corresponding cash flows for the securities
using prepayment models. Credit losses are considered through explicit
loss models for positions exposed to significant default risk in the
underlying collateral, and through option-adjusted spreads that also
incorporate additional factors such as liquidity and model uncertainty for
all positions. The models use discount rates that are based on the
Treasury curve, plus the option-adjusted spread. Key points on the
constant maturity Treasury curve at February 29, 2008 were 1.63% for
2-year Treasuries and 3.78% for 10-year Treasuries, and ranged from 1.57%
to 4.44%. The weighted average spread was 207 basis points and 561 basis
points for agency mortgage-backed securities and other mortgage- and
asset-backed securities, respectively, at February 29, 2008.
22
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Weighted key economic assumptions used in measuring the fair value of
retained interests in assets the Company securitized at February 29, 2008
were as follows:
Other
Agency Mortgage-
Mortgage- and Asset-
Backed Backed
------------------------------------------------------------------
Weighted average life (years) 5.9 3.1
Average prepayment speeds (annual rate) 8% - 36% 8% - 40%
Credit losses - 0.9% - 53%
------------------------------------------------------------------
The following hypothetical sensitivity analysis as of February 29, 2008
illustrates the potential adverse change in fair value of these retained
interests due to a specified change in the key valuation assumptions. The
interest rate changes represent a parallel shift in the Treasury curve.
This shift considers the corresponding effect of other variables,
including prepayments. The remaining valuation assumptions are changed
independently. Retained interests in securitizations are generally not
held to maturity and are typically sold shortly after the settlement of a
securitization. The Company considers the current and expected credit
profile of the underlying collateral in determining the fair value and
periodically updates the fair value for changes in credit, interest rate,
prepayment speeds and other pertinent market factors. Changes in portfolio
composition, updates to loss and prepayment models, and changes in the
level of interest rates and market prices for retained interests, can
combine to produce significant changes in the sensitivities reported even
if aggregate market values do not change significantly. Actual credit
losses on retained interests have not been significant.
Other
Agency Mortgage-
Mortgage- and Asset-
(in millions) Backed Backed
------------------------------------------------------------------
Interest rates
Impact of 50 basis point adverse change $ (78) (113)
Impact of 100 basis point adverse change (167) (232)
------------------------------------------------------------------
Prepayment speeds
Impact of 10% adverse change (5) (33)
Impact of 20% adverse change (10) (58)
------------------------------------------------------------------
Credit losses
Impact of 10% adverse change (18) (161)
Impact of 20% adverse change (36) (294)
------------------------------------------------------------------
The above table should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the table. Changes in fair value based on adverse variations
in assumptions generally cannot be extrapolated because the relationship
of the change in assumptions to the change in fair value is not usually
linear. In addition, the table does not consider the change in fair value
of offsetting positions, which would generally offset the changes detailed
in the table, nor does it consider any corrective action that the Company
may take in response to changes in these conditions. The impact of
offsetting positions is not presented because these positions are
established on a portfolio level and allocating the impact would not be
practicable.
Mortgage Servicing Rights
In the normal course of business, the Company originates and purchases
conforming and non-conforming, conventional fixed-rate and adjustable-rate
residential mortgage loans and sells such loans to investors. In
connection with these activities, the Company may retain MSRs that entitle
the Company to a future stream of cash flows based on the contractual
servicing fee. In addition, the Company may purchase and sell MSRs.
The Company follows SFAS No. 156 and carries its MSRs at fair value, with
changes in fair value reported in earnings.
23
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The determination of fair value of the Company's MSRs requires management
judgment because they are not actively traded. The determination of fair
value for MSRs requires valuation processes which combine the use of
discounted cash flow models and extensive analysis of current market data
to arrive at an estimate of fair value. The cash flow and prepayment
assumptions used in the Company's discounted cash flow model are based on
empirical data drawn from the historical performance of the Company's MSRs
adjusted to reflect current Market conditions, which the Company believes
are consistent with assumptions used by market participants valuing
similar MSRs. The key risks and therefore the key assumptions used in the
valuation of MSRs include mortgage prepayment speeds and the discount
rates. These variables can, and generally will, change from quarter to
quarter as market conditions and projected interest rates change. The
Company mitigates the income statement effect of changes in fair value of
MSRs by entering into economic offsetting transactions.
At February 29, 2008, the key economic assumptions and the sensitivity of
the current fair value of MSRs to immediate changes in those assumptions
were as follows:
February 29,
(in millions) 2008
--------------------------------------------------------------------------
Fair value of MSRs $ 771
Weighted average constant prepayment rate (CPR) 10.7%
Impact on fair value of:
10% adverse change $ (30)
20% adverse change (51)
Weighted average discount rate 13.3%
Impact on fair value of:
10% adverse change $ (24)
20% adverse change (46)
Weighted average constant default rate (CDR) 7.7%
Impact on fair value of:
10% adverse change $ (25)
20% adverse change (48)
--------------------------------------------------------------------------
The above table should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the table. Changes in fair value based on adverse variations
in assumptions generally cannot be extrapolated because the relationship
of the change in assumptions to the change in fair value is not usually
linear. In addition, the table does not consider the change in fair value
of offsetting positions, which would generally offset the changes detailed
in the table, nor does it consider any corrective action that the Company
may take in response to changes in these conditions. The impact of
offsetting positions is not presented because these positions are
established on a portfolio level and allocating the impact would not be
practicable.
MSRs are included in "Other assets" on the Condensed Consolidated
Statements of Financial Condition and are carried at fair value in
accordance with SFAS No. 156. The Company's MSRs activities for the three
months ended February 29, 2008 and February 28, 2007 were as follows:
--------------------------------------------------------------------------
February 29, February 28,
(in millions) 2008 2007
--------------------------------------------------------------------------
Balance, beginning of period $ 833 $ 502
Additions 2 112
Paydowns (23) (39)
Changes in fair value resulting from
changes in valuation inputs/assumptions (41) 5
--------------------------------------------------------------------------
Balance, end of period $ 771 $ 580
==========================================================================
24
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
5. VARIABLE INTEREST ENTITIES AND MORTGAGE LOAN SPECIAL PURPOSE ENTITIES
The Company regularly creates or transacts with entities that may be
variable interest entities (VIEs). These entities are an essential part of
the Company's securitization, asset management and structured finance
businesses. In addition, the Company purchases and sells financial
instruments that may be variable interests. The Company follows the
guidance in FIN No. 46(R) and consolidates those VIEs in which the Company
is the primary beneficiary.
The Company may perform various functions, including acting as the seller,
servicer, investor, structurer or underwriter in securitization
transactions. These transactions typically involve entities that are
considered to be QSPEs, as defined in SFAS No. 140. QSPEs are exempt from
the requirements of FIN No. 46 (R). For securitization vehicles that do
not qualify as QSPEs, the holders of the beneficial interests have no
recourse to the Company, only to the assets held by the related VIE. In
certain of these VIEs, the Company could be determined to be the primary
beneficiary through its ownership of certain beneficial interests, and
would, therefore, be required to consolidate the assets and liabilities of
the VIE.
The Company has mortgage securitizations that did not meet the criteria
for sale treatment under SFAS No. 140, including transactions where the
retained call option did not meet the definition of a clean up call under
SFAS No. 140. As such, the Company continues to carry the assets and
liabilities from these transactions on its Condensed Consolidated
Statements of Financial Condition.
The Company acts as portfolio manager and/or underwriter in several
collateralized debt obligation and collateralized loan obligation
transactions. In these transactions, the Company establishes a trust that
purchases a portfolio of assets and issues trust certificates that
represent interests in the portfolio of assets. The holders of the trust
certificates have recourse only to the underlying assets of the trusts and
not to the Company's other assets. In addition, the Company may receive
variable compensation for managing the portfolio and may also retain
certain trust certificates. In certain of these transactions, these
interests result in the Company becoming the primary beneficiary of these
entities.
The Company establishes and operates funds for the benefit of its
employees. These funds are considered to be VIEs of which the Company is
the primary beneficiary.
The Company has made investments in entities that own power plants.
Certain entities are VIEs of which the Company is the primary beneficiary.
The following table sets forth the Company's total assets and maximum
exposure to loss associated with its significant variable interests in
consolidated VIEs and securitizations that did not qualify for sale
treatment. This information is presented based on principal business
activity.
As of February 29, 2008 As of November 30, 2007
------------------------------------------------------------------------------------------------------------------------------
Maximum Maximum
Exposure Exposure
(in millions) VIE Assets to Loss (1) VIE Assets to Loss (1)
------------------------------------------------------------------------------------------------------------------------------
Mortgage Securitizations $ 27,322 $ 2,522 $ 30,313 $ 2,075
Collateralized Debt
and Loan Obligations 1,639 173 2,150 297
Employee Funds(2) 625 429 650 445
Energy Investments 405 128 440 131
------------------------------------------------------------------------------------------------------------------------------
Total $ 29,991 $ 3,252 $ 33,553 $ 2,948
------------------------------------------------------------------------------------------------------------------------------
(1) Represents the fair value of the Company's interest in these
entities.
(2) Maximum exposure to loss includes loans the Company has made
to employees who participate in the funds, for which the
Company is in a second loss position.
The Company also owns significant variable interests in several VIEs
related to collateralized debt obligations and collateralized loan
obligations for which the Company is not the primary beneficiary and
therefore does not consolidate these entities. In aggregate, these VIEs
had assets of approximately $5.8 billion and $11.5 billion at
25
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
February 29, 2008 and November 30, 2007, respectively. At February 29,
2008 and November 30, 2007, the Company's maximum exposure to loss from
these entities was approximately $61 million and $112 million,
respectively, which represents the fair value of its interests and are
included in "Financial instruments owned, at fair value" in the Condensed
Consolidated Statements of Financial Condition.
The Company purchases and sells interests in entities that may be deemed
to be VIEs in its market-making capacity in the ordinary course of
business. As a result of these activities, it is reasonably possible that
such entities may be consolidated or deconsolidated at various points in
time. Therefore, the Company's variable interests included above may not
be held by the Company in future periods.
6. COLLATERALIZED FINANCING ARRANGEMENTS
The Company enters into secured borrowing and lending agreements to obtain
collateral necessary to effect settlements, finance inventory positions,
meet customer needs or re-lend as part of its dealer operations.
The Company receives collateral under reverse repurchase agreements,
securities borrowing transactions, derivative transactions, customer
margin loans and other secured money-lending activities. In many
instances, the Company is also permitted by contract or custom to
rehypothecate securities received as collateral. These securities may be
used to secure repurchase agreements, enter into securities lending or
derivative transactions or cover short positions.
At February 29, 2008 and November 30, 2007, the fair value of securities
received as collateral by the Company that can be repledged, delivered or
otherwise used was approximately $303 billion and $280 billion,
respectively. Of these securities received as collateral, those with a
fair value of approximately $211 billion and $189 billion were delivered,
repledged or otherwise used at February 29, 2008 and November 30, 2007,
respectively.
The Company also pledges financial instruments owned to collateralize
certain financing arrangements and permits the counterparty to pledge or
rehypothecate the securities. These securities are recorded as "Financial
instruments owned and pledged as collateral, at fair value" in the
Condensed Consolidated Statements of Financial Condition. The carrying
value of securities and other inventory positions owned that have been
pledged or otherwise encumbered to counterparties where those
counterparties do not have the right to sell or repledge was approximately
$54 billion and $65 billion at February 29, 2008 and November 30, 2007,
respectively.
7. SHORT-TERM BORROWINGS
The Company obtains unsecured short-term borrowings through the issuance
of commercial paper, bank loans, medium term notes and other borrowings.
In addition, the Company obtains secured short-term borrowings primarily
through master notes and secured bank loans. A master note is an agreement
under which a lender may make one or more loans to a borrower, the
repayment obligation of which is reflected in a promissory note to the
lender. In the case of secured master notes, these agreements are secured
by collateral. The interest rates on such short-term borrowings reflect
market rates of interest at the time of the transactions.
The Company's short-term borrowings at February 29, 2008 and November 30,
2007 consisted of the following:
February 29, November 30,
(in billions) 2008 2007
-------------------------------------------------------------------------
Commercial paper $ 3.9 $ 3.9
Bank loans 1.7 3.1
Medium term notes 0.5 1.9
Other borrowings 2.4 2.7
-------------------------------------------------------------------------
Total unsecured short-term borrowings 8.5 11.6
-------------------------------------------------------------------------
Secured borrowings 7.8 12.4
-------------------------------------------------------------------------
Total short-term borrowings $ 16.3 $ 24.0
=========================================================================
26
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Committed Credit Facilities
As of February 29, 2008, the Company had a committed revolving credit
facility ("Facility") totaling $2.9 billion, which permitted borrowing on
a secured basis by the Parent Company, BSSC, BSIL and certain other
subsidiaries. The Facility terminated on April 7, 2008. There were no
borrowings outstanding under the Facility at February 29, 2008 or on the
date of termination.
The Company has a $1.50 billion committed revolving securities repo
facility ("Repo Facility"), which permits borrowings secured by a broad
range of collateral under a repurchase arrangement by the Parent Company,
BSIL, BSIT and BSB and BS Forex. The Repo Facility contains financial
covenants that require, among other things, maintenance of specified
levels of stockholders' equity of the Company. The Repo Facility
terminates in August 2008, with all repos outstanding at that date payable
no later than August 2009. There were no borrowings outstanding under the
Repo Facility at February 29, 2008.
The Company has a $350 million committed revolving credit facility ("Pan
Asian Facility"), which permits borrowing on a secured basis by the Parent
Company, BSSC, Bear Stearns Japan Limited ("BSJL"), and BSIL. The Pan
Asian Facility contains financial covenants that require, among other
things, maintenance of specified levels of stockholders' equity of the
Company and net capital of BSSC. The Pan Asian Facility terminates in
December 2008 with all loans outstanding at that date payable no later
than December 2009. There were no borrowings outstanding under the Pan
Asian Facility at February 29, 2008.
As of February 29, 2008, the Company had a $450 million committed
revolving credit facility ("Tax Lien Facility"), which permitted borrowing
on a secured basis by the Parent Company, Plymouth Park Tax Services and
Madison Tax Capital LLC. The Tax Lien Facility terminated in March 2008.
There were no borrowings outstanding under the Tax Lien Facility at
February 29, 2008 or on the date of termination.
As of February 29, 2008, the Company had a committed revolving credit
facility ("AAA Facility") totaling $750 million, which permits borrowing
on an unsecured basis by Bear Stearns Financial Products ("BSFP"). Under
the AAA Facility, BSFP may borrow up to the committed amount in the event
of: (i) a Bankruptcy Event, as defined, at The Bear Stearns Companies
Inc.; (ii) the downgrade of The Bear Stearns Companies Inc.'s short term
debt rating to A-2 by S&P or to P-2 by Moody's; (iii) the failure of Bear
Stearns Capital Markets to post collateral with or make payments to BSFP
in accordance with BSFP's Operating Guidelines; (iv) the failure of BSFP
to meet the capital requirements required by its Operating Guidelines; or
(v) the downgrade of BSFP's counterparty credit rating below A by S&P or
below A2 by Moody's. The AAA Facility terminates on April 25, 2008, with
all loans outstanding at that date payable no later than April 2009. There
were no borrowings outstanding under the AAA Facility at February 29,
2008.
The Company also maintains a series of committed credit facilities, which
permit borrowing on a secured basis, to support liquidity needs for the
financing of investment-grade and non-investment-grade corporate loans,
residential mortgages, commercial mortgages, listed options and whole
loans. The facilities are expected to be drawn from time to time and
expire at various dates, the longest of such periods ending in fiscal
2008. All of these facilities contain a term-out option of one year or
more for borrowings outstanding at expiration. The banks providing these
facilities are committed to provide up to an aggregate of approximately
$6.7 billion. At February 29, 2008, the borrowings outstanding under these
committed credit facilities were $3.3 billion.
27
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
8. LONG-TERM BORROWINGS
The Company's long-term borrowings (which have original maturities of at
least 12 months) at February 29, 2008 and November 30, 2007 consisted of
the following:
February 29, November 30,
(in billions) 2008 2007
--------------------------------------------------------------------------
Fixed rate notes due 2008 to 2047 $ 32.5 $ 28.7
Floating rate notes due 2008 to 2046 30.3 31.3
Index/equity/credit-linked notes 9.0 8.5
--------------------------------------------------------------------------
Total long-term borrowings $ 71.8 $ 68.5
==========================================================================
The Company's long-term borrowings include fair value adjustments in
accordance with SFAS No. 133, hybrid financial instruments accounted for
at fair value as elected under SFAS No. 155, as well as $263 million of
junior subordinated deferrable interest debentures ("Debentures"). The
Debentures will mature on May 15, 2031; however, effective May 15, 2006,
the Company, at its option, may redeem the Debentures. The Debentures are
reflected in the table at their contractual maturity dates. During the
three months ended February 29, 2008, the Company issued and
retired/repurchased $4.4 billion and $3.5 billion of long-term borrowings,
respectively. The weighted average maturity of the Company's long-term
borrowings, based upon stated maturity dates, was approximately 4.6 years
and 4.3 years at February 29, 2008 and November 30, 2007, respectively.
9. STOCKHOLDERS' EQUITY - RSU TRUST
In connection with the Company's deferred compensation plans, during the
first quarter of fiscal 2008, the Company established an irrevocable
grantor trust (the "RSU Trust") for the purpose of holding shares of
common stock of the Company underlying awards granted to selected
employees and certain key executives under The Bear Stearns Companies Inc.
Capital Accumulation Plan for Senior Managing Directors and The Bear
Stearns Companies Inc. Restricted Stock Unit Plan. During the first
quarter, the company transferred 27.3 million treasury shares to the RSU
Trust. In accordance with EITF Issue No. 97-14, "Accounting for Deferred
Compensation Arrangements where Amounts Earned Are Held in a Rabbi Trust
and Invested," assets of the RSU Trust are consolidated and both the
shares held by the RSU Trust and the related deferred compensation
obligation are recorded in equity. Shares issued to the RSU Trust are
recorded in "Shares held in RSU trust" and obligations under deferred
compensation plans are recorded in "Employee stock compensation plans,"
both at an amount equal to the original amount of the compensation
deferred (fair value of the deferred stock award at the date of grant) in
the Condensed Consolidated Statements of Financial Condition. Changes in
fair value of amounts owed to employees are not recognized. Shares
transferred to the RSU Trust do not affect the total number of shares used
in the calculation of basic and diluted earnings per share. Accordingly,
the RSU Trust has no effect on total equity, net income, book value per
share or earnings per share.
28
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
10. EARNINGS PER SHARE
Basic EPS is computed by dividing net income applicable to common shares,
adjusted for costs related to vested shares under the CAP Plan, as well as
the effect of the redemption of preferred stock, by the weighted average
number of common shares outstanding. Common shares outstanding includes
vested units issued under certain stock compensation plans, which will be
distributed as shares of common stock. Diluted EPS includes the
determinants of basic EPS and, in addition, gives effect to dilutive
potential common shares related to stock compensation plans.
The computations of basic and diluted EPS are set forth below:
Three Months Ended
--------------------------------------------------------------------------------------------------
February 29, February 28,
(in millions, except per share amounts) 2008 2007
--------------------------------------------------------------------------------------------------
Net income $ 115 $ 554
Preferred stock dividends (5) (6)
Income adjustment (net of tax) applicable to deferred
compensation arrangements-vested shares 5 15
--------------------------------------------------------------------------------------------------
Net earnings used for basic EPS 115 563
Income adjustment (net of tax) applicable to deferred
compensation arrangements-nonvested shares 4 9
--------------------------------------------------------------------------------------------------
Net earnings used for diluted EPS $ 119 $ 572
==================================================================================================
Total basic weighted average common
shares outstanding (1) 129 133
--------------------------------------------------------------------------------------------------
Effect of dilutive securities:
Employee stock options 2 7
CAP and restricted units 8 10
--------------------------------------------------------------------------------------------------
Dilutive potential common shares 10 17
--------------------------------------------------------------------------------------------------
Weighted average number of common shares 139 150
outstanding and dilutive potential common shares
==================================================================================================
Basic EPS $ 0.89 $ 4.23
Diluted EPS $ 0.86 $ 3.82
==================================================================================================
(1) Includes approximately 12 million and 13 million vested units for
the three months ended February 29, 2008 and February 28, 2007,
respectively, issued under stock compensation plans which will be
distributed as shares of common stock.
(2) Options to purchase approximately 8 million shares of common stock
at prices ranging from $87.68 to $165.32 were outstanding but were
not included in the computation of diluted EPS because the exercise
price was greater than the average market price of the common stock.
11. REGULATIONS
The Company is regulated by the SEC as a consolidated supervised entity
("CSE"). As a CSE, the Company is subject to group-wide supervision and
examination by the SEC and is required to compute allowable capital and
allowances for market, credit and operational risk on a consolidated
basis. As of February 29, 2008, the Company was in compliance with the CSE
capital requirements.
Bear Stearns and BSSC are registered broker-dealers and futures commission
merchants and, accordingly, are subject to Rule 15c3-1 under the Exchange
Act ("Net Capital Rule") and Rule 1.17 under the Commodity Futures Trading
Commission. Bear Stearns uses Appendix E of the Net Capital Rule
("Appendix E"), which establishes alternative net capital requirements for
broker-dealers that are part of consolidated supervised entities. Appendix
E allows Bear Stearns to calculate net capital charges for market risk and
derivatives-related credit risk based on mathematical models provided that
Bear Stearns holds tentative net capital in excess of $1 billion and net
capital in excess of $500 million. At February 29, 2008, Bear Stearns' net
capital of $2.89 billion exceeded the minimum requirement by $2.34
billion. Bear Stearns' net capital computation, as defined, includes $545
million, which is net capital of BSSC in excess of 5.5% of aggregate debit
items arising from customer transactions.
29
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
BSIL and BSIT, London-based broker-dealer subsidiaries, are subject to the
regulatory capital requirements of the United Kingdom's Financial Services
Authority.
BSB, an Ireland-based bank principally involved in the trading and sales
of fixed income products, is registered in Ireland and is subject to the
regulatory capital requirements of the Financial Regulator.
Bear Stearns Bank & Trust Company ("BSBTC") (formerly known as Custodial
Trust Company), a Federal Deposit Insurance Corporation ("FDIC") insured
New Jersey state chartered bank, offers a range of trust, lending,
deposit, and securities-clearing products and services. BSBTC provides the
Company with banking powers, including access to the securities and
funds-wire services of the Federal Reserve System. BSBTC is subject to the
regulatory capital requirements of the FDIC.
At February 29, 2008, Bear Stearns, BSSC, BSIL, BSIT, BSB and BSBTC were
in compliance with their respective regulatory capital requirements.
Certain other subsidiaries are subject to various securities regulations
and capital adequacy requirements promulgated by the regulatory and
exchange authorities of the countries in which they operate. At February
29, 2008, these other subsidiaries were in compliance with their
applicable local capital adequacy requirements.
12. COMMITMENTS AND CONTINGENCIES
In the ordinary course of business, the Company has commitments in
connection with various activities, the most significant of which are as
follows:
Leases
The Company occupies office space under leases that expire at various
dates through 2024. At February 29, 2008, future minimum aggregate annual
rentals payable under non-cancelable leases (net of subleases), including
383 Madison Avenue in New York City, for fiscal years ended 2008 through
2012 and the aggregate amount thereafter, are as follows:
(in millions)
-----------------------------------------
FISCAL YEAR
2008 (remaining) $ 91
2009 117
2010 118
2011 128
2012 95
Thereafter 640
-----------------------------------------
Total $ 1,189
=========================================
Lending - Related Commitments
In connection with certain of the Company's business activities, the
Company provides financing or financing commitments to investment-grade
and non-investment-grade companies in the form of senior and subordinated
debt, including bridge financing. Commitments have varying maturity dates
and are generally contingent on the accuracy and validity of certain
representations, warranties and contractual conditions applicable to the
borrower. Lending-related commitments to investment-grade borrowers
aggregated approximately $2.59 billion and $3.42 billion at February 29,
2008 and November 30, 2007, respectively. Of these amounts, approximately
$841 million and $952 million of the credit risk was offset at February
29, 2008 and November 30, 2007, respectively. Lending-related commitments
to non-investment-grade borrowers approximated $2.77 billion and $3.30
billion at February 29, 2008 and November 30, 2007, respectively. Of these
amounts, approximately $267 million and $220 million of the credit risk
was offset at February 29, 2008 and November 30, 2007, respectively.
30
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company also had contingent commitments to non-investment-grade
companies of approximately $110 million and $501 million as of February
29, 2008 and November 30, 2007, respectively. Generally, these commitments
are provided in connection with leveraged acquisitions. These commitments
are not indicative of the Company's actual risk because the borrower may
not be successful in the acquisition, the borrower may access the capital
markets instead of drawing on the commitment, or the Company's portion of
the commitment may be reduced through the syndication process.
Additionally, the borrower's ability to draw may be subject to there being
no material adverse change in either market conditions or the borrower's
financial condition, among other factors. These commitments generally
contain certain flexible pricing features to adjust for changing market
conditions prior to closing.
Private Equity-Related Investments and Partnerships
In connection with the Company's merchant banking activities, the Company
has commitments to invest in merchant banking and private equity-related
investment funds as well as commitments to invest directly in private
equity-related investments. At February 29, 2008 and November 30, 2007,
such commitments aggregated $667 million and $729 million, respectively.
These commitments will be funded, if called, through the end of the
respective investment periods, with the longest of such periods ending in
2020.
Underwriting
In connection with the Company's mortgage-backed securitizations and fixed
income and equity underwriting, the Company had commitments to purchase
new issues of securities aggregating $248 million and $652 million,
respectively, at February 29, 2008 and November 30, 2007.
Commercial and Residential Loans
The Company participates in the origination, acquisition, securitization,
servicing, financing and disposition of commercial and residential loans.
At February 29, 2008 and November 30, 2007, the Company had entered into
commitments to purchase or finance mortgage loans of $1.33 billion and
$2.83 billion, respectively.
Letters of Credit
At February 29, 2008 and November 30, 2007, the Company was contingently
liable for unsecured letters of credit of approximately $1.71 billion and
$1.42 billion, respectively, and secured (by financial instruments)
letters of credit of $1.55 billion and $1.33 billion, respectively. These
letters of credit are primarily used to provide collateral for securities
borrowed and to satisfy margin requirements at commodity/futures
exchanges.
Energy
In connection with its energy activities, the Company has entered into
contractual obligations (primarily obligations under tolling agreements,
net of re-tolling agreements) that require future cash payments. At
February 29, 2008 those contractual obligations, by maturity, were as
follows:
(in millions)
-----------------------------------------
FISCAL YEAR
2008 (remaining) $ 65
2009 91
2010 90
2011 260
2012 417
Thereafter 3,403
-----------------------------------------
Total $ 4,326
=========================================
31
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Other
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $189 million and $170 million, respectively, at February
29, 2008 and November 30, 2007.
With respect to certain of the commitments outlined above, the Company
utilizes various hedging strategies to actively manage its market, credit
and liquidity exposures. Additionally, since these commitments may expire
unused, the total commitment amount may not necessarily reflect the actual
future cash funding requirements.
Litigation
The Company is the sole defendant in an action commenced in the United
States Bankruptcy court for the Southern District of New York by the
Chapter 11 Trustee for Manhattan Investment Fund Limited ("MIFL"). The
complaint seeks to recover from the Company, among other things, certain
allegedly fraudulent transfers made by MIFL in the amount of $141 million
plus pre-judgment interest. The Company provided prime brokerage services
to MIFL prior to its bankruptcy. In January 2007, the Bankruptcy Court
granted the Trustee's motion for summary judgment on the fraudulent
transfer claims against the Company.
On appeal, the District Court affirmed the Bankruptcy Court's findings in
part, but also reversed in part, the Bankruptcy's Court's grant of summary
judgment to the Trustee, finding that a trial is necessary to make a
factual finding as to whether the Company acted in good faith with respect
to its receipt of the alleged fraudulent transfers. The Company believes
it has substantial defenses to the Trustee's claims.
The Company and certain subsidiaries have been named as defendants in
various investor lawsuits and FINRA arbitrations relating to the failure
of the Bear Stearns High Grade Structured Credit Strategies Master Fund,
Ltd (the "High Grade Fund") and the Enhanced Leverage Master Fund, Ltd.
(the "Enhanced Leverage Fund"), which were managed by Bear Stearns Asset
Management. Also, the Company and certain subsidiaries have been named as
defendants in a lawsuit by the Joint Voluntary Liquidators of the overseas
"feeder funds" of the High Grade Fund and Enhanced Leverage Fund. The High
Grade Fund had net investor contributions of approximately $775 million.
The Enhanced Fund had net investor contributions of approximately $1.08
billion. The relief being sought by the plaintiffs in these matters
includes specified and unspecified damages, costs and fees. The Company
believes it has substantial defenses to the claims asserted against it in
these proceedings. Additionally, the Company and its subsidiaries have
been the subject of various state and federal regulatory and law
enforcement inquiries, and a state administrative proceeding relating to
the Funds.
In the normal course of business, the Company has been named as a
defendant in various legal actions, including arbitrations, class actions
and other litigation. Certain of the legal actions include claims for
substantial compensatory and/or punitive damages or claims for
indeterminate amounts of damages. The Company is also involved in other
reviews, investigations and proceedings by governmental and
self-regulatory agencies regarding the Company's business, certain of
which may result in adverse judgments, settlements, fines, penalties,
injunctions or other relief. Because litigation is inherently
unpredictable, particularly in cases where claimants seek substantial or
indeterminate damages or where investigations and proceedings are in the
early stages, the Company cannot predict with certainty the loss or range
of loss related to such matters, how such matters will be resolved, when
they will ultimately be resolved, or what the eventual settlement, fine,
penalty or other relief might be. Consequently, the Company cannot
estimate losses or ranges of losses for matters where there is only a
reasonable possibility that a loss may have been incurred. Although the
ultimate outcome of these matters cannot be ascertained at this time, it
is the opinion of management, after consultation with counsel, that the
resolution of the foregoing matters will not have a material adverse
effect on the financial condition of the Company, taken as a whole; such
resolution may, however, have a material effect on the operating results
in any future period, depending on the level of income for such period.
See also Note 17, "Subsequent Events," of the Notes to Condensed
Consolidated Financial Statements.
The Company has provided reserves for such matters in accordance with SFAS
No. 5, "Accounting for Contingencies." The ultimate resolution may differ
materially from the amounts reserved.
32
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
13. INCOME TAXES
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109"
("FIN No. 48"). FIN No. 48 clarifies the accounting for uncertainty in
income taxes recognized in an enterprise's financial statements in
accordance with SFAS No. 109. FIN No. 48 prescribes a recognition
threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition
The Company adopted FIN No. 48 effective December 1, 2007 and recognized a
decrease to beginning retained earnings of approximately $90.7 million.
The gross amount of unrecognized tax benefits ("UTB") as of the date of
adoption of FIN No. 48 was approximately $578.4 million. Of this total,
approximately $371.4 million (net of federal benefit of state issues,
Competent Authority and foreign tax credit offsets) represents the amount
that, if recognized, would favorably affect the effective tax rate in
future periods.
The Company recognizes the accrual of interest and penalties, if any, to
UTB's in income tax expense. Interest accrued on UTB's as of December 1,
2007 was approximately $108.9 million.
The Company is under examination by the Internal Revenue Service ("IRS")
and other tax authorities. The other major exams include Japan, the United
Kingdom, and locations in which it has significant business operations,
such as New York State and City. The tax years under examination vary by
jurisdiction as follows:
Open Tax Years Open Tax Years
Examination Examination
Jurisdiction in progress not yet initiated
United States 2003-2005 2006-2007
United Kingdom 1999-2005 2006-2007
Japan 2000-2003 2004-2007
New York State 1999-2002 2003-2007
New York City 1997-2000 2001-2007
It is reasonably possible that these tax examinations will be completed
within the next 12 months. Based on the status of these examinations and
the protocol of finalizing audits by the relevant tax authorities, which
could include formal appeal and/or legal proceedings, it is not possible
to estimate the impact of any amount of such changes, if any, to
previously recorded uncertain tax positions.
The tax benefit associated with employee stock plans reduced taxes payable
by $254 million, $363 million and $426 million for 2007, 2006 and 2005,
respectively. These benefits have been reflected as additional
paid-in-capital in the accompanying Condensed Consolidated Statements of
Financial Condition, except for certain 2007, 2006 and 2005 stock awards.
On December 1, 2005, the Company adopted SFAS No. 123 (R). Under SFAS No.
123 (R) all share-based compensation is required to be recognized as an
expense in the year of grant with a corresponding tax benefit recorded to
the tax provision. See Note 17, "Subsequent Events," in the Notes to
Condensed Consolidated Financial Statements for a discussion of the impact
the merger agreement between the Company and JPMorgan Chase will have on
the realization of the deferred tax asset recorded in prior years.
14. GUARANTEES
In the ordinary course of business, the Company issues various guarantees
to counterparties in connection with certain derivative, leasing,
securitization and other transactions. FIN No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees
of Indebtedness of Others," requires the Company to recognize a liability
at the inception of certain guarantees and to disclose information about
its obligations under certain guarantee arrangements.
33
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The guarantees covered by FIN No. 45 include contracts that contingently
require the guarantor to make payments to the guaranteed party based on
changes related to an asset, a liability or an equity security of the
guaranteed party, contracts that contingently require the guarantor to
make payments to the guaranteed party based on another entity's failure to
perform under an agreement and indirect guarantees of the indebtedness of
others, even though the payment to the guaranteed party may not be based
on changes to an asset, liability or equity security of the guaranteed
party. In addition, FIN No. 45 covers certain indemnification agreements
that contingently require the guarantor to make payments to the
indemnified party, such as an adverse judgment in a lawsuit or the
imposition of additional taxes due to either a change in the tax law or an
adverse interpretation of the tax law.
The following table sets forth the maximum payout/notional amounts
associated with the Company's guarantees as of February 29, 2008:
Amount of Guarantee Expiration Per Period
---------------------------------------------------------------------
Less Than One to Three Three to Five Greater than
(in millions) One Year Years Years Five Years Total
------------------------------------------------------------------------------------------------------------------------------
Certain derivative contracts (notional)(1) $ 537,763 $ 515,993 $ 859,651 $ 742,403 $ 2,655,810
Municipal securities 3,131 58 - - 3,189
Residual value guarantee - - 570 - 570
------------------------------------------------------------------------------------------------------------------------------
(1) The gross carrying value of these derivatives approximated $130.9
billion as of February 29, 2008.
Derivative Contracts
The Company's dealer activities cause it to make markets and trade a
variety of derivative instruments. Certain derivative contracts that the
Company has entered into meet the accounting definition of a guarantee
under FIN No. 45. Derivatives that meet the FIN No. 45 definition of
guarantees include credit default swaps (whereby a default or significant
change in the credit quality of the underlying financial instrument may
obligate the Company to make a payment), put options, as well as floors,
caps and collars. Since the Company does not track the counterparties'
purpose for entering into a derivative contract, it has disclosed
derivative contracts that are likely to be used to protect against a
change in an underlying financial instrument, regardless of their actual
use.
On certain of these contracts, such as written interest rate caps and
foreign currency options, the maximum payout cannot be quantified since
the increase in interest rates and foreign exchange rates is not
contractually limited by the terms of the contracts. As such, the Company
has disclosed notional amounts as a measure of the extent of its
involvement in these classes of derivatives rather than maximum payout.
Notional amounts do not represent the maximum payout and generally
overstate the Company's exposure to these contracts.
In connection with these activities, the Company mitigates its exposure to
market risk by entering into a variety of offsetting derivative contracts
and security positions.
Municipal Securities
In 1997, the Company established a program whereby it created a series of
municipal securities trusts in which it has retained interests. These
trusts purchase fixed-rate, long-term, highly rated, insured or escrowed
municipal bonds financed by the issuance of trust certificates. Certain of
the trust certificates entitle the holder to receive future payments of
principal and variable interest and to tender such certificates at the
option of the holder on a periodic basis. The Company acts as placement
agent and as liquidity provider. The purpose of the program is to allow
the Company's clients to purchase synthetic short-term, floating-rate
municipal debt that does not otherwise exist in the marketplace. In the
Company's capacity as liquidity provider to the trusts, the maximum
exposure to loss at February 29, 2008 was approximately $3.2 billion,
which represents the outstanding amount of all trust certificates. This
exposure to loss is mitigated by the underlying municipal bonds held by
trusts. The underlying municipal bonds in the trusts are either AAA or AA
rated, insured or escrowed to maturity. Such bonds had a market value, net
of related offsetting positions, approximating $2.9 billion at February
29, 2008. See Note 17, "Subsequent Events," of the Notes to Condensed
Consolidated Financial Statements for a further discussion.
34
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Residual Value Guarantee
The Company has entered into an operating lease arrangement for its world
headquarters at 383 Madison Avenue in New York City (the "Synthetic
Lease"). Under the terms of the Synthetic Lease, the Company is obligated
to make monthly payments based on the lessor's underlying interest costs.
The Synthetic Lease expires on August 10, 2012 unless both parties agree
to a renewal prior to expiration. At the expiration date of the Synthetic
Lease, the Company has the right to purchase the building for the amount
of the then outstanding indebtedness of the lessor or to arrange for the
sale of the property with the proceeds of the sale to be used to satisfy
the lessor's debt obligation. If the sale of the property does not
generate sufficient proceeds to satisfy the lessor's debt obligation, the
Company is required to fund the shortfall up to a maximum residual value
guarantee. As of February 29, 2008, there was no expected shortfall and
the maximum residual value guarantee was approximately $570 million.
Indemnifications
The Company provides representations and warranties to counterparties in
connection with a variety of commercial transactions, including certain
asset sales and securitizations and occasionally indemnifies them against
potential losses caused by the breach of those representations and
warranties. To mitigate these risks with respect to assets being
securitized that have been originated by third parties, the Company seeks
to obtain appropriate representations and warranties from such third-party
originators upon acquisition of such assets. The Company generally
performs due diligence on assets purchased and maintains underwriting
standards for assets originated. The Company may also provide
indemnifications to certain counterparties to protect them in the event
additional taxes are owed or payments are withheld, due either to a change
in or adverse application of certain tax laws. These indemnifications
generally are standard contractual terms and are entered into in the
normal course of business. Generally, there are no stated or notional
amounts included in these indemnifications.
Maximum payout information under these indemnifications is not readily
available because of the number, size and lives of these transactions. In
implementing this accounting interpretation, the Company reviewed its
experience with the indemnifications on these structures. Based on such
experience, it is unlikely that these arrangements will have a material
impact on the Condensed Consolidated Financial Statements of the Company.
Other Guarantees
The Company is a member of numerous exchanges and clearinghouses. Under
the membership agreements, members are generally required to guarantee the
performance of other members. Therefore, if a member becomes unable to
satisfy its obligations to the clearinghouse, other members would be
required to meet these shortfalls. To mitigate these performance risks,
the exchanges and clearinghouses often require members to post collateral.
The Company's maximum potential liability under these arrangements cannot
be quantified. However, the potential for the Company to be required to
make payments under these arrangements is remote. Accordingly, no
contingent liability is recorded in the Condensed Consolidated Financial
Statements for these arrangements.
35
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
15. SEGMENT DATA
The Company operates in three principal segments -- Capital Markets,
Global Clearing Services and Wealth Management. These segments offer
different products and services and are managed separately as different
levels and types of expertise are required to effectively manage the
segments' transactions.
The Capital Markets segment is comprised of the institutional equities,
fixed income and investment banking areas. The Capital Markets segment
operates as a single integrated unit that provides the sales, trading and
origination effort for various fixed income, equity and advisory products
and services. Each of the three businesses work in tandem to deliver these
services to institutional and corporate clients.
Institutional equities consists of sales, trading and research, in areas
such as domestic and international equities, block trading,
over-the-counter equities, equity derivatives, energy and commodity
activities, risk and convertible arbitrage and specialist activities on
the New York Stock Exchange, American Stock Exchange and International
Securities Exchange. Fixed income includes sales, trading, origination and
research provided to institutional clients across a variety of products
such as mortgage- and asset-backed securities, corporate and government
bonds, municipal bonds, high yield products, including bank and bridge
loans, foreign exchange and interest rate and credit derivatives.
Investment banking provides services in capital raising, strategic advice,
mergers and acquisitions and merchant banking. Capital raising encompasses
the Company's underwriting of equity, investment grade, municipal and high
yield debt products.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to
clearing clients worldwide. Prime brokerage clients include hedge funds
and clients of money managers, short sellers and other professional
investors. Fully disclosed clients engage in either the retail or
institutional brokerage business.
The Wealth Management segment is composed of the PCS and asset management
areas. PCS provides high-net-worth individuals with an institutional level
of investment service, including access to the Company's resources and
professionals. Asset management manages equity, fixed income and
alternative assets for leading corporate pension plans, public systems,
endowments, foundations, multi-employer plans, insurance companies,
corporations, families and high-net-worth individuals in the United States
and abroad.
The three business segments comprise many business areas, with
interactions among each. Revenues and expenses include those that are
directly related to each segment. Revenues from intersegment transactions
are based upon specific criteria or agreed upon rates with such amounts
eliminated in consolidation. Individual segments also include revenues and
expenses relating to various items, including corporate overhead and
interest, which are internally allocated by the Company primarily based on
balance sheet usage or expense levels. The Company generally evaluates
performance of the segments based on net revenues and profit or loss
before provision for income taxes.
36
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Three Months ended
-----------------------------------------------
(in millions) February 29, 2008 February 28, 2007
- --------------------------------------------------------------------------------
NET REVENUES
Capital Markets
Institutional Equities $ 811 $ 513
Fixed Income 66 1,149
Investment Banking 159 303
- --------------------------------------------------------------------------------
Total Capital Markets 1,036 1,965
Global Clearing Services 253 276
Wealth Management
Private Client Services (1) 161 136
Asset Management 39 119
- --------------------------------------------------------------------------------
Total Wealth Management 200 255
Other (2) (10) (14)
- --------------------------------------------------------------------------------
Total net revenues $ 1,479 $ 2,482
================================================================================
PRE-TAX INCOME
Capital Markets $ 171 $ 736
Global Clearing Services 86 113
Wealth Management (42) 44
Other (3) (62) (58)
- --------------------------------------------------------------------------------
Total pre-tax income $ 153 $ 835
================================================================================
Three Months ended
-------------------------------------
February 29, 2008 February 28, 2007
-------------------------------------
(1) Private Client Services detail:
Gross revenues, before
transfer to Capital
Markets segment $ 183 $ 166
Revenue transferred
to Capital Markets segment (22) (30)
-------------------------------------
Private Client Services net
revenues $ 161 $ 136
=====================================
(2) Includes consolidation and elimination entries.
(3) Includes certain legal costs and costs related to the CAP Plan.
37
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
As of
------------------------------------------------------------------------
February 29, February 28,
(in billions) 2008 2007
------------------------------------------------------------------------
SEGMENT ASSETS
Capital Markets $ 244 $ 278
Global Clearing Services 124 101
Wealth Management 4 4
Other 27 12
------------------------------------------------------------------------
Total segment assets $ 399 $ 395
========================================================================
38
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
16. ASSET ACQUISITION
In connection with the acquisition of substantially all of the
power-related and natural gas assets comprising the power trading business
of Williams Power Company, Inc., an energy trading and marketing
subsidiary of The Williams Companies, Inc., which closed on November 8,
2007, the Company recorded intangible assets and intangible liabilities
based on contractual arrangements, at their estimated fair values. As of
February 29, 2008, the weighted average amortization period for intangible
assets and intangible liabilities was approximately 10.6 years and 13.3
years, respectively. The results of operations of the power-related assets
and liabilities acquired are included in the Company's Capital Markets
segment.
The estimated aggregate amortization expense for each of the five
succeeding fiscal years for intangible assets and intangible liabilities
were as follows:
------------------------------------------------------
(in millions) Intangible Intangible
Assets Liabilities
------------------------------------------------------
FISCAL YEAR
2008 (remaining) $ 83 $ 171
2009 98 129
2010 96 98
2011 64 74
2012 50 47
Thereafter 456 359
------------------------------------------------------
Total $ 847 $ 878
======================================================
17. SUBSEQUENT EVENTS
BACKGROUND OF THE MERGER
The Company experienced a significant liquidity crisis during the end of
the week of March 10, 2008 that seriously jeopardized its financial
viability and which raises substantial doubt about its ability to continue
as a going concern. As a result, on March 16, 2008, the Company and
JPMorgan Chase & Co. ("JPMorgan Chase") entered into an agreement and plan
of merger, and on March 24, 2008, entered into an amendment to the
agreement and plan of merger (as amended, the "Merger Agreement").
Pursuant to the Merger Agreement, each share of the Company's common stock
outstanding immediately prior to the merger will be exchanged for 0.21753
shares of JPMorgan Chase common stock. A summary of the Merger Agreement,
related transaction documents and the accounting implications are
described in more detail in the Transaction Documents and Accounting
Implications sections of this note.
In connection with the entry into the amendment to the Merger Agreement,
the Company and JPMorgan Chase entered into a share exchange agreement
under which JPMorgan Chase will purchase 95 million newly issued shares of
the Company's common stock, or 39.5% of the outstanding common stock of
the Company after giving effect to the issuance, in exchange for the
issuance of 20,665,350 shares of JPMorgan Chase common stock to the
Company and the entry by JPMorgan Chase into the amendment to the merger
agreement, an amended and restated guaranty agreement and the guaranty
agreement with the Federal Reserve Bank of New York ("New York Fed"). The
share exchange was completed on April 8, 2008.
Concurrent with the closing of the merger, the New York Fed will take,
through a limited liability company formed for this purpose, control of a
portfolio of $30 billion in assets of the Company based on the value of
the portfolio as of March 14, 2008. The assets will be funded by a $29
billion, 10-year term note from the New York Fed, and a $1
39
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
billion, 10-year subordinated note from JPMorgan Chase. The JPMorgan Chase
note is subordinated to the New York Fed loan and will bear the first $1
billion of any losses associated with the assets. Any funds remaining
after payment of the New York Fed loan, the JPMorgan Chase note and other
expenses of the limited liability company, will be paid to the New York
Fed.
TRANSACTION DOCUMENTS
Agreement and Plan of Merger
Upon the terms and subject to the conditions set forth in the Merger
Agreement, a wholly-owned subsidiary of JPMorgan Chase will merge with and
into the Company with the Company continuing as the surviving corporation
and as a wholly-owned subsidiary of JPMorgan Chase (the "Merger"). At the
effective time of the Merger, each share of Company common stock will be
converted into the right to receive 0.21753 of a share of JPMorgan Chase
common stock. Outstanding Company stock options and phantom stock units
will be converted into JPMorgan Chase equity awards, adjusted to reflect
the exchange ratio in the Merger. The Company and JPMorgan Chase have
agreed to consider providing holders of restricted stock units and capital
accumulation plan units with the right to elect, prior to completion of
the Merger, to have outstanding awards distributed in cash (rather than
stock) at the same time the units would have been settled absent such
election, and otherwise subject to the same terms and conditions in the
applicable plans and award agreements, as amended.
The Merger Agreement contains representations and warranties of Bear
Stearns and JPMorgan Chase relating to their respective businesses.
Pursuant to the Merger Agreement, the Company has agreed to operate within
its existing credit, principal, market and other risk limits and comply
with existing risk-related policies and procedures, subject to JPMorgan
Chase's right to oversee the Company's setting and changing of such
policies, procedures and limits. Subject to the continued effectiveness of
the Guaranty (as defined below), the Company has granted JPMorgan Chase
the right to oversee the business, operations and management of the
Company in its reasonable discretion. The Company also granted JPMorgan
Chase the rights to custody of, and to manage, a scheduled collateral pool
and related hedges, which rights were delegated to the New York Fed.
Additionally, the Company has agreed not to (i) solicit proposals relating
to alternative business combination transactions or (ii) subject to
certain exceptions, enter into discussions, or enter into any agreement,
concerning, or provide confidential information in connection with, any
proposals for alternative business combination transactions.
Consummation of the Merger is subject to the satisfaction of certain
conditions including, among other things, (i) approval and adoption of the
Merger Agreement by the Company's stockholders; (ii) registration and NYSE
listing of the common stock to be issued by JPMorgan Chase in the Merger;
(iii) absence of any order, injunction or decree preventing or making
illegal the consummation of the Merger; and (iv) receipt of specified
governmental and regulatory approvals.
The Merger Agreement contains certain termination rights for both the
Company and JPMorgan Chase. In the event the Company's stockholders do not
approve and adopt the Merger Agreement at the first stockholders meeting
called for that purpose, JPMorgan Chase will have the right to exercise an
option to purchase the Company's headquarters building for an amount equal
to $1.1 billion less assumed indebtedness and transfer costs. In addition,
JPMorgan Chase will also have the right to exercise such option following
the termination of the Merger Agreement under the following circumstances:
(i) JPMorgan Chase terminates the Merger Agreement because (A) the
Company's board of directors made any change of recommendation, (B) the
Company breached its no-solicitation and related obligations under the
Merger Agreement, or (C) the Company breached its obligations to hold a
meeting of its stockholders to approve and adopt the Merger Agreement, or
(ii) (A) JPMorgan Chase or the Company terminate the Merger Agreement
because both (x) the approval and adoption of the Merger Agreement by the
Company's stockholders has not been obtained and (y) 120 days have elapsed
from the date of such stockholders meeting (provided that the parties may
mutually agree to extend the 120-day period); (B) JPMorgan Chase
terminates the Merger Agreement because there has been an uncured breach
by the Company of any of the covenants or agreements or any of the
representations or warranties in the Merger Agreement that would cause the
failure of the closing conditions set forth in the Merger Agreement to be
satisfied; or (C) JPMorgan Chase or the Company terminates the Merger
Agreement because the merger has not been consummated on or before the
first anniversary of the date of the Merger Agreement, and prior to any
termination of the merger agreement described in this clause (ii) an
alternative proposal has been publicly announced or otherwise communicated
or made known to the
40
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Company and has not been irrevocably withdrawn. Upon the exercise of the
option to purchase the Company's headquarters building, the Company will,
upon the request of JPMorgan Chase, exercise its option to purchase the
headquarters building and take all action required to acquire the building
and simultaneously convey it to JPMorgan Chase.
The foregoing description of the Merger Agreement does not purport to be
complete and is qualified in its entirety by reference to the Merger
Agreement, which is filed as Exhibit 2.1 to the Company's Current Report
on Form 8-K filed on March 20, 2008 and March 24, 2008 (Amendment No. 1).
Beginning March 17, 2008, various stockholders of the Company filed
several purported class action lawsuits against the Company, its board of
directors and certain of the Company's present and former executive
officers. Among other things, these actions allege that the individual
defendants breached their fiduciary duties and obligations to the
Company's stockholders by agreeing to the proposed merger. Five of these
actions have been filed in the Supreme Court of the State of New York and
consolidated under the caption In re Bear Stearns Litigation. Two actions
have been filed in the Delaware Court of Chancery where plaintiffs have
filed a motion to consolidate their cases in Delaware. JPMorgan Chase is
named as a defendant in certain of these cases. In each of these actions,
plaintiffs seek to enjoin the proposed merger and enjoin JPMorgan Chase
from voting the 95 million shares acquired pursuant to the Share Exchange
Agreement (as defined below), other injunctive relief and an unspecified
amount of compensatory damages. On April 9, 2008, the Delaware Chancery
Court granted JPMorgan Chase's and the Company's motion to stay the
Delaware action in favor of the New York action, at least until the
preliminary injunction motion is resolved. The Delaware court also granted
plaintiffs' motion to consolidate their cases. Additionally, on April 10,
2008, an amended complaint was filed in a previously-filed shareholder
derivative suit naming the Company's directors and certain former and
present executive officers. This amended complaint seeks, among other
things, a declaration that the Merger Agreement is unlawful,
unenforceable, and seeks to enjoin the merger.
Share Exchange Agreement
On March 24, 2008, the Company and JPMorgan Chase, in connection with
entering into the amendment to the Merger Agreement, entered into a share
exchange agreement (the "Share Exchange Agreement"), under which JPMorgan
Chase will purchase 95 million newly issued shares of the Company's common
stock, or 39.5% of the outstanding shares of the Company's common stock
after giving effect to the issuance, in exchange for the issuance of
20,665,350 shares of JPMorgan Chase common stock to the Company and the
entry by JPMorgan Chase into the amendment to the merger agreement, an
amended and restated guaranty agreement and the guaranty in favor of the
New York Fed (each as described below). The share exchange was completed
on April 8, 2008.
The foregoing description of the Share Exchange Agreement does not purport
to be complete and is qualified in its entirety by reference to the Share
Exchange Agreement, which is filed as Exhibit 2.2 to the Company's Current
Report on Form 8-K filed on March 24, 2008.
Amended and Restated Guaranty Agreement
On March 24, 2008, JPMorgan Chase, in connection with the amendment to the
Merger Agreement, entered into an amended and restated guaranty agreement
(the "Guaranty"), effective retroactively from March 16, 2008, which
replaces the guaranty agreement entered into on March 16, 2008 in
connection with the Merger Agreement. Pursuant to the Guaranty, JPMorgan
Chase will guarantee certain liabilities of the Company and certain of its
operating subsidiaries (the "Guaranteed Bear Entities") to the extent such
liabilities arise prior to the end of the specified "Guaranty Period",
including (i) liabilities and obligations under revolving credit
facilities, letters of credit and letter of credit facilities, term loan
facilities, lines of credit or uncommitted loan facilities, in each case
whether secured or unsecured, of the Guaranteed Bear Entities, (ii)
brokerage and trading contract obligations of the Guaranteed Bear Entities
(including liabilities and obligations arising under prime brokerage
agreements and accounts, securities lending agreements, custodial and
carrying agreements, securities accounts and securities contracts,
commodity contracts, forward contracts, futures contracts, tolling
agreements, energy management agreements, repurchase or reverse repurchase
agreements, swap agreements, foreign exchange and currency contracts,
options or other derivatives, settlement or clearing agreements and
arrangements, margin loan agreements, other contracts or transactions
similar to any of the foregoing, any customary brokerage commission with
respect to
41
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
the foregoing, any contractual obligation to provide collateral or margin
in respect of any of the foregoing or any obligation under a guaranty of
any of the foregoing and (iii) obligations of the Guaranteed Bear Entities
to deliver cash, securities or other property to customers pursuant to
customary custody arrangements. The Guaranty Period will end (subject to
provision of further notice by JPMorgan Chase posted on its website at
least three days prior to the end of the Guaranty Period), no sooner than
the earliest to occur of (i) the date that is 120 days following the
failure of the Company's stockholders to approve and adopt the Merger
Agreement at a meeting of the Company's stockholders convened for that
purpose, (ii) the date that is 120 days following closing of the Merger
and (iii) the date of termination of the Merger Agreement.
The foregoing description of the Guaranty does not purport to be complete
and is qualified in its entirety by reference to the Guaranty, which is
filed as Exhibit 99.1 to the Company's Current Report on Form 8-K filed on
March 24, 2008.
Guarantee and Collateral Agreement
On March 24, 2008, JPMorgan Chase, in connection with the amendment to the
Merger Agreement and the Guaranty, entered into a guarantee and collateral
agreement (the "Guarantee and Collateral Agreement") with the Company and
certain of its subsidiaries (collectively, the "Collateral Parties")
pursuant to which the Collateral Parties agreed to guarantee the
obligations of each of them to repay to JPMorgan Chase (1) any loans or
other advances of credit by JPMorgan Chase and its affiliates to the
Company and its affiliates and (2) any amounts paid by JPMorgan Chase to
creditors of the Company and its affiliates under the Guaranty and the Fed
Guarantee (as defined below). Each of the Collateral Parties secured their
guarantee by granting a lien on substantially all of their respective
assets, subject to certain carve-outs.
The foregoing description of the Guarantee and Collateral Agreement does
not purport to be complete and is qualified in its entirety by reference
to the Guarantee and Collateral Agreement, which is filed as Exhibit 99.1
to the Company's Current Report on Form 8-K filed on March 28, 2008.
Fed Guaranty Agreement
On March 24, 2008, JPMorgan Chase, in connection with the amendment to the
Merger Agreement, entered into a guarantee in favor of the New York Fed
(the "Fed Guarantee"), pursuant to which JPMorgan Chase guaranteed certain
obligations of the Company and certain of its affiliates to the New York
Fed. Such guarantee will apply with respect to transactions entered into
prior to the termination of the Merger Agreement and may be terminated by
JPMorgan Chase with respect to transactions thereafter.
The foregoing description of the Fed Guaranty does not purport to be
complete and is qualified in its entirety by reference to the Fed
Guarantee, which is filed as Exhibit 99.2 to the Company's Current Report
on Form 8-K filed on March 24, 2008.
ACCOUNTING IMPLICATIONS
Based on the activities discussed above, the following accounting impacts
on the Condensed Consolidated Financial Statements have occurred or are
expected to occur for periods ending after March 10, 2008:
Municipal Securities
The Company acts as placement agent and as liquidity provider under a
municipal tender option bond program as described in Note 14, "Guarantees"
in Notes to the Condensed Consolidated Financial Statements of the
Company. Under the program, the Company has created a series of municipal
securities trusts which purchase fixed-rate, long-term, highly rated,
insured or escrowed municipal bonds financed by the issuance of trust
certificates. The trust certificates entitle the holder to tender such
certificates at the option of the holder on a periodic basis. Subsequent
to March 10, 2008, holders of all the Class A trust certificates had
tendered such certificates to the Company, resulting in the Company owning
100% of the trusts and consolidation of the trusts. As a result, the
Company recognized losses of approximately $200 million in the second
quarter of 2008.
42
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Deferred Tax Asset
As of February 29, 2008, the Company had approximately $1.5 billion in net
deferred tax assets (approximately $1.3 billion was associated with its
stock-based compensation plans). In accordance with SFAS No. 109, the
gross deferred tax assets of $1.7 billion will be evaluated for future
realization and be reduced by a valuation allowance if, based on available
evidence, it is more likely than not that some portion or all of the
deferred tax asset will not be realized. Management will be required to
make certain estimates and assumptions in order to assess the
realizability of the deferred tax assets. Further full realization of the
deferred tax asset for stock-based compensation requires the shares for
RSUs and CAP units to be distributed at a price equaling or exceeding the
fair value at the grant date. The provisions of SFAS No. 123 (R), however,
do not allow a valuation allowance to be recorded based on the current
fair value of the Company's shares. Accordingly, given the activities
discussed above, the Company believes it is likely that a significant
portion of this deferred tax asset will not be realized in the future.
Goodwill and Intangibles
As of February 29, 2008, the Company had goodwill and intangible assets.
Based on the proposed merger agreement, the Company believes an impairment
loss for the $88 million is probable, and would be recorded in the second
quarter of 2008.
Since the liquidity crisis and the announcement of the merger, the Company
has experienced substantial deterioration of its earnings capacity. The
closing of the merger is expected to occur by June 30, 2008. The Company
believes that the termination of the JPMorgan Chase guaranties prior to
consummation of the merger or the parties' failure to consummate the
merger could seriously jeopardize the Company's financial viability. In
addition, absent the Guaranty, the Company could face the increased risk
of rapid loss of customers and counterparties. The lack of liquidity and
the loss of customers and counterparties would materially adversely affect
the Company's financial stability and its viability as a going concern.
Accordingly, the Company could be forced to file for bankruptcy protection
and need to liquidate. The accompanying Condensed Consolidated Financial
Statements do not reflect any adjustments that might result if the Company
were unable to continue as a going concern.
43